The TNK-BP joint venture has been in and out of the news for months now. I have been promising to share my thoughts on it for almost as long. It is not a pure finance topic, but highly relevant to the emerging markets theme. My procrastination has been a consequence of more pressing responsibilities, but the passage of time has not really shed much light on the issue. Living and working in Russia certainly gives a clearer perspective of what may or may not be going on, but it certainly doesn’t provide conclusive insight. With that disclaimer, here are my thoughts on the subject.

To start, let’s take a brief look at the company’s history. TNK-BP was formed in 2003 as a 50-50 joint venture by BP and Alfa-Access-Renova (AAR), a consortium of companies owned by Russian oligarchs, predominantly Mikhail Fridman, Vitkor Vekselberg and Len Blavatnik.

At the time, the deal, which was approved by Vladimir Putin, was hugely praised as a courageous and far-reaching investment. Many western companies had charged into Russia in the 1990s and been forced back out. (Those not driven back by the pains of the 1998 default were raided and diluted out of their legitimate businesses by oligarchs using unclear regulations and the legal vacuum of the times.) To be fair, what was going on in those days was not anti western per se – Russians were (and continue to) using equally brutal tactics against one another too.

BP was among those burned in the early days. A fact that underscores the courageousness of its investment with TNK – it was TNK (under AAR ownership) that stripped assets out of Sidanco, a holding company in which BP was a minority shareholder.

Suddenly, here was BP forming a deal with those very owners that had stiffed it in the past. And not just any deal. The 50-50 terms were praised at the time, and throughout the subsequent Yukos turmoil, as a model for doing business in Russia. Both parties were tied in with stringent terms – investment commitments and lock-in periods, but BP secured one key advantage that justified the risk it was taking: It would retain exclusive right to select the company’s CEO.

For the best part of five years, TNK-BP looked a resounding success (although insiders confidentially expressed concern at the challenge of holding it together). Profits soared, driven by prices and improved operations (thanks to the import of western technology and expertise) and BP succeeded to maintain healthy reserve replacement.

Heavy Sour Blend?

Fast forward to the present, and what is going on? Over the last couple of years, Russia has changed its policy toward cross-border hydro-carbon projects. Notably, Gazprom has elbowed its way into Shell’s Sakhalin project, and taken over BP’s Kovytka field, achieving its means by having the regulators apply deliberately unclear and unattainable licensing requirements, for which Russia is renowned. Even as these cross-border deals crumbled, rumours began circling that the state was also eyeing a piece of TNK-BP, which would become available when the ownership lock-in expired at the end of 2007.

What Of Medvedev?

Let’s pause here to consider the role of the Dmitry Medvedev, Russia’s new president is broadly praised for being a market liberal, he claims to be an ardent defender of the rule of law and to understand that the state’s role must be limited to regulation and maintaining a fair playing field. And yet he was Chairman of Gazprom as it drove down Russia’s investment image by forcing its way into these projects. What gives?

Few people anywhere can fully understand how this comes to be. One thing I can say is that Gazprom’s behaviour under Medvedev’s leadership significantly contributes to my scepticism of his interests as president. Yet, he keeps saying the right things, which leaves me hoping.

Gazprom is a beast of a company, well representative of the Russian bureaucracy that Medvedev now oversees. The truth is that he was unable to control Gazprom fully. I can only hope that these legislative abuses represent events he was unable to prevent. And yet, if that is true, what chance for him to streamline and increase the efficiency of the Russian state, one of his key presidential tasks?

50-50 Divisions

Rumours of Gazprom’s desire to buy into TNK-BP came and went. At one stage it confirmed having held talks with BP. This may have been one of the factors that drove the wedge between AAR and BP. Whatever the cause, the owners fell out dramatically and publicly.

AAR launched a stringent offensive accusing BP of running TNK-BP as a subsidiary (arguably fair), of not being interested to expand beyond the CIS (a given from the outset) and (indirectly) of benefiting from seconding its employees to the company.

This latter point is very curious. Beyond the ownership wrangling, TNK-BP has benefited significantly from BP’s expertise and know-how as it has trained a competent local staff (to the benefit of all Russia). Knowledge catch-up is a key factor explaining how emerging markets manage to grow so fast, and TNK-BP is a great case study. However, it seems dubious to claim that BP (with a market cap of $200 bln) is profiting from the outsourcing of a couple of hundred employees. To the contrary, the Russian employment market is notoriously tight and these employees are likely contributing substantially to operational success.

While AAR have unleashed their corporate complaints, expat staff have been driven out of the country due to visa problems, licensing issues have arisen with regulators and BP staff have been arrested on espionage charges. In Russia, as the saying goes, it never rains.

There are two plausible explanations for this proverbial downpour: Either the Russian owners are leveraging their local connections to make life difficult for BP, or “independent” local protagonists are jumping on the bandwagon.

The former is certainly more likely, but the latter is also possible. Russia is held together with a thin string of authoritarian control. Below the surface, everyone is doing whatever they can get away with. Hence, if a western company falls to one knee there are plenty of local interests ready to pounce on it.

What Does AAR Want?

Ostensibly at least, AAR does not want to sell its stake to a state-owned giant (and many high ranking politicians do not want the state to enlarge its role in business any further). The oligarchs are calling for two things. They want CEO Robert Dudley out, and they want TNK-BP to grow internationally.

The latter is logical, as the Russian government has been making expansion in Russia punitively difficult for some time. The former is easily understood too, as Dudley was appointed by BP and will not execute a strategy to cannibalise that company’s core business.

AAR is also reported to have expressed a willingness to sell (for the right price), or to do a swap for BP shares. This brings us back to the basest of elements: money. Valuation was a key sticking point in the negotiations to form the JV, and is likely a sticking point again now. After all, who really thinks they are getting enough in any deal?

Destroying The Business To Create Value?

If this analysis is correct, the Russian owners of TNK-BP are pursuing the curious tactic of sabotaging their business to get a higher price. It may work, as long-term value is only beginning to be threatened (by the ouster of foreign experts). But it will be a bloody battle, BP certainly has the strength (although perhaps not the belligerence) to fight a long war of attrition.

Other Motives

There are a couple of other contributory motives to consider too. Perhaps the Russian owners are doing the dirty work for those they will sell to. It is hard to imagine a state-owned major agreeing to BP’s right to appoint the CEO. If the Russians can reverse this agreement (which, let us not forget, was the very lynchpin of the deal), then the company will be more attractive to Gazprom (or – less likely – Rosneft) and the ownership transfer will be smoother.

Or, perhaps they are pursuing a face-saving exercise, with the added benefit of making Gazprom look benign. Russia is essentially an Asian culture, so face saving is critically important here. If AAR can convince the world (or at least convince itself that it has convinced the world) that it really cannot work with BP, then selling to the state will be a logical solution. If one follows this idea through, then Gazprom can present itself as a saviour, stepping in to bail out the cross-bored JV.

Of course, no-one will really buy into it. The final outcome of this case remains unclear, but whatever it is the world will ceratinly understand that is was the objective from the outset. No matter though, in the face-saving game, superficiality is king. Think of Gazprom claiming it had no connection to the environmental allegations against Shell (which magically receded after it bought into the project).

Back To The Future

The TNK-BP dispute remains relatively civilised by classic Russian standards, but BP was long the canary in the coal mine. Other major companies investing in Russia would do well to learn from this case. Staying away is not an option, which is why such things can and do happen, but those engaging Russia should remember at all times that they are on the merry-go-round.

As one of my friends once said, anyone doing business in Russia needs to bring a gun to the negotiating table. Russia is enjoying an unprecedented economic boom, and there is much to be hopeful about. But the new administration’s key challenge is to overhaul the bureaucracy and develop institutions that uphold the law to ensure sustainable economic and social progress. The TNK-BP dispute serves perfectly to demonstrate how much work there is to be done.