Petrostate:Putin, Power, and the New Russia

by Marshall I. Goldman

  To ensure the continuation of the privatization process, Potanin along with most of the other oligarchs used his bank to finance Yeltsin’s presidential campaign effort. They all worked together to defeat Yeltsin’s main rival and critic of the privatization process, Gennady Zyuganov, head of the Communist Party. As a reward for his support, in August 1996, after the election, Yeltsin appointed Potanin first deputy prime minister. After a short time, however, Potanin left office in March 1997 to go back full time into business. He did not return empty-handed. With the help of his Loans for Shares program, Potanin ended up owning twenty former state enterprises. These included not only the petroleum company Sidanko, which in late 1997 joined in a partnership with the British firm BP, but in an equally good deal, he won ownership of Norilsk Nickel, a company that produces one-fifth of the world’s nickel, two-thirds of its palladium, and one-fifth of its platinum. As the profits of his company INTERROS began to grow, he expanded it into foreign markets, including the United States. There it bought up the QM Group, a nickel-producing company in Cleveland, and Stillwater Mining, a palladium and platinum producer in Montana.14

  Given how low the price of petroleum and ferrous and nonferrous metals was in the 1990s, ownership of these Russian companies did not always look like the bargain it would become once commodity prices began to rise and oil prices hit $30 a barrel or more. Yet even in the mid-1990s, when prices were low, there was a growing awareness that the Loans for Shares scheme benefited an opportunistic and unscrupulous few at the expense of the state. More than that, the victors frequently quarreled among themselves and on occasion settled their disputes with mayhem and occasionally murder.

  PLAYING HARDBALL

  None of the oil oligarchs was willing to give a potential challenger the benefit of any doubt. TNK (Tyumen Oil) was particularly aggressive. In one instance that was not widely publicized, NOREX Petroleum of Canada charged that in June 2001, TNK and its parent bank, Alfa, sent in “machine gun-toting guards” to seize the production facilities of Yugraneft in Siberia. NOREX insists that at the time, it owned 60 percent of the shares of the company and that it, not TNK, was the governing partner in their joint venture.15 TNK has justified its decision to send in its armed guards by claiming “that NOREX’s capital contribution in the form of ‘know how’ had been improperly valued.” In other words, NOREX did not own as large a share of the joint venture’s capital as it claimed. Using that as a justification, TNK argued that NOREX was obligated to surrender its operating control of Yugraneft.16 Since NOREX refused to yield control, TNK says it had no choice but to send in its armed persuaders.

  In much the same spirit and in another equally brazen move, TNK also decided to take over ownership of the Chernogorneft oil fields in West Siberia. TNK wanted these fields because they were adjacent to TNK’s big Samotlor Field. It made sense to combine these two fields to prevent one company from attempting to draw oil from underneath its neighbor’s reservoirs. When that happens, the pressure is reduced and output in both fields is less than it otherwise would be. At the time Chernogorneft was owned by Potanin’s Sidanko and Potanin’s new junior partner, the U.S. oil company, Amoco, to which he had sold a 10 percent interest. Amoco in turn was purchased a short time later by BP.17

  To gain control of Sidanco and its Chernogorneft fields, in October 1998 TNK arranged for a minor creditor to sue Chernogorneft in a provincial court for an unpaid bill of only $50,000. Two months later the local bankruptcy judge declared that because it had not paid this bill, even if a trifle, Chernogorneft was indeed bankrupt. (Once a company is declared bankrupt, it is too late for the parent company to try to pay off the debt.) The judge then assigned its assets (which were more than adequate to pay off the rather trivial $50,000) to a creditor who turned out to be a front—surprise, surprise—for TNK. The suit did nothing to enhance Russia’s reputation for adherence to honest and ethical business codes, especially when it became known that the bankruptcy judge was an appointee of Leonid Roketsky, who at the time was governor of the Tyumen Region. That was not the problem. The problem was that in his off hours, Roketsky also just happened to be the chairman of TNK. Simultaneously, a straw subsidiary of TNK bought up 60 percent of Chernogorneft’s debt. By the time the judge was finished, TNK had become Chernogorneft’s effective owner. As a result, BP had to write off $200 million of its investment in Sidanco.

  Seeking revenge, BP launched an attack on TNK that eventually involved both Madeleine Albright, then the secretary of state, and Dick Cheney, then the CEO of Halliburton, the petroleum service company. In an effort to enhance its productivity in its oil fields, TNK signed a $198 million contract with Halliburton for the purchase of its services and access to more advanced technology. To finance this, Halliburton and TNK applied for a loan from the U.S. Export-Import Bank in Washington. Angry that an official agency of the U.S. government had agreed to underwrite what it viewed as the theft of its property, BP protested to Secretary of State Albright, who found a way to abort the loan. After some bitter recriminations on both sides, however, BP and TNK kissed and made up, and in August 2003, in the presence of Vladimir Putin and British Prime Minister Tony Blair, the heads of both companies agreed to form a TNK-BP 50/50 partnership that would operate TNK’s assets under BP management within Russia. BP later encountered some problems as the Russian government adopted a more hostile attitude toward foreign involvement in the Russian energy sector, especially in cases where foreigners own as much as 50 percent of the venture. Despite occasional statements to the contrary, Putin made it very clear that while he was happy to have foreign investors put their money in Russian energy companies, he did not want foreigners running them. In September 2007, he made it explicit, complaining that too many foreigners were managing Russian companies. Reflecting that same xenophobia, there were widespread rumors that Putin would arrange for the state to buy out TNK-BP’s Russian partners.18 Then once it owned 50 percent of the TNK-BP venture, the state would move to reduce BP’s share to below 50 percent or push it out completely. Dick Cheney, of course, went on to become vice president under George W. Bush. Before long, he found himself being blamed because the United States had become mired in Iraq, so neither TNKBP or Cheney has lived happily ever after.

  PETROLEUM OUTPUT DECLINES

  Such infighting did nothing to advance the interests of the state or petroleum production. For eight years oil production continued to decline. By 1998 it was about 60 percent of what it had been at its peak. In desperation to break out of the yearly decline and in an effort to spark new output, just as it had seventy years earlier, the Russian government grudgingly allowed foreign companies such as BP to acquire an equity in Russian energy ventures, especially as it sought to develop some of the more remote offshore and Arctic locations. To make it worthwhile for Western companies to tackle the very difficult working conditions offshore near the island of Sakhalin and in northern Siberia, fields that required technology that Russians companies lacked, the Russian government agreed to sign three Production Sharing Agreements (PSA) with foreign companies, something it had been reluctant to do earlier. A PSA is more attractive to an oil company than a regular operating agreement because it allows the oil company to recoup all of its costs before it has to share any profits with the state. For the same reason, states do not like to make such concessions because they feel they should share immediately in the resulting revenue.

  One PSA was offered to the French company Total as an inducement for it to undertake the development of the Kharyaga field in Timan-Pechora. According to the geologist John Grace, no Russian company seemed to be able to work with the poor quality oil in the field. The other two PSAs were offered in an effort to attract developers to the island of Sakhalin. The first PSA was signed in June 1994 with a consortium led by Royal Dutch Shell, which agreed in exchange to work the Sakhalin II offshore oil and gas fields. Because of the extreme weather, it is impossible to work there in the winter months. Shell agreed to put up 55 percent of the equity with
two Japanese partners, Mitsui, which took 25 percent, and Mitsubishi, which took the remaining 20 percent. Notice that there were no Russian partners in the Sakhalin II project. By contrast, in the Sakhalin I consortium signed a year later, Sakhalinmorneftegaz was included with a 11.5 percent equity and Rosneft with 8.5 percent. But because they too lacked the technology and experience of working in Arctic offshore conditions, it was agreed that Exxon-Mobil would serve as the lead partner with a 30 percent share. The other partners were SODECO, a Japanese company with 30 percent, and an Indian company, ONGC Videsh, with the remaining 20 percent.19

  The Russian government agreed to these PSAs with great reluctance and only because the authorities were so eager to halt the slump in petroleum and natural gas production. Russian oil companies, including Yukos and its owner, Mikhail Khodorkovsky, led the opposition to PSA concessions.20 He and some others viewed the offer of a PSA for a foreign company as a form of unfair competition. But with petroleum prices barely rising above $10 a barrel in 1999 and output 40 percent below its 1987 peak, the prospects for a recovery in petroleum and gas production were not very good. Thus as in times past, Russia was forced to make concessions to obtain the help it needed. However, in a repeat of history, as soon as it felt confident enough to operate on its own, it moved to invalidate those same concessions.

  4

  Post-1998 Recovery

  The Petroleum Export Bonanza

  THE 1998 FINANCIAL MELTDOWN

  The 1998 financial crisis hit Russia hard. There were obvious signs that the Russian fiscal system was in desperate shape, but at the time, few saw that a collapse was eminent.1 Indeed, the almost universal conventional wisdom was that Russia had successfully managed its transition from Communist central planning to market capitalism and that the future was bright. Many had come to believe that Russia had become the next Klondike. They urged investors to put in their money before share prices rose even higher! Only fools and anti-Sovietchiks could think otherwise. Typical were studies such as Anders Aslund’s How Russia Became a Market Economy, published in 1995, and Richard Layard and John Parker’s The Coming Russian Boom, published in 1996. Both appeared just in time for investors to buy in before the financial crash that followed shortly thereafter in August 1998.2 While the economy and its stock market have recovered significantly since then, there were many as we shall see who took their advice at the time and lost considerable sums as a result—in several cases, hundreds of millions of dollars.

  It was easy to be misled. Bullish signs were everywhere. By October 6, 1997, the RTS index, the Dow Jones Index of the Russian Exchange, hit 571, an all-time high. That represented an almost fivefold increase over just a half dozen years. Investors who bought shares on October 31, 1996, in the Lexington Troika Dialog Russian Fund, which invested only in Russian companies, had a threefold increase in one year, a higher one-year return on their investment than stock market investors anywhere else in the world. Bankers in London, Frankfurt, and even New York trampled over each other to buy Russian stocks and lend money to Russian companies and government borrowers. Few could resist the frenzy.

  What such analysts and investors chose to discount or ignore, however, was the deplorable state of the Russian economy. As of 1998, the officially reported GDP, as well as crude oil output, had fallen by 40 percent or more from its 1991 level. At the same time, there was also inflation. In 1992 alone, prices rose twenty-six-fold, and then more than doubled each year for a several years thereafter. By 1997, price increases had moderated to 11 percent a year, an improvement, but by most standards, still high. Overall, by December 1999, it took 1.6 million rubles to buy what 100 rubles could have purchased in December, 1990. Of course there wasn’t much on the shelves to buy in 1990, but be that as it may, this hyperinflation wiped out whatever savings most Russians had built up.

  Nor did it look like inflation would be less of a problem in the future. How could it be, when the government was generating an immense deficit and growing debt each year? Few Russians were paying their taxes and those that made a payment rarely paid as much as they actually owed. Combined with inflation, the underpayment of taxes meant that each year the budget deficit grew larger, which in turn meant that the government had to borrow even more money.

  By mid-August 1998, government authorities concluded they could not continue what, in effect, was “kiting their checks.” This involved writing a check to pay a bill from a bank account with not enough money in it at the time but with the expectation that there would be a check from another bank a few days later, which would cover the first check before it was presented for payment at the first bank. This is done in the hope that neither bank would realize that initially there had not been enough actual money to pay the bill. The Russian Central Bank and the Treasury had simply run out of money to pay the bill. When a government bond matured, the only way Russia could compensate the bondholder was to roll over the loan and issue another bond in the hope that the original bondholder would accept the new bond as a replacement for the old one and not ask for cash. Alternatively, the government could hope that someone new would be foolish enough to buy a new government bond so the funds could be used to pay the first bondholder for the same amount he had paid for the bond, plus interest. But because the revenue the government collected was so little and slow in coming in and the interest rate it had to pay to attract lenders willing to buy those reissued government securities was so high, after a time the government was forced to borrow larger and larger sums of money just to pay the ever-increasing amount of interest. It was a marathon race without a finish line.

  Since this fiscal slight of hand was unsustainable, the government eventually was forced to default on its debt. Simultaneously, it found it no longer had enough dollars to meet the demand of those who wanted to exchange rubles for dollars at the official rate of exchange. In other words, it had also run out of dollars. Unless it acquired enough new dollars, it would eventually have to devalue the ruble and require that those who wanted to buy dollars pay more rubles for them. As of mid-August 1998, because it could not find enough lenders willing to buy new or reissued government securities, combined with the fact that it had run out of dollars and convertible foreign currencies and could not pay its bills, the Russian government, in effect, had become bankrupt.

  It was inevitable that the Ponzi-like scheme the Russian Treasury was running—where each day it had to find more and more new lenders so it could pay off earlier lenders—could not endure. By August 17, 1998, the Treasury and Central Bank were forced to announce that they could no longer redeem the country’s bonds and pay back its lenders. This collapse was precipitated and made even more serious by the financial upheaval that hit Southeast Asia earlier in 1997. As Thailand and what had seemed to be the other dynamic economies of Southeast Asia fell into recession, commodity prices collapsed. Since most of what Russia exported was commodities, this hurt Russian export revenues. When speculators around the world sensed that Russia might also be vulnerable, they began to sell off their Russian stocks and bonds, thereby anticipating and precipitating such a collapse. This increased the hesitancy among those investors and governments who might otherwise have been willing to provide additional financial support. The IMF did provide a last-minute loan, as did Goldman Sachs, but both loans proved to be inadequate and controversial. Because Russian officials met with the owners of some of the oligarch-run banks before the government publicly announced the debt and a foreign currency exchange moratorium, some of the private Russian bankers used their insider information to sell their government securities and cash out their ruble holdings for the dollars sent in by the IMF and Goldman Sachs before outsiders could seek similar protection. This further undermined confidence in both the government and public officials.

  The consequences of such domestic and international economic and financial mismanagement were far-reaching. Since government securities (that is, bonds and short-term securities called GKOs) were the main assets on the balance sheets of m
ost of the country’s banks, and since these securities were now all but worthless, most Russian banks were no longer viable. In all but a few banks, liabilities exceeded assets. Many of the oligarchs who had only recently been at the top of Russia’s income pyramid found their banks were worthless. For a time it looked as if as many as 1,500 Russian banks would have to close their doors.3 In effect, Russia found itself in the midst of a bank holiday similar to the one Franklin D. Roosevelt declared in the United States in the early 1930s. Some bankers, like Khodorkovsky, managed to survive because before his bank Menatep went bankrupt, Khodorkovsky used it to finance the purchase of properties such as the oil company Yukos, which he bought through the Loans for Shares auctions. While most of those companies were not wildly profitable, they made enough to sustain Khodorkovsky’s other operations. But like Menatep, most other banks simply had to close. It did not make Menatep depositors very happy to learn that Khodorkovsky had arranged to transfer the few viable assets that remained out of his Menatep Bank into another financial entity that he operated in St. Petersburg. There they were beyond the reach of all the helpless depositors who had put their money into Menatep.