Russia's Latest Bad Habit

Only a few things are absolutely inevitable in today's world: death, taxes, and the Russian government's lusting after energy projects once they've been developed by Western companies. In fact, we may all awaken one day soon to the news that Russia has employed trumped-up charges against British-based integrated energy producer BP (NYSE: BP  ) to strip the company of its license to develop the huge Kovykta gas field.

Let me tell you what's afoot here, and why it appears that business ethics in Russia may not have progressed beyond the days of Tolstoy or perhaps Chekhov. BP is only the latest in a string of Western integrated companies, including ExxonMobil (NYSE: XOM  ) , Royal Dutch Shell (NYSE: RDS-A  ) (NYSE: RDS-B  ) , and Total (NYSE: TOT  ) , that have initiated production projects in Russia, only to have their hosts begin to play hardball as time passed and energy prices rose.

In fact, I'm convinced that this chain of events bodes ill for the energy markets in general and could ultimately result in a disruption of the geopolitical balance of power in oil for years to come. Therefore, I become more convinced every day that sensible Fools should not be caught without meaningful energy components in their portfolios.

BP's bear hug
In BP's case, its TNK-BP partnership has a license to develop the 2.1 trillion-cubic-meter field in the central part of the nation. But the deputy head of Russia's environmental enforcement agency, Oleg Mitvol, maintains that the partnership has fallen short of the annual stipulated production rate of 9 billion cubic meters. In fact, the partnership is currently producing less than a third of that amount.

But guess what? While the partnership's current level of production is more than sufficient to service local consumers, it has been blocked from sending the difference to China by an export monopoly that's been granted to OAO Gazprom (OTC BB: OGZPY), the massive -- and largely state-owned -- gas company.

TNK-BP was to have learned its Kovykta fate three weeks ago, but that would have advanced a probably questionable decision before Messrs. Putin, Bush, Blair, et al., convened in Germany for the G8 summit. That progression would have created awkwardness for the convening dignitaries. Now, however, with that international gathering out of the way, I'm betting that either the partnership's license will be revoked completely or Putin's government will find a way to insinuate Gazprom into the operation -- likely at a bargain price.

Shoo, Shell
BP's difficulties come closely on the heels of a December 2006 "sale" by Royal Dutch Shell of 50% plus one share of its interest in its Sakhalin-2 project to Gazprom, following a finding of "environmental damages" by the Russian government. Shell received $7.5 billion from the local company, likely a discount to the project's true value.

The Sakhalin-2 consortium, which also included a pair of Japanese companies, had been in existence for a dozen years. Nevertheless, prior to Shell's sale to Gazprom, Oleg Mitvol -- who, you'll recall, has moved on to serve as the ramrod in the BP "project" -- threatened Shell with $30 billion in legal claims as recompense for the purported environmental damage transgressions.

Shortly after the Shell-Gazprom transaction, former Foolish contributor Vitaliy Katsenelson wrote, "The 'environmental' issue was very simple: Product sharing agreements (PSAs) with Shell signed by the Russian government were not considered advantageous to Russia -- at least not anymore." He further observed (prophetically, it turns out): "Companies that have already invested in Russia -- ExxonMobil, BP, ConocoPhillips (NYSE: COP  ) , and others -- are wondering if they'll be the next 'environmental' culprits and may be trying to find a graceful way out."

But for those cynics in need of a periodic infusion of absurdity, Shell's 2006 fleecing in Russia may turn out to be the gift that keeps on giving. (I hope my Foolish friends have assumed a seated position.) Recently, the company's CEO, Jeroen van der Veer, stated on Dutch television that his company will continue to seek business in Russia.

Exxon stepping aside
Not so ExxonMobil, at least not for now. Until Shell's eviction from remote Sakhalin Island, which the aforementioned Chekhov labeled "a hellish place" more than a century ago, Exxon had been the Dutch company's neighbor in the area as the operator of Sakhalin-1. Exxon has been eminently successful in the 500-mile-long swath in the Sea of Okhotsk, which is north of Japan. In its head-over-heels effort to please the Russians, the company has ramped up the project's production ahead of schedule and set a record for drilling the world's longest diverted well.

However, all is not hunky-dory between the world's largest private oil company and Mr. Putin's minions. Last month, The Wall Street Journal noted in a lead article that Exxon's relationship with the government has become progressively more contentious, "with the Russian authorities increasingly unwilling to defer to Exxon's business logic as they had been in the past. Last summer, Russia rejected an appeal by Exxon to extend [Sakhalin-1's] production license to cover a recently discovered section on the north side of its field."  

Will Exxon suffer the same fate as Shell -- and, likely, BP? Exxon appears disinclined to engage Russian officials in a staredown. In fact, unlike his glutton-for-punishment Royal Dutch counterpart, ExxonMobil CEO Rex Tillerson stated recently that his company needs more clarity about how the Russian government will treat foreign companies before it will undertake more projects there. Interestingly, Tillerson ascended to his current position in part because of his solid record in guiding the Sakhalin-1 project to fruition.

Where's this going?
Now, lest you think you haven't seen this movie before, you should know that Reuters reported in April that Russia was considering cutting payments to operators at Sakhalin-1 and Sakhalin-2 -- by 10.4%, in Exxon's case -- based on a (Russian) cost audit. And earlier this month, the news service said Gazprom was in talks with TNK-BP about taking a stake in the Kovykta gas field.

So, as I stated above, the first conclusion I draw from these almost-too-predictable events is that, with the world's largest reserves of oil and gas stuffed beneath such volatile places as Russia, Saudi Arabia, Iran, and Iraq, the world of energy is likely to remain on the dangerous edge of chaos for about as far as the eye can see. For that reason, Fools should watch current events in Russia especially carefully and invest accordingly.

Also, I must observe that Russia is rightfully renowned for its exquisite music and its captivating literature. Nevertheless, its food and its ethics still leave something to be desired.

For related Foolishness:

Bill Mann, lead analyst for the Motley Fool Global Gains newsletter service, recently spent time in China, India, and Taiwan in search of market-beating investment opportunities for Global Gains subscribers. To find out which international stocks Bill is currently recommending, try out the service with a 30-day free trial.

Fool contributor David Lee Smith does not own shares in any of the companies mentioned. He welcomes your questions or comments. Total is an Income Investor recommendation. The Motley Fool has a disclosure policy.


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