Thesis - Relationship between Political Decisions and FDI in the Russian Energy Sector

Relationship Between Political Relationship Between Political Decisions and FDI in the Decisions and FDI in the Russian Energy SectorRussian Energy Sector

AbstractAbstract

This paper will look at two case studies of This paper will look at two case studies of Western energy companies doing Western energy companies doing business in Russia to explore the factors business in Russia to explore the factors that have the biggest impact on large that have the biggest impact on large scale Foreign Direct Investment (FDI) scale Foreign Direct Investment (FDI) projects. projects.

Outline of ThesisOutline of Thesis

IntroductionIntroduction The History of Soviet Energy Policy The History of Soviet Energy Policy Risk and FDI in Russia Risk and FDI in Russia Case study: Sakhalin-1 - Consortium led by Case study: Sakhalin-1 - Consortium led by

Exxon Exxon Case Study: Sakhalin-2 - Consortium led by Case Study: Sakhalin-2 - Consortium led by

Shell Shell Case ComparisonCase Comparison ConclusionConclusion

IntroductionIntroduction

Investment climate in Russia is fairly riskyInvestment climate in Russia is fairly risky 2008 –Corruption Perceptions Index – Russia was 2008 –Corruption Perceptions Index – Russia was

ranked 147 out of 180ranked 147 out of 180 Government break up of YukosGovernment break up of Yukos BP cedes control of its joint venture TNK-BP to BP cedes control of its joint venture TNK-BP to

Russian executivesRussian executives Legislative and political risk Legislative and political risk

IntroductionIntroduction

Economy is heavily dependent on the oil and Economy is heavily dependent on the oil and gas sectorgas sector Revenues from this sector account for around 20.5% Revenues from this sector account for around 20.5%

of GDP of GDP 30% of FDI in Russia goes to this sector30% of FDI in Russia goes to this sector Oil and gas exports comprise approximately 64% of Oil and gas exports comprise approximately 64% of

all export generated revenues all export generated revenues

Soviet Energy PolicySoviet Energy Policy

Within context of a Socialist systemWithin context of a Socialist system True prices not knownTrue prices not known Inefficient allocation of resourcesInefficient allocation of resources Energy resources were abundantEnergy resources were abundant

Policy was to increase spending to fulfill Policy was to increase spending to fulfill centrally planned production targetscentrally planned production targets Irregardless of pricesIrregardless of prices Little incentive to improve technological and Little incentive to improve technological and

managerial processes managerial processes

Soviet Energy PolicySoviet Energy Policy

Export revenues subsidized domestic Export revenues subsidized domestic consumptionconsumption Oil and gas at high prices – consumption remained Oil and gas at high prices – consumption remained

the samethe same Oil and gas at low prices – consumption declined due Oil and gas at low prices – consumption declined due

to increase in production to maintain export levels, to increase in production to maintain export levels, leaving less oil and gas available for domestic leaving less oil and gas available for domestic consumptionconsumption

Risk and FDI in RussiaRisk and FDI in Russia

Uncertain property rights – only short term Uncertain property rights – only short term licenses issued for natural resource licenses issued for natural resource property rightsproperty rights Short term licenses encourage under-investment and Short term licenses encourage under-investment and

short term profit taking.short term profit taking. This means companies are acting rationally given This means companies are acting rationally given

their operating environment. their operating environment. Not Irrationally!Not Irrationally! YukosYukos


Inherent risks of a Petro-state Inherent risks of a Petro-state Energy sector main driver of economyEnergy sector main driver of economy

Revenues account for around 20.5% of GDPRevenues account for around 20.5% of GDP

Addicted to resource rent?Addicted to resource rent?Abnormal profits increase as production increases Abnormal profits increase as production increases

due to a resource being non-renewabledue to a resource being non-renewable


Inherent risks of a Petro-state cont’d Inherent risks of a Petro-state cont’d Can Russia diversify away from this sector?Can Russia diversify away from this sector?

Production declines attributed more to rational Production declines attributed more to rational political decision making given their addiction to oil political decision making given their addiction to oil and gas rather than authoritarian irrational and gas rather than authoritarian irrational decisionsdecisions

This knowledge can mitigate risk allowing foreign This knowledge can mitigate risk allowing foreign firms to work successfully within this environmentfirms to work successfully within this environment


CultureCultureRegional attitudes toward foreign companies Regional attitudes toward foreign companies

vary tremendouslyvary tremendouslyDistrust of foreigners vs. need for foreign capitalDistrust of foreigners vs. need for foreign capital

Capitalist system with continuing remnants Capitalist system with continuing remnants from the socialist systemfrom the socialist systemAttitudes of politicians, management, and workers Attitudes of politicians, management, and workers

toward economic systemstoward economic systems


Uncertain legal environmentUncertain legal environment

Uneven application of environmental and tax lawsUneven application of environmental and tax laws Justice is more about who you know and less about Justice is more about who you know and less about

working out differences through legal meansworking out differences through legal means

Sakhalin-1Sakhalin-1

Exxon led consortium in Sakhalin, RussiaExxon led consortium in Sakhalin, Russia


Largest single FDI project in RussiaLargest single FDI project in Russia Formed through production sharing agreement Formed through production sharing agreement

(PSA) with Russian government(PSA) with Russian government Partners:Partners:

Rosneft (Russia) 20%Rosneft (Russia) 20% Sodeco (Japan) 30%Sodeco (Japan) 30% ONGC (India) 20%ONGC (India) 20%


2006: Exxon announced budget increase. 2006: Exxon announced budget increase. Following events occurred - in orderFollowing events occurred - in order

1.1. Possible cost overruns made known to government Possible cost overruns made known to government Would negatively affect Russian government’s stake in the Would negatively affect Russian government’s stake in the

projectproject

2.2. Government accused Exxon of violating Government accused Exxon of violating environmental regulations and threatened litigation environmental regulations and threatened litigation

3.3. Exxon warned Russia to honor PSA as the project Exxon warned Russia to honor PSA as the project was highly visible worldwidewas highly visible worldwide

4.4. Government backed offGovernment backed off


Natural GasNatural Gas 17.3 trillion cubic feet 17.3 trillion cubic feet No LNG facilityNo LNG facility Gazprom (Russia) wants gas for domestic useGazprom (Russia) wants gas for domestic use

Will buy at below market pricesWill buy at below market prices

Can export under PSACan export under PSAEast Asian customers only accept LNGEast Asian customers only accept LNGChina will accept gas but a pipeline needs to be China will accept gas but a pipeline needs to be

builtbuilt Russia has denied permitsRussia has denied permits


Has met requirements of PSAHas met requirements of PSA Doesn’t need budget approval from RussiaDoesn’t need budget approval from Russia

Government pressure on ExxonGovernment pressure on Exxon Using environmental regulationUsing environmental regulation Through state-controlled Gazprom to buy gas at Through state-controlled Gazprom to buy gas at

below market pricesbelow market prices

Exxon remains majority ownerExxon remains majority owner


Gazprom led consortium in Sakhalin, Gazprom led consortium in Sakhalin, RussiaRussia


Largest integrated oil and gas project in Russia Largest integrated oil and gas project in Russia Formed through production sharing agreement Formed through production sharing agreement

(PSA) with Russian government(PSA) with Russian government Partners:Partners:

Gazprom (Russia) 50% + 1 shareGazprom (Russia) 50% + 1 share Shell (Netherlands) 27.5% - 1 shareShell (Netherlands) 27.5% - 1 share Mitsui (Japan) 12.5%Mitsui (Japan) 12.5% Diamond Gas (Japan) 12.5%Diamond Gas (Japan) 12.5%


Original owner was Shell with 55%Original owner was Shell with 55% Gazprom not originally in consortiumGazprom not originally in consortium Gazprom sets strategic objective to gain Gazprom sets strategic objective to gain

controlling stake in Sakhalin 2controlling stake in Sakhalin 2 Natural Gas from this project expected to add Natural Gas from this project expected to add

5% to global capacity5% to global capacity LNG facility planned (Opened 2009)LNG facility planned (Opened 2009)


Starting in 2005: Starting in 2005: 1.1. Gazprom and Shell agree to asset swap giving Gazprom and Shell agree to asset swap giving

Gazprom 25% stakeGazprom 25% stake

2.2. Shell then Shell then unexpectedlyunexpectedly announced $10 billion cost announced $10 billion cost overrun. (significantly decreasing revenues to overrun. (significantly decreasing revenues to government and Gazprom under PSA)government and Gazprom under PSA)

3.3. 2006 - government accused Shell of environmental 2006 - government accused Shell of environmental violationsviolations

4.4. Government recoups environmental damage costs Government recoups environmental damage costs by giving Gazprom controlling stake in projectby giving Gazprom controlling stake in project

Case ComparisonCase Comparison

Always had domestic partnerAlways had domestic partner Informed government and Informed government and

Russian partner of budget Russian partner of budget issues well in advanceissues well in advance

Strong connections to Russian Strong connections to Russian officials through Rosneft officials through Rosneft partnershippartnership

No LNG facilityNo LNG facility Remains majority partnerRemains majority partner

Did not have domestic partnerDid not have domestic partner Cost overruns came as a Cost overruns came as a

surprisesurprise Loose connections to Russian Loose connections to Russian

officialsofficials LNG facilityLNG facility Lost majority controlLost majority control

Case ComparisonCase Comparison

Quotes explaining outcomes:Quotes explaining outcomes:

““Shell is always resisting, instead of accommodating, Shell is always resisting, instead of accommodating, they come out with lawyers and try to prove their they come out with lawyers and try to prove their

case.”case.” - - Project contractorProject contractor

““The problem is that in the Russian psyche justice The problem is that in the Russian psyche justice and law are not the same thingand law are not the same thing” ” - Senior Russian official- Senior Russian official

ConclusionConclusion

Russia not as inclined to respond as strongly to Russia not as inclined to respond as strongly to global feedback mechanismsglobal feedback mechanisms Russia seems to be more concerned with securing energy Russia seems to be more concerned with securing energy

resources than reputationresources than reputation Strategic sector to National SecurityStrategic sector to National Security

Continues to pressure foreign energy firmsContinues to pressure foreign energy firms Uses indirect methods of expropriationUses indirect methods of expropriation

Energy firms not as prone to curtail FDI when Energy firms not as prone to curtail FDI when compared to other sectors in Russiacompared to other sectors in Russia FDI continues to increase in Russian energy sectorFDI continues to increase in Russian energy sector

ConclusionConclusion

Legislative riskLegislative riskGetting riskier but Getting riskier but cancan work within the system work within the system

Exxon exampleExxon example

Geopolitical riskGeopolitical riskCan mitigate by understanding history, Can mitigate by understanding history,

culture, and operating environmentculture, and operating environmentDecisions are almost always rationalDecisions are almost always rational

Documents

Thesis - Relationship between Political Decisions and FDI in the Russian Energy Sector