Business Watch: June 17, 2003

LUKoil announced its financial results to U.S. Generally Accepted Accounting Principles (GAAP) in a 6 June press release posted to the company's website (http://www.lukoil.ru). Revenues rose from $13.426 billion in 2001 to $15.334 billion in 2002, while net profits fell 12.6 percent year-on-year to $1.843 billion and EBITDA (earnings before interest, taxes, depreciation, and amortization) dropped 10.5 percent to $3.569 billion. LUKoil Vice President Leonid Fedun told a 6 June news conference that the less-than-impressive results resulted from such industry-wide woes as higher taxes, rising transport costs, and low domestic prices, RBC reported the same day. United Financial Group analyst Pavel Kushnir told "Kommersant" of 9 June, however, that rising costs in the fourth quarter coupled with flat production figures indicate that the company is having trouble reining in expenses. Fedun told journalists that 2003 is already shaping up to be a banner year, with the company's $1.1 billion in proceeds from the sale of its 10 percent stake in the Azeri-Chirag-Guneshli project paving the way for potential 2003 net profits of more than $3 billion. A group of industry analysts polled by "Vedomosti" seconded the forecast. DK

The Federal Property Fund stopped accepting applications on 10 June for participation in the 18 June auction to privatize a 26 percent-minus-one-share stake in insurer Rosgosstrakh, Interfax reported on 10 June. A final list of participants will we determined on 16 June. For now, the only surefire suitor is investment company Troika Dialog, which already owns 49 percent of Rosgosstrakh. (The state currently owns the remaining, controlling, stake.) "Kommersant" named Rosbank, Evrofinance Bank, MDM Bank, holding company Basic Element, and United Financial Group among the "likely contenders" in the auction. Rosbank spokesman Valentin Shapka told the newspaper of 11 June that the bank was acting "in the interests of a client who is in no way affiliated with Interros Group." (Interros controls Rosbank.) A source told "Gazeta" of 11 June that Rosbank's application to take part in the auction is "an imitation of competition to give the stake to the right structure at a previously agreed price." Vladimir Skvortsov, director of Alfa Insurance, told "Vedomosti" of 11 June that the presumed seven applications mean that "two or three investors will actually take part." The starting price at the 18 June auction will be 651 million rubles ($21.3 million). For its part, Troika Dialog seems intent on obtaining a controlling stake in Rosgosstrakh. Oleg Tsarkov, the company's managing director of investment banking, told "Kommersant": "We've put in our application. We don't know who else is going to participate. We're going to win." DK

Physical control of the Taganrog Boiler Plant passed to Pavel Svirskii, director of investment company Sigma, during the weekend of 7-8 June, "Vremya novostei" reported on 10 June. Armed with a court decision, Svirskii gained entry to the plant with the help of court bailiffs and local militia units, displacing board Chairman Sergei Bidash. Each side in the conflict claims to own a majority stake, and has conducted its own shareholders' meeting and elected its own board. According to both "Kommersant" and "Vedomosti," however, Bidash and the factory's management together control a 54 percent stake, while Sigma owns 27 percent. "Vedomosti" reported on 10 June that the factory's director, Vladimir Sennikov, helped Svirskii and Sigma gain operational control of the enterprise as part of deal that allowed him to retain his post under the new management. Svirskii summed up the arrangement to "Kommersant" of 9 June: "We offered Sennikov a chance to keep the post of director, while I would take the position of chairman of the board." According to Svirskii, his first act will be to raise workers' salaries by 15 percent. Meanwhile, local newspapers published enthusiastic articles on the dawn of a new era at the plant. For his part, Bidash told "Vedomosti" that a 23 June hearing will review the court decision that allowed Svirskii to pull off the takeover. The Taganrog Boiler posted $40 million in sales in 2002 and is one of Russia's three largest energy-sector engineering plants. DK

Representatives of the Mechel Metal Plant and Southern Kuzbass Coal Company announced on 10 June that the Mechel Steel Group has completed the consolidation of its assets, "Kommersant" reported on 11 June. The group owns more than 80 percent of the Mechel Metal Plant, 100 percent of the Southern Kuzbass Coal Company, more than 75 percent of the Beloretsk Metal Plant, 70 percent of the Southern Ural Nickel Factory, and 100 percent of the Vyartsilya Steel Works. According to "Vedomosti," the Mechel Group's annual revenues will top $1 billion in 2003. Troika Dialog analyst Vasilii Nikolaev told the newspaper on 10 June that the consolidation will give the group an edge in obtaining financing for future projects. DK

Mobile TeleSystems (MTS) First Vice President Mikhail Susov announced on 9 June that his company's Jeans tariff plan has attracted more than 1 million subscribers, "Vremya novostei" reported the next day. Introduced in November, Jeans now accounts for 12 percent of MTS customers; according to Susov, MTS would prefer to keep the percentage of Jeans subscribers below 25 percent of the company's total. Jeans targets first-time and economy-minded cell users. Aleksei Kukushkin, editor in chief of telecommunications portal wol.ru, told "Vedomosti" of 10 June that MTS competitor VimpelCom's prepaid Bee Plus Hit plan "looks more interesting than Jeans. According to a selective poll of sub-dealers, the ratio of Jeans sales to Hit sales is one to two in the latter's favor." A 2 June analysis of the cellular market by RosBusinessConsulting noted critically that with both MTS and VimpelCom currently focusing on improving profitability, "mobile operators are merely making their rates more complicated so that when ordinary users buy 'cheap' rates they don't realize they've begun to pay more." DK

Hans-Joachim Koerber, CEO of Germany's Metro, told a 10 June press conference in Moscow that the retailer plans to invest $1 billion in Russia the course of its regional expansion, "Kommersant" reported the next day. The retailer just opened its fourth cash-and-carry store in Moscow and will open its second in St. Petersburg next week. The company hopes to have 20 stores up and running in Russia by 2005, "The Moscow Times" reported on 11 June. Vladimir Karnaukhov, director of Russian retailer and Metro competitor Seventh Continent, told "Kommersant" that Metro faces an uphill battle: "In our country, only 1 percent of the population buys food in supermarkets, while in Poland the figure is 21 percent and in the United States, more than 80 percent. You'll have to invest several times more to raise commerce to such a high level in Russia." Be that as it may, a recent study by consulting firm A. T. Kearney ranked Russia the fourth most attractive country for investment in retail (behind China, Hungary, and Slovakia), "Kompaniya" reported on 9 June (No. 22). DK

Nothing quite reaches out and grabs the world's attention like the word "nuclear" in the right context. Take, for example, mullahs, bombs, and Tehran, with a dash of Moscow thrown in for good measure. But the ongoing to-do over Iran's nuclear program is about more than the bomb. While attention has justifiably focused on the issue of Iran's ability to produce nuclear weapons, the nature of Russia's involvement highlights the interdependence of business and politics in Russia, and raises the question of how that interdependence affects Russian foreign policy.

At the eye of the storm stands the Bushehr nuclear-power plant in southern Iran. Bushehr began life as a German construction project in the 1970s, only to be put on hold for Iran's Islamic revolution and subsequent war with Iraq. A 1992 contract reanimated Bushehr as a Russian project worth some $800 million. Today, the reactor is almost ready. Russian Atomic Energy Minister Aleksandr Rumyantsev said recently that Bushehr could begin operating in 2005, AP reported on 6 June. Iranian officials are apparently more optimistic, forecasting a start date later this year.

With the specter of weapons of mass destruction actively haunting U.S.-Iranian relations of late, Bushehr has been very much in the news, with Russia's role in the reactor's past, present, and future usually lurking at the margins of the story. When the reactor comes online, Russia is slated to begin 10 years of uranium sales to Iran to fuel Bushehr, leading some to fret that spent fuel could be reprocessed for nefarious purposes. Others worry that Iranian specialists will develop skills in the course of building and running Bushehr that they could then apply to less peaceable projects. The entire business has put Russia in a bit of tight spot, as a recent flurry of diplomatic exchanges made abundantly clear.

St. Petersburg's 300th anniversary bash and the Group of Eight summit in Evian, France, at the beginning of June found U.S. President George W. Bush and Russian President Vladimir Putin at pains to demonstrate a shared approach to international monitoring of Iran's developing nuclear potential. As Putin summed up with admirable ambiguity, "The Russian and U.S. positions on this problem are closer than they seem." But specific concerns soon rained on the parade of general agreement. On 4 June, British Prime Minister Tony Blair told Parliament that Russia was asking Iran to submit to greater scrutiny from the International Atomic Energy Agency (IAEA) and that President Putin had "made it clear that in the meantime, Russia would suspend its exports of nuclear fuel to Iran," "The New York Times" reported the same day. But according to Russian Foreign Ministry spokesman Aleksandr Yakovenko and Atomic Energy Minister Rumyantsev, uranium-fuel shipments would begin as soon as Tehran signed an agreement to return the spent fuel to Russia, AP reported on 6 June. In their words, any delays were purely "technical."

The hemming and hawing took place against the backdrop of a hardening U.S. position on Iran's nuclear program. John R. Bolton, undersecretary of state for arms control and international security, succinctly stated that position in 4 June remarks before a House committee on U.S. nonproliferation policies after Iraq: "The conclusion is inescapable that Iran is pursuing its 'civil' nuclear energy program not for peaceful and economic purposes but as a front for developing the capability to produce nuclear materials for nuclear weapons," according to the State Department website (http://usinfo.state.gov).

For its part, Iran has done little to allay fears that it might be pursuing a covert weapons program. It was 12 years late in reporting to the IAEA that it had received a small amount of uranium from China in 1991, and last week prevented a team of inspectors from conducting tests at the Kalaye Electric Co., "The Times" reported on 13 June. Moreover, Iran has thus far refused to sign an additional protocol to the Nuclear Non-Proliferation Treaty (NPT) that would impose more stringent inspections.

International pressure has been building to compel Tehran to sign the protocol and accept heightened scrutiny. European Union foreign ministers chimed in on 16 June that Iran must act "urgently and unconditionally," the BBC reported the same day. A spokesman for Iran's Atomic Energy Organization suggested that his country might be willing to sign in exchange for access to nuclear technology, which promptly drew a withering reaction from U.S. State Department spokesman Richard Boucher, MSNBC reported on 16 June: "That's a nonstarter."

As the European and U.S. positions continue to converge and harden, the clock is starting to run down on the current Russian policy of avoiding any direct statement of policy. The stakes, of course, are higher than the sum of the contracts involved. Just as too great an attachment to cooperation with Iran could imperil relations with more important countries, too little obstreperousness could entail a loss of face. As the Iranian daily "Towse'eh" noted on 29 May: "Why is it that despite Iran's open and defendable performance, its allies are taking opposite stances? Russia has required Iran to provide guarantees that it will not use Bushehr nuclear facilities as a cover for manufacturing nuclear weapons. Russia required this at the same time as America's concerns grew in this regard."

So what will drive Russian policy when one emerges? The standard interpretation is that it's all about the money. Commercial-intelligence firm Stratfor provided a workmanlike summation on 13 June: "Moscow will ignore warnings from the United States as long as it can. It will make as much money as possible from helping Iran...until U.S. pressure forces it to stop. Russia cannot withstand U.S. pressure indefinitely and, in the end, does not want to see Iran acquire nuclear weapons any more than Washington does."

But this "Moscow" sounds suspiciously like the all-powerful Kremlin of the Sovietologist's USSR. Perhaps the centers of power have shifted. Independent defense analyst Pavel Felgenhauer suggested as much in a 5 June op-ed for "The Moscow Times": "In the last year the building of the Bushehr reactor has been legally taken over by one of Russia's oligarchs, and the [Atomic Energy] Ministry is not in charge anymore. The Iranians are paying very generously, in cash, for work done. If the U.S. wants to stop the nuclear cooperation promptly, it should talk compensation with the real people in charge, not irrelevant officials, including President Vladimir Putin."

Felgenhauer is referring to United Heavy Machinery (OMZ). Headed by Kakha Bendukidze, who is a vocal member of the oligarchic lobbying club known as the Russian Union of Industrialists and Entrepreneurs, OMZ recently took a plunge into nuclear-power engineering. In March, OMZ purchased a 19.9 percent stake in Atomenergoexport (AEE) and a 50.94 percent stake in Zarubezhenergoproekt, "Izvestiya" reported on 28 March. Moreover, with 50.08 percent of AEE in the hands of subsidiaries, OMZ effectively controls 40.06 percent of AEE, putting a controlling stake within reach (although the state retains a "golden share" that would give it veto power over board decisions). AEE subsidiary Atomstroiexport is building Bushehr, and OMZ is its main subcontractor.

Much as analysts might long for the clarity of an omnipotent Kremlins or oligarchic star chamber, the bumbles and stumbles of LUKoil's Iraq odyssey might prove a more instructive example of Russian conduct in politically charged commercial crises. Saddam Hussein's regime canceled the oil major's multibillion-dollar contract to develop the West Qurna oil field in December, apparently because LUKoil was holding secret talks with the Americans about the possibility of a post-Saddam role for the company. The entire episode took place against a backdrop of impeccably principled statements by Russian officials whose sole concern was the inviolability of international law and the necessity of diplomatic due process.

Clearly, conditions in Iraq were different. LUKoil is a fully private company, the extent of its coordination with the Kremlin is unknown, and the future of West Qurna remains unclear. What might prove instructive, however, is the division of labor between diplomacy and business. In Iraq, the former dealt unpredictable, principled rhetoric, to little or no effect; the latter took flexible, unfettered action, to as yet uncertain effect. As events continue to develop around Bushehr, we might soon have an opportunity to decide whether this division is also a pattern. DK

These are perilous times for foreign oil companies working in Kazakhstan. The country is home to some of the world's most sought-after resources and also arguably the toughest revenue-raising tactics in the CIS.

President Nursultan Nazarbaev has most recently threatened foreign developers of its huge Kashagan oil field with stiff penalties if they fail to start production in 2005, the "Financial Times" reported on 9 June. The field, with 7 billion-9 billion barrels of recoverable reserves, is frequently cited as the world's biggest oil find in the past 30 years. That claim is likely to be heard often in Kazakhstan's newest feud with investors, who might need constant reminding of why they are there.

Nazarbaev told the London-based daily that the government plans to "switch on" a penalty clause in its 1997 contract with the Agip KCO consortium for Kashagan if the group sticks with plans to delay startup until 2006 or 2007. The president was apparently reacting to a statement made on 29 May in Almaty by Pascal Lalouel, general director of France's TotalFinaElf unit in Kazakhstan. Lalouel said, "Agip KCO's task is to begin extracting oil and gas. But this is likely to occur in only about three years' time," Interfax reported.

Total is a partner (20.3 percent) in Kashagan with Agip's parent, ENI of Italy (20.3 percent), as well as ExxonMobil (20.3 percent) and ConocoPhillips (10.1 percent) of the United States, Royal Dutch/Shell (20.3 percent), and Inpex ofJapan (8.3 percent).

The lag time could cost Kazakhstan an untold amount of tax revenue, probably running into hundreds of millions of dollars. But the oil group needs time because of the problems of drilling in the delicate shallow waters of the northern Caspian, which freeze over in winter. The government has been poised to pounce over even minor oil spills.

With the double bind of contract penalties on one side and environmental fines on the other, the oil companies also face a retroactive tax threat, perhaps in retaliation for their slower schedule. The government has told Agip KCO that its operations since 1999 are not entitled to the value-added-tax (VAT) exemptions it took because its activities did not involve production. Costs and penalties could reach $500 million, the "Financial Times" said. On 13 June, the Petroleum Argus FSU Energy weekly estimated the liability at $370 million. The message might be that Kazakhstan intends to collect, one way or the other.

The troubles seem to be mounting along with Kazakhstan's importance, which has been magnified in the minds of some countries as a result of Middle East risks and the Iraq war. In March, two Chinese oil companies agreed to buy one-sixth of Kashagan for $1.2 billion, seeking an alternate energy source. But in May, the bids by China National Offshore Oil Corporation and Sinopec were preempted when five of the existing consortium members exercised rights to the shares offered by Britain's BG group. Reports of the hot competition neglected to mention the pressures that the Agip KCO members now face. On 19 May, Platts Global Energy news service suggested that the VAT move may have been a "direct retaliation" for blocking China's investment, which Nazarbaev reportedly sought.

But the tactics are also familiar to investors who lived through last November's struggle over a $3 billion expansion plan by Tengizchevroil (TCO), Kazakhstan's oldest and largest petroleum joint venture. The partners stopped work after the government objected to pay-as-you-go funding out of revenues in a move that the government said would cost the country's budget $200 million a year. The firms soon found themselves fighting tax claims by Finance and State Revenues Minister Zeinulla Kakimzhanov, while a court upheld a $71 million (11 billion tenge) environmental fine against TCO for storing sulfur extracted from Tengiz oil. Two months after TCO settled its funding dispute with the government on 25 January, Kazakhstan's Supreme Court cut the fine to $7 million, Reuters reported on 26 March.

Relations with foreign companies have been tense since December, when Kazakhstan's parliament passed a new investment law curbing investors' rights to international arbitration without government consent. The final version, negotiated over two years, is supposed to protect past contracts against tax changes while leaving new contracts vulnerable. The law has yet to be tested, but company officials have reported numerous government attempts to reopen old contracts.

The business environment has also been blackened by the bribery and kickback scandal involving James H. Giffen, the U.S. investment banker and Nazarbaev adviser who was arrested on 30 March in New York on charges of making over $78 million in illegal payments to senior Kazakhstan officials. On 1 April, "The New York Times" cited Swiss legal documents implicating Nazarbaev.

Giffen pleaded not guilty to the charges, while Nazarbaev called the allegations "provocative and baseless" in a 12 June interview with the "Financial Times." On the same day, J. Bryan Williams, a former Mobil Oil Corporation executive, pleaded guilty in New York to conspiracy and tax-evasion charges related to a $2 million kickback after Mobil won a stake in Tengiz.

While oil investment seems certain to outlast the scandals, Kazakhstan seems to promise unpredictability in endless supply. In addition to the new investment law and back taxes, oil companies are trying to figure out the implications of a new tax for "subsurface users" that surfaced suddenly in the past few weeks. The plan announced by Kakimzhanov would impose a sliding tax rate on oil sales based on international prices. Rates range from 10 percent when oil is sold for $12 to $15 per barrel, up to 31 percent when the price rises to over $25.

In an 11 June "Tax Alert," the international consulting firm Deloitte & Touche quoted Kakimzhanov as saying that "one of the main reasons for the introduction of this new regime is that tax provisions contained in existing subsurface use contracts, under certain circumstances, allow large oil and gas producers to minimize their taxes to a level that is unacceptable for Kazakhstan, which often leads to the necessity for renegotiations of existing contracts."

Kakimzhanov said the new tax system would apply only to new contracts, Petroleum Argus reported. But the statement cited by Deloitte & Touche implies that pressure to reopen signed contracts remains constant, despite the guarantees of the new investment law.

Oil companies are old hands at protecting their investments and evaluating risks. But Kazakhstan's growing list of laws and tax changes might soon place it in a class by itself for unpredictability, adding a hidden cost to its oil. Michael Lelyveld