Petrostate:Putin, Power, and the New Russia

by Marshall I. Goldman

  In addition to its retail presence in the United States, LUKoil, as a national champion, also purchased from ConocoPhillips 376 Jetts gas stations that were located in Belgium, the Czech Republic, Slovakia, Poland, Hungary, and Finland. This is in addition to the refineries it operates—or plans to operate—in Turkey, Kazakhstan, the Netherlands, Bulgaria, Romania, and Ukraine. Before the U.S. invasion, LUKoil also operated in Iraq.

  In all these endeavors, LUKoil consulted with President Putin. It was also careful to ask for Putin’s blessing when LUKoil wanted permission for ConocoPhillips to buy up a substantial percentage of LUKoil stock. Putin agreed but insisted that ConocoPhillips limit itself to no more than 20 percent ownership. He seemed comfortable with an investment of that size. Unlike the TNK-BP arrangement, holding ConocoPhillips to only a 20 percent share was more likely to ensure that LUKoil would retain operating control.

  IS TNK-BP NEXT?

  Putin seemed especially appreciative that LUKoil had the courtesy to ask him for his approval before negotiations were completed, not after, as was apparently the case when BP bought 50 percent of Tyumen Oil (TNK). While Putin attended the TNK-BP merger ceremonies along with British Prime Minister Tony Blair in London, it later became clear that Putin was not happy with this arrangement. TNK made the mistake of not only involving Putin after most of the terms had been agreed to but additionally of allowing BP to take over the company’s management and thus gaining effective control of a valued Russian resource. Officially this was a 50/50 partnership, but under the agreement, BP personnel took over operating control of the partnership.

  Nevertheless, despite some rough patches when the BP personnel assigned to the partnership found their work culture at odds with TNK’s, BP was able to bring a more efficient and productive management to the operation. Using its own technology, BP has been able to tap deposits heretofore beyond TNK’s ability to exploit; as a result, it discovered that TNK-BP has considerably more workable reserves than TNK realized it had.67

  By mid-2007 there were recurring rumors that Putin and the Russian government were not happy with the extent of BP’s involvement and that the government was seeking some way to ease the private Russian owners of TNK out of the partnership, put state-controlled Gazprom in their place, and then reduce BP to a minority stockholder. Putin and Co. may again be maneuvering to create another national champion and in effect, renationalize the company.68

  In hopes of preventing pressure on BP, the CEO of BP, Lord John Browne, and his successor, Tony Hayward, sought to ingratiate themselves and BP with Putin. That is why they arranged a meeting with President Putin in March 2007 and proposed that BP bid in the auction to buy 9.44 percent of the Rosneft shares that Yukos owned before it went into bankruptcy. As we saw, to be legal, there had to be at least two bidders in the auction and at the time it looked as though there would be only one bidder, Rosneft. By entering its bid and thereby ensuring that there were two bidders, but not bidding enough to win, BP acted to help out Rosneft and Putin. For much the same reason BP bought up $1 billion of Rosneft stock in an initial public offering of its stock in London earlier in 2006.69 By doing so, BP pushed up the price of Rosneft stock, and yet its stock purchase was not large enough to give BP any operational control. BP hoped that these two gestures combined would ward off future attempts by Gazprom or even Rosneft to muscle out either their Russian oligarchs or BP itself from their TNK-BP partnership.

  All of this chess board maneuvering has led to a good deal of second guessing as to whether there would have been less harassment of TNKBP if BP had settled in the beginning for just 49 percent ownership. This became clear after Putin declared that exploration in new Russian fields off and onshore would be limited to companies in which the Russian partner had at least 51 percent control. Given the historic reluctance in Russia to let foreigners have too much control over Russian resources (foreign money is welcome; it is the control that is not), Putin might well have set the Russian share even higher if BP had agreed to only 49 percent or even 45 percent. Compared to ConocoPhillips’s 20 percent limit, anything even close to 50 percent was considered dangerous.

  IT’S TIME TO CHANGE PARTNERS AGAIN

  With petroleum prices hovering around $100 a barrel, all of Russia’s petroleum producers have prospered. Nevertheless the companies that are not state-dominated national champions, even those firms controlled by Russian executives, are occasionally reminded that they are there to do the state’s bidding. Like a well-bred and carefully trained horse that still needs the periodic sting of the whip to remind the horse that it is a horse and the man in control is the jockey, the Kremlin will almost as a matter of routine periodically send in tax collectors and inspectors, not only to collect taxes and carry out inspections but also to harass. Beginning in 2006, environment authorities joined in this minuet. Almost every private energy company operating in Russia (foreign and Russian alike) has been subjected to such visits and harassment in one form or another. LUKoil, for example, has had to deal with charges that it was behind schedule in exploration, drilling, and starting production at eleven oil fields in the Komi Republic.70

  As often as not, given the sorry track record of Soviet and the successor Russian oil companies in polluting their oil fields, there is probably something to the pollution charges. But recently there has often been another reason for these accusations. The unpublicized agenda for such warnings is meant to mask the effort by state-dominated Rosneft or Gazprom to muscle their way to an equity position in these private ventures at a reduced price. That seemed to be the real motive in a whole series of cases: LUKoil in the Komi Republic; Royal Dutch Shell, Mitsui, and Mitsubishi on their Sakhalin II project; Exxon and its partners on the Sakhalin I project; as well as threats against the TNK-BP partnership at the Kovykta natural gas project near Irkutsk, a threat the BP March 2007 bid for Rosneft stock seemed designed to ward off.71 Once Gazprom becomes a partner, especially if it becomes the dominant partner, the charges of pollution miraculously seem to disappear.

  SAKHALIN

  The Shell dispute in Sakhalin is complicated. Sakhalin is a large island off the Russian mainland in the Sea of Okhotsk north of Japan. There was evidence as early as the late nineteenth century that Sakhalin had deposits of oil. But because the environment there involves such extremes in weather and offshore working conditions, Soviet and then Russian companies were unable to work the deposits on their own. Thus in 1975, Soviet authorities agreed to allow Japanese companies in to explore the region for gas and oil. This was one of the rare instances after World War II when the Soviet Union allowed a foreign company to engage in commercial activity inside the Communist state.

  Working conditions on and around Sakhalin are some of the most challenging in the world. Russian authorities understood that and knew that most of the work would have to be done offshore. It is so cold that the sea freezes over most of the winter, putting a halt to existing work; and the ice floes are a continuing risk to the drilling rigs. That was why Russian authorities concluded they could not do the work themselves and agreed to sign favorable Production Sharing Agreements (PSA) with foreign companies who have had more experience working in such a difficult environment. Exxon-Mobil, for example, solved the ice floe problem by locating its drilling rig on dry land and then after drilling vertically, it redirected its drilling efforts horizontally under the sea to the oil-bearing deposits. That is a technology that Russian companies have so far not been able to master.

  Yet it is easy to understand why the Russian authorities went after Shell to revise the original Production Sharing Agreement (PSA). Shell had initially indicated that developing their project would cost $10 billion. That allowed for how risky the work would be. Under the terms of the PSA, only after Shell and its partners (none of whom were Russian companies) had recouped their costs would Russia begin to share in the profits of the operation. In July 2005, however, Shell announced that it had underestimated the costs and challenge. In fact, because of higher steel prices a
nd more complicated work, the cost would be $20–22 billion.72 About the same time Exxon reported that its costs would also be higher than anticipated, not the originally estimated $12.8 billion, but $17 billion. This was high but not double the original price like Shell’s.73 But if the Russian government were to wait while Shell recouped $20–22 billion, they might never see any profit. Whether the higher estimate was accurate or not, Shell must have known the higher cost would upset the Russians. The Russians could understand that there might be some increase, but not as high as twofold.

  Not surprisingly, therefore, the Russians began to pressure for a rewriting of the original PSA. They would have done that as a matter of course even if Shell’s costs had not risen so much. As we have seen, concessions such as PSAs offered at a time of need tend to be disavowed once Russia regains its strength and self-confidence.

  As in the past, the Russian government sought to protect its interests by forcing Shell to include Gazprom in the venture as a partner. Remember that Sakhalin II was the only PSA project until that time that had no Russian partner. Recognizing its shaky status, Shell agreed to yield to Gazprom and sold it a 50 percent equity plus one share at the bargain price of $7.45 billion. Considering Shell’s earlier estimate that the project would entail an expenditure of $22 billion, Gazprom evidently was able to bully its way in for $3.55 billion less than it should have paid for a half interest share. As the Godfather would have said, Gazprom made Shell an offer that it couldn’t refuse. What was embarrassing to outside observers, however, was the alacrity, even enthusiasm, with which Shell, Mitsui, and Mitsubishi agreed to Gazprom’s offer, as if they normally write off $3.55 billion every day. Insisting that Shell harbored no hard feelings, the CEO of Shell, Jeroen van der Veer, fairly bubbled over with gratitude to Gazprom for its willingness to step in as a partner for such a trifle while he also “enthusiastically thanked Mr. Putin for his support.”74

  Shell is not the only company that has been forced or found it necessary to kowtow to the Russians. Total, the French petroleum company, has been equally submissive and humble. Like all energy companies, it has discovered that as-yet-untapped investment opportunities are more and more difficult to find, so it must take what is offered. A good example is how Total responded after Gazprom changed its mind and decided to bring in Western companies to help it develop the vast but difficult to work Shtokman natural gas deposits. Earlier Gazprom had solicited proposals from several Western energy companies as to how they would develop the Shtokman gas fields, but in October 2006, Gazprom rejected them all and decided it would do the work itself. However, after reflecting on the location of the deposits—500 to 600 kilometers (300–360 miles) offshore in the Barents Sea with its icebergs and storms—Gazprom decided to seek Western help after all. It selected Total from a half dozen companies that offered to do the work even though Total has relatively little experience in such harsh Arctic work conditions. Total does, however, have extensive experience with liquified natural gas (LNG) operations, and much of the Shtokman gas will eventually be shipped in liquified form.

  There was little doubt that Total was eager to win the contract. That explains why it agreed to participate even though it will have no equity in the project. Total insists this will not prevent it from carrying some of the Shtokman reserves on its financial statements, something all energy companies are under pressure to do because the more reserves that are listed on their books, the higher the price of the company’s stock is likely to be. The reason it may not be able to include some of the Shtokman reserves on its books is that Total has agreed to operate primarily as a service company; in addition, the project involves enormous risk. But since it wanted to be involved, Total did not have much choice in the matter. This was another instance where the Russians realized that they could drive a hard bargain—and they did.

  Total is not alone. Exxon and its partners in their PSA in Sakhalin I came under similar pressure. Strictly speaking, the Russian authorities did not question the earlier tax concession and cost estimates they had originally agreed to in December 1993.75 That would have been an outright contract violation. Instead, they latched on to cases when both Shell and Exxon had violated pollution standards (in some instances, serious violations) as a way of calling for the cancellation of the original PSA.

  Gazprom used the same tactics on TNK-BP in Kovytka, also in northern Siberia. For fear of being pushed out of Kovytka entirely, BP offered Gazprom a controlling share in the project, which according to some estimates is worth as much as $20 billion. For BP’s 62.42 percent stake in Rusia Petroleum (worth about $12.5 billion), which holds the license to develop Kovykto, Gazprom has agreed to pay between $700 and $900 million—quite a bargain, at least from Gazprom’s point of view.76 It did not seem to matter that the reason for TNK-BP’s failure to produce the 9 billion cubic meters of gas per year it had promised is that Gazprom refused TNK-BP access to its monopoly pipeline network. The only alternative was for BP to sell its gas to a nearby community. But because there was so little industrial development there, there was only need, at most, for 2.5 billion cubic meters of gas in the region.77 If it were to produce 9 billion cubic meters of gas as it had promised, the only thing it could do with it would be to burn it (flare it). That would not only be a waste of a valuable resource but would violate a Russian law and also add to the carbon dioxide in the atmosphere, a form of pollution that would also warrant criticism. To Putin, BP’s failure to act was inexcusable. In a June 1, 2007, press conference, Putin pointedly insisted that BP had been fully aware of these requirements beforehand and should never have entered an agreement if it could not meet them. The Russian owners of TNK were reported to believe that this was all a pressure tactic to force them to sell their share of the partnership at a cheaper price to Gazprom.78

  There was also speculation reported in Forbes Magazine online that in an effort to hold on to its stake at Kovykta in the north, BP had offered to create a joint venture with Gazprom that would provide Gazprom with an equity interest in BP’s LNG operation in Trinidad and Tobago.79 Such an offer would require that Gazprom allow BP to stay in Kovykta at least as a partner with Gazprom. What makes this attractive to Gazprom is that the Trinidad-Tobago facility that BP operates there is the supplier of 65.5 percent (16.56 billion cubic meters) of the LNG the United States consumes. If such a joint venture is created, it will provide Gazprom with its first major entry into the U.S. natural gas market, something they can broach at this point only with LNG capability.

  Gazprom’s refusal to allow petroleum producers to ship their byproduct gas through the Gazprom pipeline network was a legacy of the Soviet era when the Ministry of Gas was assigned a target in cubic meters of natural gas and the Ministry of Petroleum was assigned a target in tons of petroleum. Neither ministry was credited if it produced the other’s product. For the Ministry of Petroleum, the easiest way for its producing units to dispose of the by-product gas released as they extracted crude oil was to flare it. When these oil wells were privatized, the private firms saw the value in the by-product gas, and it made as much sense for them to burn money as to burn gas. By contrast, Gazprom, even though it has private shareholders, is still essentially a state-dominated company that has not fully rid itself of the Soviet bureaucratic culture, and so profit is not the only or even uppermost consideration. And since these “Gazoviki,” as John Grace says they are called,80 control the major cross-country pipelines, energy producers have to play by their rules, which strictly limit the amount of natural gas produced by non-Gazprom-controlled units into the Gazprom pipeline distribution system. That is why, according to a report in the Moscow Times and estimates by the World Bank and the International Energy Agency, Russia accounts for almost 11 percent of the more than 110 billion cubic meters of gas flared worldwide each year into the atmosphere.81

  As if to show they play no favorites, not only did the Russian government harass TNK-BP and Shell, which are British and Dutch, and LUKoil and its minority stockholder, ConocoPhi
llips, which is American; they also went after the French company Total in 2006. It, too, had been granted a Production Sharing Agreement in December 1995 to develop the challenging Khargyaga oil project in the Nenets Autonomous District in the far north. Just as with similar projects in the Russian Far North, the weather is extreme: bitter cold and dark in the winter and swampy and infested with mosquitoes in the summer. The mid-1990s was also a time when the Russian economy had serious problems and needed all the outside help it could get. Total had a 50 percent share in the project. Forty percent of the remainder was held by Norsk Hydro of Norway, and 10 percent by the Nenets Oil Company, which is owned by the Nenets Autonomous Region. Total was charged with failing to drill as many wells as it had promised. Moreover, Total also failed to pump the associated gas released with the crude oil from the well back into the well. Instead, it flared that gas. As a penalty, Total was told its license for the PSA would be withdrawn.82