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Getting Past Yukos


For much of the past year, Russian President Vladimir V. Putin has been on a mission to take down Mikhail B. Khodorkovsky, the former CEO of the country's second-largest oil company, Yukos. The only time the fallen oil baron is allowed out of his Moscow jail cell is when he's sitting behind bars inside a cramped cage in a federal courtroom, where he is on trial for what many consider politically motivated charges of fraud and tax evasion. Soon the company itself will be destroyed, as the government seizes core assets with the aim of selling them off. The Russian stock market has fallen 25% since early April.

So who in the world would want to invest in Russian oil right now? ConocoPhillips (COP), that's who. And Exxon Mobil Corp. (XOM). And Royal Dutch/Shell Group (RD). And BP PLC. In fact, at a time when oil prices are spiking and new fields are scarce, the global oil companies are looking hungrily at Russia despite the Yukos debacle. Acts of terrorism, gruesome as they are, don't seem to deter them, either. Conoco, for instance, is ready to bid at least $1.9 billion on Sept. 29 for the government's remaining 7.59% stake in Lukoil (LUKOY), Russia's largest oil producer. "We'd like to be a major player in Russia," Conoco CEO James J. Mulva said in July after meeting with Lukoil Chairman Vagit Y. Alekperov and Putin in Moscow.

The bidding for the Lukoil shares is open to other Russian and foreign companies. But Mulva's meeting with Putin, plus Conoco's former partnership with Lukoil in the Polar Lights project in northern Russia, lead many to believe that Conoco has the edge. There is speculation that the 7.59% Lukoil stake could be just the start, with Conoco eventually upping its holdings to 25%.

The oil companies' growing enthusiasm for Russia may seem puzzling, given the continuing legal and political risks. On the other hand, the lessons from the Yukos affair seem clear enough. Yukos' troubles are widely attributed to the political ambitions of Khodorkovsky. In other words, stay on the right side of the Kremlin, avoid meddling in politics, and you should be O.K. "You obviously need political support [from the Kremlin] to do big deals in Russia," says Stephen O'Sullivan, co-head of research at Moscow investment bank United Financial Group. For Putin, a successful sale of its last small stake in Lukoil would be one way to mitigate some of the damage done to Russia's image by the Yukos conflict.

"FULL STEAM AHEAD"

BP and Shell certainly aren't shy about pumping more money into Russia. Last year, BP paid $8 billion to form a 50-50 venture with Russia's TNK oil company. The venture, TNK-BP, plans to invest $1.4 billion on upgrades and exploration this year, all from cash flow, and at least $1 billion a year over five years. "For us it has been full steam ahead," says Robert Dudley, CEO of TNK-BP. Profitable, too. BP says the gross dividends from TNK-BP this year will exceed $2 billion.

Shell, meanwhile, recently approved a $1 billion investment into the Salym oil field in western Siberia, where it operates a venture with Russian independent Evikhon. Shell is also a 55% shareholder of Sakhalin II, which began production in 1999 off Russia's Pacific coast. Last year Sakhalin II won shareholder approval to proceed to its second, more ambitious $10 billion phase.

Even Exxon, which was on the verge of buying a big stake in Yukos when the company's woes began last fall and which is fighting the government's move to revoke its rights to develop the big Sakhalin III project, isn't sour on Russia. It controls a 30% stake in Sakhalin I, which will eventually require some $12 billion in investments. "We see Russia as having great potential in the oil and gas business," says a spokesman.

In fact, Russia's reserves may be far larger than the standard estimates suggest. According to the U.S. Geological Survey, some 21% of the world's undiscovered oil -- an additional 171 billion barrels -- is in the former Soviet Union. While most Russian oil production is in western Siberia, interest is shifting toward largely undeveloped eastern Siberia. "The last oil frontier is going to be east Siberia," says Ronald Smith, an analyst at Renaissance Capital in Moscow. Eastern Siberian reserves could be as much as 51 billion bbl., according to United Financial Group.

Russia's reserves are cheap as well as plentiful. The $1.9 billion starting price tag for 7.59% of Lukoil works out to $1.70 per bbl., well below the $4.94-per-bbl. average acquisition cost in the West, says Renaissance Capital. Extraction costs are low, too -- some $2 a bbl., vs. $1 in Saudi Arabia, compared with a global average of $4 to $5. It helps that most Russian oil is onshore and that surveys have revealed where much of that oil is, so it's relatively easy to get at. "There's no danger of drilling a bunch of dry wells," says Smith.

Adding to the attraction, Siberia borders China and the economies of eastern Asia -- the very markets that are set to drive global oil demand in the decades ahead. Although a lack of export pipelines could curb Russia's export growth over the next few years, the government looks set to give the go-ahead to a $10 billion pipeline to the Far East, with a capacity of 1 million bbl. a day, that should be up and running by the end of the decade. Meanwhile, Russian oil production is set to rise 8% this year.

Little wonder the oil majors are interested. The bigger issue may be how to invest. Apart from the Lukoil deal, acquisition targets are scarce. France's Total (TOT) was rumored to be eyeing a 25% stake in Sibneft, Russia's No. 5 producer. But Sibneft may be the last company on offer. Increasingly, foreign investments are likely to be project-specific ventures.

For investors, working in partnership with Kremlin-backed companies is one way to mitigate the political risks. For the state, they're a means of bringing in Western capital and expertise without losing control over the industry. But the new model brings risks as well. The fear is that the state's growing clout will kill the sector's dynamism, which has been driven largely by privatized companies. If the Kremlin ends up putting political considerations before commercial ones, the results could be ugly -- as the Yukos fiasco illustrates. For now, though, these are risks that reserve-thirsty investors such as Conoco may just have to live with.

By Jason Bush in Moscow, with Wendy Zellner in Dallas and Stanley Reed in London


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