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Monday, January 31, 2011

An Egyptian Power Struggle: Why the Worst Will Win (Lesson’s from Lenin’s Playbook)

The media has again begun its celebration. Another repressive dictator has been overthrown (or is about to be). The people are massed in the streets demanding freedom. Talk turns to a successor who will restore order and create a new and better order. We hear these familiar words as the thirty-year-old Mubarak regime totters on the brink.

The hard reality is that this optimistic scenario rarely works out. A worse (or equally bad) dictator rises to the top, not a democracy or even a more benevolent dictator. Throughout history, it is the Lenins, Stalins, Ayatolla Khomeneis, Saddams, and Aristides who replace the Czars, the Shahs, the al-Bakrs, and the Papa Docs. Successful transitions from dictatorship to democracy of the Philippines and South Korea are the exception and require special circumstances.

Machiavelli advised that “a man, who wishes to profess goodness at all times, must fall to ruin among so many who are not good.” Even a well-intentioned “Prince” must learn “how not to be good.” F. A. Hayek expressed the same sentiment when he explained why “the worst will rise to the top” in a power struggle played without rules. In Russia, the “good” Kerensky fell to Lenin. In Iran, the good “Bakhtiar” could not contend against Khomenei. In Egypt a “good” El Baradei will fall to a yet unidentified leader of the Muslim Brotherhood.

The Lenin-Stalin-Khomenei-Saddam has substantial advantages in a power struggle, and there is little the outside world can do. He is unconstrained by a moral compass; he is willing to do whatever is necessary to gain power. These advantages are multiplied when the dictator-to-be does abhorrent things in the name of a powerful ideology. Lenin and Stalin had socialism and its intellectual admirers in the West. Saddam had Arab nationalism, and Khomenei had his vision of a fundamental Islamic revival.

Dictators are loathe to designate a successor (unless it is their son or daughter, but even then they hesitate). Hence, the power struggle will take place in a vacuum without established rules. In such a free-for-all, the most brutal contender is advantaged, particularly if he has organizational skills. Nor does it particularly matter what the people want. In the absence of established democratic institutions, their voices can be scarcely heard.

Lenin’s playbook of 1917 is still the classic. His Bolshevik party was organized as a tiny party of professional revolutionaries. The Bolsheviks were part of the February-revolution coalition that dispensed with the Czar. The victors agreed to elect a constituent assembly to create a new multi-party parliament. Lenin had carefully wooed supporters within army and navy units, and he had enough of them to drive Kerensky’s timid provisional government from the Winter Palace in November 1917 without a shot.

After the Bolsheviks received only twenty percent of the popular vote for the constituent assembly, Lenin sent in armed sailors to its first meeting and bolted the doors forever. Lenin then ordered his bloody Red Terror against rival parties and independent thinkers. Notably, he suppressed those parties most brutally that were the closest to the Bolsheviks in ideology. He could not afford to have any rival in the wings. The Czar and his young son and teen age daughters were slaughtered in Siberia.

It was left to Lenin’s successor, Stalin, to move against his own party. By 1938, he had executed any and all party leaders, whom he regarded as a threat.

Lenin’s formula for power fits the Egyptian situation to a T: A popular revolution overthrows a despised dictator. There is no planned succession. Any figure associated with the old regime is tainted. There will be some popular figures among the “revolutionaries,” but they are disorganized and have no ideology to sell. The dictator-to-be’s party may be small, and it may not be particularly popular, but it is well organized and can bring force to bear when necessary. It employs its organizational superiority, brutality, and raw power to outmaneuver or liquidate rivals. Once the dictator-to-be’s party is in power, he can turn his attention within to eliminate his rivals.

The Egyptian army is the one wild card, just as the Czarist army was Lenin’s wild card. Indeed, remnants of the white army fought Trotsky’s Red Army to a standstill, until they were split apart by internal disputes. The advantage to Lenin and the next Egyptian dictator is that both armies were conscripted rather than professional. Conscripted armies are less likely to fill a power vacuum than professional armies.

Wednesday, January 26, 2011

Russia Needs Our Money Now, But For How Long? Medvedev in Davos

Dimity Medvedev’s Davos charm offensive was cut short by the suicide bombing at Domodedova airport. He could not afford to be seen mingling with “Davos Men” as victims of the tragedy lay dying. Vladimir Putin learned this PR lesson when he continued his vacation as the Kursk submarine sailors suffocated under water. Medvedev returned today to Davos, his agenda reduced to two events: meeting with world business leaders and delivering a keynote address. In both events, he will deliver the same message: Russia is open for business. His listeners will be told that state companies are being spruced up for sale. Only a few will remain off limit to foreigners. Goldman Sachs has been gearing up, beefing up its presence in Moscow. Goldman and other venerable investment houses will lend an air of credibility to the undertaking.

There is no mystery why Russia is again open to foreign investment. The state budget receives half its revenues from oil and gas, whose prices are no longer soaring and whose outputs are stagnant. The Russian economy has been in a funk for a few years, and tax revenues are down. The vaunted rainy-day fund from the halcyon days of the energy boom is almost exhausted. In a word, the Russian state badly needs money.

Putin and company will be actually interested in selling state companies at high prices this time around. Previous “privatizations” have brought precious little into state coffers. The most lucrative state companies have already been sold (or resold) to the Kremlin’s friends at bargain basement prices. None remain under the control of unreliable oligarchs to be confiscated as was Khodorkovsky’s Yukos. Not that much remains to be sold. Rossneft, now owned ten percent by BP, is the big prize, so to speak. Other companies on the auction bloc are less appealing, such as RusHydro and Sovcomflot.

Medvedev’s invitation is not the first, nor will it be the last. Mikhail Gorbachev counted on a huge influx of foreign investment when he liberalized rules in 1986, but no one came. The Yeltsin administration courted foreign investment, but few ventured in. There were still no laws and rules. Willing foreign investors were subjected to endless waits for finalized versions of production sharing agreements and the underlying “normative acts.” Putin came to power on a platform of offering stability and a rule of law. BP, Exxon, and Shell took the bait to be bloodied by arbitrary tax police, environmental agencies, and local oligarchs. The passive foreign investors in Russia’s best-run oil company, Yukos, saw their investments fall to zero as Putin’s tax police and courts dismembered Yukos on phony charges.

We are now assured by Medvedev that this time it will be different. Russia is truly open for business as a reliable partner. It is said that Putin himself stands behind such deals. Medvedev’s economic team is spreading further good news at Davos, such as the government’s intent to streamline rules and lower taxes. Are such siren songs to be believed?

Recent history warns that foreign buyers should be wary for a number of reasons:

First, it matters little whether Putin and Medvedev both stand behind these deals. Putin, or whoever else is in charge in the future, can always change their minds, as BP, ExxonMobil and Shell can attest. In the absence of a rule of law, whatever those in power say is the law is the law. And there are number of ways to break agreements without violating the words written in the contract.

Second, the state will likely remain the major shareholder; minority shareholders would have to search the world for a worse partner. The Russian state will continue to use companies in which it has controlling shares as instruments of state power without much real interest in creating shareholder value.

Third, potential foreign investors should be aware that, despite the participation of the world’s leading investment bankers and accounting firms, they will have to buy a “pig in a poke.” As far as I know, there has been no real audit of any substantial Russian company, despite the respected accounting firms whose names are listed in the prospectuses. A real audit cannot be conducted because it would reveal the web of corruption and related party transaction that lie buried beneath the surface of each of these companies.

The most likely outcome is that foreign money will indeed flood in (the unknown is the price, of course). Putin, Medvedev and the Russian state will behave as long as they need access to world capital markets. With the money safe in its coffers (either in Russia or Switzerland), Russia will again at some point put the screws to hapless foreign partners when the price of oil soars or some other serendipitous event occurs.

Any foreign investor considering investing in Russia for the long run must consider two metrics: Russia currently ranks 154 out of 178 countries in corruption, equal to Tajikistan, Cambodia, and Laos, lower than Pakistan. In terms of political risk, it ranks 186 out of 196. These miserable numbers are not made up. They reflect the reality of what it has been like to do business in Russia.

How Western investors accept the Medvedev-Putin invitation is yet another test for world capital markets. If bids are low enough to reflect the reality of Russian risks and corruption, it will have done its job, and Russian public finances will not be bailed out by naïve foreign investors. If foreign investors pay prices that ignore this reality, they are again like Charlie Brown rushing forward to kick the football that Lucy will snatch away at the last moment.

Sunday, January 16, 2011

Wikileaks, Gazprom, the Putin Wealth Tax, and the Chinese Counter Example

Buried in the Wikileaks releases is an account of a rare meeting of Moscow Embassy officials in September of 2008 with the reclusive management of Russia’s largest company, Gazprom. In the meeting, the Gazprom official stated that Gazprom’s first priority is to provide reliable and affordable gas to the domestic population. The second priority is to "fulfill Gazprom’s social obligations," including charitable projects. The American envoys asked whether the maximization of shareholder value and its market share were also goals? Yes, was the perfunctory answer, but the official added a third priority: to maximize "control over global energy resources." Gazprom, the official said, is “a socialist rent-seeking monopolist."

Despite the fact the Gazprom official was speaking for the official record, his remarks are remarkably candid. Translated into clear language, he was stating that Gazprom is not run as a company that creates shareholder value for its owners (the Russian state and favored billionaire oligarchs). Its job is to exploit its monopoly position to generate “economic rents” for “society” and to act as an instrument of state power, while keeping the people happy with low gas prices and the sponsorship of sports teams.

As Soviet managers used to quip: “Under socialism, property belongs to everyone and no one. Therefore it might as well belong to me.” The veiled language of “socialist rent seeking” really means that Gazprom is to be used to make the life of the elite extremely comfortable. If it is not interested in or feels a sense of responsibility to minority shareholders, it is legitimate to ask why they should buy Gazprom stock?

“Control over global energy resources” tells us that Gazprom intends to maintain, at all costs, its monopoly over the export of natural gas from the former Soviet Union, including gas-rich Central Asia. It will use its economic power along with the diplomatic and military might of the Russian state to prevent rival pipelines from threatening its monopoly.

In order to keep the people on board with these first two goals, Gazprom must offer them cheap energy, even if that means a severe loss of potential profits. Again, the last person in line appears to be the minority shareholder.

The Russian state is the majority shareholder of Gazprom and the Russian Oil Company (Rosneft). The shares of each trade publicly. Gazprom is an almost obligatory holding for funds that invest in Russia. It accounts for more than a quarter of Russia’s meager $500 billion stock market capitalization. Other energy companies are owned by control-exercising oligarchs favored by Putin’s Kremlin. They also have minority shareholders, and their shares trade publicly.

The example of the jailed former owner of the now-defunct Yukos oil company, Mikhail Khodorkovsky, taught these “private owners” that they must also run their companies according to Gazprom’s guiding principles. Maximizing shareholder value is not among their top goals. It need not be: These private owners can benefit more from siphoning company resources into their own pockets than by creating value through efficiency gains, innovation, and investment. This is entirely rational. Who knows when they will find themselves on the wrong side of the Kremlin.

Putin’s intentions for Russian energy concerns did not become clear until 2007. They were not clear even after the 2003 arrest of Mikhail Khodorkovsky and the destruction of his Yukos oil company (One of the few that sought to maximize shareholder value).

Between 2003 and 2007, Putin was thought to be pursuing a “liberal” policy of rationalizing Russian energy concerns, “liberalizing the energy market, and encouraging cooperation and even joint ownership with international energy giants. During this spurt of optimism, Putin even spoke of making Gazprom the world’s most valuable company – even worth more than ExxonMobil – with a target market capitalization of over one trillion dollars. International investors responded to such talk by driving up Gazprom’s shares, and in the second half of 2006 Gazprom’s market capitalization briefly ranked it as the third most valuable company in the world (but still a hundred billion behind ExxonMobil).

Investor optimism was spurred by the fact that Gazprom had the world’s largest reserves with huge likely but unproven reserves. It should be remembered that the share prices of Gazprom and other publicly traded energy companies are determined in stock markets by international investors. These prices reflect the stream of future profits and dividends anticipated by investors.

Gazprom’s share price plummeted as investors began to understand Putin’s real intention. Russia’s energy reserves were to be strictly off limits to outsiders, Russian energy companies were to be run in the interests of the Russian state by its favored elite. There would be little difference between private and public management. Putin’s deputy was to run Gazprom; trusted Oligarch Vagit Alekperov could run Lukoil. Putin’s blatant and unapologetic use of tax authorities, environmental agencies, and the prosecutor’s office to threaten and blackmail foreign energy concerns could not go unnoticed even by the most bullish investors.

Putin’s energy policies enriched the favored elite, including Putin himself, and they have transformed both public and private Russian energy companies into instruments of state power. They have prevented new technology and investment from entering the industry, and output is stagnant or declining. These policies have had remarkable economic effects in the form of lost wealth and, more importantly, missed investment opportunities.

There is a consensus that Russia’s energy sector has a creaking infrastructure and that its remote and inaccessible reserves require huge capital investments. Russian energy companies lack the will and capital to make these huge investments. High share prices mean that Russian companies could tap international capital markets to obtain “cheap” capital. If Gazprom’s share price is $60 dollars, it can raise $60 million dollars by issuing a million shares. If the share price is $20, it can raise only $20 million by issuing the same number of shares.

It is relatively straightforward to calculate the wealth destruction and lost investment opportunities of Putin’s energy policies. Currently, the market value of Russia’s six largest energy concerns is some $317 billion. They constitute almost 65 percent of the market capitalization of publicly traded companies in Russia. Proven reserves are a major determinant of share values, and currently Russian energy company shares are valued between $1 and $4.50 per barrel of reserves, with Gazprom having the highest current valuation (and the small Tatneft having the lowest). At the peak of optimism concerning Putin’s energy policy in May of 2006, Gazprom traded at $10.40 per barrel of reserves, remarkably close to the world’s foremost run state-owned oil company (Statoil of Norway).

Simple calculations show that if Russian reserves were valued today at these rates of peak optimism, the market value of the top five Russian energy companies would almost triple from $317 to $1.1 trillion – an $814 billion increase that is 1.5 times the current market capitalization of the entire Russian stock market. Gazprom’s market cap alone would rise by 175 billion. This $814 billion destruction of wealth is a massive “Putin Tax” levied as a consequence of inefficiency, corruption, and political objectives. The $814 billion figure also represents the huge investment opportunities that well managed companies and a proper investment climate could yield.

It should be a major embarrassment to Putin that an energy company with much more modest reserves located in China is closer to fulfilling his goal of making Gazprom the most valuable company in the world. In September 2010, Petrochina ($329 billion) briefly surpassed ExxonMobil ($316 billion) as the company with the highest market capitalization in the world. Although Petrochina has only three quarters of Gazprom’s reserves, it is more than twice as valuable (at times three times as valuable) and its reserves are valued as highly as those of Statoil. If Putin’s energy industry had matched the achievements of Petrochina, its value would be $211 billion higher than it is today.

The valuation of Petrochina’s reserves as highly as Statoil’s may suggest an overvaluation, but it does show the huge chasm between investor sentiment concerning China’s versus Russia’s investment climate.

Again, Russia is the loser and China is the winner, although property rights are far from perfect in China, and China is embarking on its own “national champions” program. The world investment community looks at Petrochina and Gazprom through quite different lenses. These lenses say that Russian energy concerns are going nowhere but down, that property rights are insecure, that corruption is rampant, that assets are being diverted to private hands. In this regard, international investors appear to have an accurate picture of Russian reality.

BP, Putin, and Russian Oil: Will They Never Learn?

Robert Dudley, CEO of British Petroleum, and Igor Sechin, Russian Deputy Prime Minister and board chairman of Rosneft, announced a new mega-deal between BP and the state owned Russian oil company. Through a stock swap, BP acquires 10 percent of Rosneft in exchange for giving Rosneft 5 percent of BP. Together, the two companies will explore offshore tracts in Russia’s South Kara Sea. As a ten percent owner of Rosneft, BP, in theory, acquires over two billion barrels of oil reserves – enough to replace the reserves BP sold to help pay for its Gulf oil spill. The deal makes the Russian “national champion” oil company BP’s largest single shareholder. BP becomes one of Rosneft’s largest private shareholders (the state owns three quarters) along with Oligarchs Roman Abramovich and Oleg Deripaska. Deripaska, a survivor of Russian gang warfare over aluminum and nickel, has been banned from travel to the US due to his suspected ties with organized crime – an unlikely partner for the staid British company.

The BP-Rosneft deal reminds me of the Charlie Brown cartoon in which Lucy pulls the football away from Charlie Brown for the umpteenth time as he approaches to kick after solemnly promising that she will never do this again. Is this not the same Robert Dudley, the CEO of the TNK venture with Russian oligarchs, who was expelled from the country, was accused of violating Russian laws, whose employees were charged with espionage, and who saw a Russian oligarch appointed to his position – while Vladimir Putin looked on from the sidelines?

One news account of the deal points out understatedly that BP was able to acquire its ten percent share in Rosneft so cheaply due to the “political risk of investing in Russia,” reminding readers that Dudley himself had been expelled from Russia, that Shell was forced to cede its majority stake in its Sakhalin project, and that other foreign investors had been harassed out of Russia by the tax police or by threats from the prosecutor’s office.

What assurances does BP have that Russia will not again use its time-tested Lucy-Pulling-Away-the-Football trick? The BP announcement stresses that the deal was approved by Vladimir Putin himself. And none other than his trusted deputy, Igor Sechin (also board chairman of Rosneft), signed off. What greater guarantees could there be?

In Putin’s Russia, it makes little difference who signs and who approves! In the absence of a rule of law, a contract is what those in power say it is. Moreover, deals can always be scuttled in ways that leave those at the top who signed off blameless. Shell, which had a legal contract to produce in Sakhalin without a local partner, was deemed in violation of environmental regulations and was under immediate threat of losing its drilling rights. These same serious environmental violations disappeared overnight when Shell ceded majority interest in the project to Gazprom. Poor Putin, of course, was helpless. He could, not interfere in the legitimate work of his environmental protection agency. Similarly, Russian regulators used technicalities to abrogate ExxonMobil’s contractual right to market gas from its Sakhalin project outside of Gazprom’s export monopoly – another agreement approved at the highest levels of the Russian government.

The West has lectured Russia since 1991 on the importance of the rule of law. Actions, such as BP’s, tend to render these lectures hot air. No matter how badly Western energy concerns are treated, they (like the hapless Charlie Brown) will take another kick at the disappearing football.