Igor Sechin’s appointment as Chairman of the Rosneft Board could be interpreted as a preparatory step to allow the company to take over YUKOS’s assets. Yet can the Russian oil industry maintain efficiency under state control?

Alexander Koksharov

Over the last four weeks, YUKOS has constantly been in the news. The company’s main production assets were frozen, and then unfrozen by the courts. YUKOS’s accounts were also frozen, but then suddenly the block was lifted. This news made many anxious in the West, as the Ministry of Justice decision means that YUKOS will stop oil production (20% of Russian exports). Oil prices in London and New York broke record after record. The Ministry of Justice rejected this interpretation of events. Prices fell. The Sunday papers carried statements from Western and Arab investors that they were willing to pay YUKOS’s back taxes. But by Monday, they had withdrawn these statements. Banks declared default on loans made to YUKOS and then immediately rescinded. The stock market reacted to all these contradictory events: YUKOS stock rose and fell by ten or more percent 22 (!) times.
What was left after all this hemming and hawing? YUKOS still owes the state 99.4 billion rubles ($3.4 billion) in back taxes for 2000. The company has to pay this debt by August 29th. As of the beginning of August, only 30% had been paid. Yuganskneftegaz and Tomskneft’s assets, responsible for 80% of YUKOS’s oil production, are still frozen. The Tax Ministry has already presented YUKOS with a bill for 2001 (another 98 billion rubles) and announced the beginning of its audit for 2002. Total back taxes for 2002-2003 can be estimated at around $8-12 billion.

Assets in limbo

Before August began, many observers still had their doubts regarding Russian authorities’ resolve to liquidate YUKOS. After its main production assets were frozen, these doubts disappeared. “For quite some time, I remained optimistic and assumed that the authorities were fighting Mikhail Khodorkovsky as an individual, which meant there were options for saving YUKOS as a company,” Julian Lee, Senior Analyst at  the London-based Centre for Global Energy Studies. On August 6th, the courts ruled that Yuganskneftegaz and Tomskneftgaz’s assets were to be frozen as “property that cannot be considered basic resources belonging to the primary area of investigation in connection with legislation regarding the executive function.” Thus, YUKOS’s holding structure has played a cruel trick on the company. According to the Ministry of Justice, YUKOS was a corporate shell not engaged in any production activity. As a result, the first item up for sale to pay back taxes will not be the stake in Sibneft YUKOS acquired in 2003, but the company’s stake in its main production assets.
Clearly, without these assets YUKOS will cease to exist in its current form. As YUKOS CEO Steven Theede put it, should YUKOS lose Yuganskneftegaz and the company’s oil fields, YUKOS will be bankrupt in three weeks.
The Arbitration Court’s ruling to overturn the decision to freeze Yuganskneftegaz made little difference. That very day, the Ministry of Justice froze the assets again. “The insistence of the Russian authorities on freezing these assets demonstrates that these assets will be sold first and moreover in the very near future,” Craig Kennedy, an analyst at Morgan Stanley, explained to Expert. In late July, the Ministry of Justice’s Bailiff Service appraised Yuganskneftegaz at $1.75 billion. However, American geological firm DeGolyer & MacNaughton, based on data from YUKOS itself, estimated Yuganskneftegaz’s confirmed reserves at $30.4 billion in today’s prices. Russian and foreign investment banks estimate the company’s market value (taking into account production costs and discounting) at $15-17 billion.
Why does the government believe the company has such limited value? “There are two answers to this question. The first is that the authorities want to make sure Yuganskneftegaz is sold to an oil company loyal to the Kremlin. The second answer is that they don’t want YUKOS to be able to use the proceeds from the sale to pay off all the company’s back taxes, which means the company will go bankrupt,” argues James Neil, an analyst at Citigroup in London.
Last Thursday, the plot thickened further. On August 12th, the Ministry of Justice announced that Yuganskneftegaz could be appraised by the investment bank Dresdner Kleinwort Wasserstein (DrKW). Analysts expect the foreign bank, with a reputation to uphold, to name a price as close as possible to market. This complicates matters, yet the YUKOS Affair has involved so much contradictory information in the last few weeks that it is difficult to see this move as the real deal. Officials are merely buying time. If Yuganskneftegaz were to be appraised seriously, then only a foreign company would be in a position to buy, which would not be profitable for Russia. One way or another, while DrKW estimates the value of these assets (and that means at least two to three months), the authorities will do everything they can to work out a scheme to get them into trusted hands, all the while maintaining the appearance of doing the right thing.

The Sechin factor

Analysts this week were pointing to the state oil company Rosneft as the most likely buyer for both Yuganskneftegaz and possibly other YUKOS assets. The unanimous opinion is the result of recent cadre juggling. On July 25th, Igor Sechin, Deputy Chairman of the Presidential Administration, was appointed Chairman of Rosneft Board. This is the first interest Sechin, Putin’s close comrade and colleague at the secret police, has ever shown in economic matters or the oil industry. “Igor Sechin is one of Putin’s key political allies and friends, which means his appointment to Rosneft, a small oil company, was a serious step down. To all appearances, his appointment is connected to the new role the Kremlin will grant to Rosneft,” explains Christopher Weafer, Chief Strategist for the Analysis Department at Alfa Bank.
It is difficult to see Sechin’s appointment as anything other than a way of prepping the company to take on major oil assets. Especially as tax audits of YUKOS began after Sergei Bogdanchinkov, at that time the president of Rosneft, announced that apparently his company was the primary candidate to receive assets as YUKOS went under.

Dreams and schemes

Just what the Kremlin’s scheme regarding the future of Rosneft is, analysts can only guess. If the government decides not to hire DrKW to estimate Yuganskneftegaz’s value, then the company could be sold to Rosneft for a song. Even if the price reaches a mere $10 billion, the state will have to either invent a more complicated plan or get other loyal oil companies involved, such as Surgutneftegaz, which according to analysts could scrape together about $6 billion in cash.
If Rosneft gets its hands on Yuganskneftegaz, it will instantly become Russia’s second largest oil producer. In production volume, it will be second only to LUKoil. If Rosneft gains control over of the rest of YUKOS’s key assets, it will be number one.
Some analysts take this scenario even further. They are predicting a merger of the newly expanded Rosneft with Gazprom and also with Surgutneftegaz. A merger of this sort seems unbelievable, but the current events surrounding YUKOS would have also seemed preposterous just a year and a half ago. Be that as it may, today we can already speak of the end of the oil and gas industry that emerged in Russia in the 1990s. At that time, the industry was focusing mainly on breaking up monopolies and privatization. Now many in the political elite believe that the oil industry, with its great economic significance for the country, should be under state control. However, though the state might be trying to strengthen its influence, that doesn’t mean that it will completely reject market institutions. Rosneft could go public and part of the company’s shares could circulate on the open market. Nonetheless, the situation in the oil industry will not change radically.
Should YUKOS’s main assets fall into the hands of a state-owned company, a significant part of the oil and gas industry, earning around 55% of Russia’s export income, will wind up under direct government control. The other companies in the industry—LUKoil, Surgutneftegaz, Sibneft, and even TNK-BP—will naturally remain as loyal as possible to the state sector. The first two companies have always been on good terms with the government. Sibneft, which only six months ago was growing aggressively thanks to takeovers and its own reserves, has suddenly disappeared from the news. The English-Russian TNK-BP, which was founded according to some sources with the Kremlin’s blessing, has also proven itself extremely loyal to the authorities in the past six months. Let’s not forget that YUKOS is negotiating with TNK-BP to sell its 53% stake in Rospan. This fact alone demonstrates that TNK-BP feels completely at home in Russia.
If the state gets control of oil, this will substantially change the rules of the game even for loyal private companies. “More likely than not, they will have to pay higher taxes. A stricter concession program will be implemented and the government will play closer attention to licenses, and so on,” believes Weafer. This process is already underway

After YUKOS

“The optimism some felt regarding YUKOS has long disappeared. YUKOS has already been put to rest psychologically. Now everyone is waiting to see when the company will be finally destroyed and some kind of stability will return to the Russian oil sector,” says Laza Kekich, Senior Economist at EIU. This stability will come from a stronger state position in oil. One of the central questions for the Russian economy is how the government will manage the industry. Analysts are not prepared to comment on what model this state-run development might follow, the Venezuelan or the Norwegian one.
The oil industry in Venezuela was nationalized in 1975-1976 and has been run by the 100% state-owned Petroleos de Venezuela (PdVSA) ever since. In the company’s first 25 years of existence, it provided for around 40% of the Venezuelan GDP, maintained a high degree of independence from the government, and made small but stable profits. In the late 1990s, President Hugo Chavez did away with the company’s autonomy. A completely new executive team was brought in and privatization prohibited in the 1999 constitution. Ever since the industry has been destabilized, costs are increasing, and regular strikes have led to dramatic declines in production and exports. As a result, the per capita GDP of Venezuela has not changed in the last five years.
In Norway, the state has always played a leading role in the oil and gas industry. The state company Statoil and partially state-owned Norsk Hydro provide a stable source of income to the budget and state stabilization fund. However, in the late 1990s, the Norwegian government decided to partially privatize the industry. Today, private investors hold 18.2% of Statoil and 66% of Norsk Hydro. The Norwegian government plans to gradually reduce the state’s role in the oil and gas industry, where costs are constantly increasing, and to attract private investment.
“Though in both countries the oil and gas industry was in the hands of the state, their different political cultures led to different results. State companies usually operate according to the dictates of the state, while private companies operate according to the dictates of the market. If the state pursues populist goals, as it did in Venezuela, the state company will suffer financially,” argues Lee at CGES.
Russia’s political culture obviously differs from that of Norway. In the post-Soviet history of Russia, state companies have proven inefficient. Over the course of the 1990s, state-owned Rosneft and partially state-owned Slavneft lagged behind their competitors in every possible way.
“It is highly likely that the state has decided to use the oil and gas industry as a cash cow to modernize the economy. Perhaps the idea is well-meant, but without a full-fledged banking system, it will never become a reality. The most dangerous approach would be if the state were to ignore the interests of the oil industry, which requires significant investments of $10-12 billion a year,” notes Craig Kennedy of Morgan Stanley.
This refers primarily to investment in new oil fields and deposits outside the government’s current sphere of interest. If YUKOS is destroyed, then only the old areas of oil production will be under direct or indirect state control, namely Western Siberia (70% of production) and the Ural-Volga region. New oil areas like Eastern Siberia, Timano-Pechora, or Sakhalin will require significant investment, which in turn demands decisive action. Yet the Russian government is convinced it is broke and has a hard time making strategic decisions. Western oil companies, on the other hand, are accustomed to taking strategic steps. If the old oil-producing areas will be completely divided up among Russian companies, then Western companies will try to get into new areas, despite high costs. “Western oil companies will naturally be wary of conducting business in Russia, but they won’t be able to ignore Russia. Russia is the last virgin territory. Of course, the political risks will be higher, but oil companies have operated under even higher risks,” believes Julian Lee. This is why the arrival of companies such as Exxon Mobil or Chevron Texaco in Russia is merely a matter of time.
Foreign capital could form an outer ring around the Russian core of the oil and gas industry. Part of this outer ring includes the unexploited reserves of Eastern Siberia and increased oil exports to Asia which could have a huge multiplying effect on trade and the Russian economy as a whole.
Russia risks losing its strategic prospects on the world oil market due to this redrawing of the oil industry map and the insecurity of long-term infrastructure projects. At a time when the global demand for oil continues to rise rapidly, the redistribution of property and power continues in Russia, and all strategic issues are postponed until tomorrow. The industry’s new structure will not necessarily provide the requisite level of investment. As a result, Russia is wasting time, money, and potential. It risks remaining a regional oil power with extremely limited ambitions.

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