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Russian gas and aluminium Revisiting the outlook for consumption and exports in a post-depression economy
Resources Policy. Vol. 22, Nos 1/2, pp. 123-131. 1996 Copyright © 1996 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0301-4207/96 $15.00 + 0.00
Pergamon S0301-4207(96)00028-1
Russian gas and aluminium Revisiting the outlook for consumption and exports in a post-depression economy
Istvan Dobozi Senior Economist, The World Bank, 1818 H Street, NW, Washington, DC 20433, USA
This paper examines the export implications for natural gas and aluminium of Russia's ongoing e c o n o m i c transition. The rapid run-up in aluminium exports and the formation of a large capacity surplus ('bubble') in natural gas are seen as a direct result of the drastic shifts in the level and mix of aggregate demand, and the marked rise in the real price of these commodities. Based on a set of macroeconomic, structural and price assumptions, the paper provides a set o f quantitative projections for the prospective evolution o f Russian d o m e s t i c demand for aluminium and gas, and draws out the potential implications for the international markets. For natural gas, the capacity hangover is seen to deflate by 2000, in tandem with the buildup of domestic consumption. In the case of aluminium, the recently experienced 'export bubble' is predicted to ease back gradually, and eventually disappear by 2005. Copyright © 1996 Elsevier Science Ltd.
Natural gas and aluminium are key items in Russia's exports: in 1994, their combined share was over one-fiRh of total exports. Production of natural gas and aluminium has held up remarkably well in the middle of the GDP collapse during 1991-95. Between 1990 and 1995, gas and aluminium production fell by only 7% and 8% respectively, compared to a reported 40% decline in GDP and a 50% decline in industrial output. Changes on the consumption side were, however, more dramatic: internal demand dropped by 16% for gas and as much as 82% for primary aluminium. In the case of aluminium, exports took up all of the spare capacity left by the collapse of domestic demand. Over 1990-95, Russian exports surged from 0.8 to 2.4 million tonnes, flooding an already saturated world market with extra supplies and triggering a marked downward drift in prices. Russia's world market share jumped from 10% to 21%. With the sharp run-up in exports, aluminium has become one of the leading export commodities of Russia; the US$2.6 billion annual revenue makes up 5% of total exports.
For natural gas, the external markets were not ready to pick up the slack caused by insufficent domestic demand. Gas exports - the outlet for one-third of the production - have fallen faster than domestic demand. The lack of internal and external markets has led to the emergence of a sizable capacity overhang ('gas bubble') and a consequent downward pressure on prices in European markets. The large capacity overhang is believed to be a major underlying factor in Russia's relatively tolerant stance towards non-payment by important CIS customers such as Ukraine and Belarus. Although the transition from the command system to a market-driven economy is far from complete, there are growing signs that the Russian economy is turning the corner. It is therefore timely to revisit the demand prospects for gas and aluminium, as Russia is emerging from the economic doldrums and assumes more of the behavioural pattern of a market economy. Following a review of the consumption patterns during the early period of economic transition, the paper examines the macroeconomic and market fundamentals shaping the 123
124 Russian gas and aluminium: 1 Dobozi outlook for gas and aluminium demand to the year 2005, and draws the potential implications for the international markets.
700 Production
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Consumption behaviour during post-Soviet depression Natural gas: capacity hangover
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Given favourable resource endowments, Russian gas production is predominantly demand-constrained. In recent years, the contraction of domestic sales and exports to countries of the former Soviet Union (CIS) led to the emergence of a 'gas bubble' ie deliverability exceeding immediate demand including exports. Between 1990 and 1995, gas consumption fell by 16%, a relatively moderate drop, compared with the reported plunge of GDP (see Figure 1). The slight increase in exports to other destinations - mostly Western European countries - was insufficient to offset even the decrease in CIS sales. The resulting capacity hangover, or bubble (ie capacity shut in for lack of markets), is estimated in the range of 30-50 billion metres per year, equivalent to 5 - 8 % of the production potential (Stern, 1995, p xvi; Sagers, 1995, p 562). It could be argued that the 'real' capacity surplus might be several multiples of this figure if adjustment is made for the pricing of gas below true market value in the residential/municipal sector and the rampant nonpayment for gas among domestic customers and those in the FSU republics, particularly Ukraine and Belarus. The size of the capacity bubble carries important implications. It can financially plague Gazprom through shutting in considerable production capacity and, potentially, it also exerts downward pricing pressure on the European gas market. Existing transmission infrastructure and supply security concerns on the part of major Western European customers act in tandem in prolonging dissipation of the capacity hangover through quantum leaps in exports. Hence the future growth in internal demand for gas will be the single most important factor in determining the size and duration of the bubble. Aluminium." demand atrophy and export surge Russia's aluminium consumption shrank to only about 0.4 million tonnes (Mt) in the mid-1990s, compared with the peak of 2.3 Mt in 1 9 9 0 - a n astounding 82% decline (see Figure 2). On top of the slump in GDP, Russian aluminium consumption has been hit hard by the catastrophic fall of 90% to 95% in defence orders. Until 1991, this sector absorbed more than half of aluminium products (Metal Bulletin Research, 1996). There was also an about 70% fall in demand in the non-defence sectors (particularly power cables). Sharply surging ex-
Domestic sales
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Figure 1 Russian natural gas: production, consumption and exports Source:
Goskomstat(various issues).
ports took up all of the spare capacity left by the slump in domestic usage. Exports rose from 0.7 Mt in 1990 to 2.4 Mt in 1995, leaving total output 8% lower, at 2.8 Mt, than the 3.0 Mt peak registered in 1990. Price developments Natural gas prices continue to be administratively regulated and they are uniform across the country. Big hikes (especially in 1995) have brought industrial wholesale prices to around 80% of the European border price (Karnauhov, 1995), thus overshooting the economic value of Russian gas in the internal market. In October 1995, the average wholesale price at the prevailing exchange rate was US$61/thousand metres. Assuming full cost recovery on the existing gas supply system, the average economic price of gas to industrial users is estimated by the World Bank at US$30~40/thousand metres (the low estimate applies to the Urals region, Russia's industrial heartland), which is about half the European export price. At these prices, netbacks to the wellhead are roughly identical to netbacks on export sales. Residential gas prices (US$4.4/thousand cubic metres in October 1995) remain, however, grossly underpriced at less than one-tenth of the industrial price. But there is a downside to the rapid rise in domestic prices: rampant non- and late payments for deliveries bring the effective price much below the market price. The gas sector is a major involuntary net creditor to the rest of the economy. In 1995, Russian consumers paid only for about half of the gas delivered to them (Goskomstat, 1996). The accumulated consumer debts to Gazprom exceed US$10 billion.
Russian gas and aluminium: 1 Dobozi
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Figure 2 Russia: production, consumption and exports ofaluminium
Since the abolition of the administrative price control on non-ferrous metals in January 1992, the domestic wholesale price of aluminium has shot up so steeply that by December 1995 it had surpassed the world price by 10% (Goskomstat, 1966, p 175). The extent of non-payment for aluminium deliveries is believed to be less dramatic than in the case of gas due to the relative ease with which aluminium can be exported when faced with declining cash-financed demand in the domestic market•
Fundamentals underlying Russian demand prospects Improved macroeconomic outlook The post-Soviet economic decline, a major factor behind depressed domestic demand for metals, appears to have bottomed out in 1995 and it is reasonable to expect that real economic activity will begin to recover quite rapidly in the near future. The government's medium-term macroeconomic stabilization and structural reform programme aims at laying the basis for sustained economic growth by lowering inflation further toward a singledigit annual rate and achieving medium-term viability of the balance of payments. Provided the key macroeconomic targets and structural benchmarks developed in coordination with the IMF and the World Bank are achieved, real GDP growth is foreseen to accelerate to 2.5% in 1996, 4.0% in 1997, 5.1% in 1998 and to be sustained at a relatively high rate of 6% a year over the rest of the decade (IMF Survey, 1996, p 119). For the
2001-05 period, GDP growth is assumed to hold steady at 6% per year. The envisaged buoyant economic activity is bound to boost domestic demand for natural gas and aluminium - both being income elastic commodities in Russia.
Sectoral restructuring: implications of underlying comparative advantage and demand backlog Natural gas The mainstream view among Western observers expects the market-driven shake-out of energyintensive activities to make a major dent in Russian gas consumption. For example, a recent study by Stern (1995, p 42) predicts that by 2000 industrial gas usage will shrink by as much as 50 billion metres, or 35%, relative to the depressed level of 1994. A decline is predicted also for gas used in power generation, the most important market outlet for gas. Forecasting such deep fall-offs in gas demand might, however, be far fetched. A good deal of caution is warranted with regard to predictions of massive sectoral restructuring for several reasons. First, the highly energy-intensive industries are the backbone of the Russian economy. Simply for social and political reasons, a large-scale phase-out of these activities does not appear likely in the foreseeable future, even if market forces render them inefficient. Second, economic analysis suggests that while a great deal of misallocation of resources exist in Russia, its economy seems to possess competitive advantage in a range of energy-intensive industrial sectors, based in large part on favourable natural resource endowments, including natural gas (Dienes et al, 1994, pp 153-155;
126
Russian gas and aluminium: I Dobozi
Dobozi, 1995, pp 6-7). As noted above, the economic or market value of Russian gas in the internal market is only about half of the European export price. This suggests that Russia does seem to have a strong competitive advantage in gas-based activities, ranging from metallurgy to chemicals/fertilizers to power generation. The historically high concentration of energy-intensive commodities in Russia's exports is an additional pointer to the underlying pattern of comparative advantage. Third, structural change is a double-edged sword: it is misleading to consider only activities where further contraction seems inevitable in no small measure because of the continuing retrenchment in the military production. An offsetting influence will be exerted by the apparently large pent-up demand for a host of directly and indirectly energy-intensive goods such as gas-based chemicals and plastics, pulp and paper, living space and comfort, consumer durables etc. In these areas, the current level of per capita consumption is woefully inadequate. For some energy-intensive metal products, for example steel, the weakness in domestic demand could be offset, at least in part, by an upsurge in exports, similar to what has occurred on a large scale in some nonferrous metals (aluminium and nickel particularly). I Finally, it is not immediately obvious why industries that have managed to survive the recent deep depression would go under when the economy moves onto a path of sustained growth. Under an investment/construction led economic upturn, some of the structural changes may well become reversible, with a number of gas-intensive goods like steel products or construction materials poised for a demand rebound. There is strong evidence that Russia's improving aggregate economic performance is largely attributable to the steady recovery of the energy-intensive heavy industries. While gross industrial output fell by 3% in 1995, production was up by 9% in ferrous metallurgy, by 23% in the pulp and paper industry, by 11% in basic chemicals, and by 2% in nonferrous metallurgy. Production in machine-building and light industries continued its downward drift (Goskomstat, 1996).
Powerplant use As the single most important outlet for gas (taking more than 40% of domestic sales in recent years), power generation is especially important for the future evolution of gas utilization. Wrong electricity consumption forecasts automatically lead to wrong gas demand forecasts. For the period 1995-2000, a recent study predicts a 30% drop in electricity generation, a IExports of ferrous metals and products to non-CIS countries increased very rapidly in recent years. Between 1992 and 1994, exports of iron and steel semis jumped from 3.7 to 9.0 Mt (rolled steel from 1.7 to 5.9 Mt).
much larger fall than occurred since 1990 (Stem, 1995, p 42). But such a steep drop-off would be grossly out of sync with the ongoing upturn in industrial production and total output 2 and the relatively low penetration of electricity in the Russian economy. 3 Assuming a plausible range for the income elasticity of electric power consumption-0.5 to 0.8, instead of the implied negative values found in some studies 4 - would bring the projected power output in 2000 close to the pre-crisis level, pulling up demand for gas as a result. Looking beyond 2000, electricity consumption is expected to track more closely the overall economy, as is typical in the advanced market economies.
Gas penetration It is reasonable to expect that gas will continue to increase its already high share in the overall fuel market, although at a slower pace than observed so far. Both for cost and environmental reasons, gas will be pushed into a new tier of existing coal and oil fired power plants during the next decade. Russian coal and oil industries are experiencing deep trouble and sharply rising costs. A major downsizing of the coal industry seems inevitable over the long term. When oil refineries rationalize their product mix in favour of lighter products, the current glut of relatively cheap heavy fuel oil (mazut) is bound to dissipate, leading to a potentially larger market base for gas. A similar impact is expected from the significant near- and medium-term need of some regions to install new generating capacity for peak demand coverage. 5 Nuclear energy is a potential substitute for gas-based electricity generation. Russia produces 12% of its electricity from nuclear power plants and currently there are no plans to increase this share over the next 10 years. Given the need to decommission 9000 MW of existing nuclear capacity by 2010, the enormous financing requirements associated with the safety upgrade of existing units and building new nuclear capacity, and the local opposition to construction of new nuclear plants, maintaining even the 12% nuclear contribution seems highly uncertain. A more likely scenario is that a part of the retired nuclear capacity will be replaced by high efficiency, combined cycle gas fired units. 21n 1995, the drop is electricity consumption was only 2%, mirroring the bottoming out of the GDP decline. Electricity use is expected to post an increase in 1996 and thereafter, in tandem with the upturn in overall economic activity. 3The share of electricity in total final energy use is only 13% in Russia, compared with the average 18% in the OECD countries - a sign of underelectrification of the Russian economy, industry and households alike. 4See, for example, Stem (I 995). 5A case in point is the ongoing preparation of a proposed World Bank loan for the construction of a 900 MW gas fired combined cycle plant at Krasnodar, a power deficit area in the North Caucasus Region.
Russian gas and aluminium: I Dobozi 127
Penetration of gas into the residential-municipal sector is limited, taking only 15% of total domestic sales, in sharp contrast with the typical demand pattern of Western countries, where this sector is the largest consumer. Over the next decade, this sector is expected to be the most buoyant expansion market for Russian gas, possibly offsetting the contraction in consumption by some of the declining industries. However, much greater further gas penetration into the residential-municipal sector will be contingent upon the upgrading and extension of the existing distribution networks (Dienes, 1996; Sagers, 1995). Aluminium
Russia lags considerably in the use of aluminium. The aluminium intensity of Russian GDP is less than half of the OECD average (Dobozi, 1993, p 17). Due to the post-Soviet collapse in consumption, per capita aluminium use in 1995 was less than 3 kg, compared with 15 kg in 1990 (or 32 kg in the USA). This indicates a large amount of pent-up demand for aluminium, which is expected to be released gradually over the next decade. Given high underlying income elasticity, the consumption of aluminium is expected to move in tandem with the expanding economy. Anticipated structural changes in the mix of total output are expected to benefit aluminium. All major civilian end-use sectors are gearing up for an upswing. The coming investment recovery is bound to trigger vigorous demand growth for aluminium in the building and construction sector. The boom in housing construction appears to be well under way: in 1995, residential construction was up by 9% (including a 40% jump in private housing construction). The steel to aluminium shift is expected to speed up in this end use. Substantial demand growth will come from the transport segment, particularly motor vehicles, where aluminium stands to benefit not only from the quantum leap in vehicle production, driven by a huge backlog of consumer demand, but also from its displacement of steel in a broad range of automotive applications in connection with weight reduction requirements forced upon the industry by the steeply rising fuel prices. With the anticipated shift toward consumer industries, the packaging sector will turn in vigorous growth. In this area, Russia lags behind international consumption trends by an exceptionally large margin. Finally, even in the defence and aerospace industries, historically the dominant end use, the sharp fall in aluminium consumption might be close to hitting bottom. 6
6There are reports suggesting an 80% jump in Russianarms exports in 1995, including aircraft (Washington Post, 7 April 1996).
Downstream processing offers an important way to rebuild domestic demand for aluminium. The Russian aluminium industry can greatly expand its demand base by adapting the relatively modern, but military needsoriented fabricating facilities to civilian commercial uses, while broadening the assortment of semis and finished products, including the more advanced, high value-added products. 7 These new market segments will account for a growing portion of total aluminium consumption as in the developed Western economies. Primary aluminium consumption will benefit from the recently adopted 'long tolling' system that requires foreign traders wishing to have permission to produce primary aluminium using imported raw materials to deliver no less than 20% of the volume to Russian rolling mills for further processing. In 1996, primary aluminium consumption is seen to rise by 7% to 12% due to the 25 to 30% increase in exports o f 'long tolled' rolled products and aluminium stamplings (Metal Bulletin Research Ltd, 1996). 8 The large potential for energy conservation in the Russian economy is a well-known fact. It is generally accepted that sizeable demand reduction could be realized through market-based pricing and the application of energy-efficient technology and equipment. The existing energy demand forecasting record for Russia (and the transition economies in general) suggests a tendency to overstate the practically feasible efficiency gains, largely because the estimated technical saving potential is taken too much at its face value. A number of ' l o w ' forecasts suffer from such built-in downward bias (see, for example, Stern,1995, p 42; Schipper and Meyers, 1992, pp 296-299). In a transition economy like Russia, there remain formidable barriers inhibiting the quick realization of the large potential for energy efficiency improvements. Energy is not utilized more inefficiently than other factors of production such as labour, capital or land. Indeed, energy inefficiency is linked to all other inherited systemic inefficiencies of the Russian economy. Furthermore, a
Efficiency reservoir
7Russian rolling mills were not equipped to make more sophisticated downstream products like beveragecans, foil or construction materials for domestic consumption. They specialized on producing relatively simple products such as ingots, low-gradesheets and tubing (McDonald, 1994, p. 60). 8Tolling operations have played a major role in maintaining Russia's aluminium production at relativelyhigh levels, despite the collapse in internal consumption. In 1994 tolling operations totaled 1.8 million tons or 70% of primary aluminium production (Metal Bulletin Research Ltd, 1996). In 1995, Russian authorities introduced regulatory measures to increase the degree of processing of the foreign customer's raw materials on the basis of 'deeper' (or long) tolling.
128 Russian gas and aluminium: I Dobozi large part of the energy inefficiency is 'locked in' the preexisting fixed assets that can be replaced only gradually over an extended period o f time. 9 This condition should be factored into a forecasting model to avoid a serious undershooting of future demand. Price impact and non-payment One possible source o f error in forecasting energy/metal demand in the transition economies is treating them as full-blown market systems, with correspondingly higher price elasticities o f demand than is reasonable. This approach inevitably leads to grossly undershooting demand projections. It is more realistic to model Russia as a semi-market economy which, for some time to come, will combine elements o f a new market e c o n o m y with the anti-market legacies o f the command economy (such as concentrated market structures with extensive monopolies, an underdeveloped financial system, a relatively weak entrepreneurial class, and heavy-handed state interventions). This condition blunts the demand impact o f higher prices, resulting in price elasticities that are lower than those observed in mature market economies. 10 Non-payment for energy is a special factor in blunting the demand effect o f higher prices. As Stem asserts (1995, p 38) in the context o f Russian gas demand, For as long as non-payment is allowed to continue to any significant extent, all calculations of 'demand' are fatally flawed. What is being shown is not 'demand' but 'deliveries'. 'Demand' is a concept which presupposes that those to whom gas is being delivered are paying an agreed price, and that if they fail to pay they will not be supplied. Part of the reason why Russian gas demand projections continue to show significant increases is due to a conceptual difference: for Russians, demand is what consumers need, for westerners it is what consumers can afford. While this statement is correct in theory, it fails to recognize two special circumstances: (1) tolerance o f n o n - p a y m e n t is a systematic feature o f the economic transition in the FSU countries, and (2) Gazprom is a semi-captive seller crucially dependent on a group o f large industrial users and electric power stations, which creates an incentive to agree on continued supplies to non-payers in the hope that most o f the arrears can even-
9It is worth noting that the energy efficiency of the Russian economy has suffered a major deterioration since the beginning of perestroika due in large part to the marked slowdown in capital-stockturnover, deferred maintenance, and lack of finance even for low cost/high return conservation measures. I°A case in point is Hungary, an early reformer, where the short-and long-term price elasticities of energy demand were estimated at onehalf and two-thirds of the typical elasticities observed in developed market economies (Dobozi, 1988).
tually be recovered in some form. In a broader strategic context, even this option may be preferable for Gazprom to the alternative o f forced shut-ins o f wells, given the infeasibility o f diverting the surplus from reduced domestic sales into foreign markets. 11 Finally, it is reasonable to expect that the arrears crisis will progressively be solved (like in the fast-track reforming countries o f Central and Eastern Europe) as a result o f macroeconomic stabilization, economic recovery and an easier access by large consumers to working capital credits from the banking sector.
Quantitative demand projections to 2005 Assumptions For the purpose o f quantitative projections, parameters were developed consistent with the above-mentioned assumptions on the future evolution o f total output, shifts in the sectoral mix of GDP, and the price effect. In the case o f aluminium, only lagged price effects (specifically, those triggered by price increases in recent years), were modelled, since domestic prices stand higher than the world price. The assumed short- and long-run price elasticities are M).05 and ~3.15 respectively. In the case o f natural gas, the price effect is much stronger (-0.10 and--0.30, respectively) due to the assumed catching-up o f household prices with industrial prices by 2000 and the presumed higher degree o f payment enforcement than hitherto practised vis-~i-vis industrial gas consumers (this has the effect o f making higher prices 'bite'). For aluminium, the assumed income (GDP) elasticity of demand is assumed to reach the historical value o f 1.3 (Dobozi, 1990, p. 119) with the economy moving onto a buoyant recovery path and the massive demand backlog progressively released. For natural gas, the extremely high historical income elasticity (2.6) was adjusted downward (to the range of 0.64).8) recognizing that, as the dominant incremental fuel, gas will absorb much of the effects of non-price driven structural changes in total output and o f the efficiency improvement in energy use. A special regulatory variable was specified for aluminium to account for the primary metal consumption-boosting effect o f the 'long tolling' requirement noted before. For the purpose o f projection simulations, a straightforward dynamic consumption model has been specified for both commodities, This model is able to explore the effects o f changes in the rate o f growth o f GDP, price changes, and structural shifts in total output. The priceI tMost recently, Gazprom began to bypass local distributing companies by striking direct deals with large industrial users and accepting various forms of payment like barter or equity.
129
Russian gas and aluminium: I Dobozi
VINIIGAZx VlNIIGAZx
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Figure 3 Russia: projections of natural gas consumption
and non-price induced changes in the output mix are introduced through judgmental adjustments to the historical income (GDP) elasticities. The general form o f the model is: n
c, = A rb, H P%-i+l (U,) i=1 where C is energy consumption, Y is GDP, P is the real price, b is G D P elasticity, Ct represents the structure o f the lagged price-elasticity coefficients, A is a constant, t denotes year and u is the error term. Natural gas
The path o f future gas d e m a n d in Russia is uncertain and the range o f possible scenarios is wide. Figure 3 illustrates some recently made forecasts. The low forecast c o m e s f r o m Stern (1995, pp 42, 85) and w h i l e it is within the realm o f possibility, I nevertheless consider it as an e x t r e m e ' l o w c a s e ' rather than the likely o u t c o m e . 12 The high forecast was p r e p a r e d b y V N I I G A Z (the Russian gas research institute closely related 12The Stern forecast suffers from a built-in downward bias by using an (implicit) negative income elasticity of demand- not a realistic assumption for a gas driven economy in which gas is poised to play a special role in offsetting the inevitable decline in the production of other fuels (coal and oil).
to G a z p r o m ; Cedigaz, 1994, p 96) and looks too sanguine for the m e d i u m term, even under a very optimistic assumption about R u s s i a ' s m a c r o e c o n o m i c prospects. The ' m i d d l e ' forecasts shown were adapted from Dienes et al (1994; referred to hereafter as DDR). They show the projected d e m a n d paths associated with fast-track and slow reforms. The fast-track s c e n a r i o e m b o d i e s most o f the key assumptions specified above with respect to the pace and structural directions o f the Russian economy in the period to 2005. For the first four years (1992-95), the D D R forecast held up r e m a r k a b l y well, with actual c o n s u m p t i o n falling within the u n c e r t a i n t y range b r a c k e t e d by the rapid and slow reform scenarios. A c t u a l c o n s u m p t i o n seems to track the 'rapid reform' forecast fairly closely. In the DDR forecast, internal gas demand hits bottom in 1995, followed by a strong build up, coinciding with the onset o f economic recovery. The export bubble is seen to deflate g r a d u a l l y b y 2000. During this period, the increased gas demand can be met from already producing fields in Western Siberia (particularly Yamburg and Urengoy). 13 But after 2000
13Bycontrast, the gas bubble keeps growing until 2000 under Stem's falling demand forecast, implying continued downward pressure on gas prices in European markets (Stem, 1995, p xvii).
130 Russian gas and aluminium: I Dobozi
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Figure 4 Russia: primary aluminium production consumption and exports
new fields (including the Yamal Peninsula reserves) will have to be developed in order to meet the anticipated rise in internal and external demand. Aluminium
Figure 3 shows the projected primary aluminium demand under the assumptions specified above. The projected turnaround in total output and the smelters' move downstream into aluminium products - like alloys and rolled aluminium and foil rather than relying wholly on primary metal production/exports - are shown to trigger a strong recovery in primary aluminium consumption. By the end o f the projection period (2005), consumption is seen to reach the pre-crisis peak of 2.3 Mt. During this period much of the pent-up demand for aluminium is presumed to be met, with per capita use, at 15 kg, reaching the pre-crisis levels by 2005 (versus 3 kg in 1995). An assumption also needs to be made about the output side of the aluminium equation in order to gauge implications for Russia's prospective export performance in aluminium. It is assumed that primary aluminium production will hold steady at 2.8 Mt - the average value over the past seven years. Clearly, this is an optimistic assumption. A series of adverse cost factors are
coming into play, which may dent aluminium production as early as 1996-97. First, production costs escalate as power, labour, transport and alumina all become more expensive. 14 Some particularly high cost Russian smelters will have to improve operational efficiency or close down. Secondly, the domestic alumina industry suffers from a severe competitiveness problem, leaving smelters excessively dependent on tolling and prefinancing agreements with foreign traders who supply alumina. Thirdly, the expected further real appreciation of the rouble reduces the attractions for Western traders in aluminium production on a tolling basis for exports, since margins have already been squeezed by rising power and transport costs. Finally, there is little evidence of serious investment activity (including foreign investment) in the primary aluminium sector that could set the stage for a production upturn in the foreseeable future. With the assumption of a flat output level, the 'export bubble' in aluminium is likely to dissipate gradually, with predicted exports in 2005, at 0.5 Mt, moving close
L4Theaverageproduction cost in Russia in 1995 was around US$1700 per tonne, comparedto metal produced by low-cost Western smelters at about US$1200 per tonne (Metal Bulletin, 22 January 1996, p 6).
R u s s i a n g a s a n d aluminium: I D o b o z i
to the 'normal' level recorded before the onset of demand collapse. Under a more pessimistic supply-side assumption, Russian aluminium exports may be seen as shrinking to a trickle after around 2000 (see Figure 4).
Summary and conclusions The upsurge in aluminium exports and the formation of the gas bubble are a direct result of the adjustment process taking place in the Russian economy. Demand patterns were affected by not only the drastic shifts in the level and mix o f aggregate demand, but also by the marked rise in the real price of fuels and metals. Although the transition from the command system to a market-driven economy is far from complete, there are growing indications that the Russian economy is turning the corner. It is therefore timely to revisit the demand prospects for gas and aluminium, as Russia is emerging from the economic doldrums and assumes more of the behavioural pattern of a market economy. The demand secanarios presented in this study carry important implications for the future evolution of Russia's aluminium exports and surplus capacity in natural gas. The presently sizeable 'gas bubble' is seen to deflate gradually by 2000, in tandem with the build-up of internal consumption. During this period, incremental gas demand could be met from already producing fields in Western Siberia. After 2000, new fields (including Yamal) will have to be developed in order to meet the envisaged growth in internal and external demand. In the case of aluminium, the rebounding economy, the progressive release of pent-up demand and the smelters' shift downstream into value-added products are seen to trigger a strong demand recovery. The key variable to watch will be production where a string of adverse cost factors may wipe out much of the competitive edge of Russia's primary metal production. Even under an optimistic production scenario - that is, holding output steady at the level of
13 l
recent years - the 'export bubble' is seen to ease back gradually, and eventually disappear by 2005.
Acknowledgements Paper presented to the conference, Competitiveness and Sustainability in Natural Resource Exploitation, organized by the Economics Research Program at Lule~ University, Lule~., Sweden, 30 May 1996. Views expressed in this paper are solely those of the author and should not be identified with the World Bank.
References Cedigaz, 1994 Natural Gas in the Worm 1994 survey (cited in Stern) Dienes, L (1996) Corporate Russia: Privatization and Prospects in the Oil and Gas Sector The Henry M Jackson School of International Studies, University of Washington, Seattle, WA Dienes, L, Dobozi, I and Radetzki, M (1994) Energ3, and Eeonomic Reform in the Former Soviet Union St Martins Press, New York Dobozi, I (1988) "The responsiveness of the Hungarian economy to changes in energy prices' in Brada, C and Dobozi, 1 (eds) The Hungarian Economy in the 1980s: Reforming the System and Adusting to External Shocks JA! Press, Greenwich, CT Dobozi, I (1990) 'The centrally planned economies: extravagant consumers' in Triton, E (ed) World Metal Demand: Trends and Prospects Resources for the Future, Washington, DC Dobozi, 1 (1993) 'Impact of market reforms on future patterns of nonferrous metal consumption of the former Soviet Union' Natural Resources Forum 2 15-32 Dobozi, 1 (1995) 'The prospects for Russian gas demand and exports" OxJord Energy Forum 12 5-8 Goskomstat, X (1996) Sotsialno-ekonomicheskoye polozheniye Rossii 1995 Moscow Karnauhov, S (1995) 'Stabilizatsiya ili stagnatsiya?' Ekonomika i zhizny I I (46) McDonald, K R (1994) 'Russian raw materials: converting threat into opportunity' Harvard Business Review May-June, 54~64 Metal Bulletin Research (1996) A Profile o f Russian Aluminium Industry London Sagers, M (1995) 'The Russian natural gas industry in the mid-1990s' Post-Soviet Geography 9 521-564 Schipper, L and Meyer, S (1992) Energy Efficiency and Human A ctivity: Past Trends, Future Prospects Cambridge University Press, New York Stern, P (1995) The Russian Gas 'Bubble' Consequences fi~r European Gas Markets Royal Institute of International Affairs, London
Pergamon S0301-4207(96)00028-1
Russian gas and aluminium Revisiting the outlook for consumption and exports in a post-depression economy
Istvan Dobozi Senior Economist, The World Bank, 1818 H Street, NW, Washington, DC 20433, USA
This paper examines the export implications for natural gas and aluminium of Russia's ongoing e c o n o m i c transition. The rapid run-up in aluminium exports and the formation of a large capacity surplus ('bubble') in natural gas are seen as a direct result of the drastic shifts in the level and mix of aggregate demand, and the marked rise in the real price of these commodities. Based on a set of macroeconomic, structural and price assumptions, the paper provides a set o f quantitative projections for the prospective evolution o f Russian d o m e s t i c demand for aluminium and gas, and draws out the potential implications for the international markets. For natural gas, the capacity hangover is seen to deflate by 2000, in tandem with the buildup of domestic consumption. In the case of aluminium, the recently experienced 'export bubble' is predicted to ease back gradually, and eventually disappear by 2005. Copyright © 1996 Elsevier Science Ltd.
Natural gas and aluminium are key items in Russia's exports: in 1994, their combined share was over one-fiRh of total exports. Production of natural gas and aluminium has held up remarkably well in the middle of the GDP collapse during 1991-95. Between 1990 and 1995, gas and aluminium production fell by only 7% and 8% respectively, compared to a reported 40% decline in GDP and a 50% decline in industrial output. Changes on the consumption side were, however, more dramatic: internal demand dropped by 16% for gas and as much as 82% for primary aluminium. In the case of aluminium, exports took up all of the spare capacity left by the collapse of domestic demand. Over 1990-95, Russian exports surged from 0.8 to 2.4 million tonnes, flooding an already saturated world market with extra supplies and triggering a marked downward drift in prices. Russia's world market share jumped from 10% to 21%. With the sharp run-up in exports, aluminium has become one of the leading export commodities of Russia; the US$2.6 billion annual revenue makes up 5% of total exports.
For natural gas, the external markets were not ready to pick up the slack caused by insufficent domestic demand. Gas exports - the outlet for one-third of the production - have fallen faster than domestic demand. The lack of internal and external markets has led to the emergence of a sizable capacity overhang ('gas bubble') and a consequent downward pressure on prices in European markets. The large capacity overhang is believed to be a major underlying factor in Russia's relatively tolerant stance towards non-payment by important CIS customers such as Ukraine and Belarus. Although the transition from the command system to a market-driven economy is far from complete, there are growing signs that the Russian economy is turning the corner. It is therefore timely to revisit the demand prospects for gas and aluminium, as Russia is emerging from the economic doldrums and assumes more of the behavioural pattern of a market economy. Following a review of the consumption patterns during the early period of economic transition, the paper examines the macroeconomic and market fundamentals shaping the 123
124 Russian gas and aluminium: 1 Dobozi outlook for gas and aluminium demand to the year 2005, and draws the potential implications for the international markets.
700 Production
600
Consumption behaviour during post-Soviet depression Natural gas: capacity hangover
500 E o
400
..................................
.~ 300 '....
Given favourable resource endowments, Russian gas production is predominantly demand-constrained. In recent years, the contraction of domestic sales and exports to countries of the former Soviet Union (CIS) led to the emergence of a 'gas bubble' ie deliverability exceeding immediate demand including exports. Between 1990 and 1995, gas consumption fell by 16%, a relatively moderate drop, compared with the reported plunge of GDP (see Figure 1). The slight increase in exports to other destinations - mostly Western European countries - was insufficient to offset even the decrease in CIS sales. The resulting capacity hangover, or bubble (ie capacity shut in for lack of markets), is estimated in the range of 30-50 billion metres per year, equivalent to 5 - 8 % of the production potential (Stern, 1995, p xvi; Sagers, 1995, p 562). It could be argued that the 'real' capacity surplus might be several multiples of this figure if adjustment is made for the pricing of gas below true market value in the residential/municipal sector and the rampant nonpayment for gas among domestic customers and those in the FSU republics, particularly Ukraine and Belarus. The size of the capacity bubble carries important implications. It can financially plague Gazprom through shutting in considerable production capacity and, potentially, it also exerts downward pricing pressure on the European gas market. Existing transmission infrastructure and supply security concerns on the part of major Western European customers act in tandem in prolonging dissipation of the capacity hangover through quantum leaps in exports. Hence the future growth in internal demand for gas will be the single most important factor in determining the size and duration of the bubble. Aluminium." demand atrophy and export surge Russia's aluminium consumption shrank to only about 0.4 million tonnes (Mt) in the mid-1990s, compared with the peak of 2.3 Mt in 1 9 9 0 - a n astounding 82% decline (see Figure 2). On top of the slump in GDP, Russian aluminium consumption has been hit hard by the catastrophic fall of 90% to 95% in defence orders. Until 1991, this sector absorbed more than half of aluminium products (Metal Bulletin Research, 1996). There was also an about 70% fall in demand in the non-defence sectors (particularly power cables). Sharply surging ex-
Domestic sales
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i
i
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Figure 1 Russian natural gas: production, consumption and exports Source:
Goskomstat(various issues).
ports took up all of the spare capacity left by the slump in domestic usage. Exports rose from 0.7 Mt in 1990 to 2.4 Mt in 1995, leaving total output 8% lower, at 2.8 Mt, than the 3.0 Mt peak registered in 1990. Price developments Natural gas prices continue to be administratively regulated and they are uniform across the country. Big hikes (especially in 1995) have brought industrial wholesale prices to around 80% of the European border price (Karnauhov, 1995), thus overshooting the economic value of Russian gas in the internal market. In October 1995, the average wholesale price at the prevailing exchange rate was US$61/thousand metres. Assuming full cost recovery on the existing gas supply system, the average economic price of gas to industrial users is estimated by the World Bank at US$30~40/thousand metres (the low estimate applies to the Urals region, Russia's industrial heartland), which is about half the European export price. At these prices, netbacks to the wellhead are roughly identical to netbacks on export sales. Residential gas prices (US$4.4/thousand cubic metres in October 1995) remain, however, grossly underpriced at less than one-tenth of the industrial price. But there is a downside to the rapid rise in domestic prices: rampant non- and late payments for deliveries bring the effective price much below the market price. The gas sector is a major involuntary net creditor to the rest of the economy. In 1995, Russian consumers paid only for about half of the gas delivered to them (Goskomstat, 1996). The accumulated consumer debts to Gazprom exceed US$10 billion.
Russian gas and aluminium: 1 Dobozi
125
3.5
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" - - . Consumption
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0 1988
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Figure 2 Russia: production, consumption and exports ofaluminium
Since the abolition of the administrative price control on non-ferrous metals in January 1992, the domestic wholesale price of aluminium has shot up so steeply that by December 1995 it had surpassed the world price by 10% (Goskomstat, 1966, p 175). The extent of non-payment for aluminium deliveries is believed to be less dramatic than in the case of gas due to the relative ease with which aluminium can be exported when faced with declining cash-financed demand in the domestic market•
Fundamentals underlying Russian demand prospects Improved macroeconomic outlook The post-Soviet economic decline, a major factor behind depressed domestic demand for metals, appears to have bottomed out in 1995 and it is reasonable to expect that real economic activity will begin to recover quite rapidly in the near future. The government's medium-term macroeconomic stabilization and structural reform programme aims at laying the basis for sustained economic growth by lowering inflation further toward a singledigit annual rate and achieving medium-term viability of the balance of payments. Provided the key macroeconomic targets and structural benchmarks developed in coordination with the IMF and the World Bank are achieved, real GDP growth is foreseen to accelerate to 2.5% in 1996, 4.0% in 1997, 5.1% in 1998 and to be sustained at a relatively high rate of 6% a year over the rest of the decade (IMF Survey, 1996, p 119). For the
2001-05 period, GDP growth is assumed to hold steady at 6% per year. The envisaged buoyant economic activity is bound to boost domestic demand for natural gas and aluminium - both being income elastic commodities in Russia.
Sectoral restructuring: implications of underlying comparative advantage and demand backlog Natural gas The mainstream view among Western observers expects the market-driven shake-out of energyintensive activities to make a major dent in Russian gas consumption. For example, a recent study by Stern (1995, p 42) predicts that by 2000 industrial gas usage will shrink by as much as 50 billion metres, or 35%, relative to the depressed level of 1994. A decline is predicted also for gas used in power generation, the most important market outlet for gas. Forecasting such deep fall-offs in gas demand might, however, be far fetched. A good deal of caution is warranted with regard to predictions of massive sectoral restructuring for several reasons. First, the highly energy-intensive industries are the backbone of the Russian economy. Simply for social and political reasons, a large-scale phase-out of these activities does not appear likely in the foreseeable future, even if market forces render them inefficient. Second, economic analysis suggests that while a great deal of misallocation of resources exist in Russia, its economy seems to possess competitive advantage in a range of energy-intensive industrial sectors, based in large part on favourable natural resource endowments, including natural gas (Dienes et al, 1994, pp 153-155;
126
Russian gas and aluminium: I Dobozi
Dobozi, 1995, pp 6-7). As noted above, the economic or market value of Russian gas in the internal market is only about half of the European export price. This suggests that Russia does seem to have a strong competitive advantage in gas-based activities, ranging from metallurgy to chemicals/fertilizers to power generation. The historically high concentration of energy-intensive commodities in Russia's exports is an additional pointer to the underlying pattern of comparative advantage. Third, structural change is a double-edged sword: it is misleading to consider only activities where further contraction seems inevitable in no small measure because of the continuing retrenchment in the military production. An offsetting influence will be exerted by the apparently large pent-up demand for a host of directly and indirectly energy-intensive goods such as gas-based chemicals and plastics, pulp and paper, living space and comfort, consumer durables etc. In these areas, the current level of per capita consumption is woefully inadequate. For some energy-intensive metal products, for example steel, the weakness in domestic demand could be offset, at least in part, by an upsurge in exports, similar to what has occurred on a large scale in some nonferrous metals (aluminium and nickel particularly). I Finally, it is not immediately obvious why industries that have managed to survive the recent deep depression would go under when the economy moves onto a path of sustained growth. Under an investment/construction led economic upturn, some of the structural changes may well become reversible, with a number of gas-intensive goods like steel products or construction materials poised for a demand rebound. There is strong evidence that Russia's improving aggregate economic performance is largely attributable to the steady recovery of the energy-intensive heavy industries. While gross industrial output fell by 3% in 1995, production was up by 9% in ferrous metallurgy, by 23% in the pulp and paper industry, by 11% in basic chemicals, and by 2% in nonferrous metallurgy. Production in machine-building and light industries continued its downward drift (Goskomstat, 1996).
Powerplant use As the single most important outlet for gas (taking more than 40% of domestic sales in recent years), power generation is especially important for the future evolution of gas utilization. Wrong electricity consumption forecasts automatically lead to wrong gas demand forecasts. For the period 1995-2000, a recent study predicts a 30% drop in electricity generation, a IExports of ferrous metals and products to non-CIS countries increased very rapidly in recent years. Between 1992 and 1994, exports of iron and steel semis jumped from 3.7 to 9.0 Mt (rolled steel from 1.7 to 5.9 Mt).
much larger fall than occurred since 1990 (Stem, 1995, p 42). But such a steep drop-off would be grossly out of sync with the ongoing upturn in industrial production and total output 2 and the relatively low penetration of electricity in the Russian economy. 3 Assuming a plausible range for the income elasticity of electric power consumption-0.5 to 0.8, instead of the implied negative values found in some studies 4 - would bring the projected power output in 2000 close to the pre-crisis level, pulling up demand for gas as a result. Looking beyond 2000, electricity consumption is expected to track more closely the overall economy, as is typical in the advanced market economies.
Gas penetration It is reasonable to expect that gas will continue to increase its already high share in the overall fuel market, although at a slower pace than observed so far. Both for cost and environmental reasons, gas will be pushed into a new tier of existing coal and oil fired power plants during the next decade. Russian coal and oil industries are experiencing deep trouble and sharply rising costs. A major downsizing of the coal industry seems inevitable over the long term. When oil refineries rationalize their product mix in favour of lighter products, the current glut of relatively cheap heavy fuel oil (mazut) is bound to dissipate, leading to a potentially larger market base for gas. A similar impact is expected from the significant near- and medium-term need of some regions to install new generating capacity for peak demand coverage. 5 Nuclear energy is a potential substitute for gas-based electricity generation. Russia produces 12% of its electricity from nuclear power plants and currently there are no plans to increase this share over the next 10 years. Given the need to decommission 9000 MW of existing nuclear capacity by 2010, the enormous financing requirements associated with the safety upgrade of existing units and building new nuclear capacity, and the local opposition to construction of new nuclear plants, maintaining even the 12% nuclear contribution seems highly uncertain. A more likely scenario is that a part of the retired nuclear capacity will be replaced by high efficiency, combined cycle gas fired units. 21n 1995, the drop is electricity consumption was only 2%, mirroring the bottoming out of the GDP decline. Electricity use is expected to post an increase in 1996 and thereafter, in tandem with the upturn in overall economic activity. 3The share of electricity in total final energy use is only 13% in Russia, compared with the average 18% in the OECD countries - a sign of underelectrification of the Russian economy, industry and households alike. 4See, for example, Stem (I 995). 5A case in point is the ongoing preparation of a proposed World Bank loan for the construction of a 900 MW gas fired combined cycle plant at Krasnodar, a power deficit area in the North Caucasus Region.
Russian gas and aluminium: I Dobozi 127
Penetration of gas into the residential-municipal sector is limited, taking only 15% of total domestic sales, in sharp contrast with the typical demand pattern of Western countries, where this sector is the largest consumer. Over the next decade, this sector is expected to be the most buoyant expansion market for Russian gas, possibly offsetting the contraction in consumption by some of the declining industries. However, much greater further gas penetration into the residential-municipal sector will be contingent upon the upgrading and extension of the existing distribution networks (Dienes, 1996; Sagers, 1995). Aluminium
Russia lags considerably in the use of aluminium. The aluminium intensity of Russian GDP is less than half of the OECD average (Dobozi, 1993, p 17). Due to the post-Soviet collapse in consumption, per capita aluminium use in 1995 was less than 3 kg, compared with 15 kg in 1990 (or 32 kg in the USA). This indicates a large amount of pent-up demand for aluminium, which is expected to be released gradually over the next decade. Given high underlying income elasticity, the consumption of aluminium is expected to move in tandem with the expanding economy. Anticipated structural changes in the mix of total output are expected to benefit aluminium. All major civilian end-use sectors are gearing up for an upswing. The coming investment recovery is bound to trigger vigorous demand growth for aluminium in the building and construction sector. The boom in housing construction appears to be well under way: in 1995, residential construction was up by 9% (including a 40% jump in private housing construction). The steel to aluminium shift is expected to speed up in this end use. Substantial demand growth will come from the transport segment, particularly motor vehicles, where aluminium stands to benefit not only from the quantum leap in vehicle production, driven by a huge backlog of consumer demand, but also from its displacement of steel in a broad range of automotive applications in connection with weight reduction requirements forced upon the industry by the steeply rising fuel prices. With the anticipated shift toward consumer industries, the packaging sector will turn in vigorous growth. In this area, Russia lags behind international consumption trends by an exceptionally large margin. Finally, even in the defence and aerospace industries, historically the dominant end use, the sharp fall in aluminium consumption might be close to hitting bottom. 6
6There are reports suggesting an 80% jump in Russianarms exports in 1995, including aircraft (Washington Post, 7 April 1996).
Downstream processing offers an important way to rebuild domestic demand for aluminium. The Russian aluminium industry can greatly expand its demand base by adapting the relatively modern, but military needsoriented fabricating facilities to civilian commercial uses, while broadening the assortment of semis and finished products, including the more advanced, high value-added products. 7 These new market segments will account for a growing portion of total aluminium consumption as in the developed Western economies. Primary aluminium consumption will benefit from the recently adopted 'long tolling' system that requires foreign traders wishing to have permission to produce primary aluminium using imported raw materials to deliver no less than 20% of the volume to Russian rolling mills for further processing. In 1996, primary aluminium consumption is seen to rise by 7% to 12% due to the 25 to 30% increase in exports o f 'long tolled' rolled products and aluminium stamplings (Metal Bulletin Research Ltd, 1996). 8 The large potential for energy conservation in the Russian economy is a well-known fact. It is generally accepted that sizeable demand reduction could be realized through market-based pricing and the application of energy-efficient technology and equipment. The existing energy demand forecasting record for Russia (and the transition economies in general) suggests a tendency to overstate the practically feasible efficiency gains, largely because the estimated technical saving potential is taken too much at its face value. A number of ' l o w ' forecasts suffer from such built-in downward bias (see, for example, Stern,1995, p 42; Schipper and Meyers, 1992, pp 296-299). In a transition economy like Russia, there remain formidable barriers inhibiting the quick realization of the large potential for energy efficiency improvements. Energy is not utilized more inefficiently than other factors of production such as labour, capital or land. Indeed, energy inefficiency is linked to all other inherited systemic inefficiencies of the Russian economy. Furthermore, a
Efficiency reservoir
7Russian rolling mills were not equipped to make more sophisticated downstream products like beveragecans, foil or construction materials for domestic consumption. They specialized on producing relatively simple products such as ingots, low-gradesheets and tubing (McDonald, 1994, p. 60). 8Tolling operations have played a major role in maintaining Russia's aluminium production at relativelyhigh levels, despite the collapse in internal consumption. In 1994 tolling operations totaled 1.8 million tons or 70% of primary aluminium production (Metal Bulletin Research Ltd, 1996). In 1995, Russian authorities introduced regulatory measures to increase the degree of processing of the foreign customer's raw materials on the basis of 'deeper' (or long) tolling.
128 Russian gas and aluminium: I Dobozi large part of the energy inefficiency is 'locked in' the preexisting fixed assets that can be replaced only gradually over an extended period o f time. 9 This condition should be factored into a forecasting model to avoid a serious undershooting of future demand. Price impact and non-payment One possible source o f error in forecasting energy/metal demand in the transition economies is treating them as full-blown market systems, with correspondingly higher price elasticities o f demand than is reasonable. This approach inevitably leads to grossly undershooting demand projections. It is more realistic to model Russia as a semi-market economy which, for some time to come, will combine elements o f a new market e c o n o m y with the anti-market legacies o f the command economy (such as concentrated market structures with extensive monopolies, an underdeveloped financial system, a relatively weak entrepreneurial class, and heavy-handed state interventions). This condition blunts the demand impact o f higher prices, resulting in price elasticities that are lower than those observed in mature market economies. 10 Non-payment for energy is a special factor in blunting the demand effect o f higher prices. As Stem asserts (1995, p 38) in the context o f Russian gas demand, For as long as non-payment is allowed to continue to any significant extent, all calculations of 'demand' are fatally flawed. What is being shown is not 'demand' but 'deliveries'. 'Demand' is a concept which presupposes that those to whom gas is being delivered are paying an agreed price, and that if they fail to pay they will not be supplied. Part of the reason why Russian gas demand projections continue to show significant increases is due to a conceptual difference: for Russians, demand is what consumers need, for westerners it is what consumers can afford. While this statement is correct in theory, it fails to recognize two special circumstances: (1) tolerance o f n o n - p a y m e n t is a systematic feature o f the economic transition in the FSU countries, and (2) Gazprom is a semi-captive seller crucially dependent on a group o f large industrial users and electric power stations, which creates an incentive to agree on continued supplies to non-payers in the hope that most o f the arrears can even-
9It is worth noting that the energy efficiency of the Russian economy has suffered a major deterioration since the beginning of perestroika due in large part to the marked slowdown in capital-stockturnover, deferred maintenance, and lack of finance even for low cost/high return conservation measures. I°A case in point is Hungary, an early reformer, where the short-and long-term price elasticities of energy demand were estimated at onehalf and two-thirds of the typical elasticities observed in developed market economies (Dobozi, 1988).
tually be recovered in some form. In a broader strategic context, even this option may be preferable for Gazprom to the alternative o f forced shut-ins o f wells, given the infeasibility o f diverting the surplus from reduced domestic sales into foreign markets. 11 Finally, it is reasonable to expect that the arrears crisis will progressively be solved (like in the fast-track reforming countries o f Central and Eastern Europe) as a result o f macroeconomic stabilization, economic recovery and an easier access by large consumers to working capital credits from the banking sector.
Quantitative demand projections to 2005 Assumptions For the purpose o f quantitative projections, parameters were developed consistent with the above-mentioned assumptions on the future evolution o f total output, shifts in the sectoral mix of GDP, and the price effect. In the case o f aluminium, only lagged price effects (specifically, those triggered by price increases in recent years), were modelled, since domestic prices stand higher than the world price. The assumed short- and long-run price elasticities are M).05 and ~3.15 respectively. In the case o f natural gas, the price effect is much stronger (-0.10 and--0.30, respectively) due to the assumed catching-up o f household prices with industrial prices by 2000 and the presumed higher degree o f payment enforcement than hitherto practised vis-~i-vis industrial gas consumers (this has the effect o f making higher prices 'bite'). For aluminium, the assumed income (GDP) elasticity of demand is assumed to reach the historical value o f 1.3 (Dobozi, 1990, p. 119) with the economy moving onto a buoyant recovery path and the massive demand backlog progressively released. For natural gas, the extremely high historical income elasticity (2.6) was adjusted downward (to the range of 0.64).8) recognizing that, as the dominant incremental fuel, gas will absorb much of the effects of non-price driven structural changes in total output and o f the efficiency improvement in energy use. A special regulatory variable was specified for aluminium to account for the primary metal consumption-boosting effect o f the 'long tolling' requirement noted before. For the purpose o f projection simulations, a straightforward dynamic consumption model has been specified for both commodities, This model is able to explore the effects o f changes in the rate o f growth o f GDP, price changes, and structural shifts in total output. The priceI tMost recently, Gazprom began to bypass local distributing companies by striking direct deals with large industrial users and accepting various forms of payment like barter or equity.
129
Russian gas and aluminium: I Dobozi
VINIIGAZx VlNIIGAZx
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Figure 3 Russia: projections of natural gas consumption
and non-price induced changes in the output mix are introduced through judgmental adjustments to the historical income (GDP) elasticities. The general form o f the model is: n
c, = A rb, H P%-i+l (U,) i=1 where C is energy consumption, Y is GDP, P is the real price, b is G D P elasticity, Ct represents the structure o f the lagged price-elasticity coefficients, A is a constant, t denotes year and u is the error term. Natural gas
The path o f future gas d e m a n d in Russia is uncertain and the range o f possible scenarios is wide. Figure 3 illustrates some recently made forecasts. The low forecast c o m e s f r o m Stern (1995, pp 42, 85) and w h i l e it is within the realm o f possibility, I nevertheless consider it as an e x t r e m e ' l o w c a s e ' rather than the likely o u t c o m e . 12 The high forecast was p r e p a r e d b y V N I I G A Z (the Russian gas research institute closely related 12The Stern forecast suffers from a built-in downward bias by using an (implicit) negative income elasticity of demand- not a realistic assumption for a gas driven economy in which gas is poised to play a special role in offsetting the inevitable decline in the production of other fuels (coal and oil).
to G a z p r o m ; Cedigaz, 1994, p 96) and looks too sanguine for the m e d i u m term, even under a very optimistic assumption about R u s s i a ' s m a c r o e c o n o m i c prospects. The ' m i d d l e ' forecasts shown were adapted from Dienes et al (1994; referred to hereafter as DDR). They show the projected d e m a n d paths associated with fast-track and slow reforms. The fast-track s c e n a r i o e m b o d i e s most o f the key assumptions specified above with respect to the pace and structural directions o f the Russian economy in the period to 2005. For the first four years (1992-95), the D D R forecast held up r e m a r k a b l y well, with actual c o n s u m p t i o n falling within the u n c e r t a i n t y range b r a c k e t e d by the rapid and slow reform scenarios. A c t u a l c o n s u m p t i o n seems to track the 'rapid reform' forecast fairly closely. In the DDR forecast, internal gas demand hits bottom in 1995, followed by a strong build up, coinciding with the onset o f economic recovery. The export bubble is seen to deflate g r a d u a l l y b y 2000. During this period, the increased gas demand can be met from already producing fields in Western Siberia (particularly Yamburg and Urengoy). 13 But after 2000
13Bycontrast, the gas bubble keeps growing until 2000 under Stem's falling demand forecast, implying continued downward pressure on gas prices in European markets (Stem, 1995, p xvii).
130 Russian gas and aluminium: I Dobozi
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Figure 4 Russia: primary aluminium production consumption and exports
new fields (including the Yamal Peninsula reserves) will have to be developed in order to meet the anticipated rise in internal and external demand. Aluminium
Figure 3 shows the projected primary aluminium demand under the assumptions specified above. The projected turnaround in total output and the smelters' move downstream into aluminium products - like alloys and rolled aluminium and foil rather than relying wholly on primary metal production/exports - are shown to trigger a strong recovery in primary aluminium consumption. By the end o f the projection period (2005), consumption is seen to reach the pre-crisis peak of 2.3 Mt. During this period much of the pent-up demand for aluminium is presumed to be met, with per capita use, at 15 kg, reaching the pre-crisis levels by 2005 (versus 3 kg in 1995). An assumption also needs to be made about the output side of the aluminium equation in order to gauge implications for Russia's prospective export performance in aluminium. It is assumed that primary aluminium production will hold steady at 2.8 Mt - the average value over the past seven years. Clearly, this is an optimistic assumption. A series of adverse cost factors are
coming into play, which may dent aluminium production as early as 1996-97. First, production costs escalate as power, labour, transport and alumina all become more expensive. 14 Some particularly high cost Russian smelters will have to improve operational efficiency or close down. Secondly, the domestic alumina industry suffers from a severe competitiveness problem, leaving smelters excessively dependent on tolling and prefinancing agreements with foreign traders who supply alumina. Thirdly, the expected further real appreciation of the rouble reduces the attractions for Western traders in aluminium production on a tolling basis for exports, since margins have already been squeezed by rising power and transport costs. Finally, there is little evidence of serious investment activity (including foreign investment) in the primary aluminium sector that could set the stage for a production upturn in the foreseeable future. With the assumption of a flat output level, the 'export bubble' in aluminium is likely to dissipate gradually, with predicted exports in 2005, at 0.5 Mt, moving close
L4Theaverageproduction cost in Russia in 1995 was around US$1700 per tonne, comparedto metal produced by low-cost Western smelters at about US$1200 per tonne (Metal Bulletin, 22 January 1996, p 6).
R u s s i a n g a s a n d aluminium: I D o b o z i
to the 'normal' level recorded before the onset of demand collapse. Under a more pessimistic supply-side assumption, Russian aluminium exports may be seen as shrinking to a trickle after around 2000 (see Figure 4).
Summary and conclusions The upsurge in aluminium exports and the formation of the gas bubble are a direct result of the adjustment process taking place in the Russian economy. Demand patterns were affected by not only the drastic shifts in the level and mix o f aggregate demand, but also by the marked rise in the real price of fuels and metals. Although the transition from the command system to a market-driven economy is far from complete, there are growing indications that the Russian economy is turning the corner. It is therefore timely to revisit the demand prospects for gas and aluminium, as Russia is emerging from the economic doldrums and assumes more of the behavioural pattern of a market economy. The demand secanarios presented in this study carry important implications for the future evolution of Russia's aluminium exports and surplus capacity in natural gas. The presently sizeable 'gas bubble' is seen to deflate gradually by 2000, in tandem with the build-up of internal consumption. During this period, incremental gas demand could be met from already producing fields in Western Siberia. After 2000, new fields (including Yamal) will have to be developed in order to meet the envisaged growth in internal and external demand. In the case of aluminium, the rebounding economy, the progressive release of pent-up demand and the smelters' shift downstream into value-added products are seen to trigger a strong demand recovery. The key variable to watch will be production where a string of adverse cost factors may wipe out much of the competitive edge of Russia's primary metal production. Even under an optimistic production scenario - that is, holding output steady at the level of
13 l
recent years - the 'export bubble' is seen to ease back gradually, and eventually disappear by 2005.
Acknowledgements Paper presented to the conference, Competitiveness and Sustainability in Natural Resource Exploitation, organized by the Economics Research Program at Lule~ University, Lule~., Sweden, 30 May 1996. Views expressed in this paper are solely those of the author and should not be identified with the World Bank.
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