Russia's British Turning Point

British Petroleum in Russia

By: Dr. Sam Vaknin

Also published by United Press International (UPI)

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February 12, 2003

British Petroleum teamed up with the Alfa Group-Access-Renova (AAR) concern to equally form Russia's third largest energy company. The new titan will digest Tyumen Oil Company (TNK) International, Rusia Petroleum and Sidanco Oil, which produce, between them, c. 1.2 million barrels per day. The combined outfit will tap between 5-9 billion barrels of proven oil reserves as well as perhaps 100 trillion cubic feet of gas.

The mix includes lucrative exploration contracts in Sakhalin (an island in Russia's Far East) and in western Siberia as well as 2100 gas stations and five refineries in Russia and Ukraine. Slavneft shares owned by AAR are excluded as are Sibneft's warrants convertible to TNK stock. BP keeps out its interests in various local businesses and its sizable oil trading operations in the Russian Federation.

BP will pay $3 billion for its stake in cash and another $3.75 billion in shares over three years. The market valuation of BP's stock is at an ebb - but some analysts say that, in a world of rising global tensions and surging oil prices, the deal may yet turn out to be a masterstroke. BP's earnings jumped a whopping 49 percent in the fourth quarter, they point out.

But the far likelier scenario is less friendly.

BP was forced - by a series of humiliating revisions to past released figures - not to set a future production growth target, merely claiming to be in a "strong competitive position". Moreover, when the change in the value of its oil inventories is stripped, the company's profits last year are down by a quarter compared to 2001.

Its return on capital also plummeted from 19 percent in 2001 to 13 percent the year after. Dwindling margins in refining and retail - mainly in the USA - threaten the viability of these operations, though they have been improving as of late. Only hefty reserves and a higher dividend cushioned the - widely expected - decline in net earnings.

According to the Dow Jones Newswires, the energy behemoth embarked on an ambitious $2 billion share buyback plan. BP has withdrawn from the Russian market posthaste, having been scorched by shady dealings in Sidanco, a tenth of which it acquired in 1998. At the time, it claimed to have been defrauded by the very partners it has taken on board in the current collaboration.

But it now firmly believes that its Russian re-entry is auspicious: "The deal would be immediately accretive to cashflow, earnings per share and return on capital employed, and it expected to improve performance significantly over the next four years through synergies, cost reductions and output growth."

Alas, life - let alone Russia - are far more complicated.

In the proposed partnership, BP is paying c. $3 per barrel. It stands to gain c. 500,000 barrels per day from the joint venture. Only two fifths of this quantity can be exported as crude and another 15 percent as refined products. The rest must be sold domestically at artificially subdued prices.

Russia is already flooded with c. 170 million barrels of unsold oil, in no small measure due to an ongoing conflict between private producers and the country's state-owned pipeline monopoly, Transneft. LUKoil foresees an increase of yet another 130 million barrels by November, according to the New York Times.

With the indigenous market thus saturated, any post-war plunge in world prices could prove calamitous to BP.

As Venezuela's output recovers, the weather warms, the global recession deepens, and a regime-changed Iraq rejoins the world market, an oil glut is in the cards. Despite crude's currently bloated price, OPEC has been talking about production cuts to sustain a level of $18-20 per barrel.

Russia is unlikely to support such a policy.

Its dependence on oil has matured into a full-fledged addiction in the last three years. Russia's budget assumes an average price of $21.50 per barrel. Its production is also more rigid than Saudi Arabia's. It cannot turn extraction on and off at will. Output increased by 9 percent last year.

Additionally, Russia will gleefully leverage the fortuity of a crumbling and internecine OPEC into gaining the number one oil producer spot by increasing its market share. BP may find this policy reckless and shortsighted but still be forced to cooperate with it to the detriment of its long-term interests.

Analyst Frederick Leuffer of Bear Stearns reiterated his "outperform" recommendation for BP's shares before it embarked on the Russian joint venture. The analyst predicted "restructuring and capital expenditure reduction initiatives shortly ... the company (is expected) to redeploy proceeds and cash flow towards share buybacks and dividend increases." These seem less likely now. BP is also involved in other costly projects in Georgia, Ukraine and the countries of the Caspian Basin.

This pervasive exposure to the east is nothing short of a gamble.

BP's attempts to minimize the weight of its latest foray into Russia is disingenuous. Once concluded and cleared by competition authorities in the Russian Federation and the European Union, this single venture will account for one third of British Petroleum's reserves and one seventh of its production.

BP's traditional haunts in the North Sea, the Gulf of Mexico and Alaska are mature and extraction may become prohibitively expensive at much reduced crude prices. But the company is endowed with massive - and oft-replenished - reserves. it is also geographically diversified. Its output is poised to grow by one fifth, to 4.3 million barrels per day, within 3-4 years.

So, why risk another round of bad governance, venal bureaucracy, oil transport monopoly, obstructive local partners, corrupt judiciary, capricious legislation, restive employees, organized crime and cunning competitors? In short: why risk Russia?

Virtually all other oil majors steered clear of Russia and chose to invest in countries like Kazakhstan, or Azerbaijan. BP's move is driven by an unorthodox assessment that the Caspian is over-rated and that black gold is to be found in the Far East. Russia's low cost of production and its enormous reserves make it as attractive as the Gulf once was.

And Russia is changing for the better. BP implausibly claims that the country is now a stable and promising investment destination. This may be going too far. But alternative crude transport infrastructure is being put in place - from pipelines to deep sea harbors. Corporate governance has improved. The oil sector is almost entirely private. Awareness of property rights has grown.

BP's shares went up a mere 4 percent following the announcement. This cautious welcome reflects the uncertainty surrounding the company's strategy. In ten years time, its managers would be either praised as visionary pioneers - or castigated as gullible dupes who were taken for a second ride by the very same partners. Time will tell.

Also Read:

Russian Roulette - The Energy Sector

Russia's Israeli Oil Bond

Lukoil's Changing Fortunes

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