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Oil Prospecting Under Kremlin Watch

MOSCOW - As the Russian government moves to reassert its sway over the country's lucrative energy business, the British oil and gas giant BP would seem to be an obvious target. The company's 50-50 Russian venture, called TNK-BP, is posting record profits, and now pumps one of every five barrels of BP's worldwide oil supply.

But even as it reaps the benefits of soaring oil prices, BP, the only Western concern that owns a controlling share in a major Russian oil company, is maneuvering gingerly in hopes of avoiding any direct conflict with the Kremlin.

The need to respond to a shifting political climate has been driven home ever since Russia's largest oil company, Yukos, came under attack last year from the authorities. Yukos's founder, Mikhail B. Khodorkovsky, is in jail facing criminal charges and the company, its largest oil fields seized by the government, is tottering under nearly $8 billion in back-tax claims.

In response to the Yukos debacle, TNK-BP and other Russian oil companies have moved quickly to avoid becoming targets themselves. TNK-BP received Moscow's blessing when the deal was consummated - with President Vladimir V. Putin and Prime Minister Tony Blair of Britain on hand for the signing - and has avoided the political involvement that contributed to Mr. Khodorkovsky's downfall. Nonetheless, it made sure to reincorporate on Russian territory and gave up its favored tax status elsewhere.

Before Yukos's troubles, Russian oil companies sometimes paid effective tax rates as low as 5 percent. Now, they boast about how much tax they are paying.

"The legislation was not very clear and made it possible to be interpreted in different ways," Viktor Vekselberg, one of BP's Russian partners, said in an interview here. But TNK-BP decided not to take any more risks, he said, adding that "the majority of companies today no longer use these tax regimes."

"This is one of the lessons," Mr. Vekselberg said, of watching what Yukos has gone through.

Under Mr. Putin, the effort to re-establish the Russian government as the dominant force in the oil and gas industries also means that TNK-BP may have to cede some control over its valuable assets. The state-owned natural gas monopoly, Gazprom, which recently merged with Rosneft, the country's fifth-largest oil company, is already muscling in on some TNK-BP projects.

Lord Browne, the BP group's chief executive, acknowledged that the political climate in Russia had changed since the deal was sealed, but preferred to look at the changes in wider perspective.

"Since Gorbachev, a lot has happened in Russia," Lord Browne said in an interview in his office in London. "No country has come so far in such a short space of time. Is there a lot to do? Of course, there is. Is the transition complete? No."

Yukos, Lord Browne added, is an "event related to a person, place and a time."

"Everyone is continuously reinforcing the point that we are welcome, and a positive addition to the nature of the industry in Russia," he said.

But as BP seeks to make itself at home in Russia, some smaller shareholders in TNK-BP are crying foul, asserting that BP is emulating an all-too-common Russian corporate practice by denying them a fair share of the profit from its lucrative oil business.

The joint venture was formed early last year when BP bought 50 percent of Tyumen Oil, the country's third-largest oil company behind Yukos and Lukoil. TNK-BP took advantage of high crude oil prices and grew swiftly, increasing production 14 percent in 2003. This year looks potentially more promising: it hopes to pump 1.7 million barrels a day, up from 1.27 million barrels on average last year.

With oil prices rising steeply, TNK-BP's net profit in the first half of 2004 totaled $1.73 billion. (Net income for all of last year was $2.8 billion.) The partnership is expected to return $2 billion to BP in 2004, a fifth of its original investment.

TNK-BP's five biggest fields in western Siberia hold particular promise, Robert Dudley, chief executive of TNK-BP, told investors at a conference in Washington early this month. Mr. Dudley predicted that Western recovery techniques could yield a further 750 million barrels of oil.

But Gazprom is aggressively pursuing private energy projects. In one prominent case, TNK-BP and Gazprom are sparring over a prize asset, the Kovytka gas field in eastern Siberia.

Mr. Vekselberg of TNK-BP - who is ranked by Forbes as one of Russia's richest men, with a net worth of $3.3 billion - said the project had languished, risking the loss of customers in countries like China and South Korea.

"We don't have a lot of time until we lose a window of opportunity," Mr. Vekselberg said. Gazprom, he said, "understands this, and hopefully we will have an agreement by the end of the year."

The Kovytka field is huge, thought to hold some 1.9 trillion cubic meters of natural gas, or enough to supply all of China's gas needs through 2010.

But TNK-BP cannot ship the gas to markets in and out of Russia without using Gazprom's pipelines.

Paul Collison, an oil analyst with UBS Brunswick in Moscow, said, "TNK-BP has to come to some kind of agreement with Gazprom, which is holding all the cards.''

Even as it moves to develop vast energy resources, TNK-BP faces many growing pains bringing the two sides of its company together. Mr. Vekselberg said employees from outside Russia "are used to certain procedures of making decisions and certain relations between employees of the company.''

"Here, they encounter a completely different milieu and atmosphere," he said.

Adding to the difficulties, the Kremlin views oil and gas as strategic national assets. That presents a logistical nightmare for foreigners trying to do business in Russia, where, according to the law, they are forbidden from even looking at statistical data on energy reserves.

"We have this law on state secrets," Mr. Vekselberg said with a hint of despair. "It's a problem, it's really a problem."

But the venture's sorest point may be the treatment of minority shareholders. The corporate parent is squeezing together hundreds of holding companies, refineries and drilling subsidiaries into one new structure, but has not made clear what the terms will be for the minority shareholders.

Steven Dashevsky, oil analyst with the Aton Bank in Moscow, said, "Everyone in the industry accepts that it's hard work to consolidate the company, to work with appraisers and auditors. But oil prices are at record high levels. Investors have missed out on all of these profits. It's unacceptable that it's coming from one of the largest global oil majors in the world."

Minority shareholders in TNK-BP and its many units, including some Western investors, say that BP is allowing its Russian partner to continue a practice called transfer pricing. Most other Russian companies have stopped transfer pricing altogether.

Under the practice, subsidiaries sell oil at close to their cost - sometimes as low as a few dollars a barrel - allowing the parent company to book most of the profit by selling the oil at the global market price, currently more than $50 a barrel.

"It's just plain stealing," says Mattias Westman, chief executive of Prosperity Capital and a shareholder in some of the subsidiaries. "When is it going to stop?"

Adam Landes, an oil analyst with Renaissance Capital, a Russian investment firm, agrees: "BP isn't behaving very well. They're treating the minorities as they would in any third world market."

BP responds that it respects the rule of law and does not condone "corrupt or unacceptable business practices."

"We have been very clear,'' Lord Browne said, "that fair and equitable treatment of minority shareholders has to happen, and a lot of work has gone on with that. The board of TNK-BP is aware of that, and agrees with it."

As the board reviews its options, Lord Browne added, "I think it will be done at a standard which will be, you might say, Western."

Morgan Stanley has been providing advice on the structural changes and on how to deal with minority shareholders, other energy bankers say.

TNK-BP's chief financial officer said recently that the parent company aimed to make a fair cash or swap offer to minority shareholders in its production subsidiaries. He said more specifically that TNK-BP would eliminate transfer pricing from the calculation as it prepared an offer.

Still, many shareholders are far from satisfied. Two hedge funds, Vostok Nafta of Sweden and Prosperity Capital, which manages money for European pension funds, wrote to Lord Browne and Mr. Dudley to demand better treatment. Vostok Nafta is suing some trading companies of TNK-BP to reclaim money it considers its due. "We want the real profits from the oil trades," Alex Williams, a Vostok partner, said. "That is one of the corporate governance issues."

Vostok says a TNK-BP unit, Megionneftegas, in which it is a shareholder, should have earned $16 a barrel, instead of the $7.50 a barrel it recorded in 2003. The fund is suing for some $750 million it estimates it lost in profit.

TNK-BP says its corporate revamping will solve the problem, but it has not said when that will be completed. In the meantime, while minority shareholders have received little or nothing in cash, TNK- BP paid $500 million in dividends in the first half of 2004 to its controlling shareholders, which besides BP and Mr. Vekselberg include Mikhail M. Fridman, founder of the Alfa Group, and Leonard Blavatnik.

As BP and TNK struggle to make their partnership work, Mr. Vekselberg acknowledged that the 50-50 arrangement is not likely be repeated in Russia. That is because the government, while wanting Western expertise and capital, is no longer willing to cede half of Russia's valuable resources to foreign enterprises.

Total, the French energy company, has bought 25 percent of Novatek, an independent gas supplier. ConocoPhillips said it would increase its stake in Lukoil, a company with friendly Kremlin relationships, to 10 percent by year-end and 20 percent over the next few years, but the stakes are not expected to grow much beyond those levels.

For all the challenges, Lord Browne said that the British expatriates and the Russian staff members were getting along better than he thought they would. Mr. Vekselberg is not so sure.

"50-50 is a very difficult partnership,'' he said. "In all decisions, you must reach a consensus and if one side doesn't agree, it's impossible to move ahead."

Indeed, Mr. Vekselberg remembers meeting with Lord Browne, Mr. Fridman and President Putin shortly before the deal was formally sealed. "The president expressed only one doubt - whether we would be able to successfully manage a company with 50-50 ownership,'' Mr. Vekselberg said. "I have to say he was correct."

Erin E. Arvedlund reported from Moscow for this article and Heather Timmons from London.

Editorial Notes: Registration reqd, use ciccio ciccio thanks bugmenot.com

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