The Rosneft-BP alliance and foreign investment charm offensive

Company-specific operational and financial issues will naturally be the focus of much comment on the just announced “strategic partnership” between Rosneft and BP, but I would like to highlight another more general implication which looks set to be an important driver of overall Russian equity market performance in 2011. This deal – comprising an agreement on joint exploration in the Arctic basin backed up by quite a substantial share swap – is the first major fruit of the Russian government’s latest drive to attract foreign direct investment. For although it comes after last month’s announcement of PepsiCo’s takeover of Wimm-Bill-Dann, worth a hefty US$5.4 billion and which boosted the Russian market rally, this Rosneft-BP deal is not only bigger (the aggregate market value of the shares being swapped is around US$16 billion), but also more governmental.

Putin has always tried hard to attract foreign strategic investment into Russia – very much including investment in the natural resource sectors. In addition to the reasons which make FDI attractive to virtually all emerging market countries (not just investment capital, but also technology and know-how), Putin clearly prefers solid global companies to oligarchs. Even after the Khodorkovsky affair put an end to oligarchs’ open pursuit of domestic political agendas, they are still regarded (often justifiably) as relatively flaky owners with short-term horizons.

But there have been two problems with this charm offensive – both of which illustrate life’s hard truth that it is not enough to will the end: one must also will the means.

Problem #1

The first problem is new legislation (in force since 2008) which ostensibly contradicts the goal of attracting FDI by introducing formal restrictions on such investment. The core new regulation of foreign investment in sectors defined as strategic (the Foreign Strategic Investment Law – FSIL) is meant to be investor-friendly by creating an environment of rules-based transparency, hence much greater certainty for companies interested in making potentially sensitive investments in Russia. In contrast to the planning of the TNK-BP joint venture announced in February 2003, when BP’s advisers (including the firm I was working for at that time) had to take informal and therefore inconclusive soundings of various Kremlin officials about the political acceptability of the deal, an investor like BP today (and yes, it’s BP again, as ever a pioneer in Russia) will know where they stand: if the envisaged transaction falls within the FSIL definition of strategic, formal government approval will be required. A clear and tightly time-bound procedure is prescribed for this, culminating in a decision by the Government Commission for Control over Foreign Investments – closely modelled on the equivalent body in the US and chaired by Putin in person in his capacity as Prime Minister.

These good intentions behind the FSIL were undermined by the security establishment’s insistence on defining no less than 42 sectors as strategic. Another serious flaw was the removal of a saving clause which would have exempted foreign legal entities with Russian beneficial owners. As a result, the FSIL has facilitated the most visible and brazen corporate governance scandals in the wake of the crisis of 2008 – namely, two oligarchs using the FSIL to renege on their legal obligations to buy out minority shareholders in thermal gencos.

Even despite such flaws, the FSIL as such has worked reasonably well in practice, with Putin’s Commission readily approving all deals submitted to it (including some cases where the prospective foreign investor subsequently walked away as a result of the global crisis rather than any Russia-specific issues). And incidentally, BP will not need permission to increase its stake in Rosneft from the existing 1.2 per cent to 10.7 per cent as envisaged in the share swap. For while acquisitions of shareholdings of more than 10 per cent in companies engaged in mineral resource E&P are subject to approval, Art. 2.7 of the FSIL exempts from this requirement an investment in such a company which is more than 50 per cent state-owned (as, of course, is the case with Rosneft, with the government still owning over two-thirds of the company even after the dilution resulting from this deal with BP). Still, visible approval is always good, and there can be no doubt that the deal is approved after Bob Dudley’s meeting with Putin in his dacha on Friday (14 January).

The most damaging of the regulatory changes introduced in 2008 was not the FSIL itself but the accompanying amendments to the Subsoil Law (SL). Having defined hydrocarbon and other mineral deposits of any reasonable size (greater than about half a billion barrels of oil and a mere 50 bcm of gas) as “strategic”, these SL amendments go on to ban any foreign investor controlling such deposits and, worst of all, state that a foreign investor involved in E&P operations (even if only as a minority with a 10 per cent stake) may be deprived of the right to produce from deposits which, as a result of the exploration carried out by that investor, prove large enough to be strategic. The compensation provisions for such cases are also clearly inadequate. What makes this serious disincentive to foreign investment in the extractive sectors highly relevant to the new Rosneft-BP deal is that it also applies to foreign investors partnered with a Russian state-owned company (i.e., the “safe harbour” Art. 2.7 of the FSIL does not extend this far). So unless I am missing something, BP’s proposed cooperation with Rosneft on exploring three blocks in the Arctic will only make sense if these rules are relaxed.

I assume that Putin reiterated to Bob Dudley his previously stated intention to do just that. For the past year or more, officials such as the Natural Resources Minister Yury Trutnev have flagged plans to ease various FSIL/SL restrictions, and these signals have subsequently been repeated in public by Putin himself – notably at the VTB Capital conference in Moscow last October, when he replied positively to a request from Prosperity Capital’s Alexander Branis to close the FSIL loophole which has allowed oligarchs to abuse minority shareholder rights, and most recently at the last meeting of the Government Commission for Control over Foreign Investments on 29 December.

Problem #2

The second – and more general – obstacle to the success of Russia’s charm offensive on foreign investors is quite simply that the overall investment climate fails to charm. This failure is partly down to specific problems such as those with the FSIL/SL. But I think the problem also goes deeper. In the much tougher global environment since 2008, Russia will have to do that much more to prove itself. Regardless of the accuracy of perceptions that high levels of corruption are getting even higher, the reality of entrenched and brazen corruption wears down and discourages potential investors.

This effect is crystallized by negative newsflow. The Khodorkovsky affair acts mainly on portfolio investment – not so much driving out portfolio investors already experienced in Russia and capable of seeing the Khodorkovsky trial outcome in perspective, but rather by deterring incremental portfolio investment flows which might otherwise be attracted by Russian asset valuations but for the perception of intolerably high risks. As far as strategic investment is concerned, the equivalent damage (i.e. to the perceptions of companies not yet present in Russia as opposed to those already on the ground which, surveys show, are generally happy with the risk-reward balance) is done by public scandals affecting foreign companies. A recent example has been IKEA suspending shopping mall developments rather than accept bribe demands; but perhaps the most lasting damage to perceptions was the conflict between the TNK-BP shareholders in 2008 and the spectacle of Bob Dudley being hounded out of the country (even if, in reality, top Russian government officials used their influence to promote the compromise as a result of which BP suffered no fundamental losses). Things I have heard in the past year make me convinced that but for the resulting high risk perceptions, there would have been major FDI announcements in Russia well before the Rosneft-BP tie-up which has now been unveiled.

During 2011, I expect the Russian leadership to focus more strongly and effectively on these problems – that is, facilitating the means to the end of higher FDI. An immediate incentive is the success of the new privatization programme (and the Rosneft-BP deal is relevant to that as well). But the underlying imperative is to increase the country’s investment rate. The key practical action to watch for is the amendment of the FSIL/SL as described above – which would give a fair wind to the Rosneft-BP alliance and help attract more FDI in its wake. I predict that these amendments will have become law by the end of the Duma’s “spring” session in late June. More generally, I think we will see explicit efforts to compensate for developments which depress investor sentiment. There is nothing new here. The timing of the liberalization of the Gazprom share market to coincide with the climax of the Yukos affair in late 2004 was patently designed as a sop to portfolio investors. Likewise now, it was on the day after the Khodorkovsly trial judge gave his guilty verdict that Putin convened the semi-annual meeting of the Government Commission for Control over Foreign Investments – and used the occasion to reaffirm plans to relax the FSIL/SL as well as talking up the PepsiCo acquisition of Wimm-Bill-Dann.

POSTSCRIPT: I cannot understand why this deal was on the Commission’s agenda. While food may be central to national identity in France (as reflected in President Chirac’s criticism in 2006 of Coca Cola’s rumoured designs on Danone), food processing is not defined as a strategic sector in Russia’s FSIL. I would be grateful if anyone could put me right on this.