Petrostate:Putin, Power, and the New Russia
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While the White Nights project succeeded in producing more than Varyeganneftegaz alone working without Western technology would have been able to do, from the point of view of the Western partners, the project was nonetheless a failure. By the time all the taxes were collected (many imposed just for the occasion), the increased transit fees deducted, and the bureaucrats properly mollified (paid off), there wasn’t all that much left over to share. It was not a gratifying or unique experience.
For more than a decade, another company, Conoco, faced similar problems and similar losses.25 Conoco entered the Russian market as early as 1989. It joined with Rosneft in a venture called Polar Lights in 1991 to develop wells in the Timan Pechora Basin not far from Arkhangelsk.26 Conoco also formed a joint venture with Northern Territories.27
But after unending extortion and interference from various federal and regional government officials, particularly Vladimir Butov, governor of the Nenets Autonomous District that encompasses the Timan Pechora fields, several Western firms including Exxon, Texaco, Amoco, and Norsk Hydro of Norway abandoned similar efforts, including a joint venture called Timan Pechora Co.28 Their run-in with Butov is a good example of the political interference that the oil companies, domestic as well as foreign, often encounter. Butov was elected governor of the energy-rich Nenets region in the northern part of European Russia in 1996. This was despite two earlier criminal convictions. His most recent difficulty in 2002 was the result of his refusal to recognize a Moscow court order that awarded an oil field to a company other than the one he favored.
While the other companies walked away from the millions of dollars they had already invested in the region, Conoco held out. But that was largely because they were stubborn, not because they were making a profit. Among other forms of harassment, Conoco had to deal with six different local taxes, almost all of which, after a time, were increased. By 1999, they found themselves having to pay twenty different taxes.29 The federal government also surprised them by instituting a heavy export tariff after the agreement to begin the joint venture was signed.30 That was not all. Permission to export their output was revoked periodically. They were denied access to the export pipeline. To top it off, one of the fields Conoco had hoped to develop in the Barents Sea was suddenly transferred to a Russian firm without warning or compensation.31 Over the decade, ConocoPhillips, as it is now called, invested $600 million in return for which it earned little and sometimes nothing.32
IF AT FIRST YOU DON’T SUCCEED
Despite these early difficulties, ConocoPhillips decided to try again. As company officials debated whether they should go back to Russia, ConocoPhillips, like other major energy producers, concluded that energy companies seeking new untapped reserves do not have many options, and those reserves they do find are likely to be located not only in difficult geographical areas but within politically problematic countries.33 So after much internal discussion and debate within ConocoPhillips, in July 2004, the CEO of ConocoPhillips, James Mulva, and the CEO of LUKoil, Vagit Alekperov, met with President Putin to ask if it would be okay for ConocoPhillips to spend more than $7 billion to buy up to 20 percent of LUKoil’s stock.34 For ConocoPhillips, despite everything that had gone wrong in the past, this was worth the risk. By investing in LUKoil, they acquired access to crude oil reserves at a cost of $1.70 a barrel. As the going price at the time was around $40 a barrel, that was quite a bargain.35
That both CEOs thought it prudent to check with Putin in advance tells us how central Putin and his government’s role have become in what elsewhere, certainly among the other non-Russian members of the G-8, would usually be a purely commercial decision. But Putin and those around him had earlier signaled considerable displeasure at what, for a time, almost seemed to be a coordinated campaign by foreign energy companies to buy up control of Russian natural resource companies. As we shall see, that was one of the reasons the Kremlin was so concerned about Mikhail Khodorkovsky and the rumors and evidence that he was trying to sell off Yukos, in whole or in part, to Exxon-Mobil and Chevron. To the nationalists in the Kremlin and to the public at large, that was a heretical if not treasonous act. It was bad enough that, also in 2003, TNK (Tyumen Oil) sold half of its interest to BP and allowed BP to become the managing partner after the merger.
The way BP became a major player in Russia makes a good case study of how hazardous such a quest in Russia can be. BP itself did not initially invest directly. Instead, in 1998, it bought up AMOCO, a U.S. company that in 1997 had bought a 10 percent share in Sidanko, a Russian oil company, for $484 million. (We discussed Sidanko’s privatization in Chapter 3.) By resort to chicanery in a bankruptcy court, TNK managed to destroy Chernogorneft, a Sidanko subsidiary, which it then seized from BP/AMOCO for itself. In response, BP/AMOCO decided to play it safe and wrote off $210 million of its investment in Sidanko, not something stockholders like to hear. This was followed by vituperation and lawsuits in U.S. courts against TNK. But as is sometimes the practice in post-Soviet Russia, the fact that businesses are violent enemies one day does not preclude them from holding their noses and forming a partnership the next. Thus, in August 2003, BP and TNK agreed to reconcile their differences and, of all things, form a 50-50 partnership. This cost BP $7 billion but it made geological as well as legal sense as BP’s and TNK’s oil fields were adjacent to each other and coordination rather than competition would be more likely to result in the maximum volume of extraction. But as both BP and ConocoPhillips have subsequently discovered, partnerships with a Russian petroleum company are not always warm and cuddly. Because of almost unbridgeable cultural differences, not to mention the premeditated attacks on one another, as often as not the partners came to feel that their union was more like a shotgun wedding than a marriage made in heaven. Viktor Vekselberg, TNK-BP’s chief operating officer and one of the main Russian owners, acknowledged as much in an interview reported in the New York Times.36
To further complicate matters, President Putin himself has criticized the BP investment. He has also referred to the Production Sharing Agreement (PSA) as “a colonial treaty” and expressed his regret that the Russian officials who authorized such arrangements had not been “put in prison.”37
Cultural differences are not the only hazard faced by Western expatriates working for the TNK-BP partnership. The company has also had problems with Russian government authorities. Although Russia is now more open to foreign business investment—even foreign investment leading to operating and manufacturing control—than in the Soviet era, not everything has changed. The sense of paranoia and xenophobia is still very much alive. Non-Russian executives in TNK-BP, for example, are prohibited by Russian law from having access to official state data about Russia’s petroleum and natural gas reserves. These reserves are regarded as a state secret; foreigners who acquire such data risk being charged with espionage. But how can anyone operate a petroleum or natural gas company without data about that company’s reserves? To avoid arrest, TNKBP buys petroleum reserve data from Western companies. John Grace reports that TNK-BP uses Degolyer-McNaughton or Miller and Lenz. Other maps are also freely available on the Internet.38 Nonetheless, in October 2006, some Russian government officials were charged with turning over state secrets to TNK-BP employees, and some TNK-BP subsidiaries have had their state secret access licenses revoked.39
In yet another reflection of Russia’s historic xenophobia, in October 2007 Putin complained that there were too many foreign managers in senior positions in Russian companies, especially those producing raw materials. As he put it, “a thin top management stratum dominated by foreign specialists” is the reason why Russia imports so many foreign made goods and hires so many foreign specialists.40
In all fairness, the way the Russian government reacts when foreign investors attempt to buy their energy resources is not that atypical of how most countries react in a similar situation. If anything, most members of OPEC, for example, are even more protective. But while Russians restrict what foreigners can do and kno
w within Russia, they see no problem when Russian companies seek to buy energy producers in other countries. Thus, Putin helped LUKoil dedicate one of its new gasoline stations in New York City after LUKoil bought up the Getty oil filling-station network, a long established U.S. business operation. Neither the U.S. government nor the Congress did anything to hamper or limit LUKoil’s acquisition. Of course, LUKoil purchased Getty’s 1,300 filling stations, not its oil wells, which might have triggered a more protectionist reaction. While some Americans would likely react negatively to such foreign investments because of feelings of nationalism and fear, Russian investment in the U.S. energy sector—at least in petroleum production, refining, and servicing—is a good idea. The Russians are more likely to export petroleum to us and avoid any halt in deliveries if they have operations in the United States. Otherwise, some strategists argue, in the event of an embargo these facilities would have to be closed down. At the same time, of course, the properties Russians buy in the United States can serve as hostages if that should ever be necessary to offset similar pressure on U.S. companies in Russia. In any event, U.S. investment in Russian companies and Russian foreign direct investment in the United States symbolizes Russia’s emergence as an economic and a political player of consequence.
IS THIS JUST ANOTHER BLIP?
Given how often runups in the price of energy have been followed by rundowns, might the high energy prices of 2006–2007 be just a temporary increase? During almost all of the previous energy price hikes, it certainly seemed that higher energy prices were here to stay. For that matter, when energy prices subsequently fell, few thought prices would rise again. As a glance at Table 2.1 suggests, however, price cycles, with their ups and downs, appear to be an inescapable part of the world’s economic energy life.
The way economics works, it is to be expected that almost all economists would insist that energy price cycles are inescapable. Energy markets can be likened to the corn-hog cycle that economists teach to their students. When corn is scarce corn prices rise, which makes it too expensive for many farmers to breed hogs. So they kill their hogs, which reduces the demand for corn. This precipitates a drop in corn prices, which makes it cheaper to breed hogs so the demand and the price of corn rise. In much the same way, although you can not grow or kill oil wells like you can breed or slaughter hogs, when energy prices rise, energy becomes too expensive for some users who then look for substitutes or cut back. Not only are there fewer buyers (less demand) at higher prices, but the higher prices stimulate suppliers to offer more for sale. They want to sell more not only to earn a higher profit but also because the higher prices make it profitable to develop substitutes or to open up marginal sources of supply where heretofore the costs were too high to operate profitably.
While the supply and demand process needs no human organizer or controller to make it work, the Saudis have traditionally sought to ensure that swings in the price of petroleum were not too extreme. Consequently, when crude oil prices fall too low, they lobby the other members of OPEC to reduce output in order to tighten supplies and nudge up prices. On occasion, they have acted unilaterally. Similarly, when prices climb too high, the Saudis use their standby capacity to increase output because too great a price rise would stimulate the search for substitute fuels and conservation, measures that could prove hard to undo.
The rapid growth in prices in the early 2000s induced just such a Saudi reaction. After skyrocketing from $15 a barrel in 1998, to $77 a barrel in July, 2006, oil prices leveled off and for a time in early 2007 fell to slightly under $50. At that point the Saudis responded by curbing production by almost 1 million barrels a day (50 million tons) to prevent a further slide in prices.41 But since the Soviet Ministry of Petroleum and now the Russian oil companies are not part of OPEC, Soviet and then Russian producers have traditionally tried to take advantage of Saudi and OPEC cutbacks by doing just the opposite. When OPEC has reduced output the Russians usually have increased theirs. That explains why in late 2006 when the Saudis reduced their output, Russia once again became the world’s largest producer of petroleum.
In post-1998, however, there was something different about the way energy producers and consumers reacted. Producers did increase and reduce output in tandem with price increases and decreases (at least OPEC producers did), and the higher prices did revive interest in and production of renewable biofuel energy substitutes such as ethanol. Yet as prices approached the $100 a barrel mark, there seemed to be a new factor pushing prices to that level. There seemed to be less and less slack in the market. According to calculations of Fatih Birol, the chief economist at the International Energy Agency, the world needs 5 million barrels a day (250 million tons) of spare oil production capacity to avoid energy disruption.42 That is equivalent to almost half of Russia’s annual production. In 2005, there was only 1.5 million barrels (75 million tons) spare capacity.43 Paolo Scaroni, CEO of the Italian energy company Eni, estimates that as of 2006 the world’s spare petroleum capacity had fallen from 15 percent of world consumption to 2–3 percent.44 That suggests that energy prices are unlikely to drop in the near future. What remains to be seen is what sources of supply that before were too marginal will now become profitable and how extensive such new projects will prove to be.
THE NEW DEMAND EQUATION
Equally important, not only did there seem to be less spare capacity but energy consumption seemed to be increasing faster than normal. According to an estimate by Edward Morse, chief energy economist at Lehman Brothers, the investment banking firm, overall world energy demand rose by 10 million barrels a day (500 million tons) from 2000 to 2006.45 Subsequently, the high petroleum price in 2006 precipitated a drop in consumption of 100,000 barrels a day within countries that belong to the Organization for Economic Cooperation and Development (OECD), especially the United States. But as we noted earlier, demand in the developing countries, especially in China and India, rose faster than elsewhere thus offsetting that drop. While petroleum consumption in the United States has risen by 17 percent since 1995 to a massive 20.7 million barrels a day, the comparable figures in India were a 57 percent increase to 2.5 million barrels a day and for China, now the world’s second largest consumer of petroleum, there was a 106 percent increase to 7 million barrels a day.46
It is always risky to predict the future, especially when it comes to the discovery of new energy supplies and energy prices, but the recent very rapid growth in demand within the developing world is unlikely to abate. As the GDP continues to rise rapidly in countries like India and China, their energy consumption is likely to grow even faster as their new wealth brings an even faster demand for energy intensive products such as automobiles, refrigerators, and air conditioners. Because all three items are considered to be icons of the middle class, demand for such products is especially strong. Given that each Chinese consumes the equivalent of two barrels of oil a year and that each American consumes twenty-six barrels, the odds are that even with higher prices, China will substantially increase its energy per capita consumption; this means that future worldwide energy demand will continue to increase rapidly and outpace discovery of new energy supplies.47 It is this demand and supply dynamic that enhances the financial and political clout of energy-rich Russia. Undoubtedly, as is in the past, sometimes there will be an increase in supply and a slowing of demand growth (and even occasionally a decline), but it is the coming of affluence to India and China that changes the equation. As their demand for energy continues to grow, this will provide enormous economic and political opportunity for Russia.
ARE RUSSIAN RESERVES LARGE ENOUGH?
With this new dynamic, future energy markets and supplies are bound to be tighter and substitutes and supplemental supplies harder to find. While this strengthens the hand of all energy producers (and partly explains the behavior and danger of someone like Hugo Chavez in Venezuela), it is particularly important for Russia. Russia is doubly blessed. While its proven reserves of 10.9 billion tons of petroleum or 79 billion barr
els (6 percent of the world’s reserves) are not nearly as large as Saudi Arabia’s 36 billion tons (264 billion barrels), they nonetheless make up 42 percent of the non-OPEC country reserves. Moreover, much of Russia remains unexplored by geologists, and while it is unlikely that there are any giant fields left to be discovered, given high enough prices and the right time and infrastructure there is probably still more petroleum to be found.48
In more recent times, as the country has allowed in Western petroleum companies and their more advanced technologies, companies like BP have found that the reserves they purchased were actually larger than they and the previous Russian operators had originally thought.49 In April 2004, Lord John Browne, then CEO of BP, indicated that TNK-BP, which officially reported it had proven oil reserves of six billion barrels, could actually have considerably more. Although most geologists think it unlikely, Lord Browne said the total could be as high as 30 billion barrels. Robert Dudley, CEO of TNK-BP, predicted that the enhanced recovery techniques used in the West alone would make it possible to increase output by 750 million barrels. Most of the higher estimates result from advanced technology: when BP, with its Western knowledge and equipment, was able to put to work its “stronger pumps and more powerful tools,” it was able “to crack open the underground sandstone,” which holds in the crude oil and which TNK on its own could not tap.50 The expectation is that as technology continues to advance, there will be similar happy surprises.51