A Russian Roulette

II. State within a State - The Energy Sector

By: Sam Vaknin, Ph.D.

Also published by United Press International (UPI)

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Written February 2002

Updated May 2005

The pension fund of the Russian oil giant, Lukoil, a minority shareholder in TV-6 (owned by a discredited and self-exiled Yeltsin-era oligarch, Boris Berezovsky), forced, in February 2002, the closure of this television station on legal grounds. Thus was fired the opening shot in the re-politicization of the lucrative (and economically pivotal) energy sector in Russia.

Gazprom (Russia's natural gas monopoly) has done the same to another television station, NTV, in 2001 (and then proceeded to expropriate it from its owner, Vladimir Gusinsky).

Gazprom is forced to sell natural gas to Russian consumers at 10% the world price and to turn a blind eye to debts owed it by Kremlin favorites.

But the sector is still in flux, reflecting the shifting fortunes of oligarchs and bureaucrats in Putin's Byzantine court.

On May 15, 2005 Gazprom surprisingly announced that it is calling off a Kremiln-supported proposed merger between itself and another Russian oil giant, Rosneft.

The fate of Yuganskneftegaz, the prime subsidiary of the now bankrupted Yukos, is also still undecided - though technically, it was purchased by Rosneft in a pretend "auction".

Mikhail Khodorkovsky, erstwhile oil magnate and largest shareholder-cum-CEO of Yukos, is largely out of the picture, his punishment for having dared to challenge President Putin, however obliquely. But members of President Putin's St. Petersburgh "clan" (clique and camerilla), Gazprom CEO Alexei Miller and Rosneft CEO Sergei Bogdanchikov, are at each others' throats.

It is, therefore, clear that Lukoil and Gazprom are used by the Kremlin as instruments of domestic policy - and by political factions, both pro and anti-Putin as pawns on an ever-shifting chessboard.

But Russian energy companies are also used as instruments of foreign policy.

A few examples:

Russia has resumed oil drilling and exploration in war-ravaged Chechnya. About 230 million rubles have been transferred to the federal Ministry of Energy. A new refinery is in the works.

Three years ago, Russia signed a production agreement to develop oilfields in central Sudan in return for Sudanese arms purchases.

Armenia owes Itera, a Florida based, Gazprom related, oil concern, $35 million. Originally, Itera has agreed to postpone its planned reduction in gas supplies to the struggling republic to February 11, 2002. Then it became a rather permanent arrangement, at the Kremlin's behest.

In January 2002, President Putin called for the establishment of a "Eurasian alliance of gas producers" - probably to counter growing American presence, both economic and military, in Central Asia and the much disputed oil rich Caspian basin. The countries of Central Asia have done their best to construct alternative oil pipelines (through China, Turkey, or Iran) in order to reduce their dependence on Russian oil transportation infrastructure. These efforts largely failed (though a new $4 billion pipeline from Kazakhstan to the Black Sea through Russian territory is in the works, having been inaugurated in early 2002). Russia is now on a charm offensive.

Its PR efforts are characteristically coupled with extortion. Gazprom owns the pipelines. Russia exports 7 trillion cubic feet of gas a year - six times the combined output of all other regional producers put together. Gazprom actually competes with its own clients, the pipelines' users, in export markets. It is owed money by all these countries and is not above leveraging it to political or economic gain.

Lukoil is heavily invested in exploration for new oil fields in Iraq, Algeria, Sudan, and Libya.

Russian debts to the Czech Republic, worth $2.5 billion in face value, have been bought in 2002 by UES, the Russian electricity monopoly, for a fraction of their value and through an offshore intermediary. UES then transferred the notes to the Russian government against the writing off of $1.35 billion in UES debts to the federal budget. The Russians claim that Paris Club strictures have ruled out a direct transaction between Russia (a member of the Club) and the Czech Republic (not a member).

In the last decade, Russia has been transformed from an industrial and military power into a developing country with an overwhelming dependence on a single category of commodities: energy products. Russia's energy monopolies - whether state owned or private - serve as potent long arms of the Kremlin and the security services and implement their policies faithfully.

The Kremlin (and, indirectly, the security services, the siloviki) maintain a tight grip over the energy sector by selectively applying Russia's tangle of hopelessly arcane laws. This strategy first saw light in January-February 2002, when the Prosecutor General's office charged the president and vice president of Sibur (a Gazprom subsidiary) with embezzlement. They have been detained for "abuse of office".

Another oil giant, Yukos, long before its systematic looting commenced, was forced to disclose documents regarding its (real) ownership structure and activities to the State Property Fund in connection with an investigation regarding asset stripping through a series of offshore entities and a Siberian subsidiary.

Intermittently, questions are raised about the curious relationship between Gazprom's directors and Itera, upon which they shower contracts with Gazprom and what amounts to multi-million dollar gifts (in the from of ridiculously priced Gazprom assets) incessantly.

Gazprom is now run by a Putin political appointee, its former chairman, the oligarch Vyakhirev, ousted in a Kremlin-instigated boardroom coup. But Miller's relationship with Putin is under strain. Miller's natural (and rapacious) competitors are all Russian - his potential investors and clients all Western. This alignment runs counter to Putin's emphasis on autarky and the unprofitable leveraging of economic assets for political and global purposes.

Gazprom defied Putin, for instance, by brawling over natural gas contracts with Turkmenistan, one of the only remaining Central Asian allies of a geopolitically-dilapidated Russia. With 1.45 million bpd (barrels-per-day) in combined output, Rosneft is emerging as a more reliable - and equally weighty - policy tool.

Media stories to the contrary notwithstanding, foreign (including portfolio) investors seem to be happy. Putin's pervasive micromanagement of the energy titans assures them of (relative) stability and predictability and of a reformist, businesslike, mindset. Following a phase of shameless robbery by their new owners, Russian oil firms now seem to be leading Russia - albeit haltingly - into a new age of good governance, respect for property rights, efficacious management, and access to Western capital markets. Khodorkovskyu, the robber-baron, many whisper, had it coming.

The patently dubious UES foray into sovereign debt speculation, for instance, drew surprisingly little criticism from foreign shareholders and board members. "Capital Group", an international portfolio manager, is rumored to have invested close to $700 million in accumulating 10% of Lukoil, probably for some of its clients. Sibneft has successfully floated a $250 million Eurobond (redeemable in 2007 with a lenient coupon of 11.5%). The issue was oversubscribed.

The (probably temporary) cooling of Russia's relationship with the USA is counter-balanced by Russia's acceptance (however belated and reluctant) of its technological and financial dependence on the West. All said and done, the Russian market is an attractive target.

Commercial activity is more focused and often channeled through American diplomatic missions. The watershed year was, again, 2002.

The U.S. Consul General in Vladivostok and the Senior Commercial Officer in Moscow have announced in 2002 that they will "lead an oil and gas equipment and services and related construction sectors trade mission to Sakhalin, Russia from March 11-13, 2002." The oil and gas fields in Sakhalin attract 25% of all FDI in Russia and more than $35 billion in additional investments is expected.

Other regions of interest are the Arctic and Eastern Siberia. Americans compete here with Japanese, Korean, Royal Dutch/Shell, French, and Canadian firms, among others. Even oil multinationals scorched in Russia's pre-Putin incarnation - like British Petroleum which lost $200 million in Sidanco in 11 months in 1997-8 - are back.

Despite Putin's newly-discovered nationalist "Great Peter" streak, takeovers of major Russian players (with their proven reserves) by foreign oil firms have not abated. Russian firms are seriously undervalued - their shares being priced at one third to one tenth their Western counterparts'.

Some Russian oil firms (like Yukos and Sibneft) have growth rates among the highest and production costs among the lowest in the industry. The boards of the likes of Lukoil are packed with American fund managers and British investment bankers. The forthcoming liberalization of the natural gas market (the outcome of an oft-heralded and much needed Gazprom divestiture) is a major opportunity for new - possibly foreign - players.

This gold rush is the result of Russia's prominence as an oil producer, second only to Saudi Arabia. Russia dumps on the world markets c. 4.5 million barrels daily (about 10% of the global trade in oil). It is the world's largest exporter of natural gas (and has the largest known natural gas reserves). It is also the world's second largest energy consumer. In 1992, it produced 8 million bpd and consumed half as much. In 2001, it produced 7 million bpd and consumed 2 million bpd.

Russia has c. 50 billion oil barrels in proven reserves but decrepit exploration and extraction equipment. Its crumbling oil transport infrastructure is in need of total replacement. More than 5% of the oil produced in Russia is stolen by tapping the leaking pipelines. An unknown quantity is lost in oil spills and leakage.

Transneft, the state's oil pipelines monopoly, is committed to an ambitious plan to construct new export pipelines to the Baltic and to China. The market potential for Western equipment manufacturers, building contractors, and oil firms is evidently there.

But this serendipity may be a curse in disguise. Russia is chronically suffering from an oil glut induced by over-production, excess refining capacity, and subsidized domestic prices (oil sold inside Russia costs one third to one half the world price). Russian oil companies are planning to increase production even further. Rosneft plans to double its crude output. Yukos (Russia's second largest oil firm) was planning to increase output by 20% a year when it was decimated and devoured by Rosneft. Surgut will raise its production by 14%.

In early 2002, Russia halved export duties on fuel oil. Export duties on lighter energy products, including gas, were cut in January 2002. As opposed to previous years, no new export quotas were set since then. Clearly, Russia is worried about its surplus and wishes to amortize it through enhanced exports.

Russia also squandered its oil windfall and used it to postpone the much needed restructuring of other sectors in the economy - notably the wasteful industrial sector and the corrupt and archaic financial system. Even the much vaunted plans to break apart the venal and inefficient natural gas and electricity monopolies and to come up with a new production sharing regime have gone nowhere (though some pipeline capacity has been made available to Gazprom's competitors).

Both Russia's tax revenues and its export proceeds (and hence its foreign exchange reserves and its ability to service its monstrous and oft-rescheduled $158 billion in foreign debt) are heavily dependent on income from the sale of energy products in global markets.

More than 40% of all its tax intake is energy-related (compared to double this figure in Saudi Arabia). Gazprom alone accounts for 25% of all federal tax revenues. Almost 40% of Russia's exports are energy products as are 13% of its GDP. Domestically refined oil is also smuggled and otherwise sold unofficially, "off the books".

But, as opposed to Saudi Arabia's or Venezuela's, Russia's budget is always based on a far more realistic price range ($14-18 per barrel in fiscal year 2002/3, for instance). Hence Russia's frequent clashes with OPEC (of which it is not a member) and its decision to cut oil production by only 150,000 bpd in the first quarter of 2002 (having increased it by more than 400,000 bpd in 2001). It cannot afford a larger cut and it can increase its production to compensate for almost any price drop.

Russia's energy minister told the Federation Council, Russia's upper house of parliament, that Russia "should switch from cutting oil output to boosting it considerably to dominate world markets and push out Arab competitors". The Prime Minister told the US-Russia Business Council that Russia should "increase oil production and its presence in the international marketplace".

It may even be that Russia is spoiling for a bloodbath which it hopes to survive as a near monopoly in the energy markets. Russia already supplies more than 25% of all natural gas consumed by Europe and is building or considering to construct pipelines to Turkey, China, and Ukraine. Russia also has sizable coal and electricity exports, mainly to CIS and NIS countries. Should it succeed in its quest to dramatically increase its market share, it will be in the position to tackle the USA and the EU as an equal, a major foreign policy priority of both Putin and all his predecessors alike.

Part III. The Financial Services Sector

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