TOWARDS REGAINING ENERGY CONTROL: FOREIGN INVESTMENT, KOVYKTA PROJECT, AND THE RISE OF GAZPROM (LESSONS LEARNED) by Igor Osipov

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1 UNIVERSITY OF ALBERTA TOWARDS REGAINING ENERGY CONTROL: FOREIGN INVESTMENT, KOVYKTA PROJECT, AND THE RISE OF GAZPROM (LESSONS LEARNED) by Igor Osipov Center for Applied Business Research in Energy and Environment (CABREE) University of Alberta School of Business

2 ABSTRACT The paper offers an outline of current politico-economic dynamics in the Russian energy sector, particularly in oil and gas business, as well as the legal and institutional frameworks in which oil and gas projects operate. The main focus is the role of state and its implications on international investment and the rising power of state-owned corporations, such as Gazprom, promoting the ideology of state capitalism. The analysis touches on the exemplary case of British Petroleum joint venture in Russia TNK-BP, which owns the license for Kovykta, the history and key milestones of the Kovykta project one of the largest gas projects with foreign participation. International businesses that are willing to come to Russia and get into the strategic resource niche need to understand several important nuances, which have been introduced during the last 5 years of economic reform under President Vladimir Putin s administration. Concluding section provides a lessons learned scenario, summarizing the key elements of the potential involvement into the large resource projects in Russia

3 TABLE OF CONTENTS 1. INTRODUCTION LEGAL AND INSTITUTIONAL FRAMEWORK... 5 Laws and Institutions: key facts... 5 Decision-making: public participation and the strategic interests TNK-BP, KOVYKTA, AND THE INTERNATIONAL OIL/GAS INVESTMENT IN CONTEMPORARY RUSSIA... 8 Foreign oil and gas investment: quick facts... 8 TNK-BP towards a new type of cooperation... 9 Kovykta gas field: project status RUSSIA S NEW OIL/GAS LANDSCAPE: NATIONAL RESOURCE INTERESTS AND THE RISE OF GAZPROM President Vladimir Putin and the Russian natural resources Gazprom the raising power CONCLUSION: A SUMMARY OF LESSONS LEARNED REFERENCES

4 1. INTRODUCTION Contemporary energy debates, high gas and oil prices and their global political implications as well as the role of Russia and Russian companies on the world s energy stage attract more and more attention. Recent developments in internal and external affairs show that the Russian state and the state-owned companies are turning to taking more control over the country s hydrocarbon resources and energy sector, while allowing less participation to foreign investment in this particular market segment. On the other side, several moves to reforming energy and gas monopolies resulted in opening free stock trading for both RAO United Energy System Russia (electricity) and RAO Gazprom (gas) shares, although at a somewhat limited scale. Today, Russia produces the second largest amount of oil after Saudi Arabia (and, according to many expert opinions, has a good chance at taking over as the largest producer in 2007) and is the largest exporter of gas worldwide. The quick rise of Gazprom currently the third largest global corporation by capitalization is increasingly associated with ambitious projects and Russia s state interests both at home and abroad. Altogether, these developments require further analysis and understanding of its short and long-term impacts on the global energy market and perspectives this may bring to the international business community interested in investing into the Russia s booming resource industry. Picture 1. Extent of Russia s oil and gas development. Source: Kommersant First oil shells in Russia have been launched in 1864 in Kuban region (adjacent to Northern Caucasus) and in 1866 one of the shells has given a fountain with 160 tons daily debit. During the beginning of the 20 th century the main oil regions included Baku, Maikop, and Grozny (Caucasus), Perm (adjacent to Urals) and Volga Region. From 1974 and onwards leading position shifted to Western Siberian regions across Urals (Khanty-Mansee, Tyumen region) which are now producing close to 60% of all Russian oil. Gas deposits have been discovered in association with the oil exploration and were largely developed during 70s and 80s in Yamal peninsula (NE from Urals). Gas field have also been discovered in Caucasus, Ukraine, Volga Region, Central Asia, Siberia and Far East. Today Russia possesses about 35% of overall discovered natural gas deposits, totaling up to 48 trln. cubic meters. Gazprom is responsible for development of about 85,5% of the Russian gas (based on figures cited in The trend that has been particularly visible during the year 2006 is the renegotiation of the state role in virtually all major projects/licenses with international control given out by the previous Yeltsin administration during the outrage of falling economy and shocking liberal reforms of the - 4 -

5 early 1990 s. These included Kovykta license and Sakhalin-2 SPA, both in Eastern Siberia / Far East. Off-shore shelf development has also indicated shifts in approach, to which Shtokman participation debate (Barents sea region) between Gazprom and several interested EU companies and their respective governments is indicative. This paper is based on twelve months of fieldwork and desktop research in Russia ( ), and is a brief introductory outline (review) of the state-of-the-art and key trends that exist on the Russian oil and gas market. Analysis is based on an outstanding Kovykta business case, which is currently debated on the both sides of the Atlantic. The project is framed into the largest British Petroleum (BP) joint venture with Access-Renova of the Russian Federation. Entering the Russian market has already cost BP about 6 billon USD during the merger with TNK, and the biggest project for which the deal has been made, is the Kovykta gas field (together with oil deposits) one of the largest found so far on Earth in the Eastern Siberia. During the last 2 years, Kovykta project has been the exemplary case, which visibly highlighted the major developments and trends of the Russia s newly proclaimed state capitalism and its impacts in oil and gas business. Needless to say that given the very dynamic nature of the industry and related decision-making, considerable changes may take place even during the few months after this paper is written. At the same time, the major politico-economical trends presented and analyzed will most likely continue at least in the mid-run perspective. The paper is structured in 5 sections. Sections 1 and 2 provide the introduction and outline the baseline legal and institutional framework of oil and gas development in Russia, including issues of public participation. Section 3 focuses on international investment, British Petroleum s involvement and gives the detailed picture and perspective for Kovykta project, its main participants, and milestones in the context of contemporary Russian policy approach to oil and gas assets. Section 4 is devoted to the analysis of current strategy of natural resource ownership and utilization as well as Gazprom s position and strategy as it relates to the President Putin s general tactic on natural resources. Section 5 summarizes the paper and provides a lessons learned list for the potential international investors as well as those interested in contemporary energy debate and business in the Russian Federation. 2. LEGAL AND INSTITUTIONAL FRAMEWORK Laws and Institutions: key facts Legal and institutional framework for the oil and gas resources extraction is regulated by an array of federal and ministerial laws and regulations. Some local regulations have also been created and apply. However, those are subject to confirmation of the federal laws as the current presidential administration took a large effort to bring regional and federal legislation into consistency. The institutional framework is chiefly composed of federal ministries and agencies, which also have regional representative offices, which conduct their activities locally. The key laws and regulations, that influence oil and gas development, include, but are not limited to: Laws 1 Constitution of the Russian Federation Federal law issued N FL "On subsoils" Federal law issued N 128-FL "On licensing of selected types of activities" Federal law issued N 225-FL On product sharing agreements (PSA) Federal law issued N 116-FL "On industrial security of the dangerous industrial objects" Federal law issued N 184-FL "On technical regulation" Federal law issued N 7-FL On environmental protection 1 Almost all of the listed key laws went through a considerable number of amendments

6 Regulations Decree On licensing of the subsoil use (approved by the Decree of the High Council of the Russian Federation issued N ) Decree of the Ministry of Natural Resources of Russia issued N 457-р Methodological recommendations on organization of conditions and the order of conduct of auctions and competitions for granting rights of subsoil segment use Decree of the Ministry of Natural Resources of Russia issued N 1026 "Approval of the Order of subsoil segment use licenses re-assignment Decree of the Russian Government issued N 382 On licensing of the industrial security expertise activities" Decree of the State Committee on Ecology issued N 372 On environmental impact assessment of the economic and other activities in the Russian Federation. Institutional framework has been changing over the last 10 years with several government reforms, which would sometimes create ministries and agencies while delete others (for example, during the last reform the State Committee on Ecology has been deleted and its authorities were transferred to the newly organized Ministry of Natural Resources). The main reform has been performed during the last five years which finally solidified the array of ministries, federal agencies and commissions that have a say in the oil and gas industry. Mostly, these activities are regulated by the: Ministry of Natural Resources, which includes Federal Agency for Water Resources Federal Agency for Forestry Resources Federal Service for Monitoring of the Subsoil Use Federal Agency for Subsoil Use Ministry of Industry and Energy Ministry of Energy and Industry Ministry for Economic Development and Trade, including Federal Agency for Managing Federal Assets Federal Service for Ecological, Technological, and Atomic Supervision Other important players include institutions such as the President and Presidential Administration, The Government, Federal Anti-monopoly Service, regional Governors administrations, and the Presidential Representatives in the Federal Districts 2. Each case for subsoil use is licensed by the Russian Government and its respective Ministries and Agencies responsible for licensing activities within its operation e.g. licensing for a particular type of activity (geological, oil and gas survey, drilling, shell development, pipeline building and operations), rights to usage of segments of subsoil for particular activity (survey, oil/gas development), et cetera. Additional to the license are the payments, which are determined by the Federal Tariff Service of the Russian Government. For an example, below is the table from the law revision of the year 2004, showing the level of expense for payments for the hydrocarbon resources: RUR 3 for 1 square meter of the subsoil section being used Scale Minimum Maximum 1. Regular payments scale for usage of subsoil for the aims of survey and assessment of the natural resources fields Hydrocarbon resources Hydrocarbon resources on the shelf and other economic areas in jurisdiction of RF Regular payments scale for usage of subsoil for the aims of searching for natural resources Hydrocarbon resources Hydrocarbon resources on the shelf and other economic areas in jurisdiction of RF Regular payment scale for usage of subsoil for building and using undersoil objects, not related to the extraction of natural resources Storage of oil or gas condensate (RUR/1 ton) There are 7 federal districts okrug (rus.): Northwest, Central, Southern/Caucasus, Volga, Ural, Siberian, Far East. 3 RUR Russian Rouble

7 Storage of natural gas or helium (RUR / 1000 cubic meters) Table 1. Payment tariff scale. Source: Law on Subsoils, 2004 The usual timing step in licensing of the oil and gas development after the deposits have been confirmed is regulated by the Law on Subsoils and constitutes 5 years for initial survey and predevelopment and 20 years for full development and usage. The granting period may vary, in some cases the license may be granted for entire 25-year period. According to the law, the license is sold only at the auctions, where the best price is offered for each piece of subsoil. In reality, the auction is organized and delivered by the state authorities and close attention to the participants is paid whether it is a Russian, or an international-owned company. Recent regulations and overall spirit of approach to these issues have confirmed priority for Russian companies and established principles of national strategic resources with regard to natural resources and, particularly, oil and gas. Each license is a subject to the license conditions, which have to be fulfilled by the licensee of the subsoil use. Not fulfilling the conditions of license and other federal regulations as above (for example, by the year XX of the license period the producer has to deliver Z bln cubic meters of natural gas a year to the regional market), lead to the grounds for license revoking. Continuing development and a good standing (paying taxes and fulfilling agreed conditions of license) result in re-assignment of the license after the first license term. Before the project initiation, a number of expertise rounds are run (local, ecological, public hearings) of which the two major final ones are: expertise of the Federal Service for Ecological, Technological, and Atomic Supervision (Rostechnazdor rus.) and the Higher State Expertise, both by the Federal Government. Based on the latter, the project receives a go or a no go decision to start operations. Decision-making: public participation and the strategic interests Public participation and associated activities has been largely limited during the Soviet times anywhere on the territory of the former Soviet Union until the early 1990s. Starting with the reforms of the 1990 s and after 2000, public participation has increased dramatically, comparing to the communist regime time. However, many experts have noted that first public participation efforts are now being considerably limited by the government of all levels, mainly federal, which, given the rising prices, have again assigned oil and gas the label of strategic national interest 4 resource. Speaking of the facts all major projects currently developed in Russia have to go through the open public hearings procedure. This right is clearly given to the citizens by the federal law "On environmental protection" and Decree On environmental impact assessment of the economic and other activities in the Russian Federation. Kovykta, Nord Stream, Taishet-Skovorodino and other major projects, both international and domestic, have taken this route and consulted with the public at the stage of Technical Requirements design and approval. In most of the reported cases (Ecopravo, 2005; Fondahl and Sirina, 2006; Forbes, 2006; Kryukov et. al., 2004), little outcome is noted. The aim of the hearings is largely understood by companies as informing the public of their projects, rather than truly consulting with local people (including indigenous) and local ecology teams. A bright example of positives and negatives of the current 4 Strategic interest concept in the Russian environment refers to something which is of lively importance to the state and its people, and is most often related to the national security largely, but not necessarily, in military terms. In this case, when we speak of oil and gas, which the Russian budget currently is heavily dependent upon, it directly relates to the economic, and, given present value of energy resources, political security of the country. Likewise, this concept applies to nuclear power stations and other assets of similar delicacy

8 procedure for public hearings is the Kovykta gas pipeline project, which Technical Requirements of the line Kovykta Irkutsk (about 650 km) have been presented at open hearings in Irkutsk. During the public hearings - maps, schemes, and PPTs on project have been absent, representatives of the developing company came with the advertisement and marketing materials Little attention has been given to the actual discussion of working plan of the Kovykta development and building of the pipeline at the same time, the forum has been very representative consisting of local 83 experts and businessmen. The hearings resulted in constructive dialog and the developer accepted the need to reformulate some of the TR sections. Given this is a new procedure we have started developing methodology for conducting such public hearings (Ecopravo 2005). We were able to attend one of these [public hearings], on 13 July, in the village of Kholodnaia [Company] officials, at least at the meeting we observed, seemed disinterested in listening to Evenki 5 concerns, did not appear to record any of them, and failed to respond in more than a dismissive fashion to most of the matters raised by community members. The meeting hardly seemed to fit the spirit of laws protecting indigenous rights to participate in the evaluation of development project plans in a meaningful manner (Fondahl and Sirina 2006: 65-66). Other hearings were held in rural districts of Irkutsk region (Ecoindustry 2006). Given a little actual history (5 years) of the law, which legally gave the right for public to participate in public hearings it will take more time not only for the local people, but also for companies to make the process a two way road. 3. TNK-BP, KOVYKTA, AND THE INTERNATIONAL OIL/GAS INVESTMENT IN CONTEMPORARY RUSSIA Foreign oil and gas investment: quick facts The destiny of international investment in Russian oil and gas has been a complex issue often associated with paradoxes. Since the rise of the new independent Russian state, international investment was the aim of many efforts, particularly by the Boris Yeltsin administration. However, the only visible input produced were three major deals based on PSA production sharing agreements. The law on PSA has been issued right then in the mid 1990 s (December 1995). Sakhalin-1 project includes three offshore fields: Chayvo, Odoptu, and Arkutun Dagi. Potential recoverable resources are 2.3 billion barrels oil and 17.1 trillion cubic feet of gas (or 307 million tons of oil and 485 billion cubic meters of gas). The project has started in 1995 (Exxon Mobile (US) 30%, Indian National Oil Co. (India) 20%, Sodeco (Japan) -30%, Rosneft and Sakhalin Morneftegas (Russia) the rest 20%). By the end of 2006 the consortium has invested into the project about 6 billion USD. Sakhalin-2 also started in The project is aimed at the development of two off-shore fields: Piltun- Astokhskoye, primarily an oil field with associated gas, and Lunskoye, predominantly a gas field with associated condensate and an oil rim. Main participants Royal Dutch Shell - 55%, Mitsui 25%, Mitsubishi - 20%. Together, the fields contain recoverable hydrocarbon volumes of over 1 billion barrels (150 million tonnes) of crude oil and more than 500 billion cubic meters (18 trillion cubic feet) of natural gas. By the end of 2006 the consortium has invested 12 billion USD. After raising construction costs from 12 bln to 20 bln consortium has run into discussion with the Russian government and in December 2006 sold control package of 50% + 1 share to Gazprom for 7.45 billion USD. Haryaga is a large oil field in the Arctic Russia - Nenets Autonomous District. The project started in 1995, PSA came into force in Operated by Total (50%), Norsk Hydro (40%) and Nenets Oil Company (10%). Oil deposits of the field are considered tobe at 160 million tons. Investment is less then 1 bln by the end of 2006 (based on public business media sources). PSA s are considered by many Russian experts as a somewhat unfavorable third world/weak economy type of deals, where the investor not only allowed operating free of all taxation in the long run, but also takes the initial profit to cover the investment, while having enormous control over claiming the volume of costs. Considerable returns for the country s budget, if any, are expected only much later in the project. Therefore, the incentive is to make the development and construction costs very high, which, in turn, leads to continuing tax free and oil and profit pumping. Another point of view maintains that this is the only way to develop large scale projects that require massive investment and technology capabilities with mid- to long-term profits. 5 Local reindeer-herding indigenous people, some still maintaining subsistence lifestyle

9 During the President Putin administration, the first view took dominating position. The PSA-type deals have not received further support and, given the first ones were negotiated when Russian economy and political weight was weak, were considered unfavorable to the country s strategic interests. Further implications of the policy shifts are closely considered in the section 4. As a result, a new type of deals joint ventures the largest of which is TNK-BP took place. TNK-BP towards a new type of cooperation TNK-BP had been created in 2002 through alliance of two large companies British Petroleum (UK) and Alfa Access Renova Group (owner of TNK, Russia), which brought together their assets in Russia. In order to enter into the large scale oil business and get a 50% (equal ownership 50/50) of the newly formed company TNK-BP British Petroleum paid 6.35 billion USD the largest one-time investment made to this point in Russia, plus 1.25 billion after asset consolidation. TNK- BP emerged to become the 3 rd largest oil company in Russia and made it into top 10 of largest oil and gas developers globally (Ferguson, 2004). TNK-BP is a vertically integrated oil company with a diversified upstream and downstream portfolio in Russia and Ukraine. The company s upstream operations are located primarily in West Siberia (Khanty-Mansiysk and Yamalo- Nenets Districts, Tyumen Region), East Siberia (Irkutsk Region), and Volga-Urals (Orenburg Region). TNK-BP's principal refining assets are located in Ryazan(near Moscow), Saratov (Volga-Urals),Nizhnevartovsk (West Siberia) and Lisichansk in Ukraine and have a total throughput in 2005 of 632 kbd or mmtpa. TNK-BP operates a retail network of approximately 1600 filling stations Russia and Ukraine working under the BP and TNK brands. The company employs approximately 93,000 people, mostly located in eight major areas of Russia and Ukraine. (quote from the TNK-BP corporate web site) The deal has been blessed by the President Vladimir Putin after a personal meeting with BP President Robert Dudley. Putin announced that the governmental position is supportive of the merger and welcomed the partnership. One of the main reasons why BP has entered into such a large deal in a country, generally considered as one with high political risks, is the shrinking resource base, which needed a considerable refreshment as well as potential control over the largest gas field so far discovered on Earth Kovykta. The license to Kovykta is held by RUSIA Petroleum where TNK used to have 29% and BP 33%. With the merger, TNK-BP received control with 62% of RUSIA Petroleum, Kovykta operator and the license holder. Kovykta gas field: project status Kovykta gas/condensate field is located 450 kilometers from Irkutsk and 250 kilometers from the lake Baikal. First surveys and exploration had been conducted in the mid 1970 s, when the initial seismic works were done. Official opening took place in 1987, when IrkutskneftegazGeology conducted exploratory drilling. The field opened with 24 sectors in which gas and condensate lay in depths ranging from 2,838 to 3,388 meters beneath the soil surface. (Kuznetsova amd Chernobylets, 2005). Surveyed deposits have been recorded at the level of 1.9 trillion cubic meters of recoverable gas, of which 1.4 billion m 3 of C1 category (proved deposits) and 572 billion m 3 of C2 category (initially surveyed deposits). Kovykta field also contains about 107 million tons of liquid gas condensate of which 81.3 million tons are recoverable. Based on these facts, Kovykta gas field is a unique super giant. Customer base and market demand is guaranteed by the rising necessity of China, South Korea and Japan, with further outlook into entire Asia Pacific energy hub. RUSIA Petroleum and TNK-BP projects the following demand prospects for Kovykta (planned annual output of Kovykta is planned at 30 billion m3): - 9 -

10 Customers Irkutsk Region (Russia) Buryatiya Region (Russia) Chita Region (Russia) China Korea Years / bln m3 natural gas Table 2. Regional demand for natural gas. Source: RUSIA Petroleum Web site The license to the gas field belongs to the RUSIA Petroleum, which, after the merger, is controlled by TNK-BP (62%). Although the license had been granted in 1992, the actual initial production started only in the last two years. The license, however, clearly stated that RUSIA has to deliver 9 billion m 3 for the local market in the year Not fulfilling this obligation provides potential grounds for license revoking. Several analysts say there have been many reasons why the development was postponed for such a long period of time. Among the key reasons: Internal disputes among the many shareholders (before the TNK-BP merger), Lower gas prices, Lack of understanding with Gazprom (with its sole transport system), Potential conflicts over ownership, Underdeveloped regional infrastructure and market (RUSIA fact sheet, business media). In 2006, RUSIA and TNK-BP received clear signs that the license can be revoked, given that the conditions are not being fulfilled. This scenario would be quite damaging for both parties Russia and international stakeholders of BP. In addition, 2006 has been a remarkable milestone in the project and in the overall Russian energy political scene. Gazprom, the sole owner of the transporting system and the key to all gas exports in Russia, announced a plan that did not account for Kovykta in both the regional gasification as well as export routes even at expense of building a pipeline Yamal-China. Sometime during the Kovykta negotiations (but not necessarily in direct relation to their conduct), Gazprom officially became coordinator of the national program of Russia s gasification. About the same time TNK-BP announced the regional gasification program, trying to accommodate the regional needs and make a better deal over the Kovykta. At that point, all parties understood that doing business alone, without access to Gazprom transport system will halt any export efforts, for which this project is naturally destined. At the end of the 2006, Gazprom s celebrated victory in negotiations with the Shell consortium over control package of Sakhalin-2 project, and this showed the way for TNK-BP on how to settle the issue with Gazprom on Kovykta, based on shifting model of energy ownership in Russia. From the very context of the project, it is quite obvious that the main route for the expected annual extraction of 30 billion m 3 of the natural gas is the export route to customers in China, Korea, Japan, and countries of the Asia Pacific. The question is - on which (and whose) conditions? The response came about at the same time, when Gazprom Board Director, and Vice-Premier of the Russian

11 Government Mr. Medvedev, announced that Gazprom is not looking for anything less than control package in large resource projects in Russia. The last quarter of 2006 saw a very active round of negotiations highlighted by the media, which finally led to the offer made by BP to form a consortium with Gazprom where the latter would have 50% + 1 share (Rebrov and Grib 2006; Sallier and Colomer 2006). This consortium would develop Kovykta and would have through Gazprom full access to existing and potential transport pipelines to monetize the value of the super giant gas field. It is very likely, as it seems from other similar examples of 2006, that once Kovykta s ownership is finalized favorably in the national interests of Russian resource politics, it will not wait long to have a both regional and export go from both the Government and Gazprom strategic gasification plans. 4. RUSSIA S NEW OIL/GAS LANDSCAPE: NATIONAL RESOURCE INTERESTS AND THE RISE OF GAZPROM President Vladimir Putin and the Russian natural resources Oil and gas constitute the principal share in Russia s export goods and the key source of currency income for the country s budget. Recent rises of oil prices allowed the country to re-pay its huge interest with regard to Western banking clubs debts and to begin conversation on re-paying them entirely with each individual creditor. Importance, which is assigned by the state to the issues of oil and gas, has also been manifested in recent legal cases which re-shaped ownership of one of the largest oil company in Russia. The reason which has been named by the media was that the company had been planning to sell its oil assets to the foreign owners (Olkott 2005). It is interesting how oil and gas thematic is interplayed in recent research published in the beginning of the year 2005 by the Moscow Carnegie Center for Peace, a research and intelligence unit providing important insights into Russian politics. One of Carnegie s premier researchers, Marta Olkott, writes regarding President Putin s view on oil and gas politics (Putin s words, extracted from the President s PhD dissertation defended in 1999 in Geological Institute of S.-Petersburg): Russia s ownership of its strategic resources has critical importance for the county s economic development and its strategic global influence Oil and gas resources play important economical role, but, at the same time, they serve as a guarantee in Russian foreign affairs. It is strongly maintained that only state, not corporations, shall be setting long-term strategic priorities for the oil & gas development in Russia (Olkott 2005: 10-11). According to this account, which is claimed to be based on comparison between the current political dynamics and materials of President Putin s dissertation, it is also highlighted that Russia will not suffice a role of simple oil and gas exporter. Instead, the country will use oil and gas high prices to begin investments into both oil infrastructure including refineries as well as high-tech sectors of the national economy to significantly diversify its economy, still dependent on natural resource export. Putin also maintains that the national corporations have to be joint ventures where the state has to play the key role, given the lively importance of natural resources to the country s life at this point. Among the main themes of new Russian energy politics, which began in , is the YUKOS case that always stood out as a milestone event, after which a lot of things have changed. Other analysts, for example, William Engdahl echoed Martha Olkott understanding of Putin s strategic direction and logic behind the situation, and, in fact, provided an important contextualization interpretation to the Putin s actions: The Khodorkovsky arrest of December 2003 followed an unpublicized meeting earlier that year on July 14, 2003 between Khodorkovsky and Vice President Dick Cheney. Following the Cheney meeting, Khodorkovsky began talks with ExxonMobil and ChevronTexaco, Condolizza Rice`s old firm, about taking a major stake in Yukos, said to have been between 25% and 40%. That was intended to give Khodorkovsky de facto immunity from possible Putin government interference by tying Yukos to the big US oil giants and, hence, to Washington

12 It would also have given Washington, via the US oil giants, a de facto veto power over future Russian oil and gas pipelines and oil deals. Days before his October 2003 arrest on tax fraud charges, Khodorkovsky had entertained George H.W. Bush, the representative of the powerful and secretive Washington Carlyle Group in Moscow. They were discussing the final details of the US oil company share buy-in of Yukos. Yukos had also just made a bid to acquire rival Sibneft from Boris Berezovsky, another Yeltsin-era Oligarch. Yukos/Sibneft, with 19.5 billion barrels of oil and gas, would then own the second-largest oil and gas reserves in the world after ExxonMobil. Yukos/Sibneft would be the fourth largest in the world in terms of production, pumping 2.3 million barrels of crude oil a day. The Exxon or Chevron buy-up of Yukos/Sibneft would have been a literal energy coup dґetat. Cheney knew it; Bush knew it; Khodorkovsky knew it. Above all, Vladimir Putin knew it and moved decisively to block it. Beyond the YUKOS case, which is rather an exception, one of the common critics that is put forward against the centralization of energy sector in the hands of the state, is that the Russian President and Government directly interfere into the negotiations and expect foreign investors to directly consult prior to arranging any significant deals in the strategic resource sector. This criticism would be fair in the case there is no legal ground for the action. However, let us not forget that Vladimir Putin is a lawyer, and, as a lawyer, he certainly uses the weapons of law to move forward his strategic position, as outlined by Olkott otherwise, it would be just too easy to make a nationalization of oil and gas industry (like it has been done or is currently in the making in some South American countries). Legally, Russian president at that time Mr. Yeltsin reserved the right to directly manage the subsoil use, which President Vladimir Putin is now extensively using. This right is given to him (and to the Government) by the article 36 of the Law on Subsoils, which says: The state governance of the subsoil relationships is carried out by the President, Government, Regional Authorities as well as federal agencies managing state assets of the Russian Federation (N FL). Turning to the facts re-shaping oil and gas sector and regaining the state control over its key assets is proved by the following analysis of deals between the state/state-owned companies and the oil/gas sector, which crosses 6 years of Putin administration (Zakharov 2006): Picture 2. Source: RosBusinessConsulting, Denis Zakharov The tendency is clear first tenure was preparatory work and some continuation of privatization (several state-controlled share packages have been sold to private investors in 2000, 2002, and 2004) and the second tenure has been the time for strategy realization (Gazprom became fully statecontrolled, and several purchases of the formerly private controlled companies have been made by the state or state-controlled business). This is when many large oil and gas assets have been bought back, so to speak, by the state-owned companies from the private owners

13 Gazprom the raising power Lastly, the most important trend of the year 2006 has been the rise of Gazprom as a vehicle to vocalize and deliver the Russia s strategic interests. Russian gas deposits controlled by Gazprom constitute about 1/3 of global, and currently Gazprom is responsible for close to 20% of entire gas production on the planet. Picture 3. Source: Gazprom, Annual Report 2005 With no surprise this third largest company and the biggest producer of natural gas started serving the task very well. Several moves that have been performed by the company is extended diversification of its business. Formerly a gas company, it is now becoming one of the largest oil producers as well. Gazprom is currently well positioned to negotiate in main directions of the Russian energy politics Shtockman holds the energy key to Western Europe, while Kovykta and Sakhalin to the Asia Pacific will solidify Gazprom s control over major projects with foreign participation Sakhalin-2 and Kovykta. Shtockman will also be controlled by Gazprom in association with its allies in Germany and France (BASF, Rurh-Gaz, and E.On.). The company has also literary full control over the transport system and with the rate of acquisitions and expansion shown during the last two years, has a good chance of becoming not only the largest gas producer but also a very large oil company as well. National presence and administration of regional gas systems development make Gazprom both an unbeatable partner to cooperate with as well as literary a wall to any project that has not accounted for Gazprom position. Visible fact contributes to the manifestation of importance which energy is attributed to in the European economy, and, as a result, in its politics. Angela Merkel, who did not want to maintain friendship relationships with Russia, unlike her predecessor Gerhardt Schreder, was not supportive of Nord Stream the Gazprom and several German companies pipeline project going via Baltic Sea from Russian Northwest to German port especially during her election campaign. Once she acquired the office, the tone and sharpness of the critique lowered significantly and now the Nord Stream debate has almost exhausted. The economical reason, therefore, may significantly overwrite individual and political preference when it comes to energy issues. At the same time, it will not be a large overstatement to say that critique, which Angela Merkel and other EU leaders put forward to their counterparts across the Baltic, has also contributed to the decisions made by the Russian government and Presidential administration to diversify oil and gas export in the short- and mid-run. Main reasons certainly lay on the economic stage. During

14 and 2006, the Russian Minister of Energy Resources provided several comments on putting significant focus to the booming North East Asian market, which demand for oil and gas has greatly increased and will be increasing in the years to come. Given some of the key projects are delivered in the near future (Siberia-Pacific Pipeline, Kovykta-China/Korea, Sakhalin-2 and Sakhalin-3), this will indeed make both economic and political position of Russia and Gazprom stronger and less dependent on a single customer (which EU is at the point) that is willing to impose its own conditions (for example, EU Energy Charter, which Russia refuses to sign negotiations will continue in 2007). 5. CONCLUSION: A SUMMARY OF LESSONS LEARNED One cannot understand Russia with the mind, And common measure will not be applicable It has its own being, In Russian one may only trust Fedor Tyutchev Russian energy politics is often called Byzantine style and unclear (Lahn and Paik 2005; Skyner 2006). Year 2006 showed that this is not true any more to a large extent. Clear trend is on centralization of the resources and regaining of control in oil and gas sectors (Zakharov 2006). From the above, several important implications of the industry dynamic can be summarized, especially for those companies which aim at gaining access to the rich pool of Russian hydrocarbons and natural gas. 1. Alliance with state, or state-owned / state-loyal corporations is essential for successful business in oil and gas. Sakhalin-2 and Kovykta cases show that working solo in the strategic sector of Russian economy is no longer an option. Stronger position of the Russian state and focus on centralization in contrast to Yeltsin s regional sovereignty and free granting of resource base (Kriukov et. al. 2004) has been solidified with the large deals by Gazprom, especially during Time for 1990 s loose PSA s are unlikely to return. 2. Sharing of production, transportation, and market with the right Russian partner. All transport of oil and gas in Russia belongs to the state-owned (or state-controlled) companies. Gazprom largely controls gas transport pipelines (both export and internal), Transneft controls oil transport export pipelines, while both are state-controlled. Private export pipelines are unlikely to emerge in the near future, chiefly due to the importance assigned to exports of hydrocarbons. Therefore, cooperation on expert grounds with either of the two companies is a pre-requisite. 3. Non-control position in oil and gas development projects. According to the strategic approach of the President Putin administration which has indicated, over the last several years and particularly in 2006, that international companies will not be allowed to fully control the resource base of the Russian Federation. The reason for this is strategic interest political concept which is assigned to the assets of lively importance to the country s existence (e.g. nuclear stations, security, weapons, electricity, water, oil and gas). Foreign investors are welcome to participate in development under the coordination of a Russian company, preferably state-controlled. 4. Formalization of the strategic interest concept. When this paper was 95% complete, the business media in Russia announced that the new law for strategic resource management has been filed and is now being processed in the Parliament and the Federal Government. The law project called "On the order of foreign investment in the Russian Federation into commercial organizations of strategic importance" 6 outlines the list of strategic industries, companies, and oil and gas field and establishes formal federal oversight over all the deals with the control (not blocking) package of shares in the 6 A literary translation from Russian

15 indicated areas, including deals made by the companies, which are not state-owned but working in the strategic industries. According to the Kommersant and RosBusinessConsulting the leading private business information providers the list of strategic industries is extended to 40. For the hydrocarbon resources, the participation of non-russian investors is limited in the subsoil fields of federal importance (Netreba 2007) and their participation format and volume requires direct authorization from the Federal Government. Falling into the category of subsoil fields of federal importance are oil deposits of equal or more than 70 million tons, gas deposits of 50 billion m 3, gold deposits of 50 tons and copper deposits of 500 thousand tons. According to the prospected law fields, projects smaller than indicated above will not require authorization of the Government (Netreba 2007, RBC 2007). The law is currently under discussion in all key agencies and ministries, such as Federal Security Bureau, Ministry of Natural Resources, Presidential Administration, et cetera. so the final dots above i-s will be put shortly for analysis of the industry experts. 5. Ability to accumulate contacts in the higher echelons of state power for effectively communicating project interests and needs. Ability to negotiate at the highest level is also essential, as BP case shows. Lord Dudley has been able to negotiate position of entering into the heartland sector of Russian economy due to communication abilities and the willingness to adapt and negotiate position according to the newly revised strategic line of Russia s energy politics (national interest first, the rest is second). 6. Readiness to bid for risks, while receiving profits. Risks for doing business in Russia stay high in Western terms, but are now lower than a decade ago all global rating agencies have already assigned Russian Federation an investor grade. As a result, the flow of direct capital investment is rising: during the year 2006 Russia attracted around 30 billion USD in foreign investment from 28.4 bln. by UNCTAD data to 31 bln. by Russian Central Bank data keeping high export potential. Most experts agree that investment rate will be rising in the next years (Ivanova 2007). However, doing business in Russia requires genuine understanding of the political currents and right alliances with key state-controlled companies, where the most discrepancies lie at the moment. Debates on diversification of EU import of oil and gas and growth of Asia Pacific market will result in diversification of Russian oil and gas export towards North East Asia in the mid- and long-run, while still keeping significant and extended customer base in Europe

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