Judging by the performance of outgoing President Vladimir Putin, Europe should beware: The so-called “links” he’s seeking may resemble those used to chain together prisoners in the Gulag.

On the other hand – though it’s admittedly unpleasant to say so – there’s a point at which the effects of high oil prices are so great that in the short run they far outweigh one’s distaste for the thuggish Russian regime. And at $123 a barrel, we may be at that point.

Politically, Russia has pretty much reverted to the pre-1991 Soviet system.

Today, just like then, there’s only one real party: The United Russia party, which controls 315 of the 450 seats in the Duma (essentially the lower house of parliament) and whose leader is one Vladimir Vladimirovich Putin. There is considerable censorship of the media, and dissident reporters and editors have a habit of disappearing – not that there are many left now. There is huge emphasis on military power, and on throwing Russia’s weight around in foreign policy.

What’s New About the “New” Russia

However, there are a couple of significant economic differences between today’s Russia and the pre-1991 Soviet Union. One key difference is economic: While the state still controls most of the property today, it doesn’t control all of it, as it did before 1991. Even so, foreign investment in strategic sectors of the Russian economy was effectively banned by a decree of May 5. For this purpose “strategic” covers not only the military sector and energy, but also more than half of Russia’s output.

So, if the afore-mentioned difference is one of substance, this next one is all about style. Prior to 1991, Politburo members were relatively impoverished and notorious for their baggy Soviet suits and lack of fashion sense; these days, the top brass – and especially Putin – are snappy dressers with a nice Italian wardrobe, and bank accounts to match.

Putin’s even viewed as a sex symbol: In a recent No. 1 single in Russia, a female pop star cooed that she needed a new boyfriend and that “Takogo kak Putin” (he must be like Putin), and not a useless wimp like her last beau!

If you analyze the economic impact of Putin’s regime since 2000, you’ll find the result has been huge economic growth – an annual average of nearly 10% since that time with growth of 8.1% in 2007. Now a certain percentage of that was due to the proverbial “dead-cat bounce” as the economy recovered from the debilitated state it had reached by 1998-99. An additional portion reflected the benefit of a Ronald Reaganesque tax reform passed in 2001, which produced a “flat tax” income-tax system with a rate of 13%.

That caused many conservative U.S. commentators to favor the Putin regime in its early years, despite the signs of human rights abuses. However, since the arrest and imprisonment of oil company tycoon Mikhail Khodorkovsky and the looting of his company Yukos, it has become obvious that the nominal rate of income tax doesn’t matter much when the state can – and does – seize anything it wants.

Since at least 2004, Russia’s economic growth has been driven almost entirely by high oil prices. At first, oil production increased along with prices, producing real economic progress. Since Putin’s partial seizure of Royal Dutch Shell PLC (RDS.A, RDS.B) concessions in 2006 and BP PLC (BP) earlier this year, it has become obvious that the Russian state will control all economic activity in the energy sector. As a result, output has now stopped increasing and in this year’s first quarter it actually declined slightly.

I wouldn’t want to be a wealthy entrepreneur in today’s Russia, no matter how many bodyguards I surrounded myself with. At the same time, however, there’s also no question that some of the benefits of economic growth have gone to the Russian people – something that was rarely, if ever, true under the old Soviet system.

Consumer spending rose 12% in 2006 and matched GDP growth of 8% in 2007. With a current account surplus of $74 billion in 2007, foreign exchange reserves of $470 billion and ever-escalating oil prices, Russia’s ruble has been strong, making imports super cheap. Given the lack of high quality goods in Russian stores before 1991, and the impoverishment of the country in the 1990s, this consumer boom is not surprising. But it does mean that there are finally investment opportunities in Russia outside the energy sector, in places where the Russian government’s heavy hand is less evident.

As long as global oil prices remain high, or continue increasing as they have in the past five years, Russian energy companies will make record profits and Russian consumers will enjoy a bonanza, producing profits in consumer sectors also. Once energy prices turn around, Russia is in trouble. However, there is no sign of that yet, and at least in the short term, there’s money to be made from the continued advance in energy prices.

Politically, it’s unclear how much of a difference Medvedev will make, since, after all, Putin will now serve as prime minister (one news report described Medvedev as the “puppet president” of Putin’s).

To be sure, as the former CEO of Gazprom OAO (OTC: OGZPY), Medvedev has at least a basic knowledge of how business works. And it’s likely that he’ll continue to follow Russia’s current “mixed economy” policy, meaning that “strategic” sectors will remain government playthings, while non-strategic sectors such as consumer goods are pretty much left to operate freely – and unharmed. Russia even intends to use its version of a “sovereign wealth fund” to go on a bit of a global buying spree, although it remains to be seen just how aggressive it will be.

Presumably, if Putin had wanted to restore full Soviet Communism he would have chosen someone else; that at least is a consolation.

Cashing in on Russian Capitalism

Does this leave any real plays for U.S. investors? It does, but you must keep in mind that this is a highly speculative market, and that you should be ready to sell if U.S. interest rates are increased. The reason: An upward increase in U.S. interest rates could cause a reversal in energy and commodity prices, which would have a major impact on the Russian economic advance. Here are a few Russian profit plays to consider:

• OAO Gazprom (OTC: OGZPY): This is one of the obvious Russian plays, the state-owned natural gas monopoly with ambitions to control Western Europe’s gas supplies. Since its ambitions don’t yet extend to the U.S. market, it is quoted only on the Pink Sheets. It has a Price/Earnings ratio of 12, based on trailing earnings, but gas prices and Gazprom’s dominance are both rising.
• Lukoil (OTC: LUKOY): The other obvious Russian heavyweight, Lukoil is the largest state-controlled oil company; again, the firm doesn’t care if you buy the stock, meaning it also is only available through the Pink Sheets. This one has a trailing P/E ratio of only 8, and that was based on 2007 earnings when oil prices for the year averaged $80. A good speculative play on a further run-up in oil prices.

Moving outside the oil sector, there are two mobile telephone companies you might look at:

• Vimpel-Communications (VIP): This company has 55 million subscribers and mobile operations in Russia, Kazakhstan, Ukraine, Uzbekistan, Tajikistan, Georgia and Armenia. Right now, it trades at 22 times trailing earnings, but only 13 times forward earnings. It does pay a dividend, but the yield is only 0.9%. I slightly prefer its collection of non-Russian operations to those of MBT (the Russian operator we’ll get to in a moment) – you especially want Kazakhstan, which is oil-rich.
• Mobile TeleSystems OJSC (MBT): This mobile operator has 73 million subscribers and operations in Russia, Ukraine, Uzbekistan and Turkmenistan. It is cheaper than Vimpelcom, trading at only 14 times trailing earnings and 12 times forward earnings, and it has a dividend yield of 2.5%.
• Finally, for a flyer on Russia’s consumer-oriented agribusiness, albeit an expensive one, you might look at Wimm-Bill-Dann Foods OJSC (WBD), which manufactures and sells branded dairy, juice, water and baby-foods products in the Russian market. The shares trade at a pricey 37 times trailing earnings, and the forward P/E of 21 isn’t much of an improvement. The dividend yield is tiny at 0.1%. However, earnings are racing forward as the Russian consumer market opens up to quality branded goods.

Don’t put your retirement savings in the Russian market – Vladimir Putin might get tempted! However, for a modest oil-related flutter, Russia is well worth a look.

[Perhaps President Chavez could be tempted out of his chaos-causing rule in Caracas with the offer of a rich and perk-filled oil-analyst’s job at Goldman Sachs Group Inc. (GS)].

My colleague – Money Morning Investment Director Keith Fitzgerald – agrees with Chavez that oil prices are headed much higher: In fact, since back in December, when crude oil was trading at $90, Fitz-Gerald has been predicting that petroleum prices would reach $187 a barrel. And there’s growing support for his view: In mid-March, Goldman Sachs forecast oil prices of $175 within two years while just yesterday (Tuesday), noted MSNMoneycentral columnist James Jubak predicted that oil would reach $180 a barrel in the next few years.

What’s “Fueling” the Oil Price Rocket?

Crude oil rose to a record $119.90 a barrel on the New York Mercantile Exchange yesterday, as the greenback dropped to an all-time low against the European euro. Crude oil is up 24% so far this year, and 88% from this time last year, Bloomberg News reported.
With this unrelenting march, it’s no wonder that industry observers continue to roll out ever-higher target prices for the “black gold.”
If we’re only considering economic factors, the steep crude prices now being predicted would be unlikely to stick for any protracted period; there are huge new oil sources of oil that become economically profitable once oil rises above $100 per barrel. The Orinoco tar sands in Venezuela and the Athabasca tar sands in Canada – each of which contains larger oil reserves than the entire Middle East are viable even at $50 per barrel (Orinoco holds an estimated 1.8 trillion barrels and Athabasca 1.7 trillion barrels, versus a current Middle East estimate of 1.6 trillion barrels).

Then there’s Colorado oil shale – also containing at least 1.5 trillion barrels of reserves – that becomes economically viable at about $100.

The bottom line: If oil prices stayed at $180 to $200 per barrel for more than a year or two, huge new oil supplies would come on line, causing crude prices to plummet and tipping the market decisively back towards consumers. The environmental cost of getting really large quantities of oil out of Athabasca and Colorado would be immense, particularly if we attempted to supply the needs of the entire U.S. market from these sources, but at $180 per barrel, I’m confident that the economic necessity would probably trump the environmental problems.

As we said, however, these scenarios consider only economic factors. And as we’ll see, there are two additional factors that make this a much-less-straightforward analysis, meaning oil prices could linger at significantly higher prices for a much-longer period than economics alone would justify.

I’ve labeled these two “wild card” factors as “politics and a paradigm shift.” Let’s look at each one.

First, political factors are increasingly restricting the areas that can be explored for oil. In fact, there are a number of places on earth where large reserves are known to exist, but political obstacles make it impossible to drill for—and remove—the crude.

So there it stays, heavily dampening an increase in production that would otherwise be taking place.

Second, world economic growth has been exceptionally rapid, and two huge population centers, India and China, have simultaneously been introduced to the joys of the automobile culture. And that’s created a major global paradigm shift that promises to shift the auto center of the world from Detroit to Shanghai, while simultaneously causing worldwide oil consumption to soar.

Now that we understand the demand side of the equation, let’s consider the outlook for supply.

Foreign Intervention

Countries that allow foreign oil-sector participation and avoid punitive taxation can reap two distinct benefits. First, production from existing fields is increased by greater efficiency. Second, modern exploration techniques are brought to bear, often resulting in new reserve finds in areas that have been closed to international exploration for decades.

For instance, it is especially noteworthy that Saudi production peaked in 2004, and that Saudi oil reserve figures are in doubt; indeed, most Saudi oil reserves derive from fields that were discovered in the 1970s, if not before.

To see how production may stagnate without the benefit of such outside participation, just take a look at Russia.

After 2000, Russia was the principal source of new oil outside the Middle East. Since 2003, however, the most efficient Russian oil company – Yukos NK OAO – has been dismembered, contracts with foreign oil companies such as Royal Dutch Shell PLC (RDS.A and RDS.B) and BP PLC (BP) have been forcibly renegotiated, and Russia has imposed an 80% tax on oil revenue above $27 per barrel.

The result of these heavy-handed machinations has been pretty much what you’d expect: We recently learned that Russian oil production declined by 1% in the first quarter of 2008, following several years of rapid growth. An oil industry with capitalism, foreign partners and modern technology has given way to autarky and state control.

When it comes to foreign oil companies, other companies are adopting a game plan that’s very similar to that of Russia. Mexico bars foreign participation in oil exploration, and expropriates almost all the net revenue of its oil monopoly Petroleos Mexicanos, more commonly referred to as Pemex. Consequently, Mexican oil production is undergoing a steep decline: It is currently about 12% below its 2006 average, according to the International Energy Agency.

Mexican President Felipe Calderon is attempting to change that, by allowing Mexico to sign joint-venture agreements with foreign energy companies (the first such agreement under discussion is not with a hated “Yanqui,” but is instead with Brazil’s Petroleo Brasilero SA (PBR), usually referred to as Petrobras – itself a state-controlled enterprise, albeit one that’s much-more open to modern exploration techniques). However, even without proposing the politically impossible privatization of Pemex, Calderon’s attempted legislation is running into huge political opposition. 

Other examples abound. Venezuela recently seized majority control of foreign owned oil concessions, so even with the world’s largest oil reserves in the Orinoco tar sands its production has declined by about 6% since 2006. Nigeria taxes foreign oil companies at 98%, so its production has declined 10% since 2006.

There are a few counterexamples. Where the oil industry is open, new reserves are found and production increases. Brazil’s Petrobras participates freely with foreign companies, and has discovered several large offshore fields recently. Iraq’s oilfields were opened to foreign participation after 2003, and Iraq’s estimated oil reserves have since doubled to 200 billion barrels, ranking it second behind only Saudi Arabia as having the largest crude-oil reserves in the entire Middle East.

Globally, oil production from existing fields has declined 7.7% annually since 2000, with British and Norwegian offshore fields showing a particularly sharp decline. That means that large new oil discoveries are required simply to keep pace with demand and to halt oil prices from spiraling up toward infinity. Allowing international participation in oil exploration and production is essential to this process, but the list of countries in which such participation is allowed has declined and appears to be diminishing further.