Yukos, Russia's second-biggest oil company, increased its oil output by 25 percent year-on-year in 2002's fourth quarter. But this year growth is expected to slow to about 10 percent, crimping CEO Mikhail Khodorkovsky's ambition to make Yukos the world's biggest oil producer within a decade (Institutional Investor, October 2002). Yukos isn't running short of oil: It has reserves of 12.6 billion barrels, roughly as much as OPEC's two smallest members -- Algeria and Indonesia -- combined. Like its Russian competitors, however, it is running out of pipeline capacity to ship crude from the Siberian tundra to eagerly waiting world markets. Instead of exporting their entire output at $25-plus a barrel, the companies are forced to sell half domestically for as little as $5 a barrel.
Yukos's quandary illustrates a major paradox of Russia as a global oil producer. As the war in Iraq underscores the vulnerability of world oil supplies, the former Soviet Union is sharply stepping up its production of crude -- by 25 percent over just the past three years. That should help assure the West of a steady supply of petroleum in the future, lessening Europe's and the U.S.'s dependence on the volatile Gulf. Russian oil politics, however, can be every bit as byzantine and unpredictable as those of the Middle East. Consider Yukos's straightforward project to build a pipeline to ship Siberian oil west.
The company is desperate enough for export capacity to have joined forces with archrival Lukoil -- and smaller competitors Sibneft, Surgutneftegaz and Tyumen Oil Co. -- in a projected $4 billion, 4,000-kilometer pipeline from western Siberia to the warm-water Atlantic port of Murmansk. The partners say the venture will increase Russian exports by 1 million barrels a day while cracking the U.S. market and lessening the West's dependence on Mideast oil. Yukos also wants to invest in a $2.8 billion, 2,200-kilometer pipeline from Siberia into China that is the subject of negotiations between Moscow and Beijing.
The oil companies have money to build pipelines aplenty; Yukos alone is sitting on $4 billion in cash. Their chief obstacle is Russia's government, which controls all pipelines and prefers it that way. Prime Minister Mikhail Kasyanov, touring Murmansk with Russian oil barons in January, told them bluntly that no private competition would be allowed.
Kasyanov's word isn't final. Only President Vladimir Putin can make decisions of this magnitude. But the premier's statement did signal the end of three years of symbiosis between the profit-minded new lords of oil and Putin, an ex-KGB operative who has sought to strengthen Mos-cow's sway over Russia's infrastructure. Kasyanov's declaration kicked off a struggle that will help define Russia's political and economic character.
Pipelines make a potent symbol of Russian state authority, but they are also of bread-and-butter economic importance in a country where private oil companies pay more than one third of all taxes. The companies, which took shape under president Boris Yeltsin through the chaotic sale of state assets, now contend that Russia's growth -- and their own -- will be choked off unless they have a free hand to build and export. Their opponents, meanwhile, argue that the state must strictly control oil to ensure cheap fuel for Russian industry.
Similar confrontations between private capital and public monopoly are looming on other fronts -- over state-owned utility United Energy Systems and, once the presidential election is out of the way in the spring of 2004, perhaps over natural gas monopoly Gazprom. Putin's call on the oil pipelines will help set the tone.
"The business elite is facing the new statist power elite Putin has brought in, with its close links to the KGB and Interior Ministry," says Evgeny Gavrilenkov, chief economist at Troika Dialog, a Moscow-based investment bank. "There are serious working negotiations going on."
The pipeline decisions will affect the expanded role Russia seeks on the world economic stage, not least as a counterweight to OPEC, whose own oil capacity could well expand with a resurgent, post-Saddam Iraq. Pumping 8 million barrels a day, Russia already vies with Saudi Arabia as the world's top crude producer. The oil companies backing the Murmansk project expect Russia's output to hit 10 million barrels daily by 2010, with the entire 2 million additional barrels -- as much as Kuwait's entire current production -- going for export. "OPEC needs to be wary of rising Russian oil production," notes Julian Lee, senior analyst at the Centre for Global Energy Studies in London.
KHODORKOVSKY AND HIS homegrown rivals have wrought a small miracle with Russia's oil industry. Putin took office on New Year's Day 2000, amid speculation that he would toss the oligarchs in prison and repossess the resources they had bought cheaply under Yeltsin. Instead, he slashed oil company taxes to stimulate expansion. His pragmatism was brilliantly rewarded. The oil companies have filled a near-bankrupt national treasury with $50 billion in reserves, made billions for themselves and proved, with BP's recent $6.5 billion purchase of half of Tyumen Oil, that Russia can lure foreign investment on a grand scale.
Now, to clear the export bottleneck, the oil companies want to wrest their economic lifeline from the hands of state pipeline monopoly Transneft. But pipelines in private hands would decrease economic leverage for a Russian state still bleeding from cumulative capital flight of as much as $200 billion. It would undermine the ad hoc subsidy achieved by forcing oil to be sold within Russia at knockdown prices. And it would run counter to Putin's apparent inclination to keep vital infrastructure under the Kremlin's thumb. "Putin's consistent ideological line is that infrastructure, the commanding heights of the economy, should be in the hands of the state, whether it's the electricity grid, gas transmission or the railways," says Dominic Gualtieri, chief of equities at the investment arm of Russia's Alfa Bank.
The oil barons staked out their position late last November, treating Moscow journalists to an extraordinary spectacle. Khodorkovsky, the audacious genius of post-Soviet business who took over Yukos before he was 30, shared a press conference podium with Lukoil's president, Vagit Alekperov, a taciturn Soviet veteran who was building cities in the Siberian wastes when Khodorkovsky was in high school. Also on hand were bosses from Sibneft and from Tyumen Oil.
The four rivals had united to unveil the Murmansk pipeline -- the key, they argued, to taking Russia to the next level in oil wealth and global economic influence. Murmansk, an open ocean port on the Barents Sea used in World War II to ferry Allied supplies to the USSR, is deep enough for supertankers and, thanks to the Atlantic Gulf Stream, navigable year-round. Russia's existing oil ports are on the Black Sea, which is accessible only to much smaller ships, or the Baltic, also limited in tanker size and choked by ice for much of the winter.
Proponents say the proposed Murmansk terminal would lift Russia's oil export capacity by one quarter and its share of the U.S. import market from essentially zero to 13 percent. The companies say that they want to rush the project on line by 2007. But they have a few conditions. They want to build it themselves and, once it's built, control who ships through it and at what price -- effectively breaking the state pipeline monopoly.
"The Murmansk terminal must be built, or Russian oil will not develop," says Leonid Fedun, Lukoil's chief of strategic development. "And private companies will build it."
Nyet, Transneft says. "Like any businessmen, the oil companies are trying to avoid taxes and slip out of the state's control," thunders Sergei Grigoriev, a member of the pipeline operator's manage- ment board. The state holds 75 percent of Transneft's equity and controls all of the company's voting shares; the remaining one quarter of the equity is in the form of preferred shares held by investors. "If we let them, they will export all their oil, and Russia's factories will have no fuel," says Grigoriev. "Whatever pipelines are built, we will build them."
Transneft boss Semyon Vainshtok won the hearts of Russian patriots by building a detour around Chechnya for a pipeline that carries Azerbaijani crude north to Russia's Black Sea coast. He completed phase one of a new Baltic pipeline system on time. And he is said to be close to Putin.
Some investors, too, would rather see oil transportation stay in the hands of the state. "Transneft management does not seem to be particularly concerned about outside investors," says William Browder, who manages $750 million in Russian equities, including nonvoting Transneft preferred shares, for Hermitage Capital Management. "But they're running the system quite fairly, while private companies might use it to squeeze competitors."
Others, however, question the existing system, under which Deputy Prime Minister Viktor Khristenko sets pipeline quotas for oil companies and Transneft enforces them. Although everyone's quota is supposed to be 35 percent of their production, some companies, such as Sibneft and Tyumen, ship more than 40 percent, according to Troika Dialog oil analyst Kaha Kiknavelidze. "There is no logical explanation for these discrepancies," he comments. "They can only stem from influence." The companies won't confirm that their shipments are higher but say it is possible to buy extra quota from smaller producers that don't use all of theirs.
Transneft has not been shy, either, about using petroleum as a political weapon. This winter it cut off Russian oil flows to the Latvian port of Ventspils -- and will not renew them, Grigoriev says, until Latvia allows Russian investors to buy into Ventspils' port facility. The European Union has expressed concern. "The Latvians are telling us there is a Russian boycott of Ventspils, and no one would be very happy about that," says a spokesman for EU external relations commissioner Chris Patten. But Transneft is unmoved by the EU's qualms. "Why should we invest to develop another country?" Grigoriev asks.
The Ventspils shutdown, which cut Russian oil exports by one tenth with prices near ten-year highs, was also aimed at demonstrating Transneft's power to the producers before the hard bargaining on Murmansk and other pipeline routes, contends Mattias Westman, director and chief investment officer of Moscow-based Prosperity Capital Management, which runs $275 million in Russian assets.
Russian oilmen say that they have until this summer to get Putin's go-ahead for Murmansk. Lukoil's Fedun brushes aside Prime Minister Kasyanov's stand against private pipelines. "We've had one statement from the government so far. I'm sure we'll have others," he remarks.
Meanwhile, the companies are employing every means available to move oil out of the country. Yukos has bought a fleet of 2,000 rail tanker cars. Lukoil is floating crude down the Volga River on barges, then across the Caspian Sea for export through Iran. Russia is exporting a million barrels a day of refined oil products like gasoline, on top of 4 million barrels of crude. Transneft has a separate pipeline system for petroleum products, and it's not quite full yet.
These end-run strategies push the companies' real exports to more than 60 percent of production, instead of the 35 percent that Transneft allows in pipelines. They are less profitable than oil shipped via pipeline but a better deal than selling it at home. Lukoil loses $6 or $7 a barrel on oil used domestically rather than sent abroad, Fedun says.
In his heart Putin likely agrees with Transneft about keeping the oligarchs' hands off Russia's oil aorta, Kremlin watchers say. That way cheap domestic oil also keeps flowing to key constituencies, such as the military and agriculture, though regular consumers pay about $1.70 a gallon for gasoline, comparable to U.S. prices.
Putin's favorite economic liberal, Minister of Economic Development and Trade German Gref, has launched his own attack on the oil companies, demanding that their taxes be raised so that manufacturers and small businesses can pay less and Russia can be spared from becoming a one-crop petroleum economy.
The buildup to the election is already under way. Although Putin's 75 to 80 percent approval rating makes him look like a shoo-in for a second term, he's battling to lift the 14 percent poll score of his United Russia Party before Duma elections in December. Favors to oil billionaires will rank low on his list of vote-getting measures. The Duma is some- thing of a sideshow in Russian politics. The president appoints the whole government, and 106 of the 450 deputies are independents, with the remainder split among six parties. Putin would be embarrassed if his United Russia lost any of its current 139 seats.
Tacit cooperation with the oil barons has served Putin handsomely as chief of state. When he took office on January 1, 2000, Russian oil production was at 6 million barrels a day, down more than one third from late Soviet times. Last year it was 7.6 million barrels, representing an annual gain of nearly $14 billion (based on the average 2002 world price of $23.60 a barrel for benchmark Urals Light). The higher volumes leave Russia less vulnerable to the oil market's ups and downs.
In the crisis year of 1998, when Russia defaulted on its debt, the federal budget was contingent on fetching $26.50 a barrel for Urals Light on the international market; the average price was then $11.50. This year, even though Putin has hiked spending, the break-even point is about $18 a barrel, and oil is trading abroad at above $25.
The oil companies' trump card in pursuing the Murmansk pipeline may be ready-to-hand funding for multibillion-dollar projects. Transneft, which has no apparent intention of selling more equity, could at best raise $1 billion in debt, Troika Dialog estimates, and laying the groundwork would take it a year at least. The pipeline monopoly could in theory raise all the money it wants from the oil companies simply by increasing its fees. But transportation already adds $2 a barrel on average to the cost of Russian crude, a significant sum if prices sink as expected once the war in Iraq is resolved. And Transneft doesn't really want to build Murmansk anyway, pushing instead for a 600,000 barrel-a-day expansion of the Baltic Pipeline System. About half the size of the Murmansk project, the Baltic expansion would be targeted at Russia's traditional European market.
"At first glance Murmansk looks very expensive to us," Transneft's Grigoriev says. "The real price would be more like $6 billion" (or half again as much as the oil companies have estimated). The oil companies say they need both the Baltic pipeline and Murmansk.
IT IS A TRIBUTE TO PUTIN'S presidency that everyone in Moscow, Transneft possibly excluded, expects some orderly compromise on the pipelines. Billion-dollar economic battles in Yeltsin's Russia were marked by deputy ministers bought and sold, slander poured forth from competing oligarch-owned press outlets and, not infrequently, bullet-riddled corpses in Moscow doorways. The process under Putin is not much wilder than Washington lobbying.
"The great difference in Russia these days is that things actually get done," says Laurent Ruseckas, who follows the ex-Soviet Union for Daniel Yergin's Cambridge Energy Research Associates. "Questions get attention at the appropriate level of government, and decisions get made that make some sense." Ruseckas predicts that the Murmansk pipeline will be built and will pay off, though he declines to speculate how oil companies and the state will split the burden. "When it's built, it's going to be used, if only to replace these railcars and exporting of refined products, which is all value-destroying," he says.
Lukoil's Fedun lays out the industry view of a deal on Murmansk. "We will build the pipeline, and Transneft will manage it," he proposes. Well, not quite. The investing companies reserve the right to determine their own export volumes and transport prices, he adds. Yukos spokesman Hugo Erikssen is a hair more conciliatory, leaving the door open to Transneft as builder, providing the pipeline monopoly gets started soon. "We don't want to run a pipeline," he says. "What we care about is throughput capacity, level of tariffs and the timing of construction."
To Transneft's Grigoriev, the idea that one group of companies should be able to lock in higher proportional exports than competitors, even if they build their own pipeline for the purpose, is heresy. "The principle of equal access cannot be broken," he says flatly. Putin, to judge by his record, will likely be more pragmatic than that.
One indication of Putin's thinking could come in May, when the government is expected to deliver a blueprint for future pipelines in Russia's Far East. Yukos and Sibneft are pushing for a pipeline that would carry 600,000 barrels a day from Yukos's eastern Siberian refinery at Angarsk to China. Transneft has a much more ambitious project on the boards -- to pump 1 million barrels a day across 3,900 kilometers, from Angarsk to Nakhodka, a port near Vladivostok. This route would open Japan and South Korea as markets, too, the company argues, rather than leaving Russia hostage to China's commercial whims.
Analysts expect the Energy Ministry to approve the China pipeline first, a moral victory of sorts for the private companies. But questions of ownership will likely be delayed, and the state may not need private funding if it gets enough help from the Chinese. In any case, Transneft says it expects to build and operate any Far Eastern pipeline.
The lurking danger, at least in the oil companies' view, is that Putin will delay a definitive ruling on private pipelines until after the presidential election in March 2004 and miss a moment of unexpected geoeconomic advantage for Russia. OPEC created ideal conditions for the Siberian oil boom of 2000'02, maintaining high oil prices (consistently above $25 a barrel) by cutting its own output five times -- all but inviting Russia to pump more and grab market share. Oil should have deflated after September 11, 2001. It didn't, thanks mainly to fears of war in the Middle East, which were realized last month.
The next three to five years could look materially different. Growth in demand for oil is the slowest since the 1980s and is expected to be stagnant this year, after creeping along at less than half a million barrels a day, or about 0.6 percent, in 2001 and 2002. Producers from Venezu-ela to Angola to Kuwait have, like Russia, feasible plans to add millions of barrels a day worth of new supply.
That's not to mention Iraq, home to the world's second-richest oil reserves (after Saudi Arabia), where post-Saddam investment could lift output from 2 million barrels a day before the war to 7 or 8 million by decade's end. Either someone's plans will flop or the world will -- in theory -- be awash in oil. The Economist Intelligence Unit predicts an average price of $15 a barrel by 2007, though other forecasters cluster around $20.
The oddest element of the oil equation may be that Putin's Russia suddenly looks like one of the most attractive oil provinces for foreign investment -- and not just to BP. Even as political upheaval wreaks havoc on OPEC's No. 3 producer, Venezuela, and war in Iraq threatens supply from the whole Persian Gulf, Russia's credit rating is soaring (Institutional Investor, March 2003) and its reserves swelling. Russian oligarchs increasingly seem less buccaneers than sound businessmen. Shares in Yukos and Sibneft have both more than tripled in price in the past 18 months as international funds piled in. Foreign banks and bond investors lent Russian corporations $12 billion last year.
All that could change abruptly as Venezuela and Iraq regroup and Russia's many unvanquished demons resurface. Eleven years after the Soviet Union collapsed, Russia has no coherent and popular political party except the Communists. Reform, such as it is, rests on Putin's slender shoulders. Russia ranks 74th out of 102 countries in Transparency International's 2002 corruption perceptions index, tied with India and Zimbabwe. A banking system scarcely exists, the judiciary inspires little faith, and the war in Chechnya has no end in sight.
"Russia is clearly benefiting from problems elsewhere in the world, but everything could still go wrong overnight," says Michel Perhirin, head of Russian operations for Austria's Raiffeisenbank.
Even in the best of circumstances, Russian oilmen's claim that they can grab 13 percent of U.S. imports looks optimistic, says the Centre for Global Energy Studies' Lee. "All sorts of long-term contractual relationships have built up for decades between U.S. buyers and Middle Eastern sellers that would make it difficult for Russian companies to take market share," he says. "The logical outlet for Russian oil will still be Europe."
Yet it really doesn't matter where Yukos and Lukoil sell their oil, as long as they get the world price and add to the world supply in the face of rising demand. And no one doubts that their sales will keep increasing -- whether through the Baltic, China or through tweaking of the existing pipeline network. Both Cambridge Energy and the Centre for Global Energy Studies see Russian oil output growing by 5 percent annually for the next few years.
THE LOOMING DECISION ON Murmansk is one key to defining Russia's presence in the world oil market in the longer term -- after 2007, the earliest possible completion date. It will also help define the type of capitalism that takes root in post-Communist Russia: A state accustomed to absolute supremacy must reluctantly admit that it is now dependent on profit-making enterprises, and the oligarchs who accumulated wealth and power when the state was weak must search for a long-term modus vivendi with a mostly hostile larger society.
The best guess in Moscow is that Putin will indeed stall his decision until after the March 2004 election. Then he will give the lords of oil a rough approximation of what they want -- offset by an operator's role for Transneft, largely symbolic provisions allowing state intervention for national security purposes and perhaps higher taxes. "The oil companies will finance the pipeline and probably fix their quotas through it," says Troika Dialog's Gavrilenkov. "A full solution will come after the elections."