BP's Russian deal oils the wheels

Jun 21, 2007 02:00 AM

by Stanley Reed and Jason Bush

The deal announced by BP and Gazprom on June 22 resolving the dispute over the Kovykta gas fields is probably the best the London energy giant could have hoped for. Right down to the wire it looked as if BP might be a big loser.
Now it appears BP has finessed the situation to form what could be a promising partnership with Gazprom. If so, such a linkup may ease the pressure on BP in Russia and allow it to move ahead with other projects there. Such a tie-up might also aid Gazprom's international ambitions.

Under the deal, BP's 50 % owned Russian subsidiary, TNK-BP, will sell its 62.89 % interest in Russia Petroleum -- which holds the license for the fields in East Siberia -- to Gazprom for as much as $ 900 mm. In return, the memorandum of understanding gives TNK-BP an option to later buy a 25 %-plus-one-share stake in Kovykta.
BP will also form a "strategic alliance" with Gazprom to invest in energy projects and swap assets both inside and outside of Russia.

Eager to expand
BP said the two companies will initially look at projects worth at least $ 3 bn.
"Of all the possible outcomes, this is definitely one of the better ones," says Chris Weafer, chief equity strategist at Alfa Bank in Moscow. "It means that BP now finally has in place a mechanism by which it can grow its business in Russia and get involved in some of the big projects."

Working with BP might also make Gazprom more efficient at home and a more welcome investor internationally. Gazprom, which has tremendous gas reserves, lacks technical expertise in areas such as management of major projects, offshore drilling and production, and working with liquefied natural gas (LNG). Gazprom also is eager to expand internationally, though it is not obvious what competitive advantage it brings to projects that don't involve Russia or Russian gas.
At present the Russian giant suffers from a reputation for clumsy, hardball tactics. Weafer speculates that Gazprom may be interested inusing BP as its route into the British gas market, where Gazprom has been stalking Centrica, the major domestic gas distributor.

Arduous negotiations ahead
Gazprom has been stiffing BP on Kovykta for years, but a breakthrough occurred in a meeting between BP chief executive Tony Hayward and the Gazprom CEO Alexei Miller about a month ago. Since taking over from former boss John Browne earlier this year, Hayward has made improving BP's Russia situation a top priority. He says he has visited Russia six times already in 2007.
While the price tag doesn't represent anything close to the potential value of Kovykta, TNK-BP had been stuck and was on the verge of losing its license. It was unable to export the gas without the cooperation of Gazprom, which monopolizes all Russian gas exports.

Moreover, according to Kris Sliger, TNK-BP's executive vice-president for strategy, the project's costs are likely to exceed $ 20 bn and will involve arduous negotiations with China, which is the customer envisioned for the gas.
"Ultimately it will be developed, but we don't know when or for what price," Sliger says. "We never had the reserves on our books."

People close to BP have been saying for months that a 25 % stake was the outcome for which they were aiming. BP has invested $ 400 mm or so in infrastructure in Kovykta.
"It's better than could be expected," says Valerie Nesterov, oil and gas analyst at Troika Dialog, a Moscow investment bank. "They received decent compensation for incurred costs and spent time." Still in its early stages, Kovykta is not in the same league as Sakhalin-II, a multibillion dollar project that was well underway when Royal Dutch Shell was forced to cede control to Gazprom last December, Nesterov says.

End of the Oligarchs?
The lesson that all big international oil companies are learning in Russia is that in the current high-price environment it is very difficult to survive without a powerful local partner. BP in particular wants to be seen as a company that will be a good corporate citizen in Russia and do business in the way the Russians want. And that means helping the Russians, who have plenty of cash, with advanced technology and overseas expansion.
"What Russia wants is reciprocal investment opportunity abroad," says TNK-BP's Sliger. "Real reciprocal engagement is the critical next step."

The deal with Gazprom leaves wider issues still unresolved. Above all there is the future of TNK-BP. The company, which is jointly owned by BP and three Russian oligarchs, was formed in 2003 with the blessing of President Vladimir Putin, but it has seemed to lose favour of late.
Observers speculate that BP's 50 % ownership is too high for current Russian tastes, and that the Kremlin eventually wants to replace the oligarchs with a state-owned company such as Gazprom or Rosneft, Russia's other major oil and gas player. Still, some analysts think that cutting a deal with Gazprom may ease the pressure on BP.

While it remains to be seen whether Miller will deliver, it would certainly be an advantage for Hayward if he could persuade such a major player to be his partner.
"I believe that now political risks for TNK-BP are mitigated in Russia," says Troika analyst Nesterov. BP appears to remain committed to Russia and still holds a lead there over international rivals such as ExxonMobil and Royal Dutch Shell. The company says it has already earned back its roughly $ 8 bn investment in TNK-BP.

BP can ill afford to lose a venture that accounts for one-fifth of its world reserves, a quarter of its production, and 10 % of profits. The company has other Russia interests, including a joint venture with Rosneft on Sakhalin-Island.
Recently Hayward told an audience in Moscow, "I would be misleading you if I claimed everything has always been sweetness and light. It hasn't. There have been bumps in the road -- you might have seen we are going over one at the moment." But he says BP is in Russia for the long haul. At this point it doesn't have much choice.

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