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Misreading the Kremlin Costs BP Control in Russia Venture

The highest-profile joint venture between Russian and foreign investors, oil producer TNK-BP Ltd., is about to get a new chief executive. It has been anything but a smooth transition.

[Tony Hayward]

Key Players and Timeline of a Tangled Alliance

A look at the Russian oligarchs, the Putin confidant and the Western oil executives at the center of the TNK-BP alliance and how it when from dream to nightmare.

Executives at BP PLC thought they were onto a Russian oil jackpot. Already the country’s biggest foreign players thanks to a lucrative 2003 deal that created TNK-BP, the British company’s prospects broadened in 2007 when state oil giant OAO Gazprom signaled its interest in forming an unprecedented partnership.

What followed, though, was a series of miscalculations and missed signals that leaves BP’s position in Russia shakier. The Gazprom deal is now all but dead. BP, meanwhile, was forced to give up substantial control over TNK-BP, whose BP-backed CEO fled Russia. A replacement is expected to be named as soon as this week — this time with links to the Russian partners.

BP thought it understood the Kremlin’s latest tacit rules: Foreign investors were welcome — but only as minority owners with control preferably in the hands of big state companies. In that environment, BP’s 50-50 partnership with a group of Soviet-born billionaires looked like an anachronism.

BP assumed that a deal with Gazprom, considered the most powerful of Russia’s state companies, would cement its position as the dominant foreign player in Russian oil. It also hoped such a deal would secure the future of TNK-BP Ltd., its existing venture, since Gazprom indicated it might buy out the so-called oligarchs who owned the other half of the operation.

Things didn’t turn out the way BP expected. Instead, Gazprom suddenly proved unable to close the deal. As for the Kremlin, it stood by as the oligarchs snatched substantial control of TNK-BP.

Officials at BP are still trying to figure out what went awry. Based on interviews with more than a dozen participants on both sides of the drama, a few lessons are clear.

Landov

BP joined with Russian oligarchs to create TNK-BP, a top foreign player in that nation’s oil industry. The Saratov Refinery, above, is a subsidiary.

tnk-bp

tnk-bp

BP’s travails highlight how difficult it is even for well-connected outsiders to read the shifting winds of factional politics inside the Kremlin, which continue despite the dramatic centralization of power that’s taken place under Vladimir Putin. The task has become even harder in recent months as the global financial crisis puts the secretive Putin system under intense stress.

The U.K. company bet heavily on Gazprom, which suffered from a politicized management that had failed to complete big foreign deals in the past. BP also underestimated its Russian partners in the TNK-BP venture, and misread the murky, shifting alliances within the Kremlin itself.

“They were talking to the wrong people,” said one person close to the situation. People familiar with the matter say BP should have cast a wider net — and involved its Russian partners — as it sought to confirm Kremlin support for the Gazprom proposal.

A BP spokesman declined to comment for this article, saying that BP is looking forward to TNK-BP’s continued success.

People close to BP point out that the outcome, which allows it to retain its 50% stake in TNK-BP, isn’t all bad. The British giant has won some public praise from Mr. Putin and still commands a far larger presence in the Russian oil industry than any competitors. Ceding some management control to the Russian partners could prove an advantage for BP as the oil industry grinds through a rough patch of plunging prices.

An early investor in Russia, BP has seen first-hand the dramatic shifts in the business environment over the past two decades. In the late 1990s, BP nearly lost its $500 million investment when the oligarchs took advantage of Russia’s weak courts to seize the assets of a BP-owned company.

But after Mr. Putin came to power in 2000 and began reasserting Kremlin authority, the same oligarchs came to BP looking for a deal they hoped would protect them from rising government pressure — the sort that later led to the partial nationalization of oil giant OAO Yukos. In 2003, BP swallowed its reservations about the oligarchs and it paid $7.6 billion for its 50% share in the new entity, TNK-BP, and installed a former BP executive, Robert Dudley, as CEO.

Mr. Putin personally approved the deal, presiding over its signing in 2003. Still, the 50-50 structure looked increasingly out of place as the Kremlin began retaking control of the strategic oil sector in the years that followed. Foreign companies were relegated to minority stakes. Facing a wave of regulatory pressure, for example, Royal Dutch Shell PLC in late 2006 ceded control of a $22 billion gas project to Gazprom.

BP read the tea leaves, and quietly began looking for signs that it would be the next to get a Kremlin-backed partner.

Relations inside TNK-BP were tempestuous from the start. The billionaire shareholders, known as AAR for the initials of their companies — Alfa Group, where Mikhail Fridman is the largest shareholder, Len Blavatnik’s Access Industries and Viktor Vekselberg’s Renova — had built their fortunes in the chaotic 1990s. They frequently clashed with BP’s buttoned-down, bureaucratic culture.

When Gazprom started pushing for a broad deal with BP in the summer of 2007, the British company assumed that the Kremlin had blessed the potential union.

No other Russian company enjoyed such close Kremlin ties. Mr. Putin knew chapter and verse of its operations and finances. The chairman of Gazprom’s board was Dmitry Medvedev, then a top government official and soon to be tapped to replace Mr. Putin as president.

With its long history in Russia, BP had some of the best top-level contacts of any foreign oil company, industry officials say. In meetings with Mr. Putin and other top Russian officials, the response was vague but generally positive. BP executives were encouraged, but didn’t press for any promises.

The proposed deal seemed to fit both sides’ interests. Having long coveted global reach, Gazprom wanted stakes in big BP projects overseas. Political opposition in the West had stymied most of the Russian company’s expansion efforts. An alliance with BP, however, stood to make Gazprom a much more palatable player. In return, Gazprom would contribute, among other assets, a large stake in its oil unit. Combined with TNK-BP, it would become Russia’s biggest oil producer.

[TNK-BP]Landov 

TNK-BP’s Saratov Refinery, one of Russia’s oldest, employs 1,600 people.

A Gazprom spokesman denied the company had discussions on buying AAR’s stake, declining to comment on detailed questions for this article.

BP Chief Executive Tony Hayward traveled repeatedly to Moscow in late 2007 to meet with Gazprom CEO Alexei Miller. Extremely bureaucratic, Gazprom was riven by fiefdoms that made even simple deals very difficult to complete, according to people who’ve dealt with the company. But Mr. Hayward wasn’t deterred.

BP officials figured that with Gazprom and the Kremlin behind their plan, getting the AAR oligarchs to sell out wouldn’t be much of a problem. Though tycoons had once been the main gatekeepers for foreign oil companies seeking to buy Russian assets, their influence had waned under Mr. Putin.

BP had often clashed with the AAR partners — especially German Khan, an Alfa shareholder who was also a top manager in TNK-BP. But the two sides had usually managed to resolve their differences. The British company made it clear to Gazprom that while it wasn’t looking to push AAR out, it wouldn’t object if the Kremlin wanted them replaced.

“Gazprom’s response was always, ‘Don’t worry, they want to sell,’ ” said one person close to the British company. But the AAR partners insisted they weren’t looking for an exit, leaving BP a in a bind over how much to tell them about the Gazprom talks.

Mr. Hayward delegated much of the handling of TNK-BP and the relationship with the Russian partners to James Dupree, the head of Russia and Kazakhstan for BP. He knew the business well, having worked as a senior TNK-BP executive. But that history also complicated relations in his new role, since he’d been formally a subordinate to some of the Russian shareholders, who also held management jobs.

“Dupree was a midlevel functionary who wasn’t senior enough to make any decisions,” said one person close to AAR. BP officials acknowledge they mishandled the relationship. A spokesman said Mr. Dupree wasn’t available for comment.

Though BP and Gazprom never spoke publicly about the substance of their discussions, the Russian shareholders said they knew of the talks from early on. And they weren’t happy at what they saw as BP trying to sell their stake for them.

“We know what they’re talking about with Gazprom….This is Russia,” Mr. Fridman said in an interview earlier this year.

Still, the billionaires weren’t feeling any significant pressure to sell and had had only very vague hints about interest from Gazprom, according to government officials and people close to them.

“They can make us an offer we can’t refuse, but we haven’t seen anything like that,” one person close to AAR said in late 2007.

Seeking to increase its leverage, AAR began stepping up the pressure inside TNK-BP, lobbying to remove Mr. Dudley and blocking board approval of TNK-BP’s business plan for 2008.

BP remained convinced it could handle the problems, brushing off informal offers of help from British officials early this year. But it missed some early signs that Gazprom’s legendary clout might not be so effective.

In April, Mr. Hayward visited Igor Sechin, a powerful Putin confidant. According to people familiar with the meeting, Mr. Hayward laid out BP’s efforts to reach a deal with Gazprom.

Mr. Sechin was in an interesting position: He also serves as chairman of state oil company Rosneft, and is generally opposed to further expansion of Gazprom, especially into the oil business, say several people who’ve discussed these issues with him.

Mr. Sechin offered support, but noted that Gazprom hadn’t always been able to deliver on its ambitions for making major international deals, according to people briefed on the conversation. Mr. Hayward didn’t make much of the comment, according to people close to him. But some of BP’s Russia veterans saw a clear signal.

“That was Sechin’s way of telling you, ‘I’m not going to allow that,’ ” said one. Through a spokesman, Mr. Hayward declined to comment. A spokesman for Mr. Sechin didn’t respond to requests for comment.

About that time, the pressure inside TNK-BP jumped sharply. Within weeks, dozens of BP specialists assigned to TNK-BP were forced out by Siberian court order. Labor and other inspectors deluged the company with audits that would ultimately lead to Mr. Dudley’s disqualification by a Moscow court.

BP officials, as well as a number of others close to the situation, suspected AAR was behind the efforts. AAR denied this.

In May, Mr. Hayward met with a former Kremlin official, who told him that BP’s discussions over AAR’s head with Gazprom were “indecent.” He said BP needed to be less confrontational with AAR, whose close ties to the government made it certain to win any fight on its home turf. He also said the Kremlin wasn’t going to force AAR to sell out.

But BP hadn’t given up hope on Gazprom, which seemed to be behind leaks at the time in the Russian press about an impending buyout of AAR’s stake. On May 14, Mr. Hayward met top Gazprom officials at a soccer match in Manchester, expecting to confirm the broad outlines of a deal, according to people close to the talks.

Gazprom was noncommittal, saying the two sides should come back to the discussions in a month or so. BP officials were stunned and angry. A Gazprom spokesman declined to comment on the meeting, but said the company has completed other large foreign deals.

Just why the deal didn’t happen isn’t fully clear. Gazprom seems to have lost some influence in the personnel reshuffle after Mr. Medvedev became president in May and gave up his post as Gazprom chairman. It’s also not clear whether Mr. Putin ever really backed the deal.

Further weakening Gazprom, Mr. Sechin, who had seemed skeptical of BP’s plans with Gazprom in April, was promoted to the post of deputy prime minister in charge of the entire energy sector in May. “The mistake was believing that there was consensus among all the guys that make these decisions,” said one person close to BP.

Its faith in Gazprom shaken, BP in June hoped the Kremlin would come to its aid in the fight with the oligarchs, which had become nasty and public and threatened to hurt TNK-BP’s operations.

At a meeting in Moscow in early June, Mr. Hayward complained angrily to Mr. Sechin about AAR’s pressuring of the company. After the Russian official promptly summoned some of the Russian shareholders and appeared to tell them to lay off, Mr. Hayward came away reassured, according to people close to BP.

BP’s Russia veterans, however, suspected Mr. Sechin’s scolding was little more than a set piece played out for Mr. Hayward.

“There’s a group of people who know what’s going on and know what to expect,” said one person close to BP. “And then there’s the London office.”

Meanwhile, as AAR lambasted BP publicly for mismanaging the venture, the administrative squeeze only tightened.

BP scrambled to come up with a new strategy, preparing lawsuits in Western courts against AAR for violating the TNK-BP shareholders’ agreement. Turning to the government for help, BP asked U.K. Prime Minister Gordon Brown to raise its plight with Mr. Medvedev at a summit in July.

Mr. Hayward also brought in a top troubleshooter with years of Russian experience, Lamar McKay, to take over talks with the AAR partners instead of Mr. Dupree, the executive who had worked for them inside TNK-BP.

Fearing detention, Mr. Dudley fled Russia in secret in late July. BP’s board was meeting the day he left and several directors were stunned when told of the news, according to people close to the company.

Within a few weeks, BP was seeking peace.

“Ultimately, BP caved on all the things AAR wanted,” said a person close to the Russian shareholders.

BP officials dispute that, but admit they conceded on key issues like the ouster of Mr. Dudley and the continued presence of Russian shareholders like Mr. Khan — a longtime rival of Mr. Dudley — in top jobs. With the conflict adding pressure to the swooning stock market, the Kremlin also signaled to both sides it wanted the matter settled.

AAR had largely achieved its goals: quashing a potential Gazprom deal and weakening BP’s control over TNK-BP. By late fall, most of the foreign managers at the company had left. Mr. Khan has moved to expand his control, people close to the company say.

BP “misread the political situation,” said one person close to AAR. “The sun was not setting on the oligarchs. This particular group of oligarchs has a very good relationship with the government.”

Write to Gregory L. White at [email protected] and Guy Chazan at [email protected]

WSJ ARTICLE

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