Rags-to-riches surprise for Russia’s power engineering industry

Graham Stack for Russia Profile

The flood of investment in expanding Russia’s power generation capacity has taken most people by surprise – not least the power engineering companies who will build it.

Russia’s huge and unanticipated success in raising 150$bn investment to expand its power generation capacity has taken power equipment producers largely by surprise, causing bottlenecks in production, soaring prices for equipment, and oligarch acquisition of engineering plants.

“No one anticipated the success of the UES spin offs in raising investment funds,” says Alfa’s Alexander Kornilov, “and so the power generation machinery sector was caught unprepared for the huge surge in demand.”

Caught unprepared

St. Petersburg based Power Machines, a conglomerate of several large power engineering plants which took shape in 2004, has 60% of the Russian market, so is taking a lion’s share of the capex. But according to Kornilov, Power Machines is facing a “severe shortage of qualified personnel and manpower.”

It was only in 2007, as the sell-off of the state’s stakes in power generation companies started, that the scale of the coming investment boom became clear. Power Machines announced February 2007 that its sales revenue could jump to $1.5bn in 2010 from $680m in 2006, as the result of $1bn in investment through 2010.

This abrupt change in fortune turned loss-making Power Machines into a hot property – with strategic importance.

Both electricity utility UES (25%) and financial-industrial group Interros (30%) announced they would sell their stakes to a strategic investor, promptly unleashing a bidding war between metal oligarchs Oleg Deripaska and Alexei Mordashov that resulted in the latter consolidating a 55% stake in the company for close to $1bn.

With a strategic investor in the driving seat, new management, and an additional share issue having raised $275m, Power Machines’ plans to more than double generation capacity of machinery produced from 8-17 GW annually looked more realistic.

But it was still running to catch up, with new demand exceeding current output fivefold. Moreover, construction of new generation capacity is on an extremely tight schedule: mandatory investment programmes stipulate 280 turbines to be built by 2011.

This bottleneck it does not just relate to turbine producers. A whole range of further industries engineering services, construction materials and construction work are coming up short.

It is not only lack of capacity. Russian produced-technology still lags far behind western counterparts.

Luckily for Power Machines, but unluckily for Russia’s electricity generators, foreign giants such as Siemens and Alstom are also running at full capacity.

“The world’s largest producers of generating equipment, such as General Electric, Alstom, Siemens and Mitsubishi, are just as overloaded as Russian Power Machines, leaving no room for an increase in their production,” says Alfa’s Kornilov.

Freedonia market report puts global electric transmission and distribution equipment demand to rise 4.4% annually through 2011, and International Energy Agency forecasts at least around €140 billion per year to be invested in power generation until 2030

As a result Russian power generators have to queue to place orders. Mosenergo reportedly paid a $54m booking fee for a $500m equipment order from a foreign producer, according to Russian Today.

The surprise guest at the feast has thus been no-name Chinese producers. OGK-2 invited Harbin Power Equipment was chosen as equipment supplier for the Troitsk HPP and at the end of April announced it was inviting a project developer from China to take part in the construction of new generating units at the plant.

These steps awakened alarmist fears of flood of cheap Chinese power station components and companies flooding the market. However, according to Alfa’s Kornilov, Chinese manufacturers still lack the quality to make real inroads.

Chubais vs. Chemezov: How to kick-start engineering

The upshot is that Anatoly Chubais – the godfather of 90’s economic reform, scourge of industrialists and idol of free-marketeers – has succeeded magnificently where the government’s interventionist silovik faction has little to show: By kickstarting a revival of the ailing machine-building sector.

For much of Kremlin economic policy in Putin’s second term was focused on reorganising the machine-building sector – including ‘deprivatisation’ where necessary.

The culmination of this policy was the establishment December 2007 of the Russian Technologies state corporation, dedicated to supporting and developing machine-building, and excercising direct control over upwards of 300 companies, and headed by Putin’s old friend Sergei Chemezov.

Chemezov argues – with some justification – that turning the sprawling machine-building sector around is the key to achieving economic diversification.

“In any country, and especially in ours, machine-building is the key sector of industry,” Chemezov told Nezavisimaya Gazeta in an interview May 28th.

And this is what Chubais has achieved with the rags-to-riches tale of power equipment producers – without a ruble of state support, and without infringing on property rights or creating opaque structures as the siloviki are wont to do.

On the same day, 21st May, that headlines were full of the maiden flight of Russia’s new regional jet, the Sukhoi Superjet 110, a product of state-owned holding United Aircraft-building Corporation, Chubais opened the first Russian-produced, combined-cycle power unit in Komsomolsk, the work of private companies and private investment, saying “a breakthrough for the country’s heavy-machinery sector.”

One company had double cause to celebrate: Yaroslav-based turbine producers NPO Saturn built the engines for the Superjet, and also the turbines for Konsomolsk power plant.

The case of NPO Saturn also perfectly illustrates the very different approaches between the ‘industrialists’ Chubais and Chemezov.

Chubais, in his speech opening the power plant, congratulated Russia’s power engineering managers, but warned them they had to stay internationally competitive to keep winning tenders:

“I’m for Siemens as well, and I’m for General Electric. If you fail to produce the 10 new units, I’ll strangle you with my own hands,” he warned them playfully, as quoted by Interfax.

Chemezov’s threats towards NPO Saturn, on the other hand, are far less playful: Russian Technologies holds a 37% stake in the company and is pushing for the company to be merged into a state-controlled conglomerate, effectively renationalizing it. Company director, Yury Lastochkin, who controls 57%, is bitterly resisting this.

Deputy Industry Minister Denis Manturov, a Chemezov ally, has publicly called Lastochkin’s position ‘destructive’, adding in a Kommersant interview, ‘I advise Mr Lastochkin to read what is set down black on white in the presidential decree about who is to do what and when,” and stating Russian Technologies would ultimately require 100% control over Saturn.

Lastochkin responded in Vedomosti that “to hand over assets we have been developing and structuring for over 10 years to complete nobodies would be beyond a laughing matter.” Asked if he feared pressure from law-enforcement agencies forcing a management sell-out, he said he hoped the state was clever enough to realize that any such ‘games and experiments’ would have a disastrous effect on such a finely-tuned technological enterprise.

Which of these two battling paradigms – Chubais vs. Chemezov, unbundling of UES vs. snowballing of Russian Technologies, competition and private investment vs. state control – wins out, is one of the first things that new president Dmitry Medvedev will have to decide.

SMEs top Russia agenda, but will Medvedev succeed where Putin failed?

Graham Stack for business new europe

Putin was a small man with big ideas, but Russian President Dmitry Medvedev is a small man who is turning to the small details. He launched his first term as president by inviting 5,000 small- and medium-sized enterprise (SME) bosses to the Kremlin to listen to their gripes.

This is new for Russia. Over the last 15 years, the Kremlin has always been first and foremost concerned with big issues, big companies and has made some big mistakes. The little people in the street have largely been ignored and bore the brunt of the suffering. However, if Medvedev is successful in cutting the red tape that entangles small businessmen, as he is promising, it would have a big effect on the Russian economy.

Medvedev has so far been hitting all the right notes when it comes to making life easier for the beleaguered SMEs. Barely a week into his new job, Medvedev called a meeting with SME representatives and prepared decrees slashing permit and licensing requirements. “You know what I am talking about,” he said at the meeting May 14 with the assembled small business bosses. “Firstly, I mean reducing the number of inspections to one every three years, with extra inspections requiring special permission from the procurator’s office… I mean a transition to predominantly notification procedure for registering small businesses, and wide-ranging introduction of compulsory insurance for small business instead of bureaucratic licensing… I remind you that our goal is that by 2020, 60-70% of the workforce should be involved in entrepreneurial activities.”

Is this a break with gigantism of the Putin area, and its focus on oligarchs, state monopolies and massive pipeline and infrastructural projects?

Heard it before

“Dear colleagues,” began the president. “We often say that it is very important for starting businesses to ‘find their feet’… Business in general – and small business in particular – has an enormous amount of complaints about unjustified administrative pressure. And this primarily comes from supervisory bodies and inspections. Hundreds of thousands of people oversee this order. Thousands of commercial organizations are accredited at these bodies to’ feed’ off inspections. Their dictates and fines, just like extortion and bribes, are an excessive burden and oppress enterprise… The government should ensure that these inspections are reduced to a minimum.”

Impressive? But this was not President Medvedev, but President Vladimir Putin in his presidential address to parliament in 2002, detailing a plan drawn up and subsequently implemented by German Gref’s reformist Ministry of Trade and Economic Development. So, six years later, why are we back to square one?

Currently, SMEs in Russia employ 24% of the workforce and contribute 22% of the GDP, compared with 78% of the workforce and 55% of the GDP in Japan, and on average approx 50% of workforce in developed countries. A study published December 2007 by the Centre for Economic and Financial Research (CEFIR) at Moscow’s New Economic School about the effects of the Gref de-bureaucratisation programme found there had been an overall average effect on SME development, but subject to massive regional differences. Federal measures only worked effectively where local government got behind them, and this only occurred in regions with, according to the survey, relatively high standards of transparency and information. In other regions, local authorities simply continued inspections as previously, ignoring the new regulations.

Another survey released in April, conducted by Trust Bank and Romir Monitoring, established that SMEs had never had it so good in terms of current business in 2007: 66% of SMEs said their market grew in 2007, compared with 51% in 2006 and 54% said business was better. But, paradoxically, despite feeling good, the same businesses say they lack confidence in their future. In comments on the survey, Trust’s managing director for development of SMEs, Nadia Cherkasova said: “for both small and midsized companies, the index of expectations was significantly lower than the index of current business. This indicated that entrepreneurs are in a permanent state of anxiety regarding the future.” Trust makes no secret of the reason for this: “administrative and criminal pressure.”

This indicates that, with small business revenues growing, the temptation for law enforcement and inspection agencies to line their pockets also grows. Entrepreneurs suspect that whatever legislative changes are introduced, local state organs will find new ways of extracting rents. SME confidence in the future falls as their business grows. In turn, lack of confidence in the future deters companies from accessing credit, and thus limits business expansion.

Big business looks out for small

The solution to all this is to replace the whole system of government licensing and inspections in favour of compulsory insurance, which was what Putin was calling for way back in 2002, in vain as it turned out. It failed to materialize then, as there was no insurance sector worthy of the name. Even compulsory third-party motor insurance was only introduced in 2003, and encountered significant initial difficulties.

But in 2008, the insurance sector has transformed beyond recognition, after five boom years, with almost all major European insurance companies now present in Russia, and professional standards soaring. This makes transition to an insurance system now feasible. Moreover, it means that there is a power lobby in favour of implementation and enforcing such a system: precisely the federal-level insurance companies. For the first time, big business is looking out for small.

In banking, as well, huge changes have taken place. And after the retail banking boom, banks are starting to look to the SME sector as a new source of business. According to Trust Bank, 2007 was the first year where the growth rate of loans to SMEs was higher than the growth rate of corporate and retail loans, according to Nadia Cherkasova. VTB has announced plans to increase SME financing by 80%. And Russia’s largest bank, Sberbank, has a special interest in small business: its new CEO, German Gref, was as economy minister the author of the 2002 deregulation initiative.

Large banks looking to do business with small companies constitute another lobby with an interest in protecting SMEs against local inspections. And not only in terms of legislation, but also in terms of enforcement. Local officials are less likely to harass entrepreneurs where this involves entangling with the corporate security services of federal–level insurers or banks.

New government legislation could work this time round if it’s backed by such powerful federal players, with money at stake where clients come under administrative pressure.

It is no coincidence that a leading lender to small business such as Trust Bank, with one of Russia’s largest branch networks, sponsors of the Romir Monitoring Small Business Index, lobbies both for extensive deregulation for small business, but also for criminal liability for creditors who fail to return loans.

Oil field services: The market’s answer to Russia’s stalling oil production

With Russian oil production beginning to fall, the new and growing Russian oil field service (OFS) sector (specializing in oil exploration and production services, solutions, and technology) could hold the key to turning this trend around — by cutting costs, increasing competition, and introducing new technologies.

Russian oil production in April of 2008, at 9.72 million barrels, was 1.8 percent below the production peak in October, despite world oil prices having soared to $126 per barrel (compared with $12 ten years ago).

In an interview with Smart Money, Vagit Alekperov, CEO and largest shareholder of LUKoil, Russia’s second largest oil company, called the drop in production “a trend.” His colleague, LUKoil CFO Leonid Fedun went even further, telling the Financial Times on April 15th that last year’s 10 million barrels per day peak was the “highest he would see in his lifetime.” The Russian government has been swift to respond with the promise of tax cuts to stimulate new production.

But another market-driven development will also be crucial to kick starting production growth: the ongoing emergence of an independent oilfield service sector in Russia.

Emerging from the shadow of oil majors

Global market leaders in oilfield services, such as Schlumberger and especially Halliburton, are household names, not least due to the latter’s controversial role in Iraq and links to U.S. Vice President Dick Cheney. Although what OFS companies sell are technologies for extracting oil, and not the oil itself, they constitute a trillion-dollar business. Schlumberger, the market leader, has a capitalization of $110 billion, a turnover of $23.28 billion, 80,000 employees worldwide, and holds 8.9 percent of the Russian market.

Characteristic of Russia’s capitalist energy field, only in the last three years have Russian OFS companies crystallized as a sector independent of integrated oil companies, mostly by spinning off from the latter. In 2008, the process is snowballing. The global practice is for oilfield services to be independent of oil companies, but the Soviet industrial legacy means that in Russia, over 50 percent of the market is still dominated by in-house services, not directly exposed to competition or shareholder scrutiny. Yet this is set to change and competition to increase.

“In the West, very few oil companies have their own oilfield service departments. You only find this in Russia and in China,” Andrew Gould, the president of Schlumberger, told the Vedomosti business daily on April 23rd. Gould added that the current trend for spinning off oilfield services is “excellent for competition,” and spoke highly of Russian technological expertise–Schlumberger itself employs 15,000 Russians worldwide, constituting almost 20 percent of its workforce.

“Oil companies are going to keep spinning off their non-core assets,” said Aleksandr Dzhaparidze, president and owner of Eurasia Drilling, also interviewed by Vedomosti in January. Eurasia Drilling and Schlumberger both possess just under nine percent of the market share in Russia.

Eurasia Drilling was formerly “LUKoil Burenie,” the OFS division of the LUKoil oil giant. Now it is the largest Russian OFS company, with market capitalization of $3.4 billion, having raised $450 million through an IPO in November of 2007.

Russia’s largest oil company, the state-owned Rosneft, also confirmed its plans to float its three OFS divisions following fundamental restructuring: the restructuring of Rosneft Service, uniting all regional service subsidiaries, was completed in April. Rosneft Service along with RN Drilling and RN Energy IPOs are slated for 2010-211.

TNK-BP, Russia’s third largest company by output, is also restructuring its 12 OFS units into one division, with the aim of either selling or floating it, or, alternatively, running it as a profit center. The service units earned $500 million in 2007, and Timothy Summers, Chief Operating Officer of TNK-BP, told journalists in April that he expects a profit of $700 million in 2008, along with a market capitalization of about $1-2 billion. The Siberian Services Company (SSK), a former YUKOS OFS arm, currently enjoys a market share of 2.5 percent.

A number of smaller operations are also being set up in the sector. Britain’s Imperial Energy announced early February that it is mulling an IPO of its freshly-consolidated oil services arm Rus Imperial Group (RIG). In March, Russia’s TMK, one of the world’s top three oil and gas pipe producers, announced the launch of the TMK Oilfield Services division.

Other investments in the sector include Geotech, conducting a $100 million private placement to institutional investors in preparation for an IPO in 2010, and in March, the leading Russian OFS company Integra announced a joint venture with America’s Smith International Inc., another global leader.

In contrast to the increasingly restrictive investment environment for foreigners in the oil sector per se, the OFS sector is very much open to foreign competition, which tends to focus on the high-end hi-tech niche. According to Rencap’s Roman Eleagin, this means that within five years, majors will outsource 70 percent of oil services to independent companies, in contrast to the current 50 percent.

Government tax break will further boost OFS

This change in the sector will go hand in hand with a double-digit growth of the OFS market, that will grow from approximately $11.5 billion to $15 billion per year. Driving the coming boom is the challenge posed by oil production, due to field depletion and greenfield development, combined with soaring oil prices. Analysts and executives agree it’s getting harder and costlier to extract oil in Russia.

“One of the most important global trends is the increasing challenge of maintaining the level of oil and gas production,” said Schlumberger’s Gould in March. “This is the fundamental reason behind the rise in costs. The second global trend is to replace reserves by conducting exploration. In Russia, this is being done mostly in Eastern Siberia. But infrastructure there is underdeveloped.”

Oil field services do make a difference, by employing state-of-the-art technologies to get the most out of depleted oil fields and by cost-efficient exploration. “We all know about high global energy prices,” Vladimir Putin said, addressing the Duma as prospective prime minister on May 8th. “Revenues of oil companies are not small. However, we are taking a large chunk of these revenues (about 75-80 percent) into the budget in the form of taxes and export duties. To a large extent, this leads to an increasing number of idle, low-debit wells. Exploration and development of new deposits take place slowly.” Putin concluded that “In order to stimulate production and refining of crude oil, it is now time to make a decision to reduce the tax burden on this sector.”

On Monday May 26th, the first meeting of the new Presidium of the Russian government approved a reduction of the mineral extraction tax (MET), by increasing the non-taxable base rate from $9 per barrel to $15 per barrel. It also approved seven-year-long tax holidays, for developing new regions such as Yamal, Timano-Pechora, and the continental sea shelf (in the Russian Arctic).

This is music to the ears of OFS companies. As analysts at the UralSib investment bank said, Russia’s OFS companies such as Integra, Eurasia Drilling, and C.A.T. oil, are now set to “benefit handsomely from the expected wave of capex growth that integrated companies will pour into exploration and development

Russian IPOs back on the cards after slow first quarter

Graham Stack for businessnew europe

A roaring trade in IPOs last year hit a brick wall at the start of this one as the aftershocks of the US sub-prime debacle reached emerging markets. Stock markets sold off sharply and conditions were so stormy that almost all Russian companies with plans to float put them on ice. However, following the smooth transfer of power from Vladimir Putin to his friend and ally Dmitry Medvedev the markets have rallied and IPOs are back on the agenda.

May kicked off with a $449m GlobalTrans IPO for Russia’s first pure freight-train play, and concluded with two large internet IPOs announced for later in 2008 – the yandex.ru search portal and the mail.ru mail portal, valued at $5bn and $1bn respectively, according to financial daily Vedomosti. “In 2007, the surprise were the retail and real estate IPOs,” says Deutsche Bank’s Yaroslav Lissovilik. “Infrastucture is going to be hot in 2008, and that for me includes internet and IT.”

Commenting on the IT and internet IPO trend, Renaissance Capital’s David Ferguson says there is a whole cluster of IT companies, having crossed the $500m per year revenue mark, in line to IPO. “They all want to do it, and they come to us for advice, and we tell them they’re not ready yet, but they will be soon. They’re all on the path towards there.” Ferguson underlines it was the software programming houses, and not the huge, but hard to monetise, social networking sites such as odnoklassniki and vkontakte, that were most likely candidates.

Market sentiment on the mend

May saw a long-awaited stock market rally follow the inauguration of President Medvedev, making all-round conditions more palatable for new listings. As Troika Dialog’s strategist Andrey Kuznetsov notes: “Sentiment changed in May, with companies resuming IPO programmes after a first quarter that saw few placements.”

Artyem Dovlatov, vice president of PBN, agrees that the mood is definitively looking up, and is looking for significant developments in the third and fourth quarters. “The first quarter is never huge in any year, and this year the market conditions were also bad. Dovlatov says PBN, which provides consultancy services for companies considering IPOs, has several big names in our pipeline, with sectors to watch out for being retail, mining, telecommunications – “which all represent the economic diversification the government is aiming for.”

Dovlatov says that while the amount raised in IPOs this year will be less than in 2007, the exact amount is extremely difficult to predict due to uncertainty about whether monster IPOs such as aluminium giant RusAl will take place this year or not. He points out that the huge 2007 figure was largely down to two huge IPOs by Sberbank and VTB, each worth around $9bn. Kuznetsov’s overall forecast is for around $26bn-30bn; Deutsche Bank’s Lissovolik puts the figure nearer $20bn, a drop from 2007’s record of $30bn, but still up from 2006’s $15bn.

Troika lists among its top IPOs for 2008: Gazprombank, Mechel’s spin-off of Mechel Mining, and OGK-1 – each expected to raise around $2bn. But underlining how unpredictable the final figure will be, the top-three potential IPOs – RusAl, world’s largest aluminium producer (estimated $7.5bn), Megafon, Russia’s third largest mobile phone company (estimated $6.25bn), and metals and mining giant Metalloinvest (estimated $3bn) – are all interlinked through a succession of complex corporate intrigues. As such, it’s not so much the market conditions as how the oligarch-owners handle these machinations that will determine the timing of their IPOs.

Megafon’s long had murky final beneficiaries, rumoured to include Leonid Reiman, the former long-serving minister of telecommunications who lost his job in the May reshuffle. But Reiman’s departure from office, the mysterious disappearance in Latvia earlier this year of a bitter Reiman foe, former Megafon shareholder Leonid Rozhetskin, who left behind only a pool of blood in his home, combined with the sale of the disputed stake to Alisher Usmanov, owner of Metalloinvest, have now cleared the air for an IPO likely this year.

Usmanov also figures in determining two further potential major IPOs – of his own concern Metalloinvest, and of RusAl, due to both their involvement in the complex three-way M&A manoeuvring around nickel and copper giant Norilsk Nickel. Ongoing merger talks between Metalloinvest and Norilsk Nickel were paused May 28 to allow a Metalloinvest IPO in 2008. The Metallinvest IPO is intended to provide a market valuation for Metalloinvest, on which the merger terms with Norilsk will then be based.

Norilsk co-owner Vladimir Potanin and Usmanov have now invited Deripaska’s RusAl to consider a three-way merger. This in its turn muddies the water around the expected massive RusAl IPO. Analysts expect the RusAl IPO to only happen after the Norilsk tie-up is in the bag, so not in 2008 as originally expected. “The whole market is waiting for the RusAl IPO,” says Dovlatov, “that’s when its going to get really interesting.”