The Observer: Red alert as Russia floats its oil giant: 'I don't see the likes of Exxon or Shell taking part in a Rosneft auction. I think the state having a dominant stake might put them off.': Sunday January 8, 2006

With Putin flexing his muscle in the energy market, investors should think twice before taking a stake in state-controlled Rosneft, writes Conal Walsh

Sergei Bogdanchikov, president of Rosneft, laughed when The Observer asked whether his Kremlin-controlled company was an example of 'state capitalism'.

'I'm not a politician,' he replied. 'I don't really care what kind of capitalism it is.'

That was 15 months ago, and as Rosneft prepares for a London and Moscow flotation, Western investors don't seem to care either. Russia's biggest oil firm plans to make around a fifth of its stock available at IPO, and to raise up to $20bn (£11.4bn). It will probably succeed - even though the Russian government will retain a majority shareholding.

It may seem ironic that the London market is being asked to finance one Kremlin-run company just as another - gas giant Gazprom - has been engaged in an alarming dispute over energy supplies to neighbouring Ukraine that threatened to disrupt Western Europe's own supplies. But high oil and gas prices have created huge investor appetite for Russian energy stocks.

The Russian government is keen to capitalise on this demand. As well as planning the Rosneft float, the president, Vladimir Putin, allowed Gazprom to make 49 per cent of its stock available to foreign investors. Russia is set to become the principal provider of energy to Western Europe, and Putin is busy giving his corporate monoliths a friendlier face, hiring Gerhard Schroder, Germany's former chancellor, to chair Gazprom's $5bn Baltic Sea pipeline project, and trying (though failing) to recruit US politician Donald Evans to Rosneft.

But Gazprom and Rosneft will both remain under state control, which raises questions about how productive either is going to be, and how well run.

'There is plenty of fat to be cut, especially at Gazprom,' says Stephen O'Sullivan, an analyst at Moscow-based United Financial Group. 'But painful cost- cutting and efficiencies aren't greatest priorities when gas prices are so high.'

Minority shareholders will also be powerless to prevent Putin using the companies for political and diplomatic ends, as he appears to have done in the recent Ukraine dispute. Some, including Merrill Lynch, saw Russia's dramatic decision to withdraw the heavily subsidised gas supplies Ukraine has hitherto enjoyed as sound commercial logic, and the inevitable consequence of Ukraine's growing political independence from Moscow. But the episode has cast doubt on Russia's reliability as an energy supplier, not least because it led to temporary supply cuts to several countries further west. Both the EU and America accused Russia of heavy-handedness. In Britain, the incident will boost calls for nuclear power and a lessening of our dependence on foreign imports.

Analysts agree that the Kremlin is determined to extract full political capital from Russia's emerging dominance in world energy markets. To that end, it has used fair means and foul to bring more of the country's oil and gas assets under state control. It spent $7.5bn last year bringing its shareholding in Gazprom up to 51 per cent - money that subsequently helped the gas giant buy Sibneft from Roman Abramovich. It barred foreign companies from owning energy assets deemed 'strategic'. Most controversially, it jailed oil oligarch Mikhail Khodorkovsky for fraud and effectively renationalised Yukos, his highly profitable oil firm. Yukos's assets were confiscated and sold to Rosneft, tripling its asset base in a stroke for the allegedly knock-down price of $9.5bn.

Putin's tightening grip on the energy sector has commercial as well as geopolitical implications. Private companies, which have driven exploration and development in recent years, will now find it more difficult to win licences and concessions; the Kremlin can be expected to award the most lucrative work to Gazprom and Rosneft. And while that is no bad thing if you are a minority investor in Gazprom and Rosneft, there are doubts that either firm will exploit its favoured status as effectively as it could.

Neither, despite its size, is famed for its productivity or profit margins: while Yukos and Sibneft used to enjoy 25 per cent annual growth in private hands, government-owned Gazprom and Rosneft were stuck in single digits. O'Sullivan believes their inefficiencies will be factored into their share prices. But he adds that Rosneft might have more trouble finding takers for its mooted plan to sell a further 25 per cent to a 'strategic investor': 'I don't see the likes of Exxon or Shell taking part in a Rosneft auction. I think the state having a dominant stake might put them off.'

Chris Weafer, an analyst at Alfa Bank, takes comfort from recent moves on the Kremlin's part to restructure the energy industry, introducing tax breaks and involving Gazprom in liquefied natural gas, which can be shipped for export.

But Weafer finishes with a word of caution for would-be Rosneft shareholders: the company is still facing litigation from Yukos's old shareholders, who argue that the break-up of their company was illegal. Should their claim succeed, it would have a devastating effect on the company's share price. 'An [out-of-court] deal will have to be done before Rosneft's IPO,' Weafer says.

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