USSR-EASTERN EUROPE: CONFRONTING THE OIL QUESTION

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• Original Classification: S
• Document Page Count: 20
• Document Creation Date: December 27, 2016
• Document Release Date: March 8, 2012
• Sequence Number: 1
• Publication Date: July 1, 1987
• Content Type: REPORT

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Directorate of ~r^ct
Intelligence
Oil Question
USSR-Eastern Europe:
Confronting the
An Intelligence Assessment
SOV 87-10038X
July 1987
Copy 2 9 5
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Directorate of Secret
Intelligence
Oil Question
USSR-Eastern Europe:
Confronting the
An Intelligence Assessment
This paper was prepared by the
Office of Soviet Analysis, with contributions from
analysts in the Office of
European Ana ysis.
Division, SOYA
Comments and queries are welcome and may be
directed to the Chief, Economic Performance
Secret
SOV 87-10038X
July 1987
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USSR-Eastern Europe:
Confronting the
Oil Question
Key Judgments In the next year or two, Moscow will probably have to grapple with the di-
Information available lemma of cutting soft currency oil exports to Eastern Europe or sharply re-
as of 4 May 1987 ducing its oil sales for hard currency. We believe the USSR will not be able
was used in this report.
to sustain for long the 400,000-barrel-per-day (b/d) increase in oil produc-
tion achieved in 1986. Without an increase in investment much greater
than currently planned, we believe that by 1990 production will fall by
about 1 million b/d, to a rate of 11.25 million b/d. Soviet domestic demand
for oil during the period 1987-90 is likely to remain close to the current
rate of 9 million b/d-even allowing for some success in conservation and
fuel substitution measures-thus freeing no additional oil for export.F25X1
Moscow's hard currency bind makes it unlikely that the Soviets would let
deliveries to the West take the full brunt of production declines as they did
in 1985. At current prices, a reduction in sales to the West comparable to
the projected production decline could reduce hard currency oil earnings to
under $5 billion, which is less than one-third of the peak revenues of almost
$16 billion in 1983. Moscow has stepped up foreign borrowing and gold
sales in the past two years to help cope with declining hard currency oil rev-
enues, but we doubt that it will maintain the current pace over the longer
term. The Soviets' net hard currency debt of about $22 billion is more than
double the 1980 level, and Moscow appears hesitant to let it double again
over the next few years, even if foreign bankers are eager to lend.
Thus, in addition to the stiffer pricing terms the USSR is pushing on
Eastern Europe, Moscow will probably cut soft currency oil deliveries to
the region over the next few years. The size and timing of the cut will de-
pend on trends in Soviet oil production and world oil prices. As with the
10-percent cut in 1982, even a small cut could make a difference in
Moscow's ability to purchase Western goods on the margin. For example, a
5-percent diversion of oil from Eastern Europe to the West phased in
between 1988 and 1990 would generate an additional $150 million the first
year and almost $500 million in 1990, if world oil prices held at about $17
per barrel. A 10-percent diversion implemented at the beginning of 1988
would boost Moscow's annual oil earnings by roughly $1 billion.
Secret
SOV 87-10038X
July 1987
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Moscow will carefully weigh these potential benefits against the costs-
economic and political-of reducing soft currency oil exports to the region.
A cut of more than 10 percent seems unlikely. The Soviets have tradition-
ally supplied oil to Eastern Europe on favorable terms to foster political
and economic stability in the region. Oil deliveries make up almost 40
percent of the value of total Soviet exports to Eastern Europe. Therefore, a
sharp cut could impede Gorbachev's efforts to get the region to meet more
of the USSR's import needs through increased deliveries of better quality
goods.
The East Europeans would resist any Soviet effort to reduce soft currency
deliveries. Although its nominal price is currently higher than world levels,
Soviet oil is still a bargain for Eastern Europe because payment is largely
made in soft goods. Moreover, the East Europeans would have difficulty re-
placing sizable cuts in Soviet oil deliveries and would see economic growth
suffer. In addition, reduced Soviet oil deliveries would probably put a
crimp in East European reexports of crude oil and oil products to the West
for hard currency.
A more serious conservation program in Eastern Europe would mitigate a
reduction in Soviet oil deliveries, but success would require an extensive
infusion of new capital-an effort already impeded by the slowdown of
investment throughout the region. Attempts to replace Soviet oil with other
energy sources would provide only limited savings because of the extremely
tight energy balances in the region. Even Soviet gas deliveries above
planned levels appear unworkable because Eastern Europe is unable to
absorb the additional gas without massive expenditures to expand the gas
pipeline network and convert plants to gas use.
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Oil: The Linchpin of Trade ...
... But Also a Center of Controversy
Altering CEMA Prices 7
Another Round of Soft Currency Oil Cuts? 8
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Figure 1
Eastern Europe: Oil Balance
E] Imports of Soviet oil
0 Imports of non-Soviet oil
Oil production
? Total oil consumption
0 Exports of crude oil
and refined products
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USSR-Eastern Europe:
Confronting the
Oil Question
remain depressed and Soviet oil production falters.
Two consecutive years of declining hard currency oil
earnings have renewed speculation that the USSR
might divert oil deliveries from Eastern Europe to the
West.' The drop in hard currency oil revenues-1986
earnings of about $7 billion were just half the level
recorded two years earlier-comes at a time when
General Secretary Gorbachev probably is counting on
purchases of Western technology and equipment vital
to his modernization efforts. The Soviets, nonetheless,
continue to direct roughly 40 percent of their total oil
exports to Eastern Europe, almost entirely on soft
currency arrangements. During Moscow's last hard
currency crunch in 1981-82-which was also at the
beginning of a new five-year plan-the Soviet leader-
ship chose to cut Eastern Europe's oil deliveries by 10
percent and may opt to do so again if world prices
Oil: The Linchpin of Trade ...
Oil deliveries have for some time played a key role in
Moscow's relationship with Eastern Europe. Soviet oil
exports to Eastern Europe of 1.5 million barrels per
day (b/d) constitute over 90 percent of the region's net
oil imports and roughly 40 percent of the total value
of Soviet exports to Eastern Europe. The region's
dependency on oil began in the 1960s when it reduced
its reliance on domestic coal in favor of oil. Eastern
Europe's net oil imports of just 40,000 b/d in 1960-
about 1 percent of primary energy consumption-
climbed to over 1.7 million b/d by 1980, or a fifth of
primary energy consumption. The Soviet Union was
the chief source of the import surge, supplying East-
ern Europe with almost 1.6 million b/d by 1980 (see
figures 1 and 2).
' Eastern Europe refers to the six East European members of the
Council for Mutual Economic Assistance (CEMA): Bulgaria,
Czechoslovakia, East Germany, Hungary, Poland, and Romania.
Figure 2
Eastern Europe: Net Oil Imports as a
Share of Total Energy Consumption
Bulgaria
Czechoslovakia
East Germany
Hungary
Poland
Romania
Total
1970
80
84
313518 7.87 25X11
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Eastern Europe's growing dependence on Soviet oil
can largely be explained by the favorable payment
terms Moscow provided. The Soviets did not, raise oil
prices to Eastern Europe during the first OPEC price
explosion in 1973, and, although the USSR modified
the CEMA pricing mechanism in 1975 to benefit
from rising world oil prices, CEMA oil prices still
lagged considerably behind world levels (see inset).
Moreover, Moscow did not require payment in hard
currency and was willing to tolerate large trade
deficits once the CEMA oil price began to rise, tilting
the terms of trade heavily in Moscow's favor. This
arrangement shielded most of Eastern Europe from
the worldwide oil price shocks of 1973 and 1979 and
provided a continuing subsidy as world oil prices
climbed.
The USSR'S willingness to provide this assistance
hinged on economic and political factors. Moscow's
initial decision to subsidize oil deliveries may have
been made because the cost was small. But even as the
growth in world oil prices made the program more
costly, overall trade with the region was still charac-
terized by a net flow of real resources from Eastern
Europe to the USSR. Supplying oil to Eastern Europe
on easy terms also furthered Soviet interest in foster-
ing political and economic stability in the region.
Making Eastern Europe dependent on the USSR for
oil has helped Moscow to maintain some control over
the region and extract unconventional gains from
trade, such as Eastern Europe's contributions to
Soviet security through manpower and military bases.
... But Also a Center of Controversy
The Soviet-East European oil connection has pro-
duced disagreements, especially during Moscow's pe-
riodic attempts to reduce the growing economic bur-
den of its policy. Moscow has apparently been willing
to test how much of the costs can be passed on to
Eastern Europe without jeopardizing Soviet leverage
and regional stability. The 1974 revision of the
CEMA oil pricing formula, for example, caused
prices to rise by more than 100 percent by 1975,
forcing Eastern Europe to divert goods from domestic
and hard currency markets to the Soviet Union to pay
for the higher priced oil (see figure 3). According to
US Embassy reporting, the East Europeans fought off
Although world oil prices serve as the basis for
CEMA oil prices, various formulas have been adopt-
ed over the past three decades. Until 1974, prices in
intra-CEMA oil trade were set at five-year intervals,
based on the average of world oil prices during the
preceding five-year period. With prices for the period
1971-75 set at the average world oil price for
1966-70, the boost in OPEC prices in 1973 had no
immediate impact on CEMA prices except to create a
large gap between CEMA and world oil prices. To
reduce this discrepancy, the Soviets changed the
pricing system to allow CEMA oil prices to adjust
more rapidly to world prices. The new method calcu-
lated CEMA oil prices in 1975 as the average of
world prices during 1972-74, and, beginning in 1976,
prices were to change annually according to average
world oil prices during the previous five years. For
example, in 1976 the CEMA price was approximately
$6 per barrel and the world price was $12 per barrel.
Following the second oil price shock, the CEMA
price climbed to only $13 per barrel in 1980, while
the world price jumped to $31 per barrel.
Actual oil prices charged the individual CEMA
countries have sometimes differed from the CEMA
pricing formula because of special pricing arrange-
ments on a portion of oil deliveries worked out
between Moscow and the individual countries.
under one such
arrangement, Czechoslovakia received 5 million tons
of crude oil annually between 1973 and 1984 at a
fixed price of 15 rubles per metric ton (or $3 per
barrel) in exchange for Czechoslovak investments in
the Soviet Union. East Germany may have had a
similar arrangement with the USSR. Romania, on
the other hand, until recently paid for its Soviet oil in
hard currency or hard goods at world market prices.
To the extent Moscow accepts overpriced East Euro-
pean manufactured goods in exchange for oil-a
claim Moscow has made repeatedly-the real price
charged each country becomes even more blurred.
Moreover, official Soviet and East European ex-
change rates-dollar to ruble or ruble to some East
European currency-do not accurately reflect re-
source costs and further distort an estimated "dollar
price" of CEMA oil.
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Figure 3
Chronology of Soviet-East European Oil Trade
Oil price collapse hits
CEMA price formula
85 87a
Index of Soviet oil exports
to Eastern Europe
world price.
Second oil price shock
hits CEMA price formula
I
75
a Soviet plan to accelerate the rise in CEMA oil
prices following the second surge in OPEC prices in
1979-80. As it was, the CEMA oil price rose 35
percent between 1978 and 1980, but it would have
climbed almost 140 percent had Moscow charged the
Perhaps of even greater concern to the East Europe-
ans has been Moscow's efforts to limit the growth of
oil deliveries. To meet their own growing oil needs-
both domestically and for export to the West-the
Soviets initially proposed that annual oil deliveries
during the period 1976-80 be kept at the 1975 level of
1.2 million b/d. They eventually eased the limitations
because of the region's willingness to undertake new
investments in the USSR and growing economic
difficulties in some of the countries. Nonetheless, the
average annual growth in Soviet oil deliveries to the
region in 1976-80 was only half the 10-percent aver-
age annual growth registered in 1971-75. The slower
growth in oil deliveries was probably a contributing
factor to the estimated 60-percent slowdown in GNP
growth recorded by Eastern Europe in the second half
of the 1970s. F -1 25X1
The Soviets again sought to curtail growth in oil
deliveries during 1981-85. In 1979, then Soviet
Premier Kosygin publicly stated that annual deliveries
of crude oil to Eastern Europe were to remain at
approximately 1980 levels over the next five years.
East European trade statistics confirm that the Sovi-
ets did indeed limit oil exports to Eastern Europe in
1981 to roughly the 1980 level of 1.6 million b/d. This
was the first time in over 10 years that oil deliveries
had not increased from one year to the next.
The most telling blow came in the fall of 1981 when
Moscow informed most of its Eastern Bloc allies-the
one notable exception being Poland-that soft
currency oil deliveries would be cut beginning in
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1982.2 Authoritative statements by both East Europe-
an and Soviet officials up to that time provided little
warning of the impending shock. For example, Erich
Honecker, the East German Communist Party leader,
speaking at that party's national congress in April
1981, assured his audience that annual deliveries of
oil from the USSR "have been securely agreed upon
on a long-term basis." Shortly thereafter, the Secre-
tary General of CEMA reiterated that "under no
circumstances" would Moscow reduce oil deliveries to
Eastern Europe before 1985. Despite these assur-
ances, annual deliveries to Czechoslovakia, East Ger-
many, Hungary, and possibly Bulgaria were each cut
by about 10 percent, or almost 200,000 b/d total for
the region. The decision to spare Poland-which was
in a state of economic and political turmoil at the
time-reflects the Soviet decision not to push any one
country over the brink.
Moscow's desire for increased hard currency reve-
nues-not increased domestic oil needs-was proba-
bly the major factor in the cuts because record grain
purchases in 1981 pushed imports to an alltime high
when world oil prices were beginning to fall. The
Soviets also may have believed that the East Europe-
ans were not making adequate progress in either
conserving oil or finding alternative oil supplies de-
spite Moscow's continual prodding. The countries
singled out by the USSR had, as a group, boosted
reexports of Soviet oil to the West in 1980-81 to twice
the 1979 level, thus earning hard currency at Soviet
expense. The 350,000-b/d increase in Soviet oil ex-
ports for hard currency between 1981 and 1982-
while Soviet oil consumption increased only 100,000
b/d-supports the argument that hard currency needs
materials. At the CEMA Council meeting in October
1983, Soviet Premier Nikolay Tikhonov announced a
tougher policy on trade with Eastern Europe:
? Eastern Europe would have to export more and
better quality machinery, foodstuffs, and consumer
goods to the USSR to continue receiving energy and
raw materials.
? The region would have to help shoulder the increas-
ing costs of Soviet energy production by investing in
energy development projects in the USSR.
The USSR repeated these demands in June 1984
when East European party leaders met in Moscow for
the first CEMA economic summit in 15 years. In
response, Eastern Europe agreed to boost exports and
undertake a number of projects benefiting the USSR:
? Poland agreed to build a series of compressor
stations for the Progress Gas Pipeline.
? East Germany was slated to build plants and supply
equipment for the Soviet oil and gas industry.
? Romania planned to invest and participate in off-
shore oil development in the Caspian Sea and to
increase deliveries of meat and grain.
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were at the heart of the decision
Since 1982, Moscow has leaned on Eastern Europe in
other ways. The Soviets have stepped up pressure on
the region to raise the quality and quantity of its
exports to the USSR in payment for oil and other raw
2 Eastern Europe was given the opportunity to acquire additional
quantities of Soviet oil for hard currency, but poor financial
conditions throughout most of the region ruled out any large
Tensions over the CEMA oil-pricing formula were
evident at the 1984 CEMA summit. Pressures from
both sides for change apparently led to a decision to
consider pricing alternatives. At the postsummit press
conference, a Soviet official noted that the five-year
moving average would be replaced by a new system
that would better reflect current world price levels.
however, the CEMA foreign trade commission
in December 1984 decided to maintain the status quo
and to set foreign trade prices during the period 1986-
90 according to the established formula.
The issue resurfaced in 1986. According to the US
Embassy in Berlin, prices of both Soviet and East
European goods were a contentious issue at the
summit among CEMA party officials in Moscow last
November. Although no public declaration was made,
a compromise solution
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pricing formula.
was reached. Recent Polish press releases, however,
indicate that Poland is paying the CEMA oil price in
1987, suggesting that no binding agreement was
reached on an immediate revision of the CEMA
currency imports
The Tables Are Turned
Moscow has not reduced oil deliveries to Eastern
Europe even though its hard currency oil trade picture
has darkened considerably in the past two years. A
300,000-b/d fall in domestic oil production-includ-
ing natural gas liquids-in 1985 resulted in a decline
of the same amount in oil exports to the West, costing
Moscow about $3.7 billion in hard currency. The
Soviets maintained deliveries to Eastern Europe that
year at the 1982-84 level of 1.4 million b/d. Although
Moscow did not publicly provide any reasons for
sparing Eastern Europe, it is likely that the 1985
production drop was seen as only temporary, and the
Soviets did not want to strain relations when they
were pushing for still closer economic integration with
the region. The dent in Soviet hard currency oil
earnings was offset by increased gold sales, additional
borrowing from the West, and a reduction of hard
By favoring East over West, however, the Soviets
were left in a weakened hard currency position when
oil prices unexpectedly collapsed in early 1986. A
400,000-b/d rebound in domestic oil production last
year enabled Moscow to boost oil deliveries to hard
currency markets by roughly 100,000 b/d, but it was
not enough to offset the price decline.' Estimated total
hard currency oil earnings plummeted by over
$4 billion in 1986 to roughly $7 billion. Although part
of last year's decline in oil earnings was offset by an
estimated $2 billion increase in arms exports, much of
the gain was only on paper, as Moscow extended
credits to the LDCs to finance a large portion of these
sales)
' Deliveries to Eastern Europe also increased in 1986, with Roma-
nia receiving an additional 80,000 b/d. Unlike the past, when
Bucharest had purchased Soviet oil with hard currency at world
prices, the 1986 deliveries were apparently priced at the CEMA
level on a soft currency basis, according to US Embassy reporting
Moscow again responded to low export earnings by
increasing gold sales and continuing heavy borrowing
in Western financial markets. Nonetheless, Soviet
hard currency imports dropped by more than 10
percent during the year, a cut made somewhat less
painful because of Moscow's reduced need to import
grain in the wake of last year's good harvest. Mos-
cow's financial position is more precarious than it was
in the fall of 1981 when it chose to cut Eastern
Europe's oil rations. Its net hard currency debt has
increased by 100 percent since 1981 to approximately
$22 billion, and its debt service ratio climbed from 14
percent in 1984 to 25 percent by yearend 1986 (see
table)
Moscow's hard currency oil earnings are projected to
remain depressed for the foreseeable future-annual
revenues through 1990 are likely to average less than
$7 billion at current prices, about half the average
annual oil revenues for the period 1981-85. A
projected production decline adds to the problem of
low energy prices; we believe the USSR will not be
able to sustain for long the 400,000-b/d pickup in oil
production achieved in 1986.? Our judgment is that oil
production could begin falling by the end of 1987
and-without an increase in investment much greater
than currently planned-will drop from the 1986 rate
of 12.3 million b/d to a rate of about 11.25 million
b/d by 1990. Moreover, the USSR's domestic oil
demand in 1987-90 is likely to remain close to the
current rate of 9 million b/d (see inset). As Gorbachev
pushes forward with his industrial modernization
program, demand for oil will pick up in some sectors
of the economy and offset success in conservation and
fuel substitution elsewhere.
If Moscow takes the brunt of production declines in
reduced exports to the West as it did in 1985 and if oil
prices remain constant, annual hard currency oil
revenues could fall below $5 billion by 1990. Other
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Table 1
USSR: Selected Hard Currency Indicators a
Billion current US $
(except where noted)
Merchandise trade
balance
1.8
1.8
0.4
Exports, f.o.b.
23.2
27.9
28.3
32.0
32.4
32.2
26.4
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Oil
9.6
12.3
12.2
14.8
15.6
15.1
11.4
7.0
Imports, f.o.b.
21.4
26.1
27.9
27.5
27.7
27.4
25.9
23.1
Gross debt
19.7
18.8
20.0
19.4
21.0
21.5
28.2
36.7
Net debt b
10.3
9.5
10.8
8.3
8.9
10.0
14.9
21.7
Debt service
ratio c (percent)
20
17
16
13
15
14
22
25
a Totals may not add because of rounding.
b Net debt is gross debt minus assets held in Western banks.
c The debt service ratio is defined as the percentage share of
payments of principal and interest on Soviet debt in total hard
currency receipts and is a widely used indicator of a country's
2FX'I
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than maintaining a high volume of gold sales and
increasing borrowing, the USSR has few options to
counter these declining revenues:
? An estimated 50-percent increase in the volume of
gas exports by 1990 will only partially compensate
for falling earnings from oil exports as lower gas
prices-following that of oil-will depress gas
revenues.
? The level of arms sales is tightly linked to the oil
market, and we doubt that Moscow can greatly
expand these exports as long as depressed oil prices
weaken the economies of major arms purchasers in
the Middle East.
? Attempts to boost exports of nonoil commodities-
such as machinery and equipment and raw materi-
als-are likely to have limited success given gener-
ally weak demand for raw materials and Western
resistance to shoddy Soviet manufactured goods.'
Low energy prices will further strain trade relations
with Eastern Europe.' As the fall in world oil prices is
worked into CEMA oil prices, it could complicate
Gorbachev's efforts to extract more resources from his
allies and possibly result in reversing the creditor-
debtor roles in the Soviet-East European economic
relationship. CEMA oil prices are projected to fall by
a third between 1986 and 1990 (see figure 4). Lower
energy prices could create Soviet trade deficits begin-
ning as early as this year, not only enabling Eastern
Europe to repay its trade debt to the USSR-
estimated to be at most 16 billion rubles-but also
possibly making the Soviets debtors to Eastern Europe
by 1990 if no adjustments were made to current five-
year trade plans.
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instrumentation
Domestic demand for oil is likely to remain close to
the current rate of 9 million b/d as Gorbachev pushes
forward with his industrial modernization program.
Most of the easy gains in substituting gas for oil have
already been made, especially for boiler fuel in
electric power generation. A further decline in the
power industry's use of oil is possible-as much as
300,000 b/d oil equivalent by 1990 if coal supplies
increase, nuclear power plant construction acceler-
ates, and hydropower generation is not constrained by
low water levels. Additional gas substitution-
though technically feasible-is likely to be con-
strained by the lack of feeder pipelines and control
Forced conservation through reduced oil allocations,
though possible, is risky. Most Soviet enterprises
lack the proper measurement and control instrumen-
tation to effectively monitor and adjust their expendi-
ture of fuel (either oil or gas). Given the heavy
emphasis on rapid output growth in the energy-
intensive sectors of the economy, such as machine
building and metalworking, it seems unlikely that
much forced conservation could occur without seri-
ously jeopardizing Gorbachev's plans for moderniza-
hard currency.
The modernization program will also increase de-
mand for more light fractions in the mix of refined oil
products (gasoline, jet fuel, diesel fuel). Importing
refining equipment from the West would be the
fastest and technically most efficient option to meet
increases in demand, but could cost over $1 billion in
toward Eastern Europe
Old Options Revisited
Faced with the prospect of reducing imports or in-
creasing indebtedness in its trade with East and West,
Moscow is likely to reexamine its oil export policies
Altering CEMA Prices. Although Moscow has no
control over world oil prices, or hard currency mar-
kets, it has more flexibility regarding CEMA oil
Figure 4
Eastern Europe: Nominal Crude
Oil Pricesa
., OPEC prices are assumed to climb to almost
$20 per barrel by 1990.
CEMA price
OPEC price
prices. The effective oil price received from Eastern
Europe is a function not only of the CEMA formula 25X1
but also of the value of East European goods received
in exchange, both of which the Soviets have sought to
change in the past. With the official CEMA price still
well above world oil prices, it is unlikely that Moscow
would seek to alter the CEMA pricing formula in the
near term. (Indeed, Moscow may have to fend off East
European pressures to lower CEMA oil prices.)
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2bAi
Moscow's efforts are more likely to be directed at
acquiring lower prices for imports from Eastern Eu-
rope in exchange for oil. Price concessions could go a
long way toward maintaining the real growth of East
European imports at rates that had been agreed on
before the fall in world energy prices. For example, a
5-percent across-the-board reduction in Eastern Euro-
pe's export prices could offset the loss in Moscow's 25X1
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in the CEMA price of oil. Alternatively, the Soviets
might opt to increase pressure on Eastern Europe to
provide higher quality goods without an increase in
hard goods.' Romania, until recently, has been re-
quired to pay in hard currency or hard currency goods
for nearly all of its imported Soviet oil.
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price.
The East Europeans, for their part, would resist
efforts by Moscow to change trade terms that are now
moving in their favor. They hope that lower priced
Soviet oil will allow them to reduce the growth rate of
exports to the Soviet Union and instead to use the
resources domestically. Eastern Europe's economic
outlook is dimmed by many of the same problems
facing Soviet planners-raw material constraints,
limited hard currency import capacity, and outdated
technology-and most of the countries are particu-
larly anxious to restore the investment cuts of recent
years. The East Europeans would also like to boost
hard currency oil and petrochemical export revenues
that are lagging because of current world oil prices.
Their plastic, chemical, and petroleum refinery indus-
tries have continued to take advantage of the differen-
tial between higher Western prices and inexpensive
Soviet oil, even after the 1982 reduction in Soviet oil
deliveries. Now that the price advantage has nar-
rowed during the last five years, so have profits on
reexports of Soviet oil and other commodities that use
the oil as an input.
Another Round of Soft Currency Oil Cuts? Given
their hard currency dilemma, the Soviets will proba-
bly consider cutting soft currency oil deliveries to
Eastern Europe to free oil for hard currency sales.
One option would be an immediate cut in soft
currency oil deliveries similar to the 10-percent cut in
1982, or perhaps a cut introduced in phases over
several years. Another option, which amounts to a de
facto cut, would be for Moscow to require hard
currency payment for a portion of the oil now deliv-
ered to Eastern Europe on soft currency terms. In the
past the East European countries have purchased
Soviet oil outside trade protocols for hard currency.
Although the lack of data precludes an exact break-
down of deliveries between hard and soft currency
purchases, we believe that Hungary and East
Germany have purchased marginal amounts of Soviet
oil at world prices in exchange for hard currency or
Moscow would have to weigh carefully the costs and
benefits of cutting soft currency oil exports to the
region. Given low world oil prices and some continu-
ing waste in oil consumption, Eastern Europe could
probably absorb marginal cuts in Soviet oil deliveries
without much damage to economic growth, especially
if the cuts were implemented over an extended
period-say three years. But small, gradual reduc-
tions would only partially offset the decline in Mos-
cow's hard currency oil revenues. For example, a
5-percent diversion of oil from Eastern Europe to the
West, phased in between 1988 and 1990, would
increase the Soviets' annual hard currency oil reve-
nues by approximately $150 million the first year and
$450 million by 1990 if world oil prices held at about
$17 per barrel. A 10-percent cut implemented at the
beginning of 1988 would boost Moscow's annual oil
earnings by roughly $1 billion (see figure 5). To match
the $2.1 billion generated by the 10-percent cut in
1982, Moscow would now have to trim deliveries by
almost 25 percent.
Nevertheless, even small gains in hard currency earn-
ings would benefit Moscow's purchasing power in the
West at the margin. We estimate that a $1 billion
increase in annual hard currency revenues, above our
current projection for 1988 and 1990, could enable
Moscow to boost hard currency imports by 5 percent
annually. Even a small boost in annual hard currency
oil earnings of less than $1 billion could be a contrib-
uting factor in Moscow's plans to undertake those
projects that depend on imports of Western machin-
ery and equipment.
A sharp cut in deliveries to Eastern Europe at a time
when Gorbachev is pressing these countries to meet
more of the USSR's import needs could be self-
defeating. Although the East Europeans would proba-
bly not argue openly with the cuts, they might use
' Moscow may also receive hard currency or hard goods as payment
for those oil deliveries to East Germany that East Berlin refines and
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Figure 5
USSR: Hard Currency Revenues From
Diversion of Oil From East to West'
Diversion
implemented At $10 per barrel
immediately At $25 per barrel
Diversion p1 s At $10 per barrel
a Diversions based on Soviet oil deliveries to Eastern
Europe of 1.5 million barrels per day.
affected, while Romania would be hurt the least.
According to our estimates, a 10-percent cut in oil
deliveries to Eastern Europe could reduce annual
GNP growth for the region by as much as 3 percent-
age points, if no adjustments were made. These
estimates are based on historical patterns of East
European oil consumption, trade, and domestic pro-
duction.
Reduced Soviet oil deliveries would probably put a
crimp in East European trade with the West. The
region continues with the brisk sales of oil and oil
products-some of which are of Soviet origin-for
hard currency. Eastern Europe earned well over $4
billion in both 1984 and 1985 from hard currency
sales of oil and oil products-roughly 10 to 15 percent
of annual hard currency exports-but saw oil earn-
ings plummet over $1 billion in 1986 as oil prices
dropped. Indeed, Eastern Europe's overall hard cur-
rency position is deteriorating, with prospects poor for
a turnaround in the near term. A cut in Soviet oil
imports would probably force some reduction in sales
to the West, further depressing-hard currency earn-
ings. To offset the loss in hard currency purchasing
power, the East Europeans would have to increase
borrowing in the West, reduce imports, or find ways
to boost nonoil exports.
cooperation in science and technology.
them as an excuse to drag their feet on deliveries of
better quality goods. Such foot-dragging occurred last
year when economic disputes between Moscow and
Berlin reportedly contributed to a decline in East
German exports to the USSR. Moreover, with oil
making up 40 percent of the value of total exports to
Eastern Europe, sharp cuts that reduced Soviet-
Eastern Europe trade could also impede Moscow's
efforts to develop joint enterprises and to increase
Impact on Eastern Europe
Although the East Europeans could probably cope
with price adjustments or minor reductions in Soviet-
supplied oil, they have few means at their disposal to
offset sizable cuts in oil deliveries. The impact of an
oil cut on GNP would vary by country and would
depend on several economic factors, including the
structure of the economy, the efficiency of energy use,
and the state of technology. Poland-if its imports
were cut this time around-would probably be most
The prospects for replacing sizable Soviet oil cuts with
imports from OPEC sources are not favorable, even at
current low prices. Despite the East Europeans' grum-
bling over the CEMA oil price, Soviet oil is still
preferable to hard currency purchases. Indeed,
Romania's recent willingness to pay the CEMA oil
price for the right to purchase Soviet oil without
expending hard currency underlines the significance
the East European regimes attach to clearing account
arrangements. The bulk of current transactions with
the Middle East takes place on a barter basis, often
with the oil exchanged for construction services and
manufactured goods, including arms, but reduced
earnings have forced the OPEC countries to scale
back development projects that usually involve East
European inputs. In addition, the Middle Eastern
countries continue their attempts to increase nonoil
exports to Eastern Europe.
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A more serious energy conservation program in East-
ern Europe would also mitigate the effects of lower
Soviet oil supplies, but the costs would not be cheap.
The oil conservation drive of the early 1980s, aimed at
high-volume oil consumers, has met with mixed suc-
cess in most of the region. Moreover, to tap additional
oil savings through technological adjustments, the
conservation effort must focus on marginal savings
from the large array of small to medium users.
Measures that have received little attention in the
past include:
? The upgrading of inefficient boilers and furnaces.
? Improved insulation, especially in apartments or
along heat-carrying pipelines.
? Better monitoring of consumption through the in-
stallation of metering devices.
Success, however, would require an extensive infusion
of new capital, an effort already seriously impeded by
the slowdown of investment throughout the region.
As with conservation, most of the easy energy substi-
tutions for oil were made in the early 1980s, especially
the replacement of a number of oil-fired power plants
with those that burned coal. Since most energy sup-
plies in Eastern Europe are already tight, any attempt
to replace lost Soviet oil with alternative domestic
fuels would probably cause energy shortages else-
where. Likely shortfalls in planned additions of
nuclear power and coal production over the next
several years will further aggravate the problem.
Although increased deliveries of Soviet gas above
planned levels would appear the best bet to offset a
decline in Soviet oil, a number of factors indicate that
even this option has limitations. Published CEMA
plans for 1986-90 indicate that, even with stable
Soviet oil supplies, Soviet gas deliveries for the period
are to be one-third larger than the 1981-85 total. On
the basis of past trends in Eastern Europe's absorption
of Soviet gas, we believe increased gas deliveries
substantially above this amount would overwhelm the
region's ability to provide the capital necessary to use
the gas.' In addition, Eastern Europe's commitments
to help build the Progress Gas Pipeline over the next
four years could cause shortages of skilled labor
needed for use on domestic pipelines
Near-Term Outlook
There are no indications that reductions of soft cur-
rency oil deliveries are imminent. As noted earlier, the
Soviets boosted deliveries to Romania by 80,000 b/d
last year, and press reports have indicated that Po-
land, Czechoslovakia, and Hungary may also have
received marginal increases. Moreover, Moscow is in
a relatively good position to honor this year's commit-
ments-East German press reports indicate that im-
ports of Soviet oil in 1987 will remain at the 1986
level. Indeed, with oil production still high, Moscow
plans to increase sales to soft currency partners
Finland, Yugoslavia, and India, according to Western
press reports, to help cut into rising trade deficits
resulting from low oil prices. The oil industry trade
press has not reported unusual Soviet behavior in
Western oil markets, which suggests that Moscow has
not responded to low world oil prices by significantly
boosting export volumes to hard currency markets.
Indeed, oil exports to the West declined in the first
quarter of 1987 because of oil production problems
and increased domestic consumption associated with
the harsh winter.
On the pricing issue, however, Moscow is likely in the
near term to continue its heavy prodding of Eastern
Europe to supply better quality goods in exchange for
oil. Oleg Bogomolov, director of the Main Soviet
Institute for Research on CEMA, hinted at such an
approach in statements made last year to East Euro-
pean journalists and to US Embassy officers. On both
occasions, he said that Moscow pays twice the amount
it should for East European goods, suggesting that the
Soviets still see bargaining room regarding East Euro-
pean prices. Other Soviet officials apparently hold
of gas annually for each 100,000-b/d cutback in oil.
views similar to Bogomolov's.
the Soviets responded to a ungar-
ian request for lower oil prices sometime during 1985-
86 by reminding the Hungarians that 60 percent of
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the machine tools manufactured by Hungary were of
insufficient quality for sale in the West, yet were
purchased by the USSR. They implied that, if the
Hungarians contested oil prices, they would review
their purchases of machinery from Hungary.
continue falling
Moscow is likely to increase pressure on Eastern
Europe for increased participation in joint ventures
and exchanges of science and technology as a means
of indirectly increasing the costs of Soviet oil supplies.
Moreover, when formalizing agreements on compen-
sation for Eastern Europe's investment in Soviet
development projects, Moscow is reportedly trying to
tie the price of future energy deliveries associated
with the given project to the prevailing CEMA oil
price in the year the agreement is signed. If completed
within the next few years, such agreements would lock
in a relatively high CEMA oil price on at least some
oil deliveries to Eastern Europe, even as CEMA prices
comings would continue to complicate trade
Approaching the pricing issue on the quality side
would appear to be the easiest avenue over the short
run, considering the difficulties of past efforts to
revise the pricing formula. Moreover, recent discus-
sions among CEMA members suggest that problems
within the CEMA trading network go beyond just
prices based on a five-year moving average. The
Hungarians, for example, have been particularly vocal
with their concerns about exchange-rate issues and
the use of the "transferable ruble" in Bloc trade. Such
issues suggest that CEMA may wish to forgo piece-
meal adjustments to the system-such as coming up
with a new pricing accord-since other serious short-
Beyond 1987
Although Moscow's oil commitment to Eastern Eu-
rope beyond 1987 is less certain, we believe that
Moscow will confront Eastern Europe with a decision
to cut soft currency oil deliveries. So far, the only
evidence that reductions may be under consideration
is one line in Poland's 1986-90 plan that states Soviet
deliveries of gasoline and fuel oil are expected to
diminish. No quantities were mentioned, nor was
there any indication that increased crude oil would
replace the reduced deliveries of refined products.
Our projection of declining Soviet oil production
beyond 1987 leads us to believe that Moscow will
have little choice but to cut soft currency oil deliveries
to Eastern Europe sometime before 1990. The size of
the cut is much more difficult to predict, but we
believe it will be small. Moscow could earn about
$700 million in hard currency for each 100,000 b/d
reduction in deliveries to Eastern Europe. It is keenly
aware, however, that a sizable cut-probably greater
than 10 percent or more than 150,000 b/d-could
jeopardize both economic and political stability in
some East European countries and lessen Moscow's
leverage over the region.
Within the next few years, a number of countries in
Eastern Europe are likely to be wrestling with both
political and economic problems. Every country in
Eastern Europe-with the probable exception of Po-
land-could face the transition to a new leadership by
1990. Serious hard currency problems remain in
Poland and could surface again soon in Hungary and
Romania. Moreover, large cuts could impede Gorba-
chev's efforts to get the region to meet more of the
USSR's import needs through better quality goods
and participation in Soviet raw materials development
projects.
Stable or increasing world oil prices would help the
Soviets keep reductions in oil deliveries to Eastern
Europe to a minimum or even postpone the need for
an oil cut. Rising prices may even help offset small
declines in Soviet oil production by stabilizing hard
currency oil revenues. For example, a drop in produc-
tion of 100,000 b/d can be roughly offset by a
10-percent price hike. Another price war that lowers
oil prices over an extended period, however, would
prompt Moscow to consider cutting Eastern Europe's
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oil supplies even if Soviet oil production rates fell
minimally. Although oil deliveries to Eastern Europe
were not cut last year when prices fell, Moscow's
rising indebtedness may make it less generous the
second time around, especially if lower prices are
coupled with a sharp drop in domestic oil production.
Moreover, Gorbachev would not hesitate to risk push-
ing the East Europeans harder than before if he felt
his own domestic programs were at stake. Such a
move might be made easier if Eastern Europe proved
unable-or unwilling-to provide much help to his
program.
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