19 Mar 2013, Alexander Osipovich, Energy Risk
As energy companies venture into ever more remote, inhospitable corners of the world in search of oil and gas deposits, they often find the biggest challenge is not the extraction of hydrocarbons from deep underground, but the above-ground difficulties of dealing with capricious local governments and managing political risk.
Russia is one country where this statement rings true. It is the world’s largest oil producer after Saudi Arabia and boasts untapped reserves off its Arctic coast that are currently drawing keen interest from international energy firms. But investing in the Russian oil and gas sector has often been a bruising experience for foreign companies – and none more so than UK-based oil major BP, which is currently on the verge of exiting its Moscow-based joint venture, TNK-BP. While TNK-BP has accounted for more than one-quarter of BP’s global oil production in recent years, it has experienced the full range of nightmares that keep Russian investors awake at night: being hit with billion-dollar back-tax claims; having its offices searched by the successor to the Soviet-era KGB; and having its chief executive, a BP appointee, forced to leave Russia.
Nonetheless, analysts say TNK-BP was actually a rather successful investment. BP invested just under $8 billion in the joint venture in 2003 and since then the firm has earned $19 billion in dividends. On top of that, BP received a lucrative payout by selling its 50% stake in TNK-BP to Russian state-owned oil firm Rosneft, in a deal that closed on March 21. The value of the payout - a mix of cash and Rosneft shares - was about $26.7 billion, based on the price of the firm's shares at the time. In total, that means BP has received a 472% return on its investment over a roughly 10-year period.
“Overall, this was an excellent transaction for BP,” says Kaha Kiknavelidze, managing partner of Rioni Capital, a London-based hedge fund, which has previously held shares in both BP and TNK-BP. “Even though the exit was not clean, financially this was a great investment.”
To a large degree, however, that financial success was due to a rise in energy prices. The price of North Sea Brent crude oil more than quadrupled from the day BP signed the deal creating TNK-BP in June 2003 to the day BP announced its exit plan in October 2012.
More significantly, the firm’s handling of its investment raises questions about its management of political risk. While BP can boast of genuine accomplishments – such as boosting TNK-BP’s production through improved drilling technology – the history of BP’s dealings in Russia is marred by missteps, lost opportunities and political miscalculations, sources say.
“I don’t think the problems BP had in Russia were the fault of the Russians,” says Shamil Yenikeyeff, a research fellow at the Oxford Institute for Energy Studies (OIES) and the author of a forthcoming book on the struggle over Russian oil wealth. “BP had serious shortcomings in its efforts to understand the Russians and their domestic energy politics.”
The deal establishing TNK-BP was signed on June 26, 2003, at Lancaster House, a nineteenth-century landmark in central London, during a ceremony attended by Britain’s then-prime minister Tony Blair and Russian president Vladimir Putin.
Signing on behalf of BP was its chief executive at the time, John Browne. Signing on behalf of the Russian side was Mikhail Fridman, co-founder and chairman of Alfa Group, a Moscow-based company that had emerged from the collapse of the Soviet Union to become one of Russia’s wealthiest conglomerates, with a broad array of assets ranging from banks to supermarkets.
Fridman was the central figure in a group of Soviet-born tycoons who had banded together to become BP’s partners in the joint venture. The others were German Khan, the second-largest shareholder in Alfa Group; Victor Vekselberg, head of Renova Group, another Moscow-based conglomerate; and Len Blavatnik, head of the New York-based international investment firm Access Industries. To manage their interests in TNK-BP, the tycoons formed a consortium called Alfa-Access-Renova (AAR).
BP and AAR agreed the two sides would each have a 50% stake in TNK-BP. That structure would eventually cause difficulties, as the shareholders became deadlocked and unable to resolve disputes. Browne had sought to prevent such problems by pushing for BP to have a 51% stake, but neither Fridman nor Putin would agree to that, according to Browne. “I knew if we had 49% we would have no power whatsoever,” he writes in his 2010 memoir, Beyond Business. “So in the end the only option was to go for a 50:50 deal.”
The early years of the joint venture were marked with success. TNK-BP’s oil and gas production surged by 24% from 2003 to 2005, as BP engineers introduced new drilling technology to reverse a long decline in TNK-BP’s prize asset, the Samotlor oil field in western Siberia. That helped BP surpass its rival Shell to become the world’s second-most valuable private oil company, after Texas-based ExxonMobil.
But behind the scenes, tensions were mounting, with the two shareholders repeatedly clashing over the direction of the joint venture. Among other things, AAR wanted TNK-BP to invest in countries outside of Russia, such as Iraq, Lithuania and Turkey. Those ambitions were blocked by BP, which treated TNK-BP as its Russian subsidiary and saw no value in having TNK-BP compete with its own projects, according to people familiar with the thinking of both sides.
"Our position was that TNK-BP was an independent company and that, yes, there could be situations in which it competed with BP,” says Stan Polovets, New York-based chief executive of AAR. “We never had an agreement with BP stipulating that TNK-BP would refrain from activities outside of Russia.”
More fundamentally, the two sides had sharply different philosophies and investment objectives. Unlike BP – a century-old firm accustomed to long-term exploration and production projects – the AAR shareholders had come of age in Russia’s rough-and-tumble 1990s, amassing huge fortunes in a few short years, often by snapping up cheap assets in privatisation auctions. Consequently, AAR grew frustrated when TNK-BP chief executive Robert Dudley, a US citizen chosen by BP to oversee the joint venture, pushed for costly long-term investment. For their part, UK managers at TNK-BP grumbled that AAR demanded unrealistically quick profits.
“The Russian investors, because of the nature of the Russian business environment, just didn’t think that far ahead,” says a London-based former TNK-BP senior manager.
AAR’s Polovets acknowledges the two companies saw things differently. "We were always ready to make investments, but we wanted to understand what the returns would be because, after all, we are financial investors,” he says. “If we earn profits from TNK-BP, we can always reinvest them in other businesses – in telecommunications, banking, aluminium, media and entertainment, and lots of other industries – or we can reinvest them in TNK-BP. It all depends on the rate of return.”
In addition, the Russian energy sector began to undergo profound changes almost immediately after TNK-BP was created, as the state began to play a more prominent role.
Most significantly, in October 2003, police arrested Mikhail Khodorkovsky, Russia’s richest man and head of Moscow-based oil firm Yukos. His arrest and subsequent conviction on charges of fraud and tax evasion were widely seen as a signal the Kremlin was cracking down on the so-called oligarchs who had become hugely wealthy and powerful during the 1990s. Yukos eventually went bankrupt in 2006 due to its inability to pay massive back-tax claims, and its most valuable assets were acquired by Rosneft.
International oil companies that had invested in Russia also came under pressure. In 2006, for instance, Shell agreed to give up control of the Sakhalin II offshore oil and gas development after being accused of environmental violations and threatened with multi-billion-dollar penalties. Gazprom, the Moscow-based state-owned gas producer, took a majority stake of Sakhalin II, while Shell and other foreign companies had their shares in the project reduced.
Increasingly, that made TNK-BP, with its 50% ownership by an international oil company, an oddity in the Russian energy landscape. “The oil and gas investment environment really started to change in a radical way not long after the deal that created TNK-BP was announced,” says Alex Brideau, a senior analyst at Eurasia Group, a New York-based political risk research and consulting firm.
There was a brief expropriation scare in 2005, when Russian tax authorities hit a TNK-BP subsidiary with back-tax claims adding up to $936 million. But those fears were eased after BP’s Browne held a meeting with Putin, in which the Russian president lauded BP as a “good corporate citizen”. The back-tax claims were later significantly reduced.
Amid growing uncertainty over the Russian state’s relationship with oligarchs and international oil firms, BP entered into talks with Gazprom after the 2005 back-tax drama. Media reports at the time suggested BP was seeking to replace its Russian partners with a state-owned company – an arrangement that could help shore up the oil major’s relationship with the Russian government. But a shareholder agreement signed by BP and AAR in 2003 stipulated neither party could sell its stake in the joint venture until January 1, 2008.
The BP-Gazprom talks were ultimately inconclusive. However, they succeeded in further rankling AAR, which was irritated the oil major was attempting to do a side-deal without its involvement, according to sources familiar with the situation.
“BP didn’t understand the true political picture,” says Yenikeyeff at OIES. “[It] didn’t understand the fact that replacing AAR with Gazprom was not going to be allowed. Having Gazprom become the major player in Russia’s oil industry, overtaking Rosneft in terms of oil production and reserves, was never going to happen.”
A London-based BP spokesman declines to comment on the BP-Gazprom talks, dismissing them as “ancient history”.
War breaks out
The tensions between BP and AAR burst into the open in 2008, when TNK-BP became subject to intense pressure from the Russian authorities and the shareholder dispute exploded into public view.
On March 19, 2008, officers from Russia’s Interior Ministry raided the Moscow offices of BP and TNK-BP in connection with a set of tax evasion investigations. The probes, which had begun in 2007, picked up steam in early 2008, and by April that year, the ministry was investigating back-tax claims of more than $900 million against various TNK-BP units.
Other legal problems also plagued the joint venture. The Federal Security Service – the KGB’s successor agency, known by its Russian acronym, the FSB – arrested an employee of TNK-BP and his brother, an independent energy consultant, and charged them with industrial espionage. The FSB later conducted a second raid on BP’s Moscow office in May 2008. Separately, Russia’s Natural Resources Ministry announced an environmental inspection of TNK-BP’s Samotlor oil field.
Meanwhile, BP and AAR became embroiled in a public spat about Western employees at TNK-BP. AAR insisted the expatriates were overpaid and unnecessary, while BP defended them. Dudley, the TNK-BP chief executive, accused AAR of meddling with the Russian work-permit application process to ensure Western employees would be unable to renew their Russian visas, forcing them to leave the country when their old visas expired.
TNK-BP was hit with multiple lawsuits over the issue. One such lawsuit came from Tetlis, a Moscow-based firm that was among a small proportion of minority shareholders in TNK-BP Holding, the joint venture’s listed subsidiary. In April 2008, the company sued TNK-BP in a Siberian court over a longstanding agreement that allowed technical specialists from BP to be seconded to TNK-BP. The court issued an injunction that left 148 BP secondees physically unable to enter the firm’s Moscow headquarters. In a separate lawsuit filed in July 2008, a group of Russian managers at TNK-BP accused Dudley of discrimination, complaining that TNK-BP’s Western employees were paid much better than local staff. Dudley decried the lawsuit, saying it would “tear apart the company”.
The controversy played into genuine resentment among some Russian employees of TNK-BP. “If I were one of the Russian shareholders, I would have done the same thing,” says a Russian former employee of TNK-BP, who is currently based in eastern Europe. “Why would you pay an expat 10 times as much for work that a Russian employee could do? Especially if he was working in the interests of the British side?” he asks.
Ultimately, the 148 secondees left Russia. Dozens of Westerners directly employed by TNK-BP also quit the country after they were unable to renew their visas. One of them was Dudley himself, who finally left on July 24, 2008, ending a long struggle with AAR and the Russian authorities.
“There was incredible pressure on Dudley,” recalls the former TNK-BP senior manager. “He is a very resilient man. He did not leave the country suddenly. He could have left, in my view, a lot earlier, given the pressure that he was subjected to, because life was becoming dangerous for him. There was a very real risk he could have gone to jail.”
After Dudley’s departure, BP reached what some market observers describe as a peace deal with AAR, which largely involved ceding control over the joint venture to the Russian shareholders. Under the terms of the deal, announced in September 2009 and finalised four months later, Dudley stepped down as TNK-BP chief executive and AAR won the right to approve his replacement. The two sides also agreed to increase the size of TNK-BP’s board of directors and add three independent directors, fulfilling another key demand of AAR.
TNK-BP’s legal worries eased significantly after the deal. In September 2008, the Interior Ministry announced TNK-BP had settled most of its back-tax claims, and the ministry eventually ceased its tax evasion investigations against the TNK-BP units. The two brothers arrested by the FSB for industrial espionage were given suspended sentences. Meanwhile, Tetlis and the Russian managers dropped their lawsuits.
The role of the Russian state in the BP-AAR clash of 2008 is the subject of intense speculation. Those familiar with the dispute do not believe the Russian government orchestrated the legal campaign against TNK-BP. Instead, they believe AAR used its ties to government agencies to apply pressure on Dudley and his team. “The security services were used by AAR as one of the means of achieving their main goal,” says Vladimir Milov, a former Russian deputy energy minister who is now president of the Institute of Energy Policy, a Moscow-based think-tank. “They wanted to seize operational control of the company and squeeze out Dudley, who was a very major irritant for them… It’s no secret that they had the ability to do this, since they had tight relationships with very senior individuals in the Russian leadership.”
AAR’s Polovets would not speak on the record about the tax evasion investigations, the visa dispute or any other legal difficulties the joint venture faced in 2008. A Moscow-based spokesman for AAR declined to comment, while spokespeople for the Interior Ministry and the FSB did not respond to requests for comment.
Looking back at the clash of 2008, former TNK-BP insiders voice frustration with BP’s inability to deal with the setbacks. “BP was not properly prepared for the pressure,” says a source familiar with the events. “It reacted slowly, sometimes even passively, since it is a huge and risk-averse bureaucratic machine that functions relatively well in normal times, but at the time it was not fully up to the task of outright corporate warfare in the Russian style.”
According to another source, who met with BP executives in London when the shareholder dispute was in full swing, part of the problem was the sudden departure of Browne from the helm of BP in 2007 and his replacement with a new chief executive, Tony Hayward, who took less interest in the oil major’s activities in Russia and was detached from the brewing conflict.
“Hayward was not really aware, as the crisis developed, of how bad things were on the ground in Moscow,” says the source. “He really didn’t have the same finger on the pulse that Browne had.”
A spokesman for Hayward, who is now chief executive of London-based Genel Energy, declined to comment for this article.
When asked about its handling of the shareholder dispute, BP stresses the strong financial performance of TNK-BP. “For most of the life of the joint venture, the 50:50 partnership worked well and TNK-BP was a very successful joint venture,” says the BP spokesman. “We are proud of our record.”
BP played a more passive role after 2009, mostly allowing AAR to run the joint venture. However, that calculus changed after April 20, 2010, when an explosion on the Deepwater Horizon oil rig in the Gulf of Mexico triggered a massive oil spill that saddled BP with tens of billions of dollars in fines and potential liabilities. In the wake of the spill, BP unveiled a plan to divest $38 billion of assets and refashion itself into a leaner company focused on high-value exploration projects. The spill also cost Hayward his job as chief executive of BP. His replacement was Dudley, the former head of TNK-BP.
In January 2011, Dudley announced a grand scheme that would simultaneously shore up BP’s finances and give it access to sizeable untapped oil and gas reserves. The plan was a proposed share swap between BP and Rosneft, under which Rosneft would take a 5% stake in BP in exchange for BP taking a 9.5% stake in the Russian oil firm. In addition, BP and Rosneft agreed to explore and develop three promising licence blocks in the Kara Sea, a Russian part of the Arctic Ocean.
It was to be the ideal arrangement, uniting BP’s offshore expertise with Rosneft’s exclusive rights to explore Russia’s continental shelf. But it was derailed by Dudley’s old partners at AAR, who were upset BP had failed to include them in the Arctic deal. Citing the original BP-AAR shareholder agreement, which said BP needed to pursue any Russian projects exclusively through TNK-BP, they sued to block the BP-Rosneft alliance. A London court and a Stockholm arbitration tribunal agreed BP was violating the shareholder agreement – and despite last-minute negotiations with AAR to salvage the deal, Dudley’s plan collapsed in May 2011.
The embarrassing failure led many market observers to wonder why BP attempted to conduct the deal without first getting AAR’s approval. Russian energy sector experts believe BP miscalculated by placing too much faith in the power of Rosneft and its chairman, Igor Sechin, a deputy prime minister who is often described as Putin’s right-hand man. As it turned out, Sechin’s blessing was not sufficient to overcome the determined resistance of the AAR shareholders, especially Alfa Group’s Fridman.
“BP is apparently poor at analysing political situations,” Fridman said in a May 2012 interview with Russian newspaper Kommersant. “Their perception of the Russian [political system] is too primitive. They thought if the deal was blessed at the very top, we would never, ever do anything to defend our interests, because we would be afraid of the anger of the prevailing authorities.”
BP should have known better than to exclude the Russian tycoons from the deal, according to Carlo Gallo, London-based founder and director of political risk firm Enquirisk. “The Russian shareholders of TNK-BP had a very peculiar profile within the Russian oligarchic scene,” he says. “They had a very international profile and a highly diversified range of assets, which basically insured them, to some degree, against strong political pressure from the Kremlin. Also, they played loyally vis-à-vis the Kremlin and had very good, long-established connections within the government. So knowing all that, it could have been expected they would not just sit quietly and do what they were told with regards to the attempted share swap deal.”
The spokesman for BP declines to answer questions about the failed deal. “We didn’t manage to complete the deal and we have moved on,” he says.
In 2012, BP finally decided to sell its stake in TNK-BP and escape from its long and exasperating relationship with AAR. The contours of BP’s exit strategy became clear in October last year, when BP and AAR simultaneously announced they were selling their respective 50% stakes in TNK-BP to Rosneft – a giant deal that values the joint venture at $55 billion. AAR agreed to sell its half of TNK-BP to Rosneft for $28 billion in cash. BP’s $26.7 billion of cash and Rosneft shares will make it a significant minority shareholder in the Russian oil firm.
Some market participants say BP may simply be exchanging one difficult partnership for another. When the deal is finalised, BP will own 19.75% of Rosneft, making it the company’s largest shareholder after the Russian government, which owns 75%.
“Rosneft is a government-controlled company, and Russian state-owned companies are run in their own peculiar way, not always in the best interest of minority shareholders,” says Rioni Capital’s Kiknavelidze.
Rosneft insists BP has nothing to fear and notes BP will gain two seats on its nine-member board of directors. “BP will receive all the rights corresponding to its participation as a shareholder,” the firm says. “Rosneft welcomes BP as a strategic investor in the company.”
BP professes optimism about its arrangement with Rosneft. “BP intends to be a long-term investor in Rosneft, an investment which I believe will deliver value for our shareholders over the next decade and beyond,” says the London-based spokesman.
Political risk analysts say BP’s turbulent experience demonstrates that a solid understanding of business partners and a concerted effort to manage relationships are crucial ingredients for a successful strategic investment. As BP proceeds with its new partnership, it should bear those lessons in mind, they add.
“One of the lessons that companies need to learn from the TNK-BP case is that when you are going into these kinds of strategic alliances in Russia, you need to do a lot of homework,” says Gallo at Enquirisk. “You need to try to understand your partners’ real motivations, their track record, strategy and ambitions, as well as their political connections.”
Tony Brenton, who served as British ambassador to Russia from 2004 to 2008, agrees. “You can do very profitable business in Russia, but it takes a lot of concentration and hard work,” says Brenton, who is now a fellow at Cambridge University’s Wolfson College. “You need to keep talking to everyone and make sure they know where you’re coming from. You need to be willing to be tough when toughness is needed. And you need to maintain a very, very close relationship with the people you’re dealing with.”
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