Oil On Troubled Waters

It was one of history's great oil deals: In June 2003, U.K. energy giant BP agreed to pay $7 billion to Russian oil company TNK to form a 50-50 joint venture to exploit some of Siberia's richest petroleum deposits. But a few months later, the partners were barely on speaking terms. A multibillion-dollar dispute had erupted over how fast BP should pay TNK stockholders for sharing their oil riches. The board of directors of TNK-BP stopped meeting.

"Especially at lower executive levels, there were deep suspicions of what each side's intentions really were," recalls Mikhail Fridman, chairman of the joint venture and its largest Russian shareholder.

Fridman's security chief reported to his boss that the BP side, led by the joint venture's CEO, Robert Dudley, was convening clandestinely once a week, possibly to plot how to rid the joint venture of Russian influence. Fridman called Dudley into his office and told him, "Bob, I don't want to have to listen to these silly reports, so just tell me -- why are you guys having secret meetings?"

Dudley responded that tensions over the payments issue were running high and that the board was inactive. "We had people in the company who were nervous, so I called a meeting with the foreign folks and told them not to get rattled or to speculate about anything," he explained to Fridman. Then, from his own informants, Dudley found out that the Russian side was having secret meetings of its own.

"Basically, they were discussing the same things we were," says Dudley. Although such behavior is "unusual in a joint venture," he concedes, "it was effective in settling everybody down."

To the outside world, the biggest danger facing TNK-BP and other oil companies operating in Russia today is an unpredictable, increasingly nationalistic Kremlin. But interviews with the highest executives at TNK-BP paint a complex picture of a joint venture that until recently felt more threatened by bickering between its Russian and foreign partners than by President Vladimir Putin.

When BP, Fridman and two other Moscow oligarchs created TNK-BP, it immediately became the poster child for foreign deals in Russia. The British company's investment was hailed as the largest foreign capital inflow of the post-Soviet era. Putin even attended the signing ceremony in London.

But ever since the Yukos Oil Co. affair erupted a few months later, TNK-BP has been portrayed in the media as more of a bull's-eye poster. Threats of retroactive tax assessments against the company -- though they have abated recently -- unnervingly resembled the methods used by the Russian government to effectively renationalize Yukos, then the country's largest oil concern, and to jail its chairman, Mikhail Khodorkovsky. Bureaucrats have seized upon BP's half ownership to suggest that TNK-BP isn't Russian enough to qualify for important new natural-resource development projects. And some government officials have accused the company of revealing "state secrets" by disclosing its reserves.

All this time, TNK-BP was embroiled in an internal struggle that turned so bitter that the company's Russian and foreign executives spied on one another and exchanged accusations of conspiracies. Russian executives and technicians were openly contemptuous of BP's management policies in the oil fields.

Today, although not all the contentious issues have been laid to rest, both sides insist that the worst is over. "We have made a lot more progress than I expected," says Fridman. Explanations for the improved relations run the gamut from earnest efforts to bridge the cultural divide between Russians and Westerners to intensive motivational sessions for field managers and technicians. But nobody disputes the main reason for the new bonhomie: windfall profits linked to oil prices that have rocketed well past $60 a barrel. "I believe all the shareholders would say their expectations have been exceeded," says Dudley.

Last year TNK-BP recorded net income of $4 billion on $14.3 billion of sales -- a leap from $2.8 billion on revenues of $10.4 billion in 2003. With daily output of 1.45 million barrels in 2004, TNK-BP became the second-largest Russian oil producer behind Lukoil Oil Co., which last year produced 1.68 million barrels a day. (Operations at Yukos are in disarray as Russian state-owned and private companies fight over its properties.)

Yet in some ways TNK-BP has fallen short of the high expectations set for it. Given the new economic nationalism in Moscow, it is unlikely that another foreign oil corporation will be allowed to own anywhere near 50 percent of a joint venture in Russian natural resources. And despite hopes that TNK-BP would herald a new era of abundant Russian oil production to meet global needs at reasonable prices, the country's growth in oil output has actually declined.

This much is certain, however: The joint venture has been a boon for its shareholders and for BP. (The U.K. company's share price climbed 28 percent last year and a further 24 percent in the since the beginning of this year, hitting 683.50 pence a share ($71.11) on September 29.) In 2004, its first full year of operation, TNK-BP accounted for 23 percent of BP's total daily production of 4 million barrels of oil and oil equivalents (such as natural gas). This enabled BP, the world's second-biggest oil company by market capitalization, to boost hydrocarbon output by 11 percent over 2003 levels. That compares with flat 2004 output by Exxon Mobil Corp., the largest energy company by market value, and a 3 percent production decline at No. 3 Royal Dutch/Shell Group. "There aren't many companies out there besides us that are increasing production and raising their total reserves," says James Dupree, TNK-BP's executive vice president for technology.

Both the foreign and Russian sides of TNK-BP insisted on a 50-50 joint venture rather than a minority share for either side. At the London signing ceremony that launched TNK-BP, Putin wondered aloud how disputes would be settled under such an arrangement. It was a prescient question. The biggest argument, unsurprisingly, was over money. Under the agreement creating the company, BP was supposed to dole out its $7 billion payment to its Russian partners over three years. But the Russians later wanted those funds immediately, urging BP to take out bank loans if necessary to pay them.

The trio of oligarchs on the Russian side is unusually cohesive. Fridman, 41, chairman of Alfa Group Consortium, a financial-industrial conglomerate, holds 25 percent of TNK-BP through Alfa. Viktor Vekselberg and Len Blavatnik, 47-year-old former university buddies, each hold 12.5 percent of the joint venture through their companies. Of the three, Blavatnik, chairman of Access Industries, a New York­based private equity investment firm, is the least active in TNK-BP, though he sits on its board. The partner most involved in the joint venture's everyday affairs is Vekselberg, chairman of Moscow-based JV Renova, an investment firm with large industrial holdings in Russia; he is an executive director and board member at TNK-BP.

Vekselberg gained notoriety last year when he bought the largest private collection of Fabergé eggs from the Forbes family, publishers of the magazine of the same name, for about $100 million. He then donated the fabled eggs, which had once belonged to the czars, to several Russian museums in what was viewed as a philanthropic gesture to help raise the public's low esteem for Russian business magnates. But Vekselberg has been teased so often about the Fabergé donations by friends and the local media that he has banned all mention of eggs of any sort in his presence. He and Fridman bond outside of business by taking annual two-week treks to exotic places around the world: Mongolia's Gobi desert, the Australian outback and the plains and glaciers of Patagonia.

Fridman met Vekselberg and Blavatnik in the mid-1990s, and the three joined forces in the often lawless, violent battles for control of Siberian oil. In 1996 they made a successful $800 million bid for a controlling share of Tyumen Oil Co., or TNK, which was being auctioned off by the government. "Back then it was too heavy a financial obligation for each of us alone to afford," says Fridman.

Seven very tumultuous years ensued. Using private security forces and questionable court rulings, the three Russian partners seized petroleum fields that BP had bought for $471 million in 1997 from another oligarch, Vladimir Potanin. According to Fridman, BP was an unintended victim in the struggle against Potanin. Nonetheless, the U.K. oil giant sued Fridman and TNK in the Russian courts and exerted its influence to stall a $500 million loan that TNK was seeking from the Export-Import Bank of the United States. BP sought to regain its lost Siberian fields by appealing directly to Putin and then by getting U.K. Prime Minister Tony Blair to make a written plea to the Russian leader, who declined to get involved.

In the end, self-interest brought TNK and BP together. BP needed to replace its depleting fields in Alaska and the North Sea and was willing to buy Siberian reserves a second time for a much higher price. TNK needed BP's technical expertise and worldwide marketing network -- and its money. But even allowing for the wild history of the oil industry, the ability of both sides to overcome their past problems and form their joint venture surprised observers. "I still find it amazing that they were able to reconcile," says Yulia Woodruff, a Russian oil analyst at Energy Security Analysis in Boston.

In contrast to the bitter, widely publicized fracas leading up to the joint venture, the subsequent impasse between the Russian and foreign partners over how quickly BP should pay for its half of TNK was largely hidden from public view. One reason was the shifting political and economic environment. By late summer 2003 the Yukos affair had begun. Khodorkovsky was under investigation by the government, allegedly for tax evasion and fraud but also, many analysts believe, because he had violated an agreement by business oligarchs not to challenge Putin politically.

Russian investors were convinced that the brief era of rampant capitalism was being reined in. Some oligarchs sent billions of dollars abroad. Others, like Fridman, rushed to invest part of their swelling profits in economic sectors that the government considered less strategic than hydrocarbons. "We don't want to just concentrate on oil and gas," says Fridman. "We have diversified into telecommunications, banking and supermarkets."

But hydrocarbons remained his biggest business, and bad blood in the TNK-BP boardroom soon spilled over into the company's oil fields. Output had stagnated over the previous decade, and the Russian shareholders questioned whether BP's managerial strategy to restore production growth would work in the overstaffed, demoralized oil camps. The executive picked by BP to spearhead the turnaround was technology chief Dupree, a tall, soft-spoken Texan, now 45, who had worked for the U.K. oil company all over the world.

When Dupree first visited the giant Samotlor field in western Siberia that is the joint venture's largest oil producer, he was stunned by the waste and disrepair. Fully 45 percent of the wells were not working. The remainder operated with technology that hadn't been upgraded in two decades. Even more discouraging were the listless and incompetent management practices that had all but immobilized the labor force. "My initial impression was of a field that was severely neglected for many years," recalls Dupree. "My second thought was, What an opportunity."

A car buff, Dupree likened Samotlor to an antique automobile that hadn't been polished or tuned for years but didn't require a major engine overhaul. "It just needed a clean carburetor, maybe a catalytic converter and a change of tires," he says. This is no idle metaphor. The money TNK-BP has spent to get Samotlor and its other Russian fields up to cruising speed is chump change by oil industry standards. In 2004, its first full year of operation, TNK-BP invested $800 million to raise its output to 1.45 million barrels a day from 1.28 million in 2003.

Russia has some of the lowest production costs in the world. TNK-BP spends only about $2.50 to bring a barrel of oil out of the ground and ready it for shipment. And the cost of increasing the company's proven reserves can be downright cheap. For example, at TNK-BP's vast Nyagan field, west of Samotlor, an investment of just $7 million last year led to a rise in proven reserves of almost 2 million barrels. "I mean, we want to do that all day long, right?" says Dupree.

According to Dupree, management and politics were bigger obstacles than technology to boosting output and proven reserves. Samotlor began pumping oil in the 1970s, and production ran smoothly enough until 1991. Then the collapse of Communism and the breakup of the Soviet Union undermined the command economy without replacing it with a new management model. "The wells were breaking down, and there was nobody in authority to ask for money or make the effort to fix them," says Dupree.

TNK-BP's Russian partners insisted that the quickest way to revive production was to return to traditional ironfisted management. "You must be willing to impose penalties on people who fail to fulfill work standards or obligations," says Fridman. "Otherwise employees won't respect you and will just ignore your directives." BP managers rejected this approach. They were convinced that any attempt to revert to Soviet-era, command-economy management style would bring only short-term gains. "It's just not a sustainable way to take the company forward," says Dupree. "The better alternative is to get people to figure out the problems and solutions."

Dupree had begun to work on the turnaround in early 2003 to build confidence between TNK and BP months before they officially signed their joint venture that June. He formed a team of eight BP managers -- dubbed an "expert working group" -- who held intensive training sessions for senior Russian personnel from every oil field to tackle major bottlenecks. Each participant then trained another elite group of managers in an expanding network that today has 400 graduates. The first expert working group, led by Dupree, holed up for two bitterly cold days in February 2003 at the Hotel Tatyana, a small, nonluxury establishment in downtown Moscow. "We did an analysis of the biggest technology gaps and how to best solve them," says Dupree. Those gaps ranged from poor drilling performance to faulty pumps to the outdated software that operated the wells.

The most urgent task was to restore the water flood system. At almost all TNK-BP fields, water is pumped into the ground to push oil deposits toward the wells. For the system to work best, the oil must be pushed on all sides by onrushing water. But with so many water pumps broken down, much of the oil either remained undisturbed in its deposits or was flushed away from the wells. "For ten years these water floods just ran nonproductively," says Dupree.

While the water flood system was being restored, TNK-BP had to repair the pumps that lifted oil up the wells. They dated to the Soviet era, and all were the same size and power. "It was like the old Volga automobile, which was assembled with the same door handles for 20 years," says Dupree, ever the car buff. New pumps of four different dimensions were put in place, along with sophisticated software to keep them running at top efficiency.

To implement the new technology, TNK-BP had to win over its Russian workforce. The expert groups, almost all trained at the Hotel Tatyana sessions, encountered stiff resistance when they returned to the oil fields. There were rumors that productivity would be raised by cutting jobs. But TNK-BP chose not to dismiss any of its nearly 100,000 Russian employees. (There are barely 1,000 foreigners on the joint venture's payroll.)

Even so, many Russian technicians felt their skills were being slighted. Although Soviet technology was obsolete, the old era had inculcated a commendable obsession with measurements and data collection. Engineers knew exactly what machinery and wells were in disrepair and why. "The issue was getting somebody to put together all that information and act on it," says Dupree. Some old-timers distrusted the new foreign bosses and equipment. When Dupree sent one of his top managers out to the Nyagan field, the chief engineer refused to talk with him.

But the disgruntled Russians were all too willing to talk to Fridman. They complained that the foreigners brought over by BP knew nothing about handling Russians and were overly confident about high-tech equipment. Deeply skeptical himself about the BP team's management style, Fridman was attentive. "I told the BP executives, 'Maybe it's possible for Russians and foreigners to understand each other at corporate headquarters, but it's a lot harder in the fields,'" he says.

Dupree and his working groups persevered with their softer approach. After deciding that much of the resistance to change among the Russian oil field technicians and managers was tied to their fears of being held liable for failures, Dupree volunteered to personally accept all responsibility for setbacks. "If it made them more comfortable to blame me, that was okay," he says.

Such tactics began to gain converts. Even the grumpy Nyagan chief engineer opened up to the new managers. On their third visit to his campsite, he invited them to look over oil pipes being produced at a nearby factory and help him decide if they met quality standards. Soon word of changing attitudes seeped back to Fridman.

"The same people who had complained before about the BP managers were now telling me they were very professional people who knew how things worked and knew how to listen," says Fridman. What impressed him most, he adds, were reports from the Russian field staff that "our output has increased a lot."

Not only was oil production rising -- by 13 percent last year -- but so were proven reserves, which grew from 9.06 billion barrels in 2003 to 9.082 billion barrels in 2004. Moreover, TNK-BP reported an additional 8 billion barrels in probable reserves, meaning that at least half of that total likely exists. Investors and creditors look carefully at such reserve replacement figures. Last year, for example, when Royal Dutch/Shell's worldwide replacement rates proved lower than initially reported, the company's share price tumbled, leading to a management shake-up.

TNK-BP accounted for more than one third of BP's total oil output last year, and it has also turned out to be the U.K. company's most important source for replacing reserves. Thus far, remarkably, almost all increases in production and proven reserves in Russia -- for TNK-BP and other companies -- are coming from existing fields, called brown-fields. "Thanks to better recovery techniques and better management introduced by foreign companies, much more oil is being recovered from these fields than was thought possible," says François Cattier, a Paris-based analyst with the International Energy Agency.

Much more profit is being made, as well. It was the vaulting price of oil that broke the stalemate between the TNK and BP factions; the cash flow alone was enough to satisfy the Russian partners. BP kept to its investment schedule: By the first quarter of this year, it had spent $5.3 billion of the promised $7 billion. Even so, the Russian partners had been pushing for the whole amount of BP's investment to be paid out by then. But dividends had more than made up the difference. By the end of 2004, TNK and BP had split $3.9 billion in payouts. Fridman and his BP partners were ebullient.

But the euphoria does not extend to those who have been expecting Russia to greatly increase its oil production. The U.S., which had hoped to use Russian oil to reduce its depen-dence on Middle Eastern supplies, is importing less than 250,000 barrels a day from Russia. "It should be ten times that or more, given the reserves that are here," U.S. Energy Secretary Samuel Bodman complained in a press conference during a visit to Moscow in May.

Instead, Russian oil production growth is slowing. In 2004 production rose by 740,000 barrels a day, or 8.6 percent over the year before. But according to a Reuters poll of 18 experts in January, the median forecast for growth this year is only 470,000 additional barrels a day, or 5.6 percent. TNK-BP says its 2005 production will rise between 5 and 7 percent.

Analysts and oil company executives lay much of the blame on the government for its mishandling of Yukos and the onerous royalties and taxes on oil companies. "The Kremlin's actions are curbing upside opportunities for production growth in existing fields, let alone promising new ones," says Energy Security Analysis analyst Woodruff.

The partial renationalization of Yukos has led to a slowdown in its output. It has also created uncertainties among other producers about property rights and tax assessments. Earlier this year, for example, TNK-BP was hit by claims for $1 billion in back taxes in what seemed to be a repeat, on a smaller scale, of the stance taken against Yukos. Those fears subsided when the government reduced the charges to $247 million in August.

Of much greater concern are rising taxes on current oil income, which companies say discourage investment in green-field projects. The government takes almost 90 percent of any revenue above $25 a barrel. According to CEO Dudley, TNK-BP expects to pay $11.5 billion in taxes and other levies this year, compared with $6.5 billion in 2004. "The more the government takes from oil companies in taxes, the less there is left to invest," warned Lukoil vice president Leonid Fedun at a Moscow investment conference in June organized by Renaissance Capital, a leading Russian investment bank.

Investment is needed not only to develop new oil fields but also to solve transportation bottlenecks, which some analysts contend are already limiting oil export growth. "If the pipe was bigger, more would come out," says James Fenkner, chief strategist at Troika Dialog, a Moscow-based brokerage. But key pipelines are operating at full capacity. Ports are almost saturated. Roads and railways -- the costliest means of transportation -- are forced to handle excess oil shipments.

In addition to swelling taxes, TNK-BP has suffered its share of frustrations stemming from waffling government policies and aggressive bureaucrats. Visas have been held up for dozens of its foreign managers. Accusations by some government officials that the company reveals state secrets when it makes public the data on its oil reserves stem from a law left over from Soviet times. Officials have made contradictory announcements on whether or not foreign companies will be allowed minority stakes only in new natural-resource projects deemed to be of strategic economic importance. This wavering could delay or even scuttle some major green-field investments planned by TNK-BP in undeveloped Siberian gas and oil fields.

Lord Browne, BP's chief executive officer, was concerned enough about possible restrictions to fly to a Moscow meeting with Putin in April. The president said he continued to support BP's joint venture in Russia and assured Browne that TNK-BP would be allowed to invest in new projects.

Still, the company cannot rely on summit conferences to resolve all its disputes with the Russian bureaucracy, so it has developed an extensive network of contacts at multiple levels of government. Nevertheless, messages from different officials are often inconsistent, making it difficult for the company to decide what it should worry about and what it can safely ignore. "We just have to learn not to overreact and to realize that things are never as clear-cut as they appear to be," says Dudley.

TNK-BP relies on its Russian partners to help decipher the importance of competing bureaucratic claims and to deal with the more problematic issues, such as tax assessments. "Clearly, the Russian partners have more sophistication than BP does about how the bureaucracy works here," says Dudley.

In this landscape of anxieties and constraints, TNK-BP still appears to be better positioned than any other oil company. The Russian government is unlikely to allow another foreign investor to own half of a major joint venture in natural resources. "There are no opportunities of this scale left," says Tom Ellacott, an analyst at Edinburgh oil consulting firm Wood Mackenzie. "TNK-BP really did take full advantage of being a first mover in Russia."

Even after paying all those taxes, the company is generating a cash flow from its oil sales that far exceeds its investment opportunities. The government has not yet approved major green-field projects, such as the vast Kovytka natural-gas reserves in Siberia that TNK-BP is negotiating to develop with Gazprom, the state-owned natural-gas behemoth. So the high dividend payouts will continue. "From TNK-BP's perspective there is no point in building up cash in the company if you don't need it yet," says Stephen O'Sullivan, head of research at Moscow-based investment bank United Financial Group.

Both sides of the joint venture are also eager to prove to their investors that they have made a very good deal. "They are trying to return money to their main shareholders as quickly as possible -- it's as simple as that," says Zarko Stefanovski, an oil analyst at Moscow-based Aton Capital Group, an investment bank.

The gushing returns have led TNK-BP to be generous with its minority shareholders, who hold about 7 percent of the oil properties controlled by the joint venture. Before TNK-BP was created they had complained bitterly for years that their investments were being shortchanged by Fridman and his Russian partners. And they asserted that they were still receiving only a fraction of the oil profits they deserved 18 months after BP signed its deal with TNK. "BP was behaving like the Russian oligarchs, and that was disgraceful," says Ivan Mazalov, Moscow-based portfolio manager for Prosperity Capital Management, whose $600 million in Russian equities includes about $120 million in TNK-BP shares.

TNK-BP officials say the squabbles between the majority shareholders delayed a resolution of complaints by minority shareholders. Many analysts blame the foot-dragging on the Russian partners in the joint venture. "Perception can become reality," says Fridman. "It is difficult to convince people that we were as interested as BP in reaching a settlement with minority shareholders."

Under a deal announced in January, using Deloitte & Touche to make an independent valuation, TNK-BP proposed that minority shareholders accept a two-stage consolidation. In the first stage minority shareholders in the company's three biggest oil subsidiaries were offered a choice of swapping their stock into newly created TNK-BP Holding shares, or being bought out. In a second stage, scheduled for later this year, 14 smaller subsidiaries will be consolidated. Deloitte & Touche appraised the new holding company at $18.5 billion, close to the $20 billion to $25 billion valuations of TNK-BP by oil consulting firms and investment banks such as Wood Mackenzie and Aton Capital.

In March the minority shareholders accepted the consolidation offer with varying degrees of enthusiasm. "It amounts to a decent burial for people who endured a miserable life as minority shareholders," says Adam Landes, who has followed the controversy as a London-based oil analyst with Renaissance Capital. But William Browder, chief executive officer of Hermitage Capital Management, a $1.7 billion, Moscow-based fund that says it is the biggest minority shareholder in the newly consolidated company, was so delighted with the offer that he told Fridman, a man he had excoriated for years, that he would drop by his office to thank him personally.

"This is one of the few situations in which minority shareholders have been properly treated in Russia," says Browder, who declines to disclose the size of his fund's holdings in TNK-BP properties. "The consolidation valuations take into account the past dividend payouts that we missed out on."

In response to Browder's comment, Fridman quips, "Of course, it made me suspicious that we had overpaid."

Because of its huge and rapid returns on its investment, the TNK-BP deal continues to whet the appetites of other oil majors. Neither the government nor Russian oil companies, however, seem interested any longer in production-sharing agreements.

"When the Russians look for partners nowadays, they want companies that have retail capabilities," says S. Douglas Stinemetz, who specializes in Russian energy deals as a partner at Houston law firm Haynes and Boone. The new model is ConocoPhillips Co.'s 7.6 percent stake in Lukoil, which already has bought the Getty gas station chain in the U.S. and is looking to expand its downstream retail operations. For Western oil majors, promises to develop new markets abroad for Russian oil companies seem an affordable price to pay for access to new reserves, even in a climate of rising economic assertiveness by the Russian state. "Some oil companies may complain that it's getting too difficult to do business in Russia," says Stinemetz, "but it's easier than in Indonesia or Nigeria or Iraq."

TNK-BP officials insist they would not trade places with any other company. "In the history of oil, this is a fascinating joint venture that is doing very well in a very turbulent environment," says CEO Dudley. Prospects will be even rosier if the turbulence is kept outside the company. "If we on the Russian side of the company and our partners on the BP side trust each other and agree on a common policy toward the government, we will be in a stronger position than any other oil company in the country," says Fridman.