Russia's New Wealth

The oil business is mostly cleaned up. Now, Moscow's biznesmen want to move into farming, banking, and more. Have these young tycoons found the next frontier?

With his smooth cheeks and angelic looks, Andrei Melnichenko seems awfully young to be one of the key players in the next stage of Russia's capitalist revolution. Yet Melnichenko has already helped turn Moscow's MDM Group into a $3 billion-a-year chemicals, pipeline, and coal business. And in a country in which the free-market economy is barely more than 10 years old, the players may look like cherubs, but they can bite like wolves. "He's 30--and he wants to own the world," says Len Blavatnik, an influential Russian-born U.S. citizen who invests in oil and aluminum and who, at 45, is an elder in Russia's big business set.

Bona fide senior tycoons sure take Melnichenko's moves seriously. His big play? It's not oil or metals, the traditional industries where a tycoon earns his stripes in this tumultuous economy. No, he's headed back to the land, the land that once made Mother Russia great. Russia's farming sector is poised to boom with the recent passage of legislation that authorizes the private ownership of agricultural acreage. That has set off a scramble to buy the choicest plots from Soviet-era cooperatives. If a few companies can apply modern farming techniques to these vast tracts, the increase in grain yields could be enormous.

That's why Melnichenko has quietly invested $220 million in Russia's best fertilizer plants. He figures the new landowners will need massive supplies to revive plots that by European standards are underfertilized by a factor of 10. According to Melnichenko, profit margins in MDM's fertilizer foray are 20% and rising. "It is relatively easy money," he says between puffs of his habitual Philip Morris cigarette.

Melnichenko--and Blavatnik and a host of other tycoons old and new--are deep into the hunt for the Next Big Thing in Russia's economy, a hunt that's drawing capital into previously neglected areas such as agriculture, natural gas, electricity, railroads, and financial services. These investments are still in the early stages. But a coterie of Russia's billionaire businessmen are building on their political intelligence and dealmaking skills to choose the right initial investments. And if they succeed in grabbing big stakes in the newly open markets, they may well decide to pump a big portion of their fortunes into Russia rather than Swiss villas or bank accounts in Cyprus.

This is the third big-money game in Russia since the demise of the Soviet Union. In the first stage, beginning before the Soviet Union's crack-up in 1991, communist industrialists carved behemoths such as gas giants Gazprom and Lukoil directly out of Soviet ministries. Assets were stripped and massive sums spirited out of the country. In stage two, in the mid-1990s, government-connected bidders won prize oil and metals companies in rigged privatization auctions. The boldest players made a killing.

Then something amazing happened: The more astute winners wised up and actually invested in their oil and metal holdings, boosting productivity and, in a few cases, improving the rights of shareholders. The oligarchs have hardly become angels. But the partial move to legitimacy has made some of these guys even more rich and powerful, despite their reputation for cutting corners in the past. Mikhail Khodorkovsky, the controversial chief executive of Yukos Oil Co., for example, is now worth $7 billion--because Western investors believe his numbers enough to bid up Yukos stock.

Now comes the third stage. The carve-up--and the cleanup--of the Oil Patch is largely done. This time the assets, cheap by Western standards, in big unreformed chunks of the economy are the lure. Not only is President Vladimir V. Putin's government paving the way for a private market for farmland, but it's also poised to break up monopolies in natural gas, utilities, railroads, and banks, and even start the private management of pension funds. The tycoons expect to finance their investments in these areas from the rich cash flow of their existing businesses in oil and other commodities.

Altogether, the sectors up for grabs account for some 30% of Russia's gross domestic product of $300 billion. That's $90 billion in prizes. So it's no surprise that the fortune hunters are using their connections to shape the direction of barely begun reforms. "Political influence is still very crucial," says oil baron Mikhail Fridman, 38, chairman of Moscow's Alfa Group, who's pursuing plays in gas and retail banking.

There's plenty to build a business around. Before, there was only one guaranteed way to make big money in this crazy place: You sold commodities overseas for dollars or European currencies, then stashed the proceeds in an offshore bank. The domestic economy was too sick to bother with.

But four years after a financial crisis that nearly devastated the country, and with political stability seemingly assured under Putin's authoritarian rule, Russians are starting to feel secure. Although the Russian stock market is now taking some sharp hits, the big Moscow index is up 27% for the year. Inflation is relatively low at 17%, down from triple-digit levels a decade ago. A business owner could actually have an all-ruble business without worrying about losing all his profits to hyperinflation or a currency crash. Those who succeed in building legitimate, well-capitalized, and transparent businesses out of these assets could become global players in the mold of Yukos Oil. "Russians are starting to trust Russia," says senior economist Peter Westin of Aton Capital Group, a Moscow brokerage. "Money is coming back." Last year, Cyprus, a haven for Russian offshore funds, was the leading source of foreign investment at $2 billion, 15% of the total.

Of course, Russia's untapped resources are so vast that even in this go-round the oligarchs will still feel strongly tempted to act like robber barons. Putin is trying to keep things under control, as his predecessor, the enfeebled Boris Yeltsin, failed to do. In private meetings with leading tycoons, he emphasizes this message: Go ahead and make your next big money, but stop paying bribes or otherwise engaging in corruption. "The rules of the game are much clearer," says Moscow mogul Vladimir O. Potanin, author of the notorious loans-for-shares program in the mid-1990s, in which he gained control of the world's largest producer of nickel, Norilsk Nickel, for next to nothing. Now Potanin, 41, aims to make his next fortune in processed food products, land, and media.

Even if Putin contains the corruption in this next stage of privatization, he will also have to curb the monopolistic instincts of his tycoons. Russian antitrust regulation is extremely weak, and the most rapacious players may try to corner the markets in railroads and electricity to wring out maximum profits. The tycoons counter that Russia's economy is still too uncertain for them to act in any other way. "If we don't have a strong position in the market, we will lose," says 34-year-old Oleg Deripaska, who with his partner controls 70% of Russia's aluminum production.

This "cornering" mind-set helps explain why, despite Russia's highly educated and numerate population, few of the big-money players plan to get rich through high-technology projects. In high tech, the chief assets are "the brains," points out Moscow metals mogul Oleg Kiselev. "People may just leave for the United States" after a Russian investor has poured money into their training, he says. So Kiselev's Metalloinvest conglomerate is buying 320,000 hectares of farmland in central Russia. Mother Russia's black earth is never going anywhere else.

However it plays out, the game is well under way. A prime jackpot will be the country's natural-gas wells and pipelines. At the center of it all is Gazprom, which operates the monopoly gas-pipeline network and is responsible for 90% of the country's gas production. The government, which owns 38% of Gazprom, is expected soon to open Gazprom's pipeline to other producers, primarily oil companies with gas-field investments. That move will make it much more profitable to be in the natural-gas game. With Gazprom's pipeline at his disposal, a Russian operator can ship his stuff anywhere in Russia or Europe.

That's why Yukos is getting hyperactive in the gas fields. This year, Yukos paid just $121 million for 100% control of bankrupt Rospan, whose 550 billion cubic meters of reserves have a market value of $9 billion. A sharp fight followed with rival Tyumen Oil, which cried foul over Yukos' acquisition methods.

Yukos later sold 44% of Rospan to Tyumen, but it's not stopping there. Khodorkovsky may go after Gazprom itself. "One can imagine a scenario in which Gazprom is brought to bankruptcy," he says with a devilish grin. That could happen, for example, if lenders balked at debt-laden Gazprom's huge refinancings. In such a case, the Russian oil companies, with their stashes of ready money, could step in with a bailout--on terms, presumably, that would give them prime fields. A Gazprom spokesman calls speculation about bankruptcy "fantasy."

Gas fields are not the only fields drawing tycoons' attention. At 406 million hectares, Russia has 13 times the farmland of France. Land is plentiful--and cheap enough to attract players such as Metalloinvest's Kiselev. A former professor at the Moscow Institute of Steel & Alloys, he has cultivated top-notch connections as chairman of the board of Russia's TVS television station and head of a business group that is lobbying the Kremlin on agriculture.

Prices sure look good: Metalloinvest is paying just $30 per hectare for its central Russia plots, says Kiselev. He predicts that "in a few years" the price will reach $1,000 per hectare. Others are more skeptical. Gregory Berenstein, a Russian-American investment manager who directs Moscow's Agribusiness Management Co., in which major U.S. companies including Archer Daniels Midland Co. have an interest, says it could take a decade for Russia's land market to hit the $1,000-a-hectare level. But there's huge room for growth just by catering to the domestic market. Imports, mostly grain, meat, and dairy products, now account for $50 billion of Russia's $70 billion food-products market. "Can you imagine if [Russians] gain half of this market?" asks Kiselev. "It's a big deal."

Joining the land rush are other big Moscow players, including Potanin's Interros, which is investing $100 million in its new holding company, Agros. Of course, spectacular gains can be realized only if Russia's new land-owning class invests in modern farm-management techniques. And there will be an expensive and politically complicated process of consolidating numerous small collectives into productive big enterprises. For the best parcels, investors may have to pay a premium to Communist Party bosses and local governors who control the local land.

That's why Igor V. Potapenko, 36, president of Moscow agribusiness company Razgoulyai Ukrros, is trying other ag plays such as grain silos, flour mills, sugar refineries, and meatpacking plants. These operations will earn big bucks on any jump in farm productivity, without the hassle of owning land. Potapenko's company, with annual sales of $435 million, has already bought 20 grain silos at $1.5 million to $2 million each, and wants to acquire an additional 10. It doesn't hurt to have tight government connections: Major customers include Russia's Defense and Interior ministries.

Russia's electricity assets also look cheap. Generating capacity in Russia can now be bought for $50,000 per kilowatt, compared with $400,000 in Germany or Poland, estimates Moscow investment firm Prosperity Capital Management. And the system up for grabs under a government plan to de-monopolize the sector is vast. Generation plants and the distribution grid are now largely in the hands of Unified Energy System (UES), which is 53% state-owned.

Key aspects of the UES restructuring plan are stalled in the Duma over concerns that consumers may be socked with huge tariff hikes. Nevertheless, the big players are plunging in now before the plan takes off. Leading the chase is--once again--Khodorkovsky's Yukos, which has bought big stakes in several regional electricity stations. Deripaska, Blavatnik, and Moscow industrialist Viktor Vekselberg are also buying into regional generating stations: They need the juice for their energy-intensive aluminum holdings. Now, players are well-positioned with such stakes. But under pressure from Putin not to allow another chaotic asset grab, UES on July 15 said it would suspend approval of local power station restructurings pending passage of legislation in the Duma.

UES is a model of management compared with the railroad monopoly, which is under the notoriously corrupt purview of the Railway Ministry. The Ministry itself acknowledges that its $3.2 billion annual investment program cannot provide needed upgrades on its 84,000 kilometers of track. Nonetheless, "We would like a percentage of railways," says Blavatnik, who with Vekselberg sees a $20 billion-a-year industry in the making as the government embarks on what is likely to be a complicated privatization. His Siberian-Urals Aluminum Co. holding already plans to construct its own rolling stock. The bet is that railroads will boom as Russia extracts and ships more aluminum, oil, and other commodities.

Just as in railroads, the tycoons' foray into banks depends on the deconstruction of a government monopoly. That's what Alfa Group's Fridman is hoping for. As things stand, his Alfa Bank has a tiny 2.3% of Russia's ruble deposits--against 72% held by Central Bank-owned Sberbank, with its exclusive right to offer government-guaranteed deposit insurance. But back in March, Putin forced the resignation of Central Bank Chairman Viktor Geraschenko, a major opponent of reform. Now, the Central Bank is crafting a plan to allow deposit insurance at all properly supervised banks. "I see Sberbank having just 40% of the market in less than five years," says Oleg Vyugin, Central Bank deputy chairman.

Smelling opportunity, Fridman is investing $50 million in a new branch network modeled on Deutsche Bank's Bank 24 in Germany. The branches will target Russia's growing middle class, especially in Moscow, with offers of loans, credit cards, and Internet banking.

Melnichenko's MDM Bank is taking a different tack. It's acquiring a dozen or more regional banks, including some specializing in processing government pension checks. The idea is to create an expertise--and a relationship with the government's State Pension Fund--that can make MDM the top dog in 2004. That's when private pension managers can finally bid to manage the government retirement funds. The pool is projected to grow from $4.5 billion in 2004 to at least $20 billion three years later.

Then there's insurance. Total premiums from life insurance and other products account for 1.5% of Russia's GDP, compared with 10% in some developed countries. There's "huge potential," says Ruben K. Vardanian, 34, president of Moscow brokerage Troika Dialog. His play: the $40 million purchase of a 49% stake in Rosgosstrakh, the Soviet-era monopoly provider of insurance.

With its computerless offices and undertrained sales force, Rosgosstrakh, of which Vardanian is now general director, may not look like a prize. But it has a nationwide network of 2,000 branches. Greater stability, Vardanian notes, has lots more Russians buying life insurance, its highest-margin product, and a new law makes auto insurance compulsory. Over the next 15 years, the life insurance market is likely to grow by 44% annually and all other insurance products by 15%, says analyst Ilan Rubin of Moscow brokerage United Financial Group.

Of course, the tycoons could all come up empty-handed if Russia's economy takes another 1998-type nosedive. And as even Melnichenko acknowledges, anti-monopoly laws will be enforced sooner or later. Perhaps sooner rather than later. Says Russia's Anti-Monopoly Minister, Ilya Yuzhanov: "We are going to be more active in investigating" market-cornering types like Melnichenko, who controls 70% of the special-grade coal supplied to Russia's power stations.

And yet the fortune hunters' opportunities are that much greater because of the continuing perception of Russia as unpredictable. Without such wariness, the country's assets wouldn't be priced so cheaply. "Controlled chaos" is the best environment for making big money, says Khodorkovsky. And Russia's young capitalists are hungry for fresh trophies.

By Paul Starobin, with Catherine Belton, in Moscow

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