Committee for Russian Economic Freedom

State controlled Rosneft acquires TNK-BP, a joint venture between a group of Russian oligarchs and BP. The newly formed company will become the largest publicly traded oil producer, controlling up to 50% of the Russian crude oil output.

The major cause of the Soviet Union collapse was the central planning system’s failure to meet even the basics needs of the country’s population. In contrast, the Putin extraordinary popularity rests on the rapid economic growth of 1999-2007, resulted from the market reforms and privatization of 90s.

BP's CEO Bob Dudley finally exits Russia with money

Now the Putin team destroys the foundations of his regime. The de-facto nationalization and monopolization of the energy sector has already cost a lot to the Russian economy. The country’s oil industry rapid rise stumbled after the de-facto nationalization of YUKOS, once Russia’s biggest and most efficient oil company. During the last ten years state-controlled Gazprom, which has an exclusive access to the world-largest natural gas reserves, has failed to develop any new large natural gas field and faced a decrease in production.

Even if they act in the best public interest, government officials have neither instruments nor proper motivation for supervising the sophisticated corporate structures. As a result, the huge cash flows of state-controlled companies become an easy prey for managers and insiders. They make fortunes on generous contracts and illogical M&A activities of such companies as Russian Railways, Transneft, VTB, Gazprom, Rosneft and many others.

When there is little room for further oil price increases, the production growth is an obvious way to sustain the country’s economic development. The energy sector opening to the international majors and private initiative would have brought new tax revenues and prolonged the Putin team dominant position in the Russian economy and politics. However, it looks like the opportunity to get access to the TNK-BP’s multi-billion cash flows outweighs all rational arguments for a new policy in the energy sector.

FT

We previously wrote about record capital flight out of Russia due to political uncertainty. Both the New York Times and the Washington Post have articles covering this topic. While Kathy Lally at the Post relies on Olga Kryshtanovskaya, a member of Putin’s United Russia party, for her main assertions that there is no competition and it is all a show, Ellen Barry at the Times reports that something more substantive is in progress. Barry refers to a Churchill Winston remark that refers to the Kremlin transfer of power as bulldogs fighting under a carpet,

An outsider only hears the growling, and when he sees the bones fly out from beneath, it is obvious who won.

Barry doesn’t try to predict the winner but Prime Minister Putin has been in the headlines by reprimanding Russian trade officials who were seeking to comply with World Trade Organization’s rule before ascension. James Bacchus, a former chief judge for the World Trade Organization wrote,

Putin’s Russia is something considerably less than an open society. There is evidence aplenty of his decided disdain for the rule of law. A commitment to uphold the rule of law is implicit in signing the WTO treaty. Although not mandated in so many words by the treaty, conscientious allegiance to the rule of law is inherent to a national commitment to comply consistently with WTO rules.

Putin has likened the prolonged WTO accession process to an “ambush” of Russian economic interests. Evidently, he wants Russia to be able to enjoy the benefits without bearing the burdens of being in the WTO. He seeks the tariff concessions and the safeguards against trade discrimination that come with WTO membership, but he does not seem to want WTO commitments to impede unduly on his continued ability to impose the whims of what often seems an arbitrary rule.

Despite Putin’s omnipresence in Russian politics and economy, he was uncharacteristically quiet in the BP-Rosneft deal. BP trying to regain its footing after the Gulf Oil spill entered into a deal with Rosneft while ignoring their existing partners in Russia, Alfa-Access-Renova (AAR). After legal contests in London, AAR has won a major concession, Arctic exploration.

In London, an injunction prohibiting the share-swap agreement between BP and Rosneft was issued indefinitely. The group Alfa Access Renova (AAR) had an agreement with BP as their investment partner in Russia. BP, still reeling from the Gulf Oil disaster looked to the deal with Rosneft to expand their exploration into the Arctic Circle. BP’s shares have gained 2.6 percent so far this year but still trade well below their value of before the Gulf Oil Spill. The injunction is likely to give AAR more leverage, and money, from any resulting BP-Rosneft deal.

WSJ’s Heard on the Street urged potential investors in Russia to study Kremlinology, the study of the murky underbelly of the Russian government. When BP made the deal with Rosneft, it no doubt received strong support from the Russian government since Igor Sechin is both chairman of Rosneft, deputy prime minister and close confidante of Prime Minister Vladimir Putin. Despite these close ties, the Kremlin has not used its muscle to lean on AAR to forgo their legal battles against BP and Igor Sechin is about to lose his chairmanship at Rosneft.

Despite these and other efforts by President Dmitry Medvedev to make Russia more enticing to foreign investors, critical factors remain:

The country needs to attract more foreign direct investment: It fell 13% to $13.8 billion last year, half the level in 2007. Gross domestic product growth could fall to 2.5% to 3% per year in the next 10 years, compared with 6% to 7% in the last decade unless annual foreign direct investment is ramped up toward $75 billion, investment bank Uralsib forecasts. The government wants foreign investors to participate in a planned $35 billion of state-owned company flotations in the next three years. Industries from farming to oil and gas also need foreign expertise to develop.

…so long as former Yukos boss Mikhail Khodorkovsky languishes in jail, many will be sceptical Russia’s legal system is truly independent. Political risk is the reason Russian equities trade at 9.1 times expected 2011 earnings, a 20% discount to their emerging market peers. It would take a brave Kremlinologist to bet on that gap closing.

Russian Deputy Prime Minister Igor Sechin (left) with BP Chief Executive Robert Dudley and his predecessor Tony Hayward in August 2010 Photo: AP

It’s well known how Putin, Inc. treats its enemies, but the latest WikiLeaks revelations offer startling new details on the rough treatment it accords even its friends. The Telegraph published secret US diplomatic cables showing that current BP Chief Bob Dudley was tossed from his prior post leading the energy company’s Russian unit, TNK-BP, following a boardroom “coup” in 2008, and decided to “move around” from country to country” amid threats orchestrated by Rosneft Chairman Igor Sechin.

On January 14, 2010, Dudley and Sechin joined in praising their latest transaction under which BP would swap five percent of its shares, worth about $7.8 billion, for a 9.5 percent stake in state-controlled Rosneft. Perhaps, as the Telegraph reports, Dudley was forced to set his fears aside and cut a deal with his enemy because BP finds it necessary to look for new business ventures with Putin in light of American anger over the firm’s oil spill in the Gulf of Mexico last year.

Serfs

Russian natural resource minister Yuri Trutnev annoucned that TNK-BP’s licence to develop the Kovykta gas field will be handed over to the state, where Gazprom has a natural gas monopoly. Although TNK-BP was in discussions to sell Kovykta to Gazprom for $1 billion, the transaction was never comnpleted and it appears TNK-BP will walk away from Kovykta with nothing.

Details of TNK-BP’s travails are covered in a previous post, but it’s worth rementioning that in 2007 the Kremlin passed a law restricting all gas exports to public entities, yes, Gazprom. Although the recent Reuters article touches upon weakening demand for natural gas, it neglected to mention that Kovykta is located in the eastern Russia and TNK-BP was developing those fields for natural gas export to energy hungry China. According to China’s official news agency Xinhua, China’s natural gas consumption is forecasted to more than double over the next ten years.

President Medvedev’s visit to California’s Silicon Valley last week focused on Russia’s ambition to make Skolkovo into Innovation City. But as a Moscow Times op-ed mentions, the President and the government must restore trust in government procedures and laws of the land. Only through the re-establishment of trust can Russia foster the kind of environment entrepreneurs, engineers and venture capitalists need to create and execute new ideas and projects. As an indication of his commitment, Medvedev signed along with other G20 leaders their commitment to combatting corruption and protecting whistle blowers by creating a committee that will eventually draft rules for all G20 members.

While the Skolkovo project renews debate over the successful path of Russia as a state capitalist country versus democratic capitalist nations, financial commentators have renewed interest in Friedrich Hayek, Nobel Prize winning economist. Counter to John Maynard Keyes who wrote about the importance of governmental intervention, Hayek warned against government intervention as it would lead to serfdom. Having experienced serfdom for centuries prior to 1861, Russia is at a political and economic crossroad. Will Medvedev’s commitment to innovation, rule of law and transparency extend to the coming presidential election in 2012, or will a perceived tainted election redirect Russia’s political and economic path towards greater government control and, serfdom?

Zuma Press - Gazprom company worker places a Russian flag on the Nord Stream pipeline last month. The pipeline will run from Russia to Europe.

With the arrival of Ian Bremmer’s new book, “The End of the Free Market: Who Wins the War Between States and Corporations?” the future of the global economy has been set up as an epic battle between state capitalists like China and Russia and free-market capitalists like the US, EU, Japan and Canada.

State capitalists are defined by their domination of strategic assets and creation of wealth that is used to maintain and enrich the political leadership. State capitalists also tilt the marketplace in favor of state-owned companies and put multi-national corporations at a disadvantage through laws and regulations. An example of this from Ian Bremmer in the Wall Street Journal:

In December 2006, the Russian government informed Shell, Mitsubishi and Mitsui that it had revoked their environmental permits as project managers for the $22 billion Sakhalin 2 project, forcing them to halve their respective holdings and give Gazprom, Russia’s natural gas monopoly, a majority stake. This instantly wiped out 2.5% of Shell’s global reserves.

Russia is a model state capitalist as the Kremlin consolidates control over the country’s vast oil and gas reserves and increasingly pressure multi-nationals to sell their companies to state-owned entities. This recently happened with one of BP’s investments in Russia, RUSIA Petroleum.

BP purchased the Kovykta natural gas field back in the early 1990s because of its proximity to China and its enormous reserves. It created a joint venture with local businessmen to create TNK-BP. Before they could make any money, TNK-BP invested hundreds of millions of dollars to develop the infrastructure and pipelines needed to get the Kovykta gas to China.

As the project developed more Russian officials took notice and in 2007 TNK-BP was pressured to sell RUSIA Petroleum to Gazprom, Russia’s state-owned oil and gas company. That same year, the Kremlin passed a law prohibiting private gas exports from Russia, institutionalizing Gazprom’s monopolistic position.

With Gazprom the only buyer of RUSIA Petroleum and government officials dictating not only the pipeline start date but also insisting on a northern, circuitous route, RUSIA Petroleum could not get natural gas to consumers and fell behind on its loan repayments. TNK-BP, which was a creditholder to RUSIA Petroleum, is trying to recoup some of its losses by filing for bankruptcy. It will be seen whether the officials of Russia’s state government give some of TNK-BP’s money back.

Situations such as these make President Dmitry Medvedev’s goal of transforming Moscow into a global financial center and the next Silicon Valley even less likely. Matt Marshall, the only US reporter on a recent venture capitalist tour, was invited to visit Russia as part of the Kremlin’s plan to encourage more foreign direct investment. His critical assessment of Russia’s investment potential is probably not the press the Kremlin was hoping for:

Russia is the sixth-largest economy in the world, but it’s also a country relatively untouched by foreign investors, especially investors in technology. Could Russia potentially be the home of the next massive tech boom?

The short answer is: No way. At least not anytime soon. That’s the conclusion I’ve come to after a week in Moscow, a week in which I took part in the first ever delegation of US venture capital investors to visit Russia.

Now, of course, I’d be delighted if I could report that this Russia is the next India, China or Israel — all places that have seen massive foreign investment in recent years. Russia has among the highest per capita number of students in the world, boasts high levels of mathematics and science education, and being in desperate need of modernization, you’d think Russia would be a gold mine for investors. President Medvedev greeted the delegation, and made clear that technology is needed to diversify from Russian oil, gas and metals — which make up 80 percent of Russia’s total exports. That legacy industry is highly influenced by a group of about 22 so-called oligarchs — many of them exerting their power behind the scenes through corruption. Technology entrepreneurship, if it is fostered, will lead to positive change — there is no question. Everyone agrees.

But investing in Russia can be “insanity.”

The more time I spent in Russia, the more complex the story became (and I’m not the first to say that about Russia). The more I learned — about corruption, the abuses of the courts, the terribly archaic educational system, the choked up traffic, the lack of investment in infrastructure, the cultural penchant for Hobbesian brute leaders, the lack of a truly independent media, and the assassination of journalists when they do show independence — the harder it is for me see a positive short-term future for U.S.-style tech investment for this country.