Russia: Grabbing the Ring

Russian Energy: Grabbing the Ring

Summary

Consolidation is the catchphrase in the Russian energy industry. The government is aggressively taking back centralized control over the entire sector, and has already completed the reintegration of one-time powerhouses such as Yukos and Sibneft into state structures. The pace of this centralization is about to quicken as power struggles within Russian President Vladimir Putin's inner circle sharpen factional desires for expansion.

Analysis

The Russian government has steadily extended its reach over the country’s energy industry over the past four years, building its state companies into major global players. Originally, the logic for the expansion was nationalist and political. Russian power players were incensed that oligarchs (or even worse, foreigners) were able to profit from private ownership of the country’s oil wealth -- and by consolidating, the Kremlin gained access to a powerful tool for influencing the behavior of the European states downstream.

But now there is a new logic in the nationalization process: political competition. Within Russian President Vladimir Putin's inner circle there are <a href="Story.neo?storyId=286446">two power centers</a>. The first, comprising First Deputy Prime Minister Dmitry Medvedev and Deputy Chief of Staff Vladislav Surkov, is the power behind Gazprom, the Russian state natural gas mammoth. The second, comprising Sergei Ivanov and Igor Sechin -- who share Medvedev and Surkov’s titles, respectively -- controls Rosneft, Russia’s major state oil firm.

The Gazprom and Rosneft teams are more than simply two adversarial state companies. They are the two factions struggling to succeed Putin as Russia’s next president, with Medvedev and Ivanov as the candidates and Surkov and Sechin as the powers behind the throne. For these teams the Gazprom/Rosneft tussle is more than simple one-upmanship; it is the most clear-cut and public means of evaluating who is doing better at consolidating power. (Note that the firms’ CEOs -- Gazprom’s Alexei Miller and Rosneft’s Sergei Bogdanchikov -- do not play a major role in this political tussle ... although they do despise each other, adding a personal twist to this economic, strategic and political competition.)

With presidential elections (read: Putin deciding to whom he should give his office keys) slated for March 2008, the next eight months will see a flurry of activity as the two teams compete for the energy industry. And the completion of elections will not halt the contest. Putin has explicitly attempted to <a href="Story.neo?storyId=288075">balance the two factions</a> so that neither is all-powerful once he steps down. The two teams are likely to spend the rest of 2007 intensifying their efforts and trying to overturn Putin's carefully laid plans in order to enhance -- or defend -- their positions.

To date only two major private energy players have been reincorporated into state structures, and these two provide the blueprint for future reintegrations.

The first is Yukos, whose leader -- Mikhail Khodorkovsky -- found out exactly what happens to those who < a href="Story.neo?storyId=216259">meddle in Russian politics</a> without the Kremlin's express approval, direction and sponsorship: They find themselves tossed in prison, subjects of trumped-up charges, with their wealth confiscated. This is not to say that Khodorkovsky was an innocent man. He was a Russian oligarch, and like all Russian oligarchs he made his fortune by robbing the Russian state blind and then evading taxes. But among the major energy oligarchs he was the only one prosecuted, and that only happened because he did not choose to follow the Kremlin’s lead. Nearly all Yukos assets now rest on Rosneft’s balance sheets, with the last bits only being acquired at auction within the past few weeks.

The second example is Sibneft. The oligarch behind Sibneft -- one Roman Abramovich -- was just as manipulative and theft-prone as Khodorkovsky, and unlike Khodorkovsky he did not demonstrate a particularly deep penchant for reinvesting in his company or even making a semblance of effort to pay his taxes (in fact, his tax evasion ethic was certainly the most impressive of all the oligarchs). But he did not evade the Kremlin’s political dictates. Instead he put his hardly minor manipulation skills at the Kremlin’s disposal and <a href="Story.neo?storyId=225225">played a critical role</a> in engineering Khodorkovsky’s downfall. As part of a severance deal, Abramovich sold Sibneft to Gazprom for a tidy sum and was allowed to move most of the proceeds offshore to his new life in the United Kingdom as the kingpin of the Chelsea soccer club.

Note that neither Gazprom nor Rosneft has a track record of investing in and/or advancing its own technological prowess -- and neither company has significant plans to do so. The firms' plan is to leverage their political connections to expand operations by mergers, takeovers and, in some cases, methods that blur into an area that looks a lot like outright nationalization or even theft. Russian energy firms' options are collaboration and departure, or resistance and disembowelment.

What follows is how these options are likely to be applied to Russia’s remaining independent energy players, in approximately the anticipated order in which the "remedies" will be applied.

Russneft

Almost certainly, the first firm to find itself in need of a change of stationery will be Russneft.

<a href="Story.neo?storyId=283721">Russneft</a> is controlled by its president and founder Mikhail Gutseriev. Unlike many other Russian businessmen, Gutseriev does not owe his success to ties with the Kremlin. In fact, he is neither a friend of Putin's inner circle nor the pawn of a larger Russian oligarch. Gutseriev's secret is foreign support in the form of Glencore, the Swiss-based resources-trading firm founded by the infamous American power peddler (and Bill Clinton pardonee) Marc Rich. It was Glencore which supplied Gutseriev with the majority of the financing he needed to build Russneft into the firm it is today.

Gutseriev’s career in the oil business began in 2000, when he became president of Slavneft, a Russian-Belarusian state-owned oil firm. Gutseriev left Slavneft shortly before half of it was privatized in 2002, about the same time that several Slavneft assets went missing. (At privatization Slavneft was split 50/50 between private oil majors TNK and Sibneft, and is no longer an independent entity.) After leaving Slavneft, Gutseriev founded Russneft -- and those missing Slavneft assets reappeared under his stewardship, just on the books of a new firm. Since then Russneft has expanded to become Russia's ninth-largest oil producer -- its 2006 its reserves reached 4.6 billion barrels of crude, while output reached 340,000 barrels per day (bpd) -- and the firm also holds 9 percent of Russia's gasoline retail market.

Russneft appears about ready to be swallowed by Rosneft, in part because Gutseriev had the temerity to challenge Rosneft for the ownership of some assets Rosneft was seeking. Those clashes ended Gutseriev’s ability to fly under the Kremlin’s radar, and now he -- and Russneft -- are squarely in the Kremlin’s sights.

The government has already charged Gutseriev with illegal business practices and tax evasion and is using government ownership of some Russneft debt as leverage against the company itself. That state of affairs has come about because Glencore found something in Russia that it wanted more than an overbold oligarch. When in early 2007 Glencore’s Russian assetswere merged with Russian state-owned aluminum companies RUSAL and SUAL, the Russian government ended up holding nearly $800 million of Russneft’s total $2 billion in debt. Given Gutseriev’s (recent) history of looting state assets and the uncomfortably complete information on Gutseriev’s activities that the debt transfer has provided Russian investigators, Russneft is almost certainly about to fall into Rosneft’s hands.

Transneft

And right after the keys to Russneft are handed over, Transneft will follow suit. Transneft is neither private nor actually an oil company; it is Russia’s state-run oil transport monopoly and controls the country’s 50,000 miles of oil and oil product pipelines. The issue with Transneft isn’t the Kremlin versus the private sector with some oligarch on the firing line -- it is exclusively Rosneft versus Gazprom.

Gazprom owns the world’s largest natural gas transmission system and uses that control to maintain its monopoly on Russia's natural gas exports. Domestic prices are tightly regulated, meaning that Gazprom’s profits on Russian sales are minimal to negative. By maintaining a monopoly on exports, Gazprom can prevent other Russian energy firms from undermining its primary source of income.

But such control also brings a great deal of political power; Gazprom can use the network to selectively allow or bar any firm with an interest in natural gas to buy or sell the stuff. In Putin’s mind, ownership of this network is perhaps Gazprom’s greatest strength. And since Putin wants Rosneft to balance Gazprom's power, it only makes sense that Rosneft get its own network -- particularly now that Gazprom is now a major player in the oil markets as well (due to its acquisition of Sibneft, which at the time of purchase produced 910,000 bpd).

And Putin wants Transneft to get its own network soon. If Transneft is not transferred to Rosneft before the elections, then Rosneft will not be viable as a political counterweight to Gazprom.

TNK-BP

The next company likely to go is Russia’s largest foreign investment, the joint Russian-U.K. firm TNK-BP.

Russian firm TNK and U.K.-based supermajor BP formed the 50/50 joint venture <a href="Story.neo?storyId=210591"> in 2003</a> in a deal personally brokered by Putin and U.K. Prime Minister Tony Blair. Ultimately, therein lay the seeds of the firm’s upcoming destruction.

In Russia, deals are personalized to the point that they are only enforceable so long as the parties to the deals are alive or, in foreigners' cases, in power. For example, when Putin became president in 2000, outgoing President Boris Yeltsin made him promise that he would not prosecute Yeltsin's "Family" or associates as long as they did not get in Putin’s way. Yeltsin died April 23, bringing that longstanding protection to a close. The Putin government is now moving against a number of "Family" interests and explaining precisely what the rules of the game now are.

In BP's case, the situation is broadly similar. The two key personalities who met with Russian businessmen and Putin to negotiate the deal -- BP CEO John Browne and Blair -- either have already resigned (Browne on May 1) or are about to (Blair by the end of June). Their absence ends their political cover; thus, TNK-BP is now up for grabs.

Browne saw these Kremlin problems coming and so hoped to forestall the attack by making a proposal to Putin in person. He offered to put TNK-BP at the Kremlin’s disposal, so that the Kremlin could use TNK-BP as a counterbalance to both Rosneft and Gazprom. Intriguing as Putin might have found the possibility, he turned it down, sealing TNK-BP’s fate. Moreover, the BP board had never been particularly thrilled with Browne’s adventure into Russia, and Browne’s last-ditch effort to save the Russian subsidiary by enmeshing BP in the heart of intra-Kremlin power struggles almost certainly sealed his personal fate as far as the BP board was concerned. (Bear in mind that Browne suddenly “resigned” a year earlier than planned, ostensibly for personal reasons.)

Which means that all remains is for the Kremlin to decide what to do with this joint venture. Luckily, a certain amount of helpful structure (from the Kremlin’s point of view) was worked into the merger documents. In December the merger’s “lock-in” period ends -- until then neither TNK nor BP can sell their shares to anyone else. At that point the Russian authorities can push the Russian oligarch behind TNK -- one Mikhail Fridman -- to part with his share.

Fridman was brought into the Kremlin power centers <a href="Story.neo?storyId=228649">to help counterbalance</a> the now-weak factions from St. Petersburg (primarily economic reformers) and the siloviki (primarily nationalists). Now that both factions are firmly in check, to be perfectly blunt, Putin does not need Fridman anymore. However, since Fridman was helpful, it is unlikely that Putin will toss him into a Siberian cellblock.

Once December rolls around, Gazprom is likely to make (what it sees as) a relatively generous offer that Fridman dare not refuse, and begin to fold TNK-BP into its own oil operations. At that point the BP board will face a harrowing decision: walk away from an investment into which they have to date poured more than $10 billion; or become minority shareholders in a government firm with a reputation for bullying anyone it can, and watch their investment sink into the cloudy netherworld of Russian “bookkeeping.”

Surgutneftegaz

In many ways, TNK-BP will open the floodgates. Since it is half foreign owned -- and since its formation was personally midwifed by a foreign prime minister -- breaking TNK-BP down is not something that will be done lightly. But once that decision is taken and implemented, the calculus will change, and targets that were once taboo will be re-evaluated. And if taking over such targets kills two birds with one stone, they will go from being resistant to takeover to being exceedingly vulnerable.

The firm likely to follow TNK-BP -- and this is not likely to happen until after Putin’s transition of power is complete -- is one that has kept its head down: Surgutneftegaz, owned by Vladimir Bogdonov.