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Doing Business in Russian Energy

 

Executive summary

This paper analyzes the difficulties that International Oil Companies (IOCs) face in the Russian upstream by focusing on the experience of developing oil and gas resources in the framework of Production Sharing Agreements (PSAs). Thus, it is just as much a paper about the Russian policy towards international business as it is about the experience of major foreign companies in the Russian energy industry. First, the paper tracks the evolution of the general business climate starting from the Soviet period, in which there was virtually no genuine business climate to talk of, until the start of the Medvedev presidency. The economic developments under his administration are given limited space towards the end of the paper in the context of this year’s surge in energy deals. In an effort to establish a baseline for the discussion on the PSAs – to which the core part of the paper is dedicated – the analysis tracks the main differences in economic activity since the collapse of USSR, a period in which there are essentially two very distinct business environments: one associated with the Boris Yeltsin administration, the other – with that of Vladimir Putin. Next, the paper looks at the major issues confronting any foreign investor in this country: positive and negative aspects alike pertaining to legal framework, corruption, perceptions of Russian companies abroad, macroeconomic situation.

Chapter III shifts the focus of the discussion entirely to the energy sector. It outlines the early foreign involvement in the Russian oil industry, places the discussion in the general context of the oil and gas development in Russia, emphasizes the role Western capital and technology had even during the Cold War, and sketches the profile of the two main state owned companies today: Gazprom and Rosneft.

Chapter IV details some key theoretical aspects related to business structures and petroleum fiscal regimes for hydrocarbon development, what are they, how they differ and why do they matter for the foreign investor. Against this bigger picture, the analysis then proceeds to the specifics of the PSA legislation in Russia and current energy taxes.

Chapter V presents the comparative analysis of three Russian PSAs: Sakhalin II, Sakhalin I, and Kharyaga. The fourth existent PSA (Kurmangazy) is not considered since it lacks the participation of an IOC. The analysis per is preceded by a brief discussion on the principles of energy project formation, the steps involved, and the main differences between developing an oil versus a gas project. The comparison is carried out along three key lines: strategic partnering, cost control and project management. The history of JV structuring, milestones in the development of these projects, the main differences and common elements are highlighted and put into a comparative matrix. Despite the differences in location (Sakhalin Island vs. Timan Pechora), nature of the project (oil vs. gas; onshore vs. offshore), scale of the investment, some of the challenges were the same (dealing with the bureaucracy, getting the approvals, threats of revocation, harassment of tax and environmental agencies, etc). Each operator dealt the best it could with the issues that arose. However, these three cases are symbolic for the challenges and the opportunities that await an IOC in Russia. As an American CEO said: “Russia is not an easy country in which to operate. It has a large bureaucracy with its own set of rules and regulations. (…) We find that if you are perceived as a “well intentioned” company in terms of how you treat your people, comply with local and state regulations and meet your social obligations that you can be successful. The key is really

 

 

General post-soviet economic environment

 

The Soviet period

During the Soviet period, all economic activity was strictly controlled: both soviet international trade and investments abroad were part of the state policy and the result of a central planning apparatus, while foreign companies’ activity in the Soviet Union were conducted under the traditional limitations associated with doing business in a closed economy. Since the Soviet Union was a planned economy and it was the period of the Cold War, the few foreign companies doing business in Russia were closely monitored. The ruble was not convertible. In the last years of the Soviet Union, there was however a certain opening of the economy in the context of Mikhail Gorbachev’s policies of glasnosti and perestroika. The soviet citizens were allowed to engage in limited entrepreneurial activity. In 1988, the law on Cooperatives was passed, allowing the managers of the state enterprises to set up private trading companies and unregulated private banks.² Oil and gas money prolonged the life of the regime. In the words of Yegor Gaidar³, without Samotlar (the biggest Russian oil field accounting for 40% of the Russian oil production), perestroika would have come earlier.

Sheila Puffer in a 1998 article on doing business in Russia uses 1990 as a cutoff date to compare the strategies and profiles of the companies that entered Russia before and after that year. Among the early entrants were such companies as AT&T, American Express, Caterpillar, Chase Manhattan Bank, DHL (1984), IBM, General Motors Overseas Corp, Otis Elevator, the Chicago based accounting company Arthur Andersen (1970s). These pioneer companies were motivated by the desire to access a big market. Compared to the later entrants, they also had a long term vision for doing business in Russia, as opposed to the short term approach followed by those who entered this market after 1990. Puffer’s survey of 49 American firms finds that these ‘early entrants’ exhibited a firm commitment to market entry and embraced the political risks of Russia. These were companies that were powerful and confident enough to enter without any partners, also maybe because at the time of their entry, there were no significant Russian entities they could partner with. These firms have invested for the long term in the local people and assets. They adopted a strategic approach to market entry and accepted the political risk associated with doing business in Russia by embracing the “roller coaster type” business and political environment.

The ‘late entrants’ were motivated by more opportunistic reasons and by a short-term vision. They wanted to take advantage of the cheap material and similarly cheap but highly skilled labor. Their predominant form of entry was the JV. The value of personal connections weighted heavily in the decision to enter the market. They also placed value on the market opportunity, but pursued a ‘low cost’ strategy in addition to that of differentiation. Essentially, they were driven to Russia by the prospects to make a “quick buck”.

 

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