Russia’s Declining Oil Production: Managing Price

Risk and Rent Addiction

Clifford G. Gaddy and Barry W. Ickes1

Abstract: Two prominent American specialists on the Russian economy re-examine two key
political explanations commonly advanced for the slowdown in Russian oil production after
2007, namely the high tax regime and increasing state control. The authors’ objective is not to
question the validity of these explanations, but rather to argue that the outcome (i.e., the slow-
ing rate of oil output and revenues derived from it) was an intentional response to rising world
prices rather than an undesired, negative consequence of Russian policies. More specifically,
the authors outline the elements of a Russian strategy designed to avoid: (a) the launching of
long-term investment programs in a high-oil-price environment, in which future world oil
prices and the costs of lifting “new” East Siberian crude cannot be reliably predicted (thereby
reducing price risk) and (b) expenditure of windfall profits to support noncompetitive enter-
prises in other sectors of the economy (curbing rent addiction). Journal of Economic Litera-
ture, Classification Numbers: E600, O130, Q430. 5 figures, 19 references, appendix. Key
words: Russia, OPEC, oil output, oil rent, rent flows, rent addiction, oil prices, price risk, tax
policy, futures markets.

INTRODUCTION

n the middle of 2007, after eight years of sustained production increases, Russia’s daily
I output of crude oil peaked and began to decline. Although the decrease in output was ini-
tially modest (and has remained so), it came at a critical point, as global demand for oil con-
tinued to grow and supplies became tighter. The world price was headed toward historic
highs. As the largest single contributor of extra supply to the world pool of oil since 1999,
Russia had been one of the few bright spots in the global supply and demand picture. 2 The
prospect of a continued drop in supply from Russia was therefore a cause of general concern
for consumers worldwide. Typical was a statement in The Economist magazine in spring
2008: “The discovery that Russia can no longer be relied upon to cater to the world's ever-
increasing appetite for oil is naturally helping to propel prices to record levels” (Russia’s Oil
Industry, 2008, p. 71).

1Respectively, Senior Fellow, The Brookings Institution, 1775 Massachusetts Avenue, NW, Washington DC

20036-2188 (cgaddy@brookings.edu) and Professor, Department of Economics, The Pennsylvania State University,
University Park, PA 16802 (bwickes@psu.edu). The authors thank Richard Ericson, Jim Leitzel, and Ekaterina
Zhuravskaya for helpful comments on an earlier version.
2Russia’s role was especially vital during 1999–2003, when its marginal addition to world supply was nearly

60 percent of increased world consumption. Data on Russian oil output here and elsewhere in this paper come from
the Russian State Committee on Statistics website (www.gks.ru). Data on global petroleum demand are from the
U.S. Energy Information Administration (http://www.eia.doe.gov/pub/international/iealf/table12.xls).

Eurasian Geography and Economics, 2009, 50, No. 1, pp. 1–13. DOI: 10.2747/1539-7216.50.1.1
Copyright © 2009 by Bellwether Publishing, Ltd. All rights reserved.
2 EURASIAN GEOGRAPHY AND ECONOMICS

Although growth rates did not turn negative until 2007, they had been slowing signifi-
cantly since 2004. As experts on the Russian oil industry asked what were the factors causing
the turnaround, they were particularly interested in determining whether the causes were
structural, and thus unavoidable, or the result of policy choices, which could in principle be
reversed. In his analysis of the reasons for the growth slowdown, Sagers (2006, p. 513) iden-
tified “four key drivers”: politics, economics, geology, and transportation. The political fac-
tors included an onerous tax regime that gave the companies little incentive to produce more
from existing fields or (especially) to invest in expanding future production capacity, uncer-
tainties about the regulatory system, and “the direct and indirect aftereffects of the Yukos
affair” (ibid.). The takeover of Yukos, wrote Sagers, signaled “the end of the liberal energy
policy model and the ascendancy of state capitalism” (ibid., p. 509). Economics related to
“the rising costs of all inputs and the unfavorable effects of ruble appreciation” (ibid., p.
513). Geology referred to declining field quality in what he terms Russia’s “legacy” fields,
mainly in West Siberia. Finally, the transportation factors included local bottlenecks within
the domestic pipeline system and, more importantly, the prospects of inadequate future
export capacity.
In this paper, we revisit what we view as the two key political explanations for the slow-
down—the high tax regime and increasing state control. We do so not in order to question
their validity but rather to inquire into their motivation. For, as usually presented (or at least
as they are interpreted), the explanations assume that the slowdown is a necessary but undes-
ired consequence of policies pursued with other goals in mind. We argue, in contrast, that the
slowed rate of Russian oil output was intentional. Owing to two specific facts about Russia’s
oil and its economy in general, the Russian leadership wanted to curb output growth as world
oil prices rose. The first fact is that Russia is a high-cost oil producer. While that means that
more of Russia’s oil would be profitable in the short term in a high-price period, it also
means that it will be highly exposed in the event of a drop in oil prices. If Russia were to
commit to large-scale and long-term investment in a high-price period, it would bear a large
risk of a price decline. The second fact is the structural legacy of the non-oil part of Russia’s
economy. Russia has a large manufacturing sector that is noncompetitive but socially and
politically important. The sector was originally built up thanks in large part to a flow of oil
and gas rents during the Soviet era, and it has remained important enough to claim a share of
the rents ever since. The higher the oil price, the more rent that flows into the economy and
the more difficult it is to prevent that rent from exacerbating the structural distortions that
Russia inherited from the Soviet period. We refer to this as an addiction to rents because the
user cannot remain solvent without the infusion of value from the oil and gas sector; hence
the enterprise or sector is addicted to the oil rent. In contrast to oil-based economies in which
a windfall might be spent on consumption or wasteful prestige investment projects, the big-
gest danger in Russia from high oil prices is that they will spur investment in the inherited
production apparatus—create new addicts—and thus further perpetuate the misallocation of
the past.

PAST AND FUTURE OIL

The difference between Russia’s past oil and its future oil is key to understanding the
leadership’s dilemma. Until now, the Russian Federation has been producing what in relative
terms is “easy oil.” This is the oil that had been bypassed in the 1980s on account of ill-
advised extraction practices in the late Soviet years and simply not lifted during the 1990s
owing to post-Soviet economic disarray. Thanks to the availability of this oil left in the
 GADDY AND ICKES 3

Fig. 1. Russian oil output, 1970–2008.

ground with infrastructure already in place, Russia was able to achieve the dramatic increase
in output alluded to earlier. Annual production rose from 305 million tons in 1999 to 470 mil-
lion tons in 2005—a 54 percent increase.3 Output continued to grow at a slower pace until
2007, when it peaked at 491 million tons (Fig. 1).
Now, however, the situation has changed. The era of simply lifting the bypassed oil of
previous years is over. For sustained growth in the future, Russia needs new oil, and that new
oil will have to come from regions farther east and farther north. Russia has such oil in abun-
dance; the problem is that this oil is far from “easy.”4 Not only is it located in regions that are
much colder and more remote than the major producing provinces of the past; its geology
also presents greater challenges. As geographer Leslie Dienes has noted (2004, p. 326), in the
earlier period geographic difficulties “were counterbalanced by the highly favorable geology
of giant deposits” in West Siberia. In East Siberia, where the new oil is located, in contrast,
geology and geography conspire: they “act in tandem as extreme constraints on exploration
and transport to markets.” Furthermore, the eastern regions have virtually none of the basic
infrastructure yet built to begin development. There will have to be massive up-front infra-
structure investments of all kinds. The regions cannot be developed in small increments. It is

3In millions of barrels per day (mbd), the increase was from about 6.1 to 9.4 mbd.
4It is important to state that Russia is not running out of oil in an absolute sense. It is true that compared with,
say, Saudi Arabia, Russia is depleting its oil at a rapid pace, because its current proven reserves are much smaller
than Saudi Arabia’s while its annual production rate is just as high. But one of the big unknowns for Russia is the
size of its reserves. The country still has vast unexplored potential. The bottom line is that no one yet knows how
much there is. Even where figures are cited, they are often unreliable. In his overview of Russia’s present and future
oil potential, Dienes (2004, p. 340) observed: “The methodology of Russian reserve classification is still based on
Soviet concepts and, to a large extent unavoidably, utilizes numbers and metrics inherited from the years of Soviet
research. The definition and size of proved, recoverable, probable, and indicated reserves . . . are still controversial.”
4 EURASIAN GEOGRAPHY AND ECONOMICS

Fig. 2. Russian oil output: Quarterly growth rates, 1997–2008.

the combination of potentially high per unit cost and the discrete nature of the investment
required that distinguishes Russia’s potential new oil from almost all other in the world.
Development of the so-called eastern oil is a venture that necessarily must be made on a
grand scale. Once launched, it would be very costly to reverse or even to delay.
In this context, the question of the cost of developing the future oil and the prospects for
recovering those costs—that is, the future price of oil—loom larger than ever. Because nei-
ther lifting costs nor the sales price can be reliably predicted, all Russia’s investments in
future production are highly risky. And because these investments are irreversible, there is an
option value to waiting.5 Before we look more closely at the issue of price uncertainty, we
turn briefly to one of the key political factors behind the slowdown in output—the increase in
state ownership of the sector.

GROWING STATE CONTROL

Figure 2 suggests why it is so tempting to blame Russia’s production decline on state

control. Over the course of 2004, after 14 quarters of expanding its output at annual rates of 8
percent or more, the trend reversed sharply. Growth rates suddenly plunged to 2–3 percent a
year. The rise in growth rates had occurred when private companies dominated the oil sector.

5An investment is irreversible if there are sunk costs—that is, if some of the value of the investment cannot be

undone. Irreversibility thus changes the decision problem: it is not just immediate profits that matter. If prices are
volatile, then the decision maker may end up in the next period in a situation where it would have been better not to
invest at all. The presence of sunk costs thus introduces uncertainty and creates a zone of inaction. The price has to
rise enough to offset the possibility that in the future it would be better to have never invested at all. The greater the
volatility in price, the more likely this is to happen, and the greater the option value of waiting.
 GADDY AND ICKES 5

The growth slowdown occurred precisely after the major private company, Yukos, was taken
out of the hands of its owner, Mikhail Khodorkovskiy, and turned over to the state-owned
company Rosneft’ (e.g., see Hanson, 2005). For many observers, the coincidence in timing
of the slowdown in output and the Yukos affair leads to a simple conclusion: Russia’s declin-
ing performance is directly attributable to the state’s takeover of the sector.
The story, however, is more complicated. It is important to remember some of the other
circumstances surrounding Russia’s growth period of 1999–2004. One of these was dis-
cussed above: it was “easy oil.” Lifting the bypassed oil could be done quickly and without
massive investments in new fields and new infrastructure. Rather, it required mainly entre-
preneurial vision, new management techniques, and modern technology. These were pre-
cisely the attributes that Russia’s new private owners possessed. Equally important, these
owners were highly motivated to recover the bypassed oil quickly because their property
rights were so tenuous. Even before the Yukos affair the threat of expropriation hung over
their heads. That made them seek to produce as fast as possible before the threat material-
ized. As we have suggested elsewhere (Gaddy and Ickes, 2005), the Putin regime uses the
degree of insecurity of owners’ property rights as a conscious instrument to regulate deple-
tion rates in the oil sector. That is, the regime will tend to favor alternative forms of industrial
organization of the oil sector depending on its objectives for oil depletion at any particular
time. When rapid depletion is a priority, the preference will be for private ownership of oil
production with weak (contingent) property rights—that is, an ownership regime in which a
Yukos could flourish. When the goal is to restrain production, a system dominated by state-
owned or state-controlled oil companies (a Rosneft’-type organization) is most useful. Those
companies can simply be instructed to restrain output.

OIL PRICES

The question is under what circumstances would the government want rapid depletion
and when would it prefer a slower rate? The answer, as in all supply decisions, hinges in part
on the price of the product supplied. This does not mean, however, that the proper response
to high prices is necessarily to produce more. Oil is not like other commodities. It is easier to
store it in the ground than to produce. Hence, the decision of how fast to produce today
depends not on the current price but on how the current price compares with expected future
prices.6 A producer who knew that high prices were certainly going to decline in the future
would accelerate depletion today to take advantage of the windfall. If, on the other hand, it
were certain that prices would be higher tomorrow, the wise strategy would be to leave the
oil in the ground and shift depletion to the future. This logic applies to a private and a state-
owned company in equal measure. Optimal depletion in either case can be fast or slow,
depending on the expected future price path. If a producer had a fixed stock of reserves and
the only problem was to choose when to produce, then the depletion rate would respond to
the price path. But if it is costly to increase production —more oil requires more costly
investment—then the producer must also consider the duration of any increase in the price.
A temporary increase in prices may be insufficient to induce a shift toward more depletion
today in a world with irreversible investments and volatile oil prices.

6It also depends on the stock of the asset—oil reserves. But the reserves are not known. Investment in explora-

tion and discovery is both costly and irreversible, and hence risky.
6 EURASIAN GEOGRAPHY AND ECONOMICS

Fig. 3. World crude oil prices, 1945–2008, in constant 2008 dollars.

Given very recent experience, it would seem that few phenomena are more obvious than
the extreme volatility of oil prices. Yet one need think back only a year or so to recall a time
when many disputed that there was uncertainty about future oil prices. The consensus from
2006 on seemed to be that high prices would persist. And before that, there was an extended
period when observers were equally confident that prices would remain low for the indefinite
future. The history of oil prices, and of oil price predictions, presents a complex picture.
Figure 3 is a record of the history of annual averages of oil prices for the past 64 years.
During that period, world oil prices have averaged roughly $26 per barrel in 2008 prices. The
median price is lower, about $20 per barrel, reflecting the fact that the high price periods have
been relatively brief. Until as late as 2005, this long historical experience, and the sense that the
late 1970s and early 1980s was a unique episode, shaped most people’s expectations about
future prices. Even as prices rose significantly higher than their historic average, the prevailing
opinion was that prices would not stay high long and that they would generally glide back to
the low levels they had been at since the mid-1980s. A few public statements by top oil-
industry executives reflect the way thinking has evolved. In early 1999, the chairman of Royal
Dutch Shell, Mark Moody-Stuart, predicted oil would sell for $14 a barrel in 2004 (The Next
Shock, 1999).7 In 2002, his successor at Shell suggested the price might go as high as “over
$30 a barrel,” but that such a level was “unlikely to be sustainable.”8 Even as the price climbed
up to over $45 a barrel, there was a reluctance to accept a reality of sustained high prices. In
February 2005, the head of BP stated that “the fundamentals now suggest . . . a price which sta-
bilizes at around $30 a barrel.”9 Within a year the price was up to $60 and going higher.

7The actual price turned out to be $40.

8PhilipWatts, Chairman of the Committee of Managing Directors, Royal Dutch/Shell Group, speaking at the
Russia Economic Forum, London, April 18, 2002.
9John Browne, speaking at the Institute for International Economics, Washington, DC.
 GADDY AND ICKES 7

Fig. 4. World Bank forecasts of oil prices, 1998–2006.

Eventually, the continued rise in the actual oil price did shift the consensus regarding
future prices. But in many respects the pattern remained the same: each year, the forecasters
merely projected the current price path into the future. This is illustrated by the record,
shown in Figure 4, of oil price forecasts by the World Bank from 1998 to 2006 presented in
the Bank’s World Development Report (e.g., World Bank, 1999, 2001, 2002, 2003, 2004,
2005).10

PRICE RISK

In a common sense view, the fact that oil price predictions have been notoriously wrong
is not strange. Oil prices are sensitive to unpredictable political and economic events in the
very short term. Consumers, of course, worry most about events that would produce an
upward price shock—political events such as wars or geopolitical tension, or natural disas-
ters that might impact the extraction or transportation of oil from producer to consumer. For
producers, such as Russia, what matters are the factors that might cause prices to fall signifi-
cantly. On the demand side, the biggest risk is the one that the world is currently experienc-
ing, namely that a severe recession will reduce global demand for oil. At the other extreme of
the economic cycle, in a global boom, extremely high price levels will induce greater efforts
to develop alternative fuels and for consumers to reduce demand. On the supply side, one
issue is the costs of extraction of oil. During the most recent oil boom, costs in the oil

10By the time of the 2007 report, the World Bank did not risk a forecast at all. Appendix 1 shows that the oil

futures markets, which are sometimes assumed to have predictive power, are no better at forecasting actual prices
than are the various experts.
8 EURASIAN GEOGRAPHY AND ECONOMICS

industry rose sharply and, like the price, costs were expected to continue to move upward. 11
The upward cost trend was then treated as nearly axiomatic, and there was a one-sided
emphasis on the factors that drive costs upward. The most obvious of those is that as oil is
depleted, more costly deposits must be exploited.12 Another key factor is that to raise output
today required more steel, more platforms, and more petroleum engineers, and the supply of
these items is highly inelastic in the short run. However, the cost of producing oil is also sub-
ject to downward pressures. For instance, over time, new technologies may make it possible
to reduce the cost of exploiting existing deposits more cheaply.
The most powerful and most likely factor that might cause prices to fall is increased sup-
ply. During the boom period, the main reason why it was expected that high prices would
continue was an assumption of tight supply stretching into the future. But this means that
prices are highly sensitive to the promise of any significant addition to the global supply of
oil. Despite repeated statements to the effect that “there is no more oil to be discovered,”
countries throughout the world continue to report new discoveries. A recent case in point is
the announcement in late 2007 of the discovery of huge offshore fields in Brazil.
An even bigger price risk than discovery of completely new fields is that inframarginal
fields, currently kept out of production, could be brought into production. For Russia perhaps
the biggest uncertainty is the investment decisions of OPEC. By keeping some of the world’s
lowest cost deposits out of production, both through their own limited investment and by
restricting access for foreign producers, members of the OPEC cartel have constrained the
global supply of oil.13 One result has been a shift globally to high-cost deposits that other-
wise (in the absence of the political limits imposed in low-cost countries) would not be
exploited. This has been of great benefit to Russia, a high-cost producer. At the same time,
OPEC can in principle at any time decide to ease constraints on access to low-cost deposits
not currently being exploited. As a result, high-cost producers like Russia face a continual
(albeit small) risk of a sudden collapse in the oil price. If OPEC were to bring new low-cost
deposits on line, that would quickly drive down the world price of oil. If the price decline is
sufficiently large, it could render all investments in high-cost areas worthless.
Price uncertainty means that producers operating in high-cost areas will be reluctant to
commit to new projects, even at high prices. Those producers bear all the risks of the deci-
sion to invest in new production.14 Producers remember what happened when world oil

11In a study released May 14, 2008, Cambridge Energy Research Associates (CERA) said that the costs of pro-

ducing oil had more than doubled since 2000. Most of the increase had occurred in the preceding three years, and the
costs could be expected to climb even more steeply in the future, owing to soaring prices for steel and other raw
materials (Oil Industry Costs, 2008).
12This is clearly the case when output is expanded in the current period. Over time, new discoveries, or the

opening of closed areas, could result in less costly deposits being exploited.
13In the words of Roger Stern of Johns Hopkins University, the cartel thus exerted its market power to “keep abun-

dance at bay” (Stern, 2006, p. 1650). He argues that the power of the OPEC cartel derives not from its reputed “oil
weapon”—that is, the ability to suddenly cut off the supply of oil to the United States or other Western countries—but
rather from its ability to “manage abundance” and thereby create huge monopoly rents. Managing abundance is, of
course, the same thing as managing scarcity, the tactic used by any cartel to support prices. OPEC’s primary instrument is
to limit investment in new exploration in OPEC countries, the regions where low-cost oil is most likely to be discovered.
14An analogy with farmland might make the point clear. Suppose that farm policy keeps some of the best plots

idle. So instead some less productive farmland is farmed. If demand rises, will farmers respond quickly by expand-
ing production on more of such marginally productive land? No. Because to put it into production requires an invest-
ment, and there is some chance that farm policy may ease the restriction on the good plots, which would wipe out
potential profits from the poorer land. So there is an option value to waiting. Only if the price is very high and looks
to stay that way will investment take place.
 GADDY AND ICKES 9

prices collapsed in the mid-1980s, turning potentially profitable projects into red ink. 15 For
Russian policymakers this is an especially sensitive issue. They recall the last oil price boom
and its consequences for the Soviet economy. During the late 1970s and early 1980s the
Soviet Union experienced an economic boom as oil prices swelled. During the boom leaders
behaved as if the high prices were permanent. The subsequent decline in oil prices was an
important factor in the collapse of the empire (e.g., see Gaidar, 2007; Gaddy and Ickes,
2009). This is not a mistake they want to repeat.

TAX POLICY

We now return to the other proposed political factor in the Russian slowdown, the high
tax regime. As Alexeev and Conrad (2009) demonstrate later in this issue, Russia’s marginal
tax rate on oil—over 90 percent—is extraordinarily high in an international comparison.
There is little doubt that such high rates inhibit output growth. But, as indicated earlier, it is
usually assumed that the negative impact of high taxes on production rates is somehow unin-
tended, the result of a policy error.16 We suggest, in contrast, that for a leadership that is try-
ing to tackle the two challenges of managing price risk exposure and controlling a “rent
addiction,” tax policy represents an ideal instrument.

Reducing the Price Risk

To understand why the Russian government would feel compelled to keep its tax rates
high as a means of reducing the risk of a fall in oil prices, consider the counterfactual. Imag-
ine if it had reduced oil taxes to encourage Russian producers to invest in new reserves. Up
until 2008, the Russian government taxed the windfall and invested it in a special sovereign
wealth fund (earlier called the Stabilization Fund, then divided into a Reserve Fund and a
National Welfare Fund).17 If it had cut the taxes, companies would instead have invested the
windfall in expanding reserves and production capacity. 18 This would have increased total
revenue from oil, but it would also have further increased the exposure of the Russian econ-
omy to the risk of a fall in the price of oil.

15The OPEC policy of keeping lowest cost deposits out of production thus contributes, in two ways, to the ris-

ing costs of production described above. First, high-cost areas by definition require more and costlier inputs per unit
of output. By claiming a disproportionate share of people and equipment, the high-cost areas raise production costs
in low-cost areas as well. Second, just as the threat of a price fall produces a muted supply response to higher prices
on the part of oil producers, the same thing happens to producers of oil equipment. Even as prices for oil soar, they
will be hesitant to invest in expanding their capacity to produce oil rigs, drilling equipment, and the like, because
they know that the oil companies will be slow to respond. So the capacity to produce equipment is constrained, rais-
ing the cost of producing new oil even further. The same thing applies to the supply of new geologists and engineers.
The individuals who choose to enter that educational track (and the governments who help fund their education)
recall the experience of the 1980s, when thousands of new graduates were left unemployed.
16Consider, for example, the following version of the high-tax argument in The Economist magazine. “...

Russia has regulated the industry so poorly that production is falling despite the soaring oil price. ‘Tax is the major
impediment,’ says [oil industry analyst at HSBC bank, Anisa Redman]. The government levies an export duty of
65% at prices over $25 a barrel. Add to that various corporate, payroll and production taxes, oilmen complain, and
the state creams off as much as 92% of profits. Executives at TNK-BP have argued that rising costs across the oil
industry will make many investments in Russia unprofitable unless the tax regime is changed” (Russia’s Oil Indus-
try, 2008, p. 71).
17See Tabata (2007) for additional information on the funds.
18Clearly, the regime would only allow a cut in taxes if oil firms actually increased investment.
10 EURASIAN GEOGRAPHY AND ECONOMICS

The analysis is clarified by thinking of the Russian economy as solely driven by oil. 19
Then the factors that drive fluctuations in Russian consumption are oil prices and oil produc-
tion. Now consider two policy options. The first option is to maintain high taxes and invest
the windfall in a sovereign wealth fund holding the world portfolio. If world income is not
perfectly correlated with Russian income (which is the same as saying the price of oil), then
some risk has been diversified. The second option is to cut taxes and let production increase.
By choosing this option, Russia increases its exposure to the sole (domestic) risk factor—the
price of oil. A mean-variance optimizer would prefer to diversify this risk, which is only fea-
sible by following the first option. One typically hears of investing the surplus inside Russia
as a means of diversification, but if Russia is a one-good economy then this does not reduce
the riskiness of its income (consumption) flow. To repeat, given that the leadership does not
want to increase the risk borne by the economy from a fall in oil prices, the best option is to
keep taxes high and thus restrain output, while investing the surplus in a sovereign wealth
fund which holds foreign assets.20

Controlling Addiction

The second function of a high tax regime is to avoid allowing the windfall—that is, the
rents from high oil prices—to be used to exacerbate the considerable structural distortions of
the Russian non-oil economy. In writing elsewhere, about oil rents and the political economy
of today’s Russia, we have described the current Russian regime as the managing board of a
corporation—“Kremlin, Inc.”—whose business is rent management (Gaddy and Ickes,
2005).21 The rent in question is the total value of Russia’s oil and gas, a value that in 2008
was running at around one-half trillion dollars annually, less the natural cost of lifting it. Note
that we are not speaking solely of the cash earned from exports of these commodities,
because much of the value stays at home. But that value, like the export earnings, is distrib-
uted. There are three main ways this takes place. One part of the value is distributed as profits
to owners and shareholders. Another part is paid as taxes—export tariffs, excise taxes, oil
depletion taxes, value-added taxes, profits taxes. And the third part is distributed as “infor-
mal taxes,” which encompass a variety of mechanisms of rent-sharing ranging from the
directly criminal (bribes, kickbacks) to legal but carefully manipulated ones (corporations’
“voluntary” contributions to social projects, excess costs of production, and public-private
partnerships). Control of all these rent flows is a key to the power of the Putin regime.
What makes the rent management problem particularly complicated is that the Russian
economy is “addicted” to the rents. The addiction dates back to the late Soviet era. The mas-
sive influx of rents from the 1970s oil windfall flowing into an economic system that had no
notion of opportunity cost altered the physical structure of the economy. Factories, cities, and
entire industries were built on the assumption of a continued flow of value from oil. That

19We can speak of Russia as a one-good economy because so little of that economy is not dependent on oil.

This is why the term “diversification” is usually misapplied. Most investments touted as being part of a diversifica-
tion effort are in fact clever ways to promote claims to the oil rents. In real world terms, the only types of investment
inside Russia that could legitimately claim to be diversification would be in sectors negatively correlated with oil
and gas. That rules out all the industries whose performance depends on the oil windfall, including retail and whole-
sale trade, real estate, construction, and financial services.
20The fact that a world economic crisis reduced the value of these assets does not mean that ex ante this was

not an optimal policy. In any case, the value of Russian assets has fallen faster than world assets as a whole, so per-
haps the policy was optimal ex post as well.
21A forthcoming book (Gaddy-Ickes, 2009) is devoted to the theme of rent addiction in Russia.
 GADDY AND ICKES 11

structure, and hence the addiction, was inherited by post-Soviet Russia. During the extreme
low rent period of the 1990s, the idiosyncratic forms of behavior that we described as
Russia’s virtual economy (Gaddy and Ickes, 2002) served the function of ensuring the sur-
vival of the addicts. And, indeed, they did hold on and were ready to lay claim to the new
rents that flowed in from the windfall of this decade.
Russia’s current leadership has learned from history. They are aware that mismanage-
ment of the oil rent in the boom of the 1970s and early 1980s was a key cause of the downfall
of the USSR (Gaidar, 2007; Gaddy and Ickes, 2009; see also Gaddy and Ickes, 2005). One
key subplot in the story of Putin’s tenure as president can be framed as a search for an eco-
nomic management model that accepts the reality of addiction but avoids the disastrous
effects that rent addiction had on the USSR. In an economy that suffers from addiction to
resource rents, an increase in rents is likely to lead to an increase in addiction. Hence if such
an economy is faced with what is perceived to be a temporary increase in oil prices, and oil
production is allowed to expand, addiction will ratchet up. This means that the flow of rents
required to maintain the system will be higher, and any future withdrawal stage will be more
painful. A leadership that is aware of this problem would prefer to avoid the incremental
addiction.
In other words, a major problem facing Putin as supreme decision-maker in this rent-
addicted economy is to how to avoid increasing the level of addiction in response to the per-
ceived transitory increase in oil prices. Given the nature of the Russian economy (its “genetic
predisposition” to addiction) and the regime that runs it, incremental flows cannot easily be
insulated from creating addiction. Hence, the best strategy is not to earn them in the first
place. This is where the tax regime comes in. A high tax regime not only serves the purpose
of collecting and directing rents to the Center. It also keeps oil production from responding to
the transitory increase, and hence limits the creation of a new group of addicts. Should there
be a need for a marginal increase in output, the tax burden can be temporarily eased.

CONCLUSION

Although Russia has enough oil to continue to increase its output, it did not commit to an
expansion during the recent period of high prices. There were two reasons. On the one hand,
it faced pure financial risk. On the other, it wanted to avoid further rent addiction. Russia is a
high-cost producer of oil that needs high oil prices to justify any expansion of its output. But
it is not enough merely to have a current high level of prices. Russia needs to be sure that
prices remain high. Even with oil prices well above $100 a barrel in 2008, the Russian lead-
ership had little incentive to assume the huge risks that a production expansion would entail.
They knew that if Russia were to invest during a high-price regime and the price should fall,
Russia would bear all the risks. If, on the other hand, the oil price were to remain high, a pro-
duction expansion would expose Russia to a different kind of risk, that of runaway rent
addiction. One of the main day-to-day concerns of Russia’s current leadership is “managing
the addiction,” that is, organizing the distribution of the rent and regulating its flow. The first
eight years of the Putin regime were devoted to creating optimal mechanisms for this purpose
in terms of ownership relations in the economy and in tax policy. As regards the role of the
state, the system that now exists seems to have the balance the leadership wants between pri-
vate and state ownership, and between domestic Russian and foreign companies. If the lead-
ers need to constrain production, they can tip the balance more toward state ownership. If
they want to accelerate production, on the other hand, they can give more leeway to foreign
companies and private companies. The taxation regime is an even more flexible instrument
12 EURASIAN GEOGRAPHY AND ECONOMICS

for regulating the rent flow. By taxing the oil industry heavily and depositing the tax reve-
nues in a sovereign wealth fund, the government hopes to keep Russia’s rent addiction from
running completely out of control. The degree of state control and the level of taxation and
the deterrent effect of both on production are thus not a mistake but elements of policy
choice. They are instruments for regulating the volume of rents. As Lukoil vice president
Leonid Fedun has noted, “Oil production will be whatever the government decides it to be”
(Russia’s Oil Industry, 2008, p. 72).

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 GADDY AND ICKES 13

Fig. 5. June 2007 futures prices and the spot price for oil from 1998 to 2007.

APPENDIX: THE PREDICTIVE POWER OF OIL FUTURES MARKETS

There is occasional reference to the oil futures markets as a more reliable predictor of
actual future prices than expert opinions, because, it is argued, the prices on futures markets
are the result of agreements between buyers and sellers, each of whom stands to gain or lose
by an inaccurate estimate. This misinterprets the function of futures markets. Futures markets
for oil provide an opportunity for consumers of oil to hedge the risk of future changes in the
price of oil. Consumers who have a heavy and relatively inelastic demand for oil find these
markets effective. 22 But despite their usefulness as a hedge for consumers, they have no
value in forecasting actual future prices, a point illustrated in Figure 5.
The chart actually shows two series, although they mirror one another so closely as to be
practically indistinguishable. One line is the current spot price of oil in the month indicated
on the horizontal axis. The other line is the price that same month on the futures market for a
barrel of Brent oil to be delivered in June 2007. The chart indicates that at each point in this
nearly 10-year period, the market set the price of June 2007 oil at whatever the current spot
price happened to be at the time of the deal.
The reason why the futures market is of so little value in forecasting prices is that oil
prices tend to follow a random walk. Technically, the time series for oil prices contains a unit
root. If one tests for the absence of a unit root in the oil price, this hypothesis is almost
always rejected. Hence, changes in the price are permanent, so the best forecast of the future
price is the present price. 23

22Note that the futures markets are less effective for producers. For major producers, in particular, the markets

are too thin to hedge the risk. There is not enough demand for producers to sell forward the amount of oil a country
like Russia, say, will produce in 2010. Thus, producers continue to bear the risk of price uncertainty. Because they
cannot hedge the risk, they act conservatively.
23In technical statistical terms, the current spot price is an unbiased predictor of the future spot price.