Pipedreams: Khodorkovsky vs. Putin

Charles A. Kohlhaas

A detail has been overlooked in the media commentary and conjecture surrounding the Khodorkovsky Affair: his determination to build a private pipeline to export oil to China. 

Asian Russia contains very large deposits of oil and gas.  These deposits are not classified as reserves, because they cannot be economically produced under current economic and operating conditions; they are not developed and systems to transport the oil and gas to markets are not in place.  These transport systems will require billions of dollars of investment and several years to construct.  Field development will require more billions and involve a huge logistical and infrastructure system.  Commitment to such an undertaking cannot be made lightly. 

Oil and gas resources were the largest component of the Russian privatization process in the mid-1990’s, are the largest component of the overall Russian economy now, and growth of the industry is the driver for the growth of the Russian economy.  Exports of oil and gas are the largest source of foreign income for Russia. 

As has been well reported, Putin’s pact with the oligarchs was that he would not reverse the privatization process as long as they did not involve themselves in politics.  The rationale for this stance is that, although the state did not receive a fair price for its resources by their sale in the privatization process, the state can recover substantial value through taxes and fees on the production, transport and export of the oil and gas as well as income taxes on the profits of company operations and the stimulation of economic activity through these operations.  For these reasons, the pipeline network in Russia was not privatized and remains under state control through two state-owned companies: Transneft (oil pipelines) and Gazprom (gas pipelines).

BP acquired licenses for large gas reserves in Asian Russia in the mid-1990s and has proceeded for several years with planning to build a gas pipeline from their field near Lake Baikal to China and South Korea.  BP merged with TNK, a Russian company that is also a regional participant, and has negotiated with China National Petroleum Corporation and Korea’s Kogas regarding construction and financing of the project and purchase and supply contracts.  Also, some of the gas produced will supply the local Russian market. 

The local government owns part of BP’s proposed project, and all announcements regarding the project note that Gazprom will likely participate in the project. 

Indeed, the Pacific Rim, with the large growing economies of China, Japan, South Korea, Taiwan, and the US, is the preferable market for oil exports from Asian Russia.  Transneft has been evaluating the possibility of building an oil pipeline from the region to a Pacific export point at Nakhodka, which will put at least one million barrels of oil per day into the Pacific Rim market.  Construction of this pipeline will allow development of the extensive oil deposits in the region, stimulate economic activity in a strategically important but severely depressed part of Russia (see “The Sick Man of Asia: Russia’s Endangered Far East”, Rajav Menon, The National Interest, Fall 2003, no. 73).  This project will put Russian exports into a major, varied and growing market, while attracting various investors, both foreign and Russian.  Economic benefits to the region and Russia will be immense. 

Before Transneft management commits the many billions of dollars of investment needed for such a project, however, the engineers, accountants and economists will have studied thoroughly the markets, construction costs, routing possibilities, oil price forecasts and, probably the largest unknown factor, the size and productivity of the oil fields to be developed. 

Into this situation stepped Mr. Khodorkovsky, who announced, about a year ago, that he had negotiated an agreement with China to build an oil pipeline from Angarsk, near Lake Baikal, to China to transport 400,000 barrels per day of Yukos’ (his company) and its partners’ crude oil to China.  This project would commit a significant portion of the region’s production to a single market and constituted an agreement between one of the oligarchs, personified by his company, with a foreign government.  With this action, Khodorkovsky had moved from involvement in domestic politics to international relations and foreign policy as well. 

Furthermore, this project would undermine the economics of the Transneft pipeline project to the Pacific and delay or prevent its construction; thereby discouraging development of the regional oil fields by anyone but Yukos.  This project obviously was designed to pre-empt the Transneft project and establish a Yukos monopoly over the oil and gas resources of Asian Russia.  By extension, Yukos could control economic development of the entire region and establish a dominant political position. 

During the winter and spring, Yukos and the Russian government occasionally announced variously that one project or the other, or both, had been approved and the other had not; clear positions were quickly contradicted.  A detailed review of whether sufficient resources were available to supply both pipelines was announced.  The government attempted unsuccessfully to have Yukos modify its plans and allow open access for all producers to its pipeline.  In the late spring, the government announced that they would delay a decision on the pipeline approval until fall. 

Data I have reviewed indicates that there are more than enough resources in the region to supply both pipelines and I am sure the Transneft engineers have reached the same conclusion; presumably they have access to all the data.  Management, being management, however, likes to hedge its bets and the Transneft pipeline to the Pacific will be one of the biggest bets in an industry accustomed to big bets.  Transneft probably is not comfortable committing to a multi-billion-dollar, multi-year construction project with a significant amount of the possible production committed to another pre-emptive project that can be completed sooner.  The Yukos project increased the risk to Transneft. 

Khodorkovsky moved Americans into several Yukos top management positions culminating with hiring an American as Chief Operating Officer in the fall.  Also in the fall, rumors began to surface of discussions between Yukos and ExxonMobil or ChevronTexaco regarding sale of a significant portion of Yukos to one of the American companies. 

Putin could not delay.  He had been forced by Germany, Russia’s largest foreign investor, and France, Russia’s largest source of foreign income, to take an anti-Iraq War stance.  He did not want to be put in the position that a confrontation with Khodorkovsky or Yukos could be construed as a confrontation with Americans or as “anti-foreign investment” and exacerbate his difficulties with the Bush Administration. 

In early October, Putin met with Japanese Prime Minister Koizumi who committed to finance the pipelines to the Pacific.  

On October 10, Putin announced in the Wall Street Journal “the development of a new energy structure in the Asia-Pacific region, . . .through the creation of a system of oil and natural gas pipelines and tanker deliveries of liquefied natural gas from the eastern areas of Russia . . .“.

Two weeks later, on October 25, Khodorkovsky was thrown in jail. 

After Mr. Khodorkovsky’s resignation, Simon Kukes, Yukos’ Chairman, was appointed CEO.  In his first news conference, he reportedly (Wall Street Journal, Nov. 7) said that it was immaterial whether an oil pipeline is built to China as long as some pipelines are built and expressed a preference for a government-run pipeline project.  In addition, he expressed coolness toward foreign investment in the company. 

On November 14, BP announced the completion of the feasibility study for the gas pipeline project to China and South Korea and that Gazprom would probably participate. 

Khodorkovsky made a reach for dominating power; monopoly control over the economy of half the land area of Russia and its Pacific coast.  He threw down the gauntlet in Asia, but Putin picked it up.  The Yukos pipeline project was a direct threat to the Transneft project and non-Yukos investments in the entire region.  To preserve investment in the area for a variety of participants, both foreign and Russian, Putin had to counter Khodorkovsky’s plans and he had to do it now. 

Khodorkovsky’s shares, with his associates, were frozen by the Russian government – not “seized” as many media commentators have alleged – a process not unlike one we often practice.  Seizing comes later, also common with our own government.  It seems not unlikely that the Russian government believes it can find a better use for the funds from the sale of those shares to Exxon or whomever than letting Khodorkovsky use them to buy Canadian hockey teams. 

Putin never declared that his goal is to turn Russia into a Western-style democracy.  He has simply declared his goal is to revive and grow the Russian economy and improve the investment climate.  His actions are consistent with those goals.  Believe him; he seems to do what he says he will. 

Dr. Charles A. Kohlhaas is a former Professor of Petroleum Engineering at the Colorado School of Mines and has worked for, founded, managed and consults for, major and independent companies in the international oil and gas industry.