He's Got The Oil. Now Can He Make Money?

Mikhail Khodorkovsky's giant merger faces huge challenges

Mikhail B. Khodorkovsky is a Russian mogul on the move. The 34-year-old banker and oilman's philosophy: "If you want to play with the big boys, you have to be a big boy yourself." On Jan. 19, he announced that he will merge his Yukos oil company with Russia's Sibneft to create Yuksi, the largest oil company in Russia and the third-largest publicly traded oil company in the world after Royal Dutch/Shell and Exxon Corp.

Getting in the global game is one thing. Winning is another. Khodorkovsky faces a huge challenge just to get Yuksi operating as efficiently as its closest Russian rival, Lukoil--let alone international oil giants. Like many Russian entrepreneurs, Khodorkovsky has focused mainly on grabbing assets rather than maximizing profits. Now, his major task is restructuring. If he wants to attract Western financing and boost profits at Yuksi, he will have to better manage the assets he has. Says Steve Allen, an analyst at Deutsche Morgan Grenfell in Moscow: "Yukos hasn't started to make the necessary steps that Lukoil made a few years ago, such as maximizing refinery output and selling in the most profitable markets."

BIG DEBTS. The rest of his empire needs an overhaul, too. His Menatep Bank, one of Russia's first private banks, snapped up more than 100 enterprises in food, paper, metals, engineering, and other industries during Russia's privatization program in 1994 and 1995. Rosprom, his industrial holding, now manages more than 30 companies. Says Par Mellstrom, head of research at Brunswick Warburg in Moscow: "In all the companies Menatep acquired, there is not one example of a successful restructuring." Menatep bought many companies in tenders under which it was required to invest cash in exchange for shares. It often gave bank loans instead, putting the companies deeply in debt.

Khodorkovsky needs to improve his relationship with shareholders. Both Yukos and Sibneft, which is controlled by fellow mogul Boris Berezovsky, have a poor record of protecting the interests of minority shareholders. In announcing the merger, Khodorkovsky vowed that minority shareholders' interests would be "fully taken into account." Still, shareholders are worried they may not get a fair deal when the Yukos-Sibneft merger is completed. Says Stephen O'Sullivan, an analyst at MCL in London: "Neither company has focused on transparency, efficiency, and profitability. They were big enough to have done it earlier and they didn't."

Despite such complaints, Khodorkovsky needs foreign investors, and he is likely to get them. For international oil companies, Russia is among the few underdeveloped oil sources remaining on the globe. Amoco walked away from a production-sharing deal with Yukos when the two companies failed to agree on financing last year. But the merger with Sibneft could pave the way for a partnership along the lines of British Petroleum's with Sidanko and Royal/Dutch Shell's with Gazprom. Yuksi's oil production puts it "on an equal footing with Western companies and allows bigger muscle in negotiating," says Yuri Milner, vice-president of Menatep Bank.

THIRSTY. Khodorkovsky and Berezovsky came up with the idea of merging after meeting in December to discuss bidding jointly on another state oil giant: Rosneft, which is set to be privatized this spring. Two other groups have declared their intention to bid, and they each have deep pockets. Berezovsky's bitter rival, Vladimir Potanin of Sidanko, plans to bid with British Petroleum. Lukoil is making a joint bid with Gazprom and Shell. By merging their two companies, Khodorkovsky and Berezovsky enhance their chances of securing financing to make a competitive bid--and seal Yuksi's position as Russia's oil leader.

The merger with Sibneft has not quenched Khodorkovsky's voracious appetite for oil. His goal is to reach an output of 100 million metric tons annually of crude oil by 2000, up from 65 million now. At the same time, he'll begin to sell off nonoil holdings. Khodorkovsky says he wants to make Yuksi as efficient as a Western major. With new capital and ruthless cost-cutting, it's possible. But it will be a long time before Yuksi supplants Lukoil in investors' minds as the premier Russian oil stock.

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