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. Last Updated: 07/27/2016

How the State Got a Grip on Energy

APPutin shaking hands with workers during a presidential campaign stop at an oil field in Surgut on March 3, 2000.
Editor's note: This article, the 10th and last in a series about President Vladimir Putin's legacy, examines the energy sector.

It was early March 2000 when Vladimir Putin landed in Surgut, one stop on a long campaign trail that would help take the acting president to the official seat in the Kremlin.

He toured the oil fields that surrounded the bleak west Siberian city, shaking hands with the men who toiled to produce the black gold that was the country's lifeblood.

It was in Surgut -- before the high-profile arrests and well before the days of $100-per-barrel oil -- that Putin first gave a glimpse into what would become a defining strategy of his eight-year rule.

"We will support [oil and gas companies] by all means, but we will also control their work," he said, hinting at a sector-wide review that would boost the state's presence in an industry that had become the domain of dueling oligarchs.

Eight years later, two state champions -- Rosneft in oil and Gazprom in gas -- tower over a sector that provides for two-thirds of the federal budget and forms the foundation of the country's swaggering foreign policy.

The road to majority state control was rough, leaving a number of private businessmen jailed or exiled and foreign companies largely sidelined. Most worrisome, insiders and analysts said, was that the strategy of state control has left production stagnating at near crisis levels, as the firms were encouraged to focus on acquisitions rather than making much-needed investments in new fields.

"We had high hopes that this period, an eight- to 10-year period, would be one of the major breakthroughs in developing certain very important projects," said Vladimir Milov, a former deputy energy minister.

Instead, Milov, who became a Kremlin critic after leaving the Energy Ministry in 2002, speaks of an era of "disappointed expectations."

"Putin's legacy is largely a bunch of heavy discussions with few delivered projects," he said. "Putin's presidency has mostly focused on the redistribution of ownership and using energy resources as a tool for expanding Russia's international influence."

An Encouraging Start

When Putin came to power around 90 percent of the country's oil production lay in private hands. Foreign oil companies, like Shell and ExxonMobil, ran huge projects in the east, after concluding preferential contracts in the mid-1990s that offered them favorable terms in order to compensate for the country's volatile tax and legal system.

It was a total departure from the policy of the Soviet state that built Putin and an anathema to the powerful state that he hoped to rebuild. He took notice of the fact early, devoting a 1997 doctoral thesis at the St Petersburg Mining Institute to the state's role in managing natural resources.

That role was impossible to realize while the country was run by a gaggle of oligarchs long used to pulling the Kremlin's strings. Putin quickly moved to rein them in, calling a meeting in late 2000 to announce: Stay out of politics and business is yours.

Investors were encouraged. Putin appointed liberals to top government spots. In September 2000 he visited the far eastern island of Sakhalin and called for foreign investors to be supported.

He urged a revitalization of the energy industry by bringing online new oil and gas fields in the largely untouched eastern Siberia and offshore regions, as well as new export pipelines, such as a major route to the northern port of Murmansk.

The optimism reached its peak in February 2003, when a trio of oligarchs joined with British oil major BP to form TNK-BP, a 50-50 venture formed around the flagship gas field of Kovykta, in largely untapped eastern Siberia.

Announcing the deal, Mikhail Fridman, head of TNK-BP shareholder Alfa Group, said: "It is a reflection of the political change that has taken place in Russia over the past three years. Russia has stopped being associated with instability and nontransparency."

The Yukos Attack

Five months later, Platon Lebedev, a major shareholder in oil firm Yukos, was arrested on suspicion of illegally acquiring shares in a fertilizer firm Apatit back in 1994. In October 2003, Khodorkovsky, Yukos CEO and then the country's richest man, was arrested and the legal onslaught on the country's largest oil company began, forever changing the landscape of the energy sector and the view of Russia and Putin's Kremlin.

Igor Tabakov / MT
Mikhail Khodorkovsky on trial
What precisely prompted the arrest is anybody's guess -- that Khodorkovsky was on the verge of selling a 25 percent stake in Yukos to a U.S. oil company, that he was planning to build a pipeline to China to bypass state-run pipeline monopoly Transneft, that he was openly funding opposition deputies ahead of December's State Duma vote, or that he planned to grow even larger through a merger with Roman Abramovich's Sibneft.

The final straw came in February 2003, when Khodorkovsky publicly criticized Putin for state-run Rosneft's murky acquisition of medium-sized producer Severnaya Neft.

"We knew we would have serious problems," said Alexander Temerko, a former Yukos vice president now living in self-imposed exile in London. "While they had a monopoly position in gas [with Gazprom], they didn't have one in oil."

Khodorkovsky was sentenced in 2004 to eight years in prison on charges of fraud and tax evasion, and the lion's share of Yukos assets went to Rosneft in a series of orchestrated auctions, epitomized by the December 2004 sale of Yuganskneftegaz. He accused Igor Sechin, Putin's powerful deputy chief of staff and chairman of Rosneft's board, of orchestrating the attack on Yukos.

Yuganskneftegaz, which produces 11 percent of all Russian oil, went to an obscure company called Baikal Finance Group for just $9.4 billion. Rosneft bought Baikal weeks later, tripling its own production overnight and putting it on the path to becoming the country's largest oil producer -- a goal it achieved last year after buying the two remaining large Yukos units up for grabs.

"We are a state company and at the same time a public company, and one of our strategic priorities is to continue to improve our operations in order to demonstrate to our main shareholder that we are the best partner for developing new assets in Russia," said Rosneft vice president Peter O'Brien, an American who was brought to the company ahead of its July 2006 initial public offering in London, which saw nearly 15 percent of the company sold off.

"During the IPO process, clearly some market participants, whether press or investors, did have a view toward the Yukos process which inhibited them from taking part in the IPO," he said, but added, "Since the IPO, as we've followed through on increasing transparency and profitability, interest and share ownership by leading global institutions has accelerated."

Rosneft's Yukos acquisitions, plus Gazprom's purchase of Sibneft in 2005, drastically boosted the state's share in the energy game.

The approach was codified as early as May 2003, when the Cabinet passed an energy strategy through 2020 that signaled the beginning of the end of private reign over the sector.

Temerko, the former Yukos vice president, said that, after reading the strategy, "we knew they'd go after some company."

The first line of the strategy reads: "Russia possesses great energy resources and a powerful fuel and energy complex that provide the basis of economic development and are the instrument for carrying out domestic and foreign policy."

"It was then we realized the state runs everything," Temerko said.

It took foreign oil companies and foreign capitals longer to wise up.

The euphoria of the TNK-BP deal faded into widespread concern over the role foreign firms would play, as they functioned in a legal vacuum while the state carved out its strategy through practice rather than regulations.

"[TNK-BP] represented the end of that chapter, when foreign companies could get almost unrestricted access to Russia's energy sector," said Chris Weafer, chief strategist at UralSib.

A notable exception is ConocoPhillips' 2004 acquisition of a small stake in private oil firm LUKoil, which it has since increased to 20 percent.

Foreign oil firms rushed the country in the mid-1990s, capitalizing on its chaotic industrial landscape to win major contracts in the country with the world's largest proven gas reserves and vast untapped oil fields. For the most part, they were awarded production-sharing agreements, which ensured that the firms would win back all expenditures before paying out revenues to the state.

With the oil price inching ever higher on the back of instability in the Middle East and rising demand from China and India, Putin realized that the state was missing out on billions of dollars per year and soon joined the trend of global resource nationalism.

Sustained campaigns led by Oleg Mitvol, the deputy head of the Natural Resources Ministry's environmental watchdog, cast shadows over Royal Dutch Shell's PSA at Sakhalin-2 and TNK-BP's flagship Kovykta project.

Months of pressure, during which Mitvol threatened to revoke the firms' licenses over purported environmental violations, ended with Shell handing a controlling stake in Sakhalin-2 to Gazprom and TNK-BP selling the entirety of its 63 percent stake in Kovykta to Gazprom.

Rather than codifying a long-awaited law on strategic sectors, which would limit foreign involvement to 49 percent stakes, Putin laid out his strategy through practice.

"It's a strategic sector and certain rules are being applied, like in every country of the world," Kremlin spokesman Dmitry Peskov said.

"The situation with Sakhalin and Kovykta occurred when foreign companies, foreign major shareholders, were having problems with Russian law. It is easier for every company to have a joint venture with Russian partners to avoid that," he said.

Gazprom's stake in Sakhalin-2, a sprawling project in the Far East, gave it a foothold in the country's first foray into liquefied natural gas, in which gas is cooled to liquid form so it can be easier stored and shipped on tankers, rather than confined to pipelines.

Yet it has failed to follow through on decades-long promises to develop much-needed fields on the Yamal Peninsula and has delayed plans to produce from Shtokman, a field in the Arctic offshore estimated to hold 3.7 trillion cubic meters of gas.

"It is much easier to use the windfall to acquire companies that already generate cash" than bring new projects online, Milov said. "I'll quote a top Gazprom manager, who once said to me, 'Why should we bury money in Yamal, in the development of projects that will start to deliver in a decade, when many Gazprom managers will be long gone?'"

This has prompted concern in Europe, which relies in Russia for one-quarter of its gas supplies -- an amount expected to grow to half by 2030.

The Gazprom Behemoth

Many had held high hopes that Putin would seek to reform Gazprom after replacing Yeltsin's management team with his own, led by St. Petersburg native Alexei Miller as CEO.

Yet, eight years later, Gazprom remains an unwieldy behemoth, employing some 500,000 people and the domain of competing clans eager to shape what has become the country's largest firm by market capitalization, with a value of $312 billion. Its current chairman is President-elect Dmitry Medvedev.

A politically tinged pricing dispute with Ukraine in January 2006 signaled to Europe the return of "the Russian bear."

"EU fears of over-dependence on Russian gas are a concrete expression of the progressive breakdown of political relations with Moscow, stemming from a range of issues of Russian domestic and international politics," said Jonathan Stern, gas expert at the Oxford Institute of Energy Studies.

Just months after Ukraine's Orange Revolution ushered in a Western-leaning government, Gazprom abruptly announced its own brand of shock therapy in December 2005, cutting subsidies to Kiev and drastically raising gas prices to its eastern neighbor. When Kiev couldn't pay, Gazprom shut the taps, reducing shipments not only to Ukraine, but also to Europe, which gets some 80 percent of its Russian gas shipments through pipelines that crisscross the country.

"I don't think it really led to any serious change with Europe, which is traditionally our biggest market," said Ilya Kochevrin, executive director at Gazprom Export. "The only recognition is that we need to be more proactive in explaining our position."

Kochevrin said he did not believe that resistance to Gazprom expansion into Europe, as well as Brussels' proposal last year to bar non-EU firms from owning majority stakes in pipelines or power grids in the absence of reciprocal agreements, were direct responses to Gazprom's growing politicized clout.

Pricing disputes with neighboring countries prompted Gazprom to pursue a strategy of direct shipments to Europe, including the Nord Stream pipeline, which will pump gas directly to Germany, and South Stream, which will send gas to the Balkans.

Putin has spent the past few years eagerly pushing "strategic reciprocity," hoping to gain a solid foothold in the European market beyond long-term gas supply deals and pipeline agreements.

Yet, with the notable exceptions of Germany and Italy, Europe's two largest gas importers, the opposition has been stiff.

"When we talk about the energy sector in Russia it is impossible to separate politics and economics, and that's never going to change," said Weafer of UralSib.

It is also impossible to separate the personal and professional, since, as one former bureaucrat put it, "everyone is trying to be the next Armand Hammer," referring to the U.S. oil magnate who won key deals during the Soviet era through strong relationships with the leadership.

Putin's close relationship with Gerhard Schr?der put the former German chancellor at the head of the Nord Stream consortium.

Those who fall afoul of the regime and its energy champions tend to suffer. William Browder, CEO of Hermitage Capital Management, then Russia's biggest foreign portfolio investor, was denied entry into the country upon landing at Sheremetyevo Airport in November 2005, on the suspicion that he posed a threat to national security. The move was widely seen as retaliation for Browder's outspoken calls to improve Gazprom's transparency.

Supply Shortages

One of the most worrisome results of the past eight years, insiders and analysts said, is that Russia may soon face the prospect of failing to produce enough oil and gas supplies to feed growing markets both at home and abroad.

One hallmark of Putin's presidency was the decision to liberalize gas prices inside the country, due to be achieved by 2011, in order to make the domestic market more attractive for its producers.

Yet, the fact remains that production at Soviet-era fields in western Siberia is dwindling, and political distraction, in addition to unfavorably high tax regimes, means that the Arctic and eastern offshores remain largely undeveloped.

"This is the result of the fact that private initiatives have been curbed and the advantage has been given to state companies, whose interest is not in production, but in the redistribution of control," Milov said.

This has also increased Russia's dependence on buying gas from Central Asia, in the absence of long-term supply contracts and amid signs that countries like Turkmenistan are seeking to raise their own prices to market levels.

Milov said Central Asian gas comprised 8 percent of Gazprom's reserve base, up from 4 percent in 2002. And oil production, after years of a steady rising, faces the specter of falling flat this year.

"Without Rosneft, Russian production recently has basically been flat. With Rosneft, it's growing 1 to 2 percent annually," said O'Brien of Rosneft. "The vast majority of other oil producers are now fighting declining production.

"Ruble appreciation and inflation and a tax regime that is outdated will soon make it difficult to approve some potential projects," O'Brien said. "Many projects look questionable in terms of future profitability, even with fairly optimistic, that is, low, inflation assumptions."

"If something is not done soon, then many companies, particularly those with older portfolios, will need to reject investment proposals and as a result will see an accelerating decline in their oil production," he said.

Putin has followed through on promises to reassert the state's influence. Around 42 percent of Russian production now lies in state hands, versus 10 percent when he first took the reins, according to UralSib research.

That proportion is expected to rise if troubled oil producer Russneft, whose former owner Mikhail Gutseriyev last year accused the Kremlin of forcing him to sell, ends up in state hands. The fate of TNK-BP also remains unclear.

The world of energy reflects the broader state of the country. Its firms are staffed with Putin's friends and FSB agents, from new Transneft chief Nikolai Tokarev to Andrei Patrushev, the younger son of Federal Security Service director Nikolai Patrushev who acts as an adviser at Rosneft.

It is fiercely controlled from the Kremlin. Before Putin announced that he would take the prime minister's seat upon Medvedev's election to the presidency, Moscow's chattering classes proposed that he might move to chair Gazprom's board.

Beyond the importance of the state's control over the energy sector, the energy sector's control over the state is just as key.

Despite loud pronouncements on the need to diversify, Russia's economy remains inextricably linked to the dipping production of oil and gas, with revenues squirreled away in a $168 billion stabilization fund that is intended in large part to encourage wider economic growth.

Yet the problem of its politicization remains.

"The government has become used to a high oil price that suits what it wants to do in the economy," Weafer said.

An announcement last month that the three-year budget would boost its oil-price prediction to $74 per barrel -- a sum that is, for the first time ever, higher than the previous year's average -- provoked worry. UralSib predicts that the country will begin eroding its surplus if the price dips to $64.

"It's a real threat to the fiscal prudence we've had, which is part of the Russian story of the past eight years," Weafer said.

"The legacy of the Putin era is that, at the end of it, Russia is even more dependent on energy than it was at the start of it," he said.

Previous reports about Putin's legacy can be found online at

Energy Milestones

September 2000: Putin promises to support foreign investors and production-sharing agreements.
May 2001: Putin replaces Gazprom CEO Rem Vyakhirev with longtime St. Petersburg ally Alexei Miller.
February 2003: TNK-BP formed through BP's $6.75 billion investment into the joint venture with three oligarchs, the largest ever equity deal in Russia at the time.
February 2003: Yukos CEO Mikhail Khodorkovsky publicly questions Putin on state-run Rosneft's acquisition of mid-level producer Severnaya Neft.
May 2003: The Cabinet passes a state energy strategy through 2020, calling the energy sector an instrument for carrying out domestic and foreign policy.
July 2003: Major Yukos shareholder Platon Lebedev is arrested.
October 2003: Khodorkovsky is arrested.
December 2003: Yukos hit with a back tax bill of $3.5 billion, the first in a series that eventually reaches $33 billion.
July 2004: Putin's powerful deputy chief of staff Igor Sechin replaces Economic Development and Trade Minister German Gref as chairman of Rosneft.
September 2004: U.S. oil firm ConocoPhillips buys a 7.59 percent stake in LUKoil for $2 billion.
December 2004: Yukos' largest production unit, Yuganskneftegaz, is sold at auction for a knockdown price to Baikal Finance Group, later bought by Rosneft.
December 2004: The Energy Ministry approves oil pipeline monopoly Transneft's plans to build a major pipeline eastward, amid wrangling whether it will end in China or Japan.
May 2005: Khodorkovsky and Lebedev are found guilty of fraud and tax evasion and sentenced to eight years in prison.
May 2005: Gazprom and Rosneft call off a floated merger.
August 2005: Khodorkovsky accuses Sechin of orchestrating the attack on Yukos.
September 2005: Gazprom buys Roman Abramovich's Sibneft for $13.01 billion in the biggest takeover deal in Russian history at the time.
September 2005: Germany and Russia agree to build Nord Stream pipeline, providing direct gas deliveries to Europe.
November 2005: William Browder, CEO of Hermitage Capital Management and activist Gazprom minority shareholder, is barred from entering Russia on grounds that he poses a threat to national security.
January 2006: Gazprom cuts gas deliveries to Ukraine for three days following a pricing dispute.
March 2006: Putin, during a trip to China, signs a deal pledging to eventually sell gas to the country.
July 2006: Rosneft raises $11 billion during an initial public offering in London.
August 2006: A Moscow court declares Yukos bankrupt.
October 2006: Gazprom says it will develop the Shtokman gas field alone and retain 100 percent ownership, shutting down years of negotiations with foreign partners.
December 2006: Royal Dutch Shell, Mitsui and Mitsubishi each halve their shares in Sakhalin-2 to hand Gazprom a controlling stake in the project for $7.45 billion following months of pressure from environmental authorities.
February 2007: Putin says he finds the idea of a gas OPEC "interesting."
May 2007: Rosneft buys Samaraneftegaz and Tomskneft, Yukos' final two production units, at auction for $13.2 billion.
June 2007: TNK-BP seals a deal to sell its 62.9 percent stake in its flagship Kovykta field to Gazprom for $700 million to $900 million following months of pressure from environmental authorities.
July 2007: Russneft owner Mikhail Gutseriyev flees the country after accusing the state of forcing him to sell his firm through the levying of politicized tax charges; Oleg Deripaska's Basic Element says it is in talks to buy the firm.
July 2007: Reversing course, Gazprom gives France's Total a 25 percent stake in developing Shtokman.
September 2007: The EU issues proposals on unbundling of its power industry, seen as a move to bloc Gazprom's access.
October 2007: Gazprom gives Norway's StatoilHydro a 24 percent stake in developing Shtokman.
- MT