by Tom Bower
Despite the political, financial and engineering problems, Ken Derr, the chairman of Chevron, decided to gamble the corporation’s fortunes on the prospect. Chevron’s foundation, in its previous incarnation as Standard Oil of California (Socal), had been rooted in the discovery of oil just north of Los Angeles in 1879. The company’s glory years had taken place in Saudi Arabia. In 1938, Socal’s employees had found the first oil in the desert, and over the following 35 years the company, cooperating with Texaco in Aramco, had sporadically flourished, not least after it identified the giant Saudi oilfield Ghawar in the 1950s. But the corporation, one of the Seven Sisters, wilted after the Saudi government progressively nationalized Aramco’s oil wells. The 1980s were Chevron’s nadir, as inferior technology yielded a string of dry holes. Fearing that its future was at risk without new oil, in 1984 Chevron merged with Gulf, an independent oil company created by the Mellon family, operating in the Middle East. Ken Derr would admit that the merger had been a “cataclysmic event,” “just messy” and “a paper nightmare.” The cumbersome sale of 1,800 oil wells owned by Gulf — one well was sold for $12 — spawned an expensive and stodgy bureaucracy.
Struggling with unprofitable oil and gas processing plants in America, and trying to reinvent Chevron’s image, Ken Derr decided to copy John Browne. Like all American oil companies, Chevron had been compelled by Congress’s restrictions to search for new oil overseas. The corporation’s experience had been unhappy. $1 billion had been lost in the Sudan, and millions of dollars had been wasted in unsuccessfully searching for oil in China. After Chevron abandoned production off the Californian coast, its earnings were the lowest of all the oil majors — 10 percent compared to 23 percent among the leaders, largely because it cost Chevron $6.18 to extract a barrel of oil, compared to Arco’s $3.65. The company decided to sell off its American assets and, by acquiring foreign oilfields, to redefine itself as a global company. In 1985 it had owned 3,400 oilfields in America. By 1992 only about 400 remained, but Chevron’s suffering had not ceased. The corporation’s fate was balanced on a knife’s edge. Despite optimistic pledges, its oil reserves would slump in 1994 to 6.9 billion barrels, and production was also falling, by as much as 15 percent a year. To save the corporation, Derr placed less importance on improving the quality of Chevron’s engineering than on emphasizing “return on capital” and “fixing the finances.” Like Browne, he understood the value of a considered gamble, and he chose to bet $2 billion on Kazakhstan initially.
Kazakhstan offered to reverse Chevron’s slow demise, although there remained the unresolved question of finding a route for a pipeline to transport the oil to a harbor. Desperate to secure new reserves, Derr decided to ignore that problem. In June 1990, after negotiating between rival factions in Moscow and Kazakhstan, Chevron signed an agreement with the Russian government to explore and produce in the Caspian region. The estimated cost over 40 years was $20 billion. Payments would be staggered, depending upon the success of the operation.
The Western oilmen traveled noisily. The local workers in the Russian oilfields felt patronized by American prospectors seeking a Klondike bonanza. The knowledge that production in Russia had fallen by 9 percent in January 1991 gave the Americans a discomforting brazenness. “We know what to do,” one Western oil executive told a Russian minister. “We’re taking risks with our money, so don’t interfere with us.” The explicit threat was that those employed by Amoco, Texaco, Chevron and other corporations would leave if the Russians caused them to be dissatisfied or made their risk excessive. But none of the foreign oilmen understood the attachment Russians felt toward their “natural riches,” or the psychology of people emerging from 70 years of communist dictatorship. Instead of sympathizing with their plight and satisfying Russian hunger for technology with an “option value” agreement, the American oil majors insisted that any investment would need to meet American standards of due diligence. Irritation rankled among Russians already dismayed by the introduction of the market economy. Gorbachev’s supporters were criticized for succumbing to the capitalists’ greed for Russia’s raw materials. Chevron’s concession in Tengiz especially inflamed Russian fears about a “dirty deal” by which “Russia will be plundered and sold for a mere song,” while Chevron pocketed a $100 billion windfall. The news of Chevron producing oil at Tengiz’s well No. 8 in June 1991 gave Russia’s media the excuse to attack capitalists for exploiting Soviet resources under the guise of perestroika. Old nationalists spoke about the sale of the family silver. Regardless of Russia’s desperation, they urged, foreigners should be forbidden to profit from its wealth. Buffeted by the opposition and fighting for survival, Gorbachev capitulated. Instead of maintaining the slow conversion from communism to a market economy, he switched back to secure the hardliners’ support. On March 22, 1991, Russia announced a 40 percent tax on all oil exports.
Andy Hall was staggered. His $100 million investment was threatened by this unexpected turn. Unlike the oil majors, he could not easily bluster about leaving. To his relief, Gorbachev bowed to threats from the American administration on Chevron’s behalf and replaced the 40 percent with a 3 percent levy. Two weeks later, on August 19, Gorbachev was arrested during an attempted coup. Released after three days, the president was too feeble to resolve the worsening oil crisis. Kazakhstan had declared independence, and in November 1991, as Chevron was planning to start exploration, President Nazarbayev arrived in London to meet BP experts to review the Chevron agreement. As Russia’s oil production fell to eight million barrels a day, the Kremlin feared that the country’s oil supply would shortly become crippled. Fearing chaos and unable to prevent his support splintering, Gorbachev suspended some oil exports on November 15. He was too late. On December 25 former mayor of Moscow Boris Yeltsin, a corrupt, alcoholic populist, became the new president of Russia.
Oil compounded the political pandemonium of Yeltsin’s inheritance. Laws were drafted to privatize state-controlled industries and property, but the first stage of dismantling the Soviet command economy was the overnight abolition of import controls on January 2, 1992, by Yegor Gaidar, the acting prime minister. Russia’s oil production fell to 7.5 million barrels a day, inflation rose to 740 percent, and Russia’s bureaucracy was fragmenting as Gaidar, anticipating a counterattack by the communists entrenched in the bureaucracy, decided to privatize Russia’s industries by giving stocks and shares to the managers and workers. In the oilfields, the managers, ignoring orders and laws, lost any incentive to maintain production, and seized their opportunity to grab the spoils. Yeltsin’s dilemma was profound. Russia’s economy was based on cheap oil, up to 47 percent of which was regularly wasted during generation and heating. Although the government had increased the price paid for oil from 2 cents to 48 cents a barrel, the same oil was being resold in New York for $19 a barrel. In an unruly economy, Yeltsin’s officials were powerless to order local bosses to pay the oil workers, or to direct that oil be supplied to the refineries, or to command the oilfields to hand over the dollars earned from exports. While gasoline was being sold in Moscow in vodka bottles and refineries were limiting production, Yeltsin floundered, issuing ineffectual decrees asserting state control over oil and gas production and exports. On the brink of complete breakdown, the state was even short of sufficient dollars to hire American specialists to seal a huge blowout of a well in Mingbulak in Uzbekistan. Almost 150,000 barrels of oil had been burning every day since March 2, but news of the inferno only reached Moscow at the end of April. Alarmed by the chaos, in April 1992 Loïk Le Floch-Prigent commissioned a newspaper campaign in Moscow to persuade Russians to pull back from the brink of disaster and trust Elf. His appeal was ignored. On May 18, 1992, to dissuade oil workers from striking, the Kremlin shipped trainloads of rubles to western Siberia to pay wages and raised the price paid to the producers to $3 a barrel.
In late December 1991, the Soviet Union split into 15 independent states. The rulers of Kazakhstan, Azerbaijan and Turkmenistan, determined to keep all the profi
ts from their oil and gas, voiced their historic antagonism toward Russia. In Russia itself the managers of the oilfields also dug in, withholding supplies. Caught in the middle of the political battle, Western oil executives became perturbed. Despite their enthusiasm for developing Russia’s riches, the country’s officials were uncertain about their own authority and were powerless to remedy the absence of laws, valuations, taxes and balance sheets as understood in the West. The oil executives’ requests for enforceable contracts and proper accounting to safeguard their investment were met by blank stares, while their intention to earn profits aroused resentment. In that atmosphere, the oil majors reconsidered the risk of investment. “When we make multi-billion-dollar decisions,” said John O’Connor of Mobil, pondering whether to develop oilfields in northern Siberia, “you have to have confidence that the system is predictable and stable. All these things are absent.”
By September 1992, paralysis gripped the Russian oil industry. Twenty-five thousand out of 90,000 oil wells had been closed. In the Kremlin, Viktor Orlov, a former natural resources minister and chairman of the government’s oil committee, warned Yeltsin about “very irrational and wasteful” management of the Siberian oilfields. Russia’s production, he suggested, could fall to six million barrels a day, only just over half the rate in 1988. At the beginning of 1993 the forecast worsened. During a meeting in the Kremlin in April, Vladimir Medvedev, the president of the union of oilmen, told Yeltsin, “The crisis is deteriorating into a catastrophe.” With 20 percent of Russia’s oil wells idle, production could fall in 1995 to four million barrels a day, a million less than the country consumed. Yeltsin’s dilemma appeared insoluble. The country was beset by inflation, unpaid bills, unpaid workers, an unstable ruble and crumbling infrastructure in the oilfields. With Moscow and the provinces disputing each other’s authority, Siberian oil companies were illegally exporting their production, and Russian customers were not paying for their supplies. To increase output by just one million barrels a day, Yeltsin was told, would cost $15 billion. Restoring production to 11 million barrels a day to sustain the country’s foreign earnings would cost over $50 billion and would require Western expertise. Not only was that amount unaffordable, Yeltsin knew, but the country was divided over whether to admit foreign investment. Even partial privatization required the removal of political and legal uncertainties over the ownership of resources. Yeltsin was incapable of resolving that conundrum. “Russia has been a big disappointment for many people,” said Elf’s spokesman in Volgograd. “At first people thought it might be the new Middle East.” In the five years since Russia had opened its doors, the foreign rush had become bogged down by the Duma’s indecision, changing laws and taxes. Oilmen were accustomed to problems, and could console themselves with the truism, “This is where the oil is,” but none had anticipated being stymied by three straightforward deals that unexpectedly antagonized Russian sentiment.
In 1992, Marathon Oil signed an initial agreement with government officials in Moscow to exploit the oil and gas on a territory known as Sakhalin 2, a frozen island in the Pacific Ocean, 6,472 miles and seven time zones from Moscow. In the tsarist era, criminals were sent into exile on Sakhalin, and in 1983 MiG fighters flew from the island to shoot down KAL 007, a Korean passenger plane. Across that bleak 28,000-square-mile shelf in the Sea of Okhotsk, oil production was possible only during the summer. Between October and June, storms, strong currents and seven-foot-thick ice packs prevented work.
Oil had been produced onshore since 1923. In 1975, assured by the Russian government that there were between 28 and 36 billion barrels of oil under the sea, a Japanese company drilled some wells, but lacking expertise and money, its quest was soon terminated. A second agreement with another Japanese exploration company in 1976 ended in the early 1980s after the Japanese concluded that the venture was uneconomic. In November 1991, anxious to exploit the reserves, the Russian government issued an invitation to major Western oil companies to tender for a license. Most were interested, but nearly all became deterred by Russian politics. Valentin Fyodorov, the governor of Sakhalin, demanded that the successful company lend his region $15 billion to develop the infrastructure for a new republic. Reluctantly, some companies agreed, only to become involved in an intense debate in Moscow about whether foreign exploitation of Russian energy should be permitted. Some Russian politicians rejected outright any sale, some opposed catering to Fyodorov’s audacious demands, while others argued that, in the midst of its current financial crisis, Russia had no alternative but to sell its mineral wealth for hard currency.
Eventually, in April 1992, Marathon, in partnership with the Japanese company Mitsui, was allowed to start a feasibility study. Soon after, Mobil and Shell were inserted into the consortium as junior partners. To protect its investment from Russia’s punitive tax regime, Marathon negotiated over the following two years a Production Sharing Agreement (PSA) with the Russian government, giving the Americans a majority stake in the $4 billion venture and excluding any Russian participation. The PSA fixed unchangeable terms for the taxes and royalties payable by Marathon throughout the project’s life. After the agreement was signed in 1994, Russian legislators, officials and ministers, realizing that Russia would receive little income from the sale of its own oil until all the costs incurred by Marathon to develop the project had been repaid, began arguing with officials in Moscow’s oil, geology and finance ministries. Marathon anticipated making tax-free profits for 25 years before Russia earned anything. To protect its hugely favorable agreement, Marathon had successfully insisted that any dispute was subject to international arbitration rather than the Russian courts. The Russian negotiators, failing to hire Western bankers and lawyers as advisers, had unquestioningly accepted Marathon’s terms, and were ridiculed for gullibly falling into an American trap to profit from Russian oil. The critics ignored reality. Russia was technically incapable of producing oil in Sakhalin, and without a PSA agreement no Western oil company could risk developing the island’s reserves. Those arguments eventually prevailed, and Marathon’s deal was approved by the Duma.
Despite the souring mood, Exxon’s Rex Tillerson persuaded the Russian government to sign a second PSA for Sakhalin 1, a neighboring area, albeit on less favorable terms than Marathon’s. Exxon was allowed only a 30 percent share of the project, with Rosneft holding 40 percent. Exxon would receive 85 percent of the profits, while the Russian government took 15 percent. Tillerson was pleased. Like Marathon, Exxon had successfully exploited Russia’s misfortunes, with little regard for the consequences. With the support of President Clinton, Exxon had sought to make profits for shareholders rather than to win the Russian government’s trust and thereby secure a lasting balance to OPEC. In Tillerson’s opinion, Exxon’s commercial priorities were paramount. Success in Sakhalin, he hoped, would tempt the Kremlin to allow Exxon’s exploration in the Barents Sea and the Kara Sea, an Arctic zone potentially containing eight trillion cubic meters of natural gas, the world’s biggest reservoir. If developed, the natural gas could be piped through the Yamal Peninsula system, another huge Siberian energy basin. Those hopes were to be dashed. After the Russian government signed a PSA agreement with Total of France, PSAs were banned. Resurgent nationalism was stymieing Western oil companies across Russia, and even Chevron’s ambitions in Kazakhstan.
Chevron’s fraught negotiations to develop Tengiz had been stabilized by John Deuss. The trader famous for Brent squeezes was representing the government of the oil-rich Gulf state of Oman. Seeking investment opportunities, Deuss, flying his Gulfstream between Almaty in Kazakhstan, Europe, Washington and Jackson Hole, Wyoming, brokered the “deal of the century” between Kazakhstan and Chevron. His intention was to profit through the financing and ownership of a new pipeline to transport Tengiz’s oil to a port. Chevron’s success depended on the pipeline, which, despite Kazakhstan’s independence, was subject to the Kremlin’s veto if the proposals were deemed to be unfavorable. Ken Derr appeared untroubled by that hurdle. D
esperate to reverse Chevron’s decline, and haunted by the company’s loss of $1 billion in Sudan during the 1980s, he was prepared to gamble on securing the oil first, only afterward negotiating a pipeline’s construction.
The preliminary agreement to develop Tengiz, an area twice the size of Alaska, had been signed by Derr and President Nazarbayev of Kazakhstan on May 18, 1992, in Washington. In the initial $1.5 billion investment the Kazakh government, advised by Morgan Guaranty Trust and Deuss, had persuaded Derr to reduce Chevron’s share of the income from 50 percent to 20 percent. Over 40 years the Kazak government expected to make $200 billion.
In public, Chevron’s success in Kazakhstan was credited to its technical superiority. The Kazakhs and the Russians, it was said, could not manufacture the special quality of steel pipes needed to resist Tengiz’s corrosive crude oil, or provide the drills to reach 23,000 feet amid toxic hydrogen sulphide gas. In reality, Chevron’s breakthrough to secure the oilfield had been due to a combination of risk and dubious practices during excruciating negotiations that were saved from stalemate by James Giffen and John Deuss. The two maverick traders were consulted by Chevron to fashion a deal with Kazakh and Russian politicians. Giffen, a 62-year-old New Yorker acting on behalf of other oil companies, was suspected of paying $78 million between March 1997 and September 1998 into Swiss bank accounts via the British Virgin Islands for the benefit of Kazakhstan’s President Nursultan Nazarbayev and some ministers. Nazarbayev was alleged to have used some of the money to buy jewelry, speedboats, snowmobiles and fur coats. On March 31, 2003, Giffen was arrested at JFK International Airport under the Foreign Corrupt Practices Act and charged with bribing Kazakh officials. Two months later, J. Bryan Williams of Mobil pleaded guilty to evading taxes on a $2 million bribe connected to Mobil’s purchase of a stake in Tengiz costing $1.05 billion. Mobil (before merging with Exxon) had paid Giffen’s company, the Mercator Corporation, $51 million for work on the Tengiz deal, although Mobil insisted that Giffen was working for the Kazakh government and not them at the time. Giffen admitted depositing money in the Swiss bank accounts, but insisted that he had acted with the approval of the US government. The CIA, the State Department and the White House, he said, had encouraged his relationship with Nazarbayev. The prosecution remains in limbo, with Giffen on $10 million bail. The problem, as Chevron’s executives acknowledged, was the immutable relationship between corruption and securing oil supplies in the Third World. Giffen was accused of paying an immediate $450 million deposit to sweeten Nazarbayev’s interest. Ostensibly the payment was to finance Kazakhstan’s share of the investment, but the FBI would subsequently allege that the money was a bribe.