Socratic Solitaire: Russian Belligerence

One thing I like to do on this blog is engage in some “live” analytical exercises. So here is one in the vein of my reasoning from first principles post. I will play a round of Socratic Solitaire to examine Russia’s belligerence on the geopolitical stage. This is not a trivial exercise to me. I have real dollars on the line (see disclosure at bottom).

In general I think people do a poor job of analyzing geopolitical risk. There are many reasons for this. Availability bias is probably the most significant issue, especially in emerging markets. Also people do not put themselves in the shoes of the person on the other side of the table. Investment analysts especially tend to be quantitatively oriented people. They struggle to price the “squishy” stuff. So what I am really challenging myself to do here is think like Vladimir Putin.

What Motivates Me?

This is tough. But anyone who enters the political arena does it for some combination of the following three things:

  • Power
  • Money
  • To make the work a better place

Given Russia’s behavior on the geopolitical stage I would say we can safely rule out “making the world a better place.” That leaves me with money and power.

If I am Vladimir Putin, and I am motivated primarily by money, the smart thing for me to do is straightforward: play nice with the other Great Powers (US, China, EU) and simply focus my energy on looting the Russian economy. Without some overriding desire for political power, things like backing Bashar Al Assad and invading Crimea make no sense. They introduce catastrophic risks into the equation. Namely: a large scale military conflict I might lose.

Thus, on a weighted average basis I think it is safe to say that power is the most significant driver for my behavior. The relevant question from the perspective of an investor in Russian securities is: to what extent am I willing to put constraints on my drive for power?

Why Would I Constrain My Desire For Geopolitical Power?

All else equal I would simply work to swallow up the world. What would stop me?

As mentioned above, catastrophic downside risk might give me pause. That happens in a couple of different ways:

1) lose a war,

2) villagers with pitchforks revolt, and

3) a coup.

How Do I Protect Myself From Catastrophic Downside Risks?

In the short term, Risk #3 can be addressed in straightforward fashion with political repression and violence. Indeed, this appears to be the current game plan. The Financial Times recently published an interview with the Russian oligarch Vladimir Potanin. Potanin is notable for being one of the only old guard oligarchs who is still alive and wealthy.

“Why did we survive, [Mikhail] Fridman and myself? Maybe because we never tried to dictate to the government, to the Kremlin,” he says. He recalls a meeting where he and Fridman told Khodorkovsky, “Mikhail, the problem is you are trying to play political games. The perception is you are trying to buy power. It is unacceptable, not just for you but for all of us — we will all look dangerous.”

In Russia, it is perfectly okay to loot. It is not okay to play politics. A meta-reading of the interview suggests Potanin is addressing Putin and Russian state security directly. “I am not a threat,” he is saying. “I am not interested in political power. No need to bump me off or confiscate my wealth.”

Risk #2 is trickier to manage as it requires balancing economic and social considerations. The CIA World Factbook gives excellent high level macroeconomic data for Russia. We can slice and dice Russian GDP in several different ways but there are a couple of data points that stand out. Agriculture, energy and heavy industry play significant roles in the Russian economy. Russia also runs a trade surplus. Its top trade partners are China (22% of imports; 10% of exports); Germany (11% of imports; 7.8% of exports); and the United States (8% of imports). Heavy industry and energy are both intensely cyclical industries. The Russian economy is thus extremely sensitive to trends in global commodity prices, and subject to dramatic boom-bust cycles.

Unsurprisingly then, Vladimir Putin is acutely aware of “villagers with pitchforks risk.” In October 2017, The Financial Times reported on a 2009 incident where the Russian president publicly shamed oligarch Oleg Deripaska over unpaid workers:

In June 2009, in the depth of Russia’s previous sharp recession, Putin gave aluminium magnate Oleg Deripaska a public dressing-down after workers in the northern town of Pikalyovo, where his company is the main employer, took to the streets over production stoppages and unpaid wages.

“I must say that you’ve made thousands of residents of Pikalyovo hostages of your ambition, your unprofessionalism and maybe your greed,” the president told Deripaska in front of rolling cameras. As the tycoon hung his head, Putin asked why he had “neglected” his factory. Before the president had left town, Deripaska had ordered that all outstanding wages be paid.

“The effect of that show lingers until today,” says Zemlyansky. “After what happened in Pikalyovo, in all Deripaska towns, they keep on a certain number of employees even in companies that should be shut down, just because of the fear of Putin.”

And the Kremlin is keeping a close eye on things. The National Guard, the police force in charge of riot control, monitors social stability in some monotowns. The federal government has also set up a system to collect more comprehensive data on their social and economic state. The statistics are kept secret, making it impossible even for local governments to assess the situation properly.

Aside from economic policy measures, one highly effective way of managing “villagers with pitchfork risk” is through scapegoating. In fact, this tactic can be used to kill two birds with one stone. In China, for example, the Chinese premier (now dictator for life) has used an anti-corruption campaign as cover for greasing squeaky wheels. In the US, there is nothing Donald Trump loves more than making an individual or organization a scapegoat for some real or imagined threat.

The solution to Risk #1, meanwhile, is simple but not necessarily easy: do not lose a war with a Great Power.

If I Am Vladimir Putin, How Far Will I Push The Other Great Powers?

Answer: As far as they will let me.

There are military and economic dimensions to this and we could spend years gaming it all out. The bottom line is that the optimal strategy is a carefully choreographed dance, similar to the Cold War.

The underlying dynamics are similar to those of the Prisoner’s Dilemma in game theory. The Prisoner’s Dilemma, or, rather, the Iterated Prisoner’s Dilemma, is therefore an interesting model to consider. From Wikipedia:

Interest in the iterated prisoner’s dilemma (IPD) was kindled by Robert Axelrod in his book The Evolution of Cooperation (1984). In it he reports on a tournament he organized of the N step prisoner’s dilemma (with N fixed) in which participants have to choose their mutual strategy again and again, and have memory of their previous encounters. Axelrod invited academic colleagues all over the world to devise computer strategies to compete in an IPD tournament. The programs that were entered varied widely in algorithmic complexity, initial hostility, capacity for forgiveness, and so forth.

Axelrod discovered that when these encounters were repeated over a long period of time with many players, each with different strategies, greedy strategies tended to do very poorly in the long run while more altruistic strategies did better, as judged purely by self-interest. He used this to show a possible mechanism for the evolution of altruistic behaviour from mechanisms that are initially purely selfish, by natural selection.

The winning deterministic strategy was tit for tat, which Anatol Rapoport developed and entered into the tournament. It was the simplest of any program entered, containing only four lines of BASIC, and won the contest. The strategy is simply to cooperate on the first iteration of the game; after that, the player does what his or her opponent did on the previous move. Depending on the situation, a slightly better strategy can be “tit for tat with forgiveness”. When the opponent defects, on the next move, the player sometimes cooperates anyway, with a small probability (around 1–5%). This allows for occasional recovery from getting trapped in a cycle of defections. The exact probability depends on the line-up of opponents.

By analysing the top-scoring strategies, Axelrod stated several conditions necessary for a strategy to be successful.


The most important condition is that the strategy must be “nice”, that is, it will not defect before its opponent does (this is sometimes referred to as an “optimistic” algorithm). Almost all of the top-scoring strategies were nice; therefore, a purely selfish strategy will not “cheat” on its opponent, for purely self-interested reasons first.


However, Axelrod contended, the successful strategy must not be a blind optimist. It must sometimes retaliate. An example of a non-retaliating strategy is Always Cooperate. This is a very bad choice, as “nasty” strategies will ruthlessly exploit such players.


Successful strategies must also be forgiving. Though players will retaliate, they will once again fall back to cooperating if the opponent does not continue to defect. This stops long runs of revenge and counter-revenge, maximizing points.


The last quality is being non-envious, that is not striving to score more than the opponent.

If one views Russia’s behavior (or any belligerent nation state’s behavior) through this lens there are elements of the Iterated Prisoner’s Dilemma in play. In particular, some belligerence must be used as a deterrent. Likewise, some forgiveness and cooperation must be utilized to stop “long runs of revenge and counter-revenge” (read: World War III). In this context, seemingly “crazy” actions such as backing Bashar Al Assad are in fact totally rational.

Why Would I Start World War III?

As Charlie Munger says, “always invert.” So, let’s examine the issue of Russian belligerence through another angle. Why would I, as Vladimir Putin, intentionally ignite a global conflagration that could result in my total loss of power and personal demise?

  • I believe there is a high probability of winning
  • I am a pure ideologue / religious fanatic (not a rational actor)
  • Nothing left to lose

At this juncture none of these appear to dominate decision making on the Russian side. There is some level of ideology in play here in terms of a desire to ensure Russia remains a Great Power and a geopolitical player. However, it’s not the type of fanaticism that renders someone an irrational actor, such as Islamic Fundamentalism.

Key Learnings

Russian aggression is not irrational. There is a method to it. The method stems from the fact that Vladimir Putin is motivated to expand Russia’s power and influence (and by extension, his own power and influence). This requires a certain level of calculated belligerence so as not to be steamrolled by other Great Powers.

Domestically, the #1 rule for business leaders is to keep out of politics. The #2 rule is to allow the state some latitude for looting. Most investors look at #2 and say “forget it, I am  out” (availability bias). I look at SBRCY on forward PE of 5.67 with a 20% ROE, having just announced a doubling of its dividend, and say, “gee, maybe the looting is more than priced into the stock.”

The most controversial asset expropriation in the history of modern Russia is Yukos, which was owned largely by the oligarch Mikhail Khodorkovsky. Russia did not expropriate Yukos for arbitrary reasons. Khodorkovsky had political ambitions. Worse yet (from the Russian government’s point of view), his vision for Russia ran counter to that of Vladimir Putin. Therefore, if you are invested in Russia, an easy qualitative screen to run is whether company management and ownership is aligned with the Putin regime. This is a critical to assessing expropriation risk and ensuring you are taking calculated risks versus stupid risks.

Full Disclosure: Long OGZPY, SBRCY and RSXJ. Short RSX (as a partial hedge)

Gazprom vs. Sanctions

Source: Gazprom

In the interest of full disclosure, I am long Gazprom ADRs. This post is written for entertainment purposes only and is not a recommendation to buy or sell any Gazprom-related security. Readers should consult a financial advisor before buying or selling any security. An advisor will be able to make a recommendation while taking the investor’s unique circumstances into consideratiom. Now, on to the show…

Hear that frenetic popping sound? Kind of like a firing squad executing a an opposition politician? Actually it is the sound of the Russian oligarchy uncorking champagne. Gazprom, Russia’s state-owned gas company, was recently ranked #1 in the 2017 S&P Global Platts Top 250 Global Energy Company Rankings, dethroning reigning champion Exxon Mobil.

Gazprom is a fascinating entity for any number of reasons. Chief among them is that it is majority controlled by the Russian state, is a behemoth of an integrated oil and gas company and is therefore an instrument of Russian geopolitical strategy. Here are some fast facts from the 2016 Annual Report:


There is common misconception in the United States that sanctions on Russia somehow really matter. And sure, they matter at the margins. Certainly if you are a Russian oligarch they may impede your ability to make extravagant purchases. Sanctions make it harder and more expensive for Russian companies to do certain things. Project finance wrangling in particular can be a pain.

But remember – Russia via Gazprom controls nearly 20% of global gas reserves and maintains a relatively low cost position. This is something of an economic moat and if you are Russia/Gazprom it gives you options. For example, running export pipelines into China, and developing a liquefied natural gas (LNG) export hub in proximity to Southeast Asia.



It is hardly a coincidence that in 2016 Gazprom closed a EUR 2 billion credit facility with the Bank of China (the 2016 Annual Report trumpets this as “The largest deal in the Company’s history in terms of the amount of financing attracted directly from one financial institution”). The company also held investor day events in both Singapore and Hong Kong earlier in 2017. Why? Per a Gazprom press release:

The region is of strategic importance for Gazprom’s development. The Company aims to foster an increased cooperation with its Asian partners and strives to diversify its investor pool and financing sources, with a primary focus on Asia-Pacific’s potential. Specifically, 52 per cent of the Company’s loans in 2016 were provided by Asian banks, which shows that they have a high level of confidence in Gazprom.

Translation: “Ready access to Asian capital markets allows us to reduce our dependence on US and European companies and institutions for financing, just in case we lose access to western capital.”

So here is a lesson in incentives: trade restrictions like sanctions will only bite insofar as no one of means has a strong incentive to violate them. Otherwise someone or some entity is going to come in and arbitrage those restrictions. Critically, ideological incentives do not count. History is replete with examples of people and entities abandoning entrenched ideological positions when it will benefit them economically. In many cases, simple greed will do the trick.

This old Bronte Capital post provides an elegant historical example:

A typical Marc Rich & Co trade involved Iran (under the Shah), Israel, Communist Albania and Fascist Spain. The Shah needed a path to export oil probably produced in excess of OPEC quotas and one which was unaudited and hence could be skimmed to support the Shah’s personal fortune. Israel – a pariah state in the Middle East – wanted oil.  Spain had rising oil demand and limited foreign currency but was happy to buy oil (slightly) on the cheap. Spain however did not recognise Israel and hence would not buy oil from Israel – so it needed to be washed through a third country. Albania openly traded with both Israel and Spain. Oh, and there is an old oil pipeline which goes from Iran through Israel to the sea.

So what is the deal? The Shah sells his non-quota oil down the pipeline through Israel and skims his take of the proceeds. Israel skim their take of the oil. Someone doing lading and unlading in Albania gets their take and hence make it – from the Spanish perspective – Albanian, not Israeli oil. The Spanish ask few questions. The margins are mouth-watering – and they all come from giving people what they really want rather than what they say they want. We know what the Shah wanted (folding stuff).  We know what Israel wanted (oil). We know what Spain wanted (cheap oil). Who cares that Spain was publicly spouting anti-Israel rhetoric. [Similar trades allowed South Africa to break the anti-Apartheid trade embargoes.]

[…]And when the Shah fell?  Oh well – Pincus Green – an American Jewish businessman – gets on the plane to Iran and does a similar deal with the Mullahs – who – despite their rhetoric will sell oil down a pipeline through Israel – and will allow Israel to skim their take. Trading through the American embargo – well that is just another instance of getting around restrictions and profiting (very) handsomely.

The Gazprom-China relationship isn’t nearly as complex as these Marc Rich & Co. transactions. China has not agreed to the sanctions regime imposed on Russia by western countries. China and the rest of developing Asia simply need cheap and abundant supplies of natural gas. Gazprom is able to meet that need, and will be happy to have the Chinese as a source of project finance.

The political kerfuffle surrounding Gazprom’s Nord Stream 2 pipeline in Europe revolves around similar dynamics. Eastern European states such as Poland, Latvia, Lithuania and Estonia rightly fear dependence on Russian gas as it gives Russia powerful leverage over their economies and therefore their political independence. German industry, meanwhile, would much prefer cheap Russian pipeline gas to more expensive LNG imports.

While today’s headlines herald booming US LNG exports, independent research implies US exports will eventually need to price significantly higher to cover producers’ full marginal costs (including capex, liquefaction & shipping — after all it is not cheap to send tankers full of LNG halfway around the world):LNG_Transportation_Costs (1).PNG



So again economic incentives outweigh any warm and fuzzy notion of European solidarity. The result is a running trade case that has been winding its way through the EU bureaucracy for years.

And meanwhile the Nord Stream pipeline project grinds on…