Petrostate:Putin, Power, and the New Russia

by Marshall I. Goldman

  Such threats should not have come as a complete surprise to Total. This was not the first time the rug had been pulled out from under an agreement or pending agreement originally made at a time when Russia was relatively weak. In September 2004, Total had all but concluded a deal to invest $1 billion in Novatek, a semi-private gas producer in Russia.83 According to Total, the deal was canceled after Russian regulators imposed numerous obstacles. Total attributed the cancellation of the deal to pressure from Gazprom, which wanted to exclude foreign equity investors from the gas sector.

  IT’S NOT WHAT YOU DO, BUT HOW YOU DO IT

  What emerges from these cases is that once they were able to revitalize their energy sector, the Russians ceased to be a supplicant. They no longer felt the need to offer the generous terms that come with a PSA—a colonial treaty, as Putin now calls it. That change in status also led Putin and those around him to find ways to regain control over the mineral assets, energy, and metals that had slipped from state control in the Yeltsin era.

  In some cases, this was done by effectively renationalizing the properties; in other cases, it was done indirectly with threats of legal action as well as not-so-friendly visits from the tax authorities. Rather than a threat, sometimes all that was needed was a friendly chat. Whichever method Putin chose to follow, by 2008 and the end of his term, President Putin had effectively reversed the process of privatization, at least among what Lenin had called the “commanding heights” of Russian industry (see Table 5.4).

  Putin noted in our September 2005 Valdai Hills Discussion Group meeting (organized by the RIA Novosti press agency for foreign specialists) that while we in the West have criticized the Russian government when it sought to reassert control over its energy assets, this, after all, is the pattern of ownership in all but a few countries, such as the United States and the UK.

  The Western response to Putin’s effort to restore the government’s control over the commanding heights of Russian industry, should not be anger that the state wants to take control but with the way the state does it. In the case of Yukos, the state and/or Putin reasserted control of Yukos by putting Khodorkovsky in prison and harassing over two dozen of his associates by either jailing them or threatening them with jail. In the meantime, the state picked up the pieces of Yukos at laughable fire sale prices. The state also employed crude tactics against Shell at Sakhalin II, BP in Kovykta, and Total in Kharyaga. Of course, almost every foreign operator in Russia is subjected to close, sometimes too close, supervision. Exxon-Mobil, for example, as of August 2007 had been subjected to ninety inspections at its Sakhalin work site. This is not to claim that the Western companies were completely innocent of the charges made against them or to deny that other countries often harass energy companies operating within their borders. But without an independent court of appeal to adjudicate these complaints and insist on due process, Gazprom or other state surrogates seem to feel no hesitation in launching campaigns of harassment that force the foreign companies involved to yield a controlling share to Gazprom for either nothing or a vastly underpriced sum.

  TABLE 5.4 Renationalization and Control by Siloviki

  Faced with a state determined to regain what it considers to be its priceless and historic legacy, the foreign partners were given no choice but to surrender. As Daniel Yergin of Cambridge Energy Research Associates has noted, this is not the first time energy resources around the world have been nationalized or for that matter in Russia itself.84 This is Russia’s ball game, not to mention their ball, and bat, and playing field, so they can do what they please. What is disappointing is that they are not doing it in what the Russians would call “a civilized way.” Perhaps there is no “civilized way” acceptable to those who feel their property is being stolen, but if Russia wants to be—as indeed it feels it deserves to be—a member of the G-8 group of developed and democratic market economies, it will have to discipline itself from returning to the ways of its past. Instead, it should adopt less peremptory and more lawful methods of regaining control over its natural resources.

  6

  Natural Gas

  Russia’s New Secret Weapon

  POWER OUT OF A PIPELINE

  While its petroleum exports have generated the cash blizzard that has made Russia rich and allowed it to repay most of its foreign state debt, its natural gas and monopoly control of the gas pipelines that transport the gas to the West have transformed Russia from an anemic and essentially bankrupt charity case into a robust energy superpower with restored political muscle.

  Initially it seemed like such a sensible idea. Determined to reduce their over-dependence on energy from the problematic Middle East, European leaders in the mid- 1980s, especially Helmut Kohl and later Gerhard Schroeder in Germany in 1998, concluded that Germany should diversify its sources of supply. One way to do this would be to support efforts to tap into energy exports from the USSR and its most important successor state, Russia.1

  This required some rethinking by the major Seven Sister oil companies. Historically, they have worked to prevent the sale of Soviet discounted crude oil so that it would not undercut market prices in the capitalist world. This began to change in 1973. Following the lead of Eni (Ente Nazionale Idrocarburi) of Italy, which began to buy Soviet crude oil as early as 1931, Western petroleum companies began to view imports of petroleum from the USSR in a more positive light. This coincided with their need to diversify their sources of supply. The 1973 Arab petroleum embargo that accompanied the Yom Kippur War taught the West that manipulation of energy supplies not only could have important financial repercussions but could also be a powerful political tool.

  In their effort to diversify, European leaders also decided to broaden energy use in Europe to reduce their overreliance on coal and petroleum. In France this took the form of an ambitious expansion of nuclear energy. By 2004, nuclear energy accounted for 78 percent of France’s electricity. For environmental reasons, the Germans were more hesitant about nuclear energy, but for a time even they used nuclear energy to generate 30 percent of their electricity. But having decided to phase out nuclear energy, German leaders needed to find additional sources of power. Because of their physical proximity to the USSR, they agreed to supplement the natural gas they were beginning to use from the North Sea with natural gas delivered by pipeline from the USSR. Soviet gas would allow Germany to reduce its overreliance on petroleum, the risk of a nuclear accident, its exposure to turmoil in the Middle East, and the need to ship tankers through the Persian Gulf and other potentially dangerous open sea routes. In addition, manufacturing the pipe and the compressors needed to move the gas would generate jobs throughout Europe. The downside of the Soviet gas pipeline option was that it would put Germany at the mercy of a Cold War adversary. Most Germans still remembered the Berlin Blockade of 1948.

  For those who had forgotten the Berlin Blockade or were too young to have experienced it, Ronald Reagan, when he subsequently became U.S. president, did all he could to remind them of how vulnerable they could become. Reagan understood the geopolitical risks that such a pipeline would create. He was very concerned that by building such a pipeline, Germany might some day find itself held hostage to Soviet demands. Given the German determination to diversify their sources and types of energy, however, the Germans regarded Reagan’s arguments as unduly ideological and, even if it meant misleading Reagan as to their intentions, went ahead with the pipeline construction.2

  Adding muscle to his rhetoric, Reagan banned the export of General Electric compressors and pumps, the preferred technology used in most of the world’s gas pipelines. When the pipeline contractors sought out non-U.S. manufacturers, Reagan followed suit by ordering that similar bans would also apply to any non-U.S. manufacturers that utilized U.S. technology or parts in their products. This created a rift with his otherwise ideological soul mate, Prime Minister Margaret Thatcher of England.3 Close as she was to Reagan, her first allegiance was to the British public. She wanted the jobs that would come from building
the pipeline compressors that would go to the British company John Brown. It could easily fill in if GE could not. In the end, she ignored the U.S. demand that England impose export restrictions and instead allowed John Brown to build and export the necessary compressors.

  The Europeans were not unaware of the risks that would come with relying on Russian gas. For that reason they agreed to seek, develop, and promote alternative sources of supply, particularly those from Norway in the North and the Barents Sea off Norway.4 They also agreed that they would limit their use of Soviet gas to 30 percent of overall consumption, a promise they soon forgot. Not that he could do much about it, Reagan understood that with time all such initial caution would probably fade from memory and both European homeowners and industrial consumers would become more and more comfortable accepting gas imports from the USSR.

  No matter what kinds of precautions are taken, a halt in the flow of natural gas exports that lasts more than a few days inevitably is disruptive. As a consequence, once manufacturers and households begin to incorporate imported natural gas into their daily work and living routines they are at the mercy of the exporter. That is almost certain to have political ramifications. Western leaders would have to think twice before resisting the political demands of the supplier.

  Moreover, because natural gas pipelines, including the proposed Bratsvo (“Brotherhood”) pipeline from the USSR that Reagan was trying to halt, are so expensive to build, it is simply not feasible to build a standby pipeline for emergency use. Since all but a small proportion of natural gas sold in the world comes via pipeline, should the flow through a part of one of those pipelines be disrupted—whether because of the weather, human mistakes, or political mischief—the pipeline-dependent consumer becomes particularly vulnerable.

  One of the few possible alternatives to pipeline-delivered gas is LNG (liquified natural gas), but this, too, is very expensive and generally not a suitable standby for emergency use. Building the processing units needed to liquefy the gas at the exporting site and reconverting it at the importing site is very expensive. So are the specially built tankers that transport the gas. Building the combined LNG processing plant package often costs almost as much as building a pipeline. Consequently, such LNG systems are normally constructed only if the exporter and importer are willing to commit to long-term contracts similar to those signed by the parties utilizing a pipeline. That explains why, unlike the way petroleum is bought and sold on spot markets, there is still only limited use of a spot market for LNG. The result is that once a gas pipeline is built, it acts, as we said, like an umbilical cord. Severing it is bound to be disruptive.

  PUTIN REINS IN GAZPROM

  It was good luck that his rise to power coincided with a tightening in world energy markets; but in retrospect it seems clear that Putin understood as early as 1997 that with its oil and gas reserves and pipelines, Russia was well situated to take advantage of this new dynamic.5 While Saudi Arabia has the world’s largest reserves of crude oil, Russia, not Saudi Arabia, has the world’s largest reserves of natural gas. Most experts agree that Russia holds 27–28 percent of the world’s natural gas reserves.6 With a little more than half of what Russia has, Iran with 15 percent of the world’s reserves ranks second in size of natural gas reserves. Qatar is close with 14 percent. Even though Canada is a major supplier of natural gas to the United States, it has only 1 percent of the world’s reserves. Since no other country but the United States, Saudi Arabia, and the United Arab Emirates has even as much as 3 percent of the world’s natural gas, Russia is in a dominant position.7 Its reserves and its pipelines, if strategically utilized, have the potential to provide Russia with a powerful political and economic weapon. To his credit, Putin understood this potential and has been skillful in utilizing it.

  Building on his concept of “national champions,” as we saw, Putin’s first priority was to purge the self-dealers and asset-strippers from Gazprom. He seems instinctively to have recognized that Gazprom would make an ideal flagship, on the assumption, of course, that he could find managers who would place the interests of the state above their own. That is why almost immediately after his election as president, Putin sought to put managers in place who would no longer strip off producing assets into their privately held empires. To take on the task, Putin began to appoint comrades he considered loyal and trustworthy, almost all of whom were FOP (Friends of Putin) from St. Petersburg. He knew them from his days either in the KGB or in the mayor’s office when Putin headed the office of International Affairs under Mayor Anatoly Sobchak.

  Not everyone in Moscow was happy with these “provincials” from Russia’s second city taking charge of what had been the political center for eighty years. We saw in Chapter 5 how Putin began by removing Chernomyrdin in June 2000 from his post as chairman of the Gazprom board. He replaced him with Dmitri Medvedev, who also took on the job as head of the Kremlin administration. (In 2007 Putin chose Medvedev again, this time as his successor for president of Russia.) Medvedev had previously worked in the St. Petersburg mayor’s office alongside Putin. The following year Putin replaced Rem Vyakhirev as Gazprom CEO with Alexei Miller, who had also worked for the St. Petersburg mayor.

  From the outside, the transition within Gazprom appeared to be rather straightforward and routine. Both Chernomyrdin and Vyakhirev left without too much fuss. Chernomyrdin went on to become Russia’s ambassador to Ukraine. But while it may have seemed routine, it was anything but. With all their spoils and patronage to protect, Vyakhirev in particular had fought ferociously against previous attempts to oust him. Those opposed to his tenure had much to criticize. Among other charges, some members of Gazprom’s board of directors complained that the company had paid little in either taxes or dividends. In 1995 and 1996, despite having generated earnings of almost $2 billion, Gazprom paid only $3.5 million in dividends to the state.8 Even stranger, the state at the time held 38.4 percent of the company’s stock.

  Stingy as they were with dividends and taxes, the managers were overly extravagant in using company funds to pay bonuses to themselves and build resorts for the exclusive use of the staff. Others complained about what they considered the waste of money spent in building the company’s Taj Mahal–like corporate headquarters9 (see Introduction). This was all in addition to the asset stripping.

  There were also suspicions that the company’s accounting statements did not reflect the true financial situation. In 1999, for example, based on Russian accounting standards, Gazprom reported a profit of $1.3 billion. However, when calculated according to Western accounting practices, Gazprom had a loss of $3.2 billion.10

  Putin ultimately succeeded in changing Gazprom’s senior management, but others had tried earlier and failed. The difficulty is illustrated by what happened when Boris Fedorov tried to convince his fellow members of the board of directors to join him in bringing about a change in management. Before he became a member of Gazprom’s board of directors, Fedorov had been Russia’s Minister of Finance and for a time the director of the Russian Tax Office. Now as an investor in Gazprom, he sought to clean up the company. One of his goals was to bring in a new auditor. He wanted such an auditor to come up with a “second opinion” on the relationship between ITERA, that Florida-based company that at one point was Russia’s second largest producer of natural gas, and Gazprom. Most important, Fedorov began to call openly for Vyakhirev’s immediate removal as CEO before his term expired.

  Vyakhirev did not take kindly to Fedorov’s effort. Fedorov told me that he began to fear for his life, particularly after he was visited by representatives of the Russian mafia. Then as if it were all a scene from the movie The Godfather, someone poisoned Fedorov’s dog!11 If there were any doubts as to what was happening, more than fifty newspaper articles in the Moscow press suddenly and simultaneously appeared with vicious attacks on him. Only when Vyakhirev was fired by Putin in July 2001 did the attacks abruptly came to an end. Intrigued by what seemed to be the obvious orchestration of this effort, Fedorov su
bsequently canvassed each newspaper to see what had precipitated this sudden campaign. As if they were normal events, each paper explained that such attacks were a common occurrence, a normal part of the for-hire nature of Russian journalism. He managed to compile a price list indicating how much each paper charged for these attacks. Reflecting the market, the higher quality newspapers such as Vedomosti, which is jointly owned by the parent companies of both the Wall Street Journal and the Financial Times, charged the highest rate: $6,000 for each of the four articles they published.

  No one knows what might have happened if Vyakhirev had been able to continue his campaign against Fedorov. Fortunately for Fedorov, he and Putin had similar agendas. Putin was just as eager as Fedorov to put an end to the asset stripping, the self-indulgent extravagance, and failure to compensate the state and other stockholders for their investment. But unlike Fedorov, Putin had the power to implement it. Yet Putin also had a supplemental and—in his view—equally important agenda. He wanted Gazprom to become the first of what he had hoped would be those “national champions.”

  Once in charge, one of Medvedev’s and Miller’s first assignments was not only to bring a halt to any further asset stripping but to reclaim assets that had been stripped earlier. This was not easy to do, but Miller moved aggressively. One of his first targets was ITERA. From the mid-1990s, ITERA had operated as a middleman between a bunch of countries such as Ukraine, some of the Caucasus countries, and Central Asian producers. In the process, ITERA earned a handsome profit for that Florida-based corporation whose trustees were mostly associated in one way or another with Gazprom management. To persuade it to cooperate, Miller denied it access to the Gazprom pipeline, a step that by 2004 all but forced ITERA into bankruptcy.12 In 2006, faced with an offer they could no longer refuse, ITERA’s managers agreed to resell their 51 percent interest in Sibneftegaz back to Gazprombank for the bargain price of $130 million.13