GLOBAL INITIATIVES IN MANAGEMENT:

The Russian oil industry presents tremendous opportunities for firms, particularly in areas of engineering services, technical consulting and finance (raising capital, auditing). Russia has about 49-55 billion barrels or about 4.7% of the world’s proven oil reserves, and about 1,700 trillion cubic feet or 33% of the world’s natural gas reserves. Of total oil production, 40% is exported to take advantage of unregulated world oil prices. Further, 16% of total European oil consumption, and 20% of natural gas consumption is of Russian origin. In sum, oil and gas account for 10% of Russian GDP, and about 50% of exports making the sector critical for Russia’s economic fortunes.

This stature has led to significant challenges. Oil and gas are more than commodities and are also, tools of international power, components of foreign policy, elements of national security and a source of national pride. The fallout has been for Russia to be slow on sector reform with measures such as Production Sharing Agreement Legislation (PSA) that would help define tax, production, cost, and revenue sharing between the government and oil firms. Similarly, 90% of gas production and pipeline distribution remains in the hands of Gazprom, a quasi-state body. Higher world oil prices may also have bred a sense of complacency in these sectors badly in need of approximately $25-40 billion in investments over the next 5 years.

The experience of foreign oil firms (e.g., BP, Arco) in Russia has been disappointing due to a misalignment of interests. Russian oil companies tended to view Western companies as cheap sources of capital and advanced technology, but reneged on promises to provide choice exploration and drilling opportunities. Western companies did not provide the technical know-how and training, but rather sought to gain cheap access to rich fields. Assessing activities of both Russian and Western oil companies, to be successful, a company should vertically integrate (to provide reliability throughout the value chain), combine Russian assets with Western management, focus on a few activities for large investments (outsourcing or partnering for others), choose partners carefully to calibrate business goals, build political networks at every level of government (rather than solely rely on higher executive power) and demonstrate a long-term commitment to Russia.

For the future, the industry is likely to be dominated by large vertically integrated Russian corporations relying on Western engineering and consulting firms for know-how and skills. Western companies are expected to be active in hard-to-reach areas such as offshore sites and fields in the Far East. PSA legislation should move ahead as the Duma is increasingly recognizing its benefits and it could attract up to $85 billion in much needed investment over the next 5-7 years.

2. INTRODUCTION

Understanding the Russian oil industry is fundamental to understanding the country’s economy, its involvement in an increasingly global industry and the dynamic changes shaping government policy, strategy and the competitive landscape. As the second largest oil producer after Saudi Arabia, Russia accounts for 8.8% of world oil production and 4.7% of world reserves. Closely related, Russia accounts for 33% of the world’s natural gas reserves and is the world's largest gas exporter, with 7.1 trillion cubic feet (tcf) in net exports. Despite the interactivity between the two sectors, this report will focus primarily on Russian oil, and upstream activities in particular.

The oil industry has experienced dramatic change over the past decade. After the demise of communism, the oil sector became fragmented. Privatization prompted the emergence of disparate Russian oil companies and the new environment encouraged the entrance of foreign investors. Despite much investment, oil analysts estimate the industry still needs $25-40 billion in additional capital investment over the next five years to exploit the country’s naturally endowed resource.

After the August 1998 financial crisis, the weakened ruble combined with a tight oil market made Russian exports very attractive. Countries in the former Soviet Union accrued significant debt and were no longer able to meet payment obligations. Therefore, Russian oil exporters have targeted Western Europe, where demand for oil is strong, supply is limited, and payment is in cash. This strategy remains in place although Russia is broadening its reach eastward towards Asia and other states under various international sanctions.

The research objectives have been to:

1. Understand the role and importance of the oil industry to Russia’s development;

2. Identify opportunities and barriers to growth;

3. Assess the implications and role of foreign companies in Russian oil industry development; and,

4. Determine how Russia could better leverage its vast oil reserves and sustain future growth.

To accomplish these objectives, the research methodology was comprised of two phases:

1. Pre-Russia Research: The main sources of information were industry experts, analyst reports and research obtained from the Internet, Russian media, and industry journals. Contact was established with industry-related companies and organizations to meet while in Russia.

2. Field Research in Russia: There was an opportunity to meet with executives from British Petroleum (BP), Tyumen Oil Company (TNK) and Yukos to hear firsthand about their Russian experiences. Additionally, meetings with several industry analysts from firms such as PricewaterhouseCoopers and The Boston Consulting Group (BCG) were beneficial. Furthermore, oil experts from the US Department of Commerce and the US Embassy’s Economic Section provided valuable information.

This document is the outcome of several weeks of research and will be structured accordingly:

· General industry overview

· Key opportunities and challenges

· Case studies

· Learning points, recommendations and future implications.

3. INDUSTRY OVERVIEW

3.1 History Background – Pre-privatization Era

For decades, the Soviet oil industry was a complex structure of oil drillers, producers, refiners and a sole transporter, all of which were controlled by the State. Control was enforced in various ways such as imposing production quotas on oil drillers and obligating them to sell to the state-owned transportation company. The production methods used did not foster quality assurance, continuous improvement, optimal lifetime of the oilfields, or high system efficiency. Instead of being shaped by common business principles, production was defined by the nature and composition of national fuel demand. Downstream operations were primarily designed to supply heavy fuel oil to energy-inefficient heavy industry and power stations. At the time, there were relatively few cars, and light refined products (e.g. gasoline) were not a priority. Consequently, much of the refining capacity lacked secondary processes to produce high-margin light products.

The State structure is comprised of three ministries to oversee the oil industry. The Ministry of Geology was responsible for finding oil, the Ministry of Oil and Gas was responsible for drilling, and the Ministry of Refining managed crude processing and downstream activities. The Ministry of Refining created a strong refining capability that still remains a major portion of current capacity. Russia’s refining capacity is 6.6 million barrels (bbl) per day, although demand is only 50% of that level.

Russian oil production peaked in 1988, with daily deliveries of 11.4 million bbl to domestic and export markets. From this peak, oil production steadily declined until it reached a low of 6.04 million bbl per day in 1996. This shrinkage was due to several reasons. The Russian economy experienced a slowdown between 1990 and 1992, thereby lowering energy demand. More importantly, most oil produced was extracted from fields that were already 60-90% depleted. The situation was worsened since the drilling equipment came from Azerbaijan, which after independence, increased the equipment prices, substantially increasing costs for Russian oil firms.

Another factor that made privatization the most suitable solution to alleviate this industry in decay was low world oil prices. Whereas the State historically would secure foreign loans, this was no longer the case. Now, there was a desperate need to finance immediate maintenance expenditures throughout the value chain, but declining production levels exacerbated by low oil prices made it difficult to secure loans. Therefore, privatization sought to encourage direct investment in the industry and was critical to its modernization and future development.

3.2 Privatization

During the first stage (1993-mid 1994), President Yeltsin’s administration started the commercialization of state enterprises into joint stock companies. Although the State maintained 38-55% of company shares for a minimum three years, remaining company shares were sold through a voucher system, with ownership restricted to Russian citizens and workers. In doing so, the plan was to create vertically integrated oil companies (VICs). Initially, four VICs resulted from this process: Lukoil, Surgutneftegas, Yukos and Rosneft. The remaining VICs were formed soon thereafter.

During the second stage (1995-today), the State’s shares were auctioned off in blocks to foreign investors in exchange for (i) commitment to maintain employment levels and make future contributions and (ii) cash payment. Examples of second-stage privatization include the sales of 9% of Lukoil for $200 million in cash plus $240 million in investment commitments, and of 48.7% of TNK for $90 million plus $184 million in investment commitments. In general, privatization has lacked transparency and has had problems with Russian bureaucrats and businessmen ‘discouraging’ or effectively prohibiting foreign investment through coercive tactics.

As part of this second stage of privatization, the State sought loans from domestic banks through the loans-for-shares program to address the desperate cash need since the mid 1990s. Selected Russian banks granted the State loans with flexible repayment conditions with the State’s shares serving as collateral in a disguised auction procedure. At maturity (three years hence), the State had two options: (i) repay the loan and get back its shares, or (ii) sell off the shares. If the State opted for the second alternative, it would pay the banks 30% of the difference between the privatization sale price and the original loan amount. The State assured the non-participation of foreign bidders in the process by describing the companies up for auction as ‘strategic’ and enacting vague legislation that essentially barred any foreign attempt to bid.

The State has since abandoned such covert practices. One recent promising example was the September 2000 sale of Onako, which realized $1.08 billion, twice the asking price. The privatization process is not yet complete, as the State still holds a 19.6% and 25.5% stake in Rosneft and Slavneft respectively.

3.3 Role of Oil in Russia Today

The oil industry plays a significant role in Russia’s macroeconomy, investment environment, infrastructure development, politics and foreign policy. When combined with natural gas, it comprises approximately 10% of GDP and more than 50% of exports. During the past couple years, oil companies have become the most profitable sector of the economy primarily due to high oil prices, a five-fold increase in export revenues, streamlined operations and lower costs.[1] Consequently, analysts estimate the oil industry has driven much of Russia’s economic recovery since 1998, with estimates ranging from 35-85% of economic growth fueled by oil.[2] Anders Morland, President of British Petroleum (BP) Russia, candidly explained, “Energy is the only sector that makes a real difference to the Russian economy;” several industry experts and executives share Morland’s sentiment, thereby underscoring the fundamental role of oil to Russian economic progress.

Given its central role in the economy, it is logical that oil is a significant driver of both domestic and foreign investment. Domestically, oil companies not only make huge investments in upstream and downstream operations but also invest in infrastructure development and invest across industries and other business groups. Naturally, these large oil conglomerates also invest outside Russia, as evidenced by the large capital outflow in recent years via offshore zones. With respect to foreign direct investment, the sector has had mixed results, as will be discussed more thoroughly in Chapter 4. For example, some Western companies have invested large amounts of capital, such as BP, Russia’s single largest foreign investor, which has invested $1.5-2 billion total to date but may be scaling back future investment.

Given the money and power associated with the industry, it is no surprise that oil does play a role in Russian politics. This legacy is in part due to the rapid privatization era that witnessed several oligarchs and individuals with political connections take big stakes in the oil companies. Over the past few years though, several firms have tried to shed that stigma by bringing in new management and equity holders disavowing such political connections. Today, VICs claim to keep a low profile and stay below the Kremlin’s radar screen. At the same time, it would be naïve to believe they do not wield influence over and lobby politicians to implement policies favorable to them. Notwithstanding, it appears the trend is favorably towards a western model in which companies’ primary concern is bottom-line profits, and not exerting political power.

Last, the oil industry occupies a fascinating role in Russian foreign policy; President Putin has referred to it as Russia’s “main strategic asset.” Oil reserves and transport dramatically shape Russia’s relations with its neighbors, notably the former Soviet republics, Caspian states and Turkey. Russia is certainly not alone in linking oil and foreign policy (e.g. US and Persian Gulf). However, it has come under increasing scrutiny for its tendency to use oil as a foreign policy weapon over places such as Ukraine, Georgia and Lithuania to keep them away from the West.[3] More cause for concern is Russia’s oil investments in ‘rogue states’ (e.g. Vietnam, Iraq, Iran, Cuba, North Korea) as an area of strategic commercial advantage or vacuum where Western companies do not compete. US Embassy-Moscow Energy Officer Geoffrey Lyon explained, “Russia is using energy to be the other pole in a bipolar world.” There also seems to be a clear linkage between arms sales and oil; this is evidenced by recent situations like Russia’s lobbying on behalf of Iran for part of the Caspian Sea and India’s successful bid for part of a Sakhalin project, both deals coincidentally in exchange for arms purchases. Clearly, Russia has found multiple ways to leverage its oil industry, and the fundamental role it takes in shaping Russia today is undeniable.

3.4 Industry Statistics

Today, Russia’s total proven reserves are estimated to be 49-55 billion bbl, comprising 4.7% of world crude reserves or 7.0% when combined with other former USSR states (Exhibit A). It supplies 16% of Europe’s oil needs, with Germany being a particularly important customer (Exhibit B). During the 1990s, exports were stable comprising approximately 40% of total production, but the export structure has changed significantly in recent years. Before the Commonwealth of Independent States (CIS) was created, Russia sold crude to other former Soviet republics in barter transactions for equipment and technical services. However, CIS market prices were well below world prices making it uneconomical for Russian firms to continue exporting there at such high levels. Thus, in 1993, exports to the CIS dropped 52% and have since stabilized at an annual average of 20 million tons (Exhibit C). Non-CIS exports are transported through terminals in the Baltic Sea (e.g. Ventspils), Black Sea (e.g. Novorssiysk, Tuapse, Odessa) and the Friendship pipeline. To diversify the transport network for exports and minimize risk, there are currently significant investments underway to improve overall export capabilities.

Although overall oil production decreased in the 1990s, production grew marginally in 2000 (Exhibit D). Since 1996, annual production has stabilized around 6.3 million bbl per day. Thus far, the oil industry has been developed primarily in the Western Siberia, Tyumen and Caspian Sea Regions; Western Siberia alone accounts for more than 60% of Russia’s total hydrocarbon reserves (refer to Exhibits E and F for detailed maps of such deployment). The industry as a whole is entering a late development phase so it is imperative to explore and exploit other regions, such as Eastern Siberia, Sakhalin Island, the Arctic offshore and Timan-Pechora fields. Unfortunately, most of these regions are under extremely harsh permafrost conditions, which makes development very costly and complex. Other significant fields include the offshore Shayvo, Odoptu, and Arkutun-Dagi oil and gas fields, together containing an estimated 2.5 billion bbl of crude oil and 15 tcf of natural gas.

As previously mentioned, the significant increase in world oil prices since 1998 greatly benefited Russia, fostering 3.2% macroeconomic growth in 1999 and 7.2% in 2000. This cash inflow helped Russia pay its debts and generate a $29 billion cash surplus.

3.5 Industry Structure and Key Players

It is important to understand the overarching structure, key players, their respective roles and priorities. The industry is comprised of various components of the value chain from exploration, drilling, extraction and production to refining and retail. The major players in the oil business and industry policy can be categorized into two broad groups: 1) domestic and foreign oil companies and 2) government.

Domestic Companies

Since privatization, domestic companies have been the biggest players in the oil industry. Most Russian companies have deemed it strategic and cost-effective to be vertically integrated and to maintain a presence in all parts of the value chain. This phenomenon has resulted in the emergence of some of the largest companies in Russia, commonly referred to as the oil majors or VICs. In 1999, thirteen VICs comprised 87% of oil production and export, and there continues to be a trend towards consolidation. Despite such consolidation, there remain approximately ninety smaller production companies, which drive 3.3% of oil production and 3% of exports.[4]

Although historically criticized for corrupt practices and operating inefficiencies, some Russian companies appear to be altering their ways; they are improving business practices in hopes of, gaining investor trust, confidence, and capital and expanding their overseas presence. The biggest Russian oil company holdings include Lukoil, Yukos, Surgutneftegaz, TNK, Sidanco, Sibneft, Slavneft and Rosneft. See Exhibit G for brief profiles of select companies.

Foreign Companies

Despite attractive prospects in the early-mid 1990s, foreign oil companies have not yet found a way to operate successfully in Russia. Initially, given Russia’s abundant untapped resources, privatization brought much enthusiasm to foreign firms. Despite such enthusiasm, as of 1999, merely 6.4% of total oil production and 8.3% of oil exports were generated by foreign company ventures.

To date, there have been 54 US, 13 Canadian, 37 European and 17 other nationality ventures with Russian companies. Over the past years however, the mood to invest in oil by foreign companies has been dampened and Western firms are scaling back. Most notably, BP appears to be selling down its assets and “gracefully exiting” by abandoning its equity stake in Lukoil and exiting the Sidanco arrangement.[5] At the same time, other firms such as Shell, Mitsui, Mitsubishi, Texaco and ExxonMobil remain involved in the offshore Sakhalin projects; in fact, Sakhalin is the only venture in which significant foreign investment still exists and is proceeding.

Foreign firms have faced many challenges while doing business in Russia, many of which will be assessed in further detail in Part 4. It is becoming increasingly apparent that foreign companies are best suited to participate in major offshore greenfield projects, as opposed to traditional onshore drilling. Russian oil firms want foreign companies to play a role in projects that necessitate sophisticated technology, equipment and complex project management, and not areas in which domestic firms have substantial experience or cases in which Russian companies’ less sophisticated assets can be utilized in a cost-effective manner.

Government

For decades, the government played a central role in the oil industry but has been much less involved since privatization. In fact, several industry and country analysts assert that Russian oil companies actually wield more influence over government officials today than vice versa. The government has taken an active role in promoting the privatization of remaining state shares, as there are no longer any national oil companies. It has also shifted roles from operational to rule making and policy formulation, particularly regarding taxes, trade, production and pricing.

For example, the government stipulates the tax code and has increased efforts for tax collection. Similarly, it determines de facto export quotas and tariffs, domestic crude prices and foreign investment regulations. One pending issue that may significantly impact the industry, and one in which the Duma has been grappling with for years, is Production Sharing Agreements (PSA). Last, the government also maintains the ultimate approval for big new projects and field development.

3.6 Three Key Issues: Pricing, PSA legislation, Shift to Natural Gas

Pricing

Perhaps the most important current issue with respect to the oil sector is pricing, in terms of domestic versus world prices and the expected trend of future prices. Today, domestic prices remain a function of government regulation, export capacity and low solvent demand. In many cases, the government subsidizes the industry by maintaining low prices, and prices remain uniform countrywide, ignoring different transport costs, creating further inefficiencies in the domestic market. Due to these factors, domestic oil prices are significantly lower than the Brent reference price. For example, since 1995 domestic prices typically have been discounted 35-55% from world oil prices, although there are exceptions as in early 1998 and 1999 (Exhibit H). It is no surprise that such a domestic-world price disparity has shaped Russian oil companies’ export strategies.

This idiosyncratic domestic-world oil price relationship reflects the variation in broader world oil prices. As recently as a couple years ago, world market prices slipped to approximately $10 per bbl driven by lower demand precipitated by the Asian, Brazilian and Russian currency crises; such low price levels traumatized the industry. Subsequently, OPEC coordinated with non-OPEC countries to take a disciplined approach in controlling production, reduce exploration efforts, focus investment on upstream businesses, and employ a conservative reinvestment rate, thereby creating upward pressure on prices.[6] In 1999 prices recovered to an average Brent price of $17.9 per bbl, and prices continued to rise until reaching a high point $32.75 per bbl in March 2000. Despite high Brent price levels, it is important to note markets typically discount Russian (Urals blend) oil by $2-4 per bbl on average. Nonetheless, high oil prices propelled Russia’s economic recovery, facilitated by the 1998 ruble devaluation and increased attractiveness of Russian exports. Today’s Brent price remains quite high at $25-30 per bbl.

Forecast prices remain healthy for oil companies as OPEC recently announced its intentions to restrict production output. Additionally, since exploring and oil activities increasingly take place in hostile geographic environments, various dynamics (e.g., supply costs) keep prices high. As previously indicated, Russian oil companies have benefited immensely from high world oil prices, and their future profitability is very susceptible to market price movements. Nonetheless, Russian oil firms claim they can endure price declines to more sustainable levels ($16-18 per bbl) and still retain high profitability. Similarly, analysts assert that despite an eventual price decline, this will be partially offset by greater export capacity and domestic demand. Such a scenario will ultimately result in domestic and world price convergence, as most industry analysts expect during the next few years. Again, this will shape domestic energy demand and usage as well as Russian company strategies and profitability levels.

PSA Legislation

In general, Production Sharing Agreements (PSA) refer to contracts between the State and domestic and/or foreign investors (e.g. oil companies) to share in the profits of natural resource production on a project-specific basis. The Law on Production Sharing Agreements was approved by the Duma in early 1996, but in its original form, different parties found the legislation unacceptable. For foreign firms, in addition to not passing the normative acts or enabling legislation that would support PSA, they had problems with the following issues:

parliamentary approval required for fields in “strategic” areas and PSA not awarded by tender;
government’s right to unilaterally modify the contractual agreement in case of changed circumstances;
uncertainty over which fields could actually be developed under PSA;

ambiguity of investor’s right to seek international arbitration of disputes; and
lack of harmonization in civil and administrative law granting subsoil rights.

As a result, foreign companies have lobbied Russian officials for five years to modify PSA legislation so they can better invest and operate under guaranteed provisions. Most foreign firms claim they will not pursue other investments in Russia until PSA legislation and normative acts favorably support their business objectives and interests. For the few projects that have been passed under PSA, the bureaucracy has been frustrating and overwhelming. For example, Sakhalin II required three years of negotiating and more than two thousand signatures, whereas PSA in other countries usually require a few months for only 25-30 signatures. Therefore, foreign companies seek a more transparent, simplified, streamlined process. They also demand important provisions like guarantees of cost-recovery and tax code/PSA legislation alignment, so as to ensure PSA take precedent over unforeseen changes in other legislation.

Skepticism towards PSA legislation remains on the domestic front as well. There has been criticism of many Russian politicians’ reluctance in coming up with suitable PSA legislation. Concerns from Russian oil companies and officials stem from the following issues:[7]

National pride: no need for outside firms
Intensified competition for project concessions
Association with developing countries (typical of PSA)
Long gestation periods – many years before government begins to realize revenues
Belief that PSA will only benefit foreign companies

Slowly, companies and government officials are trying to address the various concerns. For example, they have recently conducted studies, such as the Petroleum Advisory Forum’s economic survey, which showed six pending PSA projects could generate $590+ billion in total economic benefits, 87% of which would remain in the Russian economy. To address national energy security concerns measures have been proposed to limit amount of proven reserves to be covered under PSA contracts (proposals limit to between 30%-40%). Such steps are critical to enlist support; otherwise, as one expert explained, “It’s political suicide for some political members to vote for PSA legislation.”[8] Experts expect PSA legislation to make significant progress in 2001, as Putin’s administration has made it a top priority. The Minister of Economic Development and Trade estimates that an investor-friendly PSA regime could attract $85 billion in new investment over 5-7 years.[9]

Shift to Natural Gas

Despite the critical role oil plays in Russia, there has been a gradual shift to natural gas as the predominant fuel, which has numerous implications for oil companies, the Russian economy, and its relationship with neighboring states. First, it is important to note the extent of Russia’s natural gas reserves and its current use of those resources. Russia has 1,700 tcf of proven reserves, which accounts for 33% of world reserves and essentially makes Russia the “Saudi Arabia” of natural gas. In 1999, Russia produced 20.9 tcf and consumed 13.8 tcf as shown on Exhibit I; the gas was primarily utilized for power generation.

As the world’s biggest gas supplier, it provides Western Europe 20% of its gas requirements and remains the main supplier to the CIS as shown in Exhibit J. Although Russia has a growing list of gas customers, it does not enjoy good relationships with all of them. For example, Ukraine has been problematic as Russia accuses it of siphoning off its gas and not paying its energy bills. However, Ukraine plays a strategic role since it controls 90% of total gas exports to Europe. Due to such ongoing disputes, Russia is looking to bypass Ukraine for all new gas pipelines and minimize its reliance upon Ukraine. This is merely one example of how natural gas is increasingly shaping Russia’s national and commercial interests.

Historically controlled by the State, the natural gas industry remains dominated by Gazprom – a quasi-state body. Gazprom controls 90% of gas production and administers 90,000 miles of gas pipelines. Despite this de facto monopoly, Russia is attempting to liberalize it as part of the Administration’s long-term energy strategy: 1) to make the Russian natural gas industry world-class and competitive, and 2) to shift the commercial focus of the country from oil to natural gas (Exhibit K). The Administration anticipates that natural gas will be the fuel of the 21^st century and experience a 20-25% CAGR through 2020, most of which will be exported.

As liberalization progresses, there will be an unbundling of the supply and distribution value chain, which should provide much opportunity for other companies. As a first step in liberalization, in November 2000 the government ordered Gazprom to grant up to 15% of pipeline capacity to other companies. This is a significant breakthrough. For decades, oil companies have extracted gas along with oil from their fields but have been unable to sell to end-users because of Gazprom’s control over the pipeline transport network. Instead, these companies have had to sell gas at low prices to Sibur (state-owned gas processor), which then sells on to Gazprom to transport to end-users. Thus, pipeline access will be critical in the future. The government must be careful in structuring pipeline access to oil companies ensuring access rights are non-discriminatory and reflective of actual transport costs.

Encouraged by hints of liberalization, Russian oil VICs perceive the massive opportunity in gas and the gradual shift in fuel from oil to natural gas and are positioning accordingly. For example, Yukos has bought a controlling stake in two gas companies that hold the license to the Yurubchenskoye and Agaleevskoye fields. By 2005, Yukos plans to self-generate power for its refineries and sell the oversupply to the domestic market. If by 2005 the government has accelerated industry liberalization, Yukos may have a first-mover advantage over its closest competitors. Foreign energy firms are also eager to participate in natural gas field development and production. Indeed, the process and pace of Russian gas liberalization over the next few years will be critical in several respects: to domestic and foreign energy companies; to the Russian economy and oil industry; and to the development, modernization, and future prospects of the Russian natural gas industry.

4. OPPORTUNITIES/CHALLENGES FACING THE OIL INDUSTRY

4.1 Opportunities

There is significant opportunity for investment and development in the oil sector, with estimated capital needs as high as $25-40 billion. Russia enjoys a wealth of oil reserves, and its favorable ratio of reserves to production is 57 years, compared to that of major international oil companies’ reserves averaging only 10-12 years. Furthermore, Russian fields tend to be younger and much larger than those in other places. For example, Russian fields’ average age is 16 years and average size is 117 million bbl versus Texan fields, which are 30 years and 3 million bbl respectively.

In addition to basic field development and extraction, there is much potential to improve productivity and efficiency. As in the comparison above, productivity of Russian oil fields remains low: 55% of a Texas on-shore site. Adjusting productivity for geology and age, the total factor productivity level falls to only 30% of a Texas on-shore field.[10] This productivity gap is due to factors such as poor reservoir management, less hydrofracturing, low quality drill bits and the quality of cleaning mud and cement being used result in inefficient drilling. Drilling equipment is in need of replacement, and despite mild downsizing, there remains an estimated 35% excess workers.

On the macro-level, Russia realizes the dire importance of structural change to improve the sector’s productivity and efficiency. Recent changes in the tax code (e.g. simplified tax regime) and business practices (e.g. increased transparency) aim to improve such productivity. Russia has also made some symbolic improvements, signaling to Western investors that the industry is taking measures to enhance efficiency and overall effectiveness. For example, Western-style commercial law and international dispute resolution should promote good practices and enhance long-term productivity. Additionally, companies are increasingly incorporating Western executives in their top ranks to abandon outdated, inefficient practices and to adopt better means of running the business.

4.2 Challenges

If the vast resources and oil boom present huge opportunity, the downside is that they breed complacency about economic policy-making. Indeed, there have been some minor triumphs on this front, such as simplified and lower customs tariffs, new tax rules and a transparent project bidding policy. However, all these triumphs come with caveats and provisions that pose challenges to industry participants. Highlighted below are a few of the biggest challenges plaguing the oil sector, particularly those that deter much-needed foreign investment.

Poor Infrastructure, Antiquated Equipment and Low Productivity

The Russian oil industry suffers from relatively low productivity as evidenced by low oil conversion (~65%), producing low margin heavy oil products. In contrast, average oil conversion in the U.S. for comparable fields is ~90% and up to 98% in some cases. This inefficiency or low productivity is driven by a few factors mentioned above. First and foremost, Russia suffers from lack of adequate domestic investment and capital expenditure in fixed assets necessary to support major oil exploration, development and transportation. Although antiquated equipment may be sufficient for standard on-shore drilling, it certainly does not maximize operating efficiency and precludes many domestic firms from pursuing complicated greenfield projects. Russian VICs not only need to replace much of their equipment but also require roads, pipelines and adequate transport infrastructure. Such shortcomings in physical capital and infrastructure are major hindrances to industry development.

Russian Business Culture

Given the rapid transformation of the sector, both domestic and foreign companies have had to deal with a different way of doing business. Historically, operations in Russia were mainly based on quantitative metrics and not on sound business principles, such as return on investment, customer satisfaction, company value maximization and shareholder accountability. Although progress has been made, a US Government energy specialist characterized the Russian business culture where “bureaucracy is the enemy, [and there’s] corruption in the ranks.” Such mismanagement has taken its toll in the capital markets where Russian oil companies may be discounted by up to 95% relative to international comparables.

The tumultuous evolution of Russian business practices in the 1990s has presented challenges not only to Russian companies but also to foreign companies. Strategic alliances between foreign firms and local companies have lost their luster as Western firms have failed to embrace the Russian way of doing business and partnerships falter. There seems to be a misunderstanding between the Western and Russian business cultures and therefore frustration and a disconnect on both sides.

Misalignment between Russian Companies and Foreign Oil Firms

Russian companies claim they welcome foreign investment to: 1) garner new technology in oil exploration/ production, 2) replace or supplement their old equipment, 3) improve their project management skills, and 4) garner international respect and a favorable reputation in international markets. In return, Russian oil firms are hesitant to give up any major stakes over field control. Conversely, Western firms seek to exploit Russia’s natural resources for higher world market share and profits and will share their technology and best practices with Russian partners only if necessary. Ideally, foreign companies would like to acquire stakes in massive-scale oil field exploitation and integrate into the downstream part of the value chain, where most profit potential lies. However, Russia considers foreign ownership in its choice oil fields to be counter to its strategic interests.

Misalignment of priorities and objectives present major challenges to ventures involving Russian and foreign oil companies. This also explains why foreign engineering/consulting firms (e.g. Schlumberger) that willingly provide know-how, technology and equipment for cash, but do not wish to achieve any sort of control have been more successful in their Russian endeavors than international oil firms. Regarding the competing objectives, priorities and strategies between Russian companies and Western firms, BP Russia President Morland said, “Operating in Russia is frustrating all the time, but you need to learn to live with it because otherwise, it’ll eat you alive.”

Legal Barriers

The current legal framework, or rather improper enforcement of it, is a significant barrier to industry development and progress. Lax tax collection, corruption, ambiguous laws, inherited bureaucracy and inadequate legal recourse negatively impact the oil sector. Foreign companies often find insurmountable legal obstacles and uncertainty that create an uneven playing field. For example, one statute stipulates that foreign joint ventures supply a certain quantity to former Soviet republics that are notorious for their payment or liquidity troubles. It is often difficult to know what rules to play by in a given situation. Furthermore, companies often have to deal with weak minority shareholder rights protection and ambiguous corporate governance rules, fueling criticism of the legal framework and subsequent “unprofessional environment.”

4.3 Role of Foreign Investment & Participation

Most foreign oil ventures there have not been successful, and foreign firms have incurred at least $10 billion in costs and losses over the past decade alone. Industry specialists and both Western and Russian executives agree that, particularly in the short to medium-term, cash-rich Russian oil firms do not need foreign companies for extensive capital investment; such capital investment has a longer time horizon. Rather, the immediate priority is technology and project management, which Russian companies can simply outsource or purchase. Western companies have expressed that they will only participate if protected under PSA legislation, which casts further uncertainty over future foreign direct investment and participation in upstream activities. Below are highlights of key foreign investments to date:

Sakhalin

The Sakhalin projects are the only initiatives with significant foreign involvement that are proceeding, and represent the most promising foreign ventures to date. Sakhalin is the largest island in Russia, situated in the far Northeast and intended to serve the Asian markets (e.g. China, Japan, Korea). The Sakhalin fields have about 3.5 billion bbl of oil and 18 tcf of natural gas. There has been extensive foreign involvement in Sakhalin characterized by more optimism than other Russian oil opportunities. For example, Shell, Mitsui, Mitsubishi, Texaco and Exxon-Mobil have developed these oil projects backed by agreements with the government and retain a stake in remaining Sakhalin projects as shown in Exhibit L.

Other Projects

Some of the other projects that have involved foreign investment are profiled:

· Polar Lights: first oilfield developed and brought on stream by a Western company; led by Conoco.

· Arco’s stake in Lukoil: first major Western oil firm to partner with a Russian company; spent $300 million in 1995-96 to acquire about 8% of Lukoil shares and establish the joint venture; together, earmarked $10 billion for investment in oil production that has not materialized.

· BP ventures: involvement in several projects (covered in detail in Chapter 5); now appear to be selling down assets in Russia and “gracefully exiting;” abandoning equity stake in Lukoil (acquired through Arco acquisition) and exiting Sidanco.

· The Vanyoganneft Joint Venture: located in western Siberia and operated by Occidental.

· Timan Pechora Company (TPC): example of the largest PSA being negotiated; led by Texaco (30%), ExxonMobil (30%), Amoco (20%) and Norsk Hydro (20%); includes exploration and development of 1.8 million acres north Arctic circle.

As evidenced, foreign firms would like to participate in various parts of the value chain, but it is becoming increasingly apparent that the best foreign investment prospects lie in complex greenfield projects that require sophisticated technology and project management expertise that Russian firms lack. Thus, foreign companies’ best prospects are big, complicated projects in which they can not only make attractive profits but also facilitate development and modernization of the Russian industry.

5. CASE STUDIES

5.1 Yukos[11]

Yukos can be characterized as a typical Russian oil company that has struggled to overcome a tainted reputation for poor corporate governance, lack of transparency and improper cash flow diversion. In accordance with Russian Government decree No. 354 in April 1993, Yukos was formed a state-owned VIC consisting of a production entity, three refineries and eight petroleum product suppliers. In September 1995, decree No. 864 added a second production entity, along with a number of product marketing and research and development organizations, to Yukos. The company struggled to integrate the numerous older, smaller companies and went bankrupt shortly thereafter. This was largely due to incompetent management, mounting debts in production enterprises ($3.5 billion to the government alone) and the overall Russian economic decline.

Facing adversity, Yukos was determined to be the first fully privatized Russian oil company. The major purchaser was a group of private investors led by Mr. Mikhail Khodorkovsky, who later became Chairman of the Executive Board. He undertook significant restructuring of the company in virtually every sphere, especially financial structure (repaying government debts) and management. Currently, the foreign to Russian management mix is almost half and half, helping to imbue Yukos with more professional decision-making and an economic mode of functioning.

In 1996-97, Yukos committed $900 million, including heavy investment in drilling, capital construction and development of new oil fields to grow production capacity. In December 1997, it acquired a controlling stake in Eastern Oil Company (VNK), adding a third production entity, the Achinsk refinery, the Tomsk, Novosibirsk and Khakasia product supply companies, and several research, marketing and transportation facilities. The configuration and profiles of the VNK enterprises allowed Yukos to expand both in terms of operational capacity and eastern geographical reach.

To quickly bring greater technological expertise on board, in 1998 Yukos selected French engineering firm Schlumberger as a strategic partner. Schlumberger is the recognized leader in developing the most effective methods and technologies for hydrocarbon exploration and production, as well as renovation and servicing of oil wells. Yukos now outsources much of its oilfield service operations to Schlumberger, which has enabled it to fundamentally restructure many of its own service enterprises. The cost of well servicing has declined 22%, yielding significant cuts in overall production costs. Moreover, Yukos has developed production and reservoir enhancement networks as well as a technology network to optimize equipment utilization. Such operational enhancement efforts have yielded impressive efficiency gains as illustrated in Exhibit M. The Schlumberger partnership has also allowed Yukos to increase its overall speed of operations by providing it access to technologies that expedite information gathering and allow decisions to be made directly at the field. Indeed, the culmination of these cost saving measures has been impressive and decreased per barrel production cost from ~$11 to ~$3.50 (Exhibit N).

Overall, Yukos has decided to outsource many of its critical functions, bringing it quicker access to expertise and greater flexibility. At the same time, Yukos should consider the potentially deleterious effect this strategy might have on long-term organizational learning. Furthermore, the relationships it has entered are non-exclusive, meaning that other companies might engage a key partner such as Schlumberger. Adding to the risk, Schlumberger personnel hold several key posts within Yukos.

Yukos is very different from other Russian oil companies in that it has decided to embrace domestic technology and equipment. The underlying rationale is that Yukos’ oilfields do not require the most sophisticated equipment for exploitation. Instead, older Russian technology is selectively upgraded for critical components (e.g. motors, drill parts) to be more effective. Exhibit O shows that of the total capital expenditure, foreign equipment comprises only 4%. For example, a sophisticated western-technology oil rig may cost up to $40,000/day, whereas, a local rig may cost only $4,000/day. Yukos argues that the substantial cost savings make up for any marginal loss of effectiveness.

Yukos possesses a reserve base of 11.4 billion bbl (Exhibit P), comprising 18% of total Russian reserves and placing it among the largest private oil companies. It is the second-largest oil producer with total output of 327 million bbl in 1999, representing 15% of Russia's total oil production. The overall expansion strategy is to quickly acquire new properties in Russia and abroad. Yukos has opened an office in London and is actively exploring opportunities in the Middle East. In particular, it is focusing on markets covered under American sanctions and therefore those in which it does not face competition from large Western firms. Longer-term, Yukos has started taking interests in energy diversification (e.g. electricity generation). Based on interviews, it seems the company is pursuing a strategy to become a total energy company with forecasted increases in overall energy production (Exhibit Q). Exhibit R shows the planned increase in oil production by 2005.

Key Lessons

1. Russian oil companies should vertically integrate, as it reduces reliance on other parties, improves efficiency and expedites decision-making. Furthermore, as is true of many Russian companies that have gone through privatization, it is best to integrate operations quickly rather than support multiple management methodologies through a gradual transition.

2. As in Yukos’ case, combine existing Russian assets with Western-style management. This strategy of using existing Russian technology and equipment for normal (not overly complicated) field exploration and operations in conjunction with Western management (e.g. Schlumberger partnership) has worked very well. It defrays costs because upgraded Russian equipment is easier to procure and service. However, Western know-how is very valuable because it improves data gathering and processing and also brings better project management skills. Where appropriate, this combination can drive down per barrel production costs and be very effective.

3. Finally, demonstrating a commitment to Russia will minimize political obstacles. Despite having several foreigners in management, Yukos still portrays a very strong Russian image and commitment, thereby allowing it to sidestep political and security sensitivities of the Russian government. Therefore, for Russian companies, demonstrating that control is largely in Russian hands or that the company is devoted to Russia’s best interests helps in avoiding trouble with local authorities.

5.2 TNK[12]

Tyumenskya Neftyanaya Kompaniya (Tyumen Oil Company, TNK) is an excellent example of a Russian firm that has developed very sound business practices and adopted a more dynamic Western approach to company management. TNK was formed in 1995 as an open joint-stock company by Resolution No. 802 of the Russian Federation and was one of the last VICs to be created. In 1998, TNK underwent a corporate restructuring that began with Novy Holding replacing management with individuals that were Western-educated, had extensive experience with international oil giants and comprehensive knowledge of the Russian oil industry. Perhaps the most interesting aspect regarding TNK management is its strong commitment to shareholder value – the main motivation for this seems to be to turn around the company and make it an attractive proposition for sale. Indeed, the company’s CFO even claims that, “they [management] are not really oil men.”

Currently, TNK is one of the largest oil VICs in Russia. The company's holdings include two upstream operations, Nizhnevartovskneftegas and Tyumenneftegas, and its downstream operations include the Ryazan Oil Refinery and a network of distribution and marketing ventures in the regions of Tyumen, Ryazan, Kursk, Kaluga, Tula, and in Karelia Republic. TNK’s oil reserves are shown in Exhibit S and are the third largest of all Russian companies. The exploitation of these reserves is proceeding well per Exhibits T and U, with TNK producing almost 650 thousand bbl of crude per day in 2000. TNK’s refining capacity (Exhibit V) has steadily increased from just over 130 thousand barrels per day in 1997 to over 400 thousand barrels per day in 2000. To put this in perspective, such refining capacity would make TNK one of five largest refiners in the USA and has placed it as the fourth largest Russian refiner (Exhibit W). Moreover, TNK has developed an extensive retail network (Exhibit X) from ~250 gas stations in 1997 to over 860 outlets in 2000.

Indeed, 1998 was a turning point for the company as new management undertook a massive restructuring. For the first time, the company became cash-flow positive, introduced more transparent corporate governance standards and produced US-GAAP financial statements audited by PricewaterhouseCoopers. By the year 2000, the company’s financial health had improved enough to be granted a $300 million credit line from Sberbank, and importantly, $490 million in loan guarantees from the ExIm Bank. In 1997, the company had a US-GAAP income loss of $515.7 million, which has now turned into a $545.7 million profit.

These positive results have been achieved by focusing on the advantages of vertical integration, divesting of non-core assets, enhancing management systems with investments in information technology, and making sound acquisitions to expand reserves, refining capacity and retail outlets. Noteworthy production acquisitions include Kondpetroleum and Onako in September of 2000. The sharing of knowledge and management over a larger production base has allowed per barrel costs of production to decrease to just over $2/bbl. In order to better exploit reserves, TNK has entered into strategic agreements with world-class engineering service providers such as Halliburton and Parker Drilling. Halliburton was a key ingredient to rehabilitating TNK’s Samotlor oil field. In general, TNK has engaged Western firms for technology but avoided partnering with Western oil majors, and thus faced fewer conflicts of interests and priorities.

Refining and retail are the high margin operations in Russia. The jewels in TNK’s refining crown are the Ryazan and Lisichansk refineries. Ryazan is strategically positioned 190 km from Moscow and is operating at full capacity of 250 thousand bbl per day with a per barrel cost of $0.80. Production capacity is being enhanced to 270 thousand bbl per day for 2001 with the help of Texaco and ABB. The Lisichansk refinery was acquired in July 2000 and is the largest and most modern refining unit in the Ukraine. The refinery put through 62 thousand bbl per day in the third quarter of 2000, which is projected to significantly increase to 91 thousand barrels per day in 2001. This should help further reduce the per-barrel refining cost from the current $1.60. Furthermore, a new refinery is being constructed in Siberia. This focus on high-margin activities to quickly expand them and achieve economies of scale has helped bolster the bottom line.

Retail operations have surged resulting in healthy market shares in the Central Russian region. If the 415 TNK-owned stations are combined with franchised outlets, the total number of retail outlets totals 861. In important regions such as Moscow, TNK has achieved a sales market share of approximately 16%. In addition, areas such as Smolensk and Lipetsk have achieved shares of 12% and 13% respectively.

Key Lessons

TNK’s development into one of Russia’s most efficient, profitable oil firms highlights a few key lessons.

1. Concentrating on the vertically integrated value chain by enhancing efficiency is critical. The disinvestments in non-core assets to help fund investments in reserves’ exploitation, refining and retail have greatly contributed to enhanced profitability. Improvements in these areas have been made by engaging world-class engineering and consulting firms such as Halliburton, Parker Drilling and ABB to establish efficient facilities employing best practices.

2. A key to enhancing profitability is to reduce the cost of capital. This is done by improving corporate governance, delivering operational results and increasing financial transparency. To this end, generating accounts conforming to standards such as US-GAAP is essential. Additionally, retaining well-recognized auditors such as PricewaterhouseCoopers helps establish the required credibility, particularly for overseas expansion. These steps have allowed TNK to secure credit facilities from major western banks such as CSFB, Deutche Bank, US ExIm Bank, and Commerzbank.

3. The focus on shareholder profitability is very important and is perhaps TNK’s distinguishing factor from other Russian firms. The company has consistently maintained a relatively lower political profile and adopted a businesslike attitude of working with whoever is in power. Moreover, the focus on bottom line profits has made TNK seek to optimize efficiency and productivity, make value-enhancing investments and minimize organizational, political and other non-market complications.

5.3 British Petroleum (BP)

BP provides an excellent case study into a Western firm that has participated in various ventures in Russia. BP started operations in Russia approximately ten years ago and acquired Arco, thereby inheriting Arco’s ventures such as joint partnerships in exploration and drilling with Lukoil. Throughout this decade, BP has invested nearly $2 billion (mostly in upstream activities), making it one of the single largest investors in Russia. It operates in every major segment of the Russian oil industry including segments like air fuel as Air-BP is the single largest supplier of jet fuel to the CIS, even though there are no sales in Russia due to legal restrictions. In the lubes segment, BP started through a joint venture with ExxonMobil. Upon taking over Arco, BP dissolved its partnership with ExxonMobil to obtain European anti-trust approval. Fortunately for BP, it was able to retain the lubes business and integrated its operations with Castrol.

BP’s retail operations are one of its most successful areas in the Russian market. Total retail investment has totaled ~$100 million representing 21 full-service gas stations in the greater Moscow area, expanding an average 1.5 outlets per month, with each outlet generating large business volume (e.g. Russian BP outlet sells an estimated 2x volume of large US outlet). Each store also generates significant non-gasoline sales, adding to the success and profitability of retail operations. Altogether, BP’s retail operations in Moscow together pay approximately $1 million in sales taxes, more than all other fuel retail outlets in Russia combined. Last, BP has a significant presence in the crude oil trading segment through its OT&I division, where traders buy Russian crude to feed into the BP-Amoco export system. Through this business, last year BP was one of the largest of exporters of crude from Russia with ~$4.1 billion in business.

Sidanco – A major failure

In November 1997 BP acquired a 10% stake ($500 million) in the Sidanco Oil Company. The strategic goals of this alliance were to attract a partner to develop the Kovyktinskoye gas field and to restructure Sidanco. More specifically, BP’s goal was to obtain access to the Eastern Siberian oil and gas fields. In compliance with the Sidanco-BP strategic partnership, BP invested $172 million for the technical evaluation of the Kovyktinskoye gas field in exchange for Sidanco's 44% stake in Russia Petroleum. BP allocated fifty experts, engineers, financiers and geologists to manage Sidanco and the Kovyktinskoye field. The agreement also obliged the parties to jointly take part in all new Russian project initiatives.

In addition to incurring certain obligations, it seems that BP’s investment value in Sidanco was also inflated. Analysis indicates that the $500 million acquisition price tag (10% stake) would imply a $5 billion Sidanco enterprise value. However, Sidanco’s balance sheet in the first half of 1997 showed the company’s weak financial position, which should have raised a red flag. In short, various estimates of BP’s stake retroactively assign a value of no more than $250 million (as opposed to $500 million paid), particularly since the small 10% holding did not allow BP to exercise any meaningful control over Sidanco operations.

Even worse, only eighteen months later, Sidanco declared bankruptcy. TNK managed to acquire control over Chernogreft, a Sidanco subsidiary that owned some of the most promising reserves, by acquiring its debt and forcing bankruptcy. Throughout the tumultuous bankruptcy proceedings, BP relied heavily on its connections via business oligarch V. Potanin, from whom it had bought its stake in Sidanco. Potanin had formerly served as Vice-Prime Minister, and BP hoped that this would provide greater leverage in government institutions. Despite such efforts in Russia and lobbying through the British Government (e.g. a telephone conversation was organized between the Russian Premier and British PM), bankruptcy proceedings continued to the detriment of BP. Today, BP is making a last effort to salvage the Sidanco venture or more probable, making a graceful exit from its Sidanco debacle.

Arco-Lukoil

In order to access Lukoil’s Tengiz oil fields, Arco formed a joint venture with Lukoil and in doing so, inherited the Caspian oil pipeline run by Chevron. Arco initially took an 8% stake in Lukoil, but discord between Arco and Lukoil ensued shortly upon completion of the negotiations. Lukoil had hoped to obtain access to Arco’s technology and training. In turn, Arco had hoped for access to choice exploration sites. Instead, each partner zealously guarded its respective advantage with Lukoil beginning to view Arco as a source of cheap financing, and Arco becoming increasingly frustrated at being relegated to fields with marginal prospects. BP inherited this problematic situation through its acquisition of Arco in 1999. The turbulent relationship could not be mended so BP first diluted its stake in Lukoil and then recently sold it off altogether - yet another failed foreign venture in the Russian oil industry.

Key Lessons

BP’s experience provides some key insights for doing business in Russia.

1. Rather than dispersing efforts over a broad range of ventures, it is better to first focus resources on one or two initiatives backed by a large commitment. BP would have had greater success by making large investments in one or two areas such as business-to-business lubes, retail, or controlling stakes in companies such as Sidanco, as opposed to dabbling in disparate sectors and initiatives, with different partners, etc. Controlling stakes are particularly important as day-to-day control over funds use, project priorities, and resource allocation become critical in a risky business environment such as Russia.

2. Over-reliance on one or two political contacts is unwise. BP tried to resolve its bankruptcy and other issues by either lobbying the highest levels of British Government or engaging a powerful Russian oligarch. However, the weak executive power, coupled with facets of Russian crony capitalism, prohibits any single investor from achieving success solely based on ties to authorities, without establishing the necessary infrastructure to do business.

3. A detailed, comprehensive evaluation of potential partners is critical before formalizing a strategic alliance. Potanin’s business interests extend well beyond oil in disparate companies such as Norilsk Nickel, Permskiye Motory and a sizeable stake in Svyazinvest. Stable oil exports were supposed to provide cross-subsidies to the other businesses, making growth and stability of Sidanco all the more difficult. Therefore, selecting a partner based on strategic portfolio fit rather than on political weight, would make for a much better business decision.

4. From a non-market perspective, an investor has to build a network of political of relations throughout the entire executive chain: the Russian government - regional governmental bodies - local executive authorities. The BP experience showed that even lobbying company interests at a prime-ministerial level is not enough to resolve problems at a local level. A characteristic example is the participation and concealed interests of the Khanty-Mansiysk District administration in bankruptcy procedures against Chernogorneft.

5. Finally, to be successful, underlying interests must be served. Merely viewing Russian companies as conduits to oil fields and chaperones through the political maze, while not sharing technology and management expertise is counter to Russian long-term interests. Similarly, Russia’s view of Western companies as a source of technology, expertise, and cheap capital without adequately sharing oil and gas interests is counter to the foreign firms’ long-term interests. Compromise on these crucial points is the key to success.

6. FUTURE OUTLOOK & IMPLICATIONS

Given all the above-mentioned considerations and learning points, we now assess the future outlook and make prescriptive recommendations to ameliorate shortcomings and inadequacies in the status quo.

6.1 Domestic Companies

Undoubtedly, the Russian oil industry has undergone massive transformation over the past decade. Privatization prompted the formation of large vertically integrated companies that dominate the sector today. Within the next few years, the remainder of the sector is slated for privatization as well and will most likely promulgate the trend of industry consolidation. Having greatly benefited from high world oil prices since 1998, the cash-rich Russian VICs are poised to expand upstream and downstream operations in order to serve the domestic market and expand their global reach. The internationalization of these firms will be evidenced by an increasing share of exports as part of overall production and physical presence in overseas markets. Driven by this desire to become less insular, Russian companies will continue to increase transparency, improve operating efficiency and productivity, upgrade equipment and seek strategic alliances so as to access sophisticated technology and management expertise.

Although domestic oil firms have made much progress, there is a great degree of variability across firms, and all must strive for improvements to become world-class companies. Indeed, they are already well positioned; they have access to abundant natural resources, affiliations with political authorities, a strong Russian nationalist heritage, and invaluable experience in the local business culture and environment. However, they should address how they can better leverage foreign company expertise, particularly in modern technology and project management skills, or outsource those areas in which they are competitively disadvantaged. Furthermore, they must anticipate the shift in (inter)national energy policy from oil to natural gas. They must devise a strategy that not only insulates the existing revenue base but rather expands the profit potential. As the gas sector liberalizes, they must position themselves either to play in the gas sector directly or to address the implications that will ensue from the shift towards gas.

6.2 Foreign Companies

With respect to foreign oil firms, they must first assess the situations that have transpired over the past decade to determine the sources of failure in foreign ventures and more important, ways to promote future success. Clearly, the Russian oil sector needs massive capital investment for long-term improvements in technology, equipment and infrastructure. Short to medium-term, the sector requires investment and expertise to develop complex offshore, greenfield projects. These are the two principal capacities in which foreign companies should participate. Under these scenarios, Russian firms desperately need their Western counterparts, thereby fostering a more balanced, mutually beneficial relationship. Many past troubles have been related to projects in which Western firms just wanted to make an easy profit without serving their Russian partners’ underlying interests (e.g. knowledge-sharing, modernization, technology). This made for turbulent partnerships that have since deteriorated. Moreover, foreign companies should not hastily enter into strategic alliances with local firms but rather critically assess those which will best accomplish both parties’ objectives.

In the future, foreign firms must realize they are outsiders and make a genuine attempt to respect Russian companies’ experience in their home market and understand the local business culture, without jeopardizing their own standards. Last, they should also consider the interaction between Russian oil and natural gas interests; there are undoubtedly synergies between the two sectors that they can anticipate and position themselves accordingly.

6.3 Government

Last, regarding the regulatory framework and national policy shaping the oil sector, there are a few changes necessary to optimize the economic and strategic benefit of the country’s natural resource base. Indeed, the government has made great strides in allowing companies to operate fairly independent of government influence. However, in terms of policymaking, the government must amend pieces of legislation and practices that distort the market. For example, Russia’s mandate to keep domestic prices artificially low (effectively subsidizing industry) violates free market principles and therefore creates industry-wide inefficiencies. The government should lift such distorting mechanisms and allow the domestic and world oil prices to converge. Furthermore, it should not impose stipulations on production methods, quantity, customers, transport or export. The industry would be far more productive and competitive if government adopted a more ‘laissez faire’ approach.

Also, PSA legislation should be a top priority in the Duma until legislation is passed that is suitable to key parties and garners support from foreign firms. This is fundamental to future foreign participation, investment, large-scale projects and modernization of the industry. Similarly, the government should improve tax legislation and the regulatory framework to protect corporate interests, lower the risk premium (i.e. cost of capital) of doing business in Russia, and encourage future investment in the country’s other sectors. Last, it must carefully handle its future energy policy, particularly the interaction between the oil and natural gas sectors. This will become critical as the government sets the tone for natural gas privatization. It is imperative that the government always considers these resources as part of its national strategic interest, but it should abandon its dangerous tendency to use oil and gas as a foreign policy tool.

As the government becomes less involved directly in the oil sector, it should adopt policies predicated on industry progress, strategic foreign participation and sound market principles. Such an agenda benefits both domestic and foreign companies and allows the oil industry to realize its full potential, thereby fueling much-needed economic growth and progress in Russia.

APPENDIX

EXHIBIT G: Key Domestic Companies in Oil Industry

Lukoil – As the country’s largest oil firm, it is the only fully vertically integrated oil company. Although Lukoil has large production/reserve levels and the most expansive retail network, its relative domestic refining capacity is lowest among comparable firms, thereby prompting recent acquisitions of refineries in Eastern Europe. 69% of its upstream production currently lies in the Western Siberia fields, and it controls most reserves in the Timan-Pechora region. The firm is expanding its overseas presence as evidenced by large reserves in Iraq, Azerbaijan and Kazakhstan and the recent acquisition of Getty to enter the US retail gasoline market. In efforts to internationalize and increase transparency, Lukoil has finally released US GAAP income figures, after years of tinkering with financial statements, making them intentionally ambiguous. 2000 was a record-breaking year with ~$2.7 billion in net profits versus $1.2 billion in 1999 and $58 million in 1998, resulting in 18%, 11% and 1% net margin respectively.

Yukos – As Russia’s second largest oil producer, Yukos has struggled to overcome a tainted reputation for poor corporate governance, lack of transparency and improper cash flow diversion.[13] To shake its unfavorable legacy, Yukos has recently consolidated its subsidiaries into a single-share structure to mitigate minority shareholder rights concerns and has released US GAAP financial statements to increase transparency. Yukos has also brought in foreign oil veterans to fill management positions and has strategically partnered with French firm Schlumberger to gain legitimacy and western sophistication. It is actively expanding in retail, developing the Priobskoye field, and focusing on Eastern Siberia to supply the Far Eastern markets (e.g. China, Japan, Korea). In 1999, 63% of sales were attributable to exports, and profits grew to ~$2.3 billion in 2000 versus $1.2 billion in 1999 and $-640 million in 1998, resulting in 30%, 21% and –35% net margin respectively.

Surgutneftegaz – Although third largest in terms of production, Surgutneftegaz ranks fifth in reserves. It continues to focus on its traditional Western Siberia presence by maintaining stability and increasing production there with modern technology and equipment, despite declining productivity per well. It also enjoys remarkably high refining capacity due to its strategic location near the St. Petersburg port, resulting in nearly 80% of sales derived from exports. Like other Russian firms, Surgutneftegaz has been criticized for its corporate governance abuses and new share issuance procedures; therefore, its shares trade at significant discount relative to Russian oil peers. However, the company still managed to realize ~$2.3 billion profits in 2000 versus $1.3 billion in 1999 and $440 million in 1998, resulting in 45%, 38% and 17% net margin respectively.

TNK – Formed in 1995, the Tyumen Oil Company (TNK) ranks fifth in production but third in proven reserves. It is often recognized as the most efficient, western-like oil company. In 1997-98 it underwent a large-scale restructuring, bringing in western-educated management, hiring international financial consultants and streamlining operations. It has tried to differentiate itself from other Russian firms by emphasizing transparency, improving corporate governance and releasing US GAAP financial statements for the last three years. Its efforts have been recognized with receipt of awards such as Financial Times Energy’s naming TNK as the world’s best oil and gas company in 2000 and the American Society for Competitiveness’ granting TNK the annual award for leadership in developing globally competitive practices in emerging economies. Although TNK has acquired new assets upstream, it is more focused on downstream activities such as refining and retailing quality oil. In 2000, TNK realized $1.4 billion in net profits versus $529 million in 1999 and $45 million in 1998, resulting in x%, 30% and 3% net margin respectively.

	Exploration & Production		Refining
	1999 Production (million bbl)	1999 Reserves (billion bbl)	1999 Production (million bbl)	1999 Capacity Utilization (%)
Lukoil	453	31	214.2	75
Yukos	324	11.4	148	81
Sugutneftgaz	272	10.1	113	99
TNK	146	7.4	83	61
Sidanco	49	2.2	15.3	46
Sibneft	119	4.6	92	64
Slavneft	87	2.3	69.9	66
Onako	58	2.6	29	61
Rosneft	92	12.0	47	61

Source: Brunswick UBS Warburg

Transneft – Although not one of the Russian VICs, Transneft plays a fundamental role in the oil industry since it is essentially the government-owned monopoly that controls pipeline transport of oil within Russia. As a result, Russian firms must pay Transneft a healthy fee for transporting crude and oil product throughout the country and to seaports for export. A couple firms have plans for construction of their own pipelines, but it appears for the most part, Transneft will continue to serve as the primary transport company.

Gazprom – Although it only produces 3.3% of Russian oil and drives 1.7% of oil exports, Gazprom is an important player because as Russia’s biggest company (market cap ~$7 billion) and natural gas monopoly, there is much interaction between the oil and natural gas industries. Although the oil companies will often extract gas from their fields in addition to oil, they can not sell gas to end users due to Gazprom’s control over the gas transportation network. As a result, oil companies must sell the gas at low prices to Sibur, a state-owned gas processor, which then sells onward to Gazprom for distribution. As energy consumption shifts from oil to natural gas, Gazprom will play an increasingly important role, and the oil and natural gas industries will become increasingly interrelated.

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[1] 90% of Russian oil company costs are rouble-denominated, hence lower costs due to the rouble devaluation

[2] Roland Nash (Renaissance Capital) and Anders Morland (BP Russia)

[3] Interview with Geoffrey Lyon. US Embassy-Moscow Energy specialist. March 15, 2001

[4] BCG-Moscow analysis based on industry interviews and research

[5] Telephone interview with Phillip Ellis, BCG worldwide practice area leader, oil & gas industry. London, England. Feb. 16, 2001.

[6] Telephone interview with Phillip Ellis, BCG worldwide practice area leader, oil & gas industry. London, England. Feb. 16, 2001.

[7] Interviews with Geoffrey Lyon (US Embassy-Moscow Energy specialist, March 15, 2001), Hugo Erikssen, International Information Director, Yukos

[9] “Government Moves to Amend PSA Legislation.” Oxford Analytica Daily Brief. April 9, 2001.

[10] McKinsey & Co. report on Russian oil industry; total factor productivity refers to capital productivity combined with labor productivity.

[11] Interview with Hugo Erikssen, International Information Director, Yukos, March 20, 2001. Moscow.

[12] Interview with Alan Bigman, Director of Corporate Finance, TNK, March 20, 2001. Moscow.

[13] “Russian Oil Comes of Age.” Yahoo! article. January 15, 2001.

GLOBAL INITIATIVES IN MANAGEMENT:

RUSSIAN FEDERATION

MORS-473

1999 Production