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Home / Issue Archive / 2010 / June #6 / “The Way We Were” Oil&Gas Eurasia Looks Back at a Decade of Change in Russian Oil&Gas

№ 6 (June 2010)

“The Way We Were” Oil&Gas Eurasia Looks Back at a Decade of Change in Russian Oil&Gas

   The last 10 years have been witness to nothing short of a revolution in the post-Soviet oil and gas industry. When the millennium dawned in 2000, private Russian companies held the best reserves. Today, those reserves are the property of the state. Once an oligarch, Mikhail Khordokovsky languishes in exile in an East Siberian prison. Gazprom changed and Russia is today a Klondike for oilfield service companies and equipment sellers from all over the world.

By Svetlana Kristalinskaya, Bojan Soc, Pat Davis Szymczak, Elena Zhuk

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   As Oil&Gas Eurasia celebrates its 10 year anniversary in Russia, take a walk down memory lane with us as we recall key events that made for a “Revolution in the Oil Patch.”

The State Reclaims Its Grip over The Industry

   For a country with an economy heavily dependent on the performance of its oil and gas sector, $8-per-barrel oil can mean only one thing: disaster. The situation in the Russian economy at the Turn of the Century was exactly that – disastrous, as businesses struggled to survive the aftermath of the 1998 crisis and the government faced protests of armies of workers and civil sector employees unpaid for months.

   Luckily for Vladimir Putin, his rise to power in 2000 overlapped with the big rebound in the price of oil in global markets: in the eight years of his presidency, this commodity continued to soar, ultimately clearing the $145-per-barrel mark in July 2008.

   As Russian oil firms were dramatically boosting their outputs and threatening to strip Saudi Arabia of its title of the world’s top oil producer, the Putin administration used the windfall of tax-generated cash to restore social stability, wipe out Russia’s entire foreign debt ahead of schedule (!) and set up the Stabilization Fund as a cushion to fall on in times of crisis.

   All of this was accompanied by the government’s growing control over the industry. Awash with cash from crude exports, this was a new Russia, largely different from the country that awarded lucrative production sharing agreements to foreign firms in the early 1990s. Also, in stark contrast to that period, was the gradual shift from a privately-dominated sector toward an industry overshadowed by two state-owned giants.

   Soon after his election, Putin ushered in a post-oligarch era putting the host of Russia’s super-rich owners of large companies at equal distance from the Kremlin. Hardly anyone among them could have claimed, emerging from the 1990s, totally clean hands. And the president’s “amnesty” program relied on one sole principle – loyalty.

   Having surrounded himself with longtime trusted allies, Putin tasked Alexei Miller with securing the government's control of Gazprom, while his close associate and then deputy head of the presidential administration, Igor Sechin, was tipped as his key man in the oil industry. By the time Putin left the Kremlin, Gazprom had been transformed into a $330-billion giant, while Rosneft within the past decade grew from a midsize firm that produced 13.5 million tons in 2000 to a behemoth topping the century mark in 2007. Both these accomplishments would not have been feasible without the assistance of a loyal oligarch (Roman Abramovich sold Sibneft to Gazprom in a $13 billion deal in 2005) and the Kremlin’s conflict with a disloyal one (Rosneft grew its asset base after Mikhail Khodorkovsky’s YUKOS was torn to pieces by tax claims).

The Rise and Fall of YUKOS

   When in December 1995 a young and aspiring Moscow banker acquired Russia's second-largest oil company at the time, his name hardly rang a bell in the heartland of the country’s oil patch, let alone beyond its borders. However, for reasons both good and not very good, eight years later Mikhail Khodorkovsky became known not only as the man who built a world-class oil firm, but also as Russia’s most vocal critic of the regime that put him behind bars.

   A chemical engineer by training, the Muscovite Khodorkovsky was a bit of a misfit when in the mid-1990s he entered the company of heavyweight career oilmen such as LUKOIL chief Vagit Alekperov and Surgutneftegaz boss Vladimir Bogdanov. Not that he minded, though. Before acquiring YUKOS, the former Komsomol leader-turned-entrepreneur’s MENATEP bank scooped up a host of industrial assets, many of which (timber, titanium and copper firms, to mention just a few) it later sold to generate cash that would help build an oil empire. Having obtained 78 pecent of YUKOS for an investment pledge of $350 million (yeah, you read that right – back in 1995 Russia’s privatization regulations had been flawed to the extent that oil companies – and other prized industry assets – were sold at the so called “shares-for-loans auctions” with the “buyers” making investment pledges instead of forking out real cash!). Khodorkovsky and his team pursued a rather aggressive growth policy, attempting to build Russia’s most-modern oil company. Heavily relying on Western expertise and skills in both oilfield services and corporate governance (YUKOS was the first among Russia’s oil majors to hire Western top managers), YUKOS claimed the post of Russia’s No. 1 oil and gas company in terms of capitalization in late 2002 and vied with LUKOIL for the title of the country’s top oil producer.

   A year later, both Khodorkovsky and his longtime friend and MENATEP co-founder, Platon Lebedev, were jailed on charges of fraud, embezzlement and tax evasion, allegedly committed in a privatization deal involving a fertilizer plant in northwest Russia. They were both sentenced to eight years in prison. Though found guilty of an economic crime, Khodorkovsky’s biggest fault – as interpreted by political analysts – was his financing of the opposition parties (most notably, the Russian Communists) despite the Kremlin’s warnings not to, and ambition to pursue a career in politics, targeting the seat of Russia’s future prime minister (on several occasions Khodorkovsky had said that he planned to quit the oil business on his 45th birthday in June 2008). While in prison, he remained a strong critic of Vladimir Putin’s regime and currently faces new charges that could extend his imprisonment for up to 20 years.

   Meanwhile, YUKOS, once a $40 billion company, crumbled and its main production unit, Yuganskneftegaz, was auctioned off in December 2004 to an obscure company named Baikalfinansgroup for a fraction of its worth, at the peak of YUKOS’ success. The buyer was soon acquired by the state-owned oil giant, Rosneft, which subsequently inherited the major part of YUKOS assets.  

The Liberalization of Gazprom Shares

   The liberalization of Gazprom’s shares was one of the most significant events of the last decade. Following the company’s privatization from 1993 to 1995, the Russian government ended up with a 38-percent stake in the company; 10 percent were bought by Gazprom itself for privatization cheques; 15 percent of shares went to Gazprom’s then staff and former employees, who paid in privatization vouchers (covering at least 50 percent of payment) and cash; 32.9 percent of stock was bought by Russian citizens from 60 regions for vouchers; and 1.1 percent of shares was turned over to Rosgazifikatsiya.

   Later, Russia introduced some restrictions on trading in Gazprom stock to limit ownership by foreign investors. The law “On Gas Supplies” set a 20-percent ceiling on the purchase of Gazprom stock by foreign investors. Other rules put some limits on Gazprom stock trading, such as allowing trading only on four stock exchanges (the St. Petersburg, Moscow, Novosibirsk and Vladivostok bourses).
The decree limited foreign ownership to American Depositary Shares (ADS) whereas one Gazprom ADS was equivalent to 10 domestically-traded shares. This split in the markets led to a difference in “internal” and “external” trading prices.
Despite these restrictions, foreign investors were still interested in purchasing Gazprom shares, and invented a number of “gray schemes” to gain ownership. In particular, the United Financial Group (UFG) was suspected of using one of such scheme; for several years UFG co-owner Boris Fyodorov represented interests of minority sharegolders on Gazprom’s board of directors.

   Market estimates suggest that as much as 10 percent to 15 percent of Gazprom shares could have been owned by foreign investors through “gray schemes,” and if these were added to the 6.5 percent interest legally owned by Germany’s E.ON-Ruhrgas, and the 3.42 percent publicly traded on foreign stock exchanges, total foreign ownership could have been a blocking one.

   The liberalization of trading in Gazprom’s shares was anticipated to result in higher share prices and show Gazprom’s real market valuation.
In 2001, a working group was formed to liberalize the Russian natural gas monopolist. The group was headed by Dmitry Medvedev, who at the time was Gazprom’s board chairman. The state took a long time to select from various liberalization scenarios.  In 2004, the plan was to amalgamate Gazprom and Rosneft into one major energy holding. By then, Rosneft had already bought Yuganskneftegaz, the main production unit of the ill-fated YUKOS oil giant. However, due to conflicts between senior managers at Gazprom and Rosneft, this plan was never implemented.  Instead, it was decided that the state would buy Gazprom shares that were on the balance sheets of Gazprom affiliates (Gazprombank, Gazprominvest-Holding, NPF Gazfond, and Gazprom Finance BV). The state-owned company Rosneftegaz was founded with the special purpose of this transaction. Rosneftegaz took a loan against Rosneft shares and the loan was paid back from funds raised through the Rosneft IPO; Rosneftegaz then paid 203.5 billion rubles to Gazprom affiliates for 10.7399 percent of Gazprom’s shares. These transactions permitted Gazprom to expand its oil assets. In the months following the purchase of these shares by Rosneftegaz, Gazprom negotiated the purchase of Sibneft for $13 billion.

   Now Gazprom shares are traded through first level ADRs on foreign markets at a rate of four shares per ADR. At the beginning of 2010, 24.35 percent of shares were traded through ADRs. It should be pointed out that the percentage of shares that can be traded through ADRs is capped at 35 percent of Gazprom’s authorized capital.

   In 2001, Gazprom’s capitalization was about $12 billion. In 2005 it increased to $160 billion, and in pre-crisis 2007 capitalization reached $330 billion. Earlier this month its market value was approximately $120 billion.

Russia’s Direct Connection

   Over the past 10 years that Russia has suffered the loss of economic links and assets due to the collapse of the U.S.S.R., several attempts have been made to build gas pipelines circumventing the territory of former Soviet provinces. Most of Russia’s transit gas was pumped through Ukraine and this accounted for about 80 percent of Russian gas transported to European countries. Ukraine frequently failed to make payments for gas supplis and often blackmailed the Kremlin threatening to raise transit tariffs.  In an attempt to avoid pumping gas through the former Soviet provinces, Gazprom teamed up with Italy's Eni to build in 2003, the Blue Stream, trans-Black Sea gas pipeline. Blue Stream has a throughput capacity of 16 billion cubic meters of gas per year directly to Turkey in addition to volumes sent through Ukraine.

   In April 2010, Gazprom began construction of Nord Stream, the offshore Baltic sea pipeline. Gazprom started planning this project in 1997–1999 when Rem Vyakhirev headed the company (he resigned in 2001). At that time, Finland's Fortum was to be another participant in the project. During the last decade Nord Stream’s partners, capacity, and cost have changed. In 2002, the capacity of the North European Gas Pipeline (Nord Stream’s initial name) was estimated to be 19.7 billion cubic meters per year, while by mid-2005, planned capacity was increased to 55 billion cubic meters per year. The pipeline is designed with two parallel lines, each with a capacity of 27.5 billion cubic meters per year.
Gazprom’s partners in Nord Stream are: Е.ОN AG (24.5 percent) and BASF AG (24.5 percent), which each later passed 4.5 percent of shares to the Netherlands-based Gasunie. Gazprom itself controls 51 percent of the project The French company GDF Suez is also in negotiations to join the consortium. It was promised a 9-percent stake of the German interest, though it did not join the consortium prior to the construction commencement. Both Gazprom and GDF officials claim that sooner or later the agreement with the GDF will be signed.
The South Stream pipeline project to bypass Ukraine was planned with the intent to double the capacity of Blue Stream. The idea to increase Blue Stream’s throughput and deliver volumes to third countries, predominantly to South European markets, was presented to the public in 2004. And as early as 2005, Vladimir Putin, then Russia's president, and Gazprom CEO Alexei Miller, initiated negotiations with Turkey to double Blue Stream’s capacity. In addition to aspiring to bypass unreliable transit countries, the pipeline was indented to prevent the Caspian and Central Asian gas regions from having access to European markets. Gazprom Export chief Alexander Medvedev said that without Gazprom, Caspian and Central Asian gas projects would become a Blue, or pipe, Dream rather than a Blue Stream. So far, this policy has worked; countries bordering the Caspian are delaying confirmation of gas sales for the Nabucco project, gas pipeline lobbied by Europe.

   Gradually the shape of the gas pipeline project has somewhat changed. Initially in 2006 Hungary's MOL was picked as a Gazprom partner in building the South-European Gas Pipeline. For now, Gazprom has executed an agreement on the offshore segment of South Stream with  Eni, its Blue Stream partner.

   In 2010, Ukraine elected Viktor Yanukovych president. In his first 100 days he has proved himself quite loyal to Russia and this gives Russia a chance to settle Ukrainian gas transit issues. Still, Russian officials insist that the South Stream pipeline will be constructed regardless of the potential increase in gas volumes sent through Ukraine and Russia’s possible acquisition of shares in the Ukrainian gas transportation system.

   Russia built an onshore, 310-kilometer pipeline with a throughput capacity of 24 billion cubic meters of gas a year which bypasses Ukraine to transport gas to its own Rostov region.  Gazprom claims the Sokhranovka – Oktyabrskaya gas pipeline will save up to $40 million a year which was previously paid for Russian gas transportation through Ukraine.

M&A – Consolidation That Created Russia’s Oilfield Services Market

   Baker Hughes’ recent acquisition of Siberia-based Oilpump Services (OPS) was yet another in a decade’s worth of M&A activities that have transformed the landscape of Russia’s oil patch. OPS was Russia’s second-largest ESP service provider in West Siberia and its acquisition leaves Baker Hughes poised for serious growth in servicing the largest ESP market in the world. The acquisition will also undoubtedly boost the Centrilift ESP brand and sales in Russia.

   Though service company M&A has really revolutionized the Russian oil and gas landscape over the past 10 years. The real headline grabbers have, of course, been the production companies. Though their activity was far less, when something happened, it was big.

   In 2003, BP paid $6.8 billion to purchase a 50-percent stake in Tyumen Oil Co. (TNK) and form the 50-50 joint venture TNK-BP. In March, ConocoPhillips announced it would sell half of its 20-percent stake in LUKOIL worth $4.9 billion. In 2004, Conoco bought the Russian government’s 7.6-percent share in LUKOIL, and over the years gradually raised its stake to 20 percent.

   In sheer volume of deals however, the action has been in oilfield services. A decade ago, Russia’s majors were vertically integrated; each with their own drilling crews, production engineers, equipment handlers. Then, faced with the challenge of modernizing their business processes and becoming more efficient, they started to spin off these departments as private companies.

   Left to survive on their own, some of these companies died, others leveraged relationships with their former parent to maintain the status-quo work-wise, but under terms of an independent contractor. Others merged into larger Russian companies, and some were absorbed by international firms seeking to enter the Russian market through acquisition.

   Schlumberger was the first of the international service companies to “become Russian” by acquisition. Schlumberger started down the M&A path in the 1990s and by 2000 it was so successful with what the industry called “The Schlumberger Model” that soon competitors like Baker Hughes and Weatherford followed suit.
Similar tales are told about equipment manufacturers. Emerson Process Management, for example, purchased Metran in Chelyabinsk, where among other things final assembly of Rosemount products for East Hemipshere customers takes place. And it is not always manufacturing assets or client contracts and relationships that are the prize at stake.

   Whatever negatives might be said about Russia’s inertial style when it comes to innovation and modernization, when it comes to science and research, Russia ranks at the top. When Weatherford, for example, bought Aquatic Co. in 2008, a major driver was to acquire the research capacity and scientific institute relationships that Aquatic had built in Samara and St. Petersburg. Weatherford has since rebranded both R&D facilities under its name.

   Emerson also used such logic in its Metran acquisition. Russians often are sent abroad for training but this requires foreign language skills. But if a global company acquires a Russian R&D base, language doesn’t matter – the common language is science. And the foreign parent company injects into the Russian system an appreciation for how such science can be applied commercially.
Weatherford unveiled its acquisition strategy with the purchase of TekhInformServis and Neftegazkomplektservis in 2006. Acquatic followed in 2007 and  Neftemashvnedrenie was added in 2008. In 2009, Weatherford acquired 10 oilfield service divisions of TNK-BP with a workforce of 6,600 people.
Though hardly an exhaustive list, the following were key mergers that created a benchmark for Russian oilfield service companies:
 RIMERA – Organized in 2007 out of the pipe-manufacturing ChTPZ Group. In 2008, it acquired the ESP manufacturer ALNAS and the sucker rod pump maker Izhneftemash. The same year, it acquired these geophysical companies – Yuganskneftegazgeofizika, Tomskneftegazgeofizika and Taymyrnefegazrazvedka.

   Integra Group – Founded in 2004 out of a merger between two drilling service contractors that later acquired 17 more companies with service contracts and equipment manufacturing assets, including Smith Eurasia, First National Drilling Co., and the geophysical company Tyumenneftegeofizika.

   GEOTEC Group – Organized through a series of mergers that began in 2006 with the unification of  Naryanmarseismorazvedka, Severgeofizika, Inteneft, Khantymansiyskgeofizika. In 2008, the following companies were added to the holding – Central Geophysical Expedition, Sibneftegeofizika, Novosibneftegeofizika, Agan-Burenie, Boguchansk Geophysical Expedition, Yeniseigeofizika, Orenburg geophysical Expedition, Ilimpeisk Geophysical Expedition, Reservoir Geology, Geonis, Seismic Technologies, Severspsetstekhnika.

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