Why is Russia Choking Off Gas Supplies and How Should the West Respond?

Why is Russia Chocking Off Natural Gas Supplies?

If an Embargo of Russian Gas is a Good Idea, Why is Russia Cutting Off Supplies?

In earlier posts I have pressed for an embargo on Russian natural gas exports. I still think this makes sense, but I can also see the wisdom of a buyers’ cartel that would cap the price that Europe would pay for Russian gas (also explained here). What gave me pause in these thoughts was Putin’s decision (and I am assuming it was his idea) to reduce Russian gas exports through the Nord Stream pipeline. Why would he voluntarily forego this revenue? Does he really think it hurts the West more than it hurts him? Does he just think that Western leaders, particularly German leaders, are so weak-willed that even a small amount of pain will cause them to collapse like a house of cards? Is he just acting like a spoiled child, threatening to hold his breath until his parents give in?

The Role of Contracts

One clue as to what is behind the choking off of gas supplies is the excuse offered: technical problems with the generators that push the gas through the pipeline. The company responsible for maintaining the compressors says that it is unaware of any problems. Why offer this excuse? Presumably the gas flowing through the Nord Stream pipeline is sold under a long-term contract with a fixed price (or some complicated formula that limits the extent of fluctuation in the price). What this means is that even though natural gas prices in Europe are exceptionally high, Russia is receiving a price for the gas that is substantially lower.

Isn’t Russia Contractually Obligated to Supply the Gas?

There is, probably, an out in the contract, for technical problems or “acts of god” that make it difficult to supply the gas. My guess is that Putin is using this ruse to limit Europe’s ability to stockpile gas for this coming winter.

What Should the West Do?

If there are contracts that govern the sale of gas through Nord Stream and other pipelines, the West ought to seize the opportunity created by Russia’s abrogation of its responsibilities under those contracts. The West should “renegotiate” the terms of purchase under those contracts at a lower fixed price determined by a Western buyers’ cartel. By the way, there is no reason why this arrangement should not survive the end of Russia’s war against Ukraine. It is important to remember that this is at least the second time that Russia has, probably, violated the terms of its contracts. The first was when they insisted on payment in rubles.

Would this Work?

I am assuming a lot of facts in this argument and would welcome others, who know the details of the Nord Stream agreement, to weigh in. However, if I am right, a buyers’ cartel for gas delivered by pipeline from Russia to Western Europe could accomplish two important objectives. One, it would deny Putin an important source of funds for carrying out his unprovoked war against Ukraine. Two, it would mitigate the harm to Western Europe from continuing to impose sanctions on Russia.

What Would Putin Do?

In response, Putin could do any of the following. First, he could realize that, in the long run, his situation is hopeless and withdraw his forces from all of Ukraine and cease all hostile acts against Ukraine. (I know this isn’t likely, but one can only hope that at some point Putin will come to his senses.) Or second, he could double down on the spoiled child model and refuse to sell gas at the cartel price, in which case we have a de facto embargo. Or third, he could accept that, once again, he has overplayed his hand and accept what he is offered for his gas.

Price Cap on Russian Oil and Gas Exports?

Oil Or Gas Transportation
Oil tanker on the high sea

There is a proposal, backed by the U.S., to cap the price of oil and gas purchased from Russia. Janet Yellen, the U.S. Treasury Secretary, is apparently attempting to find international support for this plan. I am skeptical that this proposal will work, but it is not impossible.

The first thing to remember is that even if it does work, the objective is to deny Russia some of the revenues from its energy exports. Even if it worked perfectly, it would not lower world oil and gas prices. Why? Because world oil and gas prices are determined by global supply and demand. Capping the price that Russia can receive for its exports will not affect either supply or demand, unless it causes Russia to export less.

That is not to say that a price cap is a bad idea. There are two ways in which it might work.

The first way recognizes that the West has a degree of market power over Russian exports that must arrive by pipeline. If there is no feasible way for Russia to redirect these exports to other markets, Western countries can exercise that power by collectively refusing to pay more than the cap. If Russia wants any revenue from these exports it must accept the price cap. The oil and gas purchased through this buyer’s cartel can then be resold at market prices. The best way of doing this is for the oil and gas to be auctioned off by the buyer’s cartel with the difference between the price cap and the market price being shared by the participants in the buyer’s cartel.

The second way that the price cap might work, that is often mentioned in the press, is for the West to use its control over finance, shipping and insurance markets to coerce Russia to sell its oil and gas exports at the price cap. The problem with this mechanism is that it would be difficult to prevent purchasers from separately compensating Russia for the sale. If China or India, for example, receive the discounted oil and gas they can have a side deal to pay Russia the difference between the price cap and the market price or some portion of it. It is not at all clear to me how we intend to prevent these side deals. It is also not clear to me why Russia would sell its exports to anyone unwilling to provide the side payment.

My feeling is that the first of these two plans is plausible and worth trying. The second proposal strikes me as very difficult to execute effectively. It would leak faster than a ruptured tanker.

Rand Paul and Ukraine Aid

Rand Paul Delays Aid to Ukrain

While Ukrainians fight and die to defend freedom from tyranny, Rand Paul struts upon the stage. Rand Paul, single handedly, is delaying military aid to Ukraine so that he may grab some media attention. This prima donna reminds me of the “America First Committee” who resisted U.S. assistance to Britain as Britain was being attacked by Nazi Germany in 1940. He uses the same short-sighted arguments.

Rand Paul is, like a broken clock, occasionally right, but in this case he could not be more wrong-headed about America’s self interest. Unless you think that it is in America’s interest to allow Putin to reestablish the Soviet Union/Russian empire. Is it in our interest to have a despotic empire stretching from the Arctic Ocean to the Black Sea and from the Pacific Ocean to Germany and France? Is it in our interest to have Putin using the resources of that vast empire to control and dominate those states not within its direct control? If you doubt this scenario, look no further than the degree to which Russian gas exports have intimidated Germany and France in the current conflict. It takes very little imagination to foresee pro-Russian puppet states established in Germany and France through economic dominance and interference in their elections.

Make no mistake the Ukrainians are fighting our fight, just as Britain was fighting our fight in 1940. The very least we can do for Ukraine is to arm them for the fight.

And lest we forget, the U.S. and the U.K. were co-signatories in 1994, along with Russia, in the agreement for Ukraine to hand over its nuclear weapons in return for a guarantee of Ukraine’s territorial integrity. If we fail to support Ukraine the obvious message to other countries is that you are on your own. Do we really think it is in our interest to have every country with its own nuclear arsenal? Is it in our interest for every country to believe that America’s word is no more valuable than Neville Chamberlain’s piece of paper?

Ukrainian Now

Tom Paxton and John McCutcheon have written a heartfelt, stirring song, “Ukrainian Now”, that touches us all. Noel Paul Stookey edited this beautiful…

Ukrainian Now

Tariff (or Price Cap) on Russian Oil and Gas Exports as an Alternative to Boycott

A tanker on the high sea

The Economist published an excellent article yesterday about a way to begin gradually cutting off oil and gas revenues to Russia. Since an outright embargo on Russian oil and gas exports appears unlikely, much the same thing could be accomplished by a tariff.

In the limit, a very high tariff would be the same thing as an embargo. A lower tariff allows Europe to wean itself more gradually from Russian oil and gas and provides an economic incentive for markets to seek out other alternatives. It still allows some Russian oil and gas to enter Europe for very high value uses, but it places the social costs of subsidizing Russia’s war against Ukraine on those who want the benefit of using Russian oil and gas. Alternatively, if Russia wants to maintain its current level of oil and gas exports, Russia would have to absorb the cost of the tariff by lowering its prices. Either way Russia gets a smaller revenue stream.

As a side benefit, European countries get a new stream of revenues they can use to offset the impact of high energy costs on their economies. They can use these revenues to lower other taxes or rebate them on a per capita basis to their citizens. As long as they don’t use the revenues to subsidize oil and gas consumption, the European economies will adjust efficiently to reduced supplies of energy from Russia. Ideally countries that impose the tariff could use all or some of the proceeds to arm Ukraine.

Limitations

The good news about a tariff on Russian energy exports is also the bad news. It is gradual. Because it is gradual, it gives Russia more time to adapt.

A tariff also suffers from some of the same limitations as a boycott. Russia can send oil to India and India can export oil to Germany. Unless the tariff is also placed on energy exports from countries that do not, themselves, impose the tariff on Russian energy exports, Russia can, at some expense, evade the tariff. This is less true of Russian natural gas exports, since these generally flow through pipeline systems that cannot be easily redirected. Therefore, to the extent that it can be done, the tariff should apply to Russian energy exports and energy exports from countries that do not impose the tariff on Russia. One side benefit of this approach is that it can induce countries that are currently neutral to embrace the anti-Russian tariff, to protect themselves from having their own exports be subject to the tariff. This gets complicated, but it is certainly worth considering. Perhaps starting with a tariff on Russian gas exports would be a good beginning.

A Price Cap as an Alternative to a Tariff

A tariff on Russian oil and gas exports is a way for Europe to take advantage of the fact that it has a degree of monopsony power over Russia with respect to Europe’s purchases of oil and natural gas. This power is more significant with respect to oil and gas imports via pipelines, since these products cannot easily be redirected to other markets.

A price cap could accomplish the same thing. However, in the case of a price cap the difference in value between the cap and the market price is captured by the importer rather than the importing government. In cases where the government is the importer this is irrelevant. The value of the price cap approach over a tariff is largely cosmetic because it allows the importing government to claim (falsely) that it is not responsible for higher prices. In general, we favor the tariff over the price cap approach as more transparent, but for governments that find the tariff politically unpalatable a price cap is a workable alternative.

Inflation, Gas Taxes, and Ukraine

A number of states and the federal government are, or are considering, lowering gasoline taxes to offset the impact of inflation on consumers. Assuming that the gas taxes made sense in the first place, and that this is intended to be temporary, this is bad public policy.

What Causes Inflation?

Supply chain problems, surging demand as the global economy recovers from Covid and the impact of the war in Ukraine are all causes of relative price increases. As some commodities become harder to obtain, the price of the affected goods can be expected to rise relative to the price of other goods. These things are not in themselves the root causes of inflation. Absent accommodating monetary policies from central banks, like the Federal Reserve Bank (Fed) in the U.S., these price shocks would be accompanied by declines in the prices of other goods or an overall reduction in economic activity, rather than inflation.

Doesn’t Lowering Gas Taxes Reduce the Pain of Inflation?

Ok, you say, lowering gas taxes may not address the root causes of inflation, but doesn’t it reduce the pain to consumers?

Lower gas taxes can be thought of in two ways.

One, absent an increase in other forms of taxation, it is an economic stimulus payment, the exact opposite of what is needed in a period of escalating inflation.

Two, it is a relative price subsidy. If you subsidize the consumption of a commodity you get greater demand for it. One of the problems in persuading European countries to boycott Russian oil and gas exports is that the global demand and supply of oil and gas are highly inelastic, in the short run. That means that the quantity of oil and gas demanded and supplied does not change very quickly in response to price changes. As a result, even small changes in supply (or demand) result in very large changes in price, in the short run. By lowering gas taxes, the United States is subsidizing the purchase of oil and making the global demand for oil even more inelastic than it would otherwise be. That will mean that the pain of boycotting Russian oil and gas will be even higher in Europe than it would otherwise be.

Impact on OPEC Incentives.

A variable tax on oil imports was considered, in the 1970’s, but was rejected because, by reducing the elasticity of demand, a variable tax actually increases the incentive for OPEC to reduce supplies to drive up oil prices.

So What Should We Do?

What we should be doing, to lower inflation, is what we should have been doing for months. The Fed needs to end its open market purchases of bonds and begin raising interest rates. How far should this go? At least far enough that short and long-term interest rates meaningfully exceed the expected rate of inflation.

The Impact of Putin’s War on the Value of Russian Gas

Apparently, Russia is insisting that Western European countries pay for Russian gas with rubles rather than euros. Putin wants to force the use of rubles as a tool for circumventing Western sanctions. To date the Western European countries are refusing to use rubles, as they should. In fact, it would be best if these countries simply refused to take Russia’s gas exports, but that is a different issue.

Russian Gas Must be Viewed as Interruptible

What I think is missed in this discussion is the damage that Putin’s war against Ukraine has done to the long-term value of Russian gas. Russian gas exports must be viewed as interruptible as long as Putin remains in power. As a consequence, one of the costs of using Russian gas is maintaining excess capacity to switch to LNG imports or oil fired power plants.

This interruptibility also creates an incentive to use nuclear power, which permanently reduces the demand for Russian gas. Maintaining excess capacity in the form of nuclear power is simply not economically justified. Nuclear facilities are capital intensive. Once constructed, nuclear facilities should be used at capacity to the extent possible.

Russian Gas Is Far Less Valuable Than It Was Two Months Ago

Maintaining excess capacity for LNG and oil fired facilities is expensive. The only way for Russian exporters to induce Western firms to bear this cost will be to reduce the price of Russian gas.

The combined effects of the reduced demand for Russian gas because of increased nuclear power and the added cost of Russian gas because it must be viewed as interruptible, make Russian gas much less valuable. Even after this war is over, and even if sanctions are eventually lifted, Russian gas is simply worth a great deal less than it was worth a couple of months ago. This will remain the case as long as Putin remains in power.

Russia Abrogating Its Contracts Creates an Opportunity for the West

To the extent that Russia’s insistence on payment in rubles constitutes an abrogation of existing contracts, Western countries and firms should seize the opportunity to declare the existing contracts void. After the war is over, they should be able to renegotiate these contracts at much more favorable terms.

Was Biden Wrong to Say Putin Must Go?

Joe Biden often speaks from the heart. Whether it was good strategically to make the statement he made, I will leave to others to ponder. But can anyone not saturated with Russian state propaganda and totally isolated from the truth, doubt that the world would be better off without Putin in power?

The choice is ultimately up to the Russians. But here is their choice. They can remain a pariah state, isolated from the western economies, financial markets, and technology or they could rid themselves of Putin. They can embrace their status along with him as war criminals or they can rid themselves of Putin. They can continue to risk the escalation of the conflict he created for his own ego or they could rid themselves of Putin. They can continue to suffer the needless deaths of their own soldiers in a pointless war or they can rid themselves of Putin. They can continue to live in a ruthless autocracy where they are in fear of their lives and freedom for speaking the truth or they can rid themselves of Putin.

No, the Russians do not have to rid themselves of this unhinged autocrat with his head firmly planted . . . in the nineteenth century. But they do have some choices to make.

Nothing is more important than a humiliating defeat for Putin.

Support Ukraine

History will judge us based on our response to Putin’s invasion of Ukraine. The us means everyone, not just the western democracies but the rest of the world, including India, China and the Russian people. Everyone on the planet has a stake in Putin losing in this wholly pointless aggression. The only way to make sure that conflicts do not escalate into a catastrophic event for mankind is for all nations to accept the notion that you cannot seize the territory of other countries through military aggression. Nothing else on the world’s agenda is more important than making sure that Putin suffers a humiliating defeat in Ukraine. This is more important for the planet than combating climate change. It is more important than economic growth. It is more important than combating inflation. It is far more important than any domestic political agenda.

The NATO nations seem to have accepted the notion that they will not directly confront Russia by imposing a no-fly zone over Ukraine. Absent that kind of intervention, the only hope for defeating Putin appears to be arming the Ukrainians with every conceivable weapon to defend themselves. Economic sanctions, including a complete boycott of Russian oil and gas exports, are important because they will help the Russian people understand that their government is engaged in something terrible and that Putin is keeping that information from them. These sanctions also gradually degrade Putin’s ability to sustain the invasion.

What should Ukraine and the rest of the world demand of Putin? A piece of paper will not do. Russia already agreed, in 1994, to respect the territorial integrity of Ukraine. In return they received all of Ukraine’s nuclear weapons. Thanks to Putin, we have all seen how much Russia’s word is worth.

At a minimum, Putin needs to withdraw all of his forces from Ukraine, including Crimea and the Donbas region. He needs to publicly acknowledge to the Russian people that Ukraine is a separate sovereign nation. He needs to publicly acknowledge that Ukraine is free to pursue its own future, free of Russian interference, even if that means joining the EU and NATO. He needs to acknowledge that all of the former Soviet states have that same freedom. He should pay Ukraine reparations for the loss of life and property he has caused.

The sanctions should remain in place until Putin accepts these conditions or is no longer in power. The west should continue, indefinitely, arming Ukraine so that it can defend itself against this aggression and potential future aggression from Russia. This latter step is necessary because only military force can prevent Putin from going back on his, and his country’s word, again.

I don’t believe that Putin will accept these conditions. That means that we will need to continue supporting Ukraine in its efforts to repel the Russian invasion and continue to impose the maximum possible sanctions on Russia until the Russian people decide to remove Putin from power.

In the end, it is important that the Russian people, and not just the rest of the world, understand that nothing is more important than a humiliating defeat for Vladimir Putin.

Was it a mistake for NATO to expand into the former Soviet states?

Replaying history is a difficult, and often pointless, exercise. I recently read an article by Tom Friedman arguing, among other things, that NATO’s expansion into the former Soviet states was a major mistake because it unnecessarily alarmed Russia. He sites George Kennan in the article saying pretty much the same thing. Tom Friedman is a smart man and George Kennan is clearly a genius, particularly with respect to Russia and the Soviet Union. But smart people and even geniuses are not always right. It is possible that Russia, absent NATO expansion might have evolved into a less aggressive state. Who knows? It seems, to me, that the more likely scenario would have been a Russia, under Putin, just as aggressive and malevolent, but with a larger menu of defenseless Eastern European states to turn into puppet states or to invade and annex. If Putin did not have NATO to use as a pretext to foment his toxic form of nationalism, he would have done what lots of other despotic rulers do and created some other false pretext for promoting his fantasy of reviving the Russian empire.