Sunday Telegraph: Is Russia safe for British business?

Last Updated: 12:17am GMT 17/12/2006

After the Kremlin humbled Shell into selling a stake in its £10bn Sakhalin project, Iain Dey ponders the fate of the UK’s other economic interests in Putin’s Russia

And how will Londonski cope with the Russian bearhug?

In the Latvian border town of Terehova, almost 700 trucks, stuffed with goods from the European Union, are queuing, waiting to get into Russia. Following a dispute with Poland over border controls, the Kremlin has decided to make life difficult for all those attempting to import EU goods into Russia. Delays are now commonplace, with some truckers reported to be waiting for days to cross through. Similar queues are building up at border controls on the river Narva, between Estonia and Russia, and at every other entry point into Russia from the Baltic states.

So far as the outside world is concerned, this backlog of goods trucks is symbolic of the mood within Russia’s corridors of power. The Putin administration seems keen on making life difficult for business. While that perception has existed for some time, investors fear the situation is getting worse. The news last week that Royal Dutch Shell has caved in to government pressure and sold a majority stake in the massive Sakhalin-2 oil project to Russia’s state-owned energy group Gazprom has confirmed industry’s worst fears.  

If Shell, a global business behemoth, can be coaxed into submission, then who will be next? Is any Russian asset safe from the hands of the authorities?

“In the short term, the [Russian] state’s interest does seem to be restricted to the resources sector,” says Stephen O’Sullivan, head of research at Deutsche UFG in Moscow. “But if you look five or seven years ahead there’s no telling what will happen. If you had said five years ago that the state would even consider requisitioning these oil assets no one would have believed you.”

The UK’s collective involvement with Russia is huge. In the first nine months of this year, the UK’s export of goods to Russia amounted to £1.4bn, according to figures provided by the Department of Trade & Industry and HM Revenue & Customs. Separate data from the Office for National Statistics shows that at the end of last year, the net book value of the UK’s foreign direct investment in Russia amounted to £1.8bn. Statistics provided by the Russian embassy, meannwhile, suggest that figure should be nearer £4.4bn. The UK, the embassy says, has provided around one-tenth of the accumulative external investment into the post-Soviet Russian economy. Only Cyprus (where several Russian companies are registered), the Netherlands and Luxembourg have contributed more.

Since the collapse of Communism, some British companies have developed huge businesses in Russia. Shell’s £10bn Sakhalin project was the biggest foreign investment in Russia. At the time of its conception more than a decade ago, Russia lacked the knowledge and financial firepower to implement such a scheme. But now Shell is being forced to give up much of the upside over claims that it is breaching environmental laws.

BP has also been a Russian flag-bearer, through TNK-BP, its Russian joint venture. Lord Browne of Madingley, the BP chief executive, claims to have invested around $10bn into Russia since the company was set up three years ago – another figure which suggests the official UK data understates Britain’s investment in Russia. Although much of the original investment has been clawed back in dividends, the company’s interest is substantial – and under threat.

TNK-BP is in a similar bind to Shell. Russian authorities are holding the company to a target of producing 9bn cubic metres of gas from the Itkutsk region by the end of the year. TNK-BP claims that total demand for gas in the Itkutsk region will only reach 2.5bn cubic feet within three years. Nonetheless, it could lose its licences unless it does a deal with Gazprom.

Elsewhere in the resources industry, Peter Hambro Mining has been threatened with having licences revoked. The claims have been made by Oleg Mitlov, the same junior environment minister who conducted a concerted campaign against Shell. The two sides kissed and made up last week – and Mitlov was given a formal warning over his conduct. That is hardly surprising given the company’s good relations with the Putin administration. But the broader threat to resource assets remains.

Mining and energy resources are deemed strategic assets by the Russian government. It could attempt to revoke those assets, even if it does have to resort to environmental rationales. One need only look to the Aim market to see the exposure of UK plc to that threat. Dozens of Aim companies are targeting Russia, such as Highland Gold, Imperial Energy, Bema, Petroneft and Victoria Oil & Gas. Analysts say that assets held by any company that is not state-owned are potentially at risk – despite vehement statements to the contrary by numerous Russian government officials.
 
“There’s no well-defined rule book in Russia, and the sands can shift right in front of you,” says Bill Browder, chief executive of Hermitage Capital Management, who has been exiled from Russia for speaking out on corporate governance issues and exposing theft and corruption inside Russian companies.

“The rule of law is relatively primitive – it is very difficult to go to court to enforce a contract. That’s not exclusive to Russia; there are many countries in the world where a contract is just the beginning of a negotiation, and Russia happens to be one of them.”

While Browder is critical of Russia, he says the potential rewards for investors outweigh the risks for those who know what they are doing. His own fund is proof: $1,000 invested with Browder 10 years ago is worth $25,000 (£12,775) today. Although resources are where Russia’s wealth lies, the booming Russian economy is also attracting British consumer goods companies in abundance.

Gallaher, the tobacco company behind brands such as Benson & Hedges, generates more than half of its sales volumes from the former Soviet bloc. That’s a large part of the reason why Japan Tobacco has now made a bid for it.
 
Retailers including Kingfisher and Alliance Boots have made inroads into Russia. Dixons is also considering a move into Russia through an option to buy into Eldorado, a Russian electrical retailer. Scottish & Newcastle, the brewer, may soon have to consider changing its name to St Petersburg & Vladivostok. Through Baltic Beverage Holdings (BBH), a 50/50 joint venture with Carlsberg, the Danish brewer, S&N is Russia’s largest brewer. In its most recent set of results, announced in August, S&N revealed that about 35 per cent of its group profits had come from BBH. With growth in Russia substantially outstripping that in its established markets, the importance of Russia to the group will only grow.

While there is no suggestion that the Russian state will look to requisition kegs of beer or re-appropriate shopping space, some observers believe that the general political risk inherent in dealing with Russia at present is not being sufficiently factored into company valuations. The “political risk” of doing business in Russia was previously a euphemism for bribery and corruption at a local level. The recent actions of central government have changed the parameters of the discussion.

“People have underestimated the risks in Russia quite substantially,” says Mark Otto, managing director of New Europe Strategic Advisers, a consultancy that advises on corporate governance issues across Russia and eastern Europe. “There’s an implicit understanding among investors in the UK that large Russian companies won’t be allowed to renege on their commitments because they have an implicit guarantee of the Russian state. But that guarantee is only there while the Russian state is playing ball.”

The recent signs that Russia may not always play ball have been put down to one thing: high oil prices. Russia has grown cocky on the back of the resources boom, analysts say, much in the way that Iran and Venezuela have done. Russia is a major supplier of oil and gas to the world economy.
 
The Kremlin’s decision to cut off gas supplies to Ukraine last year, and much of Europe in the process, demonstrated Putin’s willingness to play hardball with the power this affords. He has since meted out a similar punishment to Lithuania after being miffed at the government’s decision to sell a refinery to a Polish company rather than a Russian one.

If oil prices were to fall further, Russia would once again become heavily dependent on foreign direct investment to keep the economy going.

“The Russian economy is fuelled by oil,” says Browder. “The reason the Soviet Union fell apart was not because of Ronald Reagan or Star Wars or the Pope, but because oil prices fell below $10 a barrel. The reason why Russia is so strong right now is that oil prices are at $60 a barrel.”

Yury Fedotov, the Russian Ambassador to London, insists that any concerns about Russia’s attitude towards business are “fundamentally misplaced”.

He says: “Publicity around Sakhalin and a handful of other cases should not mask the opportunities that are being realised in Russia. Substantial successful British investments are taking place throughout the country, not least in the energy sector.
 
“It is clear that the economic turbulence of Russia’s post-Soviet transition is over. The reform programme continues, with new legislation being passed to strengthen the rule of law and further liberalise the economy.”

But actions speak louder than words. Recent actions from the Kremlin have given business plenty of cause for concern.

“Working with Russia is sometimes hair-tearingly frustrating,” says Godfrey Cromwell, executive director of the Russo-British Chamber of Commerce. “And Russia does seem regularly to shoot itself in the foot in terms of international PR – something the evidence suggests that the Russian state does not consider a high-priority problem.

“Russia resolutely, and on occasion brutally, goes its own economic and political way. We may disagree with that way or see it as self-destructive, but the business partnership with Russia – which in the 90 years of RBCC’s existence has survived revolution, Communism, Stalin and two world wars – will continue. As RBCC members know, the purely business case for careful investment based on an eyes-open understanding of the risks remains compelling.”

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2006/12/17/ccrussia17.xml

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