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The Kremlin's Big Squeeze


It's one of John Browne's biggest personal triumphs. In September, 2003, the CEO of oil giant BP (BP) sealed a deal to create TNK-BP, a joint venture that would become Russia's fourth-largest oil company and which today accounts for a quarter of the British company's global production. Now Browne's designated successor, Tony Hayward, is surely counting on the project to keep the oil—and profits—pumping, particularly after a year that saw BP's reputation and stock hammered because of repeated missteps in production and safety. One sign of TNK-BP's importance: Browne and Hayward met with Russian President Vladimir V. Putin at his dacha outside Moscow in March to discuss the venture.

There's a lot to discuss. BP clearly wants to preserve the lucrative partnership it built with tycoons Mikhail Fridman, Viktor Vekselberg, and Len Blavatnik—a unique 50-50 venture that gave the Western company unprecedented access to vital Russian oil and gas. But BP may have to accept some changes as the Kremlin continues strengthening its grip on energy. Speculation is swirling that the tycoons may sell out to Gazprom, the state gas giant.

A more pressing issue concerns a Siberian gas field called Kovykta, which boasts 1.9 trillion cubic meters in reserves. Russian officials say TNK-BP hasn't fulfilled the terms of its license, which requires production of 9 billion cubic meters of gas a year, about 18 times its current output. If the shortfall isn't corrected by May 14, the government says, the license will be revoked and auctioned anew. "The West is always demanding that we do things strictly by the law, and here we're acting strictly by the law," says Oleg Mitvol, deputy head of Russia's Federal Resource Management Agency.

For TNK-BP, though, compliance doesn't seem to make much sense. The company estimates domestic demand for the gas to be less than a third of the required output, but TNK-BP is barred from exporting gas, a privilege reserved for Gazprom. Although TNK-BP has asked Gazprom to team up on Kovykta, the gas company hasn't made any decision. In January the joint venture's CEO, Robert Dudley, said he hoped to reach an agreement with Gazprom by midyear.

Most in the industry assume the hard line is a negotiating tactic, not unlike the pressure applied to Royal Dutch Shell PLC (RDS) last year. After Shell was accused of environmental violations at a gas project on Sakhalin Island in the Russian Far East, the company sold a majority stake to Gazprom. "The most likely scenario is that the [TNK-BP's Kovykta] license won't be revoked, but instead Gazprom will come into the consortium," operating the field, says Valery Nesterov, an analyst at investment bank Troika Dialog.

WELL-CONNECTED PARTNER?

The question is what TNK-BP might be able to get for its stake. Speculation in the market ranges from cash to asset swaps to partnerships in other energy projects with Gazprom. If the terms are acceptable to BP and its Russian partners, development at Kovykta might pick up speed. Company officials say it would cost $20 billion to develop the field and build pipelines. But that wouldn't be profitable without exports—most likely to China and South Korea—which could be permitted if Gazprom were on board.

A deal with Gazprom on Kovykta may not solve all of TNK-BP's problems. Some figure that pressure on the company will continue until Gazprom gets a big stake in the entire venture, not just the Kovykta field. Gazprom last year declared its interest in buying out BP's Russian partners, which could happen after the end of 2007, when the joint venture agreement allows for changes in the company's share structure.

Would BP want to work that closely with Gazprom? It might mean ceding some strategic decisions to Gazprom's management, which has close ties to the Kremlin. Still, BP shows no signs of losing interest in Russia. The company has a minority stake in a venture with state oil giant Rosneft to drill for crude on Sakhalin Island. And last year BP acquired 35 new operating licenses in the country and plowed $1.25 billion into TNK-BP. This year it's likely to invest about that much again.

Despite the tension over Kovykta, BP has tried hard to maintain good relations with Moscow. It snapped up $1 billion in Rosneft shares last year when the Kremlin canvassed support for the company's initial public offering in London. And bybidding in a controversial March auction of assets of bankrupt oil company Yukos, it helped legitimize their sale to Rosneft. That may be the price for global oil companies that want to do business in Putin's Russia.

By Jason Bush, with Stanley Reed in London


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