Some Perspective on the YukosSibneft Merger

Abstract: The Russian oilpatch is in rapid transformation at the moment as last week's YukosSibneft deal signifies. As with all deals Russian, there is more to the present announcement than meets the eye.

Analysis: Please allow one more review of last week's YukosSibneft merger in Russia.

These events fit a pattern. First there is excitement in the industry, characterized by accelerating rumors concerning potential exotic partners. This is the name-dropping stage. Before it runs its course, it usually mentions every potential suitor.

Next comes The Promise. The Promise is that a particular deal/development will allow a resurgent Russian oilpatch to become truly global in nature. The rumored deal is always promoted as the final tangible proof that Russia is, in fact, taking its place as a player on the world stage.

This is followed by massive confusion and surprise surrounding the event itself, usually because it turns out to be yet another insider deal.

Yes, YukosSibneft was a big deal. It creates a $36 billion company that won't easily be a target for any Western firm seeking easy entrée to sizeable Russian reserves-- the current model for doing business in Russia. Western investment in Russian oil companies is an attractive option because Russian oil reserves are copious, but valued at only 25 percent of the global average. In the grand scheme of things, Russia dazzles because there just aren't many places left globally where one can exploit significant reserves without substantial financial and technological investment.

YukosSibneft will represent between 18 and 19 billion barrels (bbbls) in reserves, making it the world's third or fourth largest for non-state-owned international companies. The company would also rank third or fourth in production for non-state-owned companies based on the 2.2 mmbbls/d combined output that both entities represented individually in 2002.

As far as the particulars, Sibneft contributes 500,000 bbls/d and is growing at double-digit rates annually.

YukosSibneft, meanwhile, will account for one-third of the Russian stock exchange's market capitalization when the deal is completed this summer.

Those are the facts.

The analysis is more challenging. For one thing, it is probably misleading to compare the new conglomerate to the integrated majors. YukosSibneft is long on reserves, but short on refining and downstream assets. It has almost zero international presence. In other words, it is a domestic Russian reserves company competing in Russia rather than an international integrated major company competing globally. But size should create the critical mass necessary to attract financing to expand production into other regions, giving YukosSibneft a running start at opening the under-explored eastern Siberian oilfields as opposed to rivals Rosneft and Gazprom.

The challenge in Russia is not getting oil out of the ground. It is getting oil into the export markets through a capacity constrained pipeline system.

As such, the deal should also be viewed within a broader context. The Russian government expects Russian oil exports to rise 15 percent this year to 4.34 mmbbls/d. And the first glimmer of an expanding horizon for additional oil exports also surfaced this month when the Russian government dropped its longstanding opposition to a privately financed pipeline that would connect western Siberian oil with the port of Murmansk--and potential export markets like the U.S.

The Russian government, which finances and owns the Transneft pipeline system, had been hostile to competitive alternatives to the nationwide pipeline monopoly. Since Yukos was the main proponent of the Murmansk pipeline, the Sibneft purchase added a unique twist to Russian rumor mongering. Yukos may well have had the blessing of the Russian government for the Sibneft deal as a way to stave off Western investment in the Russian oilpatch before the Russian election campaigns begin later this year.

Hence the change in posture over the Murmansk pipeline proposal.

Over the years, the Russian oilpatch has evolved in stages. After the collapse of the Soviet Union, state-owned assets were auctioned for pennies on the dollar to a handful of oligarchs in transactions that can be politely described as rigged. Yukos and Sibneft, which together are valued at more than $35 billion, were purchased separately for a combined $260 million just eight years ago.

Next came an era of trading loans for shares in a smoke and mirrors arrangement that usually involved banks associated with the oligarchs. Sibneft's original owner, Boris Berezovsky, eventually was indicted for fraud and is currently facing extradition from his London base.

Things began to change in the Russian oil industry after the financial collapse in 1998. When OPEC established production discipline, commodity prices recovered. Russian energy firms such as Yukos employed Western technology, typically through companies like Schlumberger, to rehabilitate neglected assets. These new flows of crude oil and external revenues revitalized the Russian economy after 1999.

While the oligarchs ended up with assets in the privatization era, these were generally non-liquid ownership stakes. The current suite of mergers, acquisitions, and swaps will enable several individuals to generate liquidity from their holdings. Roman Abramovich, the CEO and main shareholder in Sibneft, will pocket a significant portion of the $3 billion in initial cash playment, plus receive stock ownership in the new YukosSibneft.

Yukos shareholders will earn a substantial dividend payment before the shares are converted into the new YukosSibneft. Here it is worth noting that Yukos CEO Mikhail Khodorkovsky owns roughly one-third of Yukos.

Little wonder that the rumors now making the rounds suggest that the smart money investors in Russian oil firms are cashing out part of their stake in an environment where global oil prices are likely to fall--and with them the value of Russian energy companies.

And then there is the matter of local politics. The Moscow Times suggested the controversial Mr. Berezovsky was trying to raise cash by selling his Sibneft stake in order to mount a political challenge to the Putin government in December's Duma elections. That may explain the curious exchange this past week where Mr. Berezovsky admitted to Western media that he was still a shareholder in Sibneft, though the company promptly denied he owned any shares at all.

There is more. Most press accounts credit Yukos CEO Mikhail Khodorkovsky as the force that brought the YukosSibneft merger to fruition over a whirlwind 30-day courtship of Sibneft's Mr. Abramovich. Here again, the Russian rumor mill says Mr. Khodorkovsky is jockeying for position in the political landscape, possibly for a presidential bid in 2008 when Vladimir Putin's second term ends, assuming Mr. Putin is re-elected in March 2004. He has said only that he plans to step down from his position as Yukos CEO in 2007, but is pursuing a high profile life of television appearances, charitable gestures, and political bankrolling.

Oil is a highly patriotic issue in Russia, as is the case in most countries. Yukos may have saved the day with a preemptive bid on Sibneft, thwarting immediate big name Western forays into the Russian oilpatch. As a result, the YukosSibneft deal may be the last big name transaction between now and the presidential elections next spring.

Watching the Russian oil merry-go-round brings to mind an aphorism from the French Revolution:

The more things change, the more they stay the same.