Russia’s emerging energy giants

The merger of two of Russia’s largest oil companies – Yukos and Siberian Oil Company (Sibneft) – marked the first step towards Russia’s ambition of creating more home-grown, world-class Russian companies.

At first sight it isn’t obvious what Russian companies can offer the world. Most are still struggling to survive the collapse of the command economy. In the oil sector alone, production levels have halved in the past decade. “No western company could have survived these shocks,” says Tom Adshead, director of research at United Financial Group. “You can forgive them for having limited international ambitions.”

Despite the dubious legacy of their size, the juggernauts of the Russian economy are still a long way off competing head to head with the world’s multinationals. Those that pay tax are being taxed to death. They need to acquire modern management skills while, at the same time, most need to shed between a third and a half of their button pushers if they are to become nimble enough to compete internationally. The social and political implications facing executives including Eugene Tenenbaum, an ex-Salomon Brothers director charged with restructuring Yuksi, will take years to resolve. “Restructuring is a deeply political issue,” says Tenenbaum.

If Russian companies can survive such radical restructuring – and this is a big if – there is no reason why Russia’s dream of world-class Russian companies should not be realized.

Many Russian companies are already well known to the capital markets. As the titans of Russian industry gain increasing access to finance and modern management techniques, the chances look ever brighter for would-be Russian multinationals. The winners will be those companies quickest to restructure and open themselves to modern management techniques.

Russian companies, particularly in the natural-resources sector, already possess world-class assets. The proven reserves of both Yuksi and Lukoil dwarf those of any western company. At over 15 billion barrels, Yuksi’s proven reserves are half as large again as the nearest western competitor, Royal Dutch Shell, and over twice the size of Exxon’s. But according to Stephen Jennings, chief operating officer of mfk Renaissance, “they won’t compete until they have world-class management”. It is no surprise that Russian oil companies lag behind western competitors when it comes to profitability.

Even within the corporate sector itself, executives such as Nina Shemetova, vice-president of Rostelecom, admit that modern management skills are virtually non-existent. Russian managers are typically dismissive of such soft skills as project management, but they desperately need to cut costs, manage projects efficiently and create coherent business plans. With the government budget reaching the point of acute crisis, companies will not be able to rely on government hand-outs to support them for much longer. Shemetova says that little will change until the country has “a critical mass of capable management. Old directors were simply not trained to take risks”.

Most ex-state-owned companies are just beginning the painful process of restructuring. Analysts say that so much has to change for Russian companies to compete abroad that it will take a decade or more before most can harbour international ambitions. The virtual non-existence of commercial managers – as opposed to production managers whose only thought is to keep the presses running – will mean that the restructuring process will take a long time.

Turning Russia’s top companies into world-beaters will also be slowed by the country’s chronic payments crisis. Up to 75% of receivables owed to the largest companies are still settled by barter while bankruptcy suits are still a rarity. “We are trying to keep our clients alive, not bankrupt them,” says Oxana Bestoujeva, executive director at Horizont, the in-house financial consultancy of gas company Gazprom. “Solving the non-payments crisis cannot be isolated from the economic situation as a whole.” Non-payment particularly hampers the energy sector – Russia’s best hope for fostering its first multinational companies.

Lukoil, now Russia’s second-largest oil company after Yuksi, has one of the highest cash-payment ratios, but at under 50% it is still low. At Gazprom and Russia’s electricity holding company, UES, cash makes up less than a quarter of all payments.

Even so, analysts agree that Lukoil has the best chance of any Russian company to become the country’s first real multinational. It is possibly the only company with significant overseas ambitions. Its plan is to become one of the top five world-class oil companies in the next 12 to 15 years. By 2005, Lukoil expects to have not less than 25% of its operations overseas. “This is not an option,” says Lukoil director Andrei Kochetkov. “It is a necessity.” Although this forecast depends on agreements signed with Iraq, analysts think that of all the Russian companies, Lukoil’s management has the greatest chance to succeed.

Its managers already have experience of managing projects in Turkey and the Commonwealth of Independent States (CIS). Following its purchase in February of 51% of Romanian oil company Petrotel, Lukoil is stepping up its marketing network to distribute throughout eastern Europe. Lukoil also has significant experience of working with a string of foreign partners and has been quicker than most to take on board western management ideas. Through a series of convertible bonds, US oil company Arco has already built an equity stake of 8.5% in Lukoil.

One of the reasons Lukoil is so keen to exploit foreign oil fields and distribute its oil overseas is Russia’s punitive tax regime. Ask any analyst what is the biggest barrier for would-be multinationals and you receive the same reply – tax. Lukoil currently hands over 55% of its profits to the government while western oil companies pay between 25% and 38%. In January, the heads of seven oil companies sent a joint letter urging the government to halve excise taxes and refrain from raising existing pipeline tariffs.

Other Russian oil giants are also gaining recognition abroad. The merger of Yukos and Sibneft, announced in January, was reported worldwide in press headlines. The merged company, Yuksi will control the largest proven oil reserves of any publicly traded company in the world. The deal marked an alliance between Mikhail Khodorkovsky’s powerful Yukos-Rosprom financial industrial group, which owns over 90% of Yukos, and financier Boris Berezovsky, who is widely considered to be the prime mover behind Sibneft.

But looking beneath the headline figures, the holding company has yet to come up with a coherent management structure or gain full control of its subsidiaries. If the company manages to consolidate its 28 subsidiaries into a vertically integrated company as it plans, it has every chance of capturing a large share of Russia’s export markets.

But it is going to be several years until Khodorkovsky’s plan to create a “world-class integrated oil company” is realized. In the next five years, Yuksi needs to spend $9 billion updating and restructuring its domestic operations, $2 billion of this is to come from the international capital markets.

Yuksi’s management team will need to spend much of its time creating some kind of order out of the chaos created by Russia’s privatization programme, which shattered Russia’s oil sector into small pieces. “We did not create these problems,” says Tenenbaum, head of corporate finance at the merged entity. Yet the two merger partners have certain synergies. For example, Yukos produces more oil than it can refine, while Sibneft needs crude oil for its main refinery at Omsk, the biggest and, arguably, the best equipped in the country.

Most Russian oil companies have reluctantly accepted that foreign partnership is a necessary ingredient in any recipe for success. Following president Boris Yeltsin’s decision to abolish a 15% ceiling on foreign ownership of Russian oil firms last November, a string of negotiations and partnerships have come to light.

Following announcements by Gazprom and oil company Sidanko of alliances with Royal Dutch Shell and British Petroleum (BP) respectively, Yuksi has also teamed up with French oil company Elf Aquitaine. In late March, Elf announced that it will pay $528 million for a 5% stake in Yuksi. According to Tenenbaum, the company foresees more than one partnership to exploit opportunities in both Europe and Asia.

The hope is that foreign partners will bring the management skills, capital and technology needed to renew Russia’s failing pipelines and stem the decline which has halved production levels in the past decade. As part of the $570 million deal between Sidanko and BP, in which BP gains a 10% equity stake in Sidanko, senior western executives are being transferred to Sidanko. Other companies, including Yuksi and Gazprom, are discussing similar transfers of experienced managers.

So far, the oil and gas sector is one of the few areas of Russian industry in which foreign management has participated. Shemetova of Rostelecom Russian says that most Russian companies simply cannot afford to bring in western management: “One western executive would cost $300,000 and that would pay for an entire department.” Gazprom’s alliance with Royal Dutch Shell – which will be cemented by Shell’s agreement to buy a $1 billion convertible bond leading to a 3% equity stake – may lead to several international projects. More recently, Italy’s state energy company, eni, signed an agreement worth $3 billion which will also include an equity stake in Gazprom in the coming months.

But Gazprom itself has already become an international company of sorts. Through a series of debt-for-equity swaps with its clients in the CIS, it has built significant assets overseas. In some countries Gazprom is the largest creditor ahead of international institutions such as the IMF. In Moldova, for example, Gazprom will soon be the main shareholder, ahead of the government, in the country’s main distribution and pipeline company, Moldova Gas.

Although Gazprom is still renowned for its shambolic old-school management, reformers in the government have been fighting to restructure a company where a quarter of its 400,000 employees work in farms, banks, airlines, sanatoriums and other activities of no value to the company’s core business. And Gazprom is struggling to finance its most pressing project, a pipeline from the Arctic Yamal peninsula to Germany. This has an estimated cost of $25 billion, with drilling costs of a further $15 billion. The company recently announced plans to scale back the project as a result of the high costs. The strategic alliance with Royal Dutch Shell will bring easier access to finance and at the same time will help Gazprom build its oil business. But analysts say that Gazprom has little to gain from competing head to head with multinationals outside Russia. This sprawling domestic monopoly has a stranglehold of over 90% of all Russian gas production.

For foreign partnerships to take off, much progress has to be made both on the legislation governing production-sharing agreements and the uncertain tax regime. “If foreign oil companies don’t get psas [production-sharing agreements] in the next few years, they will walk away,” says Brunswick Warburg oil analyst Tom Gochenour. So far, Russia’s parliament has passed only a handful of the 230 agreements on production sharing and it has yet to amend a dozen or so laws which conflict with the idea of production sharing. “Even less politically stable countries like Nigeria have managed to negotiate viable agreements on production,” says Adshead at United Financial Group.

Driving the rapid consolidation in the oil sector, and also the alliances with foreign companies, is the government’s sale of its last significant share of Russia’s oil industry. Whichever company wins the fight for Rosneft, the eighth-biggest oil producer, will gain a significant boost in the race to become the country’s pre-eminent energy company. It is a prize most oil chiefs think is worth a hard fight.

The privatization of Rosneft, whose mixed bag of assets was recently valued at $2.3 billion by Dresdner Kleinwort Benson, has pitted Vladimir Potanin, who through Unexim and mfk Renaissance controls Sidanko, against Yuksi allies Boris Berezovsky and Mikhail Khodorkovsky.

An alliance of Gazprom/Royal Dutch Shell and Lukoil is also likely to join the fray, depending on how much of Rosneft the government decides to sell. Gazprom has been eyeing the higher returns made from oil extraction for some time and has made public its wish to expand into a sector where it has substantial undeveloped reserves. Bestoujeva of Horizont says that Gazprom’s alliances with Royal Dutch Shell and eni “are all about oil”. Winning control of Rosneft would give the gas giant a considerable kick-start in this business.

There are also rumours that Lukoil may merge with Sidanko, the country’s sixth-biggest oil producer. This would sit well with Lukoil’s ambition to join the world’s top-five oil companies, creating a colossus responsible for over a quarter of all Russian oil production, larger even than the newly created Yuksi. But a full-scale merger between Lukoil and Sidanko would be complicated by British Petroleum’s investment in Sidanko.

The rumours of a merger started when Lukoil head Vagit Alekperov began talks with Potanin who controls the majority of Sidanko shares. Both companies say that the talks revolved solely around the sale of Rosneft, but some analysts say Unexim may be looking for an exit.

Says Lukoil’s Kochetkov: “There have been no merger talks, but who knows what may happen.” After all, the merger of Yukos and Sibneft grew out of talks on the very same subject – winning control of Rosneft.