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The Oil Gods Are Smiling On Russia (Int'l Edition)

International -- European Business: Russia

The Oil Gods Are Smiling on Russia (int'l edition)

Will the country's industry modernize?

It was quite the party: The fifth anniversary of the privatization of Sibneft, Russia's sixth-largest oil producer and 12th-biggest company. For the Sept. 8 bash, Sibneft hired Seventies-style pop group Boney M to entertain a throng at the Hotel Rossiya in Moscow that included the company's largest shareholder, reclusive Russian tycoon and shadowy Kremlin courtier Roman Abramovich. Revelers rocked to Boney M's smash hit: Rah Rah Rasputin--a song hailing an infamous political puppeteer of Russia's pre-revolutionary past.

Sibneft has lots to cheer. Skyrocketing oil prices are projected to boost revenues more than 58%, to $2.7 billion this year, and net earnings will almost double, to $613 million, according to Moscow brokerage United Financial Group (UFG). Indeed, just about everyone in Russian oil is doing a boogie step or two these days--even as oil consumers in the West worry about Middle East political tensions and other uncertainties that could push world market prices still higher. For the Russian industry as whole, UFG forecasts that gross sales will rise almost 70%, to $59.2 billion this year. "These revenues are extraordinary," says Mikhail B. Khodorkovsky, chairman and CEO of Yukos Holding, the country's second-largest oil company.

You're right there, Mr. Chairman. The pressing question is whether the boom is enough to give Russia's oil industry the funds it needs to modernize and achieve its potential. There are indeed signs that Russia's oil bosses are starting to act like real managers. But the legacy of mismanagement and corruption will still weigh heavily on this most strategic of Russian industries.

There's no doubt the windfall is much needed. The biggest single beneficiary, according to a UFG analysis for BUSINESS WEEK, is the government, whose tax take this year will be fattened by $8.1 billion as a result of the spike in oil prices (table). The Russian government also reaped $1.1 billion in a recent auction of an 85% stake in oil company Onako--more than double the asking price. A new bidding war threatens to develop over state-owned oil companies Rosneft and Slavneft, expected to be on the block next year.A LONG-TERM FOCUS. But companies are reinvesting funds, too. A surge in capital expenditures, to around $5 billion this year, will push Russian oil production up 5% this year, to 319 million tons--a sharp reversal of a 10-year decline. Moreover, an industry much criticized for its insular culture and allegiance to Soviet-style planning methods is turning to Western energy-services companies to obtain state-of-the-art extraction technologies. Boards are even applying Western strategic planning techniques to streamline cost-heavy Soviet-style investments and are focusing more on long-term planning and the risks of falling prices. "Managers are taking a more sophisticated approach to investments," says Gennady Gazin, an oil-industry consultant at the Moscow office of McKinsey Global Institute. "Before, what little investment was made was aimed at squeezing as much cash as possible out of existing infrastructure."

To maintain growth, oil analysts and executives estimate that the industry needs to keep this year's investment levels up for at least the next five years. Some companies have already announced major new investment plans--Sibneft next year intends to more than double capital expenditures, to $580 million. Yukos, which this year boosted such spending fivefold to $800 million, next year plans to exceed $1 billion. And they're getting more for their investments. According to Troika Dialog, a Moscow brokerage, efficiency gains and the devalued ruble have cut extraction costs from $6 per barrel to $1.50. Managers want to improve that by a further 20%.

The industry is sinking most of its money in new fields, which have not been ruined by Soviet production techniques. Russia's largest oil company, Lukoil, is spearheading this drive in an undeveloped field in the north Russian Timan-Pechora Region. It plans to invest $4.7 billion in the field over the next eight years to triple production from the current 8 million tons per year. Initial drilling costs are quite expensive--but a new well in Timan-Pechora produces 1,000 to 2,000 barrels per day, compared with just 70 from existing wells in western Siberia.

Western advisers are also being recruited. Along with Lukoil and Yukos, Sibneft has hired Schlumberger Ltd., the international energy-services company, to boost productivity from existing wells. Some 40 Schlumberger managers are based permanently at Noyabrsk, adjacent to Sibneft's main oil field in western Siberia. Sibneft has also cut corporate fat--reducing operating expenses by 24% last year. "I think we've done one of the best jobs in the country in terms of cost cutting," says Sibneft president Eugene Shvidler, 36.WARY FOREIGN INVESTORS. Companies are trying other techniques to get a grip on costs. Lukoil is buying controlling stakes in Russian pipe makers to assure supplies at a reasonable price. Faced with high energy costs levied by electricity monopoly Unified Energy System, Yukos even plans to go into the electricity business using its own energy supplies.

Yet the great Russian oil boom still faces dangers. Khodorkovsky warns that Yukos' investment plans could be crunched if Urals grade, now at $28 per barrel, drops below $18. And he fears the government will scotch spending plans further by demanding a high take of revenues even if prices fall.

Another issue is access to foreign capital. Foreign oil companies' direct investment into Russia's vast oil resources is still limited, mostly for lack of production sharing agreements to govern development of fields and settle difficult tax, profits, and ownership issues. President Vladimir V. Putin is promising to make improvements through new legislation that aims to clear up tricky issues, such as enforcing guarantees to make sure investors are not bilked by changes in the percentages of output they are due to receive. Investors and analysts are optimistic that such legislation will pass next year. "The logjam has been busted on this one," says Matthew Sagers, energy services director at PlanEcon Inc., a Washington think tank.

Bold plans are needed, since only four production sharing agreements have been completed to date. On Oct. 17, BP Amoco PLC, a company with a bitter history in the Russian oil industry, announced an offer to buy a stake in a field governed by one of these agreements--Sakhalin 1, in the Far East. But few Western majors are as brave.

And even though the index of the Russian stock market has nearly doubled over the past 12 months, share prices for most oil companies have not kept pace. That's mostly because of unanswered questions about ownership and perceptions of unfair treatment of minority shareholders. Speculation flourishes that oil barons are spiriting substantial sums to their offshore bank accounts. Oil money undoubtedly contributes to the $25 billion that Russia's Finance Ministry estimates in capital flight this year.WORKER UNREST? Thus the dilemma for stock investors. Consider Sibneft, whose share price of 29 cents is virtually unchanged from a year ago, despite a greater-than-anticipated boost in earnings. The company is auditing its books according to U.S. accounting standards, and this year paid its first dividend. "They are trying to be more transparent," says Dmitry Avdeev, a UFG oil analyst. But investors still have few clues about the role played in the company by Abramovich, 34, a Kremlin-connected former commodities trader whose past dealings have sparked distrust in Russian and Western investment circles. Deutsche Bank oil analyst Leonid Mirzoyan says investors are suspicious that there is a fund outflow from Sibneft into new Abramovich ventures, including the Russian aluminum business. Runicom, Sibneft's offshore trading arm, controlled by Abramovich, is being investigated by Swiss prosecutors who suspect it may have siphoned off funds from a $4.8 billion bailout loan issued to Russia by the International Monetary Fund on the eve of the August, 1998, crash. Sibneft says the suspicions are groundless. Abramovich declined to be interviewed.

Even if shady dealings are still the rule, the petro-boom creates other risks. Russia's 409,000 oil workers are frustrated that wages for many remain below the peak before the financial crisis. Companies will have to tackle the pay issue or face a possible surge in worker unrest. A larger issue is that the tax windfall from oil is already reducing pressure for Putin's government to make necessary structural reforms. "Heads are spinning" from the oil windfall, says Putin's top economic adviser, Andrei Illarionov, who's worried about stalled momentum for liberal changes. But few are listening to such party-pooping sentiments. The reigning cry: Let the good times roll.By Paul Starobin and Catherine Belton in MoscowReturn to top

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