Russia gets a head start in the Arctic race

Graham Stack for Russia Profile

Despite media hysteria about alleged conflicts looming over Arctic resources, most experts say Russia is playing a constructive role.

Russia’s planting of a titanium flag on the seabed at the North Pole last summer was one of the media eventsof 2007. In combination with soaring energy prices and melting Arctic ice, the images sparked sometimes wildly speculative panic-mongering about the “coming Arctic war.”

In fact, the hype around the flagplanting was little more than an election campaign gag for the pro-Putin United Russia party – the United Russia flag was one of the items deposited on the seabed in a time capsule, and expedition leader, famous explorer Artur Chilingarov is a United Russia deputy.

But there was a scientific purpose to the expedition as well: to gather seabed samples. They were required to support of Russia’s claim that the submarine Lomonosov ridge running through the Central Arctic is an extension of Russia’s continental shelf.

Russia is filing its claim in the framework of the United Nations Convention on the Law of the Sea (UNCLOS). UNCLOS allows countries to expand their maritime Exclusive Economic Zones (EEZ) beyond the current 200 nautical miles from the coastline up to a maximum of 350nm, in the case that their continental shelf extends so far out to sea. A country has sole rights to exploit mineral deposits located in its EEZ.

And for a country like Russia that positions itself globally as an all-round energy supplier to Europe and beyond, the Arctic’s oil and gas resources constitute not just a source of extra income, but crucial to the Kremlin’s plan of building Russian energy companies into global majors.

This might be a source of friction were Arctic resources tantalisingly outside of Russia’s reach. But in fact the lion’s share of Arctic hydrocarbons seem to be located in recognized Russian waters. Making Russia the least likely country to launch aggression to change boundaries.

A tale of two studies

July 23, 2008, saw the prestigious United States Geological Survey (USGS) publish its widely awaited official analysis of the oil and gas riches of the Arctic. The document is destined to become a key reference point for US policy in the area.

The USGS study trumpeted that the Arctic “may constitute the geographically largest unexplored prospective area for petroleum remaining on Earth.” According to the survey, Arctic resources account for about 22 percent of the undiscovered, technically recoverable resources in the world: about 13 percent of the undiscovered oil, 30 percent of the undiscovered natural gas, and 20 percent of the undiscovered natural gas liquids in the world.

The USGS survey, however, ignores the very different findings of a Wood Mackenzie survey published November 2006. Wood MacKenzie’s study found that the Arctic only contained 3% of the world’s recoverable hydrocarbon reserves. “The Wood Mackenzie is proprietary and we haven’t bought it,” laconically explains the leader of the USGS Arctic team, Don Gautier.

In stark contrast to USGS’s enthusiam, Wood Mackenzie’s lead author, Andrew Latham, commented, “our assessment basically calls into question the long-considered view that the Arctic represents one of the last great oil and gas frontiers and a strategic energy supply cache for the US.”

Without entering into details of methodology, the huge discrepancy between these figures shows just how much remains basically guesswork. And memories of the hyperbole about Caspian Sea resources in the 1990s should incline observers to prefer the more conservative estimates.

But just as significant as their contradictions on quantity, are the studies shared findings on the quality of the Arctic’s hydrocarbons.

Firstly, both studies agree that the Arctic’s hydrocarbon resources consist predominantly of natural gas. ‘Arctic resources are gas-prone with around three times more gas than oil,’ according to USGS’s Don Gautier. According to Wood Mackenzie, 85% of the discovered resource and 74% of the exploration potential is gas.

The second shared finding is that, according to Gautier, while 84% of the undiscovered oil and gas is indeed offshore, most of it “lies within national boundaries as currently defined.” This means the UNCLOS rules on extending those boundaries are in fact of secondary importance.

Thirdly, and crucially, most of the gas is in the Russian sector. “The West Siberian basin in outstanding for gas,” is one of USGS’s main conclusions, and the East Barents Sea is also ranked excellent. Around 60% of total Arctic gas lies squarely in the Russian EEZ.

So it seems Russia has already won the ‘coming Arctic war’ without a shot being fired.

UNCLOS is no cause for alarm
But this still leaves around 30% of Arctic resources lying more than 200 nautical miles offshore. UNCLOS, and it’s expert Commission on the Limits of the Continental Shelf (CLCS) will decide who can claim jurisdictions over these areas.

This is where Russia’s controversial claim to the North Pole, i.e. the Lomonosov ridge, comes in.

Russia’s claim to the Lomonosov ridge is indeed disputed by Canada and Denmark – but purely within the legal framework of UNCLOS. All three countries have voluntarily signed up to accept its findings, and no party has ever said they might not do so.

The crucial point is that all signatory states have committed themselves to UNCLOS precisely as a non-conflictual, impartial means of resolving questions of marine jurisdiction. Only the US refuses to sign – because of the impingement of sovereignty this involves.

“Rights to the resources of the continental shelf beyond 200nm have been enshrined in international law since at least 1994, when UNCLOS entered into force and so far all of the Arctic states have followed the procedures established under UNCLOS for claiming those rights,” says Martin Pratt, head of research at Durham University’s International Boundaries Research Unit (IBRU). IBRU published the definitive map of Arctic boundaries August 5, 2008.

According to Pratt, “all the available evidence still points to a peaceful division of the Arctic.”

“The conflict potential is inflated mainly because people find it exciting to talk and write about, and perhaps also to some extent because some people miss the cold war,” argues Indra Øverland, Head of the Energy Program at the Norwegian Institute of International Affairs (NUPI). “There are in fact not more territorial disagreements in the Arctic than in most other parts of the world. Such disagreements are a normal part of inter-state relations.

The perceived ‘race for the Arctic,’ according to Øverland, is merely a reflection of a UN ruling that a country has 10 years to make claims beyond the 200-mile zone.

Since Russia was one of the first to sign up, in 1997, it is compelled to get a move on in filing its claims.

“Russia does play by the rules laid down in UNCLOS, and agrees with the other Arctic nations that this convention is the basis for future developments in the region,” says Alf Håkon Hoel, head of the politics department at the University of Tromsø in the Norwegian Arctic.

“But that doesn’t mean that the Arctic coastal states aren’t keen to secure rights to exploit resources in such areas in the future,” counters Pratt.

“That is the process in which Russia is currently engaged with the Commission on the Limits of the Continental Shelf,” he continues, “and once the outer limit of the Russian continental shelf has been defined, it won’t be able to claim sovereign rights over any other areas of Arctic seabed.”

However, the idea that signatories to a UN convention regulating maritime jurisdiction would then come to blows over its findings, is as absurd as suggesting war could break out between Germany and Poland over voting rights in the European Commission.

Moreover, the timescale of the division and exploitation of the Arctic is likely to stretch decades into the future, with the UN’s Commission on the Limits of the Continental Shelf (CLCS) not due to complete its work till 2020.

And only when all disputes have been solved, will it be possible to commit the massive investment and start the pioneering work needed to get at oil and gas lying far offshore.

“Referring to the extension of the continental shelf beyond 200 miles, I would say that possible resources in this area will only be relevant in a much longer time perspective, for technical and economic reasons,” argues Arild Moe of Norway’s Fridtjof Nansen Institute.

“There is no imminent conflict over resources there, of which we know little and about which the most recent USGS study is not particularly optimistic,” says Moe.

Technology, not territory, is the key to the Arctic

The barrier Russia and other countries face in accessing Arctic resources is not connected with maritime jurisdiction, but with technology.

The most ambitious current Arctic project underway is Gazprom’s giant Shtokman field in the Barents Sea. With 3.8 trillion cubic meter of natural gas and more than 37 million tons of gas condensate, the field contains enough gas to fuel Europe for seven years.

But the question is how to get it. The field is 550km off shore from the port of Teriberka, 4000m beneath the seabed. Further hazards include icebergs, drift ice, sub-zero temperatures polar nights, megawaves and an uneven seabed. Quite simply, nothing like this has ever been attempted.

“Nobody has yet attempted multi-phase gas flow transportation over such a distance, and that’s the main technical and technological problem today,” Alexander Selin,an official at Shtokman license holder Sevmorneftegaz, told Interfax at the end of July.

According to Konstantin Batunin of Moscow’s Alfa Bank, not even Gazprom knows yet what technology will be used. Russia’s gas giant has enlisted the help of Norway’s Statoil and France’s Total as junior technology partners, and this international collaboration to pool expertise is another sign of how the Arctic is likely to produce new partnerships rather than fuel rivalries.

Oil and gas development and the opening of the Arctic to shipping due to global warming – the summer of 2008 showed the lowest icelevel since records began  also mean that new shipping technologies are needed to master the Arctic waters.

And here as well Russia is kitting up.

In 2007, Russia started the merger of all state-owned shipping and ship-building assets into two giant holding companies

Sovkomflot-Novoship, now the world’s fifth largest shipping company, and the United Ship-building corporation. Both of these companies are under orders to focus on energy shipping in general, and ice-class vessels in particular.

And March 25, 2008, a state-linked investment company FLC bought a 70% stake in three German shipyards belonging to Norway’s Aker group – shipyards specialized in building dual-action ice-class ships, the stern of which doubles up as an ice-breaking bow.

Finally, August 27, 2008, Russia’s seven nuclear-powered icebreakers were transferred from the trusteeship of a private shipping company and transformed into a state enterprise – Atomflot, part of the newly-formed nuclear power state corporation.

So regarding Russia’s North Pole flag-planting stunt of 2007, the medium was the message: Russia displayed it had the bathyscape technology to conduct Arctic seabed operations.

But much of the Western media preferred to believe that Russia’s flag planting was an aggressive assertion of rule over the North Pole – and conspiracy theorists even perceived a Kremlin masterplan to seize control of Christmas.

Those conspiracy theorists will see their fears confirmed with Chilingarov s next bathyscape dive: as announced end of July, he intends to dive to the bottom of the Mariana Trench, the deepest part of in the world’s oceans. The Mariana Trench is in the middle of the South Pacific – surely indicating a Kremlin claim to Easter Island.

Russian shipping and shipbuilding: The league of national champions

Graham Stack, for Radio Free Europe / Radio Liberty

In the 1990s, as the Soviet economy collapsed, the shipping sector was one of the few to bob to the surface, buoyed by international demand for its tonnage. It migrated to offshore tax havens and operated under flags of convenience.

As a consequence, less than 10% of Russian fleets’ business was done in Russia, and a decade of surviving in international waters forced Russian shipping companies to become lean and mean.

Now the ‘Kremlin-garchs’ want to change things: they want Russian shipping home again – to increase added value in the energy sector by serving national oil and gas giants. And with the prospect of demand for ships mushrooming due to giant offshore energy projects and Arctic shipping lanes opening, they also want Russian shipping companies to buy Russian-built ships.

Actors in the Sovcomflot-Novoship merger

The vehicle for state policy in maritime shipping a new ‘national champion’, created by merging the state’s 50.3% share in Novorossisk-based Novoship, the world’s twentieth largest carrier, into 100% state-owned Sovcomflot, the world’s sixteenth largest. The result is the world’s fifth largest shipping company.

The driving force behind this policy, of which implementation started in 2007, is the former Minister of Transport Sergei Frank, himself originally from the shipping industry in Vladivistok, moving to the Ministry of Transport in 1995, and becoming minister in 2000. Frank had advocated such a merger while in office. In 2004 he left the ministry to become CEO of Sovcomflot, evidently tasked with implementing the merger and effectively renationalizing Novoship.

2004 can be considered the birthyear of the new era of industrial restructuring of state-owned assets and related private assets in Russia, including renationalisation of the latter through ‘market methods’ – a term that however in Russia traditionally has a very broad meaning, including use of legal and extralegal coercion. In the first Putin term, further privatization of state assets was formally on the agenda, but a lack of political will meant that state-owned assets remained in limbo.

In 2004, as a result of Putin’s administrative reshaping of government, a powerful Federal Agency for Industry under Boris Aleshin, an industrialist, emerged with a remit to restructure state assets to create large merged companies or sectoral holdings that could compete internationally. Instead of being privatized, these were to remain under state control, but take on (foreign) strategic investors or conduct IPOs and enter international alliances to attract funds and technology.

Moreover, the Yukos case and the post-Beslan transition to appointed governors in 2004-5 strengthened the Kremlin against big business and regional lobbies.

Alongside the appointment of Aleshin and Frank, 2004 also saw Sergei Chemezov, often regarded as the mastermind behind this plan, and an old friend of Vladimir Putin, take over as head of state arms intermediary Rosoboronexport, and launch a programme of restructuring the defence sector through renationalizing privatised companies. The reshaping of government 2004 also led to the corporatisation and connected restructuring of industrial giants Ministry of Railways and Ministry of Atomic Power, pushing industrial policy firmly to the fore, for the first time since the collapse of the Soviet Union.

Despite this ‘sea change’ in 2004, the Sovcomflot-Novoship merger has been a work of compromise, in particular regarding the regional component: Sovcomflot is registered in St. Petersburg, of which the governor Valentina Matvienko has influence in the Kremlin. Novoship, in its turn, is the largest tax payer in the southern region of Krasnodar territory, the governor of which, Alexander Tkachev, is an influential pro-Putin nationalist whom pundits occasionally tipped as a Putin successor. In addition, Sochi, successful Winter Olympic candidate, is located in Krasnodar. Tkachev was particularly active in lobbying against any reregistration of Novoship away from Krasnodar as a result of a merger, and partly as a result, Novoship will remain an independent affiliate of Sovcomflot registered in Novorossisk.

Frank himself is not overtly aligned with any Kremlin groups. As CEO of Sovcomflot he replaced Dmitry Scarga, appointed to Sovcomflot in 2000 at the age of 30. Scarga was linked to the Petersburg group around the Baltic Pipeline System that includes Alexei Miller, who in the same year became head of Gazprom. In 2005, Sovcomflot filed a lawsuit in Britain against Scarga, by then a ‘senator’in the Federation Council, due to financial manipulations uncovered at Sovcomflot’s British subsidiary causing damages of $200m. Scarga moved to London ostensibly to defend himself. Criminal charges in Russia were subsequently opened against him, and an extradition request filed in early 2008. Scarga is now claiming political asylum in Britain – alongside former Novoship CEO Tagir Izmailov (see below). Both these cases indicate at the very least that Frank can count on support from law enforcement and justice organs.

During Putin’s first term, the supervisory board of Sovcomflot was chaired by Dmitry Kozak, a close Putin aide and reformist liberal with a law background. After the Beslan hostage-taking, Kozak moved to become presidential representative to the Southern Federal District, and was replaced by Igor Shuvalov, also a Putin aide on economic matters and a liberal. Neither of them, nor Frank, are closely associated with the silovik faction of former and current KGB / FSB members – showing that the ‘national champion’ industrial policy launched 2004 currently enjoys consensus support among government groups, and can rely on the backing of law-enforcement agencies irrespective of whether siloviki are directly involved in running the business or not.

Implementing the merger

Such backing from law enforcement and legal organs soon proved necessary, since Novoship management resisted the merger from the start. Despite the state’s 50.3% stake retained, Novoship management exercised de facto control over the company through cross-ownership with subsidiaries and influence over financial flows. The company was growing strongly and expanding its fleet rapidly. But state officials and Sergei Frank argued it was doing nothing to reduce exposure to the volatile spot market, and was suspected of shifting assets offshore.

As in many other cases, the complex financial structures set up by insider management in order to control their companies ultimately proved to be their Achilles’ heel: When company president Tagir Izmailov openly expressed opposition to the proposed merger in 2005, he found himself charged with abuse of position and money laundering, and fled to London. In December 2006, ex-chairman of subsidiary Novoship-Invest, holder of 6.5% of Novoship, shot himself after being summoned for questioning. Days before the merger was finalised, management tried to offload a 14.41% stake held by Novoship’s Liberian-registered subsidiary to Gazprombank – to retain some independence from the new bosses – but Moscow blocked this at the last minute.

Kremlin mistrust of management or ‘insider’ ownership for important companies – such as titanium producer Avisma, car giant Avtovaz, plane manufacturer Irkut or Novoship – appears to be one of the driving forces behind current restructuring. Kremlin officials suspect management ownership – often through cross-ownership of companies by their subsidiaries – of restricting companies’ growth prospects, because insider owners risk losing control of the company, and thus their position, if they take on badly-needed strategic investors. The state then proves its point about vulnerability by coercing management into selling up.

Nevertheless, for all the charges brought against former Novoship management, analysts regarded Novoship as – at least formally – more transparent than Sovcomflot. Novoship disclosed its results on a quarterly basis. Sovcomflot disclosed very little and there is an ongoing criminal case against former manager Dmitry Scarga and other management members, who are accused of defrauding the company.

The league of national champions

What does the Kremlin want of its new national champion? Now that state companies Gazprom and Rosneft have secured control of development of offshore gas and oil reserves (specifically the massive Shtokman and Sakhalin projects), the idea is to create linkage to other domestic sectors to increase added value generated in Russia. Shipping services are the obvious next step. Next in line are the shipyards. Ideally tripartite alliances of Russian oil and gas giants, Russian shipping companies, and Russian shipyards should emerge. Sovcomflot management talk of the merged company acting as a catalyst for the development of maritime clusters similar to the role played by Maersk in Denmark, NYK in Japan, Stena Bulk in Sweden or COSCO in China.

Sovcomflot is moving rapidly in this direction, specializing in energy and ice-class shipping, placing orders home and abroad, and rapidly expanding its fleet of LNG carriers, with large orders placed at Korean and Japanese yards – no Russian shipyard currently produces LNG ships, although Baltic shipyards plans to start in 2011.

Supporting offshore projects is however seen to be only the first step. With the Arctic ice melting due to climate change, the Arctic is opening up both for more energy exploration – the US Geological Survey estimates that 25% of the world’s undiscovered oil and gas reserves are located in the Arctic – and also for shipping route: the North-East passage, if sailed from Hamburg to Yokohoma – is almost 40% shorter than passing through the Suez canal.

The offshore developments are expected to put in place a lot of the shipping infrastructure needed for the Arctic to become a main shipping lane, if present climate change trends continue. Sovcomflot estimates that over the next ten years, Arctic shipping will quadruple in connection with Shtokman alone. Currently there is almost no shipping in this area at the moment, and so there is little current competition.

Sovcomflot is not the only Russian shipping company to be thinking along these lines. The smaller, private Vladivostok-based Primor’e Shipping Company (PRISCO) is also an oil carrier currently increasing deadweight at 18% pa and looking to expand into the LNG market. Prisco is well placed for Sakhalin oil shipping and the company has won contracts to ship oil even against bigger players such as Sovcomflot, with a $150mn contract to ship oil for Exxon in Sakhalin. As the relationship with Sakhalin develops, Prisco expects half of its business to be domestic.

The question for PRISCO is whether Sovcomflot’s status as national champion will not jeapardise its ability to win contracts for Sakhalin, after national champions Gazprom and Rosneft having taken leading roles in these projects. Furthermore, if shipping sector consolidation were to continue, PRISCO, or other private shipping companies, might find itself under pressure to sell out to the state-owned shipping giant.

Meanwhile, having merged into a national champion, rich pickings also loom for Novoship in connection with the planned Burgas-Alexandropolis oil pipeline, in which the Kremlin is involved. According to Renaissance Capital, the company is set to become a preferred partner for shipping Russian oil to Burgas.

In early 2008, the advantages of the merger for Novoship became more evident.
Sovcomflot management outlined significant synergies in both revenue generation and on the cost side, including attracting new clients with, for instance, right of first refusal contracts, and savings potential through joint purchasing, cheaper debt financing and the reduction of administrative expenses.
Despite the fierce resistance from Novoship management, minorities and investment banks were mildly positive about the merger – pointing to the chances to increase liquidity and create economies of scale. The merger should produce both synergies and diversification: Novoship is a classic tank oil carrier working the Black Sea routes, while Sovcomflot concentrates on the ice-bound Arctic and hi-tech transport of liquid natural gas.

Analysts argue that size does matter when it comes to international competitiveness, and that the new company will enjoy considerably more pricing power. One of the tenets of the state shipping doctrine has been to move away from the spot market and time charters – where everything is short term and subject to oil price fluctuations – towards establishing long term contracts with direct customers.

Most importantly, in January 2008, Sovcomflot signed a cooperation agreement with state-owned oil pipeline monopolist Transneft for oil shipping to the Burgas-Alexandrupolis pipeline. The January 2008 agreement envisages Novoship becoming the seaborne carrier linking the Transneft pipeline ending in Novorossiysk with the new Burgas-Alexandrupolis pipeline in Bulgaria and Greece that bypasses the Turkey-controlled Bosphorus.

The agreement is very positive for Novoship, since it will support the targeted shift from the volatile spot market towards more sustainable pipeline-like utilisation. However, this deal also showed that the Sovcomflot merger was by no means purely a case of industrial restructuring. It was also a key component in the Kremlin’s pipeline policy looking to expand and diversify its oil and gas pipelines to Europe, while crowding out other competitor pipelines bypassing Russia. This means that the company is of strategic interest to the Kremlin, which could in the future run counter to commercial considerations.

The merged company is correspondingly emitting contradictory signals in terms of its interest in boosting shareholder value and internationalisation.

The new Novoship board appointed in January 2008 is positive sign in this regard, including three independent directors, a rarity in Russia, with two of them non-Russian: Marlen Manasov, managing director of UBS Securities and Robert Sasson, an investment banker, former Head of EBRD Mission in St. Petersburg. Analysts agreed this indicated Sovcomflot was intent on boosting Novoship capitalisation in preparation for an IPO of the entire group.

However, in February 2008, this policy experienced a significant set back, as state interests prevailed over commercial. Inside sources reported that Sergei Frank had been lobbying for independent directors to join the Sovcomflotboard, specifically Morgan Stanley’s Elena Titova and Deutsche Bank’s Charles Ryan. But instead, state officials supported Andrei Kostin, CEO of state bank VTB – and most significantly the new CEO of Transneft, Nikolai Tokarev, a probable former KGB man. Tokarev’s inclusion instead of an independent director indicated that strategic state interests would prevail over commercial considerations in running the company as a member of the league of ‘national champions’.

Uniting Russia’s struggling shipbuilders

The Novoship merger was the prelude to a sweeping overhaul of the shipbuilding sector, the cornerstone of which was the presidential decree of March 9th, 2007, “On the Establishment of the United Shipbuilding Corporation” (USC). This decree provided for consolidating all state-owned assets in the shipbuilding branch, totalling around 40 companies, into a holding with 100% state ownership.

The Sovcomflot-Novoship merger was child’s play in comparison to setting up the USC. The template for the USC was the United Aircraft-builders Corporation (UAC) established in 2006. However, here there are also substantial differences: the aircraft industry consolidation came initially ‘from below’, with considerable consolidation between Irkut, Sukhoi and MiG already underway. Moreover, the Russian aerospace industry includes some very internationally competitive production, such as the MiG and Sukhoi fighter jets, around which a successful company might be built.

Government officials seem, in contrast, to have made decisions about the USC at speed and without consultations. The USC bundles all existing state shareholdings in maritime shipbuilders. There was a strong political flavour to its launch, with much telegenic championing of ‘national shipbuilding’ by at that time potential presidential sucessor Sergei Ivanov. At the same time, relatively efficient fully privatised outfits, such as Petersburg’s Baltiskie Zavody and Northern shipyards, both owned by oligarch Sergei Pugachev’s United Industrial Corporation group, were not invited to join.

The formation of the new holding is not to be completed until 2009, and is already well behind schedule. In its final form, the USC will unite 40 odd companies from Kaliningrad to Konsomolsk-on-Amur, ranging from federal state unitary enterprises (FGUPs) to joint stock companies where the state is only a minority shareholder. Alone the process of inventorying FGUP’s assets and converting them into joint stock companies is, Sergei Ivanov has himself admitted, extraordinarily laborious. The need to facilitate integration influenced the decision to structure the company along regional lines, instead of functional roles; there are to be regional centres in Petersburg, Severodinsk and Vladivostock.

In fact the operation has already run into considerable difficulties, reflected in personnel turnover in top positions. There was initial confusion over who would head the supervisory board. Originally it was expected that Sergei Ivanov would do so, then defence minister Valery Serdyukov was tipped, and finally deputy prime minister Sergei Naryshkin got the job in July 2007.

The difficulties in putting together the corporation were even more apparent regarding the crucial position of CEO. Alexander Burutin, first head of the USC and charged with swift implementation of the presidential decree, resigned in September 2007 after three months of fruitless negotiations with shipyard managements about the terms of their integration. It took over a month to find a replacement for Burutin, with the first choice candidate for the job, Andrei Dutov moving instead to head the State Industry Agency. The next best candidate, retirement age Yury Yarov, a former cabinet minister, in the 1980s boss of current prime minister Viktor Zubkov, was finally appointed October 23, with six months having lapsed since the presidential decree.

What does the Kremlin expect from USC?

The declared goal of the USC is to strengthen commercial, not military, shipbuilding in Russia. To cite Vladimir Putin’s annual address to parliament 2007, the modest goal of USC is ‘for Russian shipbuilding to occupy a decent niche on the world market’.

Currently, Russia basically has zero market share in the global commercial shipbuilding industry. Whereas Japan and South Korea each produce 70m tonnes deadweight per year, Russia turns out only 1m, lagging behind Vietnam, Iran and Turkey. But Russian companies place orders worth $1bn for ships each year, 80% of which go abroad. In fact, 80% of Russian ship-building output is for naval procurement. The imbalance is a legacy of the Soviet era, where naval shipyards were concentrated on Russian territory, with merchant fleet ships being built in Poland, Finland and East Germany, and Ukraine.

As a result, even now that state defence procurement is soaring, Russian yards are on average only working to one third of their capacity. This makes the idea of Russian commercial shipping companies placing a higher proportion of orders with Russian shipyards so alluring.

However, Russian shipyards largely fail to compete even on the domestic market. They suffer from productivity levels far lower than South-east Asian countries. They are also unable to achieve turnaround times anything like the Asian countries, on average half as fast, which is critical, or reliable. Furthermore, Russian shipyards lack the capacity to build the ships with over 80,000 tonnes deadweight that enjoy wide global demand. One major problem here is the location of major shipyards, such as the Admiralty and Baltic shipyards in the historical heart of Petersburg, where there is simply no room to expand

The call of the Arctic

Despite this seemingly hopeless position, Russian planners have identified a market niche they believe Russian shipyards could fill. The grand plan for the ship-building sector is to build vessels to service the Shtokmann gas field and the Pacific shelf projects, as well as for the Arctic shipping routes expected to increase fourfold over the next 10 years.

Government estimates put the number of platforms needed for offshore oil and gas production by 2030 at 40, the number of 85 specialized ships at 80 with more than 140 support ships needed. Demand is set to boom for atomic icebreakers, hydrographic craft for exploration, ice-class oil tankers and LNG carriers, as well as platforms for oil and gas drilling, and pipeline-laying and transport ships

The policy is realistic in looking for Russian shipping to occupy a specialist niche – ships specially suited for Arctic operations. Thus the USC does have a vision going beyond the next elections: an alluring vision of Russia’s twin evils – dependency on budget money and dependency on the resource sector – cancelling each other out – with military shipbuilding diversifying into commercial, and the economy as a whole beginning to put added-value on its resource base.

However international competition still has a head start in tackling these new challenges. Japanese and Korean yards dominate global production of LNG carriers. Even in ice-class shipping, the pioneering role is held by Norwegian Aker-Kvaerner producing double-acting icebreakers (with a stern that can be deployed as an icebreaking bow). Aker-Kvaerner is already supplying freight ships to Norilsk Nickel for year-round shipping between Dudinka and Murmansk. Russian shipbuilding is going to need the sort of hidden protectionism the national champion policy implies, but the costs will be borne by the projects they supply.

In November 2007, the Ministry of Energy and Industry authored a federal target programme to support this technological transition, called “Development of civil marine technology 2009-2016”, which envisages R140 investment for this time period, of which around R100bn will come from the federal budget. The programme focuses on financing R&D and modernising testing and design bureaus. The funding is also sufficient to purchase foreign licences especially for LNG tankers. However, the programme does not foresee direct budget investment in upgrading the shipyards themselves.
The Kremlin’s grand plan thus hinges on creating a chain of ‘national champions’ to increase added-value generated in Russia from the resource sector, comprising Russian energy giants, Russian shipping giants, and a Russian shipbuilding giant. This chain can be extended into supplier sectors. For instance, ice-class shipping requires high-grade steels, of which steel giant Severstal is planning to increase production, launching an investment programme for this purpose worth R850m through 2009, in time for the start of construction of LNG and modern ice-class tankers in 2011.
What use is USC?

An additional question mark over USC is that market forces were already pushing the most efficient shipyards in this direction. Such shipyards are currently either ignoring the intervention of state officials, or regard them and USC as a threat to their efficiency. The most capable shipyards picked up on the new source of demand long before government officials. In recent years, for example, Admiralty shipyards has built five ice-class tankers for Sovcomflot and five for Lukoil. But it is precisely Admiralty shipyard management that has expressed deep misgiving about the corporation – and having to undergo a complex metamorphosis from unitary enterprise to joint stock company, entailing loss of decision making freedom.

Management is particularly troubled about how much freedom the company would retain to conclude contracts independently. In particular, since the USC is to have a two level structure, with separate shipping centres for the West (St. Petersburg and Kaliningrad), the North (Severodinsk and Murmansk) and the East (Vladivostok), united under the umbrella organisation USC, constituent companies are afraid of excessive bureaucracy and loss of the flexibility that is crucial to making effective business decisions.

Two of the most advanced shipyards in terms of producing for offshore projects are Petersburg’s Baltiiskie Zavody and Northern shipyard, both of which are affiliates of oligarch Sergei Pugachev’s United Industrial Group. There has been no attempt to strong-arm these companies into joining, which is in some ways a positive sign, but also questions the rationale behind the project.

Analysts argue that both these shipyards should comprise the core of any Petersburg-based shipbuilding holding. They have also been trailblazers in terms of restructuring, proving that private capital is more effective than government ministers in turning industry around: Baltiiskie Zavody is embarked on a complete relocation from constricted premises in Petersburg’s historical heart to the expanded facilities at out-of-town Northern Shipyards.

Baltiiskie Zavody is Russia’s main producer of nuclear and diesel powered icebreakers, and The UIG shipyards are active in moving into the Arctic shipping business, including preparation to build LNG tankers that are currently not built in Russia at all. Production is slated to commence in 2011, in time for start of operations at the Shtokman offshore gas field in the Barents Sea. In contrast, the state is dragging its heels on holding tenders for constructing shipyard facilities large enough to build ships over 80,000 tonnes, especially large LNG tankers.

Confirming this trend of efficient companies responding swiftly to energy sector demand, the to date largest shipbuilding contract resulting from the Shtokman field development – for two marine drilling platforms worth $2.5bn – went to the privately-owned Vyborg ship-building yard. Vyborg shipbuilding yard that hopes to secure four further such contracts, will also not be part of USC. Vyborg shipyard was recently acquired by influential Petersburg financial group ‘Bank Rossiya’, reputed, as is also Sergei Pugachyov, to enjoy some access to Vladimir Putin.

Further questions were then asked of the efficiency of state-owned yards when in February 2008 the Norwegian shipping concern Odfjell terminated a $500m contract with the Sevmash shipyard, based in Severodinsk, the Russian producer of nuclear submarines. Sevmash called the contract for twelve 45,000 tonne tankers the ‘deal of the century’ when it was signed in 2004.

Odfjell claims that the first tanker was slated for delivery in September 2007, but will not be ready until May 2009, and that the cost of the order has risen from $500 million to $544 million. Following termination of the contract, Sevmash will also be liable for damage claims.

Sevmash for its part argues that the soaring price of steel is to blame for the rise in costs, but in fact this is not Sevmash’s first failure of this kind. The yard also mismanaged a large Indian order to reequip the Russian aircraft carrier Admiral Gorshkov for sale to India. Originally planned for 2008, the handover has now been postponed to 2011, a delay that cost the previous Sevmash management their jobs.

The Sevmash case points again to weak management as a major problem for many state-owned shipyards, and it is unclear how the USC intends to improve this situation.

Conclusions

- The basic goal of boosting commercial production by former naval shipyards is positive, since, if successful, it will increase international economic integration of the sector and hinder the emergence of any ‘military-industrial complex’ lobbying for arms spending increases. The Arctic shipping / offshore niche has some real potential.

- The increase in state involvement should not be exaggerated. In shipping, there remain three major and expanding private shipping companies. In shipbuilding, the state has not yet tried to persuade or pressure private companies into joining the holding – even major ship-building companies with considerable defence significance such as Baltic and Northern shipyards remain in private hands.

- The selective use of criminal charges apparently to pressure former Novoship management into consenting to the merger is extremely disquietening.

- The new focus propagated for shipping and ship-building on offshore projects and the energy sector will add to Russia’s assertiveness in this area, in terms of ‘resource nationalism’. Multinationals are often regarded as reluctant to contract out to Russian suppliers, and the Kremlin is intent on maximising added value in the energy sector as part of its diversification strategy. Moreover, the increasing, and increasingly politicised, focus on the Arctic waters as being of strategic significance for Russia will lessen readiness to compromise on questions of demarcation of territorial waters.

- The developing system of ‘national champions’ is potentially detrimental to competition and the market mechanism, since it is likely that national champions, such as Gazprom and Rosneft, in the energy sector will prefer other (state-owned) national champions in shipping and ship-building, even where private companies are more competitive. Furthermore, state-owned companies that have proved themselves efficient outside of national corporations, such as Admiralty shipyards, or the Sukhoi holding in aircraft construction, risk being shackled to inefficient loss-making companies.

Gazprom’s Sochi: The Shtokman Field gas project moves towards implementation

On Feb. 21, the CEOs of Russia’s Gazprom, France’s Total and Norway’s StatoilHydro signed a deal establishing the Shtokman Development Company, a joint venture that will develop (but not own) the eponymous gas field in the Barents Sea. The timing was highly symbolic, ten days before the election of Gazprom’s Chairman Dmitry Medvedev as Russian president and ten days after lavish celebrations of Gazprom’s 15th birthday starring outgoing president Vladimir Putin.

The Shtokman project epitomizes Putin’s policy of combining state control over oil and gas with accelerated development. The deal marks a new frontier for the pivotal Russian gas industry firmly under Russian state control. The energy giant threesome formally established what had been agreed months ago. It is a special purpose vehicle that will develop the field while leaving the license in the hands of Sevmoreneftegaz, Gazprom’s 100 percent subsidiary. In contrast, Gazprom holds a 51 percent stake in the SPV. Total has 25 percent and StatoilHydro – 24 percent.

Gazprom comes up trumps

The creation of the Shtokman Development Company puts an end to a number of intrigues that developed over the past two years. In 2005, initial intense jockeying among foreign energy companies to join the Shtokman consortium resulted in a short list, comprising the Norwegian companies Statoil and Hydro, the U.S. majors Chevron and ConocoPhillips, and France’s Total.

Jaws dropped at Gazprom’s hubris in October 2006, when its CEO Alexei Miller declared that the company did not need any foreign partners to develop Shtokman, but would go at it alone.

Then, in July 2007, Gazprom relented and closed a deal with Total, which the Financial Times termed possibly “the worst a foreign oil company has ever accepted in Russia.” Gazprom retained full ownership of the field and the production license while gaining access to Total’s liquefied natural gas (LNG) expertise.Later the same year Norway’s merging Statoil and Hydro agreed to similar terms.

From the Russian point of view, there was poetic justice in avenging the humiliatingly one-sided Sakhalin PSA deals of the early 1990s. These had just undergone a major revision, and Gazprom been cut in on the deal following foreign company harassment by Russian state watchdogs.

In this case, the boot was on the other foot. The deal, which reduced Western oil and gas majors to the role of mere contractors, was seen as catalyzing the era where multinationals would only be able to access reserves in junior partnership to state-owned companies.

Gazprom’s subsequent announcement that all Shtokman gas would go to Europe (without the liquid natural gas supplies previously envisaged for North America) combined with the exclusion of US companies from the project, pointed to geopolitical considerations and caused further irritation.

But this year, the emotional reactions have given way to a calmer approach. Observers were pleasantly surprised to learn that the foreign partners will be able to book the field’s reserves – boosting a key market indicator of long-term economic health of the companies and raising their status.

“They were originally hoping for ownership rights, but it was pretty clear that they weren’t going to get these. They were allowed to book reserves, which surprised analysts. That makes them much more than just contractors,” USB Moscow analyst Dmitry Loukashov said.

“Basically, what the foreigners get from this project is booking reserves proportional to their stakes in the SPV, and secondly, they will be entitled to profits. They will have ownership rights only to infrastructure, not to the field itself or the gas produced,” said Constantine Batunin, an oil and gas industry analyst at Alfa-Bank.

According to French energy expert Pierre Noel, the same results could have been attained through a conventional contract with shared ownership of the field. He argues that the difference is symbolic, but the issue itself, he believes, is all about symbolism of who has the upper hand.

However, one crucial aspect for Gazprom will be far from symbolic. The deal means Gazprom owns the gas, and thus dictates the markets where it will be sold. This secures Russia the extra-economic leverage, the “soft power” it is demanding from its resource base.

The tip of the iceberg

Having decided who will own the gas when it comes on stream, the only outstanding issue is drilling 4,000 meters below an uneven seabed, 350 meters below an iceberg-ridden ocean 550 kilometers from the mainland.

“They simply do not know exactly how they are going to do this,” Batunin said. “Gazprom admits this openly. It doesn’t pretend to hide the fact. But they believe they can do it, and the deadlines are tight, with gas to go on stream in 2010.”

In 1988, when the Soviet Union discovered the sprawling gas field 550 kilometers northeast of Murmansk (on the Kola Peninsula), the super-giant field was estimated to harbor some 3.2 trillion cubic meters, in addition to around 31 million tons of condensate.

The unique features of the field meant that assistance from foreign partners was inevitable. It is technological expertise, and not financial resources or market access that determined Gazprom’s choice of partners.

“It would have been impossible to pursue a project like Shtokman alone both financially and technologically. Total has expertise in LNG and deep sea projects, and the Norwegian companies have expertise in the area, so for Gazprom it is about risk reduction and sourcing technology,” Batunin said.

“Frankly, it’s yet to be decided which technologies should be used for this project. It might not even be the Norwegian technologies. This is going to be an incredibly sophisticated project. All similar Norwegian projects are significantly less ambitious than this one, because the field is located very far offshore, and new technologies have to be created. These will be created on the basis of expertise that Statoil has, but they will be new.”

The project is mind-boggling. There are 565 kilometers of open sea between the Shtokman field and the onshore production facilities at the Barents port of Teriberka. A sea populated by icebergs and drift ice with sub-zero temperatures, polar nights, mega-waves and an uneven seabed. A total of 156 wells will be drilled to a depth of 1,900 to 2,300 meters below the sea floor. Four platforms will be built, and forty wells drilled directly from the seabed.

“Gazprom realized nobody would do this sort of job on a contractual basis,” says Loukashov. “The foreign partners will have more responsibility because of the technological demands.” Pierre Noel agrees that it was the technological difficulties that drove Gazprom to share risks.

But the main technological dilemma concerns the pipeline link to the mainland. Statoil managed to cover 160 kilometers from the pioneering Snovhit gas field to their liquid natural gas plant on Melkoya Island. Anything over that has never been attempted.

Is Gazprom up to the challenge? Politicized, bureaucratic and opaque, it would seem that the company is the weakest link in the Shtokman troika.

However, precisely by relegating foreign partners and taking most of the risk upon itself, Gazprom and the Russian government have turned the development of the Shtokman field into a prestige project – Gazprom’s very own Winter Olympics, substituting Shtokman for Sochi and symbolizing national revival. With the Russian penchant for gigantism and Gazprom’s chairman becoming president, this could mean there is too much hinging on the project for it to be allowed to fail.