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. Last Updated: 07/27/2016

Learning to Play by the New Moscow Rules

bloombergWorkers on an oil tank in Western Siberia, the center of LUKoil's operations.
After three years of waiting in the wings, Rosneft is poised to overtake privately held LUKoil as the country's biggest oil producer, fulfilling the Kremlin's goal of having a state-run firm in the top spot.

The shift may be symbolic -- Rosneft is already No. 1 by market capitalization -- but it signals that turmoil in the sector is settling down as the Kremlin establishes what observers have taken to calling the rules of the game.

The new Moscow rules say state-run firms will hold majority control over the country's large energy projects. But that leaves up to 49 percent of some of the world's most lucrative fields for private, and often foreign, oil companies.

Indeed, the case of LUKoil showcases the other side to the Kremlin's strategy. In an environment marked by creeping state control, LUKoil -- along with its 20 percent U.S. shareholder, ConocoPhillips -- has survived in the top spot since 2004.

Analysts never expected it to stay No. 1 for long, and now they say LUKoil is positioning itself as the country's foreign oil arm -- albeit through a link-up with the Kremlin's other national energy champion, Gazprom.

"The state is interested in promoting their experiences abroad," Kremlin spokesman Dmitry Peskov said, referring to private Russian oil firms. "At the same time, the state is interested in preserving its position in strategic sectors."

The ceding of Shell-run Sakhalin-2 to Gazprom control, and an anticipated change of ownership at TNK-BP, give the clearest indication that the new rules are at play.

"[President Vladimir] Putin doesn't want to renationalize the entire energy sector. He does want to control it through equity and regulation, but he wants a mixed ownership structure," said Clifford Kupchan, a senior analyst at Eurasia Group. "He knows there are things that Russia can't do."

ConocoPhillips' buying into LUKoil in September 2004 came as good news to a sector rocked by the state's campaign to dismantle Yukos over billions of dollars in back tax claims. Conoco's investment also encourages the "strategic reciprocity" that officials are eager to promote. LUKoil now operates several thousand gas stations outside Russia, including 2,000 in the United States.

Yet some see a darker game behind the state's choice to promote LUKoil abroad, which was formalized in an April 2 agreement between the company and the Foreign Ministry.

"Since Rosneft is not able to go overseas because of the legal cloud hanging over them from the Yukos acquisitions, LUKoil is as good a political tool as Russia has," said Julia Nanay of consultancy PFC Energy.

Rosneft has emerged the main beneficiary of Yukos' destruction, and its purchase of Yukos' main production unit at a forced auction in December 2004 transformed it overnight from a mid-tier firm to the country's second-largest producer. Rosneft is tipped to acquire the last two Yukos production units at auctions in May. Its reserves would then jump 3.4 billion barrels, overtaking LUKoil.

Yukos' majority shareholders have vowed to make Rosneft suffer as a result, and attempted to block its IPO last year.

Yukos chief Mikhail Khodorkovsky's arrest in October 2003 came amid speculation that he was close to selling a major stake to a U.S. oil major, such as ExxonMobil or ChevronTexaco.

Yet LUKoil has been able to thrive with Conoco as a partner.

"Conoco is not one of the two major U.S. companies, so it's a little less threatening," Nanay said, adding that Conoco CEO James Mulva "has been careful to meet with Putin and clear his moves with the Kremlin."

So has LUKoil's longtime CEO, Vagit Alekperov, who has managed to cement a closer relationship with the Kremlin as it has become clear that Putin expects to bless all major deals.

Rosneft leads LUKoil on market cap, with $82 billion versus $72.9 billion. It lags just behind LUKoil in proven reserves, holding 15 billion barrels versus 16 billion.

Last week, LUKoil's price-to-earnings ratio stood at just 8.2, versus 23.6 for Rosneft.

"Investors have viewed LUKoil as a company that has been on hold," said Chris Weafer, chief strategist at Alfa Bank. "Even though the state doesn't have direct ownership, its role in controlling the industry is so all-dominant, and the company's share price reflects that. Yes, it's a private company, but it really has no independent choices."

Many view the Foreign Ministry deal as a way to end uncertainty and seal its mission as the oil firm chosen to represent Russia abroad.

LUKoil's new 10-year strategy calls for it to spend $27 billion to boost overseas output to 800,000 barrels per day. It already operates dozens of fields and refineries overseas, from Eastern Europe to the Middle East.

"We have long cooperated with the Foreign Ministry, and it was time to formalize it," LUKoil spokesman Vladimir Semakov said, shrugging off Rosneft's imminent prominence as "of no concern to us."

LUKoil's turn outward was underlined by its venture with Gazprom Neft in November to acquire oil assets, in which Gazprom's oil arm will hold a controlling stake.

"International business is the attractive part of LUKoil," Weafer said. "This joint venture will eventually allow the state to get more direct access and control over its international operations."