RUSSIA - Part 4 - External Investments Are Increasing; LUKoil Becomes Trans-National.

External investments by the privatised Russian petroleum companies have become an important reality. Rich in cash thanks to high oil prices since April 1999 and aggressive in their pursuits, the integrated companies are moving primarily into East Europe where downstream assets are cheaper and more manageable for the Russians than those in the West.

With the Russian companies' emphasis in East Europe being on downstream assets and marketing, their priority for acquisition of upstream assets is the Caspian region and Central Asia. Iraq and other parts of the Near East that will eventually be accessible to Russian petroleum companies will also be a priority for acquisition of upstream assets in view of this region's vast petroleum reserves. But it has to be borne in mind that Russia itself is the biggest petroleum reservoir in the world, with its oil and gas reserves being more than 15% larger than those of Saudi Arabia.

Communist Russia's old geo-strategic control over East Europe and Central Asia is gradually being replaced by business interests from a capitalist Russia, a country stretching to the Far East. It will be interesting to see how Russian petroleum companies will move into the Middle East if Iran and Israel are to allow this region to be controlled by the US out of Baghdad (see News Service and a RIM survey of Iraq in this week's APS Diplomat Package).

Internal Acquisitions Vs Kremlin Moves: The Russian companies' branching out of their country since April 1999 - apart from external acquisitions they had made since 1993/94 (see review of the companies' external assets on the following pages) - was occasioned by these important developments:

1. From March 1999 they began to count on OPEC's defence of crude oil prices. Until late 2001, most of them went along with Moscow's active support of the OPEC price defence efforts through occasional Russian oil export cuts in line with agreements involving non-OPEC states. Until March 1999, when OPEC and four non-OPEC states including Russia agreed to cut output to defend a crude oil price that had collapsed in 1998, the Russian oil firms favoured Moscow's export cuts. That was because in 1998 Russia had suffered its worst financial crisis since the late 1991 collapse of the Soviet Union. For all the Russian petroleum companies, including the world's biggest gas producer and exporter Gazprom, a strong oil price and a brighter market perspective for both oil and gas were crucial for their growth.

By late 2001, however, the situation in Russia had changed. There had developed a split in strategic thinking among the integrated oil companies in Russia. The split was between the so-called radical firms, which had managed to increase oil production and lower operating costs rapidly as in the case of Yukos and SibNeft, and the conservatives like LUKoil and SurgutNefteGaz (SNG) which had opted against the oil production methods of the radicals (see profiles of the Russian oil and gas producers in OMT, DT and Gas Market Trends No. 8).

2. The radicals by late 2001 had opted for acquisition of smaller firms in Russia. That was because assets to be acquired were still relatively cheap despite high oil prices. Yukos, SibNeft and Tyumen Oil (TNK) were prominent among those that grew out of such acquisitions (see background in Vol. 59, No. 13). In 2003, the Russian assets of TNK and BP were merged into one group, TNK-BP. But a much bigger merger, between Yukos and SibNeft to create a much bigger group was halted as the Kremlin moved against the main owners of Yukos.

By then, Yukos had been leading Russian companies opposed to Moscow's co-operation with OPEC in defending oil prices from the beginning of 2002. Since end-2001, Yukos and the other radicals had become in better shape to operate under a low oil price environment, whereas companies like LUKoil and SNG had failed to cope with such a situation. Yukos had become the biggest among the Russian oil firms in terms of market capitalisation and had begun to raise oil production capacity at top speed.

By Oct. 25, 2003, when the company's founder and CEO Mikhail Khodorkovsky was arrested, Yukos had become the biggest oil producer in Russia. But President Putin's Kremlin, while still eager to see oil prices high, was no longer keen on being too closely associated with OPEC price defence efforts. The Kremlin now was more eager to raise taxes on Russia's oil majors to a level that should channel much of their cash piles to the state. It was payback time; they had bought their assets from the state at ridiculously low prices. This new drive began with Yukos (see Part 1).

Dresdner Kleinwort Wasserstein (DKW), the investment bank hired by the Justice Ministry to put a price tag on Yukos' main oil production unit, YuganskNefteGaz, will finish its work in four weeks, according to The Moscow Times of Sept. 1, quoting "a person close to the process".

Yukos drifted into uncharted waters after a deadline expired on Aug. 31 to pay the Tax Ministry $3.4 bn in back taxes for the year 2000, with $1.4 bn outstanding. The oil giant is now one step closer to losing its most valuable assets as authorities pursue additional tax claims and DKW prices YuganskNefteGaz (YNG) for sale. The valuation of YNG, which accounts for about 60% of Yukos' 1.8m b/d production, is eagerly awaited by a market nervous that the government will sell the asset to a more loyal company for a fraction of its fair value.

The Moscow Times quoted Sergei Suverov, head of equity research at Bank Zenit, as saying: "The valuation is important, as the assets will probably not be seized from Yukos until it is done. The authorities will bring additional tax demands" against YNG and Yukos. The paper said the valuation will not be a single figure, but a range. If the valuation of YNG takes until end-September, the government will avoid spoiling the mood for what is expected to be the single biggest privatisation auction in Russian history - the Sept. 29 tender for 7.6% of LUKoil, Yukos' rival. ConocoPhillips emerged as the front-runner for the latter stake after its CEO, James Mulva, met with LUKoil chief Vagit Alekperov and President Putin in July.

About $2 bn of the $3.4 bn claim on Yukos for 2000 has been collected. In addition, the Federal Tax Service says it is owed another $3.4 bn for 2001 and has started tax probes for the subsequent years. Prosecutors recently confiscated documents relating to 2003 and 2004, raising the prospect of additional bills, possibly even against YNG and other Yukos production units. The total bill could hit between $12 bn, according to a Bank Zenit estimate, and $16.5 bn as estimated by others.

Putin and Khodorkovsky are locked in a battle that has rocked world oil markets with WTI at times having risen close to $50/b, and provoked concern in capitals from Washington to Beijing. Yukos supplies 8% of China's crude oil imports. The interest of Chinese companies in this oil is so high that they are ready to fund rail transit for it across Russia. The drama has also undermined confidence in Russia's economy.

DKW, a unit of Germany's Allianz Group, has close links with top Kremlin officials, including Putin who was instrumental in helping BNP-Dresdner Bank move into St. Petersburg in 1993, when he headed the city's committee for external relations. German banks are among Yukos' creditors. German Chancellor Gerhard Schroder was expected to raise the issue with Putin during their talks in the Black Sea resort city of Sochi on Aug. 31, which also included French President Jacques Chirac.

Khodorkovsky is on trial for tax evasion, fraud and running an organised criminal group. His lawyers say the charges are politically motivated. Yukos has warned of bankruptcy and production cuts over a cash crunch caused by the freeze that has been placed on its accounts and assets. The company says YNG should be considered a "core asset", which would put it at the end of the list of property to be liquidated to settle the tax claims, the biggest in Russia's history.

However, Justice Ministry statements indicate that it considers Yukos' shares in YNG to be "non-core" assets. Similarly, court marshals have refused to accept Yukos' stake in failed merger partner Sibneft as collateral for the tax debt, indicating that the Kremlin has its sights on YNG. Leading US investment bank Goldman Sachs has said YNG is worth about $20 bn, but analysts say tax claims and threatened legal action against potential buyers could cut its valuation.

With the sale of the LUKoil stake looming, officials may want to delay spooking the market with a low valuation of YNG. Kirill Tomashchuk, acting head of the Federal Property Fund, said the sale could be delayed if LUKoil shares tumble. He told reporters recently: "The auction could be cancelled if LUKoil shares were suddenly to drop considerably below the market price. That could happen as a result of a macro-economic or political factor. And I think by now the Yukos affair can be called a political factor".

Chris Weafer, chief strategist at Alfa Bank, says: "The state wants YNG, but we don't know the mechanism. Outright confiscation is unlikely, so some sort of consortium with RosNeft and SurgutNefteGaz could gain control. We will have a break until the valuation of YNG and the additional tax bills are in place..."

Yukos' other two main units, SamaraNefteGaz and TomskNeft, are being probed over 2002 tax payments, though they may be left inside the company to appease thousands of minority Yukos shareholders. Suverov believes Yukos will end up losing all its big assets to reduce the influence of Group Menatep, the holding company that controls Yukos. Menatep has warned that if the oil giant's assets are sold off cheaply, the buyers may face legal action.

Eric Kraus, chief strategist for Sovlink Securities, wrote in an article published on Sept. 1 by The Moscow Times: "The government's egregious mishandling of the Yukos affair - with the administration either unable or unwilling to explain its actions, and no two ministers seeming to sing from the same hymn sheet - has clearly caused short-term damage to Russia's financial infrastructure".

"In particular the transition of the RTS from a self-contained casino into a source of long-term investment capital has been delayed, as has the well-deserved upgrade of Russia's credit rating. Institutional investors have been badly shaken by huge losses on what, just a year ago, seemed to be Russia's safest blue-chip. Yet despite this, anyone seeing parallels with the 1998 meltdown is quite simply delusional. The Yukos case seems most unlikely to furnish any happy endings. The core shareholders' problems are of their own making and...were eminently foreseeable.

"Yukos was an oil company with its own foreign policy, while Menatep, its controlling shareholder, undertook what can only be described as a hostile takeover bid for the state: Corrupting functionaries and purchasing lawmakers wholesale, they threatened to paralyze the State Duma, blocking any legislation not to their liking. Given that government by and for the oligarchs - in particular some of the same individuals now facing prosecution - was one of the root causes of the August 1998 financial collapse, it was inconceivable that President Vladimir Putin would allow their megalomania to triumph again.

"Faced with an insurmountable obstacle, Mikhail Khodorkovsky stuck his own head into the noose by adopting the Napoleonic strategy: The best defense is a robust offense. He scorned the government's offer of amnesty in return for the payment of a few hundred million dollars in back taxes and the relinquishment of his political ambitions. This self-declared patriot has instead wreaked as much damage upon Russia's international reputation as his billions could buy. Intelligent, unscrupulous and fabulously wealthy, by declaring war on the Putin government he has rendered himself far too dangerous to be allowed a comfortable London exile. With not even Menatep's supporters asserting its innocence, the government's case seems compelling. The 'everyone else did it, too' defense is devoid of legal foundation, especially given that several murders are alleged.

"Yukos' tax avoidance schemes were a flagrant abuse of laws intended to benefit the country's most miserable regions. And Menatep's well documented web of offshore companies and trading vehicles points to the desire of its greedy owners to strip as much value as possible. It is thus unforgivable that the government has allowed the minority shareholders of Yukos - innocent bystanders caught in a vicious fight between Menatep and the Kremlin - to be punished for the sole crime of having believed that Russian companies could change.

"It would be entirely possible to maintain Yukos as a going concern, while moving to have the courts seize the assets of Menatep by declaring it a criminal organisation... A great deal of intellectual effort has been wasted discussing the 'profound implications' of the Yukos affair; in fact, there are precious few, save perhaps that investors would do best to avoid companies owned by any oligarch involved in a vicious fight with the government...

"With commodities prices at historic highs, Russia is awash in liquidity; the rapid increase in fixed investment is readily funded by domestic sources, while virtually every major international investment bank and oil company is actively - sometimes desperately - seeking to increase its Russian exposure. From the macroeconomic standpoint, Russia's twin surpluses - budgetary and current account - would be the envy of any other G8 country. Certainly, high oil prices have and will continue to prove a boon...with the benefit accruing solely to a handful of oligarchs.

"Perhaps thanks to the lack of any real opposition, the Kremlin has resisted the temptation to buy popularity with fiscal profligacy, instead opting for a hyper-orthodox fiscal policy. Not only has foreign indebtedness been slashed from some 120% of GDP in 1998 to an estimated 20% by the end of 2004, but by combining the budgetary reserve fund and Central Bank reserves, Russia could repurchase its entire foreign debt load with enough cash left over to fund six months of imports.

"Facilitated by the windfall, and despite delays in restructuring the gas and power sectors, Russia is seeing impressive root-and-branch administrative reform - much of it deeply unpopular, all of it vitally necessary. Industrial production is showing robust growth, while services are exploding. As wages and consumption soar, ordinary Russians feel wealthier and more secure - Putin's popularity is clearly no artifice.

"It is deeply unfortunate that the Yukos affair should have distracted attention from Russia's ongoing transformation. Advancing over the bodies of their fallen comrades, smart investors will take advantage of the ambient pessimism to load up on cheap assets, in particular non-oligarch companies, as well as sovereign and corporate debt. Once again Russia's investment case has been pronounced dead and once again, like the proverbial nine lives of a cat, it shall soon enough be catching fat mice".