The new Cold War is over energy resources

Russian energy giant Gazprom holds oil and gas reserves that rank only behind Saudi Arabia's and Iran's. Some believe that the Kremlin intends to use this massive energy resource to start a new Cold War. And its recent actions in Ukraine suggest they might be right...

For all intents and purposes, Gazprom is an arm of the Kremlin. Vladimir Putin and the members of the security and military services he helped bring to power the siloviki have succeeded in consolidating power and creating a state-run energy giant.

This consolidation has been their aim and purpose for some time now; it was the ultimate reasoning behind the jailing of Mikhail Khodorkovsky, the systematic dismantling of YUKOS and the rough handling of the Russian oligarchs. It is not clear whether Putin controls the siloviki or whether they control him; what is clear is that all parties are on the same page when it comes to using energy as a geopolitical tool.

First, some background: Who or what are the siloviki? Wikipedia offers the following definition: "A silovik plural: siloviks or siloviki, from a Russian word for force) is a Russian politician from the old security or military services, often the KGB and military officers or other security services, who came into power in the teams of Boris Yeltsin or Vladimir Putin."

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The siloviki are alternately viewed as shadowy thugs or the true protectors of Mother Russia. They could be one or both, depending on one's perspective. Either way, they hold the power and pull the strings, with Putin acting as their visible hand.

The critical thing to understand is this: Putin and the siloviki believe their homeland is under siege. Rich in natural resources, Russia is nevertheless poor in terms of human capital, with a population in decline. A wild and untamed land with borders ridiculously far apart, holding Russia together was a tough job in the best of times. These days it is almost impossibly hard but to patriots in the Kremlin, worth any effort and any cost.

Sovereignty is a hard taskmaster. When Russia looks to the West, it sees the expansion of the European Union and the potential expansion of NATO as a direct threat to its existence. When Russia looks to the East, it sees a powerful dragon hungry for natural resources and remembers that, while feeding a dragon can be lucrative work, one must be careful not to get consumed.

China's muscle and appetite make it an arms-length comrade at best. But a skeptical detente is better than a friendly backstabbing, and in the eyes of Russia's inner circle, the West is looking more and more like an enemy. They cannot say this out loud, but they are surely thinking it.

The pro-democracy policies of the United States and Europe, the Western-sponsored, multicoloured "revolutions" in the Eastern satellite countries, the deliberate minimisation of Russia's role on the world stage all are seen by Putin and the siloviki as subversive tactics, aimed at permanently weakening the great Russian bear. In their view, Mother Russia is under attack by nonmilitary means. And the West's ultimate goal? To break the bear into pieces and plunder its wealth. Think Carl Icahn on a geopolitical scale; that is how Putin and friends view the powerful combination of all-consuming capitalist interests and all-enabling Western governments.

Imagine you are the Russian bear, fighting for your dignity and survival. How to respond when your Western "friends" are acting like enemies? How to fight back when your borders are cracking, your empire is crumbling and your geopolitical clout is bleeding away? What to do? Start a new cold war, that's what. But keep in mind that nuclear weapons are strictly pass these days more suitable for mad tinpot dictators than once mighty superpowers. Where global clout and projection of force is concerned, energy is the new black.

Back to Gazprom: Russia is the world's biggest exporter of natural gas and the second biggest exporter of crude oil. Gazprom sits at the centre of that web, controlling 20% of the world's natural gas production and 16% of the world's natural gas reserves. If those numbers don't raise your eyebrows, consider this from The Economist: "If [Gazprom] were a country, its oil and gas reserves combined would rank only behind Saudi Arabia's and Iran's" (emphasis added).

This eye-popping energy monster is about to get even bigger. On Dec. 23, 2005, Vladimir Putin signed off on a "stock liberalisation" bill allowing foreign ownership (i.e., western investor ownership) of up to 49.6% of Gazprom shares. All well and good, no? Opening up to global capital markets and such? Not exactly.

With majority ownership, the Kremlin can still do exactly what it pleases with Gazprom. To Putin and the siloviki, owning 50.4% is not much different from owning 100%, with one beautiful exception: A hefty influx of foreign capital will give Gazprom the cash to gobble up its remaining Russian competitors. Gazprom may have 16% of the world's natural gas reserves, but that is still a mere 60% of Russia's total gas reserves. There are 40% more reserves to grab, by fair (buyout) or foul (backdoor political pressure and who knows what else) means.

Another benefit of 49.6% of foreign ownership is the blanket of political cover such ownership provides. If Western investors have significant money invested in Gazprom, they will be less likely to support harsh action if, or rather when, Gazprom starts challenging acceptable boundaries.

As you might expect, this murky giant has a corporate structure that makes Enron and Fannie Mae look like paragons of transparency. Gazprom's logistics process is so complex and opaque the company's dealings with subcontractors could make for a Kafka short story.

On top of this, the company recently bought a majority stake in a Russian newspaper and has owned a Russian television station (stripped from an "oligarch" who has long since fled the country) since 2001. You would think an energy behemoth has little business with television and newspapers. Unless, of course, that behemoth is a de facto tool of the Kremlin, in which case major media outlets come in quite handy for the dissemination of propaganda. Ah yes, that.

With Gazprom as the agitator, Russia clearly has the motive and the means to initiate an energy cold war. It has already kicked things off, as you no doubt have heard, with the Ukraine natural gas dispute. A handful of observers have sounded the alarm. France's Le Monde has called Russia's action "an act of war." David Warren of the Ottawa Citizen writes, "It is an odd thing when the single biggest and most consequential event in a year happens on Jan. 1. The year 2006 may well prove odd like that."

In the final days of 2005, concerned observers noted the resignation of Andrei Illarionov, Putin's economic adviser, shortly before the pipeline shutdown occurred. Illarionov was seen as a lone free-market voice in Russia's inward-dominated power structure; his resignation underlines the fact that Putin and the siloviki may have crossed a sort of geopolitical Rubicon.

Though the Ukraine dispute is resolved (for now), Europeans remain in a mild state of shock. For good reason, too: The shutdown, which temporarily slashed gas supplies across the continent by a third, highlights just how dependent Europe is on Russian gas and thus how vulnerable Europe is to Russian hostilities. While Europe's long-term plan is (or perhaps was) to expand its reliance on Russian natural gas in the future, the dangers of such a plan are now abundantly clear.

Even before this particular wake-up call occurred, Europe was casting a covetous eye on non-Russian natural gas sources. In the United States, existing LNG (liquid natural gas) terminals are running at only half capacity, due to aggressive bidding from Europe and Asia for available LNG supplies. Even when Russia behaves, there simply aren't enough LNG tankers out there to keep three continents happy. Martin Houston, president of North American operations for natural gas powerhouse BG Group (BG: LSE), sees stiff bidding competition through the end of the decade.

Gazprom, meanwhile, continues to do its best impression of an octopus, with pipelines for tentacles and the Kremlin as its brain. Many of Russia's machinations are designed to bind the satellites even closer, if possible, or cut them off in punishment if the first option is unavailable.

Keep in mind that this not-so-little drama is only one cross section of the world's energy concerns. We have not yet discussed the troubling events in South America, where Hugo Chavez is nationalising assets and funding a "socialist revolution" with petrodollars (there is a reason some call crude oil "the devil's tears"). We have not yet looked to Bolivia, where a socialist leader and Castro commiserator has taken root, or to Iran, where President Ahmadinejad is pushing the world ever closer to the brink of nuclear confrontation, or to China, where Sinopec is consolidating power (as private oil well owners are stripped of their assets and thrown in prison if they dare protest), or to other flashpoints too numerous to mention here.

As Russia and others so amply demonstrate, there is much more confrontation and conflict to come.

By Justice Litle for The Daily Reckoning

Justice Litle is editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency traders, scrap metal dealers and everyone in between, including multiple hedge funds. Mr Litle also acted as head trader for a private equity partnership, and contributed to Trend Following, a popular trading book by Mike Covel (FT/Prentice Hall, 2004). You can order your copy here: Trend Following