Business as Usual in Russia

Abstract: Ninety days ago, the Russian oil industry stood at the threshold of significant Western investment. Now the Russian government is alleging criminal wrongdoing at Yukos, the Russian oil giant.

Analysis: The Russian media was preoccupied with controversy during the month of July. Only the issue was not Iraq, or Californian electoral politics. It was the sudden criminal investigation of Yukos, the Russian oil giant.

Russian prosecutors are alleging Yukos has been involved with criminal activity including theft, murder, and tax evasion. These allegations were released an event at a time, culminating in talk by month's end that Russia's equivalent to the U.S. Department of Justice would expand the Yukos probe to include financial shenanigans stemming from Russia's oil industry privatization in the mid-1990s.

The immediate implication is that the proposed merger between Yukos and Sibneft, an event that would create the world's fourth largest oil company, will be placed on hold until after the Russian presidential elections in March 2004.

Spokespersons for Yukos and Sibneft have been quoted as saying the deal is still on track to close by yearend.

Still, Western investors have watched the unfolding drama with a combination of curiosity and dismay. The Yukos investigation could entail far-reaching consequences, including a threat to property rights, which would endanger the momentum of Western investment in the Russian oilpatch.

It may also signal the end of an informal compromise between the Russian government and the nation's business oligarchs. Under the compromise, which followed a similar crackdown in 1999, Russian governmental agencies have not looked too deeply at past transgressions as long as the country's business leaders distanced themselves from political influence.

The controversies surfaced just as Western investment in the Russian oilpatch appeared to be on the verge of increasing. Last week, news reports speculated that ChevronTexaco had entered formal negotiations regarding a possible $6 billion investment in Yukos.

Western multinationals have a compelling interest in seeing things work out amicably in Moscow. The majors are now so large that it is difficult to maintain meaningful growth in either production or capital unless it is in frontier areas with significant untapped potential, such as the Russian oilpatch.

For its own part, Russia's oil industry needs Western investment to help develop those vast reserves. It appeared that a successful model had evolved over the last nine months involving Western investment in existing Russian businesses that held production licenses to the country's impressive mineral heritage. That model was verified when BP entered a $6.5 billion joint venture with Russian firm TNK earlier this year.

Since then, the buzz has been that Western multinationals would quickly follow. Those most frequently rumored to be in the hunt include ExxonMobil, Royal Dutch Shell, and Total.

However, the Yukos/Sibneft merger announcement early in the second quarter appeared to lock up at least one potential target for multinational investment and guarantee that Yukos would remain intact. Speculation then was that Western multinationals would pursue positions as minority shareholders in the newest Russian oil giant. The stakes involve up to 25 percent of Yukos, representing an investment of $6 to $7 billion.

The last 30 days have demonstrated that things are back to business as usual in Russia. During the month of July, armed Moscow police raided Yukos' offices, carting off computers and documents, and questioning Mikhail Khodorkovsky, the company's telegenic billionaire chairman.

Mr. Khodorkovsky had stepped up the level of financial support for opposition parties to Vladimir Putin as the Duma, Russia's lower house, prepares for elections in December.

Also in July, Platon Lebedev, a key Yukos shareholder, was imprisoned on charges he stole state property during the privatization era in the early 1990s. He has not yet been to court on the charges, and the Russian court system refused late in the month to compel his release.

Meanwhile, word came out that the prosecutor-general's office, the equivalent of the U.S. Department of Justice, was investigating Yukos' potential involvement in as many as five murders and/or assassination attempts, which was certainly a twist to the normal run of business news.

The current brouhaha is viewed as the latest permutation in the ongoing conflict between Russia's business oligarchs and the Kremlin. Generally, the business oligarchs who obtained state assets at little cost during the privatization process in the early 1990s are unpopular with the public, who suspect they are using their influence to gain greater control of Russian business.

Of course, the privatization process was so poorly handled that even cursory investigations can uncover instances in which Russia's confusing and incomplete legal structure was circumvented in some way. The easiest charges involve tax evasion, which is among the charges leveled at Yukos. The privatization era has become an Achilles heel for the business oligarchs, which political power brokers can exploit at any moment.

It is not unusual in Russia for governmental entities to announce intensive investigations of corruption or scandals years after the fact, particularly in an election season, only to have those same investigations quietly end without fanfare afterwards. In Russia, it is not the investigation that gets the public talking. It is the target.

It is easy to picture the Yukos incident as an attempt by Russian president Vladimir Putin to derail Mikhail Khodorkovsky's political ambitions. Only Mr. Putin, who holds a 70 percent approval rating among the citizenry and should be easily re-elected next March, has publicly criticized the Yukos investigation as a threat to foreign investment and property rights.

At the moment, the spotlight shines on an overly zealous and highly independent prosecutor-general. The fact that the informal agreement between the Russian government and the nation's handful of business oligarchs seems to have broken down, adds uncertainty and risk at a time when risk had dropped below the radar for Western multinationals who are seeking ways to participate in developing Russia's impressive energy reserves.

The Yukos incident turns into a catch-22 situation. If Russian prosecutors prevent the Yukos/Sibneft merger, then Sibneft would remain a potential investment vehicle for Western multinationals, who were relegated to the sidelines when Yukos made its pre-emptive strike on Sibneft earlier this year. That would be considered a positive. On the other hand, there would be no guarantee that foreign investment would be protected if a Russian governmental entity developed renewed interest in the careless privatization efforts 10 years ago.

Stay tuned. While the Yukos investigation may not get the airplay in the U.S. that accompanies Arnold Schwarzenegger's run for governor in California, it may be much more important in the long run for several U.S.-based energy firms.