Rosneft: A Deal Both Tempting And Troubling

Oil giant Rosneft has vast reserves, but its controversial past has investors wary

Imagine an oil company that has in five years seen its annual production and profits grow to six times their former size, making it one of the world's largest energy giants, with more proven oil reserves than Exxon Mobil Corp (XOM ). Now, suppose that at a time of near-record oil prices the company plans to sell up to 49% of its shares in an initial public offering worth some $20 billion. Investors would be champing at the bit, right?

Not necessarily. The company is Rosneft, Russia's state-owned oil giant. While it looks mighty impressive on paper, Rosneft has some skeletons in its closet that may give investors pause. With close Kremlin ties (its chairman is President Vladimir V. Putin's deputy chief of staff), Rosneft shot to prominence in 2004 when it acquired key oil assets of Yukos, the company that was hobbled after then-Chairman Mikhail Khodorkovsky was jailed on charges that defenders claim were politically motivated. The affair wiped out the value of Yukos, costing investors billions of dollars.

So Rosneft CEO Sergei M. Bogdanchikov has been pulling out the stops to impress investors. He's making the rounds of world financial centers, hinting at listings in London, New York, Frankfurt, Tokyo, and Moscow. And he's been looking for an experienced Western manager to bolster Rosneft's image. He's set to appoint Morgan Stanley's (MS ) co-head of investment banking in Moscow, Peter O'Brien, to a senior position with responsibility for the IPO. (Former Commerce Secretary Donald L. Evans declined a top Rosneft job last year.)

It's all a sign of how much Rosneft -- and Putin's Kremlin -- have riding on the IPO's success. The company is $11 billion in debt, and a $7.5 billion loan to its holding company from Western banks expires this year. The Kremlin makes no secret of its ambition to boost the value of its big state energy companies, Rosneft and natural gas provider Gazprom. In Rosneft's case, to make that happen, the company needs to get beyond its controversial past. Now, says former Putin economic adviser and current Kremlin critic Andrei N. Illarionov, the main aim of the Rosneft IPO "is to have a so-called Western stamp of approval on all this business [with Yukos]."

The Yukos acquisition transformed Rosneft from a relatively obscure producer to a 1.5 million-barrel-a-day giant. Its 15 billion barrels in proven reserves are second only to Russian peer Lukoil among listed oil companies. What's more, Rosneft's fields are relatively young, giving it good growth prospects. "If you look at Rosneft's oil asset portfolio, it is perhaps the best in Russia," says Kaha Kiknavelidze, an oil and gas analyst at investment bank UBS in Moscow.


But shadows of the Yukos affair linger. "If Rosneft had grown in a normal manner, people would be rushing to snap it up," says Stephen O'Sullivan, head of research at Moscow investment bank Deutsche UFG. "The issue is the potential legal overhang from Yukos." On Mar. 15 a consortium of international banks initiated bankruptcy proceedings against Yukos. Rosneft has already bought much of Yukos' debt, and will probably grab the company's remaining assets if Russian authorities declare Yukos bankrupt.

Another imponderable is whether Rosneft can achieve its ambitious performance goals. By 2010, the company aims to increase its oil production by 33%, to 2 million barrels a day. Some praise CEO Bogdanchikov's management, noting that even before Rosneft's acquisition of the Yukos oil fields he boosted annual production by 74% between 1999 and 2004. Helped by the high quality of its assets, Rosneft also has some of the lowest costs in the industry. But critics note that production has been stagnant at most of its major subsidiaries since 2000 and that the company's pretax earnings per barrel last year were 30% lower than those of rival Lukoil.

It's not yet clear how investors will react to a Rosneft offering. Much will depend on how its management team chooses to structure the upcoming deal. In a time when oil seems scarce, Rosneft, at the right price, might be hard to pass up, even for investors already buffeted by the shifting winds of Kremlin politics.

By Jason Bush

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