“Explanting” Russia

Ronald Reagan and the art of containment

The closer we get to the hotter spots of the battle for Ukraine, the more we realise that the fight is not just about Ukraine. It also enhances our appreciation of the lessons the late Ronald Reagan taught modern politicians. Or, at any rate, the lessons they would have learned from him if they had paid more attention and been less dim as pupils.

Containment is the only proven treatment for Russia’s over-aggressiveness. And the first and basic rule of containment is this: the sooner it is administered, the greater its impact – and the fewer its adverse side effects.

Unfortunately, this was forgotten by the West in 2014. The West generally consented to the annexation of Crimea, content with vague sanctions. And that encouraged Vladimir Putin’s current move on Ukraine. Belatedly, the war crimes committed by the Kremlin have made up the West’s mind to unleash a fully fledged economic war on Russia. But it’s still an open question how relevant and how effective these measures to contain Putin will be, while what isn’t in doubt is that Mr Putin is still crossing every red line in sight – and that the Ukrainians and their President Volodymyr Zelensky are still left fighting on their own.

To cut a long story short, bans on Russian crude oil and natural gas exports, both total and partial, fit well into a context of responding to war. When it comes to walking the walk, the Kremlin’s greatest vulnerability is its revenues from energy exports. The income derived from them is central among the engines of power of Putin’s regime, funding both his repressive machine at home and the troops he has sent to Ukraine, Syria and elsewhere. However, the ban on Russia’s crude oil and the potential for a ban on its natural gas is a bitter pill for many in the EU.

Reliance on Russian energy long ago passed the common-sense threshold beyond which sanctions bring joint collateral damage. Hence the unrealistic EU ‘compromise’ of reducing by two-thirds the bloc’s imports of natural gas from Russia by year-end. The theory is that, in this way, Mr Putin will feel pain of losing two-thirds of his gas sales revenues, which in 2021 topped $140 billion. Extrapolating the trend, his losses in 2022 could exceed $90 billion.

The loss of 2.7 million barrels (bbl) a day of oil sold to the EU could knock another $75 billion off the balance sheets of Russian oil companies. In 2021 oil and gas contributed $119 billion to the state budget, a good 40% of its total. As recently as February 2022, the Russian daily Izvestia had resonated an upbeat Bloomberg forecast: at an average price of $80/bbl, Russia will receive $65 billion more in 2022 than in 2021. Mr Putin believed the wind was in his sails – and he moved on Ukraine.

Lessons – and critical messages – from Reagan

Ronald Reagan brought the Soviet Union to its knees. But he didn’t do so by cutting cutting off oil and gas, as an embargo would have inflicted damage on Western consumers. Sanctions are just a means for achieving a strategic goal – and in the consumers’ case, a collateral damage. What President Reagan did, in fact, was to take steps to bring crude oil prices down to $9/bbl – a level that affected gas prices (oil indexed contracts) – thus reducing the flow of money into Moscow’s coffers. This was based on the common-sense principle that lower incomes contain Russia best. And, in the process, energy consumers benefit.

That is the difference in between ex-post sanctions and Reaganite containment. In the former, actions are punitive and late: you act when terrible things have already happened and your actions, which try to catch up with bombs, destruction and loss of human lives, hurt you as well as the aggressor you are trying to punish. In the latter, your actions are pre-emptive and timely. You stop the terrible things happening by depriving the potential aggressor of the ability to make them happen. And, in the process, you do your own people some good.

Today, sanctions against oil and natural gas could produce useful results only if prices were low, which they aren’t. Unfortunately, the rush to a zero-carbon future has aided Russia’s aggressiveness, helped along by “Fit for 55” – the EU package, proposed in July 2021, which aims to achieve a 55% reduction in greenhouse gas emissions by 2030. That shook markets off balance and set everyone praying for more and cheaper gas, with depleted gas storages across Europe adding insult to the injury.

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Now the EU is contemplating fresh knee-jerk reactions – in the form of limits to the intake of Russian gas via joint gas purchases or Gazprom market share caps. Now, while it would be possible to limit Gazprom’s European volume sales to a maximum of one third of its previous total, this would come at the cost of higher prices. Russia would sell less gas, but earn more per cubic metre for it; hence the net effect would be questionable. At least in theory, even with one third of the previous volume, Gazprom could gain more than if it were forced by market competition to sell the maximum volume at one third of the current price.

Sanctions are a feat of administrative power, with indiscriminate and dispersed effects. By contrast, playing along and using the market to discipline the abuser and deleverage Russia’s energy weapon would have a long-lasting impact.

If we in the EU were to mobilise “friendly” (primarily US shale) gas resources as well as our own gas production, adopting a strategy encouraging E&P in oil and gas, and demonstrating a will to increase supply and reduce demand, the EU would very likely be able to contain prices at pre-crisis levels of €25-30/MWh – as against €200/MWh now.

Another power-lever for containing Russian gas is the long-term contract (LTC). Now, Gazprom expects to renew existing LTCs and conclude new ones with its clients in 2022 and 2023. But that is not a given. With EC guidance and US political involvement, each EU country could explore and negotiate non-Russian gas supply options, leaving Gazprom as the last and least preferred choice.

Let’s put some numbers to this reasoning.

Limiting Russian gas to one third of its previous volume in a sanctions-only scenario would mean EU countries buying around 100 bcm less Gazprom gas than before. But the 60 bcm they did buy could well cost more.

But if we turn this logic around and find 50 bcm more gas, to displace Russian gas, and make sure that this 50 bcm actually forms part of our gas mix, then the resultant “overflow” of Russian gas would inevitably push prices down.

“Explanting” Russia from the global economy via sanctions would result in pain well beyond the target zone. Moreover, this approach would not have much impact on Mr Putin’s successor, who might be tempted to resort in future to Putinesque methods to advance political goals. Finally, we would be setting a precedent that might have repercussions for the West’s relations with China, in which interdependence is at mind-boggling levels.

Imagine, for the sake of argument, that China supports Russia militarily, and that we need to resort to sanctions against Beijing. If the damage resulting from sanctions against Russia is surmountable, just think for a moment what disruption such sanctions against China would cause for our daily lives! The pandemic has hinted at the extent of Europe’s over-dependence on China – as the manufacturing powerhouse of the world – for ensuring the supply chains of goods, components, assemblies and parts needed for the European economy.

The effects of sanctions on that delicate and complex web of interdependence are difficult to imagine. “Shock” would be a serious understatement.

Apart from anything else, the EU’s cherished goal of a green economy would be threatened. The transition from what we have now to a renewables-dominated energy sector and a low-carbon economy depends on the free flow of capital and goods to and from China. Unfortunately, Europe does not have a Plan B if things go awry with China, as they did with Russia.

Now, Ronald Reagan wasn’t the world’s most brilliant strategist. Nor was he its greatest economist or most astute financier. But he did have robust common sense and a pragmatic mind, which enabled him to pick the right move at the right time without any fears about calling his adversary’s bluffs or responding to his challenges. President Reagan talked tough but did it with a smile, which ultimately spared him resources, political energy, and time, thanks to his quick and absolute resolve. Unlike the West’s current leaders, he would not now be hesitating to face Mr Putin in Ukraine, but would be confident that the battle was not about Ukraine, but about the choice of Central and Eastern Europe, Europe in general, the post-Soviet space and trans-Atlantic relations.

In fact, one rather unexpected leader with some claim to greatness has emerged from the present crisis, and that’s Ukraine’s comedian-turned-statesman Volodymyr Zelensky. The question is no longer whether President Zelensky would be a worthy member of the club of EU and NATO leaders. It’s whether the current batch of Euro-Atlantic leaders – who seem mostly to be statesmen-turned-comedians – are worthy of him.

Ilian Vassilev

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