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October 22, 2012

The Moscow Rules


Vladimir Putin’s vision of Russia as an “energy superpower” just got closer to reality. State-controlled, London-floated Rosneft has clinched a deal to buy out BP’s stake in Russian oil operations.

Since 2003, BP has been in a joint venture with several Russian oligarchs whose companies are known as Alfa-Access-Renova. From the beginning, there was bad blood between the partners in the joint venture, called TNK-BP.

Yet it was a cash cow for BP, which reaped $19 billion in dividends from the venture. The joint venture also accounted for quarter of BP’s oil production. But the oligarchs used every trick in the “Moscow rules” book—including FSB secret police, visa trouble and tax collectors—to make the Brits’ life miserable and force them to sell.

BP’s share will now be bought out by the state-owned behemoth Rosneft, headed by Igor Ivanovich Sechin, a loyalist to President Vladimir Putin and, like him, a former Soviet intelligence officer. BP will get $20 billion in cash and 13% of Rosneft’s equity. Rosneft has separately reached a deal to buy out AAR’s half of TNK-BP.

This is a huge victory for the statists—those, like Messrs. Putin and Sechin, who want the Russian state to be the principal player in the energy sector. They are reversing the achievement of the 1990s, when oil-sector privatization allowed the industry to grow at a double-digit annual rate and to modernize by bringing Western technology and expertise. The purchase of TNK-BP will give the state control over half of all oil production in Russia, according to Leonid Fedun, the vice president of Lukoil. Supporters of oil-asset privatization, such as Prime Minister Dmitry Medvedev and Deputy Prime Minister Arkady Dvorkovich, clearly lost the fight.

Once the deals close, Rosneft will boast reserves of 33 billion barrels of oil equivalent and produce over 4.6 million barrels a day—more oil than Iran. At that point, together with Gazprom, Moscow will have two state-owned, partially publicly traded companies with more energy reserves than any global supermajor, including Exxon.

But this triumph of the Russian state comes at a cost. First, at the core of Rosneft is an oil production asset called Yuganskneftegaz, which was acquired in a single-bidder, staged auction from a straw company after it was expropriated from Yukos over allegations of tax evasion, which many consider dubious.

To get Yukos’s assets, the state intentionally bankrupted the industry leader of the Russian oil sector, sentencing its chairman Mikhail Khodorkovsky to 14 years for tax evasion and fraud. Many Russian and Western legal experts believe the two Khodorkovsky trials were political and unfair. Indeed, Amnesty International recognizes him as a political prisoner. It is unclear how BP’s lawyers, who conducted due diligence, decided that it would be wise for the company to take Rosneft stock as payment, even though Spanish and Dutch courts and arbitration panels have repeatedly found in favor of Yukos shareholders.

There are also questions regarding Rosneft’s productivity. In 2010, Rosneft produced only 15 barrels of oil equivalent per employee per day; TNK-BP produces 35. Inefficiency and corporate opacity are reflected in the relative valuation of reserves. While Norwegian Statoil and Brazilian Petrobras traded at $16-17 per barrel of reserves, Rosneft was undervalued, at $5/barrel. Even as the state has reasserted control over Russia’s energy assets, the value and productivity of those assets have declined, reversing the gains of the early post-Soviet years.

Strikingly, BP seems not yet to have had enough of Russia. In addition to accepting a stake in Rosneft and two seats on its board, BP still lusts after new, massive joint ventures with the Russian giant to access the last untapped oil and gas frontier: the Arctic Ocean continental shelf. According to U.S. Energy Information Agency estimates, Russia boasts one quarter of the world’s hydrocarbon reserves in the Arctic.

Just last week Mr. Putin, against the advice of market liberals in his cabinet, once again disallowed private oil exploration in the Arctic. Rosneft received a lion’s share of the reserves (75%), while Gazprom got a quarter. Other companies will be lining up to seek a joint venture with these two, because they lack the capital and the know-how to explore the High North on their own. The harsh climate and long distances make polar oil and gas exploration and production particularly costly and complicated.

This is a classic Soviet-style approach, which used to be called “extensive development”: exploit vast reserves instead of improving productivity. By sidelining private and foreign companies, the expanded Rosneft is positioning itself as a monopoly (or a duopoly—if one includes Gazprom). As such, it stifles innovation and keeps operational costs high. Most importantly, the revamped Rosneft provides deep pockets worldwide for Vladimir Putin and his vision of Russia as an energy superpower.

Mr. Cohen is senior research fellow in Russian and Eurasian studies and international energy policy at the Heritage Foundation.

First appeared in The Wall Street Journal Europe.

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