Lord Browne’s Russian Easter Egg
The March 27 Yukos Assets Auction

Lord Browne is the outgoing Director General of British Petroleum. Last week he visited Moscow to meet with President Putin. The meeting is almost certain to be more consequential than its declared agenda implies.

BP has a large stake in Russia, mostly via TNK-BP, which is the largest joint venture in Russia’s energy sector.1 Today, TNK-BP is Russia’s third largest oil company2 in terms of reserves3 and crude oil production.

One of TNK-BP’s most valuable assets, technically held by RUSIA Petroleum, is the huge Kovykta gas field in Eastern Siberia (1.9 trillion cubic meters). Kovykta represents the latest target in Russian authorities’ drive to re-establish control over strategic hydrocarbon reserves4.

The threat to TNK-BP’s Kovykta license is a classic Catch-22 case. The gas field is located in the Irkutsk administrative region. According to the governmental projections dating back to 1997, by the end of 2006 the region would have needed 9 billion cubic meters of gas per year. Under the terms of the license TNK-BP had to produce these 9 billion cubic meters, plus whatever gas it was ready to export.

The region’s population is barely three million. Had it consumed the full 9 billion cubic meters, it would have used roughly three times per capita the consumption of the Europe’s industrial nations. By now everybody involved – including the governmental agency which has the authority to modify the terms of the license – agree the rate of regional consumption was grossly exaggerated.5

To reach production levels mandated by their license, TNK-BP would need to export the surplus. But to do so it needs a pipeline. Alas, they are not allowed to build one because the government monopolized all export related pipeline construction and operations by delegating them to Transneft and Gasprom. And Gasprom and Transneft have no intention of building the pipeline before TNK-BP sells controlling interest in Kovykta to Gasprom.

Clearly, under such circumstances TNK-BP cannot be expected to reach the production levels stipulated in their license, right? Wrong. In the Kafkian world of Kremlin scheming, the holding was given notice it was in default of its license obligations and “generously” given a full three months to correct the violations – or risk losing the license, and with it up to one third of its proven reserves. Not even the licensing authority is pretending TNK-BP can rectify its “license violations” in three months.

Little wonder Lord Browne visited President Putin the other day. But he did not go to the Kremlin merely to plead for mercy. In all likelihood he would have never made it onto the presidential schedule without something new to offer.

After months of negotiations with Gasprom (two meetings with its head in the last four months alone), Lord Browne apparently decided to offer something valuable to those in Russia who can control Gasprom’s aspirations. Here is what he must be gambling on.

After Yukos was crushed, its key assets went to Rosneft, which made Rosneft the nation’s biggest oil company. Thus, Russia’s hydrocarbon market came to be dominated by two government controlled giants: Gasprom and Rosneft. And with Gasprom aggressively moving into oil and even electricity, the scene is set for a King Kong vs. Godzilla.

Their inevitable clash is aggravated by the fact that Gasprom and Rosneft are linked to the two opposing political camps engaged in a clandestine battle for the 2008 presidential elections. Most professional observers are failing to point out this crucial elections link.

So let’s start with the players. Gasprom’s board is chaired by Dmitry Medvedev, First Deputy Premier and believed to be the presidential candidate Putin is most likely to endorse. Sergei Bogdanchikov, Rosneft’s president, is close to the so-called ‘siloviki,’6 who are reportedly clustering around Igor Sechin, deputy head of Putin’s presidential administration and chairman of Rosneft’s board of directors. ‘Siloviki’ are associated with the national security and law enforcement communities, not merely by their Soviet careers, but through their present day links to corresponding agencies. Siloviki’s apparent presidential candidate is Sergei Ivanov, ex-Lieutenant General of the KGB, who until recently was Minister of Defence. Presently he is also a First Vice Premier7, and competing with Dmitry Medvedev for Putin’s endorsement.

March 27 is the day 9.44% of Yukos owned Rosneft stock will be auctioned off at the starting price of $7.5 billion. Before Lord Browne’s visit last week to the Kremlin, Rosneft remained the sole registered bidder. Under Russian law without at least two bidders an auction cannot be consummated8. If BP bids on the remainder of Yukos’s carcass, nobody could claim the coming auction is a scam. Hence, Lord Browne’s hospitality “Easter egg” gift to President Putin was BP’s decision to bid in the auction.

The perceptive value of BP’s move is captivating observers’ attention. Bruce Misamore, former Yukos CFO, immediately accused BP of conveying a veneer of legitimacy to what he called the “sale of stolen goods.” However, Lord Browne’s move may be much more strategic than professional analysts perceive.

BP already owns 1.25% of Rosneft stock it purchased during the company’s July 2006 London IPO for a billion dollars. The starting price of the 9.44% stake up for auction March 27 is about 10% below market. If BP succeeds in its bidding, it will end up with 10% of Rosneft and likely a board seat (there are now nine directors, five of which are senior government officials). It would make for an excellent starting position for forging a strategic partnership with Rosneft. Defending the Kovykta field from Gasprom might suddenly become much easier. Especially since Putin will see BP’s move as a favour helping bury Western investors’ memory of the Yukos heist.

Why would Rosneft look positively at BP’s latest move? Isn’t BP competing with Rosneft’s own bid?

Both Rosneft and Gasprom are carrying dangerous levels of corporate debt. In fact, industry analysts note both lack the capital to develop assets and increase production. Some even predict Gasprom’s inability to deliver on long term contracts as early as 2010. The $7.5 to $10 billion Rosneft would need to buy back its stock may push the company’s finances much too far into the red zone. Plus a closer relationship with BP could help with access to technology and expertise for developing Rosneft oil fields.

Looks like Lord Browne made a strategically wise move. The only likely downside is BP took sides in the Russian presidential brawl rather early on. But then, no knowledgeable observer expects to guess who will get Putin’s endorsement before the very last campaign months.

Politically, the situation offers an ever welcome reminder Russia has not been totalitarian for many years now. In fact, it no longer was in its last Soviet years. Totalitarian regimes just do not unravel from within – not as long as they are actually totalitarian. Putin’s sliding back on democracy notwithstanding, not even he can become a dictator. In fact, his power depends on counterbalancing the influence of various, mostly hydrocarbon rich clans. He knows the moment one clan is allowed to gain the upper hand, his presidential power will diminish drastically. Today’s Russia has multiple centers of power, and Putin is not the only one who can craftily manoeuvre between them.

Apparently, as his Easter gift indicates, Lord Browne is not alien to certain Byzantinian manoeuvres.

Endnotes

1. Formed by British Petroleum (BP) and Alfa Access Renova (AAR), which owned, among others, Tyumen Oil Company (TNK), it was inaugurated in the fall of 2003 in the presence of British and Russian heads of state. BP and AAR own equal 50% stakes in the joint venture. BP contributed assets estimated at $2 billion: its holding in Sidanco, its stake in RUSIA Petroleum, and its BP Moscow retail network. AAR – its holdings in TNK International, Onaco and Sidanco, its share in RUSIA Petroleum, which holds licenses for the Kovykta gas condensate deposit and the Verkhnechonsk oil and gas deposit, as well as AAR’s stake in the Rospan gas field in Western Siberia (the New Urengoy and East Urengoy deposits). In January 2004, BP and AAR reached an agreement to incorporate AAR’s 50% stake in Slavneft into TNK-BP. Slavneft, which has operations in Russia and Belarus, was previously owned jointly by AAR and Sibneft. Under the transaction terms, BP was committing cash as well as its own shares as future payments.

2. Its 2005 dividends amounted to $4.9 billion; in November last year the board approved an intermediate 2006 nine month’s dividend of $3.6 billion.

3. DeGolyer and MacNaughton confirmed that as of December 31, 2006, TNK-BP’s total proven reserves were 7.810 bn bbls or 1.0 bn tons of oil equivalent on a SEC (US Securities and Exchange Commission) life-of-field basis; 8.949 bn bbls or 1.19 bn tons of oil equivalent on a SPE (Society of Petroleum Engineers) basis.

4. The first and best known case of the Kremlin’s camouflaged privatization campaign was the destruction of the Yukos Oil Company, accompanied by the imprisonment of its founding owner and President Putin’s political opponent Mikhail Khodorkovsky. The remainder of Yukos assets is to be put up for auction in a few days, March 27. The last success in the camouflaged privatization drive was the coerced sale by Shell and two Japanese companies of the controlling interest in their $22 billion Sakhalin-2 project to Gasprom. Accused of environmental transgressions, Shell et al. chose to surrender control to the government controlled Gasprom rather than losing their license to these fields.

5. BP projections are 2.0-2.4 billion cubic meters by 2008, and 5-7 billion by 2020.

6. Plural for Silovik (transliteration from Russian). Wikipedia definition: A Silovik (from a Russian word for power) is a Russian politician from the old security or military services, often the KGB and military officers or other security services who came into power in the teams of Boris Yeltsin or Vladimir Putin. The term derives from the fact that these people come from "power ministries," which under Yeltsin and Putin formed a de facto higher level inner cabinet. Sometimes the term is translated as "strongman." The drawback of this translation is that it obscures the particular career background of these persons, as described above. While realists, the siloviki tend to favor a conservative "Great Russian" nationalism; an autocratic, Slavophilic, tradition that stretches back to the reign of Tsar Alexander III. However, the siloviki do not go to the ideological extremes of nationalist groups such as Pamyat, the so-called Liberal Democratic Party of Vladimir Zhirinovsky, or the Tsarist-era Black Hundreds. Opinions concerning siloviki in Russia are polarized. Some argue that the siloviki have Russia by the throat and threaten the fragile democracy; their power is immense, and they tend to favor a statist ideology at the expense of individual rights and freedoms. Another point of view in Russia is that the siloviki are an appropriate counterweight to the Russian oligarchs, who might otherwise loot Russia and subvert its government. Adherents of this view compare siloviki to American law-enforcement figures like J. Edgar Hoover, who ran the FBI (and had a disproportionately influential standing in US politics) for nearly half of the 20th century. The above refers to the meaning of the word common in Western media. In Russian, it usually means officials in police, army or special services, regardless of their political stance. Political connotations do exist in some contexts, but are very rare.

7. With Sergei Ivanov’s promotion to this post Russia created another of its oxymorons: two “First Deputy Prime Ministers.”

8. Not that it prevented anything important in the past – at the Yugankneftegas (main Yukos asset) auction an absolutely unknown company not merely bid, but won, only to resell the prize to Rosneft virtually the very next day! But such shenanigans do not convey legitimacy to Kremlin maneuvers. They could even help Yukos’ owners in their litigation in the West.