Daily Archives: January 27, 2007

The End of Foreign Investment in Russia

Here’s what Vitaly’s Contrarian has to say about the recent Kremlin moves against foreign oil companies (in short, foreign investment in Russia is doomed, and with it Russia’s last best hope to become a civilized nation). Note in particular how he exposes the outrageous propaganda of Russian stock broker Eric Kraus, who will do and say anything to get the unwitting to plonk their money into Russia so he can take a cut of it by convincing them that all is bright and rosy in Russia. He’s one of the lowest forms of reptilian life in the venal Russophile universe.

I can’t say I was surprised to see that Royal Dutch Shell (NYSE: RDS.A) will be “selling” 50% plus one share of the Sakhalin-2 project to Gazprom for $7.5 billion. Several months ago, the Russian government wanted to take Royal Dutch Shell to court because it was ruining the environment. I suppose when the Russian government referred to the environment, it meant the economic environment, not Mother Nature. The “environmental” issue was very simple: Product sharing agreements (PSA) signed by the Russian government with Shell were not considered advantageous to Russia — at least not anymore.

The 7.5 billion-dollar question comes to mind: Did Gazprom buy a controlling stake in the Sakhalin-2 project at a fair price? It’s hard to say. $7.5 billion is not chump change, but Shell didn’t sell a controlling stake in the project — which, by the way, insured a replenishment of its dwindling oil reserves for years to come — at its own will. You don’t have to be a genius to figure out that after “selling” (I use that term loosely because it assumes willing participants on both sides) its stake in the Sakhalin project, the environmental issues will not be issues any more.

I’ll be blunt: The Russian government manipulated its environmental/legal levers to muscle an ownership stake in the project out of Shell, possibly at a significant discount. I understand that it’s so much easier to be sympathetic to the poor children and elders that this oil money is supposed to go to, than to a multibillion dollar, impersonal, foreign (Dutch to be exact) oil company.

It sounds like a Robin Hood act, taking money from the rich and giving it to the poor. It’s certainly not the first time this has happened in Russia. In 1917, on Nov. 7 (still a widely celebrated holiday in Russia), under the leadership of Mr. Lenin, the masses took from the rich and gave to … themselves. We all know how that story ended. You cannot have government thievery be a part of the free market system and expect the market to function normally.

The original Sakhalin deal

Eric Kraus who runs a Nikitsky Fund, a mutual fund that invests in Russia, pointed (opens PDF) out a study done by Alfa Bank Research, showing that the terms of the original Sakhalin PSA signed in the 1990s were unusually advantageous for Shell and its partners. For instance, usually PSAs are signed for 20 years. The Sakhalin deal was signed for 25 years and renewable at five-year increments at Shell’s discretion, forever — a very unusual clause. There were no caps on costs, and only after Shell was firmly in the black would Russia see anything from the project. According to Kraus, these favorable PSA terms are very uncommon. Cost overruns on the project did not help the issue, but if anybody ever tried to do business in Russia, they wouldn’t be surprised; The country is infested with bribe-hungry bureaucrats who make doing business in Russia prohibitively expensive and inefficient.

From today’s $60 per-barrel oil perspective, it appears that Royal Dutch Shell got a great deal in the original PSA, at Russia’s expense. However, in the 1990s when this deal was consummated, oil prices were much, much lower, and thus the breakeven point and risk for the project was a lot higher. Also, at the time, Russia was cash-poor and desperately needed foreign investment and the exploration and development know-how. Royal Dutch Shell is one of the best in the field and was willing to commit billions of dollars. And unlike Shell selling one of its best assets to Gazprom (a public company which is 39% owned by — and managed in the interests of — the Russian government), nobody forced Russia to sign the original contract in the 1990s.

Who needs the West?

Similar to Al Capone — a mafia boss sent to jail, not for his murderous crimes but for tax evasion — Mr. Putin & Co. went after Shell for “environmental” violations. However, in this case, Shell’s crime is its profitability in the face of the Russian government’s lust for oil money and control of natural resources. I don’t know if the environmental problems were really problems or not. Every time you drill for oil or gas in the middle of a wilderness, “environmental” issues could be found. But few things in Russia get done because of the environment, and this was no exception.

This very transparent act of renegotiating the terms of the contract that was signed more than a decade ago abusing the government-controlled legal system didn’t go unnoticed by foreign companies. Interestingly, even if Gazprom paid more than a fair price for the Sakhalin-2, since Shell was forced into the deal, the market perception of the whole affair will still be negative.

This isn’t the first time the Russian government has done something that has abridged the law. Using similar tactics, Russia stole (for lack of a better word) Yukos from its shareholders in 2004, sending its largest shareholder to jail, and has been gradually consolidating (deprivatizing) oil resources under the government (Gazprom) wing.

Ironically, the Russian government doesn’t care about foreign investment. It’s swimming in cash and doesn’t feel like it needs the West (or the East — two partners in the Sakhalin-2 project were Japanese) any longer. However, despite the appearance of economic prosperity, Russia is a one-trick pony. It’s blessed with natural resources (i.e., oil, natural gas, steel, timber, etc…), and that pony has been in popular demand for the last three years. Take the high commodity prices away, and Russia is back in the post-Cold War Stone Age: poor infrastructure, marginal rule of law (which is even more apparent now), and corrupt local governments.

So will this commodity-pony be in demand forever? Who knows? Predicting commodity prices is very difficult. But may Russia’s soul rest in peace if commodity prices take a dip.

Considering the recent deprivatization trends of the energy industry in Russia, oil and natural gas production is likely to face a long-term decline. All governments are ill-equipped to allocate economic resources, and the Russian government is no exception. There’s a significant mismatch between the duration of time politicians spend in office and the multidecade payoff of exploration and development expenditures of the oil and gas industry.

Faced with the allocation of Gazprom’s abundant cash flows, even a well-intentioned politician has tremendous incentives to divert the funds toward social programs (i.e., paying pensions to retirees, increasing teachers wages, etc…) that have a more apparent, immediate social impact (read re-electable) than exploration and development projects that require a tremendous outlay of capital upfront and have a payoff decades in the future.

Private enterprises such as foreign oil companies (not covert, government-controlled entities such as Gazprom) have the appropriate time horizons, the needed capital, and the know-how to get the oil and gas out of Russia. Unfortunately, in lieu of recent developments, they’ll be committing less capital to Russia rather than more.

After seeing the current developments, CFOs of foreign companies that were contemplating doing business in Russia are increasing their required return on capital assumptions in their models. As the required rate of return goes up, fewer projects become profitable — and less foreign capital will flow to Russia. Companies that have already invested in Russia — ExxonMobil (NYSE: XOM), BP (NYSE: BP), Conoco Phillips (NYSE: COP), and others — are wondering if they’ll be the next “environmental” culprits and may be trying to find a graceful way out. Can you blame them?

Has Russia Lost Control of its Nukes . . . or is it just plain evil?

Captain’s Quarters reports that either Russia has lost control of its nuclear weaponry or else it has decided to release it upon the world in an endless series of assaults. The Captain can’t decide which scenario is the more ominous and, quite frankly, neither can La Russophobe. One thing’s for sure, though: If the world had listened to us russophobes earlier, we wouldn’t be in this mess. Here’s the Captain’s description:

Georgian officials, with the cooperation of American investigators, managed to snare a man selling weapons-grade uranium last summer, a victory against black-market proliferation. The victory has been fleeting, however, as the combined task force has not been able to trace the source of the material to determine the origin of the uranium. Just as in another, more splashy case of rogue nuclear material, the problem results from Russian intransigence:

“Given the serious consequences of the detonation of an improvised nuclear explosive device, even small numbers of incidents involving HEU (highly enriched uranium) or plutonium are of very high concern,” said Melissa Fleming of the U.N.’s International Atomic Energy Agency.

Details of the investigation, which also involved the FBI and Energy Department, were provided to The Associated Press by U.S. officials and Georgian Interior Minister Vano Merabishvili.

Authorities say they do not know how the man acquired the nuclear material or if his claims of access to much larger quantities were true. He and three Georgian accomplices are in Georgian custody and not cooperating with investigators.

Merabishvili said Georgian attempts to trace the nuclear material since the arrest and confirm whether the man indeed had access to larger quantities have foundered from a lack of cooperation from Russia.

Merabishvili said he was revealing the story out of frustration with Russia’s response and the need to illustrate the dangers of a breakdown in security cooperation in the region.

Russia has not covered itself in glory in recent months, even apart from the increasingly autocratic domestic policies of the Vladimir Putin administration. One of its former agents wound up dead through poisoning by polonium after he started criticizing Putin. Now a sample of HEU winds up on the black market, and Russia won’t cooperate.

A couple of scenarios could be in play. The first is that Putin has decided to gain hard cash by putting fissile material on the black market, which is not only insane but counterproductive. After all, Putin has his own insurgencies in the Caucasus, and the material could just as easily find its way there rather that against Putin’s enemies. The second possibility is even more frightening — which is that Russia has lost control over its nuclear materials and wants to keep the West from discovering it.

In any event, the lack of cooperation on such a danger speaks volumes about security arrangements in the former Soviet republics. It’s no secret that Georgia has angered Russia in its efforts to spin out of Putin’s orbit, and if this intransigence is Putin’s idea of retribution, then we can pretty much kiss nuclear security in that region good-bye. Apparently, rogue proliferation matters less to Putin than petty squabbles and influence peddling. Such a ruler is no partner for peace and economic stability, and Putin seems intent on proving that in other areas as well, such as energy transport and arms dealings with Iran.

We used to excuse the exceptions to good relations from Russia and Putin. It’s difficult to see anything else these days.

Illarionov on the Destruction of Freedom in Russia

The following is adapted from a speech delivered on October 3, 2006, at a Hillsdale College National Leadership Seminar at the Drake Hotel in Chicago, Illinois by former Kremlin economics guru Andrei Illarionov (pictured, left), recently made available on Hillsdale’s website:

The Destruction of Freedom in Russia

The story of the destruction of freedom in my own country, Russia, is sad. But this story should be told, should be known, and should be remembered—to avoid repeating it and in order one day to reverse it.

First, there was an assault on the people of Chechnya. Many Russian people thought that it was not their business to defend the freedom of the Chechen people. People in Chechnya lost their independence, their political rights and—many of them—their lives. Many Russians lost their lives as well.

Then there was an assault on the Russian media. This time many Russian people thought that it was not their business to defend the freedom of the media. As a result, the media lost its independence—first television channels, then radio stations and newspapers. And now the censors are turning their attention to the Internet.

Then there was an assault on private business. Many Russian people thought that it was not their business to defend the freedom of private business. So private business has lost its independence and has become subjugated to the caprice of the executive power. This has been accomplished through so-called PPPs or public-private partnerships, but it would be more correct to call what is happening CPC—coercion of private business by the corporation in power.

Then there was an assault on the independence of political parties. Many Russian people thought that it was not their business to defend the independence of political parties. As a result, independent national political parties ceased to exist.

Then there was an assault on the independence of the judiciary. Many Russian people thought that it was not their business to defend the independence of the judiciary. Now, there are no more independent courts or judges in Russia.

Then there was an assault on the election of regional governors. Many Russian people thought that it was not their business to defend free elections of regional governors. Today, regional governors are appointed by the president, and there are no more independent regional authorities in the country.

Then there was an assault on the independence of non-governmental and religious organizations. Finally, some people tried to defend the freedom of these organizations, but it was too late. And now even those who want to resist have neither the resources nor the institutions required to fight back.

As a result, Russia has ceased to be politically free. For 2005, Freedom House’s Freedom in the World ranks Russia 168th out of 192 countries. Transparency International’s Global Corruption Report ranks Russia 126th out of 159 countries. The World Economic Forum calculates that Russia is 85th (among 108 countries) in avoiding favoritism in government decisions, 88th (also of 108) in its protection of property rights, and 84th (of 102) when measured by the independence of the judicial system. The Russian government could form another G-8 with countries that destroyed the fundamental institutions of modern government and civil society as quickly as it did over the past 15 years by partnering with Nepal, Belarus, Tajikistan, Gambia, the Solomon Islands, Zimbabwe and Venezuela.

What is the Russian government doing now, when it has destroyed freedom and achieved next to full control over Russian society? Is it stopping its assaults? No. It continues them, both within and beyond Russia’s borders. Inside the country, the government has started a campaign against human rights. It has created and financed detachments of storm troopers—the movements “Nashi” (“Our Own”), “Mestnye” (“Locals”), and “Molodaya gvardiya” (“Young Guard”)—which are being taught and trained to harass and beat political and intellectual opponents of the current regime. The days for which these storm troopers are especially trained will come soon—during the parliamentary and presidential elections in 2007 and 2008.

Beyond Russia’s national borders, the government provides economic, financial, political, intellectual and moral support to new friends: leaders of non-free countries such as Belarus, Uzbekistan, Venezuela, Myanmar, Algeria, Iran, and Palestinian Hamas. At the same time, Russia is attempting to destroy hard-won freedom and democracy in neighboring countries. Ukraine, Moldova and Georgia find themselves in a new cold war as Russian authorities pursue hostile policies involving visas, poultry imports, electricity, natural gas, pipelines, wine, and even mineral water. The Russian government has just started a full-scale blockade of Georgia. Meanwhile, the state-controlled Russian media has launched a propaganda war against Ukraine, Moldova, Georgia, the Baltic countries, Europe and the United States.

What do non-free countries have in common? What unites such disparate countries as Nepal, Belarus, Tajikistan, the Solomon Islands, Gambia, Venezuela, Zimbabwe, North Korea, Sudan, Turkmenistan, Cuba, Myanmar, and yes, now Russia? Only one thing: war, in which governments take away property and destroy society, in which they send people to camps or kill them solely because they have a different perception of the world, of faith, of law, and of their homeland. Only through hatred, fear, and electoral violence can these governments hold on to what is dearest to them—absolute power.

Without freedom there can be no open discussion of topics of national and international importance. There is an exclusion from public life of conversation about the most important matters. This primitivizes public life, degrades society, and weakens the state. The politics of non-freedom is the politics of public impoverishment and of the retardation of the country’s economic growth.

The greatest practical lesson of Russia’s recent history is that freedom is indivisible. The failure of freedom in one sphere makes it harder to defend freedom in other areas. Likewise, the fall of freedom in one country is a blow to global freedom. The inability to defend freedom yesterday comes back to haunt us at a great price today and perhaps an even greater price tomorrow.

Looking Ahead

What position should the United States and other free countries take regarding Russia’s growing internal authoritarianism and external aggression? There was a real opportunity over the last several years: Concerted efforts by the West could have slowed significantly, if not stopped, the degradation of freedom in Russia. But nothing was done. One of the West’s last chances was to deny access to its capital markets for the sale of assets stolen from the large private company Yukos; but this did not happen, and the sale of those assets occurred at the Rosneft IPO on the London Stock Exchange. The July 2006 G-8 summit in St. Petersburg could also have been used to emphasize the clear distinction between leaders of the free world and those of non-free Russia. But in the end, nothing was done.

As I wrote in the Washington Post in April 2006:

The G-8 summit can only be interpreted as a sign of support by the world’s most powerful organization for Russia’s leadership—as a stamp of approval for its violations of individual rights, the rule of law and freedom of speech, its discrimination against nongovernmental organizations, nationalization of private property, use of energy resources as a weapon, and aggression toward democratically oriented neighbors.

By going to St. Petersburg, leaders of the world’s foremost industrialized democracies will demonstrate their indifference to the fate of freedom and democracy in Russia. They will provide the best possible confirmation of what the Russian authorities never tire of repeating: that there are no fundamental differences between Western and Russian leaders. Like us, Russia’s leaders will say, they are interested only in appearing to care about the rights of individuals and market forces; like us, they only talk about freedom and democracy. The G-8 summit will serve as an inspiring example for today’s dictators and tomorrow’s tyrants.

The West squandered both of these opportunities. None of the G-7 leaders had enough courage to raise the issues of freedom and democracy, or to discuss the principles of true constitutionalism and their absence in Russia. Everyone pretended that nothing special was going on in Russia. Indeed, the G-7 leaders agreed de facto with the Russian authorities’ approach to energy security. Instead of liberalizing and privatizing energy assets, Russia is moving in the opposite direction both internally—by nationalizing private companies and asserting state control over the electricity grid and pipeline system—and internationally, by using non-market methods to manage supply and even demand for the world’s energy resources.

Several months after the summit, the bill for this policy of appeasement is due. Now the Russian authorities are revoking the licenses of American and British energy companies in Sakhalin. BP has found itself under pressure to exchange its partner in TNK-BP in favor of the government-owned Gazprom. Otherwise, it will not have a chance to explore the giant Kovykta gas field in eastern Siberia. The billion dollars it spent on the purchase of Rosneft shares in July 2006 did not help BP much. And there is no doubt that, after the G-8 summit, the free world can expect more of the same. In truth, it should consider itself in a new Cold War-like era.

* * *

Let me conclude these remarks with words spoken by Winston Churchill about another great war for freedom:

I would say to the House, as I said to those who have joined this government: “I have nothing to offer but blood, toil, tears and sweat.” We have before us an ordeal of the most grievous kind. We have before us many, many long months of struggle and of suffering. You ask, what is our policy? I can say: It is to wage war, by sea, land and air, with all our might and with all the strength that God can give us; to wage war against a monstrous tyranny, never surpassed in the dark, lamentable catalogue of human crime. That is our policy. You ask, what is our aim? I can answer in one word: It is victory, victory at all costs, victory in spite of all terror, victory, however long and hard the road may be; for without victory, there is no survival.

That war for freedom was won. We may yet win, indeed we must win, this current war. But to win, we must work together.