The Manufacturer US: “Trade,” said the Russian

Published : February 2007

Russia wants better trade relations with the West. Is it truly an untapped resource, or is it reverting to USSR trade tactics? Ruari McCallion investigates

The close of 2006 had a strangely familiar feel to it. The energy pipeline running through a former Soviet republic was cut off as Russia unilaterally increased prices, causing oil to rise on world markets. In 2005/6, the crisis over energy supplies to the Ukraine—culminating in supplies being cut off—led to global shortages, and natural gas prices rocketed across the world. The heady days of the 1990s, with deals very favorable to the West and the promise of boundless energy supplies to replace the West’s declining sources, seem a long time ago.

The years since Ronald Reagan admonished Soviet President Mikhail Gorbachev to “tear down this wall” have been downright demeaning for Russia, a proud country with a proud history. The 1992 “100-day transformation” from state centralism to capitalism did not get anywhere near delivering the liberated economy promised. The “redistribution” of national assets quickly became looting, with political and business cronies enriched at the expense of the state and its people. Gangsters and “biznyesmen” sorted out their differences with gunfire and assassination: it was more Deadwood than Dallas, as the Great Bear tumbled toward becoming a gangster state.

Hedge fund and investor Hermitage Capital Management estimates that between 1997 and 2001, Gazprom, Russia’s state-controlled gas monopoly, lost 10 percent of its gas reserves (equivalent to Exxon’s entire reserves at the time) through share dilution to partners in various joint ventures. Over seven years from 1996, it estimates that Gazprom gave distribution company Itera half the earnings from gas markets in Turkmenistan, Ukraine, and other former Soviet states. A country that was a superpower less than 20 years ago today has an economy not much bigger than Denmark’s, but that state of affairs is being reversed. Russian President Vladimir Putin wants both to secure the country’s borders and to rebuild its global standing. He’s using Gazprom as a means to do it.

“The primary question is: how far do Putin’s ambitions go?” asks Jan Randolph, an economist specializing in Russia with Global Insight, which supplies economic and political intelligence and analysis to a client list that includes governments and global corporations like Shell.

“Our goal is to make Gazprom a strong international player that honors contract commitments and is respected worldwide,” Victor Khristenko, Russian Minister of Industry & Energy, said recently. During his December “goodwill tour” of the US, Alexander Medvedev, deputy chairman of Gazprom’s management committee, observed, “Seven years ago [Gazprom] had a $20 billion capitalization; today it is ten times more. We don’t have any problems raising money for our projects. We are introducing modern marketing techniques, project management, and not everybody likes it because it’s competition.” Medvedev is a likely candidate to replace Putin, and Putin is expected to take on the chairmanship of Gazprom.

However, while Medvedev on his goodwill tour decried “lingering suspicion from the Cold War,” former KGB agent Alexander Litvinenko lay dying in a hospital bed in London, the victim of poisoning by radioactive polonium-210. His colleague, dissident journalist Anna Politkovskaya, lay dead in Moscow with three bullets in her. “In America, investigative reporters win Pulitzer Prizes; in Russia, they are murdered,” said Randolph. Right or wrong, both deaths are viewed as contract killings reminiscent of the Brezhnev years. Medvedev found his message of transparency and goodwill a tough sell in the US.

“When Putin took the helm he was very much aware of the popular disquiet over the sale of the Soviet Russian ‘crown jewels’—oil and gas—and the way it was done,” said Randolph. “He’s trying to recapture the crown jewels to bolster the Russian state. He’s trying to establish law and order and, maybe, trying to re-establish the ‘Imperial crown.’ Russia is insecure about the loss of its empire. It was said of Britain after the Second World War that it had ‘lost an empire and not yet found a role’; the same can be said of Russia. It’s finding its role difficult to come to terms with.”

Oil and gas prices have risen, and Russia is probably now richer than it’s ever been; but some may not like the way Putin is going about recapturing the state’s assets. Take a tale of two oligarchs, Roman Abramovitch and Mikhail Kordokovsky. The former is hugely rich, owns Chelsea FC (a very successful English soccer team) and a yacht that dominates the skyline wherever it goes. He pays his taxes, has invested in the health and education infrastructure of Manchuria (where he is governor), and presents himself as “a humble servant of the state,” according to Randolph. Kordokovsky is in jail; his company, Yukos, has been driven into bankruptcy through huge tax demands; its assets have been confiscated and now form part of Gazprom. Very few corporations or individuals enjoy paying taxes, but it would appear that Kordokovsky went too far.

“Kordokovsky crossed the line by becoming political—he was funding opposition groups,” said Randolph. “That’s part of why they came after him.” The state’s powers in areas like the environment are being used to reverse or renegotiate exploration contracts such as Sakhalin II, the oil and gas field in the western Pacific.

“The initial production share agreement of 1995 was very favorable to Shell. The first call on revenues was to be the reimbursement of all production costs,” Randolph said. “Putin successfully threw in environmental breaches and threatened massive penalties, which would have run the project into the ground.” While other shareholders sold up, Shell—which badly needs large, proven oil and gas reserves—took a different route. “The environmental penalties were the way for Gazprom to get 50 percent plus one vote—majority control. Shell decided it’s better to share ownership on a project that is moving, rather than have full ownership of something that isn’t, so it renegotiated.” While the European Bank for Reconstruction and Development (EBRD) didn’t like this de facto nationalization and was reported by the UK’s Sunday Telegraph newspaper (12/31/2006) to be reconsidering loans of around $800 million it had been negotiating, the reality is that Shell would likely have gained nothing by trying to resist the Russian government’s claims through legal means.

“In Russia, no foreign company has ever won a case in the courts,” said Randolph. “Business wants a predictable environment, where contracts are honored and you get a fair hearing if you have to go to court. It expects the state to set rules but not to jump in, change the rules, and effectively act above the law. The Russian state doesn’t yet seem to understand that, if it wants to foster growth and economic development to allow the private sector to grow, it has to provide a stable business environment.” But this doesn’t mean that foreign participants in all sectors of the economy risk being stripped of assets. Russia recognizes the need for sectors like services, retail, banking, and activities like parts supply to grow and doesn’t regard them as strategic. But it’s not very good at encouraging the infrastructure.

“Putin recently made a statement about the need to diversify the economy, but Russia’s banking system is still 10 to 15 years behind the former Soviet European states,” said Randolph. “It has yet to create the rich mix of SMEs, who build and trade with each other and have the banking business to serve them.”

Russia has not reverted to Soviet-era command economics. It’s less Brezhnev and more like 1960s and ’70s Europe, with large publicly- owned corporations in the commanding heights of the economy—steel, energy, auto, and telecom-munications. Politics is never far in the background—as Lenin said, “politics is concentrated economics”—but neither Gazprom nor Transneft, the oil company at the heart of the recent Belarus crisis, is as inefficient as British Rail or the pre-privatization French aerospace. The private sector is especially strong in retail, in services—especially to the energy sector—and there are opportunities elsewhere. NCR has established a plant in Hungary to make ATMs for Russia; secure printer and cash handler De La Rue now has its largest cash-handling machine manufacturing plant near Moscow.

“The decision is both cost- and market-driven,” said Peter Daley, operations director for De La Rue’s cash-processing solutions, with particular responsibility for medium-speed sorters. “Russia is one of our biggest markets, and we opted to move production there because of labor, space, and utilities costs. It has a widely spread network of cash-handling facilities—in a country that size, it doesn’t make sense for cash to be sent to central handling areas all the time.”

The US Department of Commerce issues guidance to companies thinking of trading overseas. It doesn’t get anywhere near saying, “Don’t go there,” but it does highlight challenges.

“There is a lot of attention being paid to the exploration and production side of energy, and it’s rightfully causing a lot of concern,” said David S. Bohigian, Assistant Secretary for Market Access and Compliance. “It raises a lot of questions about the reliability of state-owned Russian companies, especially where there are requirements for a lot of capital. There is cause to think twice.”

But in general, Bohigian sees a lot of opportunities in Russia. “US exports continue to be up 20 to 25 percent year-on-year. Direct investments in the first three quarters of 2006 were significantly higher than 2005, and energy-led GDP growth in the country does seem to be trickling down to the rest of the economy.” So, not all bad news then. “While some large-scale companies aren’t making decisions in ways we would like, there are real opportunities in the consumer goods sector, from cosmetics through processed foods to toys and games.

“In certain sectors which Russia sees as more strategic, policy makes it more difficult for investment. It’s less so in the consumer sector, and there are a lot of gray areas in between. The cost of doing business is higher, but there are opportunities.” However, the law remains an area of concern.

“There are problems at the borders, in getting in goods that are declared as ‘undesirable’ by various organizations,” said Bohigian. “In commercial law, IP [intellectual property] protection and access measures need to be improved, and barriers need to be reduced. There are enough petrodollars floating around that the country isn’t feeling the opportunity cost of corruption and inefficiency. Many Russians are doing better than ever before, but they’re still missing how much better they could be doing if the bureaucracy were streamlined and the judiciary were more dependable.”

Russia is able to get away with a lot of things that wouldn’t be possible if the energy price wasn’t so high, but it doesn’t want to be—and it is undesirable for it to be—simply a long-term energy exporter. It will need friends in the future and may not be going about getting them in the right way.

“Russia needs to look beyond volatility in the energy sector, to develop long-term sustainability,” said Bohigian. “The market will not consider it a reliable partner if it behaves differently when prices are high than when they were low. It would be silly of it not to maximize its potential from energy, but it should use the opportunity of high energy prices to develop a stable economy and establish the rule of law. But is it using them as the means to paper over cracks in the rest of the economy?” Russia has a very well educated workforce; education has been a consistent theme through the Soviet era all the way up to today. The potential tragedy is that they work their backs off to raise money they then use to enable emigration to the West.

“There is a need to invest in the workforce, to continue to attract capital. It should invest in healthcare and in protecting IP in a way people around the world would recognize,” Bohigian said. “Comparisons to the Brezhnev era do make some sense—and a lot of people are nostalgic for the stability of that time—but Russia today has a much more open economy; it’s more competitive and more stable. We’re telling our people, ‘this is a place to do business prudently.’ Do not suspend due diligence; it’s an emerging market. It’s difficult to say, ‘avoid certain areas completely.’ There are opportunities for technical services in oil and gas, and even in sensitive areas like aerospace. When deploying capital, 30-year volatility in trust and the rule of law raises the cost of doing business.” So tread carefully, and carry a return plane ticket.

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