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A crude oil terminal near the Black Sea port of Novorossiisk, Russia, on Sept. 21, 2021.CPC/Reuters

The images taken by a drone of Maryinka, near Donetsk in southeastern Ukraine, present a hellscape reminiscent of the Allied firebombing of Dresden near the end of the Second World War. Maryinka lies in smoking ruins, with barely a building or tree intact. Vast swaths of the city, which once had a population of 10,000, have been flattened.

Maryinka’s “liberation” by Russian forces in December and into January (there are reports that Ukrainian soldiers still hold a few parts of the city) not only highlights the tragedy of Russia’s war of choice against Ukraine but also the appalling economic costs of rebuilding the country.

Suppose Russia, which is thought to be preparing a mass offensive, manages to keep the bits of eastern Ukraine that it now occupies. It would face paying the equivalent of tens of billions of dollars to rebuild the cities and towns it wiped off the map. It would also find itself stuck in a costly guerrilla war that could drain the Kremlin’s finances for years – or decades (see the Soviet occupation of Afghanistan).

For much of 2022, Moscow probably thought it could afford to pay all these bills, even if a war that was supposed to be over in weeks refused to end. That’s because the country’s main exports – oil and natural gas – continued to fatten the Russian treasury, even as most of Western and Central Europe cut back, then almost eliminated, the purchase of those fuels from Russia.

The prices for oil and gas kept going up, keeping Russian President Vladimir Putin’s revenue stream not only intact but growing. The Russian central bank recently reported that the current account surplus (the surplus of exports over imports) in the first 11 months of 2022 more than doubled, to US$226-billion. Yes, Russia ran a budget deficit last year, but not a crushing one, and the ruble recovered remarkably well after its plunge against the dollar shortly after the invasion started last February.

Rather suddenly, the financial calculus is going against Russia just as the Russian recession deepens and the war bills, for things such as hiring tens of thousands of ruthless Wagner Group mercenaries, pile up in Mr. Putin’s office.

Let’s start with oil. Oil prices of the Brent crude variety peaked at US$133 a barrel last March. It has been downhill ever since; Brent is now trading at about the same price it was this time last year – US$87.

World oil demand hits record as supply constraints take hold

Russia, the world’s second-largest exporter of crude, could make tanker loads of profit at that price. Problem is, Russia is not getting anywhere near that price for its benchmark Urals crude. With Europe and North America not buying Russian oil any more, India and China have emerged as its main buyers and are demanding enormous discounts. Earlier this month, Urals was selling at less than US$40 – half the world price and well below the US$60 price cap imposed on Russian oil by the Group of Seven in December.

At the same time, Russia’s other cash machine, the European gas market, is all but dead. The underwater explosions in September that wrecked the Nord Stream 1 and Nord Stream 2 pipelines connecting Russia to Germany eliminated most Russian gas exports to Europe. While Moscow is sneaking some gas into Europe through Turkey, the prices for that supply are falling, thanks partly to a warm winter. In December alone, European gas prices fell by half, though they are still well above their long-term average.

The upshot is that falling oil and gas exports, and prices, are eating a big hole in the Russian budget. Various economist and strategists have estimated that Russian energy receipts will be about US$150-billion lower this year than last, virtually eliminating the current account surplus and pushing up the budget deficit. Earlier this month, Russia’s Finance Minister put the 2022 deficit at 2.3 per cent of GDP, from the prewar forecast of a 1-per-cent surplus. And the deficit could double this year, even triple, as war spending accelerates.

Add in the sanctions, the mobilization that has forced hundreds of thousands of men into the military – leaving the labour market short of workers – the inability to import crucial technology to keep factories going and the exodus of Western companies, and returning to growth any time soon seems impossible, all the more so since Russia must spend fortunes to replenish the military hardware that Ukrainians destroyed. The 12-per-cent fall in the ruble since early December says Russia’s economic fortunes are going into reverse – fast.

Mr. Putin probably knows that his country’s financial health will keep deteriorating, to the point that Moscow may not be able to afford a prolonged campaign in Ukraine, let alone rebuild any territories it might manage to keep. This supports the theory that he will launch a monster offensive by the spring to try to end this war on his terms. Ukraine expects as much and will do its best to ensure that, economically at least, Russia becomes a failed state.

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