Russian gambit threatens to change game

07 November 2003
At dawn on 25 October at Tolma-chevo airport in western Siberia, Russian police stormed the private jet of Mikhail Khodorkovsky, chairman of Yukos, the giant oil company. Russia's richest man was arrested and - according to some reports - beaten, before being taken into detention in Moscow where he has since languished, facing charges of fraud, tax evasion and embezzlement.

The arrest may appear to be just the latest twist in the confusing chain of events since the Soviet Union disintegrated and the Communist Party was pushed from power in 1991. But the affair, which escalated on 30 October when Russian prosecutors froze the 44 per cent stake in Yukos held by Khodorkovsky and his partners, could have profound ramifications for major oil companies, petroleum exporters and the price of energy in 2004 and beyond.

Russia's recent history has been a mixture of hope, tragedy and farce. In the past 12 years, new independent states have emerged from the ruins of communism. Former Russian president Boris Yeltsin clowned his way into the hearts and minds of the outside world while the Russian economy collapsed. The Chechen rebellion was countered in a brutal campaign in which thousands of civilians died. What once was the greatest threat to Western civilisation had by the mid-1990s become a sad joke: weak, divided and poor.

This perception has changed since former KGB director Vladimir Putin took over the Russian presidency on New Year's Eve 1999. Since then, Russia has seemingly regained some of her old strength. And oil has been at the heart of that recovery.

The Russian oil industry is the world's oldest, and by 1900 it accounted for a third of world production. The industry was then in foreign hands and the forerunner of ExxonMobil Corporation was briefly a stakeholder until nationalisation in the early 1920s. After 1945, production was pushed higher and it reached a peak of 12.5 million barrels a day (b/d) in 1988 to make the Soviet Union the world's leading oil producer.

Nationalisation was reversed in the economic reform programmes implemented in the 1990s. Khodorkovsky bought Yukos in an insider privatisation deal in 1995 for $350 million. It was one of the bargains of the century. The company has proven reserves of 18,400 million barrels of crude oil - more than Egypt and Algeria combined - and has capacity to produce 2.2 million b/d. It was valued in the autumn at $44,000 million. Earlier this year, Yukos announced it was merging with Sibneft, a firm also privatised in the 1990s and controlled by Roman Abramovich.

The transformation of the Russian oil industry from a state-owned monopolistic system focused on domestic markets into a privately-owned business with international aspirations seemed to have been completed in August 2003 with the finalisation of BP's joint venture with Tyumen Oil Joint-Stock Company (TNK). Russia's third largest oil company, also privatised on the cheap in 1995, is controlled by the Alfa Group chaired by Mikhail Friedman.

The TNK-BP venture is 50 per cent owned by the UK oil firm. Its $6,800 million investment in the business is the largest so far by a foreign company in Russia. TNK-BP has declared oil reserves of 4,100 million barrels and produces 1.2 million b/d of oil. The deal broke the mould for the oil industry and stimulated interest in investing in Russia. At the start of October, it emerged that both ExxonMobil and ChevronTexaco Corporation were well advanced in talks about taking a strategic stake in the firm.

This development seems to have set the scene for the dramatic events last month. The sale of key natural resources at knockdown prices to members of a small group associated with Yeltsin had always rankled with many in Russia. Khodorkovsky, a critic of President Putin, was also dabbling in Russian politics. He started financing opposition parties and, bizarrely, was even considered earlier this year as a possible Communist Party candidate for parliamentary elections next month.

But inviting what many in Russia still consider to be the unacceptable face of American capitalism to take control of part of an industry which is the largest single source of Russia's export earnings, provides 40 per cent of government revenue and accounts for 20 per cent of gross domestic product (GDP) may have been a step too far. The prospect of the former communist and one-time chairman of the Moscow Komsomol, the Soviet-era youth group, also pocketing several billions of dollars in cash or US oil company shares was the final straw for the government, now dominated by people who had leading positions in the security forces before 1991.

The attitude at the top in Moscow was reflected in a Financial Times report on 28 October, which said that senior Russian officials were 'particularly irritated by Khodorkovsky's international activity... To them, he is a stooge of the West who acts in the interest of the US and Israel and who should be squeezed out of the country'.

The affair has shaken foreign investors. It has also highlighted the strategic role oil plays in the Russian economy and the impact its oil industry could have on the world economy. Russia has proven oil reserves of 60,000 million barrels, most of which are located in Western Siberia, between the Ural Mountains and the Central Siberian Plateau. However, some estimates put the figure far higher, perhaps as much as 150,000 million barrels, only behind those held by Saudi Arabia and possibly Iraq.

Increased investment in the industry has led to a remarkable rebound in production, which fell to a low of 6 million b/d in 1996. In 2002, the figure had risen to 7.4 million b/d, making Russia the world's second largest oil producer after Saudi Arabia. According to forecasts from the Russian Energy Ministry, production will average 8.2 million barrels in 2003, rising to 8.8 million barrels in 2004 (see chart, page 4). If that were to happen, Russia will next year overtake the kingdom to become the world's leading oil producer.

The significance of this trend is that Russia is now a major oil exporter. In 2002, it exported more than 5 million b/d of crude oil, again second only to Saudi Arabia, compared with just over 2 million b/d when output peaked in the 1980s. Exports could rise by a further 1 million b/d in 2004.

The privatisation and recovery of Russian oil has put the industry close to the top of the US energy agenda. Concerned about the stability of the Middle East, on which the West overwhelmingly depends for oil and gas, Washington is seeking alternative sources of hydrocarbons. The Russian oil industry, once seen as the motor driving an evil empire, is now viewed by US government and business as an opportunity and a potential partner.

The initial American focus has been on gas in Sakhalin in the Far East and new pipeline projects designed to deliver oil from the Russian interior to export terminals convenient for US markets. The most striking proposal is a 2,500-kilometre line to link Western Siberia with Murmansk. It is being promoted by Yukos with strong support from the US. In a visit to Russia in September, US Commerce Secretary Don Evans called for American companies to be allowed to take a stake in the project. Promoters explicitly state that the scheme's principal attraction is that it offers a shorter tanker route to the US than that used for shipments from the Gulf.

The rivalry between Russia and the Gulf was heightened early in October when the Russian Energy Minister Igor Yusufov said the OPEC price target, reaffirmed at its meeting in September, was too high for consumers. The statement implied Russia would press on with production increases regardless of OPEC. As such, it would have pleased Washington, which is concerned about the impact of higher oil prices on the US economy.

Saudi Arabia's Crown Prince Abdullah visited Moscow in September for talks with Putin about co-operation. The historic visit was the first by a Saudi Arabian of such high rank and Prince Abdullah used it to assure Russia that Saudi Arabia is not supporting and will not support Chechen rebels. But the principal preoccupation appeared to be oil and gas. 'Saudi Arabia views Russia as a partner and not as a competitor in the area of oil,' said Prince Abdullah following the visit.

And yet, the potential for conflict with OPEC - led by Saudi Arabia - has been enhanced by the contrasting attitudes to the role of major oil companies displayed by Moscow and Riyadh in recent months. While Russia has courted big oil, Saudi Arabia in June slammed the door in their faces when it killed the gas initiative. ExxonMobil and BP both signed up to the project in 2001, and their disillusionment over the possibility of Saudi Arabia allowing foreign access to upstream assets is tangible. 'Oil companies have a choice of either being in Russia or the Middle East,' BP deputy chief executive Dick Oliver has said. 'We have chosen Russia for now.'

Hopes that Kuwait would fulfill its upstream promises are beginning to founder on the terms being presented by the government for those wishing to participate in Project Kuwait. BP, ExxonMobil and ChevronTexaco are each leading bidding groups in the initiative.

The new great hope of the Middle East is Iraq, which has the world's second largest proven oil reserves. But here too the dream is fading because of security concerns and uncertainty about Iraqi oil policy. At the end of October, Lukoil, the second largest Russian oil company and one that is still state-controlled, muddied the waters by affirming that its development deal signed with the Saddam Hussein government is still in its view valid and enforceable. The new masters of oil in Baghdad have declared the deal invalid, but Lukoil will press its claim in the courts, thereby making it more difficult for Iraq to do similar deals with international oil companies without Russian acquiescence.

Until October, therefore, Russia appeared to be an answer to an oil man's dreams: vast, underdeveloped reserves in a country open to almost unlimited foreign development. BP chief executive John Browne, bruised by his experiences in the Gulf, succumbed first to the charms of Russian oil. There are now developing fears that its Russian adventure could yet end in tears.

A number of issues are now weighing on the minds of analysts of Russian affairs and oil industry trends. Do the Khodorkovsky arrest and the Yukos share freeze represent the start of a process of oil industry renationalisation? For international investors, this is a prospect almost too horrible to contemplate, but observers are beginning to conclude it cannot be ruled out in a country where state control of industry has been the rule, and not just since the 1917 revolution. Taking back ownership of natural resources which most Russians believe were effectively stolen in the 1990s could probably be a vote winner for Putin.

Even if oil industry nationalisation does not occur, could the Yukos crackdown represent a new Russian approach to oil in which politics will drive production and prices rather than profits? The answer here is almost certainly yes. By November it was evident that a process of bureaucratic assertion was taking place that seems designed to put the state above business and Moscow above the regions.

Finally, is the basis of a deal between Russia and OPEC more likely now that the Russian state has reasserted its position in the energy industry? Oil consumers and their governments sincerely hope not. But there are some common interests between the two countries that are by far the largest oil exporters on earth. A deal involving production restraint to keep prices well above $20 a barrel would make sense to the governments of both Russia and Saudi Arabia. It is also one that could worry Washington, particularly if it serves as a springboard for future shared policies.

The answers to all these questions will have a powerful impact on the oil market for the indefinite future. In the short term, it will determine whether 2004 will be the year of a new oil market share battle between OPEC, led by Saudi Arabia, and non-OPEC, led by Russia, which could drive prices down below $10 a barrel. Russia looks more financially vulnerable than the kingdom and would probably be the first to pursue oil price peace on Saudi Arabia's terms. But Moscow and Riyadh could both be losers in a war over oil prices that need not take place. n

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