How Russia is Ruled: Inights from the BP Failure

The failure of BP’s venture with Rosneft provides tantalizing hints about how Russia is governed and its 2012 Election. BP joins with Shell, Exxon, and other major international energy companies in chalking up yet another failure in Russia’s lawless investment climate. BP should have known better after losing management control of its TNK-BP venture to its Russian AAR partners. But this time, BP felt it had the right people on its side.

When BP signed with the Russian state oil company, Rosneft, to develop offshore arctic reserves, I expected this would prove to be yet another misadventure. But BP thought this deal would be different. It was negotiated with Putin’s right-hand man (Igor Sechin) and blessed by Putin himself at the signing ceremony. There was the small matter of an exclusivity agreement with BP’s billionaire-Russian partners in its TNK-BP venture, but BP thought that matter would be “taken care of” by the Russian side (a la Khodorkovsky?). Surely the Russian state would back a deal that could rejuvenate Russia’s lagging energy production and fill state coffers.

The oligarchs behind AAR -- Mikhail Fridman of Alfa Group, Len Blavatnik of Access Industries, and  Viktor Vekselberg of  Renova--  proved too formidable for BP. They also brought to the table an unusual weapon for Russian companies – a legal position that carried weight in international courts.  

Putin did not take care of the Russian side. The AAR partners took BP to court outside of Russia and won an injunction that quashed the whole deal. Fridman, Veksleberg, and Blavatnik did offer BP a “deal” early on  -- that they take half of BP’s half in the arctic venture with Rosneft.  BP first boycotted the meeting called to vote on this proposal and then vetoed it outright.

My first take was that “the Russian side” had set BP up from the very beginning. AAR, Sechin and Putin had agreed to squeeze BP’s share of the deal down to a quarter, leaving one half for Rosneft and  one quarter for the three billionaires. Maybe one quarter would be enough for a BP teetering in its recovery from its Gulf  oil spill disaster.

I was wrong. It appears there is no “Russian side.” The deal is dead. Sechin is mad  at the three billionaires and is threatening them. Rosneft has to find another partner, but what major oil company would get involved in such a mess now? BP is not out of the woods. Rosneft could sue it for damages resulting from the failed deal. This is clearly a deal gone bad for all parties. There are no winners – only losers.

BP’s saga gives us insights into how Putin’s Russia is run. Instead of  well-defined hierarchical relationships, the Russian system of governance is  comprised of swirling forces, competing against each other. Equilibrium is never reached. There are never any final victories over competitors. According to this interpretation, Russia is far from a “KGB state” of former KGB officials and allied oligarchs, who obey the “Master” Putin. Putin is the most important player, but one of many.

I was Right All Along: BP ¼, Russia ¾

In my March 4 posting, I wrote that BP was about to be rolled by Russia again. On Friday, the debacle took place.

BP’s share swap deal with Russia’s national oil company Rosneft was supposed to give it a half interest in the development of rich Arctic offshore reserves. BP’s billionaire partners in its ongoing TNK-BP venture objected. BP had signed an exclusive agreement with them, and an arbitration court agreed. To go along, the billionaire partners demanded half of BP’s half. BP vetoed that offer at a TNK-BP board meeting in early March. BP had expected Putin to take care of the billionaires’ objections. He did not. Putting Khodorkovsky in jail was one thing, but the TNK billionaires are his friends.

BP now understands that what they were offered in early March is the best deal they will get.

My March 4 prediction was that BP would end up with a quarter of the deal (instead of a half) and Russia (Putin and the billionaires) would get the three quarters they wanted.

Low and behold, BP announced on Friday, May 6, that it would hand the deal over to TNK-BP (thereby reducing its share to ¼) with the hope that its Russian partner, Rossneft, would agree. Rossneft greeted BP’s offering with grumbling. Maybe BP will get ¼, but they will have to make further concessions to get even that.

This outcome will not endear Robert Dudley to his shareholders, who accuse him rightly of misreading Russian politics. It is also another cautionary tale about doing business in Russia.

BP’s Travails Continue: Is Something Big Going On In Russia? (The NYT and BP Still Do Not Get It?)

The NYT’s “Misreading the Enigma” gets one thing right: BP has lacked “geopolitical acumen” in its Russian dealings. BP’s proposed share swap with Rossneft (the State oil giant) is on permanent hold. The Stockholm arbitration court says BP may have violated its shareholder agreement with its billionaire AAR partners in their private BP-TNK Russian oil venture.

It now turns out (according to confidential NYT sources within BP) that BP had disclosed the potential conflict to the Kremlin but thought that the Kremlin “would resolve any difficulties with the local shareholders” because the BP deal coincided with the Russian national interest. BP failed to understand that in the Russian KGB state, no one (including Putin) really cares about the “national interest.” The confidential BP source went on to state the obvious: “It hasn’t happened yet. It has to happen now.”

It also turns out that the presumed patron of the deal, Putin, was aware of the conflict and remarked at the signing that the AAR partners were “litigious.” Putin now claims he was “completely in the dark.” BP “didn’t say a word about this.”

Here is the proper interpretation of what is going on: When BP struck its deal in January, the Russian treasury was empty. It needed investment in arctic oil, and the world price of oil was low. Russia needed BP. BP, thinking Putting was on their side, assumed that Putin would “pull a Khodorkovsky” on the AAR billionaires. If they want to kick up a fuss against the deal, Putin had a steel cage ready for them in a Moscow courtroom, BP thought.

Putin did not put the squeeze on the AAR billionaires for any of a number of reasons: First, AAR had already bought him off to help them in their plan to get half of BP’s half of the Rossneft deal. (Putin might need a few billion more for his portfolio). Second, Putin can take on a single Oligarch (such as Khodorkovsky), but can’t take on three at once. If this is the reason, Putin is less powerful than we think. Third, Putin fears he faces a real challenge from Medvedev in the 2012 presidential election and needs the AAR billionaires and their media empires on his side.

Whatever the interpretation, things do not look good for BP, which is now looking for a “reasonable commercial solution.” That solution is the one I have been predicting for quite a while: AAR gets one quarter of the Rossneft drilling venture, “Russia” get a half, and BP is reduced from a half to a quarter.

Such is the price of misreading the geopolitical tea leaves.

More on BP in Russia: Predicted Final Score: Russia ¾, BP ¼

Friday and Saturday’s papers brought more news of BP’s travails in Russia and, I think, a great deal of misinterpretation. Whatever the case, BP’s chances do not look good.

Background: BP signed a stock-swap deal with Rosnet (Russia’s largest state owned oil company) to jointly develop arctic reserves, splitting the proceeds fifty-fifty. BP’s other Russian partnership (TNK, for short), of which BP owns half (but lost management control to its Russian partners’ strong-arm tactics), sued to stop the BP-Rosneft deal as violating the BP-TNK shareholder agreement. A Stockholm arbitration court has placed an injunction on the BP-Rosneft deal. While the injunction is in effect, BP cannot proceed with the Rosneft deal, and more than a billion dollars of dividends from TNK operations are held up as well. TNK offered to substitute TNK for BP in the Rosneft deal, but BP vetoed this proposal (casting the sole negative vote). Confusing to say the least! If the TNK proposal had been adopted, the Russian side would end up with ¾ of the BP-Rosneft deal and BP with ¼.

Press reports picture this as a power struggle between two Russian sides – Rosneft as represented by its chairman (and Russian deputy prime minister), Igor Shechin, and BP’s Russian oligarch partners in TNK, led by banking mogul, Mikhail Fridman. The delay in the BP-Rosneft deal is pictured as a defeat for the Kremlin and a victory for the private oligarchs. If there were such a power struggle, it would be lopsided. If Putin really wanted to end the controversy, he need only remind his oligarch friends what happened to Mikhail Khodorkovsky.

The outcome of this “power struggle” seems clear to me. BP will have to back down and accept a ¼ interest. The “Kremlin” gets one half and the “rogue” Russian oligarchs get ¼, while bringing little to the table other than their ability to scuttle the deal. This is by no means a defeat for the Kremlin: BP will give in voluntarily, and Russia will only have to give up one quarter of its “national treasures” to foreign interests.

BP should have learned its lesson last time. It should know by now that only foreign companies obey Russian shareholders agreements and international law. If a Stockholm court rules against a Russian partner, the ruling will be ignored or a way will be found around it. BP, however, must abide by the law.

BP should also have learned that there is no one on the Russian side really concerned about the Russian national interest. With this debacle, Russia’s reputation as an international partner will suffer again, but no one really cares.

The lure of its reserves are such that another BP will step forward. The deal will make Russia’s oligarchs richer and more powerful and the Kremlin insiders will get their rewards. Moreover, the turmoil in the Middle East has driven up oil prices again; so the Russian budget is in better shape. Who really needs foreign money?

BP’s New Russian Nightmare? Imagined Conversations

A meeting in the Senate Building of the Kremlin between Igor Sechin (Vladimir Putin’s Deputy Prime Minister and Chairman of the state oil company Rosneft) and Mikhail Fridman (Chairman of Alfa Group and President of the TNK-BP joint venture). Both are ultimate Kremlin insiders. They know each other inside out.

Sechin (to Fridman): We can understand that you and your associates want in on Rosneft’s deal with BP. Maybe you do have some kind of shareholder’s agreement with them that raises questions about our new deal with them. Exactly what do you suggest?

Fridman: Well, we propose to substitute TNK-BP in place of BP as Rosneft’s partner. This means that this “national Champion” project will be owned 75 percent by Russians and only one quarter by foreigners. BP really should not get half anyway. These reserves are Russian national treasures. If this is done, we’ll withdraw our objections to the deal, and everyone will be happy except BP.

Sechin: But we need BP’s capital and arctic drilling technology. What is to prevent them from withdrawing from the deal entirely?

Fridman: BP desperately needs this deal to replace the reserves it lost in paying for the Gulf spill disaster. Getting a quarter of the deal for them is better than nothing. We already know that BP caves in when we play hardball. They gave us the management of TNK-BP when we refused to grant their Robert Dudley (then President of TNK-BP) a visa and harassed their lawyers. They’ll cave again in this case.

Sechin: What if they don’t cave this time? Is there anything else we can do to be sure they will go along?

Fridman: It’s very simple. You can threaten to sue TNK-BP for damages to Rosneft if the deal does not go through. You know better than anyone how to get a huge fine out of our courts. As fifty percent owner of TNK-BP, BP is liable for half of this fine. That should scare them to death. Their liability could be as great as the Gulf coast spill. We can work out among ourselves the “damages” that we pay.

Sechin: But will not this be bad for our image among international investors? We need them now. Medvedev was already getting a lot of flak in Davos over the Khodorkovsky case. And the Hermitage Capital guy was mouthing off against Russia again.

Fridman: You should present this as a Kremlin split. After all we are private investors looking after our own interests. You can publicly warn us not to do this in the name of the Russian government. We’ll just ignore what you say, and the international press will play this as a real split between the Russian state and Alfa Group. We already have prepared as press statement for you. Here it is:

“I hope all the misunderstandings will be eliminated, but, if the deal fails, Rosneft will calculate its losses from the failed deal and will ask for compensation from those who would have inflicted the losses.”

Sechin: I think I can convince the Boss to go along with this. I assume there will be the usual financial arrangements.

Fridman: Yes, of course.

Sechin: One final word: This scheme may not work out as planned. BP may hold a wild card in its deck. If we conclude that you have to retreat, you will follow our orders. We need not remind you of what happened to your former colleague Khodorkovsky.

An imagined conversation in BP headquarters (London)

Dudley: It looks like the Russians have us backed into a corner. Our TNK partners have called a meeting in Berlin to approve the substitution of TNK-BP for BP in the BP-Rosneft deal. They want it in Berlin so their “independent” director Gerhard Schroeder (former German Chancellor) can give it the cover of respectability

BP lawyer: If there are fines, BP will have to pay as a law abiding company. There will really be no way to determine whether our TNK partners will also pay up.

Dudley: So what do you suggest?

BP lawyer: The only thing we can do now is not attend the Berlin meeting to avoid a quorum. Maybe we can think of something.

Both conversations are fictional. They may seem far fetched but anyone doing business in Russia encounters such things routinely. Even if these conversations never took place, they will be imagined by Western parties who know that the worst can happen to them in Russia.

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.

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.