Russia's Oil Patch Is Going Down The Drain

Low prices and scarce investors are devastating the industry

In Yukos Oil Co.'s fortress-like Moscow headquarters, Chief Executive Mikhail B. Khodorkovsky still talks confidently about the future. But behind the crenellated walls of the century-old building, Russia's second-largest oil producer is crumbling. Revenues plummeted 12%, to less than $4 billion, this year, and Yukos is struggling to repay $1.1 billion in loans due by the end of 1999. Regional authorities are threatening to revoke Yukos' production licenses for nonpayment of taxes. The company's chief shareholder, Menatep Bank, is on the verge of bankruptcy.

Yukos is not alone. Russia's oil industry--the crucial source of the country's tax and hard-currency revenues--is facing its worst crisis since the start of privatization in 1993. Hit by falling prices and chronic underinvestment, production has slumped 2.5% this year and could fall 5% next year, to 2.1 billion barrels--less than half the output a decade ago. Most of the country's 12 major oil companies are struggling. In the next few months, many will shrink, slide into bankruptcy, or be swallowed up in mergers. Even the survivors will find the competition rough. Production costs are $4 a barrel in Russia--twice as much as in the Middle East--even though the ruble has plunged in value.

The shakeout in Russia is long overdue. Much of the country's oil industry is inefficient and poorly managed. Over the past five years, the government sold off oil holdings to bankers such as Khodorkovsky, who wanted to build financial-industrial empires. But while the bankers grabbed assets at cheap prices, they rarely followed up with badly needed restructuring. Now, as their financial empires collapse, Russia's moguls are scrambling to keep their oil holdings afloat. Sixth-ranking Russian producer Sidanko, controlled by financier Vladimir S. Potanin's Oneximbank group, is offering to give up its biggest refinery and 40% of its oil reserves to the government to cover unpaid taxes, for example. The government has turned up the heat on Sidanko and other producers by suspending export rights when they fall behind on taxes.

Potanin has installed a new chairman at Sidanko: Boris Jordan, a 32-year-old Russian-American financial wunderkind who set up Credit Suisse First Boston's Russia operation before starting his own MFK Renaissance investment bank in 1995. But Jordan has no oil-industry experience, and most analysts doubt he can halt Sidanko's slide. British Petroleum Co., which paid $571 million for a 10% stake in Sidanko last year, says it remains committed to the company. But BP executives have privately told analysts the investment was a mistake.

SERIOUS SELL-OFF. Other Western oil majors, long courted by Russian companies as strategic partners, are also curtailing their activities. Amoco Corp., for example, is selling its 20% stake in Timan Pechora Co., which is developing an oil field in Russia's far north. Atlantic Richfield, Occidental Petroleum, and Elf Aquitaine also are downsizing or abandoning Russian projects. The timing is ironic: After years of delays, the Communist-led lower house of Parliament finally passed legislation in December to promote foreign joint ventures in oil production. But that's not enough to outweigh the disadvantages of investing in Russia today, analysts say.

Russia's oil companies aren't entirely to blame for the mess they're in. Under privatization, refineries and oil fields were parceled out among newly created holding companies. But many assets were uneconomical--in harsh climates, in need of investment, or thousands of kilometers away from retail markets. The government has exacerbated problems by imposing taxes that soak up half of oil companies' revenues and by requiring companies to sell two-thirds of their output domestically, limiting hard-currency earnings.

But oil-company managers have made things worse. Several companies borrowed money in the West, pledging export revenues as collateral, but spent the proceeds on questionable projects. Yukos borrowed $800 million last year to buy unprofitable Eastern Oil Co. As financiers took over companies, they often trampled on shareholder rights as they consolidated control over subsidiaries. Even now, Yukos is considering a stock issue that would dilute existing shareholdings by 25%.

THINKING RETAIL. A few Russian oil majors are sure to make it through the turmoil. Lukoil and Surgutneftegaz, the No. 1 and No. 3 producers, remain profitable and are scouting for assets to snap up from other, failing oil companies. Because of lower oil prices, Lukoil's profits sagged 51% in the first half of this year, and Surgutneftegaz's fell 38%. But the two companies own some of Russia's most efficient oil operations and are managed by experienced oilmen rather than financiers. To bolster its position, Lukoil is reducing its dependence on sales to industries and government facilities that can't pay their bills. And it's targeting the retail market by expanding its network of gas stations.

Some lesser-known players look promising, too. One example is Tyumen Oil Co., the No. 5 producer. CEO Simon Kukes, a former Amoco executive, has slashed operating costs 30% since taking charge last spring, while signing an agreement with Halliburton Energy Services to boost production efficiency. Although Tyumen lost $26 million in the first half of the year, Germany's Westdeutsche Landesbank was convinced enough of its progress to lend it $126 million in October--one of the first foreign credits issued to a Russian company since the financial collapse.

At Yukos, meanwhile, Khodorkovsky says he is moving to streamline the company. But he admits he waited too long. Yukos will likely have to sell assets to stay afloat. At worst, it could disappear in a merger or be forced into bankruptcy. For Russian oil, capitalism has turned out to be a slippery slope indeed.

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