Feature

Reforming Russia’s Tycoons

Something happened on the way to the fire sale of Russia's vast natural resources. In the wake of the Soviet collapse, new Russian conglomerates -- not bigger, more experienced Western firms -- unexpectedly came out on top. Now Russia's young captains of industry are poised to expand their global reach. But their success depends on how quickly they can abandon the shady business practices on which their empires were built.

In the early 1990s, the South African diamond firm De Beers seemed poised to capitalize on the collapse of the Soviet Union: Russia was the source of a fifth of the world’s diamonds, and now the industry needed investors. So De Beers entered into a joint venture with the largely state-owned Russian firm Alrosa to develop a promising deposit near Arkhangelsk in Russia’s far north. Today, Alrosa is primed to become a global leader in its own right, aggressively seeking funds for the project on its own and having strengthened its market position by modifying the terms of its sales agreements with De Beers.

De Beers is not alone in its disappointment. Many Western firms expected to capitalize on a commodities bonanza in Russian oil, gas, gold, diamonds, aluminum, chrome, and rare earth metals during the 1990s; few actually did. Tales of crime and corruption frightened many in the metals industries, while investors in the oil and gold sectors abandoned projects, wearied by endless negotiations with the government over contract terms and production-sharing agreements. In their stead, new Russian multinational corporations were the big winners in the scramble for post-Soviet natural resources. Even if Western investment in Russia dramatically increases during the next few years, a pattern has been established that will be difficult to change: The ownership of Russia’s assets is likely to stay in Russian hands.

The dominance of Russian firms should have come as no surprise. After all, national elites in most emerging markets have, time and again, ended up in control. Nonetheless, many Westerners expected a different outcome in Russia. The isolation and backwardness of the Soviet economy led them to assume, mistakenly, that the elite who managed it were also backward and incapable of protecting their own interests. The West also underestimated a younger generation of Russian entrepreneurs, all of whom were well educated, and many of whom were well connected. These men knew how the Russian system worked and had more than an inkling of how the global economy functioned, whereas Westerners who came to Russia grasped the latter but failed to develop a no less requisite understanding of local conditions.

In sector after sector, Russian entrepreneurs gained strong footing, using insider know-how to exploit Russian economic reforms and build symbiotic ties with federal and local governments. Indeed, most of these men got control of their most valuable assets by a loans-for-shares scheme through which Boris Yeltsin funded his successful 1996 presidential reelection campaign: Yeltsin offered assets of existing state-owned enterprises at bargain-basement prices in exchange for loans to the Russian government that could be redeemed for further shares. The presidents and parliaments that Russian business executives helped elect created the legal environment that their businesses needed to prosper. Working in collusion, the Yeltsin government and Russian businesses in many cases restricted the playing field for everyone else.

After Vladimir Putin took over the presidency in the last days of 1999, however, the Russian government made important regulatory changes. Now Putin and the country’s most prominent business leaders — men like Vladimir Potanin of Norilsk Nickel or Mikhail Khodorkovsky of Yukos Oil — are most anxious to convince Western investors that the Russian government and business can create a law-abiding market economy that protects foreign capital.

Westerners who return to Russia today will find that conditions have changed since Putin took office. Russia’s tax and legal structures are more business friendly, and Russia’s corporate tax of 24 percent is one of the world’s lowest. Leading Russian firms are moving toward corporate transparency and are trying to observe international accounting standards, pay regular dividends, and protect minority stockholders’ rights. These developments are drawing "big oil" back to Russia, as was demonstrated at a convivial meeting between President Putin and ExxonMobil executive Neil Duffin at the October 2001 Moscow gathering of the World Economic Forum.

As important as the changes in the regulatory framework are for attracting foreign investment, they are equally critical for Russian businesses, which must fund their expansion, both at home and abroad, through planned stock offerings in Western markets. In early 2002, for example, Yukos Oil had a successful stock offering in London.

Russia’s new tycoons are becoming a global presence, increasingly with their government’s encouragement. "The Russian government spent eight of the last ten years criticizing us for our foreign projects, arguing that this very capital should be invested in Russia," said Lukoil CEO Vagit Alekperov in an April 2001 interview with a provincial Russian newspaper. "But for the past two years we sense the support of the Russian leadership, which now understands the importance of creating close economic ties with our nearest neighbors. Economic contact serves to facilitate political ties."

Neither the president nor the country’s richest men could manage without one another. A magnate or two can be knocked off the field without much harm to the economy, but Russia’s economy has shrunk so dramatically from the Cold War days that a handful of men working in concert could wreak havoc. Of course, they have no economic incentive to do so, and thus most are willing to cooperate with the president. Further, Russia’s tycoons generally promote Russian government interests abroad — including giving priority to investment in countries where Moscow has strong strategic interests — in the hope that this will speed up the creation of the domestic political and legal environment necessary for them to retain and expand their assets.

EXECUTIVES VS. EXECUTIVE POWER

But for all their voice, Russian billionaires — and their economic and political opportunities — are still largely shaped by the powers inherent in the Russian presidency. Putin is making the most of his strong hand, carving out his own policy in critical areas of natural-resource development.

Before assuming the presidency at the end of 1999, Putin had already given serious thought to how Russia’s resource interests should be managed. While preparing his doctoral dissertation at the St. Petersburg Mining Institute in the mid-1990s, he extensively researched the development of Russia’s natural resources [see sidebar, page 73]. Putin concluded that Russia must turn to market forces to develop processing industries based on its enormous extractive capacity. Putin advocated reconstructing Russia’s natural-resource industries, providing state support for "large financial and industrial intersectoral corporations that could compete with transnational companies of the West." But he also recognized that the state lacked the necessary resources for investment, and so private capital — some of which had to come from abroad — was needed to fill the void. Russian firms therefore also needed a legal infrastructure to encourage their economic efficiency and global competitiveness. Putin’s statements were unexpected and dramatic in the context of Russian politics in the late 1990s (when communists and nationalists were both fighting to keep Russian resources in Russian hands) especially coming from a lifelong member of the Soviet security forces who was entering politics with the support of nationalists.

Putin believed that the only way for Russia to raise the necessary capital was to open bidding on Russia’s natural resources to all comers, though it was likely plenty would stick to Russian business because of the vast scale of what Russia had to sell. Putin had a stint on Yeltsin’s presidential staff in which he was charged with tracking down Russia’s foreign holdings, finding where they were and how much they were worth. And he headed the Federal Security Service, successor to the kgb. In both posts, Putin had access to detailed knowledge of just what would be on offer.

During the first years of the Putin presidency, much of the legislation he wanted has been passed, the most important being a new tax code and amended laws governing the awarding of licenses for natural-resource development. Restrictive laws on the export of gold and precious gems are being rewritten. Property rights have also been shored up through legislation on landownership. Putin is making it easier to secure production-sharing agreements, which allow developers to negotiate tax holidays and discounted royalty rates after they receive licenses for developing state assets. Putin also promises to break up existing government monopolies in natural resources. He already faced down the Communist Party bosses that ran the gas monolith Gazprom — who many thought were siphoning off revenues for personal gain — and appointed his own man to head it, Alexei Miller.

Putin’s campaign to regularize government oversight of business has been used to strip assets from those whose ambitions have clashed with his own, as in the cases of media magnates Boris Berezovsky and Vladimir Gusinsky. But he has simultaneously forged close ties with others. New tycoons such as Yukos Oil’s Khodorkovsky, Norilsk Nickel’s Potanin, and Russian Aluminum head Oleg Deripaska have all been named to the executive committee of the Union of Industrialists and Entrepreneurs, which provides them further opportunity for regular contact with President Putin. But they are not always happy with the results and still feel vulnerable to arbitrary exercises of executive power.

Some of the country’s leading corporate magnates have nonetheless been able to use Putin’s political reforms to their own advantage. When the Russian Federation began requiring businesses to pay taxes where their facilities were located rather than through the localities of their corporate headquarters, a fundamentally new relationship was introduced between business and local politics. Giant Soviet factories always fed the communities in which they were located, with the enterprise owning most of the workers’ housing and paying for local schools and hospitals. In one sense, privatization allowed companies to divest themselves of these burdens; in another sense, they reinherited them through the redefined tax code.

This reform has pushed many firms’ senior management to run for local elective office. In 2001, Yukos Vice President Boris Zolotarev was chosen governor of the Evenkia District, Norilsk Nickel General Manager Aleksandr Khloponin was elected governor of the Taimyr Autonomous Region, and a few months later, Russia’s leading gold magnate, Hazret Sovmen, became head of the Adyghea Republic. Billionaire Roman Abramovich, former Berezovsky business partner and head of the Sibneft oil firm, became head of the Chukotka Autonomous Region, earning high marks from local residents for how he uses the region’s revenue, which is largely drawn from the income tax he pays in. The new Federation Council, one of two Russian legislative bodies, is now made up of local governors’ appointees, rather than the governors themselves, and consequently includes a number of corporate executives who have taken "leave" in order to serve.

At this point, it is not easy to tell whether Western or Russian firms will benefit most from Putin’s reforms, but Russia’s new tycoons hope everyone will profit from them. As long as Putin keeps the playing field level, Russia’s leading businessmen see Western investment as raising investor confidence and increasing the share value of the assets they already control.

It is hard to know both when and how much money will come into Russia, from either Western investment or the return of flight capital. Although Western institutional investors are returning to the Russian market, those interested in investing private capital are still mostly window-shopping. Yet Moscow trumpets ExxonMobil’s decision to reinvigorate its stalled project to develop Sakhalin Island oil and gas reserves as a sign of renewed investor confidence in Russia and a harbinger of much more to come — especially in Russia’s oil industry, whose importance has increased since September 11 and the ensuing war on terrorism. Putin has appointed people like Minister of Natural Resources Vitaly Artyukhov, who promises that remaining state-owned Russian assets will be auctioned to the highest cash bidder — a policy that, if implemented, would put Western firms on equal footing with Russian ones. What Russians and foreigners both want is for Putin to elaborate a clear policy for granting and rescinding resource development licenses, to enshrine this policy in law, and to further simplify the tax structure.

The question is not whether there will be substantial new investment in Russia’s natural resources, but rather when and by whom. While the government’s recent moves raise the potential for more international involvement, much of the turf has been claimed by Russian companies now operating in the oil and gas sector, by reorganized state diamond firm Alrosa, by redefined Soviet cartels in the gold industry, and by a bunch of brash young traders and bankers in nonferrous metallurgy. All of these firms’ top executives have the advantage of being insiders with close ties to local government, and their businesses have the potential for international expansion.

OILGARCHS

In the increasingly competitive global oil market, where Western firms are consolidating to cut costs and increase efficiency, new Russian firms are emerging. Yukos’s Khodorkovsky has said that he expects two of Russia’s leading oil firms to become major multinational companies in the next decade, and that he plans for Yukos to be one of them. Most industry insiders expect that Lukoil will be the other.

Control of Russian oil is a great prize. With more than 7 million barrels of oil gushing from its wells each day, Russia is the world’s second largest oil producer, and its proven reserves constitute 4.6 percent of the world total. (In comparison, Kazakhstan, Turkmenistan, and Azerbaijan’s combined proven reserves come to 1.6 percent.) Russian oil accounts for one quarter of the oil imported into Western Europe. The region also depends heavily on Russian gas, with some states relying exclusively on Russian supplies. Russian oil also has a ready-made market in Asia, and during the next decade Russia should become a dominating force in the Far East as well.

The Russian government has long counted on Western investment to help develop some of its richest and most difficult-to-extract deposits. In 1975, the Japanese government began negotiating for development rights on Sakhalin Island, and a decade later Soviet leader Mikhail Gorbachev greatly expanded what was on offer by adding valuable fields near the Arctic Circle and the giant Tengiz field in Kazakhstan. But today, Russian companies are poised to develop these assets as well, and they can leverage their position in Russia’s internal market, where profit margins are too low to attract Western firms. A 1992 presidential decree created the first vertically integrated oil companies to unite all aspects of production, four of which — Lukoil, Yukos, tnk, and Surgutneftegaz — have promising futures.

Lukoil, headed by Soviet oil executive Vagit Alekperov, was the first. The company is still something of a hybrid — a state asset that management and workers partially privatized and whose shares are traded internationally. Its vast assets immediately made it one of the world’s largest oil companies, although its size has made introducing Western management practices more challenging. Lukoil operates in more than 20 countries, and it gained 1,300 gas stations in the United States when it bought Getty Oil in 2000. About one third of Lukoil’s reserves are outside Russia.

Khordorkovsky, former Young Communist leader and now multibillionaire banker, bought a 45 percent share of Lukoil’s main competition, Yukos, for a mere $159 million in 1995 as part of the loans-for-shares scheme. Yukos’s stock doubled in value between 2000 and 2001, and Khodorkovsky is negotiating to acquire additional assets throughout Europe. Yukos’s most ambitious plan is a project with the Chinese National Petroleum Company, which calls for the construction of a $1.7 billion pipeline from fields in eastern Siberia. The company is likely soon to surpass Lukoil in the size of its oil reserves, and the value of its assets already exceeds that of its main Russian rival.

A Western investor may eventually run another large Russian oil company, tnk, because the Alfa Group, which owns the controlling interest, has made most of its fortune by turning around unprofitable Russian assets and selling them to foreigners. Alfa Group founder Mikhail Fridman promoted American "know-how" early on, hiring Russian émigrés educated in the West and with experience in Western oil companies. tnk was quick to hire Western management, though Yukos and Lukoil now also have some senior management recruited from the oil "majors," and Yukos’s board of directors includes several foreigners.

Surgutneftegaz, whose assets may soon exceed those of tnk, is a former state enterprise whose workforce and management bought controlling interest for only $88 million. The company has yet to begin major foreign operations, although many industry insiders report that it is the best run and most transparent of all the Russian oil firms and will make an increasingly formidable competitor.

Today, Western firms have been granted production-sharing agreements for three projects, including the ExxonMobil Sakhalin project. Before British Petroleum merged with Amoco in 1998, bp bought a 10 percent share of Russia’s Sidanco oil for $571 million in 1997, which only qualified as a potentially workable asset in 2001, when a fight over the controlling interest in the project between Vladimir Potanin and Mikhail Fridman’s Alfa Group was settled by the latter buying out the former’s stake. Many other Western firms’ projects have had even more inauspicious histories, and some have failed entirely.

But the size of the prize makes it difficult for most Western firms to turn their backs on Russian oil. In 1999, Sidanco had been crippled by the loss of the Chernogorneft refinery, acquired by Alfa’s tnk in a controversial bankruptcy auction. Although undoubtedly angered by the experience with Sidanco and tnk, the bp Amoco executives kept silent and let the British and U.S. governments lobby on the company’s behalf. Now they are eagerly partnering with tnk, which they had been suing only a few years before.

THE GAS GIANT

No other country has a larger share of global gas reserves than Russia, with 32.1 percent of the world’s proven assets. Russian firms accounted for about one third of global gas exports in 2000. Russian gas is the major supplier in the European market, and sales to Turkey and Asia are expected to increase.

Although two exclusively state-owned oil firms still remain, the privatization of Russia’s oil industry has proceeded much further than that of its gas industry, which is largely controlled by Gazprom, in which the Russian government still holds 38 percent of the shares. Minister of Natural Gas Viktor Chernomyrdin was initially chosen to head the company, which cemented its privileged position with the government when Chernomyrdin was named prime minister three years later in 1992.

Yet Gazprom, with its archaic structure and many deadbeat industrial and municipal customers, has never shown the profits many thought it should have. Rumors of Gazprom management shifting assets from profitable to unprofitable ventures to camouflage profit skimming by its management circulated frequently. Gazprom CEO Rem Vyakhirev had an estimated net worth of $1.5 billion when he was removed in 2001 in a board vote orchestrated by President Putin. And despite the fact that Chernomyrdin formally owns no Gazprom stock, his net worth (excluding the assets of his children) is estimated at $1.1 billion. Alexei Miller was subsequently charged with investigating what went on in this exceedingly nontransparent firm and has tried to rein in assets gone astray. The first target was the management of Gazprom subsidiary Sibur (Siberian-Ural Petrochemical and Gas), whose CEO was jailed in early 2002 for illegally transferring company assets.

Gazprom has spawned highly profitable daughter companies, including the construction company Stroitransgaz. The privately held Itera, which took over providing Turkmenian gas to former Gazprom customers in the former Soviet Union and now has 130 subsidiaries in 24 countries, also traces its origin to the Soviet gas industry.

Itera and Gazprom will likely become greater rivals should Putin, as expected, break Gazprom into privately held companies. It is rumored that Gazprom will maintain control of the gas pipeline system, just as the still state-owned Transneft dominates the oil pipelines. But Gazprom’s executives want a much greater role. The company has a strategic partnership with the Royal Dutch/Shell Group and is in negotiations with bp for joint development of the giant Kovytka gas field. Most foreign investors will remain wary of the lucrative Russian market until the reorganization of the gas industry begins in earnest. But by then, they will have to compete with Russia’s new oil giants.

SCARY HEAVY METAL

The Russian metal industries have been the most difficult for foreign investors. On the one hand, valuable assets are at stake. Russia is the world’s largest nickel producer, second largest aluminum producer, and has about 10 percent of the world’s copper reserves. On the other hand, Western firms would have to cozy up to some shady characters to get near those assets.

Traders with alleged ties to organized crime, as well as Soviet-era managers and former security officers who controlled the processing facilities, quickly bought up contracts for Russia’s metal stockpiles in the 1990s. Take the case of Russian Aluminum, which accounts for more than 70 percent of Russia’s aluminum output. Run by Oleg Deripaska, the company was erected on the foundation of Trans World Metals, a trading company that achieved notoriety in the mid-1990s for its reputed organized-crime connections. In a U.S. district court, a former Russian colleague accused Deripaska of bribery, racketeering, and ordering murders.

The rumors surrounding Russia’s aluminum industry have been enough to scare off leading Western firms. Former Trans World Group principal Lev Chernoy, now a stockholder in Russian Aluminum, argued unabashedly in a June 2000 Fortune magazine article that foreign investors shouldn’t have expected better treatment. "Very often the most likely to succeed in these stormy oceans are not the picture-perfect, clean-shaved, deep-tanned, well-built, and fashionably-attired yachtsmen under the immaculate white sails but unpleasant-looking ugly skippers in command of a pirate ship," Chernoy said. "One should not be appalled. These are the laws of initial capital acquisition, applicable everywhere."

Deripaska is nonetheless determined to make his enterprise a model Russian company. He brought on former Finance Minister Aleksandr Livshits, hired Western accountants, is diversifying company holdings, and is preparing for a stock offering in late 2002. Key to his plans is a steady supply of cheap energy, which he now lacks.

While its corporate history is by no means as colorful, the privatization of Norilsk Nickel, which has more than $2.5 billion in annual sales, was a far more important project. Created out of six metallurgical facilities, the company accounts for sizable shares of world markets in copper, cobalt, nickel, platinum, rhodium, and palladium. Former Soviet trade official Vladimir Potanin bought a 38 percent share for only $170 million through the loans-for-shares program in 1995. In fact, Potanin is said to have dreamed up the program to facilitate his purchase of Norilsk during his tenure as deputy prime minister in the Yeltsin administration.

THE HARDEST MARKETS

During the Soviet era, gold and diamonds were controlled especially tightly by the state, and the Russian government is still actively engaged in both sectors. Russia is the world’s third largest diamond producer and has about 6 percent of the world’s gold reserves, including one of the world’s largest untapped deposits, the 1,100-ton Sukhoi Log. Despite recent steps to deregulate the gold market, foreign investors have found it tough going, with only three deposits declared eligible for production-sharing agreements. Although Putin has promised change, many of those close to him are anxious that Russian firms develop the country’s most attractive deposits at home. Canadian firms have shown considerable interest in Sukhoi Log, as has the Russian firm Polyus, which already has a valuable asset in the Olimpiad mine in the Siberian city of Krasnoyarsk, which was developed with a 1994 loan guaranteed by the provincial governor.

From its founding in 1992 until 2002, leading diamond firm Alrosa was run by Vyacheslav Shtyrov, a former high-level Communist Party official who this year became president of Sakha Republic and turned the company over to a former deputy. Alrosa would like to expand its $1.6 billion in annual business both by adding Russian projects and expanding abroad. It is rumored to be interested in mining in Antarctica, which is currently prohibited, and to be scouting projects in Angola, Namibia, and South Africa.

Alrosa already holds equal shares with the Angolan government in the Catoca mine in eastern Angola, while an Uzbekistan-born Israeli with close contacts in the Russian government, Lev Leviev, holds the remaining 18 percent.

IMAGE IS EVERYTHING

Russia’s leading magnates are expanding their holdings rapidly, but their long-term future is not guaranteed. All are still subject to some risk should their executives fall into government disfavor. All are still, to varying degrees, undercapitalized, and all are pushing into Western markets, both to gain the capital necessary for expanding and modernizing production and to get the measure of protection that large foreign institutional investors can give them. Because of these firms’ vulnerabilities and the fact that important assets have not yet been sold — for example, the Rosneft and Zarubezhneft oil firms — the landscape could still change.

Russia’s biggest capitalists are already acting like global titans, setting up large charitable foundations at home and becoming international philanthropists as well. Potanin has given so much to facilitate a partnership between Russia’s State Hermitage Museum and the Guggenheim that he was elected to the latter’s board of directors in 2002, while Khodorkovsky has endowed a permanent exhibit of Russian art at London’s Somerset House.

But it will take more than cash donations to purchase respectability for Russia’s corporate giants. Many in the West had great but unrealistic expectations that the distribution of state assets in Russia would proceed equitably. They were encouraged by young Russian reformers who monitored developments in the fledgling free press and more extensively publicized the abuses of Russian privatization than has been typical in other emerging markets.

Consequently, Western investors are now likely to hold Russia’s new tycoons to higher standards than the nouveau riche of other developing economies. For what the Russians see as cleverness, others see as theft, whether it be charges of racketeering in the metals industries or in the ease with which Russians walked away from corporate debts owed to Western banks in the aftermath of the August 1998 Russian meltdown.

They will have to do rather than just say. Russian companies must adopt Western corporate management models, foster transparency, and bring in Western accounting firms to convince Western investors that shareholder rights are sufficiently protected. One thing that remains troubling is that while economic conditions in Russia have improved, capital flight remains a persistent problem. If Russians are afraid to invest in their own economy, despite all its lucrative potential, why should Westerners believe their investments will be secure? If the new Russian multinationals are to go fully global, then they and the Russian government will have to convince potential investors that there is a system of checks and balances between the government and business. Neither has yet fully demonstrated a commitment to economic transparency and to a legal system that will protect property rights, regardless of whether the owner is a Russian business leader or a Western executive.

Everyone benefits if the Russian government and the new Russian multinationals work by example to restore investor confidence. Putin has been lobbying his fellow G-8 leaders and others to recognize Russia as a market economy and speed the country’s entry into the World Trade Organization. Putin and his country’s business leaders see Russia as more than just another emerging market — it is a former superpower bent on using its vast natural resources to secure economic recovery and restore international influence.

The proof will come from Russian behavior, and Russia’s new tycoons will set the pattern. The men atop Russia’s new multinationals maintain that they have grown beyond their sometimes inauspicious commercial beginnings. The next few years will determine whether Russia’s new top dogs can master some old tricks and play by today’s rules of free trade.

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