The Quest: Energy, Security, and the Remaking of the Modern World

by Daniel Yergin

  And they were being grabbed. As President Yeltsin put it, the economic assets of the state were being privatized “wildly, spontaneously, and often on a criminal basis.” He and his team of reformers were determined to regain control, to break up whatever remained from the command-and-control economy, and to replace it with a new economic system based upon private property. The objectives of privatization were not only economic; they also wanted to forestall any return to the communist past by removing assets from state control as quickly as possible. To make matters even more difficult, this economic upheaval took place against a backdrop of political turmoil: a standoff between the Yeltsin administration and the State Duma, or parliament, including a violent “siege” of the Duma; the first Chechnya war; and a 1996 presidential election that, until late in the campaign, seemed likely to end with a victory by resurgent communists.

  The Soviet system had left many valuable legacies—a huge network of large industrial enterprises (though stranded in the 1960s in terms of technology); a vast military machine; and an extraordinary reservoir of scientific, mathematical, and technical talent, although disconnected from a commercial economy. The highly capable oil industry was burdened with an ageing infrastructure. Below ground lay all the enormous riches in the form of petroleum and other raw materials that Gorbachev had cited in his farewell address .7

  RECONSTRUCTING THE OIL INDUSTRY

  These natural resources—particularly oil and natural gas—were as critical to the new Russian state as they had been to the former Soviet Union. By the middle 1990s, oil export revenues accounted for as much as two thirds of the Russian government’s hard currency earnings. What happened to these revenues “dominated Russian politics and economic policy throughout the 1990s and into the 2000s.” Yet the oil sector was swept up in the same anarchy as the rest of the economy. Workers, who were not being paid, went on strike, shutting down the oil fields. Production and supply across the country were disrupted. Oil was being commandeered or stolen and sold for hard currency in the West. No one even knew who really owned the oil. Individual production organizations in various parts of West Siberia and elsewhere were busily declaring themselves independent and trying to go into business for themselves. The industry was suddenly being run by “nearly 2000 uncoordinated associations, enterprises and organizations belonging to the former Soviet industry ministry.” Amid such disruption and starved for investment, Russian oil output started to slip, and then collapse. In little more than half a decade, Russian production plummeted by almost 50 percent—an astonishing loss of more than 5 million barrels a day.

  Privatization here, too, would be the answer. But how to do it? The oil industry was structured to meet the needs of a centrally planned system. It was organized horizontally, with different ministries—oil, refining and petrochemicals, and foreign trade—each controlling its segments of the industry. The resources industry was as important to the new state as to the old and had to be handled differently from the other privatizations.

  One person with clearly thought-through ideas about what to do was Vagit Alekperov. Born in Baku, he had worked in the offshore Azerbaijani oil industry until transferring at age twenty-nine to the new heartland of Soviet oil, West Siberia. There he came to the attention of Valery Graifer, then leading West Siberia to its maximum performance. Recognizing Alekperov’s capabilities, Graifer promoted him to run one of the most important frontier regions in West Siberia. In 1990, Alekperov leapfrogged to Moscow, where he became deputy oil minister.

  On trips to the West, Alekperov visited a number of petroleum companies. He saw a dramatically different way of operating an oil business. “It was a revelation,” he said. “Here was a type of organization that was flexible and capable, a company that was tackling all the issues at the same time—exploration, production, and engineering—and everybody pursing the common goal, and not each branch operating separately.” He came back to Moscow convinced that the typical organization found in the rest of the world—vertically integrated companies with exploration and production, refining and marketing all in one company—was the way to organize a modern oil industry. Prior to the collapse of the Soviet Union, his efforts to promote a vertically integrated state-owned oil company were rebuffed. Opponents accused him of “destroying the oil sector.” He tried again after Russia became an independent state. For to stay with the existing setup, he said, would result in chaos.8

  In November 1992, President Yeltsin adopted this approach in Decree 1403 on privatization in the oil industry. The new law provided for three vertically integrated oil companies—Lukoil, Yukos, and Surgut. Each would combine upstream oil production areas with refining and marketing systems. They would become some of the largest companies in the world. The state would retain substantial ownership during a three-year transition period, while the new companies tried to assert control over now semi-independent individual production groups and refineries; quell rebellious subsidiaries; and capture control over oil sales, oil exports, and the hard currency that came from these transactions. The controlling shares for other companies in the oil industry were also parked for three years in what was to be a temporary state company, Rosneft, buying time for decisions about their future.

  This restructuring would have been hard to do under any circumstances. It was very hard to do in the early and mid-1990s, when the state was very weak and law and order was in short supply. There was violence at every level, as Russian mafyias—gangs, scarily tattooed veterans of prison camps, and petty criminals—ran protection rackets, stole crude oil and refined products, and sought to steal assets from local distribution terminals. As the gangs battled for control, a contract, all too often, referred not to a legal agreement but to a hired killing. In the oil towns, the competing gangs tried to take over whole swaths of the local economy—from the outdoor markets to the hotels and even the train stations. The incentives were clear: oil was wealth, and getting control of some part of the business was the way to quickly amass wealth on a scale that could not even have been dreamed about in Soviet days, just a few years earlier.9

  But eventually the state reasserted its police powers, and the newly established oil companies built up their own security forces, often with experienced veterans of the KGB, and the bloody tide of violence and gang wars began to recede.

  LUKOIL AND SURGUT

  Meanwhile, following on Yeltsin’s privatization decree, the Russian oil majors were beginning to take shape.

  The most visible was Lukoil. Vagit Alekperov, equipped with a clear vision of an integrated oil company, set about building it as quickly as possible. The first thing was to pull together a host of disparate oil production organizations and refineries that had heretofore had no connection. He barnstormed around the country trying to persuade the managements of each organization to join this unfamiliar new entity called Lukoil. In order for Lukoil to come into existence, every single entity had to sign on. “The hardest thing was to convince the managers to unite their interests,” said Alekperov. “There was chaos in the country, and we all had to survive, we had to pay wages, and keep the entities together. Without uniting, we would not be able to survive.” They heard the message, all signed on, and Lukoil became a real company.

  Alekperov recognized the heavy burdens that the new Russian companies carried—what he called their “Soviet legacy” of “aged equipment along with obsolete manpower and production management systems.” Lukoil had to target “the best international practices.” From the beginning, Alekperov put in place international standards and used international law firms, accountants, and bankers. In 1995 the chief financial officer of the American oil company ARCO came across an article about Lukoil in the Economist magazine. He found it intriguing enough that he followed up, and ARCO subsequently bought a share of Lukoil. From the early days, Lukoil also pursued an international strategy, first in the other new nations of the former Soviet Union and then in other parts of the world.

  If Lukoil was the most international of
the new Russian majors, Surgut was the most decidedly Russian. Its CEO, Vladimir Bogdanov, was called the “hermit oil man” by some. He had been born in a tiny Siberian village, made his name as a driller in Tyumen, and the enterprise he managed there became the basis of what emerged as Surgutneftegaz, better known by its short name, Surgut. He never moved to Moscow, instead keeping Surgut’s headquarters in the city of Surgut. As he once explained, he liked to walk to work.10

  Both Lukoil and Surgut were run by people who would have been qualified as “oil generals” under the Soviet system.

  YUKOS: THE SALE OF THE CENTURY

  Very different was a company called Yukos. It was one of the first oil companies to be run by one of the new oligarchs who had emerged not from the oil industry but out of the chaotic barter economy.

  Mikhail Khodorkovsky had started off with orthodox Soviet ambitions: as a child, he announced that his objective was to rise to the highest levels of the Soviet industrial system and achieve the vaunted position of factory director. Later, while a student at the Mendeleev Institute for Chemistry, he jumped into business as a leader of the school’s Komsomol, the communist youth organization, turning it into a commercial organization. He then moved into trading in imported computers and software and then, in the late 1980s, set up a bank called Menatep, which would soon be regarded as serious enough to be entrusted with government accounts. It also provided finance to one of the new oil companies, Yukos.

  Khodorkovsky soon concluded that oil was an even better business than banking. The timing was right. By 1995 the Russian government was desperately short of funds, and some of the new businessmen and the Yeltsin government came up with a solution that went by the name of “loans-for-shares.” Businessmen would loan the Russian government money, taking highly discounted shares in petroleum and other companies as collateral. When the government, as anticipated, defaulted on the loans, the shares would end up as the property of the lenders. They would thus control these new companies. The government meanwhile got the short-term funding it needed to keep afloat prior to the 1996 presidential election. It was certainly an unusual way to privatize assets, and loans-for-shares was immortalized as the “sale of the century.” Khodorkovsky lent the Russian government $309 million and won control of Yukos’s shares.11

  Khodorkovsky set about task number one, which was to gain control of the flows of oil and money, which seemed to be going in all directions. Khodorkovsky had never attended the Gubkin Institute or any of the other Soviet oil academies, and he had no particular attachment to the Soviet approach to field development. And so he turned to Western oil field service companies to come in and apply Western development techniques, rather than Soviet techniques, to the oil fields. This would lead to dramatic improvements in output. (It would also, in later years, come back to haunt him, during his confrontation with the Russian government, with charges that he had violated recognized and sound “Russian” oil field production practices.) As his wealth and influence magnified, so did his ambitions.

  These companies—Lukoil, Surgut, and Yukos—were the three majors. They were not alone by any means. There remained the state company, Rosneft; six “mini-majors”; and a number of other companies, including those owned or sponsored by oil-rich regional governments.

  One of the mini-majors was TNK. A consortium of owners, the AAR group, came together to buy the company in 1997. They would become among the country’s most prominent oligarchs. Three of them came from the Alfa Bank. Mikhail Fridman was a graduate of the Institute of Steel and Alloys. He had worked for a couple of years in a factory, but when it became possible to go into business in the late 1980s, he jumped in, starting a dizzying host of enterprises, ranging from a photo coop to window washing. Despite the chaos and being told that his businesses could not succeed, Fridman later said, “we did have an internal conviction.” His partner German Khan, another graduate of the Institute of Steel and Alloys, ran what became the oil trading part of their new enterprise and would remain the most focused on the oil business itself. The money they made from trading commodities enabled them to set up the Alfa Bank. A third partner was Peter Aven, who had already established his reputation as an academic mathematician and had been minister of foreign trade in the early 1990s.

  The other members of the consortium included Viktor Vekselberg, who trained in transportation engineering, and Len Blavatnik, who had emigrated to the United States at age 21 and worked his way through Harvard Business School after a stint as a computer programmer. Blavatnik made his first trip back to the Soviet Union in 1988. It was a different country. He returned again in 1991—now it was Russia—and became serious about investing in a newly independent Russia, which led him to join up with the others in TNK. For its part, TNK controlled half the Samotlor oil field in western Siberia. It was a most desirable jewel—among the half dozen largest oil fields in the world.

  There was another prominent company—Sibneft, as in Siberian Oil. This was the most classic of the loans-for-shares deals. Roman Abramovich, who had been trading everything from oil to children’s toys, teamed up with Boris Berezovsky and lent $100 million to the impoverished Russian government for half the company. When, as anticipated, the government failed to repay the loans, these oligarchs had control. Berezovsky went into political exile after falling out with President Vladimir Putin. Abramovich followed a different path. He took on the additional duties of governor of an impoverished region in the Russian Far East. Abramovich eventually sold Sibneft to the Russian gas giant Gazprom and moved to England, where he was said to be the second-richest person in the country, exceeded only by the Queen herself.12

  Overall, by 1998, within six years of the collapse of the Soviet Union, the Russian oil industry had gone from a system run by a series of ministries and subordinated to central planning to a system of large vertically integrated companies, organized, at least in rough outline, similarly to the traditional companies in the West. During these years, they all operated largely autonomously from the state. Eventually the Russian Federation would have five large energy companies, each of whose oil reserves were comparable to the size of the largest western majors.

  The development of these companies was more than just a wholesale reconstruction of the Russian oil industry. It also brought visible changes in the larger cities. In Soviet times, those few lucky enough to own automobiles had to search out the rare and hard-to-find dingy service stations on the outskirts of the city. But now new, modern service stations were springing up at intersections and alongside the highways, bedecked with shiny corporate logos—Lukoil, Yukos, Surgut, TNK, and a number of others. The stations came equipped not only with high octane gasoline of dependable quality, but also in many cases things that people never expected to see, like convenience stores and, even more remarkable, automatic car washes. All of that would also have been unimaginable in Soviet times.

  OPENING UP

  How did this new Russian oil industry look to the rest of the world? In 1992 the head of one of the world’s largest state-owned oil companies was asked what he thought about Russia and all the changes that were happening there. His answer was very simple. “When I think of Russia,” he said without a pause, “I think of it as a competitor.”

  Others saw opportunity. For many decades after the 1917 Bolshevik Revolution, the Soviet Union had been closed off, an almost forbidden place, another world. The Soviet oil industry operated largely in isolation, with little of the flow of technology and equipment that was common in the rest of the world.

  In the late Gorbachev years, at the end of the 1980s, the Soviet Union started to open the doors to joint ventures with Western companies. The objective was to bring in the technology it needed to improve the performance of the Soviet industry. Then came the collapse of the Soviet Union. This provided a vast new prospect to Western companies: the potential to participate in a region rich with hydrocarbons, perhaps comparable to the Middle East in the scale of resources, and world-class opportunities. They dispatc
hed teams to research these opportunities.

  Some concluded that, whatever the “Russian risk,” they simply could not afford not to be in Russia. “When you looked at the opportunity, you became enthusiastic,” recalled Archie Dunham, then CEO of the U.S. major Conoco. “It was just a huge opportunity.” But, as time went on, the Western companies learned how difficult it was to work in the Russian Federation. As Dunham added, “You had a rule of law problem, you had a tax problem, and you had a logistical problem.”

  The uncertain political environment, the shifting cast of characters, the corruption, the security risks, the opaque and constantly changing rules, the uncertainty as to “who was who” and “who was behind who”—all of these made others more reluctant. “We had opportunities all over the world,” said Lucio Noto, CEO of Mobil. “Once you sink a couple of billion dollars into the ground, you can’t move it.”13

  When the Western companies looked across the panorama—at the operating conditions, the equipment, and the fields—they saw an industry that was suffering from decades of isolation and that lacked the most up-to-date equipment, advanced skills, and sufficient computing power. They recognized that Russian geoscientists were at the forefront of their disciplines, but that, in Russia, “theory” was quite separated from “practice.” They also saw the dire situation in the Russian oil fields and the desperate need for investment. The Westerners were convinced that they would be welcome because they brought technology, capital, expertise, and management skills. That is not how Russian oil people looked at it, however. They took great pride in what the Soviet industry had accomplished, they were confident in their own skills, and they enormously resented the implication that they were not up to world standards. The Russian industry, in their view, did not need outsiders telling them what to do. Nor did it need substantial direct foreign participation in order to transfer technology. If the Russians needed technology, they could buy it on the world market from service companies.