BP Losing 23% of Production Looms as Russians Assail Investment

By Stephanie Baker-Said and Torrey Clark

July 24 (Bloomberg) -- The dispute that has come to symbolize the challenges of producing oil in an era of high prices and short supplies boiled over in May. That's when BP Plc, the world's third-largest oil company by sales, faced off in a private meeting with its billionaire partners in a 50-50 Russian joint venture called TNK-BP Ltd. at the beachfront Four Seasons Hotel near Limassol, Cyprus.

The Russian side had a demand: The ouster of Robert Dudley, the American oil executive who had been running the venture since it was formed in 2003. They held Dudley responsible for crippling profits at TNK-BP, Russia's third-largest oil producer.

In the room were some of Russia's richest men, including Mikhail Fridman, one of the original oligarchs who made their fortunes as President Boris Yeltsin sold state enterprises. Also there were Viktor Vekselberg, who built his wealth trading metals and computers, and his business partner and friend from their student days in Moscow in the 1970s, Len Blavatnik.

BP Chief Executive Officer Tony Hayward had arrived from London to subdue the rebellion by the billionaires who hold half of the venture's shares. His company, beset by project delays, safety failures and a falling share price, can't afford to lose sway over its Russian assets. BP depends on TNK-BP for 23 percent of the oil and gas it produces, according to company filings.

Dudley chose not to attend. He stayed in Moscow because of concerns he might not be allowed back into Russia if he traveled abroad, say two people familiar with the matter.

Neither side got its way. Hayward refused to discuss removing Dudley, says Vekselberg, 51, who in 2004 paid more than $100 million for a collection of Faberge eggs. The Russian shareholders told Hayward there was nothing else to talk about.

8.2 Million Barrels

``It made no sense to continue the discussions when Bob Dudley is running the company in the interests of one shareholder,'' Vekselberg says. ``From the first day, BP regarded TNK-BP as a subsidiary.'' The three billionaires, who have seats on TNK-BP's board, bowed out of the directors meeting scheduled for the same day.

Since the Cyprus meeting, the battle over the venture has escalated. Both sides accuse the other of trying to wrest control of TNK-BP and its 8.2 billion barrels of oil and gas reserves, which would be worth almost $1 trillion, based on benchmark crude oil prices this year.

TNK-BP is being tied in knots by lawsuits, labor investigations, an industrial espionage inquiry, work permit disputes and conflicts over board elections. BP has been forced to pull out foreigners that it had employed in Russia and provided to TNK-BP under contract. Dudley is fighting to satisfy Russian authorities that he has a valid employment contract so that his visa will be renewed before it expires later this month.

Wild Card

The wild card in BP's dispute with the oligarchs is the Russian government, which is officially neutral. The government has no role in the dispute between BP and its partners, First Deputy Prime Minister Igor Shuvalov says. ``We're not involved,'' he says.

State agencies have begun investigating possible labor violations, focusing on foreign workers at TNK-BP. At the same time, the billionaire shareholders have been complaining about the high costs of those employees and taking steps to force the company to reduce their number. Russian officials and Vekselberg both say there's no connection.

Russian Deputy Prime Minister Igor Sechin told reporters earlier this month that he supports BP's work in the country. ``They bring new principles of corporate governance, new technology, training and transparency,'' said Sechin, who's also chairman of state-owned oil giant OAO Rosneft.

Shell, Yukos

The Kremlin has emerged as the winner in previous squabbles in the Russian energy industry. Last year, Royal Dutch Shell Plc sold a controlling interest in its $22 billion Sakhalin Island oil and natural gas project to OAO Gazprom, the state-controlled energy company. Shell's move came after a government environmental watchdog threatened to revoke permits and stop work at the project.

OAO Yukos Oil Co. was bankrupted after the government claimed more than $30 billion in back taxes. The company's founder, Mikhail Khodorkovsky, is serving eight years in a Siberian labor camp. Rosneft, under Sechin's watch, acquired many of Yukos's assets in government auctions to pay the tax claims.

Such events have made energy company executives leery, even as they scour the globe for dwindling supplies of oil and gas. ``There is no confidence in the rule of law in Russia,'' Exxon Mobil Corp. CEO Rex Tillerson said at a conference in St. Petersburg, Russia, in June. Gazprom blocked Exxon Mobil's plans to export gas from its Sakhalin project to China, and the government refused to expand the boundaries of the venture's license area.

Global Hunt

Companies such as BP have few good options as they hunt around the world for the oil that might help check soaring prices. In Nigeria, Africa's second-largest producer, output is falling because of rebel attacks on oil facilities and kidnappings of oil workers. In Venezuela, which has the largest reserves outside the Middle East, President Hugo Chávez has forced foreign companies to cede control and accept lower returns. The price of crude oil touched a record $147.27 a barrel in New York earlier this month, having doubled in a year and more than quadrupled in five years. It has fallen 14 percent from its high and traded at about $125 yesterday.

The clash at TNK-BP is already influencing foreign investors who are considering Russia, says Ivor Pether, a fund manager at Royal London Asset Management, who helps oversee $17 billion, including BP shares. ``Any prospective investor is not going to take any action until the outcome of this battle.''

Fox and Chicken

BP will be the loser in this dispute, says James Fenkner, managing director at Moscow-based Red Star Asset Management, which oversees about $100 million. ``It's like a Russian fairy tale, and they never end well,'' says Fenkner. ``The fox eats the chicken.''

For President Dmitry Medvedev, who took office in May, TNK- BP may be the first big test of his energy policies. Medvedev was chairman of Gazprom for six years as the gas producer and pipeline owner grew to be the third-largest company in the world by market capitalization.

Clashes with foreign investors may hobble Russia's ability to tap its energy. The country's oil output has begun to fall this year -- to 9.7 million barrels a day in June from a peak of 9.9 million in late 2007. For much of the past decade, Russia was among the biggest contributors of new global supply.

Russia depends on foreign technology and investment to keep its industry growing, says Neil McMahon, a London-based analyst at Sanford C. Bernstein & Co. ``BP needs Russia, and Russia needs BP,'' McMahon says.

Waiting in the Wings

Gazprom may be waiting in the wings as the TNK-BP spat unfolds. ``It looks like BP wants the Russian shareholders to sell to Gazprom,'' says Mattias Westman, CEO of Prosperity Capital Management, which oversees about $5 billion, including shares of OAO TNK-BP Holding, the joint venture's main operating subsidiary. A small portion of TNK-BP Holding shares trade in Moscow.

Gazprom Deputy CEO Alexander Medvedev says the company isn't in talks to buy a TNK-BP stake. If shares were for sale, Gazprom might be interested, he says. ``TNK-BP would have a natural fit with our Gazprom Neft assets,'' he says, referring to his company's publicly traded oil subsidiary.

Gazprom CEO Alexei Miller told reporters on June 17 that the company had neither made nor received offers to buy shares in TNK-BP.

Lockup Expires

A five-year lockup preventing BP and the Russian shareholders, who invested through a consortium called AAR, from selling their stakes expired at the end of last year. BP has been trying to persuade Gazprom to buy out the AAR investment, says Stan Polovets, AAR's CEO and a TNK-BP board member. ``We have no control over AAR's shares or Gazprom's decisions,'' says BP spokesman Toby Odone in London.

BP has been in talks with Gazprom about a $3 billion global gas venture that was announced in June 2007, at the same time TNK-BP agreed to sell its stake in Kovykta gas field to the state- run company.

BP can ill afford a setback in Russia, which accounts for a fifth of its reserves. The company's reputation has been sullied by safety lapses that led to 15 deaths in an explosion at a refinery in Texas in 2005, pipeline leaks in Alaska and a failure to bring facilities such as the Thunder Horse platform in the Gulf of Mexico to completion on time. Lord John Browne, Hayward's predecessor, resigned last year following allegations he let a former boyfriend use company resources.

`Corporate Raiding'

BP has been relying on TNK-BP for growth, and in 2006, the company got three-quarters of its new reserves from Russia. Shares of BP gained 25 percent in the past five years, while rival Exxon Mobil posted a 130 percent gain.

Hayward has kept his comments conciliatory. ``I'm confident we will resolve our well-publicized differences with our partners, and TNK-BP will continue to prosper,'' he said at the conference in St. Petersburg.

BP Chairman Peter Sutherland has been less diplomatic. ``It's just a return to the corporate raiding activities that were prevalent in Russia in the 1990s,'' he said at a conference in Stockholm in June. That's when foreign investors, including BP, saw their investments in Russia diluted or lost in legal battles and share sales.

Vekselberg, one of the Russian shareholders, says such comments are off base. ``We're hung with labels like 'raiders' and 'Russian mafia,''' he says. ``An exclusively corporate conflict is interpreted as some kind of political situation.''

Optimism

The current state of affairs is a long way from February 2003, when Browne and his billionaire partners agreed to form TNK-BP in a burst of optimism about doing business in Russia. The investment environment was improving under then President Vladimir Putin, Browne said at the time.

The venture was named for Tyumen Oil Co., known by its Russian acronym, TNK. That's the company the billionaires, including Fridman's partner, German Khan, began buying up in 1997.

Creating TNK-BP was Browne's attempt to put to rest previous disputes with these businessmen. BP expanded in Russia in 1997, when it paid about $500 million for a 10 percent stake in OAO Sidanco, once Russia's No. 6 oil producer. Then the price of oil fell to about $10 a barrel, the Russian financial crisis hit and the government devalued the ruble. A number of Sidanco subsidiaries went bankrupt. The billionaires and BP wrangled over the assets in bankruptcy court, and Fridman and his partners gained control of Sidanco's prized Chernogorneft oil production unit.

Sidanco

The Sidanco dispute persisted until 2001, when Tyumen returned the disputed assets after buying control of Sidanco. BP wrote off $200 million of its investment. The former adversaries became partners.

By 2003, with oil trading at about $28 a barrel, BP was ready for a bigger alliance. The company agreed to pay Fridman, Vekselberg and Blavatnik about $7.7 billion and merge its Russian assets with Tyumen to create TNK-BP.

Putin and Tony Blair, who was then British prime minister, jointly blessed the new venture in a signing ceremony in London on June 26, 2003. ``I hope their work in Russia and other markets will be successful and the realization of their plans will make Britain the biggest foreign investor in Russia,'' Putin said at the ceremony.

Dudley Appointed

Browne picked Dudley, a sandy-haired Illinois native, to head the venture. Dudley had worked closely with Browne as his executive assistant, a position that traditionally leads to bigger roles at BP. Dudley, who ran Amoco Corp.'s Russian operations from 1994 to '97, prior to Amoco's being acquired by BP, was approved by the billionaires.

TNK-BP got off to a good start. Oil production surged, partly because BP's technical expertise helped boost output through targeted drilling at aging fields such as Samotlor in western Siberia. Output from Samotlor, Russia's largest oil field, which was discovered in the 1960s, was in a steep decline by the end of the Soviet era, as traditional techniques yielded less and less crude.

TNK-BP's net income jumped to $4 billion in 2004 from $2.8 billion a year earlier. Rising production and profits helped keep peace among the TNK-BP partners for the first years of the venture.

Browne said from the outset that the joint venture could face difficulties, as oil companies often do in the countries they work in. ``There are always risks,'' he said in a 2003 interview. ``Our job is to manage our way through these risks.'' He said the success of the Russian joint venture could be judged in five years.

`Proper Respect'

Beneath the surface, though, some saw all along that BP and the Russian shareholders were pursuing different goals. ``There were storm clouds from the beginning, and they just gathered thicker and thicker,'' says Frank Rieber, an American who spearheaded production at Tyumen in 2002 and then worked at TNK-BP until 2005. ``They didn't have the proper respect for the Russians.''

After gaining no concessions from Hayward at the Cyprus meeting in May, the billionaires took their grievances public. With PowerPoint presentations and press interviews, they've argued that BP is saddling the venture with high costs and failing to boost profits with investments outside Russia.

``It's pretty basic,'' says Westman of Prosperity Capital. ``They don't feel like this company is working for them. BP has obligations to all TNK-BP shareholders, and I don't think they're fulfilling them.''

Hunting Trips

Fridman, Khan, Vekselberg and Blavatnik are self-made men who are used to outsize returns on their private equity investments. They've remained united against BP, bound by ties that stretch back to the 1990s and earlier. Fridman, 44, known for keeping a spotless desk, has been the most outspoken. His Alfa Group owns 25 percent of TNK-BP. Fridman founded Alfa with Khan, 46, in the 1990s after the two attended university together. Fridman, Khan and Vekselberg maintain tight social bonds by going together on frequent hunting safaris, colleagues say. Their group's name, AAR, comes from the initials for Alfa Group, Blavatnik's Access Industries and Vekselberg's Renova Group conglomerate. Blavatnik emigrated to the U.S. in 1978 and is an American citizen.

By last year, TNK-BP was coming up against the challenges that have now split the billionaires and BP. Capital spending in 2007 surged 53 percent to $3.5 billion as the venture spent more to boost output and find new deposits. Dividends declared that year were 49 percent of profit, down from 75 percent in 2006. TNK-BP's profit fell 21 percent in 2007 to $5.3 billion because of the sale of a production unit.

International Reach

The billionaires say BP is too focused on efforts to find new oil and gas deposits to boost its reserves. Investors value giant energy companies such as BP on their ability to discover enough new oil and gas to at least replace what they pump. The Russian shareholders, by contrast, favor production and refining that drives annual profits and their returns. Higher earnings mean higher dividends, which they split with BP.

AAR has pushed for TNK-BP to expand internationally. The largest oil and gas prospects within Russia are reserved for majority-owned Russian companies, limiting what TNK-BP can do. AAR has proposed investments in Poland, Germany, northern Iraq and elsewhere. BP's directors have shot down most of these, AAR's Polovets says. This week, TNK-BP said it signed an agreement with Venezuela to study a possible joint project in the Latin American country's Orinoco region, where heavy oil is produced. The venture is building on an analysis of the Venezuelan deposits that it began last year.

Five-Year Plan

The two sides have fought over a five-year business plan that Dudley presented to the billionaires in the summer of 2007. The proposal called for capital spending to increase 19 percent to $4.1 billion in 2008 to get new projects going.

``We never opposed capital spending,'' Polovets says. ``Our problem was that a disproportionately large part of capital spending was focused on adding reserves and not increasing cash flow.'' Dudley's plan used a conservative oil price forecast of $82 a barrel to help set spending levels and projections of how much profit could go to dividends, Polovets says. The Russian investors say the oil price forecast in the plan was too bearish and dividend assumptions too low. AAR rejected Dudley's plan at a November board meeting in Moscow.

TNK-BP is lagging behind other Russian oil companies, such as OAO Lukoil, the country's biggest independent producer, according to the billionaires. The TNK-BP Holding shares, which trade infrequently, are down 30 percent from the beginning of 2006, while Lukoil shares gained 54 percent in the same period.

TNK-BP's Record

Alastair Graham, head of BP Russian Investments Ltd. and an adviser to BP's directors on the TNK-BP board, says the complaints he's hearing aren't justified. ``This is not a poorly performing company,'' Graham says.

Squeezing profits from Russian oil has become harder in part because Putin -- like many leaders in resource-rich countries -- raised taxes on production. ``If you don't want to invest and you don't like the returns as margins are squeezed by higher costs and the tax regime, maybe you shouldn't be investing in Russian oil,'' Graham says. He also rejects the idea that TNK-BP is limited to working in Russia. ``BP has been very happy to see TNK-BP expand outside Russia where it makes good business sense and where management has brought forward good business proposals,'' he says.

BP says that TNK-BP has the best record of any Russian oil company in replacing the oil and gas it pumps. It has added reserves at a rate equal to 143 percent of what it produced each year during the past three years, the company says.

Foreign Workers

The billionaires have zeroed in on costs, especially for the BP engineers and managers who were hired under contract to offer technical expertise on squeezing more oil out of mature fields. They say these people cost the company about $120 million a year and freeze out promising Russian talent.

``There is a good English word: arrogance,'' Fridman told reporters in June. ``We have felt a kind of condescension for a long time.'' Vekselberg, in an interview in his office down the hall from Dudley's in TNK-BP's headquarters in Moscow, says the BP contractors cost TNK-BP three times more than equivalent Russian employees. He's particularly upset by perks the company subsidizes for non-Russian staff, such as private school for their children.

``The industry is short of specialist staff,'' Graham counters. ``You have to pay people a lot of money to come and work in Moscow. That's the market.'' The average BP contractor costs the joint venture $685,000 a year, including salary, housing, travel and schooling costs, according to Vladimir Buyanov, a BP spokesman in Moscow.

Offices Searched

While BP and the billionaires take shots at each other, the Russian government has taken aim at TNK-BP and its employees. On March 12, government investigators questioned Ilya Zaslavsky, a TNK-BP employee with U.S. and Russian citizenship, and his brother Alexander as part of a probe into whether they tried to obtain classified information that could give foreign energy companies advantage over Russian rivals, according to Russia's Federal Security Service.

On March 19, three large vans, two with official blue lights on their roofs, pulled up in front of TNK-BP's granite- faced building on Arbat Street, one of Moscow's oldest pedestrian thoroughfares, and security service agents searched the company's offices. Later that day, law enforcement officials raided BP's own representative offices.

Labor Inspections

The Russian government and courts have taken moves that have forced the contentious issue of foreign contractors. The government has made four labor inspections at TNK-BP since mid- April, examining health, safety and work contracts for employees at the headquarters in Moscow. Inspectors probed whether TNK-BP provided proper training on computers and paid employees on the day fixed in their contracts, among other possible infractions. ``We've never received this level of attention from the authorities in the past,'' says Peter Henshaw, a TNK-BP spokesman.

At the end of June, Dudley was fined 3,000 rubles ($129) and a unit of TNK-BP 40,000 rubles after local officials found minor labor infractions. On July 17, a group of 16 TNK-BP employees filed suit to remove Dudley for discrimination against Russians and those not loyal to BP.

Polovets says AAR had no involvement in either matter. ``AAR doesn't have the power to influence the Russian government,'' Polovets says of the fines for labor violations. ``Even if it did, slapping a CEO with a $130 fine is not a very effective pressure tactic.''

Tetlis Lawsuit

In mid-April, a minority shareholder, ZAO Tetlis, sued to force TNK-BP to scrap the contract under which it pays for workers who are employed by BP. The lawsuit, filed against TNK-BP and BP in a local court in Russia's oil-rich Tyumen region in western Siberia, says the contract illegally drains money away from the venture and shortchanges its shareholders, according to court documents. This week, the court declared invalid BP's contract to send employees to work at TNK-BP. BP says it will challenge the ruling, though in the interim it is withdrawing its 60 remaining geologists and engineers who were working at the joint venture.

Tetlis was founded by Alexander Tagayev and Vadim Zykov, former employees of financial companies that are part of Fridman and Khan's Alfa Group, Tagayev says. Fridman denies any connection with Tetlis, which in April bought $40,000 of shares of TNK-BP Holding.

``It has nothing to do with AAR,'' Polovets says. ``If AAR wanted to find someone to discreetly file a lawsuit on its behalf, don't you think we could find someone who did not advertise they are former Alfa employees?''

Executive Loyalties

More court battles loom. In June, Alexander Gorshkov, a board member of TNK-BP Holding aligned with AAR, filed a suit in a court in the Tyumen region. The case challenges the procedures used to nominate the board members of TNK-BP Holding.

The war among TNK-BP's owners is playing out in the loyalties of executives and managers within the company. Khan, who oversees the joint venture's government relations, legal and human resources departments, cut in half the number of government work permit requests for expatriates employed directly by TNK-BP -- against Dudley's wishes.

At the end of April, Boris Kondrashov, TNK-BP's head of security, blocked BP contractors from entering the joint venture's Moscow offices because of concerns over possible violations of tax, immigration and labor laws, Polovets says.

The loss of these contractors has forced TNK-BP to halt several drilling projects, BP's Graham says.

Authority Overstepped

Dudley felt his authority as CEO had been overstepped, according to letters between him and Vekselberg. At the end of April, he started looking at ways to remove Khan, Kondrashov and Igor Maydannik, head of TNK-BP's legal department, from the TNK- BP unit that employs the headquarters' staff, according to the letters. Vekselberg wrote to Dudley on May 14 saying that only TNK-BP Ltd.'s board of directors could approve their dismissal.

For now, BP and its partners are deadlocked. Putin, who became prime minister after his presidential term ended, has avoided taking sides. Instead, he's offered an I-told-you-so. In a televised interview with Paris newspaper Le Monde in May, he said he warned BP and its billionaire partners back in 2003 that the 50-50 venture would run into trouble. One side needed a majority stake, he said. ``I said, 'Don't do this,''' Putin recounted. ``When there's no clear chain of command in such a structure, there'll be problems.''

Stake Sale

One possibility for a mutually agreeable exit from the stalemate has been considered and, so far, rejected. In early June, the billionaires exchanged letters with BP officials about an accord that would give them the option to convert their stake in the joint venture into shares of BP at a price to be determined in future negotiations.

``BP proposed we do it right away, to sell and exchange our stake in TNK-BP for BP shares,'' Vekselberg says. ``We do not want to sell our stake now.'' BP has expressed no interest in getting out, even as the lawsuits have multiplied and executives within the venture have battled. Graham says the company will hang on, though he points out a ``remarkable coincidence'' between the pressures the government has brought to bear on the company and the complaints pushed by the Russian shareholders.

So far, BP has fought off all attempts to oust Dudley. When the billionaires convened again in Cyprus on July 11 for a TNK-BP director's meeting, BP's representatives rejected AAR's demands to replace Dudley and to change the makeup of the boards of TNK-BP's subsidiaries.

Consultation

Dudley, who didn't attend this meeting, defended his leadership of the venture at a press conference in Moscow on July 17: ``I cannot think of a single major decision I ever made as CEO that wasn't made in consultation with all the shareholders.'' Dudley declined to be interviewed for this story.

With no resolution to the power struggle, outsiders predict that the government will determine the outcome. ``Nothing will happen to TNK-BP without the say-so of the Kremlin,'' says Chris Weafer, chief strategist at UralSib Financial Corp., a Moscow-based brokerage. ``The endgame is clear with Putin's government having set up the model of state control.''

No way, Vekselberg says. ``Everyone thinks we're puppets in Mr. Putin's hands and the problems can be resolved with Mr. Putin, not us,'' he says.

Vekselberg argues that only BP can solve the TNK-BP dispute -- by recognizing the validity of the shareholders' complaints. Until then, he and his partners will take all legitimate steps to protect their interests, he says. BP may have no choice but to slug it out in the courts and put up with the battles among executives and managers at TNK-BP to hang on to its slice of Russia's natural resource riches.

To contact the reporters on this story: Stephanie Baker-Said in London at ssaid@bloomberg.net; Torrey Clark in Moscow at tclark8@bloomberg.net.