The latest deal between BP and TNK has sparked much talk about whether or not it is the right time to invest in Russian resources.

When British Petroleum (BP) announced at the end of February that it would buy 50 percent of Tyumen Oil Co. (TNK), the trading volume in the Russian market jumped from $14 million to $27 million. The RTS stock-market index rose to 370 points, its highest in six months.

Leading ministers in the Russian government, including the usually reserved and cautious Economic Development and Trade Minister German Gref, found poetic language with which to praise the deal and declared that it heralded a new era in Russian investments.

In the course of over four years of maltreatment in the menagerie that is Russia’s legal system, BP has committed itself to invest what amounts to 20 percent of all foreign direct investment into Russia in the post-Soviet period. And, more importantly, BP plans to commit to a company that some regard as its earlier nemesis.

BP had been mired in numerous legal actions against TNK over the treatment of its investment in Sidanco, another affiliated oil company that was bankrupted by TNK’s owners. After four years of pointless legal action, BP resorted to the novel stratagem of giving TNK another $375 million to increase its stake in Sidanco from 10 percent to 25 percent. And now, the latest act of this uneasy relationship was BP’s announcement to pay $6.75 billion to TNK owners Mikhail Fridman and Victor Vekselberg for 50 percent of the company. The deal also allows BP to obtain the management in the company.

However, a closer inspection of the financial situation of TNK and circumstances leading to the deal reveals more than just a growing Russian economy. According to John Helmer, one of the foremost commentators on Russian business, "What is remarkable about the deal is not the confidence BP is presumed to be showing in Russian business conditions – the small print of the terms of sale demonstrate there is little of that. Rather, the deal looks to be the first time two Russian oligarchs have opted to hand over control of a property they acquired unlawfully and make their getaway for clean cash."

That is not what the majority of business analysts have been saying, though. The business press and analysts are ecstatic over the deal. Fridman himself set the tone for the celebrations: "This reflects the international business community’s recognition of the growing political stability and success of economic reforms in Russia," he said.

"This is proof that a normal investment climate has been created in Russia," an ecstatic Gref was quoted by news agencies as saying. "Western investors are now moving into Russia not as participants of product-sharing agreements, but because of the new taxation regime, and this is a good signal to other global companies."

Analysts said the echoes of BP’s deal are still being heard throughout the country.

Valery Nesterov, an oil and gas analyst at the Moscow-based investment bank Troika Dialog, said the deal was good news, as it reflects BP’s optimism in a global oil market that is currently characterized by price volatility spawned mainly by the unresolved Iraqi crisis. "More importantly, the deal will have a synergetic effect – first, by encouraging other deep-pocketed investors to view Russia more seriously and, second, by boosting investments in other sectors of the economy," he noted.

Nesterov said the BP deal is not just an episode, but the beginning of a trend. As an example, he cited the announcement made recently by TotalFinElf that said it is ready to invest about $2.5 billion to $3 billion over the next few years in an oil field in Krasnoyarsk Oblast, if Yeniseineft, the local oil company that holds the oil-well license, agrees to sell up to 50 percent of the stake. "This is not a mere coincidence," Nesterov said.

Caius Rapanu, a senior energy analyst at the brokerage firm NIKoil, called the deal a benchmark for evaluating the Russian market because it shows that Russia remains a potentially attractive area for international mergers. However, Rapanu said it remained to be seen whether foreign investments will increase, as Russian companies remain wary of the Western management policies of investors.

Whose learning curve?

Has Russia become a safer place to invest? In the wake of the BP-TNK deal, many investors are wondering if Russia has finally turned the foreign-investment corner.

What BP most likely learned from its experience is something that other large foreign investors should take note of: Investing into Russian oil is chaotic and anything but transparent. Political clout and the legal system are of little help even when Russian oligarchs and politicians find themselves fighting over the oil assets.

Russia’s oil sector was the first to establish a new ownership-change paradigm: Choice assets from the state became publicly owned, then taken over by the group known as the "oligarchs."

In the previous 10-year period, when the Russian oil industry was restructuring, something occurred akin to savage urban military warfare to get control of central assets – and foreigners would have been well-advised to remain interested as by-standers.

That period has ended. However, it is questionable whether now is the right time to move in. The differences in answers may stem from whether a foreign investor is large or small.

What minority shareholders could not accomplish a year ago, majority shareholders will most likely achieve with considerable speed. And, if what happened in the oil sector is really a precedent, large foreign investors can be expected to be invited into the small circle of what will be mostly large domestic power brokers.

What has changed?

The institutional investment climate in Russia has improved over the past three years. The Federal Securities Commission and the bureaucracy, in general, have been modernized and transformed into entities beginning to resemble their Western peers. Most importantly, they have developed sharper teeth – better incentives and greater accountability. The court system and law-enforcement agencies are also rising from the ashes of the 1990s with greater responsibilities and a discernibly increased level of professionalism. However, all these state institutions remain relatively weak when confronted by aggressive Russian heavyweights.

These very heavyweights, though, appear to be turning a new leaf themselves. To get higher valuations for their companies, Russian tycoons now understand the need to improve the business climate. They have demonstrated their interest in greater transparency. Protected ownership rights and reduced bureaucratic red tape now benefit these tycoons at least as much as they do foreign investors.

But the cold fact of the matter is that "the deal is good for Russia only inasmuch as BP says it will take control of the cash flow of the oil company. TNK has an output of 1.2 million barrels per day (bpd) that is worth, at current prices, about $13 billion in annual sales. TNK has been passing this money through a chain of trading companies, brokers and other intermediaries so it can avoid domestic taxation and enrich offshore shareholders.," Helmer says. "Whether or not BP intends to operate the same kind of trading schemes is not clear. But there is enough cash in the new company to pay more tax to the Russian treasury and cover the $3 billion cash payment BP is making to Fridman and Vekselberg. The three-year deferred payments of $1.25 billion worth of BP shares, which are also part of Fridman’s and Vekselberg’s take, are an insurance policy for BP that it can in fact get control of TNK’s cash flow, and a cheap way of paying Fridman and Vekselberg with value they would have taken from TNK sooner or later themselves – and that BP will earn from the Russian properties."

A word to the wise

BP’s very significant spending in order to buy into its former adversary TNK sends a positive signal about investment into Russia. However, investors should be on the lookout for what this means in the context of Russia’s current corporate-governance environment. This means that, when the interests of domestic big business do not match those of smaller players or foreign investors, then the protection offered by the law and political connections often become ephemeral.

The main lesson for equity investors to be drawn from BP’s experience is to keep a lookout for the still-considerable opportunities in those sectors that have already undergone consolidation – oil, metals, mobile telephones and consumer goods – and wait until others are restructured by domestic insiders before venturing into them. Or rather, wait until the Russian owners stack up more debt than they can pay and take the companies to a point where there are no more assets to strip or cash to divulge to personal accounts. Then, the Russian owners will sell their assets to foreign investors. There would be no point in resisting foreign control of their cash and thus, this would create a more-welcome atmosphere for foreign direct investment and management of large Russian resource-rich corporations.