Power Play

By Peter Gumbel

On the last Wednesday of September, Russia's second largest oil company, Lukoil, hoisted the Stars and Stripes up a flagpole outside its Moscow headquarters to celebrate a landmark deal: with a $2 billion bid, the U.S. firm ConocoPhillips had just won an auction for the Russian government's 7.6% stake in the firm. The two companies promptly announced a strategic alliance to develop oil reserves in the Russian Arctic and potentially work together in Iraq. For Jim Mulva, Conoco's president and chief executive, the deal amounted to a coup, giving Conoco access to 8 billion bbl. of proven oil reserves at relatively modest cost. Lukoil was delighted too because it is counting on the Americans to help it extract and market the oil more efficiently. But as Mulva and Lukoil president Vagit Alekperov toasted their accord with champagne, they were careful not to mention the one issue that overshadows the future of the Russian oil industry: the fate of Lukoil rival Yukos, the largest and most successful Russian oilcompany, which is being hounded out of business by the Kremlin.

A year ago, Mikhail Khodorkovsky, a billionaire who had built Yukos into an energy powerhouse, was arrested and put on trial for alleged fraud and tax evasion, charges he says were trumped up. Since then Yukos has been hit with a $17 billion bill for back taxes, and the government is threatening to auction off the company's most valuable asset to pay them. Most Yukos accounts have been frozen, making it hard to pay suppliers and staff. But the company has called a shareholder vote for December to decide whether to file for bankruptcy protection; a principal reason it hasn't already done so is that a majority of board members believe it would be impossible to find a Russian court willing to approve the petition. Indeed, the day before Conoco signed the Lukoil deal, the Moscow court where Khodorkovsky is on trial refused to allow a former German Justice Minister serving as an official European human-rights representative to speak with him. The Yukos case "has set the Russian judicial system back a decade," says Sarah Carey, a Washington lawyer who serves on the Yukos board. The company, she adds, "is like the mouse being tortured to death by a cat--or a tiger."

It's an odd time for an oil rush. The West's leading oil companies are making a run for Russia just as President Vladimir Putin consolidates his power and reasserts control over the energy business (among other things). In recent months, Putin has muzzled the independent press and abolished popular elections of regional governors. Western companies may rationalize that increased government control over the press won't affect their deals, but interference in the economy--increased restrictions on foreign ownership, the assault on Yukos and big shifts in taxation--has raised concerns about Putin's commitment to the rule of law. Many Russians are voting with their wallets. This year capital flight will easily exceed $10 billion, up from $2 billion last year. Even some top officials have misgivings. Andrei Illarionov, Putin's chief economic adviser, said recently that the Yukos affair is "a Pandora's box, and it was a serious mistake to open it." Why, in such a seemingly hostile and risky environment, does Big Oil think Russia is a good investment?

The answer: the opportunities seem to far outweigh the risks. The major oil firms are under intense pressure from investors to find new reserves--now. With near record crude prices and Iraq in turmoil, Russia's vast untapped wealth of oil and gas has never looked more attractive. To be sure, there are production challenges: many of the reserves are located in remote locations deep in Siberia or above the Arctic Circle, and transport depends on clunky Soviet-era railways and pipelines whose leaks are frequently decried by Greenpeace and other environmental activists. Nonetheless, the Western oil companies are eager to export Russia's oil reserves, which are conservatively estimated at 70 billion bbl.--more than double those of the U.S.

So the oil companies are piling in. In addition to the Conoco deal, Britain's BP is investing a whopping $7 billion in a joint venture that controls huge fields in western Siberia, and in September France's Total agreed to pay $1 billion for a 25% stake in Novatek, Russia's largest private gas producer. Many other companies, including ChevronTexaco, PetroCanada and Norway's Statoil, are trying to get a foothold. All three recently signed preliminary agreements to work with state-controlled Gazprom, an oil-and-gas behemoth in which Germany power company E.On holds a 6% stake. There is widespread speculation in Moscow that Sibneft, an oil company controlled by billionaire Roman Abramovich with proven reserves of 4 billion bbl., could be in play. Sibneft was scheduled to merge with Yukos until Khodorkovsky's troubles erupted. Abramovich and Yukos jostled for power for weeks afterward, until the merger finally unraveled earlier this year, prompting speculation that Sibneft may be looking for a Western buyer.

Oil-industry executives describe the Yukos crackdown as an isolated event--a Russian oligarch incurred the wrath of the Kremlin because he got too big for his britches--not a concerted attack on the oil sector as a whole. Few top executives will talk about Yukos publicly, and most oil companies won't comment on their Russian investment strategies. But John Browne, BP's chairman, has defended his company's deal. "At present, I would say--and I believe this will continue--that there has been no effect" on BP's Russian venture from Yukos, he said earlier this year. That ties in with a common theory in Moscow that Khodorkovsky ran afoul of President Putin because he climbed into politics by financing opposition parties in last year's election.

Whatever the reason for the attack on Khodorkovsky, his supporters say the real issue is the rule of law, which affects all business. They cite what they say are the Kremlin's numerous violations of both Russian law and general business ethics, including intimidating raids on Yukos offices by armed security forces in balaclavas, harassment of the company's attorneys and the selective, retroactive application of new legal principles. If the Russian state can come down so heavy-handedly on one firm, the pro-Yukos camp argues, everyone is at risk. "It would be a very brave person that concluded Mr. Khodorkovsky is the end of the trail," says Tim Osborne, managing director of Menatep, an investment fund created by Khodorkovsky and his allies that owns 61% of Yukos.

Putin has said he wants to encourage Western investment in Russia and has no intention of destroying Yukos. Russian officials say the back-taxes claim is based on an official audit.

But Big Oil is also facing renewed Kremlin oversight of oil and gas production. After a period of privatization and deregulation in the 1990s, oil-industry specialists say, the pendulum has swung the other way. That doesn't mean the central government wants to nationalize all energy assets, but it has put an end to generous tax breaks and has introduced other limitations on the private sector, particularly foreign companies. Under the terms of the Conoco deal, for example, the American company can raise its stake in Lukoil--but only to a ceiling of 20%. That's less than the 25% it needs to be able to block strategic company decisions. BP, by contrast, whose contract was signed eight months before Khodorkovsky's arrest, has a 50% share in its Russian joint venture. (The company's Russian minority shareholders are howling because BP uses a complicated transfer-pricing method that allows the parent company, instead of subsidiaries, to book the lion's share of profits.) "That's a deal we won't see repeated," says Jonathan Stern of the Oxford Institute for Energy Studies. "The climate now is for strategic minority investments by foreign companies in Russian energy." Says William F. Browder, president of Hermitage Capital, an investment group based in Moscow: "For foreigners, the opportunities are dwindling very quickly."

Big Russian firms are stepping in where foreign companies find it harder to tread. Foremost among them is the giant state-controlled Gazprom, whose gas reserves were recently valued at $78 billion and which is actively pushing to become a big player in the oil market. It is merging with Russia's seventh largest oil company, state-owned Rosneft, and Alexei Miller, Gazprom's chief executive, has signaled his interest in another oil producer, Zarubezhneft. Most dramatically, Gazprom has emerged as the best-positioned candidate to acquire the company that forms the core of Yukos--a Siberia-based corporation called Yugansk Oil & Gas--if the government auctions it off. Yukos says a forced sale of Yugansk, which reportedly may be priced way below market value, would violate Russian statutes that stipulate that noncore assets be sold first in the event of tax claims. "This has nothing to do with taxes and everything to do with expropriation," argues Robert Amsterdam, a Toronto-based lawyer for Khodorkovsky.

There's a particular irony in the Russian-oil story because it was Khodorkovsky--now behind bars--who first demonstrated to the world just how viable Russian oil can be. Back in the 1990s, that wasn't self-evident. The collapse of the Soviet Union was accompanied by a slide in Russian oil production, from a peak of almost 11 million bbl. per day in 1987 to just 6 million in 1996. Yukos blazed the trail--and helped reverse the oil slump--by investing heavily in existing fields in Siberia, bringing in Western technology and dozens of American and other experienced foreign managers. Partnering with Schlumberger, a U.S.-based oil-field-services company, Yukos became the biggest Russian player, accounting for 20% of total production. At a presentation at a Lehman Bros. energy conference a month before Khodorkovsky was arrested, Yukos boasted that its oil production was growing 20% a year while operating costs were less than half those of the biggest U.S. firms, including ExxonMobil, Chevron and Conoco. With Yukos mired in political trouble, its production gains have ceased. But its five-year run has borne fruit: since 1998, Russian oil production has risen back to more than 9 million bbl. per day, and according to independent estimates, Yukos is single-handedly responsible for more than a third of that increase.

The experience of BP suggests that Yukos' success with modern production techniques wasn't a fluke. After a year of operations, BP recently gave the first detailed report about its joint venture, called TNK BP. The surprises are all good: it has revised the level of reserves upward, production growth is well above the expected 7% annual increase, and the firm has decided to double its capital spending to make more of the opportunities it is finding. In the Soviet era, BP officials explain, oil wells were developed in a cookie-cutter approach that didn't customize extraction techniques to the needs of individual fields. By tailoring solutions to each reservoir and well, the officials say, it's possible to exploit them far more productively.

But BP has also run into the difficulties foreign companies typically face in Russia, from a volatile economy to unreliable partners. The company's first foray into the Russian market, in 1997, ended badly after a firm in which it took a 10% stake went bankrupt. At the time, oil was near $10 per bbl., the Russian economy was sliding into crisis, and BP found its stake wasn't big enough to influence management of the company, called Sidanco. BP also ended up at loggerheads with other Russian shareholders at Sidanco, members of the private Alfa investment group headed by billionaire Mikhail Fridman. But Sidanco got back on its feet, and despite the earlier disputes, BP agreed to team up with Alfa to do the much bigger TNK deal. To help mitigate the political risk, BP took pains to keep the Russian government informed, and the final agreement was signed during a state visit by Putin to Britain. "Clearly, we needed to make sure the Russian state was not surprised by anything we did at any stage," says an executive involved in the transaction.

Yukos, by contrast, says it can't get through to the authorities, no matter how hard it tries. It has proposed settling its tax dispute, even offering to give up substantial ownership, to no avail. Lawyers for Khodorkovsky have filed a formal complaint at the European Court of Human Rights in Strasbourg, France, alleging unlawful detention, and Yukos' lawyers are bracing for the forced sale of the Yugansk subsidiary later this month. "Whoever buys it will be buying an enormous set of lawsuits," warns Stuart E. Eizenstat, a former U.S. Under Secretary of State who is advising Yukos shareholder Menatep. But prospects seem grim. Says Menatep's Osborne: "Grinding remorselessly toward the breakup of Yukos seems to be the Russian government's position at the moment. I am less optimistic with every passing day." For the moment, that's a message the Russia-bound oil companies are choosing not to hear.