By the Highest Standards

By the Highest Standards

Kommersant, Russia
Dec 18 2004

The year 2003 was a year of large-scale mergers and acquisitions for
Russia. They included the formation of the BP–TNK alliance, the
buy-up of the Georgian power industry by Russian natural monopolies,
and Shell’s commitment to invest $10 billion in the Sakhalin-2
project. However, the volume of failed deals is even more telling.

British Petroleum–Tyumen Oil Company

Photo: Aleksei Kudenko

Under the leadership of Sergei Bogdanchikov (in the photo), Rosneft
acquired AO Northern Oil for $600 million (one of its co-owners,
Andrei Vavilov, is shown in the photo on the lower right)
On February 11, the owners of Tyumen Oil Company (TNK) announced that
they were merging their assets with those of British Petroleum (BP)
in Russia and Ukraine to form a single company. The final agreement
between the shareholders was signed in London on June 26. The amount
BP paid for its share in BP–TNK was reduced by $600 million to $2.4
billion. TNK’s shareholders received $6.85 billion from the
Anglo-American British Petroleum for the right to set up a joint oil
company with TNK. In order to do this, TNK’s largest owners, Mikhail
Friedman and Viktor Vekselberg, had to give up the title of oil
magnate, since TNK shareholders receive only 50% in the new company,
called BP–TNK. Friedman believes that the next deal of this size
involving Russian businessmen will have to wait for at least two or
three years.

In many respects, the deal with BP stemmed from the Anglo-American
company’s less than successful development in the mid-1990’s,
particularly the muddled and complicated business with SIDANKO, which
bankrupted TNK. However, TNK made no secret of its intentions to form
a partnership with BP by any possible means. The deal will probably
enter textbooks on strategic management: it was the first time a
Russian company had successfully convinced a Western partner that it
was more advantageous to work with it than to expand in Russia
independently.

Rosneft–Northern Oil

Photo: Vasily Shaposhnikov

Andrei Vavilov
On February 12, Rosneft announced the acquisition of AO Northern Oil
(Severnaya neft) for $600 million.

The oil industry was the leader in the number of large deals at the
beginning of the year, although in January everyone expected problems
in this sector: it was assumed that war in Iraq would lead to a drop
in prices. Nevertheless, Russian oil became a very attractive asset
in the first quarter of 2003. For example, the owners of Northern
Oil, who included former deputy finance minister Andrei Vavilov, sold
the company to Rosneft for an even $600 million. In a departure from
Russian business tradition, the parties paid for Northern Oil through
Sberbank of Russia rather than through offshore or Western banks.

With this deal, Northern Oil set still another record as the only
relatively large oil company to increase its market value
approximately ten times between 1999 and 2003, while increasing oil
production on the same scale. It was rumored that after the head of
Rosneft, Sergei Bogdanchikov, had familiarized himself with Northern
Oil’s operations, he gave orders not to make any major changes, but
to turn the company into a model subdivision of the state company
that they could show to foreign delegations and visiting government
officials.

The Northern Oil deal sparked a lot of hearsay and false rumors. In
particular, there was talk about a huge kickback received by
structures of the presidential administration for supporting it.
Nevertheless, this deal was important primarily because it gave the
entire market an excellent reference point. A company that had grown
from zero to $600 million in only a few years was worth that much for
Rosneft as a business, not as a source of oil reserves or as a means
of increasing capitalization.

Mechel–Korshunov Ore Mining and Processing Plant

Photo: Valery Melnikov

The main event in the area of railway reform was the formation of AO
Russian Railways, headed by Minister of Railways Gennady Fadeev
Mechel’s acquisition of Korshunov Ore Mining and Processing Plant
(Koshunovsky GOK) was the last big old-style deal in the
metallurgical industry. The history of the sale by SUAL-Ruda GOK,
which supplied raw materials to Siberian steel plants, began with the
standard Russian scandal: the Korshunov plant was bankrupt, and
Mechel’s rivals from Evrazholding made no secret of their intentions
to fight for Korshunov GOK using all available means, including
force.

Nevertheless, Mechel obtained a final decision on the question at the
negotiating table and in the arbitration court, although during the
struggle for Korshunov GOK, the company had used more habitual means
of fighting for industrial facilities, e.g., legal actions, police
officers, “dropping in” on the plant’s management, and other romantic
stuff of the mid-1990s. The question cost Mechel 2.4 billion rubles,
a sum that included the amount of the deal along with Korshunov’s
debts, which the owner assumed in order to get the company out of
receivership.

The Korshunov plant was the last large ore mining and processing
company without a major corporate partner. The other ore companies
had long ago become part of Russian metallurgical companies. Not
everyone was lucky: some Russian steel companies were left without
their own raw material sources. Their only option is to buy mining
assets from other owners. Therefore, both metallurgists and analysts
believe that the investment attractiveness of Russian ore mining and
processing companies will increase.

The tension is heightened by the rapid increase in world prices for
steel raw materials resulting from increased demand for ore in
Southeastern Europe. Another source of raw materials for steelmakers,
scrap iron and steel, is inadequately collected in Russia and cannot
be relied upon.

It is not surprising that the last ore mining and processing company
went to Mechel. In 2003, Mechel had already expanded its operations
beyond Russia and the CIS and had started buying companies of its
profile in Romania and Slovakia. Thus, the company had an acute need
for a raw material base, and it had to buy this base in a way that
would not raise doubts among future partners and investors in Europe
and in other parts of the world. A reputation is worth money, so
there was simply no question of settling the situation with Korshunov
GOK by force.

Troika Dialog–Rosgosstrakh

Troika Dialog Investment Company (IG Troika Dialog) paid 661 million
rubles for the right to control Rosgosstrakh, one of the best known
brand names of Soviet times. On the results of three auctions, Troika
Dialog became the owner of 49% of Russia’s oldest insurance company
at the end of 2001. The government owned a block of 26% minus one
share of Rosgosstrakh, which it also put up for auction. Bidding for
the share package of the former Soviet insurance monopoly took all of
three minutes, beating the record set at the Slavneft auction by one
minute. As a result, Troika Dialog became the owner of 75% minus one
share of Rosgosstrakh.

The amount collected from the sale of the former giant hardly
disturbed anyone except Duma deputies, who even tried to annul the
auction. “The winning consortium of investors led by Troika Dialog
has to solve the very urgent problem of attracting investments to the
Rosgosstrakh system, ” the system’s press secretary, Igor Ignatev,
told Kommersant. According to Ignatev, Rosgosstrakh will require
about $50 million to develop automobile liability insurance programs
alone.

The government intends to keep a blocking parcel of Rosgosstrakh
shares at least until 2004, according to Kirill Tomashchuk, deputy
head of the State Property Fund. The Ministry of Property Relations
wants to use the blocking parcel as a guarantee of debt payments
under policies written by Gosstrakh (Rosgosstrakh’s Soviet-era
predecessor). However, at Rosgosstrakh, they told Kommersant that
judging from the pace of the debt offset program, it will take at
least ten years to pay off all the debt.

National Reserve Bank–Aeroflot

Monopolies, both past and present, are becoming more and more
attractive to Russian businessmen. National Reserve Bank (NRB), which
was once closely connected with both Gazprom and RAO UES of Russia
(RAO EES Rossii), turned its attention to former Soviet monopoly
Aeroflot and bought 26% of the company’s shares for $135 million, a
record amount for the Russian airline industry.

It is not hard to understand why the bank headed by Aleksandr Lebedev
wanted the shares. Aeroflot flatly refuses to buy Il-86 airplanes,
and NRB is actively involved in an Il-86 production program. Now that
it has seats on Aeroflot’s board of directors, NRB is counting on
convincing the company of the undeniable advantages of Russian
aircraft over Airbus and Boeing. A scandal is anticipated. Aeroflot
has repeatedly stated that problems with access to Western airplanes
are having a negative impact on the company’s business. Despite some
improvements in Aeroflot’s financial indicators, the company’s
situation is far from ideal. At the end of the year, Aeroflot began a
“rebranding” campaign to bring its image more in line with its
Western competitors.
Ministry of Railways–Russian Railways

AO Russian Railways (Rossiyskie zheleznye dorogi; RZhD), perhaps the
largest Russian company in terms of assets, was formed in Russia at
the end of September. Anna Belova, who at the time was still Deputy
Minister of Railways, announced that the ministry would be
transferring property worth 1600 billion rubles to Russian Railways.
RF Minister of Railways, Gennady Fadeev, was appointed president of
the company split off from the Ministry of Railways. The Ministry is
expected to be eliminated by combining it with the RF Ministry of
Transport, but Russian Railways has already started operating. It is
still difficult assess the results of the deal, since there are no
noticeable practical differences in Russian Railways’ operations
compared with the Ministry of Railways.

Georgia–Russia

The business calm in Russia did not prevent two Russian economic
giants, Gazprom and RAO UES of Russia, from carrying out an economic
blitz with record speed in a country that was previously not very
welcoming to Russian investors. The two unreformed monopolies
captured Georgia’s power industry in about a month.

On July 1, Aleksei Miller, chairman of the board of Gazprom, signed a
cooperation agreement with Georgia’s Minister of Fuel and Energy,
David Mirtskhulava, which gives Gazprom the prospect of acquiring up
to 100% of the Georgian gas market. Then in early August, RAO UES of
Russia bought 75% of the shares of the Telasi power distribution
network in Tbilisi and two power-generating units of the Tbilisi
Thermal Power Plant with a total capacity of 600 MW (this represents
a large part of Georgia’s power industry) from the American company
AES Silk Road and its partners.

On August 1, RAO Nordic, a subsidiary of RAO UES of Russia, bought
all of the American group AES’s Georgian business, which amounted to
nearly 50% of Georgia’s power facilities. RAO Nordic paid $70 million
for the assets; the only reason for such a low price was that the
assets were burdened with monstrous (by Russian standards) debts,
both payable and receivable.

The Georgian opposition accused President Eduard Shevardnadze of
betraying national interests, but neither RAO UES of Russia nor
Gazprom seems to have had any particular political aims. Although
accusations of “selling the homeland” played a certain role in the
Georgian president’s resignation, immediately after the coup,
contrary to expectations, the new Georgian leaders said nothing about
a possible review of the deals. Gazprom’s only actual interests in
Georgia are the long-distance gas pipeline to Armenia and replacing
Itera Oil and Gas Company (NGK Itera) on the Russian domestic market.
This second aim is already succeeding in a way: the first thing the
new managers of Tbilisi’s gas supply systems did was to cancel the
contract with Itera.

Russian natural monopolies had never carried out this sort of blitz
before, but RAO UES of Russia did not stop there. In keeping with
chairman Anatoly Chubais’ political policy of creating a “liberal
empire” through economic domination of the entire CIS, the company
bought 33% of the shares of a Ukrainian company owned by ten regional
power companies. RAO UES of Russia intends to continue expanding into
Ukraine next year. Gazprom’s plans include the formation of a joint
venture with the Belarussian company Beltransgaz, investments in
Central Asian gas pipelines, and a whole set of “imperial deals”.

SUAL–Fleming Family & Partners

In February 2003, OAO SUAL announced the formation of a transnational
corporation that included SUAL’s aluminum assets, the coal company
Access Industries (Eurasia), and two facilities of the English
company Fleming Family & Partners in Cuba and Mozambique. Chris
Norval, former vice-president of strategic planning of the South
African company BHP Billiton, was appointed general manager of the
SUAL International industrial group and president of SUAL Holding.

Despite of its lack of publicity, the deal between SUAL and the large
English private fund was one of the signal events of 2003. SUAL is a
company able to compete with Russian Aluminum (Russky alyuminii),
which has a virtual monopoly on the aluminum market, and Viktor
Vekselberg is one of biggest players of the “oligarchic” political
scene, which increases the investors’ risks. Nevertheless, the
Flemings approved the deal, which made similar investments in Russia
an acceptable risk for other serious partners. After all, the matter
concerns a resolutely nonpolitical deal that is also one of the
year’s ten largest transactions, which in theory should form the
basis for an increase in foreign investments in Russia and
globalization of the Russian economy.

Shell–Sakhalin-2

On May 15, 2003, the Sakhalin Energy (SE) consortium, shareholder of
the Sakhalin-2 project, decided to begin the second phase of the
project. The partners, the main one of which is Shell, committed to
invest $10 billion in Sakhalin-2.

SE had planned to make the decision to start the second phase of
Sakhalin-2 in the first half of 2003; but after SE’s management
expressed a number of complaints about legislative guarantees of the
safety of future investments (particularly the inconclusive
settlement of SE’s rights to set tariffs for oil and gas pipelines
from fields offshore Sakhalin to ports on the southern part of the
island), there was talk of suspending the project. According to
unofficial versions, SE and its shareholders (Shell, 55%; Mitsui,
25%; and Mitsubishi, 20%) wanted to postpone the decision on starting
the second phase until fall 2003 or even later.

The main factor in making the decision to start the project was
apparently a contract concluded between SE and the Japanese company
Tokyo Gas for delivery of 1.1 million tons of liquefied natural gas
(LNG) per year for 24 years. Philip Watts, Shell’s CEO, recently
announced that the company plans to conclude similar contracts for
LNG deliveries to Japan, South Korea, Taiwan, and the United States
in the near future. However, it is not inconceivable that Shell
decided to speed things up as a result of unofficial statements from
Gazprom to the effect that if something happened, Gazprom’s status as
coordinator of gas field development in Eastern Siberia and the Far
East and gas exports from Russia to countries in the Asia-Pacific
region might be extended to Sakhalin-2 as well. Shell decided not to
wait until Gazprom’s hints turned into concrete actions and announced
the start of the largest investments in Russia’s history.

No Deal

Despite the impressive appearance of the first ten deals, the list
would have been much more impressive if a number of large deals in
Russia’s most important economic sector, the fuel and energy complex,
had taken place or been concluded.

First of all, the future of the merger of YUKOS and Sibneft into the
unified company YukosSibneft, the largest deal in Russian business
history, is still unknown at present. On April 22, 2003, YUKOS and
Sibneft announced the start of the merger into YukosSibneft. In the
first phase, Sibneft shareholders were to sell 20% of their shares to
YUKOS for $3 billion; and then in the second stage, they would
exchange their remaining Sibneft shares for about 26% of
YukosSibneft’s securities. However, after the head of YUKOS, Mikhail
Khodorkovsky, was arrested, Sibneft announced a suspension of the
deal that might have formed a company worth $50–55 billion, making it
the largest company in Russia in terms of capitalization and giving
it control of nearly one-third of Russian oil production.

Two other failed megadeals also have a chance of taking place in
2004. The first is a deal to give a consortium made up of Gazprom and
the Ukrainian company Naftogaz of Ukraine control of all of Ukraine’s
gas pipeline infrastructure (for an estimated cost of no less than
$25 billion). One of the main reasons for the holdup is Kiev’s
obstinate insistence on including Kazakhstan, Uzbekistan, and
Turkmenistan in the gas transport consortium (gas from these
countries is exported through Ukrainian pipelines, but their
membership in the consortium means that Gazprom would lose its
monopoly position as natural gas exporter to Europe.

The second is the creeping privatization of Bashkortostan’s oil
production and oil refining industries. In early August, the
government of Bashkortostan reorganized the property structure of AO
Bashneft and Bashneftekhim, which had previously belonged to it in an
ownership chain, with the aim of protecting them from possible
privatization. Now the companies control their own capital according
to a complex scheme. The problem is that as a result of the deal the
republican budget lost assets worth at least $2 billion. The deal is
also being contested and is directly dependent on the outcome of the
pre-election fight between President of Bashkortostan Murtaza
Rakhimov and his rivals.

The last two deals are the attempted acquisition of Surgutneftegaz by
Sibneft shareholders, which led to an unprecedented increase in
Surgut shares in spring 2003, and the would-be sale of a large
package (25 to 40%) of YUKOS shares to either ExxonMobil or
ChevronTexaco. Based on estimates of the company’s market value, the
deal should have been worth $20–35 billion, which beats the record
set by BP–TNK by several times. Strangely enough, President Putin was
the first to officially announce that negotiations were going on. The
company itself is keeping dead silent; and Lee Raymond of ExxonMobil,
who met with nearly all members of the government and oil and gas
industry elite in Russia last October, has not said a word about the
results of these meetings.

It is certain that three of these five deals have not taken place
because of active interference of the Russian authorities. The YUKOS
affair in particular, which arose as a result of the initial efforts
to form YukosSibneft, became the determinant for businessmen who had
been planning deals two or three orders of magnitude smaller. By the
end of 2003, there were noticeably fewer of them than at the
beginning of the year; and this should be considered one of the
year’s main results.

by Dmitry Tatarinov

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