Bloomberg News

Morgan Stanley Enabled Rosneft as No. 1 Until Crimea Grab

August 18, 2014

Long before the Ukraine crisis ruptured U.S.-Russian relations, Vladimir Putin and his right-hand man, Igor Sechin, hosted then-Morgan Stanley Chief Executive Officer John Mack at an exclusive reception at Putin’s Novo-Ogaryovo estate outside Moscow.

According to the Kremlin, Putin thanked Mack and a few other foreign bankers at the October 2006 gathering for leading the $10 billion initial public offering of OAO Rosneft, the state-controlled oil giant headed by Sechin. He then chatted with the bankers for an hour in a formal meeting room.

Putin and Sechin have a lot more to thank Morgan Stanley (MS:US) for. The American investment bank helped transform state-owned Rosneft from a business the Russian government failed to sell three times in 1998 into the world’s biggest publicly traded oil producer by output. Morgan Stanley played a key role in saving it from being acquired, and Rosneft hired three consecutive chief financial officers from the bank. In 2013, Putin approved Mack’s appointment to Rosneft’s board.

Since the Soviet Union broke up a quarter-century ago, Russia has become so closely entwined with the global economy that doing anything to unwind those ties -- or successfully impose sanctions for misbehavior -- is proving difficult for the U.S. and its allies, and awkward for western businesses that embraced Putin’s Russia. With Sechin and his oil company both under U.S. sanctions, a look at the courtship, marriage, and now separation between Morgan Stanley and Rosneft is a telling microcosm of this turnabout.

Russian Influence

Under the Putin regime, the line between business and government is often blurred, especially with state-controlled companies. As Rosneft expanded, in part by buying assets that Putin had forced an imprisoned political opponent’s company to sell, it became one of his favorite tools for extending Russian influence abroad.

“Rosneft was obviously not just an ordinary market participant,” said Daniel Treisman, a professor of political science at the University of California at Los Angeles and author of several books on Russia, most recently “The Return: Russia’s Journey from Gorbachev to Medvedev” in 2011.

“Sechin had been President Putin’s sidekick for years,” Treisman said. “This was a company with very good connections that was prepared to use them. I imagine the analysts at Morgan Stanley understood this.”

With the advent of a new Cold War, the U.S. barred Americans from doing business with Sechin in April, citing his “utter loyalty to Vladimir Putin -- a key component to his current standing.” Last month, the U.S. restricted companies from providing long-term debt financing to Rosneft, as Morgan Stanley and other western investment banks used to do.

‘Threat to Globalization’

“Since 1990, we, meaning the entire banking industry, were going all over the world, lending and investing money, selling what we considered in those days the western model of market economy,” said Hans-Joerg Rudloff, former chairman for investment banking at Barclays Plc and a Rosneft board member until last year.

Sanctions against Russia pose “the biggest threat to globalization since the early 1990’s,” he added. “If you were the CEO of a big bank, are you going to put yourself on the radar screen of a U.S. government that is telling you not to deal with Russia?”

Morgan Stanley earned an estimated $360 million in investment banking fees in Russia from 2002 through 2013, more than any other Western bank, according to Freeman & Co, a New York-based consulting firm. This year, Morgan Stanley is tied for eighth place among U.S. and European banks. Morgan Stanley, which had total 2013 revenue of $32.4 billion, doesn’t break out its Russian revenue.

Russian Economy

“As everyone knows, the Russian economy has evolved over the last 30 years and Russian businesses have become integrated into the global marketplace, leading Western firms to increase their business presence there,” said Mark Lake, a Morgan Stanley spokesman. He declined to respond to a detailed list of questions about the firm’s history with Rosneft.

Now an advisory director at New York-based Morgan Stanley, Mack also declined to respond to questions. “You really need to talk to Morgan Stanley,” he said in a brief telephone conversation. “I don’t think it’s appropriate for me to comment on anything from Morgan Stanley since I’m retired.”

Morgan Stanley sought to facilitate Russia’s shift to a market economy, and couldn’t have anticipated the Ukraine crisis, said Yanni Kotsonis, director of New York University’s Jordan Center for the Advanced Study of Russia.

“What was Morgan Stanley supposed to know at the time?” Kotsonis said. “We knew that Russia was corrupt, but that applies to virtually any country producing oil nowadays.”

Rosneft’s press service declined to comment on behalf of the company and Sechin regarding the relationship with Morgan Stanley. Putin spokesman Dmitry Peskov didn’t respond to multiple requests for comment.

Ukraine, Crimea

Rosneft is part of Russia’s formidable presence in eastern Ukraine. It exports oil to Ukraine by pipeline, owns the Lisichansk refinery in eastern Ukraine and operates 150 gas stations and seven storage terminals in the country, according to its website. Rosneft announced in May, two months after Russia annexed Crimea, that it would increase jet fuel supplies to Russian airlines at the peninsula’s Simferopol airport.

Rosneft’s deals elsewhere have also dovetailed with Putin’s foreign policy goal of reasserting Russia as a world power and pivoting away from reliance on Europe and the U.S.

‘Geopolitical Purposes’

In 2009, Putin and the late Venezuelan President Hugo Chavez agreed to develop oil fields with five Russian energy companies, led by Rosneft and Sechin. The pact helped secure a $2.2 billion Russian credit line allowing Venezuela to buy tanks, missiles and an anti-aircraft defense system.

In 2010, Rosneft paid $1.6 billion to Venezuela’s oil company for its stake in four German refineries, even though refining had been losing money in Europe for five years. “Russia is very interested in the stake for geopolitical purposes,” Chavez said on Russian state television.

Rosneft’s oil is a major element in Putin’s strategy of improving relations with China as a counter-weight to U.S. influence. The company signed more than $350 billion worth of oil supply deals with China last year, which included about $70 billion in pre-payments, Putin estimated.

“The hike in crude exports signals an important, strategic shift east for Russia,” Eurasia Group analyst Emily Stromquist wrote in a note at the time. Sanctions are accelerating this redirection as Russian companies seek cash from Asian buyers to replace lost western financing, she said in an e-mail.

Oil Partners

Rosneft’s western partners, from Exxon Mobil Corp. to Norway’s biggest energy company, have been assessing the impact of the sanctions. Exxon, which began drilling this month with Rosneft on an Arctic well that will cost as much as $700 million, is “under pressure” and may be forced to suspend its participation in Russian projects, Rosneft Chairman Alexander Nekipelov said July 29.

Besides Morgan Stanley, banks that have done significant work for Rosneft include JPMorgan Chase & Co. (JPM:US), Citigroup Inc. (C:US), and London-based Barclays. All three banks declined to comment.

Rosneft traces its roots to oil exploration during the Czarist era. The modern company was created in 1993, combining more than 250 former Soviet oil extraction and refining operations. Low global oil prices and difficulty collecting debts dogged the fledgling company, prompting the Russian government’s unsuccessful efforts to sell it in 1998. Rosneft’s profits swelled as oil prices more than quadrupled between 1998 and 2004.

Gazprom Deal

In July 2004, Putin installed Sechin, his deputy chief of staff, as Rosneft’s chairman. A former Soviet military translator in Angola, Sechin had a doctorate in economics but no hands-on oil experience.

Two months later, the Russian government announced that OAO Gazprom, the state-controlled natural gas producer, would buy Rosneft. The proposed deal would have increased the Kremlin’s control over Russia’s oil and gas industry by swapping Rosneft for 10.7 percent of Gazprom held by units of the gas company. The resulting entity would have been majority-owned by the government.

Rosneft was about to disappear. Then it received a stay of execution, thanks to Morgan Stanley. The bank had opened its Moscow office in 1994, a year after Rosneft’s founding.

Lean Years

In 1998, Morgan Stanley hired Rair Simonyan, an economist and former Rosneft vice president for international investment, to run its Moscow office. When Russia defaulted on debt payments that year, causing its economy to contract by more than 5 percent and prompting several Western banks to quit the country, Morgan Stanley kept its office open, enhancing its credibility with Russian companies, Simonyan said.

The bank suffered through several lean years until work finally began to flow in. In December 2002, Morgan Stanley managed the Russian government’s $775 million sale of a stake in OAO Lukoil, then the country’s top oil producer. Three months later, Morgan Stanley led Gazprom’s $1.75 billion corporate bond issue, Russia’s largest to that point. In June 2003, the bank advised BP Plc on the creation of Russian oil company TNK-BP. (TNK-BP was bought last year by Rosneft).

By raising Morgan Stanley’s profile in Russia and at the Kremlin, those deals set the stage for the relationship with Rosneft, said a former executive of the bank, who asked not to be identified for fear of repercussions to his career.

Rescuing Rosneft

First, Rosneft needed to be rescued from Gazprom. In November 2004, the Russian government hired Morgan Stanley to value Rosneft as part of the sale. The government had already worked with Morgan Stanley on the Lukoil deal, and Sergei Bogdanchikov, then Rosneft’s chief executive, had a longstanding friendship with Simonyan.

According to its Moscow spokesman at the time, Morgan Stanley estimated Rosneft’s worth at as much as $8.5 billion -- well above the $6 billion price tag set by now-defunct Dresdner Kleinwort Wasserstein, which Gazprom had retained to do its own valuation. That difference put the companies at odds and slowed their merger, said one person who was directly involved in the discussions at the time. Sechin was grateful to Morgan Stanley for the assessment, said two people involved in the process.

The delay enabled Rosneft to take advantage of an opportunity. Besides buying Rosneft, Gazprom had also planned to bid for Yuganskneftegaz, the main production unit of then-billionaire Mikhail Khodorkovsky’s Yukos Oil Co. Once Russia’s richest man, Khodorkovsky was arrested in October 2003 on charges of tax evasion and fraud, after he had funded opposition political parties. The government had seized Yukos and was selling it off to pay tax claims.

Restraining Order

In December 2004, a U.S. court issued a restraining order effectively preventing Gazprom from bidding on Yuganskneftegaz. Baikal Finance Group, an unknown and hastily assembled entity registered to an address above a local bar in the city of Tver, northwest of Moscow, won the auction with a $9.3 billion bid. It was acquired four days later by Rosneft with funds from state banks, bringing to the oil company a unit that pumped about 1 million barrels a day. The purchase more than tripled Rosneft’s output and became the foundation for its booming business today.

Khodorkovsky, who spent a decade in a Russian prison, said last December that Sechin masterminded the state’s attacks on Yukos and his company’s demise. Last month, the Permanent Court of Arbitration in The Hague found that Russia owed $50 billion to Yukos investors for taking the company’s assets -- most of which wound up with Rosneft. Other courts, including a U.S. district court, have issued similar rulings, and the Russian government has refused to pay.

‘Stolen Goods’

“It’s always wrong to handle stolen goods and Yukos was stolen goods,” said Anders Aslund, a senior fellow at the Peterson Institute for International Economics in Washington and a former economic adviser to the Russian and Ukrainian governments. Morgan Stanley should have stopped working with Rosneft, he said.

While Rosneft’s sudden growth stymied the Gazprom takeover, the Russian government still wanted to raise its stake in the gas company. So Morgan Stanley and three other banks arranged a $7.5 billion bridge loan in 2005 to Rosneft to fund the Gazprom share purchase.

Morgan Stanley then began escorting Rosneft’s chief financial officer, Sergei Alexeev, to New York and London to introduce the company to western investors and persuade them that the Yukos purchase didn’t stain its image.

‘Cornered Us’

The presentations were so successful that when Alexeev left in February 2006, Rosneft decided to replace him with Peter O’Brien, the banker who supervised the roadshow. O’Brien was the first of three consecutive bankers from Morgan Stanley’s Moscow office who would hold the role.

In July 2006, Simonyan at Morgan Stanley and O’Brien at Rosneft led the oil company’s $10.4 billion IPO, the largest in Russian history. It wasn’t without last-minute hitches. Over-ruling bankers who wanted to set the share price at a discount compared to Lukoil, Sechin insisted on a premium.

“He cornered us,” Simonyan said.

In 2007, Morgan Stanley was among eight banks that organized a $22 billion syndicated loan to finance Rosneft’s purchase of most of the rest of Yukos’s assets.

“Russia has been a very significant area,” David Sidwell, then Morgan Stanley’s chief financial officer, said in an earnings call that year.

At its peak, Morgan Stanley’s downtown Moscow office above a Starbucks coffee shop had about 130 employees. Russia became one of Morgan Stanley’s biggest European markets, according to Simonyan.

“Morgan Stanley was a success story in Russia,” he said.

All-Night Party

Business success bred personal relationships. With Mack on hand, Putin awarded Russia’s Order of Honor to Simonyan for Rosneft’s IPO. Sechin also chartered a private dinner cruise on St. Petersburg’s Neva River with Mack and other bankers, Simonyan said. It turned into an all-night affair because drawbridges prevented the partygoers from returning to their hotels until morning.

“It was very fun,” Simonyan said. “Sechin treated Mack well and with respect.”

At the Sochi business forum in September 2009, Putin and Mack sat on a panel that also included General Electric Co. Chief Executive Officer Jeff Immelt and TPG Capital founding partner David Bonderman. Putin, who also had a private meeting with Mack, noted that $215 billion of Russian money had flowed through Morgan Stanley.

Joining Hands

Then, quoting mid-20th century Russian poet Bulat Okudzhava, Putin said to Mack, “Let’s join our hands my dear friends, we won’t get lost if we’re together.”

Mack responded, “We did not get lost because we joined hands.”

Sechin, who left Rosneft in 2011, returned in 2012 as president and chairman. In March 2013, he chose Mack to fill an opening on the Rosneft board. Putin personally approved all board appointments, according to four people familiar with the process.

A reluctant Mack agreed to the appointment, which paid $580,000 a year, after learning that Putin himself favored it, two people said. After a year on Rosneft’s board, Mack said in May that he was stepping down. He had planned all along to stay one year and had turned down Sechin’s offer of a three-year term, he said.

New Venture

Even before the Ukraine crisis, relations between Rosneft and Morgan Stanley started to fray. In late 2012, the oil company announced it would start a “full service financial institution.” Continuing its pattern of hiring Morgan Stanley executives, Rosneft brought in Simonyan and two other longtime rainmakers at the bank to run the new venture.

Eight months later, all three left. Simonyan said he quit after Sechin named Dominique Strauss-Kahn, former managing director of the International Monetary Fund, to the board of Rosneft’s new bank. Simonyan is now chairman of UBS AG in Russia.

In December, Rosneft agreed to buy Morgan Stanley’s oil trading, storage and transportation businesses. The bank has said that the sale will be completed by the end of the year. It is awaiting the consent of the Committee on Foreign Investment in the U.S., a panel that examines acquisitions of companies by foreign investors for potential national security issues.

The U.S. Treasury Department has issued seven rounds of sanctions in response to Russia’s seizure of Crimea and its alleged backing of militants who have taken over part of Ukraine. This month, Rosneft asked Russia for as much as 1.5 trillion rubles ($42 billion) of aid, signaling the U.S. ban on long-term loans is starting to hurt.

Nowadays, few deals are getting done at Morgan Stanley’s Moscow office, where the number of employees has dropped by at least a third. Morgan Stanley’s investment banking revenue in Russia has plummeted from $103 million in 2011 to $2 million this year through July 27, according to Freeman & Co.

“There is no more special relationship” with Rosneft, Simonyan said.

To contact the reporters on this story: Alan Katz in Washington at akatz5@bloomberg.net; Jesse Drucker in New York at jdrucker4@bloomberg.net; Irina Reznik in Moscow at ireznik@bloomberg.net

To contact the editors responsible for this story: Daniel Golden at dlgolden@bloomberg.net Cecile Daurat


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