New Perils for Western Investment in the Russian Oilpatch

Abstract: Some say last weekend's arrest of YukosSibneft CEO Mikhail Khodorkovsky on tax evasion charges is an isolated matter indicative of zany Russian politics before December's parliamentary elections. Others see it as evidence that power brokers hostile to western business influence are gaining the upper hand in Russian political circles.

Analysis: If Lee Raymond wants to talk with Mikhail Khodorkovsky, the YukosSibneft CEO will be easy to find. He's being held in a five-inmate cell at Matrosskaya Tishina, one of Moscow's notoriously overcrowded jails.

Mr. Khodorkovsky will remain there pending trial on seven charges of tax evasion, fraud, and embezzlement after being arrested this past weekend when his personal jet landed to refuel at Novoribirsk, a Siberian airport.

In a scene that would do Hollywood justice, armed law enforcement officials surrounded the plane at 5 a.m. and demanded: "Guns on the floor, or we'll shoot."

Mr. Khodorkovsky could face a prison term up to ten years under the various charges.

He joins Platon Lebedev, a major YukosSibneft shareholder who has been imprisoned since July on similar charges. Russian governmental officials have also charged Vasily Shakhnovsky, president of Yukos-Moskva, with large-scale tax evasion. Since the first of July, six senior YukosSibneft managers have been arrested or subjected to armed federal intrusions followed by lengthy questioning.

The events are now making headlines in U.S. mainstream publications, which is why it will be interesting to see whether ExxonMobil CEO Lee Raymond has any comment when the U.S. oil giant releases earnings later this week.

ExxonMobil had been the odds-on favorite to acquire a 40-percent stake in YukosSibneft, the darling of the Russian oil giants. With YukosSibneft market capitalization rapidly eroding, a 40 percent stake is now roughly $12 to $15 billion, down from $25 billion when rumors of the deal first made headlines last month.

One can bet that Mr. Khodorkovsky's arrest was big news in the senior management offices at ExxonMobil and ChevronTexaco, the other suitor most frequently linked to a rumored investment in YukosSibneft. The U.S. majors are anxious to follow BP's lead into the Russian oilpatch, clearly the most promising area in the world to add reserves on a cost-effective basis.

Russian oil production has been climbing steadily since the late 1990s and the country has now surpassed Saudi Arabia as an oil producer, although the Saudis seldom produce at full capacity.

BP seemed incredibly prescient when it worked out its $7 billion joint venture arrangement with Tyumen Oil Co. in February. It now appears BP may be lucky as well since the window for foreign investment in the Russian oilpatch is closing at the moment.

There are two views of the troubles at YukosSibneft. One holds that it will eventually clean up any lingering legal or tax problems that would endanger large-scale foreign investment in the Russian oil giant, which is the fourth largest oil company in the world. Once the elections pass, the current events will simply become a footnote to the idiosyncrasies of Russian politics.

The second argues that it will undermine foreign investment in Russia. The back story to this scenario holds that the Khodorkovsky affair is the public manifestation of a behind-the-scenes power struggle involving individuals who came to power in the 1990s during the Boris Yeltsin regime and a clique of former KGB hardliners in Vladimir Putin's cabinet. The hardliners are pushing events towards the endgame, which is the destruction of the most visible of the business oligarchs from the Yeltsin era.

The hardliners reportedly oppose the concept of transferring a significant stake in Russia's largest oil companies to western interests.

The first scenario sees the current brouhaha as no big deal moving forward. The second scenario counsels caution.

OAO Yukos earned $2.2 billion during the first six months of 2003, up 80 percent over the prior year. The governmental troubles have taken a toll, however. The initial dust ups in July knocked $7 billion in market capitalization off Yukos shares. After Mr. Khodorkovsky's arrest this past weekend, YukosSibneft shares fell 20 percent on Monday before they were suspended from trading.

There are advocates on both sides of the question as to how this will affect the Russian economy. During the send half of the 1990s, Russia was losing up to $20 billion annually as capital fled the country. The denouement occurred in 1998 when Russia defaulted on some of its international financial obligations.

But higher oil prices after 1999 led to a rebound in the Russian economy. As companies like Yukos benefited, they began to attract western capital into the country funding an economic revival and boosting the value of the Russian stock market.

The Yukos troubles now have shaken western confidence in the Russian capital markets, and could well reverse the capital inflows into Russia.

Meanwhile, Mr. Khodorkovsky has been a thorn in the Kremlin's side for some time. He is a passionate advocate for further economic liberalization and has pushed plans to create additional export pipelines for Russian oil. The Russian oil export pipeline system is operated essentially as a monopoly by Transneft, which is owned by the Russian government.

Mr. Khodorkovsky has also been an advocate of stronger Russian/U.S. ties. He understands the U.S. interest in finding alternative oil sources to the Middle East, which places him at odds with the Kremlin hardliners.

This weekend's events will place any western investment in YukosSibneft on hold for the foreseeable future. Russian President Vladimir Putin, in part responding to calls from three Russian business federations, said in a televised statement Monday that it would be wrong to draw any inference that the YukosSibneft investigation was a precedent against other business oligarchs.

However, the Russian government has begun examining YukosSibneft oil development licensing arrangements and said it will expand the examinations to see whether other companies, including western entities like ExxonMobil and Shell, are meeting the full terms of their licensing arrangements—evidence some say that Kremlin hardliners are attempting to slow the influx of western influence into the Russian oilpatch.

This past weekend was certainly a new development in Mikhail Khodorkovsky's stellar career. The 40-year-old is one of 17 Russian billionaires. According to the New York Times, Russia has one of the globe's largest concentrations of billionaires despite a gross domestic product equivalent to that of Italy. A small handful of business oligarchs now control over half of Russia's private sector. The group spent the latter part of the 1990s enmeshed in Kremlin politics, usually producing sweetheart deals that further enriched their companies.

When Vladimir Putin came to power in 2000, he called for an end to business involvement in Russian political affairs, promising the state would not look too closely at the shenanigans that occurred during privatization of state assets in the early 1990s as long as the hugely unpopular oligarchs stayed away from political influence and paid their taxes.

Mr. Khodorkovsky publicly flaunted the political aspects of the informal agreement by financing opposition candidates in the Russian Duma.

Still, despite Mr. Putin's efforts, the Russian oil industry remains one of the most successful lobbying entities in the Russian Duma and continues to win favorable treatment on tax and regulatory issues.