Russia - 270907- binnenwerk - final - ABN AMRO · SWOT analysis..... 13 Chapter 2: Russia’s Minerals & Mining Industry.....18 The importance of the sector to the Russian economy

Russia, a promising and exciting business environment

ABN AMRO Group Public Affairs: Economics Department: Marijke Zewuster, [email protected] Sector Research: Jan van den Berg, [email protected] Thijs Pons, [email protected] Commissioned by: Sector Advisory NL: Willem Rol Commercial Client Segment / IDCC: Nico Overwijn Finalised: September 2007

Russia

2 Economics Department/Sector Research, September 2007

Introduction When evaluating Russia, from whatever perspective, there are usually two extremes: from very sceptical or even unfavourable to nearly euphoric. From the perspective of a foreigner who has spent some three and a half very bright and intense years in the country, I can confirm the saying by the Russian poet Tutchev that there is no intellectual understanding of Russia, nor can it be measured with a standard arshin (old Russian measure that equals 0.711 metre). It can indeed be anything, but never dull. Russia is unique, diverse, challenging, exciting and promising. I could extend this list of epithets further, but the incontestable facts about Russia’s current economic situation and its potential, analysed in detail in this report, speak for themselves. The fundamentals are very strong. Russia’s GDP growth rate for the last five years has substantially exceeded that of most industrially developed countries. Growth is driven by high commodity prices and booming domestic consumer demand. Favourable prices for commodities, such as oil, gas, gold, nickel and many others that Russia has in abundance, have created excess cash in both the public and private sectors and a positive current account balance. Russian currency and gold reserves – the world’s third-largest – reached historical highs of over USD 420 bn in mid-September 2007. Inflation is coming down, the rouble is quickly becoming a currency to be reckoned with and the sovereign rating has increased to well beyond investment grade level. In summary, the Russian economy has transformed to become one of the largest (ranking ninth) and most important economies in the world. And I am convinced that this is only the beginning, given all the potential (size of the market, availability of high-quality labour, growth potential, etc.) that is yet to be tapped. The Russian Government is putting a lot of effort into attracting more investment into the country and improving the investment climate in general. It has created investment institutions such as the Investment Fund and the Development Bank to ensure investments in all sectors of the economy as well as infrastructure projects. “I want to note that 300 billion rubles [currently about USD12 bn] have been allocated to these institutions this year alone. Moreover, we have put in place a mechanism that ensures that these funds will increase each year, but only so long as they are used effectively”, - stated President Putin during his opening remarks at the International Investment Forum in Sochi (September 24, 2007). There is a clear willingness on the part of the government and the business community to develop a relationship, as long as it is based on mutual interests and benefits. International business and foreign investors are striving to increase their market share, strengthen their financial position, broaden their product range, ensure stability and find the best talent. Russia provides a solid basis for this. It may not happen overnight, but surely in the somewhat longer term. The coming year will be an exciting one for the country in general and the business community in particular, with parliamentary elections scheduled in December 2007 and presidential elections in early 2008. However, we all witnessed the local market’s rather limited reaction to the recent and sudden changes in the Russian Government. The market overall is very focused on

Russia


business and trusts that the new government will continue the on-going projects, policies and reforms. The liquidity crisis in the international financial markets is having a much greater impact on the Russian business environment. Until now the country has been enjoying a boom in the capital markets across all sectors, with one of the fastest growing equity markets in the world (up over 1000% during the “Putin era”), and stable growth in the fixed income market. Further developments in that area will greatly depend on overall international market conditions. But of course this by no means stops many foreign companies from coming to Russia as they see much greater opportunities here than elsewhere in the world. And bear in mind that of all the BRIC countries, Russia enjoys the highest percentage of satisfied foreign investors. Over 80% of foreign businesses indicate that they are generating very attractive returns on their investments in Russia, a statistic that cannot be matched by other countries. Russia should be more and better promoted. I trust this report will give you valuable insight into the country from which it is sometimes argued that doing business is, despite its challenges, the best kept secret in the world. Henk Paardekooper, Country Executive Russia

Russia


Contents

Introduction......................................................................................2

Chapter 1: Economic Overview .......................................................6 Economic structure and trade....................................................................................... 6 Economic developments .............................................................................................. 9 SWOT analysis ........................................................................................................... 13

Chapter 2: Russia’s Minerals & Mining Industry............................18 The importance of the sector to the Russian economy .............................................. 18 Exploration spending in the global mining sector ....................................................... 19 Growing demand for mining equipment...................................................................... 20 Medium-term outlook.................................................................................................. 20 Opportunities in mining equipment, services and systems......................................... 21

Chapter 3: The Russian Oil Industry .............................................22 Oil reserves ................................................................................................................ 22 Oil production ............................................................................................................. 22 Oil exports .................................................................................................................. 22 Oil production and export outlook............................................................................... 23

Chapter 4: The Russian Natural Gas Sector .................................25 Natural gas reserves .................................................................................................. 25 Natural gas production ............................................................................................... 25 Natural gas exports .................................................................................................... 26 Natural gas production and export outlook................................................................. 27 The China option ........................................................................................................ 29

Chapter 5: Opportunities in Russian Oil and Gas..........................31 Investment climate...................................................................................................... 31 Resource nationalism increasing................................................................................ 31 High investments needed ........................................................................................... 32 The E&P momentum .................................................................................................. 33

Chapter 6: Agrifood .......................................................................35 Exports from the Netherlands to Russia..................................................................... 35 Dutch companies are investing in Russia................................................................... 37

Chapter 7: “Doing Business is People’s Business” .......................39 1. Campina in Russia: ‘Ask for support from the local authorities’ ‘Establish a good relationship with the local authorities’ ......................................................................... 39 2. Jørgen de Ree, Managing Director of De Ree Holland BV ‘The Russians are loyal, reliable customers’...................................................................................................... 41 3. Mammoet in Russia A good business contact is based on friendship................... 43 4. Ottevanger Milling Engineers is successful on the Russian market ....................... 45 5. Gebroeders Van den Berk B.V. ‘With patience and respect, you can do good business in Russia’..................................................................................................... 47 6. For Econosto, Russia is a top market in the making .............................................. 49

Russia


Russia


Chapter 1: Economic Overview After the roaring nineties, which began with the collapse of the Soviet Union in 1991 and ended with the rouble crisis in 1998, the start of this century was characterised by a much more stable and prosperous development. The year 1999 was one of adjustment, and since president Putin took power in 2000 the Russian economy has shown an outstanding performance. The period of uninterrupted decline over the first eight years of the transition period were followed by a period of prolonged strong growth following the rouble crisis. And in fact, the end of this sustained growth is not yet in sight. The year 2006 was a milestone as it was the first year in which Russia was able to make up for the large decline in the real value of GDP during the years of transition prior to the rouble crisis. 1 With a population of over 140 million people, a nominal GDP of almost one trillion USD and rising wealth levels, Russia is not only attractive because of its rich natural resource base and related industrial investments and services, but has also become an interesting consumer market with a rising middle class. Although the positive economic developments since 1999 are mostly attributable to high energy prices and the much improved competitive position due to the sharp fall in the rouble at the end of 1998, sound macroeconomic management also played an important role. Fiscal surpluses became the rule and debt levels were reduced to the point that the government became a net creditor. The currency started to strengthen and inflation was brought under control. The much improved macroeconomic stability also enhanced the inflow of foreign investment, which rose considerably over recent years. There is, however, a flipside to these strong growth levels and the inflow of foreign capital. The central bank is having a hard time balancing the need to keep inflation in check and the risk of a strong loss in competitiveness due to the resulting strong currency. A loosening of fiscal policy in the run-up to the parliamentary elections at the end of 2007 and the presidential elections in March 2008 makes this balancing act even more difficult. Economic structure and trade Service sector has become more important The transition from a centrally planned economy towards a more market-oriented economy has led to far-reaching changes in the country’s economic structure. During the Soviet era, the focus was on heavy industry which was where most people were employed, while the service sector was underdeveloped. Already in the first years after the collapse of the Soviet Union, the economic structure changed dramatically. The share of agriculture in GDP fell from 17% in 1990 to 7% in 1995 and continued its gradual decline in the years thereafter to a current share of 5%. At the same time, the agricultural sector’s productivity declined strongly, as is evident by the fact that while its share in GDP has declined, the share in total employment has hardly changed and now stands at around 12%, against 13% in 1990. Furthermore, much of the activity in the informal economy likely takes place in the agricultural sector, which implies that even more people are making a living of farming as the statistics indicate. Estimates for the informal economy vary between 25% and 40% of GDP.

1 The cumulative decline in GDP in the period from 1991 to 1998 was 52%, while the cumulative growth in the period 1999 up to 2006 was 54%.

Russia 2006 2007 2008 % changes GDP 6.7 7.3 6.5 Inflation (average) 9.7 8.2 8.0 levels Current account (% GDP) 9.6 5.9 4.9 Budget balance (% GDP) 7.4 6.0 2.5 Government debt (% GDP) 9.0 5.0 5.0 Foreign debt (% GDP) 29 28 24 year-end Short interest rate (3m) 11.0 10.0 9.0 RUB per USD 26.3 25.3 25.5 RUB per EUR 34.6 36.7 34.4 Forecasts ABN AMRO Economics Department

Strong growth and… % GDP

-8

-4

0

4

8

12

1995 1997 1999 2001 2003 2005 2007

Source: Thomson Financial

…a strong rouble

24

28

32

36

40

Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

—— RUB per EUR RUB per USD


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The share of industry also showed a declining trend, with the share of industry to GDP falling from 48% in 1990 to 38% in 1995, where it still stands. Sixty percent of this continues to be heavy industry, the sector is dominated by large industrial enterprises. These statistics are not completely reliable, however. During the Soviet era, output figures were more likely overestimated while now, given the fact that tax evasion is considerable, output figures are likely to be underestimated. Services, on the other hand, increased its share from 35% of GDP in 1990 to 55% in 1995, and has remained around this level ever since. If we look at the other sectors, employment has developed more in line with the contribution of these sectors to total production. Industry’s share in employment fell from 42% in 1990 to 30% currently, while services increased its share in that period from 42% to 55%. The oil and gas sector contributes over 50% of industrial output and represents around 25% of GDP, including other oil and gas-related activities. It also generates 65% of total exports and 35% of state revenues. Due to the concentration of economic activity in the capital intensive energy sector, the current government has dedicated various measures to stimulating investments outside the resources-based industries. These measures include special zones, tax incentives, and export promotion. Meanwhile, the government is concentrating its own influence on what are called the strategic sectors of the economy, of which the oil and gas sector is obviously the most important component. Strategic sectors At the start of 2007 the Russian government finally published the long-awaited draft law on the limitation of foreign investment in the country. The law designates 40 industries as "strategic" for Russian development. Predictably, the list includes the production of military equipment, aircraft, spacecraft, ciphering tools, treatment and trade of radioactive and nuclear materials. This "strategic" status will also be assigned to fields highly endowed with natural resources, with thresholds of some 70 million tonnes for oil, 50 billion cubic metres for gas, 50 tonnes for gold and 500,000 tonnes for copper. The list of strategic industries also includes natural monopolies and arms-related metallurgy. Moreover, the regulation stipulates eight criteria for evaluating any particular company, which effectively enables any type of production to be classified as "strategic". The regulation sets up a special inter-departmental commission uniting economic and security officials to approve deals involving "strategic" companies. Its permission will be necessary for purchases and other deals related to the controlling shares of strategic companies, even if they do not belong to the state. Foreign states, their subsidiaries or international organisations will have to seek approval for deals above the 25% share threshold, and will be completely prohibited from acquiring control over "strategic"' companies. The long list of strategic industries and the provisos for potentially classifying companies beyond them as strategic, reflects the government’s increasing control over economic issues. On the other hand, the fact that there is now a policy for considering foreign involvement could lead to less uncertainty and is hence an improvement over the earlier non-transparent ad-hoc decisions.

Economic Structure Share of GDP

IndustryServices

Agriculture

Source: EIU

…real growth agriculture and industry

-20

-10

0

10

20

1996 1998 2000 2002 2004 2006 2008

—— Industry Agricutture

Source EIU

Savings and investment rate % GDP

10152025303540

1993 1995 1997 1999 2001 2003 2005 2007

—— Investment rate Savings rate


Russia


EU most important trading partner Since the collapse of the Soviet Union, Russia’s imports from non-CIS countries have grown rapidly, with especially strong growth in trade with the EU. The EU is by far Russia's main trading partner, accounting for around 50% of its overall trade. Total exports from Russia to the EU amounted to USD 177 billion in 2006. Of this total, around 65% involved energy and fuels, making Russia the EU’s single most important energy supplier. Imports from the EU amount to USD 61 billion. They include machinery (36%), chemicals (14%), manufactured goods (11%), transport equipment (10%), food and live animals (7%). Although the EU is clearly the most important trading partner, trade with China is quickly increasing in importance. China is now Russia’s fourth export market and the second most important source of imports. And Russia is China’s 10th leading trading partner. For the EU, however, trade with Russia is less important, given that most trade is of an intra-regional trade. Exports to Russia account for less than 5% of total EU exports, comparable to the share of exports from the EU to China. Exports to the Netherlands have also grown strongly. In 2006, exports to the Netherlands accounted for 12.3% of total exports, while this was only 4% in the period from 1995 to 2000. This makes the Netherlands Russia’s largest export destination. If we look at the import side, Germany is still number one, with a share of 14% of total imports. However, China is catching up quickly and has become the second largest supplier of imported goods, with a share of almost 10%, while the Netherlands doesn’t even appear in the top 10. However, if we take a closer look at the figures regarding trade between Russia and the Netherlands, there is a huge gap between the figures the IMF provides for Russia and those provided by the IMF for the Netherlands. According to IMF statistics for Russia, the value of imports from the Netherlands is just USD 2.7 billion, representing a share of 2% of total imports. However, if we take the same statistics for the Netherlands, the value of Dutch exports to Russia amounted to USD 7 billion. This would mean the Netherlands takes fifth position as a source of imports for Russia. The same discrepancy can be seen if we compare Dutch imports from Russia (USD 21 billion) with exports from Russia to the Netherlands (USD 36 billion). According to the IMF, the principal reason for this is related to differences in 1) classification concepts and detail, 2) time of recording, 3) valuation, 4) coverage, and 5) processing errors. Relations with both EU and US remain difficult Given the growing importance of trade relations and because they have become neighbours, both the EU and Russia have a shared interest in a stable and prosperous Europe. So far, however, the EU and Russia have not found a way of working together constructively. In fact, collaboration between Russia, the EU and the US seems to have become even more problematic. EU policy towards the east currently consists of three types of strategy; the enlargement process, the European Neighbourhood policy (ENP) and the Four Common Spaces with Russia. Plans to build the four 'common spaces' [in economics, education and research and internal and external security have made little headway. The EU-Russia summit in

Major exports (ITS) Agricultural products 6.1% Fuels and mining products 67.7% Manufactures 23.2% Source WTO

Main import markets (2006) USD bln % of total EU-25 61.3 46 o.w Netherlands 2.7 2 Germany 18.4 14 US 6.4 5 China 12.9 10 Ukraine 9.2 7 Total 132.5 Source Datastream/IMFdirection of trade statistics

Major imports (ITS) Agricultural products 15.4% Fuels and mining products 3.9% Manufactures 80.2% Source WTO

Value of import and export

USD bln

0

100

200

300

400

1993 1995 1997 1999 2001 2003 2005 2007

—— Import Export Source: EIU

Main export markets (2006) USD bln % of total EU-25 177.2 61 o.w Netherlands 35.9 12 Germany 24.5 8 USA 8.9 3 China 15.7 5 Ukraine 15.0 5 Total 291.3 Source Datastream/IMF direction of trade statistics

Russia


Samara on 18 May on a new EU-Russia treaty failed to achieve a breakthrough. The summit underlined that further delays should be expected to the start of talks on replacing the partnership and co-operation agreement (PCA) that is due to expire at the end of 2007. The failure to reach an agreement has a great deal to do with political tensions and differing values. Where Russia insists on strategic partnerships among peers, the EU aims at making the country more responsive to EU standards and values with respect to issues like democracy and human rights. The EU is also concerned about Russia's autocratic tendencies, its use of energy resources for political purposes and its bullying of smaller neighbours, but has so far not been able to formulate a common policy. Moscow, on the other hand, sees this as unacceptable interference in its domestic affairs and prefers to work directly with the big member-states like Germany. The ENP, the vehicle for stronger engagement of the EU with the CIS member countries, is also a source of tension between the EU and Russia. This is especially true for the relations with Georgia, Ukraine, Azerbaijan and Moldova – the so-called GUAM countries – which seek a closer connection with the EU but are seen by Russia as the “near abroad”. Furthermore, although many former CIS countries would like to be absolutely independent from Russia, they are not prepared to lose the economic benefits, such as cheap gas, which they continue to enjoy. This has resulted in the “gas wars” with Ukraine, Georgia and Belarus, for example. On the one hand, the EU supports the more independent position of these countries while on the other, it is concerned about the security of its own oil and gas supplies. Energy is hence one of the most pressing topics for discussion between the EU and Russia. Strong economic differences also play a role in explaining the difficulties in achieving economic and political cooperation. Despite Russia’s current strong economic performance, the EU is still far larger than Russia in terms of economic size, population and wealth. In fact for Russia, even trade with the EU is much more important as a share of total trade than it is for the EU. Nevertheless, now that its economic situation has improved on the back of high oil prices, Russia's international political interest has become increasingly geared towards renewing its status as a world power, which doesn’t make cooperation any easier. In addition, the forthcoming Duma elections (December 2007) and presidential elections (March 2008) cast further uncertainty on future relations, as is evidenced by the increased rhetoric from Moscow concerning both the EU and the US. Examples are the strong negative statements from Moscow regarding the US ambition to implement a military missile defence shield in Poland and the Czech Republic, and its reaction to the request by the UK to extradite the main suspect sought by the UK in the Litvinenko murder case. Given all this, we therefore expect that relations between Russia, the EU and the US will remain wobbly in the coming years. Economic developments Domestic demand will remain the sole driver behind economic growth, while the contribution of the external sector will become increasingly negative. A looser fiscal stance in the run-up to the presidential elections in March 2008 will further add to

Different in size US EU-25 Russia Nominal GDP (USD bln)

13247

14550

985

Population (mln) 299 490 142 GDP per capita (PPP) 44244 28420 12162 Source EIU

Russia


growth. Higher import demand will only partly offset the increase in domestic demand. We therefore predict that although the high growth level of 7.8% seen in the first half of 2007 might not be sustained, growth for the full year will remain robust at 7.3%, up from 6.7% in 2006. In 2008 we expect growth to remain strong, albeit slightly lower, at around 6.5%. 2000-2006, years of rising prosperity The strong growth performance over the last eight years has resulted in an even stronger increase in per-capita GDP. Measured at purchasing power parity, per-capita GDP fell from USD 8,400 in 1991 to a low of 5,800 in 1998 and has since risen to over 12,000. Driven by domestic demand, the economy grew by an average of 6.7% per year between 2000 and 2006. Consumer demand is fuelled by a strong increase in disposable income. Real wages have increased by more than 10% a year since president Putin came to power. This has given rise to a consumption boom and a rapid growth in the retail sector. Private consumption grew by 9.5% annually between 2000 and 2006. Investments accelerated by no less than 12.6% per year. The growth in domestic spending drove up import demand by over 20% a year, while export demand jumped by an average of just 9% per year. Despite the strong growth in the value of imports, the current account remained in surplus thanks to the high oil prices. Windfall oil revenues were channelled into a stabilisation fund, which was used in 2005 to repay the IMF obligations and the former Soviet debt to the Paris Club (the club of debtor nations). Despite the debt repayments, the fund now has a balance of over USD 100 billion. The Stabilisation Fund was also an important tool of macroeconomic policy, as it helped prevent an even stronger appreciation of the rouble and kept the economy from overheating. Recent developments 2006-2007 Gross investments, which dipped below 10% growth in 2005, bounced back strongly in 2006. In the first quarter of this year, gross fixed capital formation was up 19.8% yoy, compared to 17.4% in the last quarter of 2006 and just 5.7% in the first quarter of last year. Including inventories, the rise was even more impressive, amounting to 34.2% in the first quarter, against 19.7% in the last quarter of 2006 and 4% in the first quarter of 2006. Foreign direct investment increased by USD 16 bn to a total of USD 81 bn. This contradicts fears that investment would suffer from the government’s renationalisation efforts and a worsening political climate. The bulk of investments, both domestic and foreign, is directed to the energy sector, construction, transportation and services. Foreign direct investment is also increasingly directed towards the financial sector. Private consumer demand also remained robust, growing 10.9% in 2006. Private consumption growth accelerated during the second half of last year to 12.6% in the final quarter of 2006, slowing slightly in the first quarter of 2007 to 11.9%. Domestic demand is not only stimulated by the continuing increase in real disposable income but also by increased access to consumer credit. Overall credit rose 46% in 2006. Loans to individuals were up 75% during that year, while credit to the corporate sector increased by 39%.

Government debt

% GDP

020406080

100120140

1995 1998 2001 2004 2007

Source: EIU/Economics Department

GDP per capita at PPP

4000

6000

8000

10000

12000

14000

1991 1995 1999 2003 2007

Source: EIU

Growth of real disposable income

%

-15-10

-505

1015

1996 1998 2000 2002 2004 2006 2008

Source: EIU

Russia


Booming consumption market Table: Top 20 of private consumption expenditure, at current market prices in billion US dollar ranked by 2008 Country 2000 2001 2002 2003 2004 2005 2006 2007 2008 placeUNITED STATES 6739 7055 7351 7704 8211 8742 9271 9640 10087 1JAPAN 2624 2340 2259 2431 2629 2600 2495 2814 3102 2GERMANY 1122 1127 1194 1451 1621 1644 1684 1878 1924 3UNITED KINGDOM 944 946 1035 1183 1394 1439 1520 1689 1731 4FRANCE 743 751 819 1019 1166 1213 1279 1439 1483 5CHINA 554 595 635 687 771 865 988 1146 1294 6ITALY 656 657 715 888 1007 1032 1075 1193 1226 7SPAIN 347 360 402 510 605 652 713 815 847 8CANADA 401 401 418 490 553 627 709 719 758 9RUSSIAN FEDERATION 120 151 177 218 289 367 476 594 688 10INDIA 296 308 318 371 419 474 536 601 666 11MEXICO 389 433 448 439 465 525 570 596 613 12KOREA, REP. OF 276 266 305 327 351 415 474 530 592 13BRAZIL 366 309 267 287 333 442 533 563 585 14AUSTRALIA 228 218 244 308 374 407 421 428 418 15NETHERLANDS 185 201 220 270 300 308 321 362 371 16TURKEY 143 105 122 160 200 245 265 281 295 17INDONESIA 102 101 132 160 171 184 229 253 276 18TAIWAN 195 181 181 183 198 215 220 236 259 19SWITZERLAND 148 151 166 195 216 221 224 250 258 20

Total top 20 16579 16656 17408 19280 21274 22617 24002 26028 27471Total World 19279 19374 20145 22437 24903 26652 28448 31056 32824as % of total world 86 86 86 86 85 85 84 84 84 source EIU

Not only has private consumption shown remarkable increases in recent years compared to the pre-Putin era, but is also impressive when compared to other countries. This is illustrated in the table above, showing the nominal amount of national income spent on private consumption from 2000 to 2008. These countries rank as the top 20 in 2008 and, over the years, have represented around 85% of total global private consumption expenditure. Given current growth prospects, Russia is expected to move from 19th place in 2000 to 10th in 2008, outranking countries like India, Mexico, South Korea and Brazil. This will make Russia an increasingly attractive market for both retail and other consumer-related activities. Construction and manufacturing show strongest growth Looking at the supply side, it is the construction and retail sectors that showed the strongest growth. In the second quarter of this year, growth in the construction sector was 22% yoy. Overall GDP grew by 7.8% yoy in the second quarter, just below the 7.9% growth level recorded in the first quarter. Other sectors registering growth above the GDP average are trade, financial activities, real estate and transport and communication. The state administration sub-sector also showed remarkable Q2 growth at 8.1%. This merely reflects sharp increases in public sector salaries in the run-up to the elections. Growth in the manufacturing sector was below average at 6.2% following a very strong performance of 11.8% in the first quarter. Resource extraction remains sluggish due to a lack of investment in new fields and infrastructure. The sector grew by just 1.4% in the second quarter, after recording a lacklustre 2.4% growth in the first quarter. Another sector which continues to underperform is the agriculture sector, which grew 2.6% in the second quarter and 2.9% in the first quarter.

Real import and export growth % yoy

-40

-20

0

20

40

1991 1995 1999 2003 2007

—— Export Import Source: EIU

Industrial production growth % yoy

-10

-5

0

5

10

15

1996 1998 2000 2002 2004 2006 2008

Source: EIU

Russia


The construction and retail sectors are expected to continue to outperform due to further increases in overall wealth levels. The manufacturing sector might slow down furhter over the coming period, as the sector will eventually be negatively impacted by the loss in competitiveness caused by the continuous strengthening of the rouble. This will particularly affect those areas of manufacturing that are oriented to the export market or compete on the domestic market with imported goods. Current account surplus will diminish Despite strong import growth and a slight decline in oil prices in the second half of last year, the current account surplus rose further in 2006 to USD 94.5 billion, compared with USD 83.3 billion in 2005. For 2007 we expect a small decline in the nominal value of the surplus as imports continue to swell. This trend will continue in the coming years, but we do not foresee a current account deficit, at least up until 2010. Strong inflows of foreign capital will more than compensate for the lower current account surplus and foreign reserves will hence continue to swell. Figures for the first half of 2007 indicate that foreign capital continues to pour into the country. To a large extent, this is related to foreign borrowing by Russian corporates, but foreign direct investments are also surging. Total FDI inflows more than doubled in the first half of 2007 compared to the year-earlier period. FDI inflows amounted to USD 16 billion2, bringing the total amount of FDI to USD 81 billion. The Netherlands is the most important source of direct foreign investment with over USD 30 billion invested in Russia. Most of this is invested in the extraction industries. Cyprus, which is the major offshore banking centre for Russian corporates, is the second largest source of FDI. Rouble remains strong and inflation subdued The net capital inflow has led to a continuous strengthening of the rouble, which had a dampening effect on inflation, despite strong consumer demand. In March 2006, inflation fell below 10% for the first time since the start of the rouble crisis in August 1998. Inflation ended 2006 at 9%, precisely at the upper end of the central bank’s target. It fell to a low of 7.4% in March, but has since risen above 8%. We expect inflation to end 2007 around 8.5%, above the official inflation target, which is set between 6.5-8.0%. Interest rates were lowered by 50 basis points in mid-June to 10%, but there is little room for further cuts. In July 2006, the rouble became fully convertible, meaning that the remaining restrictions on capital account transactions were removed. As the balance of payments (current account plus capital balance) will remain in surplus, there will be continuous upward pressure on the exchange rate. Therefore, the central bank needs to continue maintaining a balance between efforts to reach its inflation target and heeding political pressure to keep appreciation of the currency in check. Clearly this is a difficult balancing act. Raising interest rates to stem inflation will only lead to more capital inflow and hence probably to even stronger upward pressure on the currency. The appreciation of the currency itself also attracts additional capital inflows and could thus lead to further appreciation. Another option is to further increase its reserve requirements as a loosening of fiscal policy in the run-up to elections makes it even more difficult for the central bank to achieve its inflationary targets. The one thing that

2 According to figures from RosStat

Real effective exchange rate against USD 1997=100

40

60

80

100

120

1995 1998 2001 2004 2007

Source: EIU

Inflation % yoy

0255075

100125150

1995 1998 2001 2004 2007

Source: EIU

Current account % GDP

0

5

10

15

20

25

1993 1997 2001 2005

Trade balance Current account Source: EIU/Economics Department

Russia


could exert downward pressure on the currency could be political uncertainty in the period surrounding the coming elections. However, the chances that this will lead to strong and prolonged currency volatility are small given the country’s huge international reserves and substantial current account surplus. Elections could pose some risks to our positive outlook Uncertainty about Russia’s political outlook after President Putin steps down at the end of his second term in 2008 represents a major threat to our forecast for the coming two years. Infighting among rival factions in the Kremlin that are competing for influence could give rise to political turbulence, and might even trigger some capital flight. However, the most probable scenario, given Putin’s formidable power base and his tremendous popularity, is that whoever he appoints will win the elections and carry on his policies. Although it is unclear whether this new president will be able to maintain the same powerbase as Putin, the very favourable current economic developments –particularly the extremely favourable external liquidity position – strongly mitigate the political risks. Therefore, as long as the oil price continues to prop up the economy and create growing prosperity among broader sections of the population, the current power base in the Kremlin is unlikely to be seriously threatened. The more relevant vulnerability, in our view, is therefore the fact that the government is using its oil wealth to avoid painful reforms and to expand its presence in the economy. Given the inefficiency of state-owned firms, this could constitute a long-term structural constraint on growth. Further, because both the institutions and the legal framework are very weak, many approved reforms are not being implemented. This, together with high and increasing levels of corruption, could become a serious constraint to further investments. SWOT analysis Though Russia is an extremely attractive market for investors, it is also fraught with pitfalls. The most common problems concern the complexity of the tax system, corruption, regulatory volatility, the lack of regulatory transparency, government bureaucracy, weak contract legislation, the absence of a commercial market and business ethos as well as the absence of a commercial law system. This means that deals must often be made on the basis of trust. Investors also frequently encounter financing difficulties and have problems obtaining payment from Russian companies3. Despite these problems, businesses and investors are increasingly finding their way to Russia. Western exports to and investments in Russia are steadily rising. Every day, new products and services are launched in the Russian market. The most important reason for this is the tremendous scope for entrepreneurship in this country. In the table below we have summarised the most important strengths and weaknesses as well as the respective opportunities and threats these may give rise to. As the economic strengths have already been addressed in our outline on the current economic situation and prospects, we will only very briefly summarise the strengths and emphasise the risks to our overall very benign picture of the Russian economy.

3 The Institute of Direct Investments Foundation has been set up by the Russian government to assist investors in Russia.

Short term interest rate year-end

010203040506070

1996 1999 2002 2005 2008

Source: EIU

Russia


Table : SWOT analyses of Russia

Strength: Weakness:

rich resource base

growing wealth

large domestic market

sound economic policy

Low sovereign debt levels

Sound external liquidity situation

fragile political situation

state interventionism

weak institutions and corruption

demographics, infrastructure,

education, and health

low degree of diversification

Opportunity: Threat:

deepening of financial markets

diversification of the economic base

development of SME sector

to improve transparency and corporate

governance

losing competitiveness

Lower oil prices

shrinking population

Source: ABN AMRO

Strengths Russia’s current strength is related to the fact that its rich resource base and favourable commodity prices – in combination with sound economic policies – have enabled the country to lower its sovereign debt to less than 10% of GDP and dramatically improve the external liquidity situation. This makes the country much less vulnerable to adverse internal or external developments. Although we expect that both the fiscal and the current account surplus will diminish rapidly in the coming years, the low levels of government debt and huge international reserves will cushion the economy for a long time from a possible change in investor sentiment. The oil boom has also led to a strong increase in wealth, which, given the size of the population, also makes Russia very attractive as a retail market. Weaknesses Fragile political situation The country’s present political stability has, in part, been achieved at the expense of progress in democratic development, which could in turn set the stage for longer-term instability. The biggest short-term threat to the benign risk environment is related to the question of what will happen after president Putin's second term ends in 2008. The concentration and centralisation of power in the hands of the president could result in instability in the longer run, regardless of who wins the elections. This is even more likely if the relationship between politicians and the private corporate sector further deteriorates as this could hamper future investment growth. This scenario could also have a strong negative impact on the allocation of scarce resources, impeding healthy economic development and leading to strong inefficiencies. But as we stated previously, as long as oil prices stay high and the economy continues to grow, the political risks are strongly mitigated. Another risk related to the concentration of power among only a few individuals is that the sudden death of the president could have a strong negative impact, especially if it leads to political infighting among different factions in the Duma and the country’s different regions, which now are firmly under state control. These risks range from increased fiscal instability in the regions to a rise in terrorist activities.

Russia


State interventionism In the long run, the increasing discretionary role of the state in society and the economy has several distortionary impacts. Inefficiencies in state-controlled sectors are likely to grow and corruption will rise. In addition, private business that is no longer supported by the government could suffer strongly. Weak political, legal, and economic institutions There has been rapid legislative reform since the election of President Putin, but enforcement is still a major problem due to weak institutions and a weak legal framework. This is also true for the intellectual property legislation that was passed in 2002 as Russia makes its bid to join the WTO. The lack of enforcement severely hinders the investment climate, which is also negatively impacted by the high and rising corruption levels. Russia currently ranks 121 out of 158 countries in the Transparency International Corruption index 2006. Demographics, education, health, housing and infrastructure Years of underinvestment have resulted in a dilapidated infrastructure and inadequate education and health system. Decent, affordable housing remains an important issue as well, as it hampers the movement of labour from the agricultural sector to more productive sectors of the economy. Government investments are still clearly insufficient, and increased spending in these areas is urgently needed in order to maintain a strong human capital base. This should diminish the risks related to the negative demographic trend of a rapidly declining, and rapidly aging, population. Now that the foreign sovereign debt levels have declined to the extent that Russia has become a net creditor, it could be argued that part of the stabilisation fund could be used for such government investments. This would help further bolster political stability. Russia’s poor infrastructure is a major impediment to trade. Several major projects are being carried out to improve its infrastructure with financial support from the World Bank and the European Bank for Reconstruction and Development (EBRD). The aim is to upgrade the road network as well as modernise the ports and airports. Only 9 per cent of the total freight volume is transported by road, as most of the reasonably good roads are located in the European part of Russia and only in the proximity of its larger cities. In the rest of the country, the road network is less developed. Nearly 40 per cent of the villages have no access via paved roads. The rail network is also in very poor technical condition, while the numerous ports and waterways are often poorly located or lack facilities for the transshipment of large volumes of goods4. Opportunities Deepening of financial markets The financial sector is developing rapidly. The market for consumer credit and mortgages as well as the rise of the corporate bond market are particularly encouraging. The reduction in borrowing costs was very helpful in enhancing credit growth as were improvements in the regulation of the banking sector in recent years and the introduction of deposit insurance. Nevertheless, the sector is still far from

4 For example a large portion of agri-food products destined for West Russia is transported via ports in Western Europe or the Baltic states because the ports in Russia lack the required facilities.

Russia


offering the full range of modern instruments needed to support a dynamic corporate sector. The Russian banking sector also remains relatively small, weak, and segmented. Given continued scarcity of skilled bank personnel and substantial non-transparency with respect to the operation and ownership of domestic corporations, there is inadequate means to assess the creditworthiness of clients. This increases the share of bad loans. There is no legislation to protect the banks against delinquent customers. Meanwhile, the public—the potential customers—still distrust banks, but instead prefer to keep their savings in cash. This hampers the proper working of financial intermediation in the economy. Development of the sector would clearly further enhance the economy’s growth prospects. The development could be facilitated by eliminating inconsistencies among different laws and codes, and clarifying responsibilities among the various agencies charged with overseeing the sector. Diversify the economic base To further broaden the base of economic development it is important to stimulate investments in other sectors as well as development of the SME sector. The latter is especially important, as a well-developed SME sector increases competition and is an important source of jobs and a generator of innovations. This would also be a better stimulus for achieving the government’s aim of stimulating innovation than the current trend towards more centralisation. Improve transparency and corporate governance More and more Russian companies are listed abroad. Although there are no guarantees, this will very likely expose Russia more to "international" standards (including increasing transparency and corporate governance) and will create a certain integration between Russian and Western(-European) Financial Markets. Threats Sharp fall in world oil prices A sharp drop in world market oil prices would severely slow the pace of the Russian economy’s expansion and increase all other risks. But as long as oil prices remain high and above USD 40 a barrel, most short and medium-term risks remain limited. Dutch disease development A sharp fall in the oil price is not the only risk; high oil prices also pose a threat to sound future economic development. Oil dependence makes the country vulnerable and creates uneven development. During the Soviet era the economy was relatively well diversified. But since the fall of the centrally planned communist system, import demand has started to rise at the expense of domestic production. This process accelerated when the oil boom began. Russia’s strong currency has worsened its competitive position, which was greatly enhanced by the mega rouble devaluation in 1998. As a consequence, diversification has diminished at the expense of the energy sector. So far, the shift in concentration of economic activity out of the labour-intensive manufacturing sector into the capital-intensive oil and gas sector has largely been compensated by strong employment growth in the services sector and construction, but this could come to an end when the country’s development reaches a more mature stage.

Russia


Demographics The Russian population is dwindling and – due to low birth rates in the late Soviet and transition eras – is rapidly aging as well. This could lead to labour shortages and pension problems. In addition to this negative demographic trend, the technological basis of higher education has been depleted since the fall of the Soviet Union, resulting in a lack of good technically skilled employees.

Russia


Chapter 2: Russia’s Minerals & Mining Industry This chapter describes Russia’s non-fuel mining industry, i.e. excluding coal, oil, natural gas and uranium mining. Oil and natural gas will be discussed in the next chapters. The importance of the sector to the Russian economy The non-fuel mining industry (including the further processing of ores) is of vital importance to Russia’s economy. Russia has a long mining tradition and is currently one of the world’s leading producers and exporters of minerals and mineral-based products. Blessed with vast resources, the country is a major producer of aluminium, cobalt, copper, diamonds, gold, iron ore, mica, nickel, platinum, potash, tin, titanium and zinc. In addition, many other metals and various industrial minerals are mined. The country’s most important regions for metals mining are East Siberia, the Kola Peninsula, the North Caucasus, the Russian Far East and the Urals. Mining conditions in some of these regions are harsh. Following the collapse of the Soviet Union in 1991, it became clear that the Russian mining industry – which is almost exclusively state-owned – was in a poor state due to years of underinvestment and lack of maintenance. Low labour productivity, high energy use and, at times, low product quality resulted in decreasing competitiveness in the world market. The transition from a centrally planned economy to a free market system in the early 1990s affected domestic demand for many basic metals and industrial minerals. By 1998, Russia’s industrial production had fallen to 45% of its level in 1990. One positive effect of the slump in domestic demand was that substantial volumes became available for export, resulting in a rapid increase in the export of minerals and metals. The sector’s poor performance and the free market economy caused the collapse of several large state mining companies, while private mining companies began to emerge. Meanwhile, small mining and metals companies closed down or merged, thereby creating larger and financially stronger companies. This reconstruction was necessary in order to survive against a backdrop of lower global commodity prices at the end of the 1990s and the 60% depreciation of the Rouble in 1998. However, the resulting capacity rationalisation was a major positive effect of the turmoil hitting the industry. The transition of the Russian mining industry also brought about major job losses and many miners left their regions to find work elsewhere. Privatisation was used to bring in Western know-how, technology and the much-needed foreign capital to upgrade the industry. However, many Western companies were still reluctant to invest in the Russian mining sector as a result of its negative image due to the unreliable legal system, problems with subsoil licensing, doubtful reserve classification and high federal and local taxes. Although some of the problems were overstated by the media, the Russian Government has recognised the need to improve foreign investment conditions and bring legislation up to world standards.

Russia


Exploration spending in the global mining sector Exploration is the key element in unlocking new reserves and increasing a mining company’s reserve base. Data from the Metals Economics Group (MEG)5 show that, after the peak in 1997, global exploration spending in the non-ferrous mining sector started to decline. The reasons for this decline were the low price environment and falling investor confidence in the mining sector. As a result, less capital was available for the mining sector while the more promising dot.com sector attracted huge capital flows. At the turn of the century, the combined market value of quoted mining and metals companies (representing real ‘bricks and mortar’) is said to have fallen to only about half the value of Microsoft. After bottoming out in 2002, global exploration spending began to boom once again from 2004. This type of boom-to-bust cycle is typical for the mining sector. Key drivers for the sector are global economic growth and, in particular, demand growth in the manufacturing, construction and infrastructure sectors. The current boom is based on a combination of: • years of underinvestment since the Asian crisis in 1998; • lagging reserve replacement, a key issue for the mining industry; • surging demand, particularly from the emerging economies of India and China. Metals and minerals consumption per capita in India, China and other developing countries is still low compared to consumption levels in developed countries. This implies that there is considerable scope for sustained high demand growth over the medium term as long as economic growth in these countries remains relatively high. Total global exploration spending was estimated at USD 7.13 billion in 2006, up by USD 2.2 billion (45%) from 2005. Although gold and diamond exploration spending still represents a major part of total spending, most of the increase can be attributed to base metals exploration spending. Canada, Australia and the US traditionally head the list of top ten countries, together accounting for 38% of total global exploration budgets. Since 2004, Russia has quickly moved up the top ten list, jumping from seventh place in 2005 to its current fourth place spot. In 2006, Russia accounted for 5% of global exploration spending. Expansions are usually the preferred method of reserve replacement over grassroots discoveries. A major reason for this is that grassroots projects take an average of 7-10 years from initial discovery to production. According to MEG’s survey, there is currently a clear trend towards late-stage/feasibility exploration budgets, which outpace the increases in grassroots projects. In the present price environment, with most metals at 15 to 20-year highs, several dormant, abandoned or technically difficult projects are now being re-assessed for near-term development.

5 The 2006 data collected by MEG are based on an analysis of 1,624 international nonferrous mining companies with exploration budgets of at least USD 100,000. MEG is a world leader in mining industry intelligence and a provider of information and analysis on global nonferrous metals exploration, development and production. MEG’s data are widely used by the mining industry and by governments to analyse trends and formulate policies.

Distribution of worldwide exploration budgets in 2006, USD 7.13 billion

Canada

Australia

United States

Russia

Others

MexicoBrazil

MongoliaChina

South Africa Peru

Source: Metals Economics Group

Worldwide nonferrous exploration spending USD bln, 1994-2006

0

2

4

6

8

1995 2000 2005

Source: Metals Economics Group

Russia


The data collected by MEG show that over the past few years the so called ‘junior exploration companies’6 have significantly outpaced larger mining companies in exploration spending growth. Although this can partially be explained by the focus of junior exploration companies on gold mining, they are also looking for opportunities in other commodities. In 2006, the junior exploration companies accounted for about 50% of total global exploration spending. It is becoming increasingly difficult to find economically viable metal ore and mineral deposits as most of the ‘low-hanging fruit’ has already been discovered and developed. Therefore, it will take considerably more capex to discover, explore and develop new grassroots deposits than in the past, particularly when local infrastructure is lacking. As a result, the expansion of supply will continue to struggle to keep pace with the expected continuing growth in demand. Growing demand for mining equipment MEG’s survey of exploration budgets indicates a sustainable revival of the global mining industry. However, one should realize that a substantial part of the increase in exploration spending over the past few years can be attributed to cost inflation. Since the trough in 2002, there have been significant cost increases in wages, services and mining equipment. Therefore, the amount of real capital invested in 2006 may be much smaller than the survey indicates. The revival of the exploration market and the development of new deposits will be key drivers for mining and processing equipment market. According to a recent study7 by The Freedonia Group, global demand for specialised mining machinery and equipment is forecast to increase 9.3% per year through 2009 to USD 27.5 billion. Freedonia expects Eastern Europe to offer the best regional prospects due to the long period of underinvestment and the region’s extensive mineral resources. Despite the recent turnaround in the fortunes of the global mining industry, the sector still faces many challenges. Considerable equipment cost inflation and the lack of human resources are not the only problems hindering production and capacity growth. Some projects are encountering environmental oppositions, technical problems or cost overruns. In addition, the availability of equipment is currently causing stress in the mining sector, leading to project delays. Medium-term outlook The medium-term outlook for Russia’s minerals and mining industry looks rather promising, considering the global supply/demand trends. The industry has profited from increasing global demand and rising prices since 2002, which has stimulated increased production.

6 Junior exploration/mining companies are small to medium-sized companies involved in early-stage mining projects. Their exploration expenditures vary from USD 50,000 to 1,000,000. Because they have no cash flow (i.e. no income from an operating mine) and their assets consist of exploration properties, their capital needs cannot be satisfied through normal financing channels. The capital for mineral properties, exploration, plant and equipment is raised through the issuing of shares. Investors consider junior mining companies ‘high-risk/high-reward plays’. Many are listed on the Canadian TSX Venture (TSX-V) Exchange or London’s Alternative Investment Market (AIM). 7 World Mining Equipment, World Industry Study with Forecasts to 2009 & 2014. The Freedonia Group, Inc., April 2006.

Acute shortages constrain the equipment supply side

Item Normal delivery time (months)

Current delivery time (months)

Grinding mills 20 44 Draglines 18 36 Barges 24 32 Locomotives 12 26 Power generation 12 24 Wagons 12 24 Rope shovels 9 24 Reclaimers 18 24 Tyres 0-6 24 Large haul trucks 0-6 24 Crushers 15 24 Ship Loaders 8 22 Source: Rio Tinto, Outlook for Metals and Minerals

Russia


Like many of their competitors elsewhere, Russian companies are also being confronted with the depletion of their high-grade ore deposits. They will have to develop new deposits in order to meet both increasing indigenous demand from the manufacturing sector and from exports. The potential for mineral exploration in Russia has been recognised by several large Western companies, such as Anglo American, AngloGold Ashanti, BHP Billiton and Rio Tinto. In recent years, several alliances and joint ventures have been announced with Russian companies to explore and develop attractive mineral deposits. Most of these joint ventures will develop greenfield mineral deposits in certain areas, such as western Siberia and the north-western part of Russia. Junior exploration companies are also likely to play a role in the development of these deposits. The successful development of a deposit could make these junior mining companies more attractive for acquisition by larger (‘senior’) mining companies, as this increases their reserves and production base. Opportunities in mining equipment, services and systems Despite its production potential, the Russian minerals and mining sector still faces major problems, such as ageing equipment. In 2000, about 80% of Russia’s mining machinery was near the end of its operable life and in need of urgent replacement. Although there have been some improvements since, many mining companies are still using outdated technologies from the Soviet era. According to estimates, 30-70% of Russia’s minerals reserves are not economically exploitable. Major investments will be needed to reach Western standards of product quality, pollution control, energy use per unit of output and labour productivity. Moreover, new mineral deposits will have to be developed to meet the ever-increasing demand and compensate for the depletion of existing deposits. Vast investments will therefore be required in the coming decade, offering significant opportunities for Western companies involved in exploration and development, and for suppliers of control systems, logistics, mining technology or mining equipment. Medium-sized companies will be particularly interested in optimising mining and plant operations through advanced process control systems, and minimising the idle time of mining equipment through better coordination with the transport system. Even large mining companies tend to contract specialised companies for services that require certain expertise. Automation of mining equipment is also an important issue in modern mining operations, particularly in underground mining. Automation considerably improves both productivity and safety. Some Russian mining companies have poor safety and environmental records, and automation could surely help them improve safety, health and environmental (SHE) conditions. A consistently good SHE performance is increasingly becoming a prerequisite to sell to Western customers.

Russia


Chapter 3: The Russian Oil Industry Oil reserves Russia’s proved oil reserves amounted to about 79.5 billion barrels as at year-end 2006, accounting for 6.6% of the world’s total proved reserves (BP estimate). Most of these oil reserves are located in four oil provinces: Western Siberia, Volga-Ural, Timan-Pechora and Northern Caucasus. In addition, the country has roughly the same level of probable and possible oil reserves, putting this non-OPEC country in the top league of oil-producing nations that includes OPEC members like Saudi Arabia, Iran, the UAE and Venezuela. According to BP, Russia’s R/P ratio was 22.3 at year-end 2006, i.e. its proved reserves can sustain its 2006 production level of 9.77 million bpd for 22.3 years. Oil production In the 1980s, the Soviet Union became a major world oil producer due to the development of the Western Siberia region (also known as the ‘Russian Core’). Peak production reached 11.4 million bpd (barrels per day) in 1987. Following the disintegration of the Soviet Union in 1991, Russian oil production fell over the subsequent years to bottom out at 6.1 million bpd in 1996. Oil production then stabilised at this level for several years. The production decline can be attributed to several factors: the collapse of the central planning system, the depletion of major fields due to excessive production targets and insufficient attention to matters such as infrastructural development, enhanced oil recovery techniques, maintenance and energy-saving measures. The turnaround for Russia’s oil production came in 1999. In 2000, Russian oil production showed an increase of almost 360,000 bpd, a rise of 5.8% over the previous year. This turnaround can be attributed to the introduction of Western technologies and the re-engineering of oil fields in Western Siberia. Another driver was the sector’s privatisation, leading to better management and new field developments. Yukos and Sibneft played an important role in the production increase by using Western-style production methods. Russia’s oil production (crude oil plus condensates) amounted to 9.77 million bpd in 2006, with the ‘big four’ Lukoil, Rosneft, TNK-BP and Surgutneftegaz accounting for 64.5% of total production. Oil production in 2006 showed an increase of 2.2% over 2005, the lowest growth rate seen since 1999 when oil was still at USD 10 per bbl (barrel). This represents a marked slowdown from the 8-10% annual growth rate seen in the 2001-2004 period. In fact, Russia was the motor for global oil supply growth in 2001-2004, accounting for 50-75% of non-OPEC supply growth during those years. Oil exports Russia has a vast integrated oil transportation system, which handles both crude oil (mostly Urals blend) and refined products. The pipelines, which were in urgent need of repair in the 1990s, have since been substantially upgraded. The pipeline network consists of more than 60,000 km of long-distance pipelines, local oil pipeline networks and several export pipelines, the most important of which are ‘Druzhba-1’ and ‘Druzhba-2’.

Russia’s major oil producers (production x mln tons)*

Company 2005 2006 Lukoil 87.81 90.42 Rosneft 74.42 81.71 TNK-BP 75.35 72.42 Surgutneftegas 63.86 65.55 Gazprom Neft 33.04 32.72 Tatneft 25.33 25.41 Slavneft 24.16 23.30 Yukos 24.52 21.53 Russneft 12.18 14.76 Gazprom 12.79 13.40 Others 36.44 39.31 Total 469.90 480.53 * incl. gas condensates Source: Gazprom Neft

Regional distribution of proved oil reserves at year-end 2006, 1,208 bln bbl

Saudi Arabia

Other Middle EastS&C

America

Africa

Russia

Other Europe

IranNorth

America

Asia Pacific

Source: BP Statistical Review of World Energy June 2007

Regional distribution of oil production in 2006 81.66 mln bpd

Saudi Arabia

Iran

Other Middle East

North AmericaRussia

Other Europe

Africa

S&C America

Asia Pacific


Oil production and consumption in the Russian Federation (mln bpd)

0

3

6

9

12

1985 1990 1995 2000 2005

—— Production Consumption

Source: BP Statistical Review of World Energy

Russia


Over 70% of Russia’s crude oil production is directly exported, while the remaining 30% is refined locally. Most of Russia’s oil exports are transported via pipelines (overland to other countries or to export terminals at ports). About 35% of Russia’s crude oil exports are still shipped via higher-cost railroad tankers and river barges due to pipeline bottlenecks. Some of the crude oil export capacity deficit is handled by exporting refined petroleum products to Europe, mostly fuel oil and diesel fuel. Traditionally, exports are primarily transported overland via the Druzhba trunk pipelines into Central Europe and by sea via the Black Sea ports of Novorossiysk, Tuapse and Odessa, and via the Baltic port of Ventspils and several other ports in the Gulf of Finland. The Baltic Pipeline System (BPS), which came on stream in December 2001, transports oil from the West Siberian and Timan-Pechora oil fields westward to a new terminal at the Russian Baltic port of Primorsk, diverting the flow from the Latvian port of Ventspils. The final stage of the BPS was completed in 2006. In 2006, about 85% of Russian crude oil exports went to non-CIS countries. Major destinations were Germany, Italy, France and the Netherlands. The remaining 15% mainly went to CIS countries. The Russian oil pipeline system is very inefficient due to inept management, and is often troubled by reliability and environmental problems. Over 90% of the system is owned and managed by Russia’s state-owned monopoly Transneft. The tariffs charged by Transneft for use of its pipelines are based on distance. In order to maintain control over oil exports, Transneft has so far opposed deregulation of the pipelines. In October 2005, a new export tax system was introduced to stimulate crude oil production growth by capping the export tariff rate. The unintended side-effect was a shift toward exports of refined products at the expense of crude oil exports. This was mainly due to the fact that under the new tax system, the tax on refined products has declined relative to the crude oil tax. For Urals at USD 40/bbl the difference for light products is about USD 2.8/bbl, but for Urals at USD 60/bbl, the difference is about USD 7/bbl. The differences in taxation have more than offset the higher transportation and other costs involved in the export of refined products. Oil production and export outlook Russia’s oil production is forecast to continue its upward trend. The International Energy Agency (IEA) expects Russia’s oil production to rise by 2.4% in 2007, slightly higher than the production growth of 2.2% seen in 2006. For the medium term (2007-2012), the IEA expects Russian oil production to continue to grow, albeit at a slower pace compared to the period 2001-2006. This lower growth rate reflects the fact that several major oil fields are showing signs of maturity as well as the difficulties encountered in compensating for the decline by developing new fields. As domestic demand is expected to increase less rapidly than production, this leaves room for increasing exports of crude oil and refined products. According to the IEA, Russia’s exports will start to gradually decline soon after 2010 when domestic demand outstrips the increase in production. IEA’s overall conclusion is that these production and export trends will remain highly sensitive to politics and taxes and may, therefore, differ substantially from the current scenario.

FSU net exports* of crude oil and petroleum products (million bpd)

2004 2005 2006 Crude oil seaborne 3.96 4.05 4.07 Druzhba pipelines 1.10 1.15 1.20 Other pipelines 0.23 0.25 0.38 Total crude exports 5.29 5.45 5.64 - of which Transneft 3.76 4.04 4.09 Exports petroleum products 2.19 2.38 2.51 Total exports 7.48 7.83 8.16 Source: IEA Monthly Oil Market Report

Sources of crude oil exports in 2006 38.81 mln bpd

Middle East

North America

S&C America

FSU

Other Europe

Africa

Rest of world


Differential Crude oil Urals Med. vs dated Brent USD per bbl

-8

-6

-4

-2

0

2

00 01 02 03 04 05 06 07


Russia


The medium-term outlook for Russia’s oil production growth is highly uncertain, mainly due to the fact that seismic data are neither transparent nor made externally available. Oil analysts have also pointed out the lack of exploration in potential production areas over the last decade. The key factor determining Russia’s future level of oil production essentially depends on how long Western Siberia’s current production can be maintained while new reserves are meanwhile put into production to offset the decline in maturing or post-peak fields. According to a study by John Grace ‘Russian Oil Supply’ (Oxford Institute of Energy Studies) about 20% (1.8 million bpd) of Russia’s oil production in 2004 came from fields that had cumulatively produced 80% of their total recoverable reserves. Attention is therefore likely to shift to less mature basins such as Timan-Pechora, and to frontier areas such as Eastern Siberia and Sakhalin. However, the development and production costs for such ‘greenfield projects’ are expected to be much higher than for existing ‘brownfield projects’ in Western Siberia. Government taxation and the lack of clarity regarding subsoil resources ownership will continue to create uncertainties. In this type of environment, it will be quite difficult to achieve sustained production growth. The key to Russia’s future oil production growth will be the availability of viable export routes via pipelines. Alternative methods of exporting oil (by rail or barge) are far more costly than shipment via pipelines. Both Transneft and the Russian government have acknowledged the future capacity problem and have introduced incentives to develop new export infrastructure. This export infrastructure will also take into account the growing demand for oil in the North East Asian market, which has so far been a limited target for Russian oil exports. A major project aimed at increasing oil exports to the North East Asian market will be the 4,200-km Eastern Siberia-Pacific Ocean (ESPO) pipeline, which was approved in December 2004. Many problems had to be solved before construction could start, such as the possible connection with China, the sourcing of the oil and the financing of the pipeline with an estimated cost of USD 7.0 billion for the first section and USD 6.0 billion for the second section. There were also environmental concerns related to Lake Baikal (a UNESCO-protected site) and Perevoznaya Bay (a sensitive area for whales). In the meantime, environmental and safety problems have been solved, but total construction costs may be double the initial estimate when both sections are completed. The first 2,800-km section of the ESPO pipeline, owned by Transneft, is expected to be completed by December 2008, with the second section to be finished in 2010. The route has been amended and the pipeline now passes 200 km from Lake Baikal. The pipeline is designed to deliver 80 million tons/year (1.6 million bpd) of Siberian oil to China and Asia-Pacific countries.

Pre-peak Russian oil fields (1,000 bpd), 2004 Field Owner Production Depletion* Priobskoye Rosneft 437.5 8% Tevlin-Russinkoye Lukoil 241.0 45% Tyanskoye Surgutneftegaz 191.1 20% Sugmutskoye Gazprom 191.5 44% Sporyshefskoye Gazprom 107.5 44% Total 1,168.6 * cumulative depletion Source: EIA, Country Analysis Briefs, Russia April 2007, based on John Grace’s study Russian Oil Supply

Post-peak Russian oil fields (1,000 bpd), 2004 Field Owner Production Depletion* Samotlor TNK-BP 974.1 71% Romashkino Tatneft 295.5 84% Momontovskoye Rosneft 251.5 82% Federovskoye Surgutneftegaz 456.3 67% Lyantorskoye Surgutneftegaz 168.2 81% Pravdinsko-Salymskoye

Khantymnasiysk-neftegaz

119.4 27%

Povkhovskoye Lukoil 112.1 95% Arlan Bashneft 75.0 91% Total 2,452.0 * cumulative depletion Source: EIA, Country Analysis Briefs, Russia April 2007, based on John Grace’s study Russian Oil Supply

Russia


Chapter 4: The Russian Natural Gas Sector Natural gas reserves Russia has the world’s largest proved natural gas reserves, totalling 47.65 trillion cubic metres (tcm) at year-end 2006 or 26.3% of the world’s total proved reserves (BP estimate). Russia‘s R/P ratio was 77.8 at year-end 2006, i.e. its proved gas reserves can sustain its 2006 gas production level of 612 billion cubic metres (bcm) for 77.8 years. Gazprom’s reserve estimate for Russia at year-end 2006 was 47.85 tcm. These reserves are in the Russian A+B+C1 ‘proved’ or ‘commercial grade’ category of reserve classification, comparable to the international ‘proved plus probable’ or 2P category. Iran, which has the world’s next largest reserves, has about 28.1 tcm. In addition to these proved reserves, Russia has more than 30 tcm of undiscovered gas resources (U.S. Geological Survey estimate, 2000). Some 20 giant fields have been discovered, each with more than 500 bcm in gas reserves; so far, only seven of these fields have been brought into production. Around 80% of Russia’s gas reserves are located in Western Siberia, mainly in the Nadym-Pur-Taz (NPT) region where several giant fields were discovered in the 1960s. Three major fields Urengoye, Yamburg and Medvezhye (the ‘Big Three’) still account for the majority of the country’s gas production, although these mature fields are now in decline. Significant natural gas reserves are also found offshore on the shelf of the Barents Sea and Pechora Sea, in Eastern Siberia and in the Timan-Pechora region. Natural gas production In 2006, Russia accounted for 21.3% of global natural gas production. Russia’s gas production is largely controlled by state-owned Gazprom, the world’s largest gas company. Gazprom owns and operates the 156,900-km network of high-pressure gas trunk pipelines. The company also owns 25 underground gas storage facilities in Russia, with a total of 63 bcm of gas stored in 2006/07. These storage facilities are important in matching supply with seasonal demand fluctuations. Via its ownership of Gazprom, the Russian government controls about 85% of the domestic gas production. However, the Russian gas sector has largely retained its centralised Soviet structure dating back to the 1980s. Although the restructuring of the gas sector has been high on the government’s agenda for some time, the move was blocked by President Putin. After the collapse of the USSR, domestic gas production fell sharply in response to lower domestic demand. Russian gas production peaked in 1991 at 600 bcm and bottomed out to 533 bcm in 1997. Production was flat for several years, but the turnaround came in 2002. In 2006, Gazprom accounted for about 85 % of total gas production in Russia, while oil companies and independent gas producers accounted for the remainder. The recent increase in production can be largely attributed to the independent gas producers, the largest of which is currently Novatek (with gas production of 28.6 bcm in 2006). These ‘independents’ are mostly private companies that – unlike Gazprom – have managed to increase their gas production, filling the gap between domestic gas supply and demand.

Gas reserve structure in Russia at end 2006 Volume (tcm) Share (%) Gazprom (controlled reserves) 29.85 62.4 Independent producers 10.20 21.3 Undistributed fund 7.80 16.3 Total 47.85 100 Source: Gazprom

Russia’s gas production by oil majors, bcm Company 2005 2006 Surgutneftegas 14.36 14.62 Lukoil 5.80 14.11 Rosneft 13.05 13.56 TNK-BP 6.45 8.65 Gazprom Neft 1.99 2.05 Yukos 1.97 1.89 Others 4.37 2.01 Total oil majors 47.99 56.89 Independents, Gazprom 545.04 599.34 Total Russia 641.02 656.23 Source: Surgutneftegas

Regional distribution of proved gas reserves at year-end 2006, 181.5 tcm

Qatar

Iran

Other Middle East

AfricaAsia Pacific

Russia

Other Europe

S&C America

North America


Regional distribution of gas production in 2006, 2,865 bcm

Russia

Iran

Saudi Arabia

USANL

Others

Norway

Indonesia

UK Canada

Algeria

Source: BP Statistical Review of World Energy 2007

Russia


Nearly a quarter of the gas production by independents is still being flared. This is largely attributed to the unprofitable gas processing and sales conditions for these producers compared to Gazprom. In most cases, these other producers have to sell gas to Gazprom, or Gazprom has to provide access to its Unified Gas Supply System (UGSS) to enable them to deliver gas to non-Gazprom buyers. Gazprom’s control over the Russian gas market is likely to change due to the long-expected policy shift towards gas market deregulation, necessitated by growing market imbalances. In November 2006, the Russian government approved proposals for the liberalisation and price deregulation of the domestic gas market. The proposed system should result in a better supply/demand balance for the domestic gas market due to the introduction of a new pricing system and the introduction of long-term pay-or-take contracts. The regulated market segments (households and utilities) will see quota-based deliveries with inflation-adjusted prices. Gas prices for industrial consumers and power generators (about 70% of the domestic market) will be determined by export netback parity, which is scheduled to be reached by 2011. These price hikes will create an economic incentive to improve energy efficiency, offer opportunities for independent gas producers and the monetisation of associated gas that is often still being flared. In addition, the new gas policy encourages non-regulated gas trading. Mezhregiongaz (a wholly-owned subsidiary of Gazprom) has set up an electronic trade board, which enables Gazprom and independent suppliers to sell gas at free market prices. Trading has been conducted on a monthly and ten-day-period basis since February 2007. Spot prices have often exceeded the regulated gas prices by 30-40%, reflecting the increasing dynamics of the Russian domestic gas market. Natural gas exports Gazprom has a monopoly on all gas exports outside the Commonwealth of Independent States (CIS). Via its subsidiary Gazexport, the company is the leading supplier of natural gas in the European gas market. Russian gas supplied to Europe is mainly sold on the basis of long-term contracts. In addition, Russia exports significant volumes of natural gas to customers in the CIS. CIS republics, such as Belarus, Georgia, Moldova and Ukraine have been offtakers of Russian gas for many years. These supplies were paid for at the expense of Russian citizens, who sometimes experienced supply disruptions due to these exports. Moreover, the CIS republics were charged only a fraction of what European offtakers paid for Russian gas despite the serious non-payment problems with the CIS republics. The Western CIS states (especially Belarus and Ukraine) are still important to Gazprom as transit countries to Central and Western Europe, its main markets. In 2006, Western Europe imported about 25% of its gas needs from Russia. Other major non-EU suppliers are Statoil/Petoro (Norway) and Sonatrach (Algeria). Gas exports to Europe provided 60% of Gazprom’s gas revenues in 2006, but represented only 28% of its gas sales volumes. This was due to the continuing marked difference between the gas prices realised in the European export market compared to Gazprom’s other markets. The European gas price in 2006 was RUR 5,238.5 per 1,000 cubic metre (excluding excise tax and customs duties), compared to only RUR 1,125.4 per 1,000 cubic metre (excluding VAT and excise tax) in the Russian market.

Gazprom’s natural gas sales to CIS and Baltic countries, 2005 and 2006 (bcm)

Country 2005 2006 Ukraine 37.6 59.0 Belarus 19.8 20.5 Kazakhstan 4.0 6.5 Azerbaijan 3.8 4.0 Lithuania 2.8 2.8 Moldova 2.8 2.5 Georgia 1.4 1.9 Armenia 1.7 1.7 Other 2.7 2.1 Total 76.6 101.0 Source: Gazprom Annual Reports

Gas production and consumption in the Russian Federation (bcm)

150

300

450

600

750

1985 1990 1995 2000 2005

—— Production Consumption Source: BP Statistical Review of World Energy June 2007

Increase in Russian domestic gas prices in 2007-2011, USD per 1,000 cu m

020406080

100120140

H1 2007 H1 2008 H1 2009 H1 2010 H1 2011

Source: Institute of Energy Policy, Moscow

Russia


In 2006, Gazprom’s gas sales revenues in the CIS and Baltic states increased by 93.5% compared to 2005, mostly due to the 46.7% increase in the average sales price to RUR 2,077.4 per 1,000 cubic metre (excluding excise tax and customs duties). This price increase forms part of Gazprom’s strategy to adjust the contractual terms and conditions to levels similar to those for exports to the European countries. In exchange for a gradual transition to more market-related prices in these countries, Gazprom has stated its goal of gaining access to ultimate consumers through participation in gas assets. Gazprom has ambitious plans to expand its activities in Europe as well, via joint ventures (for instance in gas transport companies) and the acquisition of distribution companies. Over the past few years, Gazprom has acquired shares in over 40 European gas transport and distribution companies, but this strategy has sometimes met with strong opposition. One example was Gazprom’s bid for Centrica, the UK’s biggest gas supplier. When several European countries expressed concern about Gazprom’s take-over plan, the company warned that it could redirect supplies to other markets, such as North America and China. Natural gas production and export outlook Over the next few years, Gazprom and independent producers will need to bring several new fields on stream to compensate for declining production from the ‘Big Three’. Gazprom expects production from these fields to decline by 7-8% a year over the next few years. The company has indicated that it prefers to develop new fields rather than trying to sustain the production levels of the ‘Big Three’. The cost of developing new gas fields, all of which are located within the harsh Artic zone, is estimated at USD 30-40 billion excluding the necessary infrastructure. This is the major reason that Gazprom will give priority to the development of a number of smaller fields in the NPT region. As these fields are in the vicinity of the super-giants, the existing pipeline infrastructure can be used. This allows Gazprom to take advantage of the spare capacity in the existing pipeline system running from the NPT region. Recent exploration in the region has indicated that there is still a large number of smaller fields with substantial potential. Although some of the gas reserves are in the ‘yet-to-find’ category, the gas reserves with economic potential in the NPT region could add another 100 bcm to the annual supply in the near future. Gazprom’s production is forecast to show only modest growth (1.0-1.5% per annum) over the next few years. This reflects the change in the company’s medium-term strategy. Gazprom is shifting its focus away from increasing its overall upstream production toward investments in midstream and downstream, both at home and abroad, moving closer to its European customers. Most of Russia’s gas production growth will therefore have to come from other companies (oil companies and independent gas producers), giving them a substantial window of opportunity as Russian domestic demand is also expected to increase. Supply from these independents is forecast to increase from 105 bcm in 2006 to over 200 bcm in 2015. European gas demand is forecast to continue rising by about 3% (12-15 bcm) per annum. As European domestic gas production is soon likely to enter a phase of decline, the EU’s dependency on gas imports will rise from 57% in 2005 to 83% by 2030. This provides considerable scope for increasing Russian gas exports, which will

Average gas prices FSU and Europe (RUR per 1,000 cu m)

0100020003000400050006000

2002 2003 2004 2005 2006

—— FSU Europe Source: Gazprom

Gazprom's production outlook (bcm)

0100200300400500600700

96 1 2 3 4 5 6 10F 20F

Source: Gazprom

uncertainty range

Gazprom’s natural gas sales to European countries, 2005 and 2006 (bcm)

Country 2005 2006 Germany 36.0 34.4 Italy 22.0 22.1 Turkey 18.0 19.9 France 13.2 10.0 Hungary 9.0 8.8 United Kingdom 3.8 8.7 Poland 7.0 7.7 Czech Republic 7.4 7.4 Slovakia 7.5 7.0 Austria 6.8 6.6 Romania 5.0 5.5 Finland 4.5 4.9 The Netherlands 4.1 4.7 Belgium 2.0 3.2 Greece 2.4 2.7 Bulgaria 2.6 2.7 Other 4.8 5.2 Total Europe 156.1 161.5 Source: Gazprom Annual Reports

Russia


necessitate the construction of new Russian export pipelines. In addition, growing gas demand in Asia (driven mainly by the power sector) will present opportunities for Russia to export gas from Eastern Siberia to several Asian countries. This will not only necessitate the development of new gas fields, but the export pipeline infrastructure and underground storage facilities as well. In 2006, the State Dume adopted the Federal Law ‘On gas export’ which grants exclusive rights to Gazprom to export gas. This allows Gazprom to pursue a coordinated production and export strategy (‘the unified export channel’), forming an additional guarantee for the reliability of Russian gas exports. Europe will remain dependent on Russian gas for the foreseeable future. European offtakers will therefore be forced to work with Gazprom on the security of the gas flows. There are currently no signs that Gazprom is unwilling to cooperate. This is clear from the agreement on the 1,200-km Nord Stream pipeline (formerly referred to as the North European Gas Pipeline, NEGP) through the Baltic Sea, which was signed in September 2005 by Putin and Schröder. Nord Stream consists of two parallel pipelines with a total capacity of 55 bcm per annum. The first part of Nord Stream is expected to come on stream in 2010 and transport up to 27.5 bcm of gas a year. Initially Nord Stream will supply Germany, but further expansion is possible to the UK, Belgium, France and the Netherlands. The Nord Stream pipeline is a new channel for Russian natural gas exports and is seen as a major infrastructure project, which sets a new benchmark in the co-operation between Russia and the EU. Nord Steam is regarded as a clear sign of Gazprom’s willingness to cooperate and find solutions to the transit risk problem. As a result, Gazprom can avoid negotiating transfer fees, in this case by bypassing Belarus, Poland and Ukraine. The International Energy Agency expects Russian gas production to rise from 598 bcm in 2005 to about 900 bcm in 2030. Despite this impressive production growth, there is limited scope to increase exports as domestic demand is also expected to rise substantially. However, imports from the Central Asian republics will enable Gazprom to increase its exports to Europe. In addition, improving domestic energy efficiency can redirect gas from the domestic market to the more lucrative export markets. Energy inefficiencies across Russia currently account for about 100 bcm of wasted gas. Gazprom has control over more than 60% of Russia’s natural gas reserves. This reserve base gives the company ample opportunity – albeit currently mostly from relatively smaller fields – to increase its future production. Gazprom can also purchase additional gas from independent producers. So far, Gazprom has used its transport monopoly to prevent these producers from getting direct access to the European market. Recent meetings between President Putin and Central Asian leaders may help shift the tense geopolitical relations and Gazprom’s policy. Given its problems with increasing its gas production, Central Asian gas is very important in filling Gazprom’s looming supply gap. Gazprom has already concluded future gas supply contracts with the Central Asian republics Turkmenistan, Kazakhstan and Uzbekistan. The additional volumes would have to come on top of the volumes already allocated by Gazprom to Ukraine. The supply contract with Turkmenistan (80 bcm/year by 2010) appears to be particularly challenging. Turkmenistan has substantial reserves of natural gas, said to be over 20

Forecast of gas demand and supply by sources

0

200

400

600

800

1000

2005 2010 2015

Russia demand Gazprom supply Europe demand Imports Central Asia FSU demand Independents Source: IEA,TNK-BP

Russia


tcm of recoverable reserves. However, there is lack of reserve transparency and so far all their production targets have failed. These three Central Asian countries have significant gas reserves, but up to now the (current) inadequate throughput capacity of the pipeline linking Central Asian gas reserves with Gazprom’s network have limited their supply. Gazprom’s recently developed satellite fields will soon – or have already – reached their peak production. If Gazprom wants to meet its targets, the company will have to improve pipeline access for these Central Asian producers and the gas sales conditions for Russian independent gas producers and oil companies. In addition to cooperation with Central Asian producers, Gazprom will need to develop more resources, which are presently inaccessible, posing immense challenges for the company. Considerable investments will be needed in greenfield projects to compensate the declining production from existing fields and prevent a future gas deficit. This will make the timing of new projects essential. Gazprom has indicated that after 2010, new strategic gas fields will be developed on the Yamal Peninsula, the shelf in the Barents Sea, the shelf in the Kara Sea (including the Obskaya and Tazovskaya bays), Eastern Siberia and the Russian Far East. This will be a challenging task, given the severe climate conditions in these regions and the environmental sensitivities. The U.S. Geological Survey (USGS) is very optimistic about the potential of the Arctic offshore as well as the opportunities in the Central Asian republics and Eastern Russia. A large part of the undiscovered resources are located in the Arctic, where Russian explorers planted a flag on the seabed just below the North Pole in August 2007. The flag is a symbol of Russia’s claim to the vast Artic territory, where an estimated 25% of the world’s undiscovered oil and gas resources lie. One of the gas fields that is very likely to be developed in the near term is the giant Shtokman field (or Shtokmanovskoye) in the Barents Sea, a ‘world-class gas project’ with reserves of 3,700 bcm and additional volumes of gas condensate. Shtokman will be developed by a consortium consisting of Gazprom, French oil company Total and other foreign companies. Starting in 2013, Shtokman should deliver 22 bcm of gas to European consumers and later – in the form of liquefied natural gas (LNG) – to US consumers as well. The investment required to develop Shtokman are estimated at USD 20-30 billion. This huge amount reflects the difficulties that will be encountered in developing this gas condensate field, situated 600 km offshore in 350 metres of dangerous Artic waters. Shtokman is just one example of the huge investments needed. The IEA expects that Gazprom will have to invest USD 330 billion over the period 2005-2030 (the amount was not further specified) to meet both future domestic and European gas demand. Ruhrgas has indicated capex needs for the Russian gas sector of USD 227 billion to 2020. This total includes USD 85 billion for upstream, USD 55 billion for new Russian pipelines, USD 67 billion to upgrade existing pipelines and USD 20 billion for new pipelines to Europe. The China option For many years, natural gas in China was mainly used as feedstock for nitrogen fertilizer production. Natural gas for other uses was limited to those areas near gas producing fields. However, given the environmental benefits of using natural gas in

Major uncommitted FSU natural gas reserves as of 31 December 2005 (tcm)

0100200300400500600700

Nadym PurTaz

Yamal* BarentsSea

Kara Sea CentralAsia

EasternRussia

Undiscovered resources Uncommitted resources

* Yamal Peninsula undeveloped resources combined with Nadym Pur Taz Source: Jensen Associates

Russia’s ‘gold rush’ for the North Pole Russian explorers have planted their country’s national flag on the seabed 4,200 m below the North Pole to confirm Moscow’s claim to the Arctic. Canada, which also claims territory in the Arctic, has criticised the mission. “This isn’t the fifteenth century. You can’t go around the world and just plant flags and say ‘We’re claiming this territory’ ”, Canadian Foreign Minister MacKay told a TV channel. Melting polar ice, said to be the result of global warming, has opened the possibility of new shipping routes in the region (the Northwest Passage). As exploration of offshore oil and gas also becomes easier, this has led to competing claims over Arctic resources.

Source: BBC News, Financial Times, 2 August 2007.

Russia’s gas production and looming gas deficit (bcm)

2004 2010 Gas production by Gazprom (a) 545 550 Gazprom’s exports to Europe/CIS 191 312 Deliveries to domestic customers 354 238 Russia’s domestic demand (b) 402 469 Supply gap (b / c) 48 231 / 202 Deliveries from Central Asia - 105 Total supply gap (b / c) - 126 / 97 (a) Optimistic estimate without output from Yamal (b) Probable scenario, annual demand growth of 4.3% (c) Reduced scenario, annual demand growth of 2% Source: CEPS Policy Brief, October 2006

Development of satellite and new fields Field Launch

date Year of peak production

Peak production (per annum)

Pestsovoye 2004 2006 27.5 bcm Kharvutinskoye 1996 2008 25.0 bcm Ety-Purovskoye 2004 2006 15.0 bcm Aneryakhinskoye 2004 2006 10.0 bcm Yen-Yahinskoye 2003 2008 5.0 bcm Yuzho-Russkoye 2007 2009 25.0 bcm Shtokmanovskoye 2010+ after 2012 67.5 bcm Source: Gazprom

Russia


power generation, China is currently undertaking a major expansion of its gas infrastructure. China’s gas pipeline system, which is currently still rather fragmented, needs more interconnections between networks. Only Sichuan province in the southwest can boast a sophisticated natural gas distribution network. Natural gas consumption (58 bcm in 2006) accounted for only 3% of China’s total energy consumption that year, but gas consumption is expected to increase to 100 bcm per year by 2010. Although China has its own substantial gas reserves, its future supply will increasingly depend on imports via pipeline and in the form of LNG. Given the fast-growing gas market in China, a widely discussed option for Russian gas companies is to export gas to China. The giant Kovykta gas condensate field (2,000 bcm of natural gas) in Eastern Siberia was discovered in 1987. Kovykta, operated by RUSIA Petroleum (until recently,8 63%-owned by TNK-BP), could provide China with natural gas in the next decade. However, this is a medium-term option as the project will initially supply 2 bcm/year of natural gas from 2007 to households and industrial consumers (power stations and chemical plants) in Russia’s Irkutsk Region. In March 2006, Gazprom and China National Petroleum Corporation (CNPC) signed an outline agreement to deliver 60-80 bcm/year of Russian gas to China. This involves the construction of two pipelines, to be completed by 2011 at a total cost of at least USD 10 billion. One of the pipelines is to carry West Siberian and the other East Siberian gas. It is still unclear which fields will supply the gas, although Kovykta and Sakhalin-1 are the most likely choices. When successfully completed, the ‘China option’ will be a crucial step in Gazprom’s strategy of becoming a global energy player and – as a consequence – will increase its bargaining power as Europe’s major gas supplier. However, Gazprom recently asked the Russian Government to annul the agreement of ExxonMobil to supply China with gas from Sakhalin-1, arguing that it needs the gas to supply its domestic customers. Although Russia seems to be the most logical supplier of gas to China, there are other options from neighbouring countries. Kazakhstan’s KazMunai Gas (KMG), for instance, has conducted a feasibility study in cooperation with CNPC for the construction of a pipeline to supply gas to China. In the longer term, this pipeline could also transport gas from Turkmenistan and Uzbekistan to China. Given the many uncertainties surrounding Gazprom’s agreement with China, the potential competition from Central Asian producers, the routing of pipelines and the sourcing of gas, it is crucial that the Russian government develop a master plan for the eastern Russian gas sector. This plan should cover the financial issues, which fields should be developed first, supplying the domestic market versus export markets (given that gas demand in Eastern Siberia is also increasing), and the potential role of foreign investors.

8 In June 2007, TNK-BP was forced to sell its stake in RUSIA Petroleum to Gazprom. BP announced that, in connection with the deal, a strategic alliance with Gazprom will be formed to invest ’jointly in major long-term energy projects or swap assets around the world’. Given the Russian regulators’ threat to withdraw the licence for Kovykta, BP had in fact no real choice and would be well-advised to accept reality.

Russia


Chapter 5: Opportunities in Russian Oil and Gas Investment climate The current political, fiscal and regulatory climate negatively impacts the development of marginal fields, particularly relatively high-cost fields. The fiscal reforms process is unlikely to be resolved before the 2007/08 national elections. In the meantime, ad hoc changes to the tax system are likely to continue. The uncertainties in the investment climate complicate the task of long-term project planning for all investors in the Russian oil and gas industry. The lack of tax holidays for new fields and reduced taxes for maturing fields (i.e. more tax differentiation) is seen as counterproductive. The Russian government has acknowledged the need to reform the current tax system. Incentives will be introduced to stimulate oil production growth in Russia’s ‘periphery’. However, Russian companies are likely to remain reluctant to invest their money in Siberian greenfield projects, as they would have to redirect their scarce financial resources from fields that are already producing. The regulatory framework governing the licensing of subsoil use is still under revision. The government submitted a draft of a new law on Mineral Resources to the State Duma in June 2005. The draft bill included several reforms recommended by the Ministry of Natural Resources (MNR), such as the creation of full-cycle licenses (combining exploration and production rights) and the replacement of the current administrative legal regime with subsoil licenses with a civil law framework. However, the draft bill contained some controversial proposals. In particular, the new rules for direct foreign participation in bidding for ‘strategic fields’ would put restrictions on potential foreign investors. Strategic fields are legally defined as oilfields with more than 1.0 billion barrels of oil, or gas fields with more than 1.0 trillion cubic metres of gas, or any fields located near military installations. Although several amendments have been made since the draft bill was introduced, the formal adoption of the new bill on Mineral Resources has not yet taken place. It therefore remains unclear how attractive the outcome will be to foreign investors and how it will impact their appetite. Resource nationalism increasing Several international oil and gas companies have recently been faced with increasing ‘resource nationalism’. Resource nationalism basically consists of changes in fiscal or operating regimes by oil and gas producing countries. These changes are used to maximise their returns or change ownership in upstream assets, often in reaction to domestic social unrest. The re-emergence of state control can have unwanted side-effects as history has shown: increasing inefficiencies, resulting in deterred upstream investments that are essential for sustained output in the long term. Bolivia, Ecuador and Venezuela are prime examples of how terms and contracts have recently been renegotiated to use their energy resources to press for their political interests. Bolivia nationalised its oil and gas fields, state-owned Petroecuador took over the former production assets of Occidental Petroleum and Venezuela doubled the taxes levied on oil production by the foreign operators in the country.

Russia


Some fear that Russia is moving in a similar direction, putting foreign participation in the oil and gas industry at risk. “Greater state-ownership of oil-producing assets is likely to distort the incentives facing the remaining private oil companies, because they fear unfair treatment when competing with large state-owned producers” (The World Bank). After the privatisation and restructuring of Russia’s oil industry in the 1990s, the sector became the most rapidly developing part of the Russian economy, contributing significantly to the country’s growth. However, since 2004 the Kremlin has taken steps to restore the government’s control over the oil and gas sectors, revising some of the deals made in the 1990s. Moreover, Russia has used its energy supplies as a political weapon, bullying its former Soviet neighbouring states. The gas dispute between Russia and Ukraine in early 2006 caused considerable upheaval in Western and Central & Eastern Europe. While Russia’s actions were based on a combination of political and economic motives, the result was that the security of energy supply was once again put high on the EU agenda. Russia’s political agenda for its oil and gas industry seems to be driven by increasing state influence, particularly when ‘key strategic energy assets’ are involved. The developments involving Shell’s Sakhalin-2 project – and more recently TNK-BP’s forced sale of its Kovykta gas field to Gazprom – are clear signs that the Kremlin wants to retain control of access to its natural resources. Tighter control on its energy resources has become the Russian government’s unwritten policy, which is said to be sustained by President Putin. This reversal of the Kremlin’s earlier policy of privatisation is evident: in 2003, state-dominated companies controlled only 16.5% of Russia’s oil production, while in 2006 this had increased to 32%. Lukoil is currently the only major Russian oil company that is not under state control. This new policy will clearly benefit state-owned companies (in the form of favourable licensing and regulation) or those companies that are politically well-connected. The clear winners of the Kremlin’s policy to secure greater control over the country’s oil and gas industry will be the state players Rosneft and Gazprom. Their desire to expand their operations will also trigger further consolidation in Russia‘s energy sector. High investments needed Russia, with its vast proved reserves of oil and gas, will remain one of the world’s largest producers and exporters of oil and gas for several decades to come. In August 2003, the Russian government confirmed ‘Russia’s Energy Strategy to 2020’ (ES-2020), sketching the key trends and parameters for Russia’s energy sector. The starting point is that the energy sector forms a fundamental element in Russia’s foreign policy. A major objective of ES-2020 is to align the energy strategies of Russia with the EU and other major energy players, such as OPEC, to make a contribution to global energy security. Aside from the recent changes in the Kremlin’s energy policy, there are doubts about Russia’s ability to meet its future production targets. Several new fields, some located in harsh environments, will have to be brought on stream to compensate for the decline of maturing fields, while at the same time production must increase. This will necessitate considerable capex in upstream production, the upgrading of existing systems and new pipelines to markets in Europe and Asia.

Putin’s views on Russia’s energy policy: nothing new under the sun

Putin’s views on state planning and the importance of energy policy for Russia’s foreign relations date back to the time when he was still a senior official. His views can be found in his dissertation for St. Peterburg’s State Mining Institute, which he defended in June 1997. In an abstract, which appeared in 1999, he laid the foundation for Russia’s current energy policy. Putin outlined that Russia’s oil, gas and mining base should be used to secure the country’s international position. In order to use the energy factor in international politics, state control over the country’s energy resources must be ensured. When Putin met Gerhard Schröder in October 2003, he told him: “The gas pipeline system is the creation of the Soviet Union. We intend to retain state control over the gas transportation system and over Gazprom. We will not divide Gazprom. And the European Commission should not have any illusions. In the gas sector, they will have to deal with the [Russian] state”. Source: Gazprom in Crisis; Conflict Studies Research Centre

An OPEC-like Gas-PEC? A major source of uncertainty among gas-importing countries is the possibility that major gas-exporting countries will coordinate their investment and production plans in order to avoid surplus capacity and keep gas prices up. The Algerian national oil and gas company Sonatrach and Russia’s Gazprom signed a memorandum of understanding (MoU) on cooperation in upstream activities in August 2006. This move has raised concerns among European gas importers about its implications for competition and prices. Such a coordinated action will put Europe at the mercy of two of its three largest gas suppliers. Source: IEA, World Energy Outlook 2006

Russia


In its World Energy Outlook 2006 the International Energy Agency forecast that Russia needs to invest USD 478 billion in its oil sector and USD 440 billion in its gas sector over the period 2005-2030. Although the Russian government would prefer to raise the necessary capital domestically, external sourcing will be inevitable. In order to be able to attract foreign capital, financial investors have indicated that several critical issues must be resolved, such as the definition of ‘strategic fields’. Another major issue is the current Russian reserve classification system A+B+C1 (for proved + probable reserves). This system will have to be brought into conformity with international reserve classification standards such as US/SEC and SPE9, and sustained by a reserves audit by external renowned consultants. However, despite these issues, Russia’s potential is so great that the major international oil and gas companies cannot afford to stand aside and wait for a more favourable investment climate. The E&P momentum The Oil Field Services (OFS) industry supplies products and services to all kinds of companies involved in the Exploration and Production (E&P) of oil and gas in onshore and offshore areas. Drilling is the industry’s most important activity. In its broadest sense, the OFS industry involves many other activities: seismic survey, installation, well testing and completion, maintenance, pipelay, heavy lift and construction. In offshore areas, in addition to several types of drilling rigs and ships, a host of other types of vessels service the oil and gas industry. The key challenge for oil and gas companies is meeting their production growth targets. As the development of new resources have long lead times, oil and gas companies therefore have to take a long-term view on their supply base and depletion rate, allocating their E&P (or upstream) spending accordingly. During the oil price plunge of 1998/1999, E&P spending was cut drastically due to the reduced level of free cash flow.

Driven by the continuing strong global economic growth, oil and gas demand has increased considerably over the past few years. Limited E&P spending in the period 1999-2002 has narrowed the gap between global oil and gas demand and production capacity. High energy prices combined with poor reserve replacement ratios at several oil and gas majors have created a strong impetus to increase E&P spending. Leading indicators in the oil field services industry, such as day rates, rig counts and seismic crew counts, have shown a positive development since 2003. According to a study by IFP (Institut Français du Pétrole), world E&P spending in 2006 was estimated at USD 267 billion, up 25% from the amount spent in 2005. As the search for new oil and gas fields continues, IFP expects E&P spending in 2007 to grow by 20-25% to USD 320-335 billion. Although part of the increase can be attributed to cost inflation, there is surely growth in volume as well. It is believed that the Middle East, West Africa, Southeast Asia and Russia will show strong growth in E&P spending in 2007 and beyond.

9 The current most widely used standards for the classification of oil and gas reserves are those developed by the US Securities and Exchange Commission (SEC) and by the Society of Petroleum Engineers (SPE).

World E&P investment 2004-2007 USD bln

050

100150200250300350400

2004 2005 2006F 2007E

North America Latin America North Sea Other Russia & China Total 2007 Source: IFP

uncertainty range

Russia


Organic production growth and reserve replacement have become important issues for Russian oil and gas companies. Vast investments will be made over the coming decade, which will make the oil field services sector very important to Russia. The size of the Russian oil field services market was estimated at USD 10 billion in 2005, with an expected growth of 20-25% from 2006 to 2007. The Russian oil field services industry currently consists of several hundred local companies, offering a wide range of services. These local companies vary considerably in size, from one-product SMEs to the internal services departments of the large Russian oil and gas companies. In the past few years, some oil and gas companies have outsourced their oil service activities. There are also many international companies active in the Russian OFS sector. These can provide the quality, reliability, sophistication and know-how that most of the local companies are not able to deliver. Foreign companies accounted for about 15% (USD 1.5 billion) of the total Russian OFS market in 2005. US-based oil service companies are currently the major foreign suppliers to the Russian market, and are mainly active in the high-end part of the market. But they are facing increasing competition from suppliers from Canada, Japan, France, Germany, Italy, Norway and the UK. The ageing production base and the potential growth of Russia’s oil and gas sectors offer significant momentum for upstream development and rehabilitation equipment and services. According to consultant Douglas-Westwood10, the Russian OFS market is set to double in value over the next five years: from USD 11.4 billion in 2006 tot 22.5 billion by 2011. “The sector will be driven by increasing use of outsourced services and a move to western business models”, the consultant concluded. Western companies can profit from the Russian oil field services boom, as modern technology is often lacking. A major problem is the lack of unified norms and standards in the Russian oil field services sector, such as the internationally used ISO, API and CEN certifications. Russian companies are therefore actively seeking collaboration with foreign partners to import expertise, technologies and technical advanced equipment. Foreign participation will be particularly needed as Russian projects are likely to become more complex and challenging, and will move to frontier areas. A prime example is the Shtokman field in the Barents Sea that will need operational partners with expertise in LNG transport and deep water gas production, the kind of expertise Gazprom does not currently have. Contracts for oil services in Russia are usually awarded through tenders, with price/quality the major competitive aspect. Working with local companies via partnerships or joint ventures is often the best strategy to gain access to the market.

10 Douglas-Westwood, The Russian Oilfield Services Market Report 2007-2011, “the first publicly available report detailing the multi-billion dollar opportunity in this high-growth sector.”

The structure of the Russian OFS market, USD 11.4 billion in 2006

Baker Hughes

WF

Oil company in-house

IntegraSSK

Small / mid

indep.

BK Eurasia

HBSB

WF = Weatherford, HB = Halliburton, SB = Schlumberger Source: Douglas-Westwood/Integra

Russian OFS market USD million

0

5,000

10,000

15,000

20,000

25,000

2005 2006 2007 2008 2009 2010 2011

Logging and Seismic Drilling, workover, technology services, etc. Source: Douglas-Westwood/Integra

Russia - Expenditure on facilities by component

0

10

20

30

40

2004 2005 2006 2007 2008 2009 2010

Oil & Gas Production Refining & Gas Processing Pipelines Maintenance & Modifications LNG Terminals Source: INTSOK Annual Onshore Market Report 2006

Russia


Chapter 6: Agrifood The Russian market for food and beverages was worth about EUR 160 billion in 2005. It is Europe’s third-largest market in terms of size after Germany and France. Russia is one of the fastest-growing markets for food and beverages in the world, expanding by 20 to 25% in 2004/05. Russian consumers spend about 40% of their income on food and beverages. Favourable economic developments, higher disposable income, improving market access, new players in the market and a more stable political climate have expanded the consumer market and triggered a change in consumer patterns in Russia. In the coming years the market for food and beverages will grow further as real incomes continue to increase. The rise of food retail One important factor in the growing food market is the rise of food retail in Russia. Though food is still largely sold in Russia through traditional distribution channels such as weekly and daily markets (known as the ‘rynok’), Russian food retail is rapidly coming to the fore. The first supermarket in Russia dates back to the late 1980s. Hundreds of supermarkets are now being opened each year in Russia, particularly in the large cities. Foreign retail chains are buying local chains and existing stores. Small independent retailers are increasingly making way for multiple chains and large shopping centres while hypermarkets are springing up around the country. This trend is set to continue in the coming years. The rise of the supermarkets is particularly crucial for manufacturers of branded articles. Supermarkets carry a larger product assortment, which mainly draws people with higher disposable incomes. However, the growth of the retail sector is mainly confined to the major cities such as Moscow and St Petersburg, where supermarkets virtually account for all food sales. In the more remote areas, food is still largely sold via markets and roadside stands. Exports from the Netherlands to Russia Alongside the consumer markets, the local food industry has also grown rapidly in Russia over the past years, with annual growth running at about five per cent per year. This growth in local food production was made possible by the expansion of production capacity and the Russian government’s policy of stimulating home-grown produce. Nevertheless, local food production is not growing fast enough to keep pace with accelerating demand. A sizeable share of the products (over 40% in 2006) is therefore sourced from abroad. The most important exporting countries are Brazil, Ukraine, Germany and the United States. The Netherlands is among the top-10 suppliers to Russia. Total agricultural imports from the Netherlands amount to about EUR 1.0 billion. The most important product groups are flowers and plants, fruit and vegetables, meat and dairy. Flowers and plants Russian consumers love flowers, especially roses. The Netherlands is the most important supplier to the Russian market. Dutch exports of nursery flowers and plants to Russia increased by 27% to EUR 128 million in 2006. Russia has thus climbed to become the ninth largest purchaser of flowers and plants from the Netherlands. Phytosanitary requirements sometimes impede nursery exports.

Top-10 Dutch exports of Agrifood products 2005 x USD 1 mln

Germany 13,461 United Kingdom 6,242 France 5,686 Belgium 5,114 Italy 4,096 United States 2,297 Spain 2,035 Sweden 1,111 Russian Federation 1,019 Denmark 945 Source: UN/Comtrade

Dutch exports of flowers and plants to Russia x EUR 1 mln

2000 46.4 2001 73.8 2002 86.9 2003 103.6 2004 93.4 2005 101.0 2006 128.4 Source: HBAG

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Fruit and vegetables Dutch fruit and vegetable exports to Russia grew by over 50% in 2006. However, this percentage does not accurately reflect the greater demand for Dutch products. In the first two months of 2005, exports were at a standstill due to an import ban on vegetable products from the Netherlands. Per capita fruit and vegetable consumption is small. Russians do not have a great culture of eating fresh vegetables and consumption is largely limited to the rougher (and cheaper) types of vegetables such as onions, various kinds of cabbage and carrots. However, interest in a more varied diet is increasing and, as a result, demand for fruit and vegetables such as tomatoes and peppers is growing strongly. Meat Per capita meat consumption showed a steady decline in Russia until 2004, then received a strong impulse in 2005. The consumption of mainly pork and poultry continued to grow thereafter, while beef consumption decreased. Domestic production in Russia is not sufficient to meet demand. Additional imports are therefore necessary. Russia imports about three million tons of meat annually, and the EU is an important trading partner. The Russian market for meat is a particularly interesting one because the Russians tend to purchase parts of pigs and cattle that are less in demand in the EU. This often concerns meat with a higher fat content. Russia is constantly threatening to impose an import ban on European meat. Dairy The Russian market for dairy produce is rapidly expanding. Russians traditionally consume lots of dairy products. Russia is the most important export destination for butter from the EU. After a dip in 2004 and 2005, butter exports to Russia rebounded in 2006. In the first ten months of 2006, 38,600 tons of butter were exported, an increase of one third relative to the entire previous year. The main beneficiaries of this increase were Poland, Lithuania and the Netherlands. One of the reasons behind the increased exports to Russia is that butter exports from Ukraine have largely ground to a halt due to the Russian import ban on dairy products from that country. Netherlands AgriBusiness Support Office In 2004, the Netherlands Agribusiness Support Office (NABSO) was set up in Moscow. This is an initiative of the Dutch Ministry of Agriculture, Nature and Food Quality and is supported by several industry and marketing organisations from the Dutch horticultural sector. This support office is entrusted with the task of improving and expanding exports of flowers, bulbs and trees from the Netherlands to Russia. In addition, the office provides information to Russian entrepreneurs and establishes contacts between Russian and Dutch entrepreneurs who are active in horticulture. Import tariffs Certain products are subject to import tariffs. Meat imports that fall within the set import quota attract an import duty of 15%. Imports of products in excess of the quota are subject to duties varying between 60% and 80%. Some products, such as sugar, are taxed at extremely high rates.

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Certificates Food and beverages that are exported to Russia must be accompanied by a certificate confirming that the products have been tested and meet Russian food safety standards. Institutions that issue such certificates must be recognised by the Russian Federal Agency for Technical Regulation and Metrology (FATR). Some products are subject to further requirements in addition to the aforementioned mandatory certification. The ‘Federal Service for Veterinary and Phytosanitary Supervision of the Ministry of Agriculture’ is the body responsible for food products. Dutch companies are investing in Russia Opportunities for foreign investors Two trends are visible in the Russian food industry. Firstly, a consolidation process is taking place, and smaller companies are being bought by the larger players. Secondly, the sector is undergoing vertical integration, with processing companies acquiring interests in their suppliers. Due to the rapid growth in the food market, the Russian food industry is in great need of investment, both on a small and large scale. Many production processes are obsolete and are incapable of meeting the rapidly rising demands in terms of both quantity and quality. About half the production facilities in the food industry are ripe for replacement and only an estimated 20% of all facilities meet international norms. The Russian government has made an effort to improve the investment climate, but investments are mainly being made in the energy sector and raw material sectors, while investments in the Agrifood sector are lagging. Opportunities abound for foreign companies interested in investing in Russia. It is therefore not surprising that foreign investments in Russia have risen sharply since 1999. The best prospects for investments within the food sector are offered by the dairy sector, the poultry sector, the beverages sector and the confectionery sector. Dairy sector The dairy industry is the least developed branch of the Russian food industry. Productivity is very low and the sector is inefficiently organised. Dairy production fell particularly sharply after the collapse of the Soviet Union. Milk production has not increased in recent years and is unlikely to show growth in the near future. As previously noted, the Russian market for dairy products is growing fast. Russians traditionally consume a lot of dairy products and the expanding range of choices gives the market great growth potential. The most important Russian dairy player is Wimm-Bill-Dann. Foreign companies that have invested in local dairy factories are Danone, Ehrmann, Arla and Campina. Poultry sector The poultry sector constitutes the most important sub-sector in the Russian Agrifood industry. Demand for poultry products is set to increase further in the coming years. Russia imposes quotas on meat imported from abroad and strict veterinary requirements are in force. An increase in domestic production is therefore necessary to meet demand. There are plentiful opportunities for Dutch companies to invest in Russian poultry processing companies.

Russian demand for agricultural and food machinery and equipment increasing

Due to the reform and modernisation in the food industry, there is a large demand for machinery and equipment. In the agricultural sector the demand for modern machinery is also significant, but supply is lagging. By 2006, Russia had 572,500 tractors (shortfall of 36%), 156,600 harvesters (shortfall of 48%), 40,300 forage harvesters (shortfall of 37%), 199,100 cultivators (shortfall of 47%) and 248,200 seeders (shortfall of 32%). Annual demand for new agricultural machinery and equipment is estimated at USD 3.0-3.5 billion. As financing in the agricultural sector remains a major problem, commercial leasing has become an important alternative financing tool. The increase in disposable income has resulted in higher demand for more variety in food products. The domestic poultry sector, for example, has seen explosive growth of 15-17% per annum due to stimulation by the Russian government in the form of soft loans. The domestic industry is incapable of meeting the huge demand for equipment and machinery from the poultry sector and is unable to compete with foreign suppliers, which can offer a full range of higher quality products. This offers opportunities for Dutch companies to supply the Russian market with high-quality machinery and equipment. Source: U.S. Commercial Service, Agrarisch Dagblad

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Beverages industry Within the beverages sector, the beer market holds the greatest potential for the coming years. The beer market currently accounts for about 40% of the total alcoholic drinks market in Russia. Beer consumption is increasing at the expense of vodka, which is set to experience a decrease in demand in the coming years. The most important beer brewers and their beer brands are: Baltika with Baltika 3 Klassicheskoye, Sun Interbrew with Klinskoye and Ochakova Moscow Beer, and Softdrinks Enterprise with Ochakova. Heineken is the third-largest brewer in Russia with a market share of 15%. In the soft drinks category the consumption of fruit juice is rising rapidly. The Russian company Wimm-Bill-Dann (with a subsidiary in the Netherlands) is the largest producer of fruit juices followed by Lebedyansky and Multon. Jointly, these companies hold about 75% of the total fruit juice market. Growth in this market is being achieved thanks to a modernised and increased production capacity, but the marketing of fruit juices has also improved compared to the past. Russians’ growing health consciousness is another factor boosting demand for fruit juices. Confectionery The confectionery sub-sector is experiencing rapid growth. Russians traditionally have a sweet tooth. Russia is Europe’s fourth-largest market for confectionery in terms of size and has already attracted many western investors. More than half the market is dominated by foreign companies. Nestlé and Mars are examples of western producers that have established a presence in the Russian market. Advisory organisations There are also opportunities for advisory organisations in the field of technical advice and project development in the agricultural sector. There is a lack of experience in this field and the demand for knowledge of new-build projects is strong. Advisory organisations that open locations in Russia can respond quickly and efficiently to this demand.

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Chapter 7: “Doing Business is People’s Business” In this chapter we have included interviews with a number of Dutch companies active in the Russian market to place the findings of the report in the perspective of the day to day reality of doing business with Russia. We thank the representatives of these companies for their time and willingness to participate in these interviews. We are convinced that their expressed views constitute a valuable contribution to this report. In this context we would also like to thank the interviewers, Mrs. Mar Oomen and Mr. Joep Auwerda, who made these interviews possible. 1. Campina in Russia: ‘Ask for support from the local authorities’ ‘Establish a good relationship with the local authorities’ If you want to set up a business in Russia, first you have to establish a good relationship with the local authorities. This is the advice of Bob Steetskamp, who for two years has been Campina International’s managing director for Russia and the former Soviet states. And, he adds, it’s best to do business the Russian way. There are a lot of restrictions initially, but ultimately anything’s possible. Over seven years ago, in 2000, Campina built a dairy plant 80 km south of Moscow in the city of Stupino. It was a ‘slimmed-down’ operation, as Steetskamp describes it, speaking from Moscow. With 80 employees and one yoghurt line to ‘limit the risks’. Now the company has 400 staff and there are three yoghurt lines, two ‘dairy drinks lines’ and a ‘coffee cup line’. Steetskamp: ‘We’ve designated Russia as Campina’s fourth home country. The other three are the Netherlands, Belgium and Germany, where 70 percent of our turnover is generated.’ In 1992, Campina began exporting yoghurt from Germany to Russia. That developed very favourably: every year more trucks full of yoghurt travelled east. Until the rouble crisis hit in 1998. From then on Campina sold nothing at all to the former East Block country. Steetskamp: ‘Exports fell to zero. Then we decided to launch our own production operation. Given the financial crisis, this was an extremely courageous decision. But everyone realised there were also significant opportunities for Campina. The home markets were saturated, so in order to grow, we had to go abroad. It was a logical step to expand our activities in Russia given that our success with exports had proven there was a market for Campina products there. Moreover, Russia is relatively close, it is a big country with a huge potential for growth.’ Enormous sales market It quickly became clear that we had to build the plant near Moscow. With 16 million inhabitants, the region is an enormous sales market. And there is enough good quality milk in the area. There were various large cattle farms, Steetskamp explains; former kolkhozes with 1,000 to 1,600 cows. The choice was made for the city of Stupino, a former military and industrial city where unemployment was high due to the collapse of industrial activities. ‘When we started, the only entertainment was a petrol station where you could buy a beer. Now it’s a thriving city with shops and restaurants, and

Russia


unemployment has fallen to zero. The local authorities have done their best to attract foreign investors. The governor of the region made a personal effort. Without the support of the local authorities, we wouldn’t have made it. We would never have been able to comply with all the bureaucratic rules that are so typical of Russia.’ The region’s farmers were also pleased with Campina’s plans. When the Soviet economy ground to a halt, so did the agrarian sector to a large extent. The farmers were happy to supply milk to the Dutch plant. However, things didn’t always run smoothly. Steetskamp: ‘The Russians were and are very adept at breeding cows but the quality of their milk was poor. The milk wasn’t refrigerated, for instance, and there were problems with hygiene. This prompted us to set up a development programme and train people locally. We gave the farmers favourable loans so they could install cooling tanks. Now there are around 16 farms in all, which supply us with a total of 200 tonnes of milk a day.’ Campina in Russia is not a cooperative, as is the case in the Netherlands and the rest of Europe. Instead, the milk is purchased from the suppliers. The company in Russia is an LLC and a wholly-owned subsidiary of Campina, which leases the land the plant is built on from the Russian government for 49 years. The staff are nearly all Russian, with only three expats among the 400 employees. Initially, there were more Dutch and Germans on site, primarily to supervise the Russian staff, but they have since left. ‘Business must be conducted with Russians by Russians,’ says Steetskamp. ‘And it should be conducted the Russian way. In other words: nothing is a given, but anything is possible. You have to be flexible. Including when it comes to credit terms. We can’t require a client in Vladivostok to pay within the same timeframe as one in Moscow – our products take a lot longer to get there. And in fact the payment morals in Russia are an important point of attention. We need to be careful with credit limits, so if an invoice remains unsettled for too long, we need to get right on it. And we won’t make another delivery until the last invoice has been paid.’ Red tape is the biggest headache The biggest problem in Russia continues to be bureaucracy and regulations. Every product has to be inspected and certified. Every new investment must be reviewed by the local authorities. If a new machine has been purchased, it can only be used if the authorities have checked it for safety, hygiene and so on. And every new product the machine produces is required to undergo extensive certification before it is sold. Steetskamp: ‘If you don’t comply with the rules, production can be shut down. When it comes to this, the law is very complex. But there are plenty of people in Russia who can advise you on such matters.’ Campina would greatly benefit if Russia joined the WTO. Ninety percent of Campina’s sales are generated locally and 10 percent are imported. Imports are subject to an even more complicated procedure. ‘For instance, they want to know the origins of the raw materials in every product, which is sometimes unfeasible for us. If the laws and regulations are harmonised, we can supply products to Russia that are accepted under European regulations.’ Despite the quirks involved in doing business in Russia, the plant in Stupino was an excellent investment. It is showing profitable growth. And the market for Campina products – ‘products with added value’ – is expanding. Russia will be the largest food market in Europe in 2010, Steetskamp predicts. Russian consumption patterns are very similar to those in Europe, particularly in comparison to Asia. That makes Russia very attractive. ‘In Russia, they eat cheese sandwiches too.’

Some tips... 1. If you want to set up a business in Russia, first you have to

establish a good relationship with the local authorities. 2. Business must be conducted with Russians by Russians,’

and it should be conducted the Russian way. 3. Be careful with credit limits.

... and some comments. • The biggest problem in Russia continues to be bureaucracy

and regulations. • Campina would greatly benefit if Russia joined the WTO.’ • Russia will be the largest food market in Europe in 2010.

Website www.campina.com

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2. Jørgen de Ree, Managing Director of De Ree Holland BV ‘The Russians are loyal, reliable customers’ Sometimes he receives a simple letter from a consumer in Siberia, addressed equally simply to: De Ree, Lisse, Holland. ‘The tulips have come up beautifully; you supply good bulbs.’ Apart from demonstrating that the Dutch postal services can still find an address without a postal code or even a street name, Jørgen de Ree, managing director of De Ree Holland BV in Lisserbroek, likes to recount this anecdote chiefly to show that his products can cope in temperatures of minus 15° Centigrade. Provided they’re planted deep enough, that is. De Ree Holland hasn’t been active in Russia for long – only since 2000 – yet Russia has already become an important market for the Dutch bulb exporter. Jørgen de Ree: ‘We export to 35 countries and Russia has climbed to fourth place. The United States, UK and France are in first, second and third place respectively, and they each take roughly the same volume of goods from us. The other top ten countries are Germany, Canada, Sweden, Austria, Switzerland and Norway.’ De Ree’s Russian sales account for approximately EUR 5 million. In 2006/7, all the Dutch bulb exporters together posted a turnover of EUR 18 million in Russia. This illustrates how important Russia is for De Ree. ‘It may not happen in the first ten years, but I’m firmly convinced that the Russian market will become just as important for the bulb sector as the American market.’ On his office desk stands a bottle of vodka. The label features a photo of Jørgen de Ree together with the words The Best Partner. It was a gift from a good customer whom he looked up in Moscow just a week before giving this interview. While he was out there, Jørgen became more convinced than ever that Russia is becoming a consumer economy like the West. ‘I visited an enormous supermarket at ten o’clock at night and there were at least 15 people queuing at each of the 100 checkouts. Just think of that: 1,500 people all ringing up their purchases, with 5,000 additional customers walking round the aisles. It looked like someone had announced happy hour.’ ‘Initially we thought that Russian consumers would only really be interested in our cheaper lines. But that’s not the case at all. In fact, our high and medium-priced bulbs are the first to sell out. Russia takes as much of our most expensive and luxurious products as the rest of Europe. As an exporter, you’ve got to understand what people want. Don’t think you can simply fob the Russians off with lower quality goods if they haven’t asked for them. They know what quality is, and they won’t settle for anything less. That’s my number one tip: make sure you deliver quality.’ Get yourself a good website In fact, Jørgen de Ree didn’t have to do much to attract customers in Russia: they came to him. ‘In 1999 and 2000, we knew that we were supplying to Russia through a German and a Polish distributor. But we didn’t know exactly who we were supplying. We found out when they came and looked us up. The Russians always want to go directly to the source. I would estimate that in the past couple of years we’ve had around 25 potential Russian clients visit us. Nine eventually placed orders. You can often identify the serious customers as soon as you meet them. To begin with, they take the trouble to make an appointment; they don’t just drop in. You very soon notice that they haven’t got much time and have no problem meeting our payment conditions, which is settlement in full prior to delivery. I won’t do business with would-be customers

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who aren’t prepared to meet those terms. Serious potential business partners usually come well prepared. They’ve done their homework on the Internet and elsewhere. So that would be my second tip: get yourself a good website: one that’s transparent, up-to date and in English; it doesn’t have to be in Russian.’ De Ree was incidentally cautious before doing business with his new customers. Just as his prospective clients conducted research on his company, he also investigated them. For that, a network in Russia is crucial, and it can often be built up simply by visiting the right trade fairs in Russia. De Ree: ‘I’ve always been able to talk very openly with the Russians at these fairs, because I’m very open about my own company. They’re happy to share their knowledge.’ The Russians, says De Ree, are reliable, loyal business partners who aren’t going to switch to a competitor just to save one tenth of a per cent. They understand that everyone in the chain from grower to consumer has to get their fair share. Loyal customers of De Ree with a proven track record of creditworthiness can often pay only half the invoice in advance and the rest 14 to 30 days later. ‘Sometimes I’ll be happy with a fax for a banker’s order, and so far, I’ve never been let down. Once or twice, though, I’ve had to postpone a delivery until the funds have cleared.’ Russians are just like the Dutch The Russian way of doing business is very similar to that in the Netherlands. De Ree: ‘In terms of directness, they’re just like us. They may appear a bit more surly at first, but they can become very relaxed once you get to know them better. They’re also efficient and keen to learn. For instance, one of our Russian customers had registered 50 complaints about our shipments. That was an awful lot, especially when you consider that the total number of complaints we’d received from all 35 of the countries we export to came to just 85. When I visited the customer to look into the matter, we found that only two complaints involved substantial amounts. He was a bit embarrassed about this and immediately told his secretary to raise the lower limit of complaints.’ ‘It’s well known that the Russians can sometimes be rather blunt and like to hammer their fist on the table for what in our view was no apparent reason,’ says De Ree. One of his customers once did this, even though De Ree only speaks two words of Russian (‘yes’ and ‘cheers’) – and he noticed that the female interpreter was leaving many phrases out of her translation so as not to upset him too much. ‘She knew her boss didn’t need to take things to that level, and everything worked out fine in the end. Russian businesswomen really are the top. They seem to beaver away quietly in the background, but in fact they often hold very senior positions with lots of responsibility. What’s more, they’re perfectionists. I’ve got at least three Russian companies as clients with all-woman management teams – and they’re a joy to do business with.’ De Ree’s third and final tip is this: ‘When you go to Russia, take a mobile phone with you, because if you don’t you’ll be completely stuck. When I’m in a taxi with a driver who speaks no English, I’ll call the hotel reception and ask them to explain where I want to go. And don’t forget: the traffic in Moscow is so often gridlocked that you can usually only manage one or two appointments a day.' That’s the downside of the ‘new, open, liberal West’.’

Some tips...

1. Make sure you deliver quality. 2. Get yourself a good website: one that’s transparent, up-to-

date and in English; it doesn’t have to be in Russian. 3. When you go to Russia, take a mobile phone with you,

because if you don’t you’ll be completely stuck.

… and some comments • Russia is becoming a consumer economy like the West. • Russian businesswomen really are the top. They seem to

beaver away quietly in the background, but in fact they often hold very senior positions with lots of responsibility. What’s more, they’re perfectionists.

Website www.deree-holland.nl

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3. Mammoet in Russia A good business contact is based on friendship Even if you or one of your employees speaks impeccable Russian, you need to hire a native if you want to do business in Russia. This is the firm belief of Roderik and Patrick van Seumeren, president and vice president of the Schiedam-based company Mammoet, which specialises in solving heavy lifting and transport challenges. Patrick van Seumeren: ‘Only a Russian knows the language and culture so thoroughly that he (or she) can help you manoeuvre through all the rules and regulations.’ Mammoet (the Dutch word for mammoth) is a specialist in moving – ‘both vertically and horizontally’ – any large structure including factories, bridges, refineries, drilling platforms, reactors and, of course, submerged submarines. In 2000 Mammoet managed to successfully salvage the Russian submarine Kursk. Roderik van Seumeren: ‘This gave a tremendous boost to our reputation in Russia. My brothers were personally decorated by Putin himself. The salvage operation was extremely important to Putin, who had promised Russia that the drowned marines would be properly buried.’ Roderik and Patrick are cousins. Over 40 years ago Jan van Seumeren, Roderik’s father and Patrick’s grandfather, laid the foundation for Mammoet with Van Seumeren Kraanbedrijf SKB. The company has since grown to become world leader in its sector and employs around 2,500 people in over 50 countries. In Russia, Mammoet has operations in Moscow; on the island Sakhalin off the Russian east coast north of Japan and in Saint Petersburg. ‘Of course we are also present in some former Soviet states like Kazakhstan, Azerbaijan and Turkmenistan,’ Roderick van Seumeren explains while sitting in his office in the middle of the office block on the Schiedam port, with a view of several sky-high red cranes with the mammoth logo. Two major orders a year It all started back in the early 1990s with the purchase of a Russian crane. The Van Seumerens met the Russian Slava Zakharov, who was then a crane sales representative and is now Mammoet’s managing director in Russia. Shortly thereafter Mammoet was awarded a contract for the construction of the Olympic stadium. Mammoet opened a branch office in Moscow and quickly established a joint venture with Staal Constructia. Roderik van Seumeren: ‘Slowly but surely we developed a name and gained increasing trust. The Russians saw what we could do, we were given increasingly large orders and then the Kursk sank. Now we have an average of two orders a year, primarily in the oil and gas processing industry. For example, we transported an entire factory for both Shell and Exxon to Sakhalin.’ The Van Seumerens may not say it directly, but without the help of their current managing director they wouldn’t have got to where they are in Russia. And if the Van Seumerens hadn’t dedicated as much time to the relationship with the managing director, he wouldn’t have offered to help them. According to Patrick van Seumeren, it’s all about gaining trust, which doesn’t happen by itself. Patrick van Seumeren: ‘Russians have been oppressed all their lives. They’ve always had to watch what they say. They couldn’t speak freely because an eavesdropping colleague might be a KGB spy. At the same time, they are very emotional people. In order to gain their trust you have to talk a great deal, explain, tell, communicate and, of course, drink – a lot.

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For traditional Russians – like their managing director – a good business contact is based on friendship, brotherhood, mutual enjoyment of a successful project. This means there is one person at Mammoet in the Netherlands – Patrick van Seumeren – who maintains the contacts with the Russians. While the Mammoet office in America contacts the appropriate department for each specific problem, the Russians only call Patrick. And they call him for everything, from a flat tyre to a broken crane, which is also typically Russian. ‘Every day I get calls about little and big things, the contact is very intensive. And they always feel their problems should top the list. They don’t much care that I’m busy signing a multi-million contract. They should come first.’ Russians are unfamiliar with depreciation Another noteworthy fact about Russians is that they don’t think much ahead. Perhaps because Russia is a former communist country. In any case, many decisions are taken ad hoc. And they are unfamiliar with depreciation. ‘How do you buy a new crane,’ Patrick van Seumeren once asked a Russian colleague. ‘That’s your job,’ was the response. An attitude reminiscent of life under communist rule. Some time ago the Van Seumerens wanted to sell two used cranes and two old trucks. But this wasn’t allowed because these items were considered ‘capital under the articles of association’. In order to carry out the sale, the articles of association would first have to be amended. Van Seumeren: ‘These types of rules are starting to change. As is tax legislation. Taxes on profits used to be so high that you ended up in the red. That’s no longer the case. And they’ve got more realistic about granting permits.’ Patrick van Seumeren explains that, until recently, it took six months to get a permit for special transport but the delivery date was often just two months away. Van Seumeren: ‘That meant you had to be really creative.’ The nouveau riche Mammoet only carries out a project after it has the money in hand. ‘Incidentally,’ Patrick van Seumeren adds, ‘Russians always pay up.’ The company doesn’t work with bank guarantees or LCs. ‘It’s coming though.’ And Russians prefer to pay in dollars. ‘But the euro is quickly gaining ground.’ As far as the Van Seumerens are concerned, Russia doesn’t necessarily have to join the WTO. ‘We already know how everything works in Russia, which gives us a competitive edge.’ Roderik and Patrick feel Russia has changed a lot over the past ten years. Particularly as a result of the emergence of the ‘nouveau riche’, as they call the 30 and 40-somethings who have gotten very rich very quickly. Their mentality is very different from that of the older generation. Patrick van Seumeren: ‘The nouveau riche aren’t interested in helping you, they’re very impressed with themselves, they’re only interested in dollars.’ The differences between urban and rural areas have also increased, particularly between Moscow and the rest of Russia. Meanwhile, Moscow has become the most expensive city in the world. The Van Seumerens don’t yet know what their future plans are in Russia. Roderik van Seumeren: ‘Our ambitions are undefined. We’re staying in any case. We have some big Russian clients and the Russian economy is still growing. For now, the possibilities seem endless.’

... and some comments • For traditional Russians, a good business contact is based

on friendship, brotherhood, mutual enjoyment of a successful project. The nouveau riche on the contrary aren’t interested in helping you, they’re very impressed with themselves, they’re only interested in dollars.

• Russia doesn’t necessarily have to join the WTO. ‘We

already know how everything works in Russia, which gives us a competitive edge.’

• The Russian economy is still growing and for now, the

possibilities seem endless.

Some tips...

1. Even if you or one of your employees speaks impeccable Russian, you need to hire a native if you want to do business in Russia.

2. It’s all about gaining trust, which doesn’t happen by itself. In

order to gain trust you have to talk a great deal, explain, tell, communicate and, of course, drink – a lot.

3. Only carry out a project after you have the money in hand.

Website www.mammoet.com

Russia


4. Ottevanger Milling Engineers is successful on the Russian market In 2009 it will be precisely a century ago that Dirk Ottevanger, a miller’s son, founded a regional windmill manufacturing company, laying the foundation for Ottevanger Milling Engineers BV. This globally operating company is located in Moerkapelle, not far from the windmill that once belonged to Dirk’s father. This company, with over 60 employees, designs and manufactures large machinery for the grain processing and animal feed industry. It took on its first Russian projects back in the early 1990s. Ottevanger is currently involved in five projects and has successfully completed 15 ventures, many of them of major size. Dick Ottevanger is third generation and no longer the company’s chairman, but is still closely involved. He has been to Russia at least 20 to 25 times on business. ‘It’s not an easy place to work, but certainly not an unpleasant country either. Culturally, the Russians aren’t so very different from us. I think the Asians, for example, are much harder to fathom. You can more easily build up a close – at times even friendly – relationship with Russians. Anyone wishing to do business there must take their time. I remember one of my first visits when I was invited for a birthday celebration where drink was flowing freely. The Dutch wouldn’t have been so quick to include a business associate.” A reference makes all the difference Ottevanger Milling Engineers started its pioneering work in Russia in 1989 and 1990 when opportunities for foreign companies improved. Dick initially focused on winning contracts via a government agency that had contacts with state-owned companies. “The agency wanted to promote us, but nothing came of it. We still have a staff member in Moscow, Nicolaï, who worked for the now defunct agency.” For the very first project, which was carried out in Lindovskaya in 1994 and 1995, Ottevanger was approached by Euroconsult in Arnhem. Euroconsult was working on the Eastern Europe Cooperation Programme for the Agency for International Business and Cooperation, a branch of the Dutch Ministry of Economic Affairs. Ottevanger: “In any market completing your first project is good for your reputation. It gives you a reference. That makes a huge difference.” In 1995 business appeared to be picking up. Ottevanger: “Stork’s Peja Export BV, which had hundreds of people working in Russia and did a lot of business with state-owned companies, closed its doors. Ten people kept the branch office going and approached us. Which brings me to our most important tip: make sure you have an agent in Russia who is active in the local market or you won’t get anywhere. Once we had a serious agent, our business in Russia got off the ground.” Rouble crisis Unfortunately, Ottevanger’s success was short-lived as the rouble crisis threw a spanner in the works in 1998. “Big projects were scheduled but they all fell apart. Business didn’t pick up again for another five years.” And that highlights Ottevanger’s second tip: have patience and staying power; both are indispensable. At times, Dick Ottevanger flew specially to Russia to sign a contract with a business partner. Upon arrival he occasionally discovered something had gone amiss with the permits, or the client had key questions about the quote. Sometimes he came home

Russia


empty-handed. Other times, the issues were resolved. And there were also instances that the competition managed to steal the contract out from under them. Tip three: “You’re often well-advised to work with women in Russia, who can be more serious than the men. They are keen workers, often have a good command of foreign languages and are well-educated. It’s clear that there has always been a large proportion of females in the Russian workforce.” Erik Ottevanger, manager of the Moerkapelle branch (fourth generation and Dick’s son), doesn’t have to think long before remembering a project in Russia that didn’t quite go according to plan, to put it mildly. “I remember quite well that the client put a lot of pressure on us to deliver on time. So we did. Then it emerged that the Russians hadn’t done anything to prepare the location where the plant was to be built. There was nothing at all, not even a hangar to store the goods. For two winters our equipment was buried under a thick layer of snow. That made it difficult to get it up and running again; the worst part was figuring out which electrical components had broken down. Then there were endless discussions about the extra costs. We had to prove that the problems with the equipment were the result of being left outside. The client probably wasn’t all that interested in this project. It was a gas company that had invested in the agricultural sector under pressure from the Russian government.” We were, however, paid without a problem. As has been the case with nearly all Ottevanger’s Russian clients, this gas company paid the entire purchase price up front. Trusting Erik: “Normally, we don’t design and manufacture the equipment until we’ve been paid. In a limited number of cases, we allow a 10 percent down payment with the remainder covered via a letter of credit. In such cases, a large percentage is due upon shipment and the rest three to four months after delivery. But we only do this if we have a very solid relationship with the client and we are nearly sure they can pay. We’ve never had payment problems with the Russians. It is often very difficult for Russians to get a bank guarantee. Usually they can get an LC, but the amount may be limited. One of our customers wasn’t able to procure an LC for three million euros. So we allowed them to arrange three successive LCs for one million euros each. Another noteworthy fact about Russians is that they are very trusting. Sometimes they pay us 600,000 to 800,000 euros in advance for a project and never ask for a bank guarantee even though we could easily arrange one. Something could actually go wrong on our end, but the Russians don’t lose much sleep over it.” Ottevanger has numerous success stories in Russia. For some three million euros, entire feed plants were set up for a Russian chicken producer listed on the London exchange. Erik: “It went very well, despite a slight postponement of the delivery date. But that’s actually common in Russia. Russians are capable of a great deal, are well-educated and have a high opinion of themselves, but their organisational skills are lacking. They’re frequently overoptimistic in their planning. Getting permits often takes a great deal of effort. We leave that to the client, who routinely hires a local project agency.”

Some tips...

1. Make sure you have an agent in Russia who is active in the local market or you won’t get anywhere.

2. Have patience and staying power; both are indispensable. 3. Work with women in Russia, who can be more serious than

the men. They are keen workers, often have a good command of foreign languages and are well-educated.

... and some comments • In any market completing your first project is good for your

reputation. It gives you a reference. That makes a huge difference.

• In a limited number of cases, we allow a 10 percent down

payment with the remainder covered via a letter of credit. In such cases, a large percentage is due upon shipment and the rest three to four months after delivery. But we only do this if we have a very solid relationship with the client and we are nearly sure they can pay.

Website www.ottevanger.com

Russia


5. Gebroeders Van den Berk B.V. ‘With patience and respect, you can do good business in Russia’ Why does Russia have so much bureaucracy? Why do new, seemingly avoidable, practical problems arise every day? These are questions you often hear from Dutch entrepreneurs gaining their first trade experiences in Russia. Russian-born Svetlana van Son, who has lived in the Dutch province of Noord-Brabant since 1996, works for Boomkwekerijen Gebroeders Van den Berk in the town of Sint-Oedenrode. She is an advisor and sales manager for the Russian market, on permanent contract since 2005. Before that she worked as a freelancer, translating brochures and other documents for Van den Berk. Commenting on the frustrations experienced by Dutch businesspeople she says: ‘It works best if you have patience and respect for Russian customs and practices. You shouldn’t try to understand everything; some things won’t make sense. If a deal with a Russian client seems to be more or less finalised and the client then goes silent for weeks on end, don’t get emotional,’ she says. ‘Keep your cool. Consider it from a rational, business perspective.’ ‘It’s not so difficult to do business if you don’t buy into all the talk and stories about fickle Russians who are incapable of planning and said to be incredibly curt and stubborn. Just be yourself and draw your own conclusions. Not only do countries differ, so do people. You might run across Russians who are more Dutch than the Dutch. And vice versa: Dutch who more than fit the cliché image of the curt Russian.’ 130-year-old plane tree Svetlana speaks fluent Dutch; at most you’ll hear a pleasant Flemish accent as she learned the language in Belgium. She started out as a German and English teacher, a legal interpreter and certified translator. Pieter van den Berk, an engineer, is the general manager of the family-owned business. Its beautiful, vast plantations, where thousands of trees are cultivated, are reminiscent of a park. Van den Berk is specialised in street and park trees as well as ornamental shrubs. The nursery can deliver over 800 varieties of trees and shrubs and excels at somewhat larger and older trees. Pieter van den Berk: ‘We have a huge plane tree that’s over 130 years old and even a batch of Taxus bonsai that have been looked after for over 100 years. You can buy trees from us that cost to EUR 30,000 and are so big you can only fit one in a huge truck.’ Pieter: ‘During our 2002-2003 financial year we completed our first real sales transaction with a Russian client we met at the German IPM Essen trade fair. It’s still an important fair for us, as is Moscow Flowers. Now we have quite a few Russian clients; it’s an important market for us, which is why we work with Svetlana.’ Svetlana: ‘We are often approached at trade fairs by Russians who are eager to set up a joint venture, even before they’ve purchased anything from us. In the case of a joint venture they usually want us to furnish the capital and products, while they provide knowledge of the local market.’ Pieter: ‘This doesn’t interest us just now. I consider the cultural differences too great for this type of venture. We recently set up a nursery in Germany. It is a neighbouring country, but the differences with the Netherlands are significant. Moreover, Russia’s climate isn’t as suitable for a nursery.’

Russia


Solid market research is key Svetlana: ‘Our first tip: anyone interested in doing business in Russia should seek advice from Dutch people with experience in Russia and Russians familiar with Dutch pitfalls.’ Svetlana: ‘Tip two: do thorough market research at trade fairs, on the internet, and by following the Russian trade press. Make no mistake: Russians are very familiar with western products. They’re price conscious and are quite capable of assessing the quality of merchandise. They have more and more money to spend, they travel a lot, they know what’s for sale in the world.’ Pieter: ‘We still have our very first client. That’s the delightful thing about doing business in Russia: the moment someone becomes a client, they’re a true client. They seriously examine the company they’re getting involved with, and don’t jump to a competitor for any little thing. It may take a little longer to build trust, but once you have, it’s unwavering.’ Svetlana: ‘There’s a Russian saying: if you take your time to properly harness a horse, he’ll ride fast. You need to thoroughly prepare and cultivate good relations.’ Of course this doesn’t mean everything will go perfectly. Pieter: ‘We once met with a potential Russian client who seemed to have everything in order. We were lavishly received, given a video presentation of the company, lots of grandstanding. The man was an incredible show-off but, in practice, not a good trading partner. So we walked away.’ ‘Another time a group of Russians came to our company who were interested in placing a sizeable order for birch and fir trees. It was July so I said: these trees are still in full bloom and it doesn’t make sense to deliver them in August because they might not survive. But they were in a hurry. I turned down the deal and they bought their trees elsewhere. Indeed, the trees died and they came back to us. It’s important to properly inform your clients.’ Put clear agreements in writing Svetlana: ‘Russians like trees with colourful leaves. They also like large crowns. But big crowns mean a lot of water evaporation so it’s best to trim back the crown prior to transport. Sometimes you need to thoroughly explain that to people.’ Pieter: ‘Everything should be crystal clear. For instance, we explain in no uncertain terms that it can be a problem if the trees are picked up from us later than scheduled, even if they’ve been paid for in advance as is the case with 90 percent of Russian clients. (Ten percent – these are longstanding Russian clients – have a credit limit.) If a lot of trees are picked up late, quality can be lost. You need to thoroughly explain such things in advance and put it all in writing. If you don’t, your Russian partner might misinterpret. Communication is a challenge. Such misunderstandings are often inadvertent and due to inexperience. Svetlana always accompanies me to meetings with Russian clients. This is an enormous help. It’s not just the language barrier, but the cultural subtleties, which she understands perfectly.’ The third and final tip comes from Pieter: ‘Don’t talk about politics. The Dutch applaud perestroika, but Russians might feel differently.’

Some tips...

1. Anyone interested in doing business in Russia should seek advice from Dutch people with experience in Russia and Russians familiar with Dutch pitfalls.

2. Do thorough market research at trade fairs, on the internet,

and by following the Russian trade press. 3. Don’t talk about politics. The Dutch applaud perestroika,

but Russians might feel differently.

... and some comments. • Not only do countries differ, so do people. • The moment someone becomes a client, they’re a true

client. They seriously examine the company they’re getting involved with, and don’t jump to a competitor for any little thing. It may take a little longer to build trust, but once you have, it’s unwavering.’

• It works best if you have patience and respect for Russian

customs and practices. You shouldn’t try to understand everything; some things won’t make sense.

Website www.vdberk.com

Russia


6. For Econosto, Russia is a top market in the making Econosto is still a relatively new player in the Russian market. And yet, this wholesaler in valves and seals landed a contract in May 2006 to supply all the seals – a total of 18,000 – for the construction of a new oil refinery in Saint Petersburg. The order is worth a whopping 40 million euros. Project manager Tim Hogervorst and financial manager Otto de Vries are still amazed at how the negotiations proceeded. ‘It was like being at an auction. We had to write figures on paper and wait out in the hall.’ It all started a few years earlier. Billionaire Vladimir Bogdanov, the owner of Russia’s second-largest oil company Surgutneftegaz, wanted to construct a hydrocracker in Kirishi near Saint Petersburg using the latest techniques. It was to be a plant where hydrogen would be used to convert heavy distillates into diesel and kerosene, for example. The international engineering firm ABB Lummus Global BV in The Hague would provide the necessary technology, design the equipment and draw up a short-list of western suppliers. Tim Hogervorst: ‘It took AAB years to land that contract.’ In order to realise the project, ABB organised several information sessions for suppliers like Econosto and launched a tender round. Hogervorst: ‘Of course we listened very closely to AAB and negotiated with them intensively. We realised that participating in this project would be a wonderful way to gain access to the Russian market. Moreover, this project would enable us to learn a lot about that market in a short period of time.’ De Vries: ‘Econosto was already doing business with Russian shipping companies and we were working with Russian agents, but we didn’t yet have a strong foundation in Russia.’ Econosto is a supplier of valves and seals. Seals are rings or discs of various shapes and sizes that prevent leaks. Valves are like faucets or open-and-close-systems; these can be heating faucets that cost a couple of euros or earthquake-proof sealant systems that run into hundreds of thousands of euros. In the over 12,000 m² distribution centre in Capelle aan den IJssel, the company has the largest European stock of DIN, ANSI and JIS appendages, instrumentation, seals and hoses of its own brand as well as a wide variety of products from international, renowned manufacturers. An amazing atmosphere For its Russian client, ABB was looking for a company that could supply all the valves needed for the refinery’s equipment. This made Econosto an attractive candidate. It was a major advantage to Econosto that the technical negotiations regarding the parts to be supplied were conducted in the Netherlands with ABB. This meant all the risks could be mapped out in detail. Hogervorst: ‘If we were awarded the contract, we would officially supply to ABB, which would be the exporting party. They are responsible for the technical equipment. Still, the big boss in Russia wanted to meet all the parties involved. ABB was not to be involved in the commercial side.’ During the tender round, there were five major contracts to be assigned and three similar companies in Russia were invited to bid per contract. Negotiations were conducted with 15 companies over a three-day period, with each company represented by four to five senior staff members. De Vries: ‘The atmosphere was amazing. We were there with 15 companies that all knew one another in their market.’ According to Hogervorst and De Vries, the owner, Bogdanov, wants the refinery to be a liberal organisation, ‘a professional global player that delivers the best products.’ De Vries: ‘Bogdanov wants everything to run as cleanly and objectively as possible. Every potential for corruption must be eliminated. Which is why he prefers to work with

Russia


Western companies. And we think it explains why he organised the auction in the last phase of negotiations.’ Econosto’s biggest concern was the financial risks. It was determined at the beginning that Econosto would not be paid until after delivery. As we went along, we managed to cover all the risks with confirmed L/Cs.’ The red tape involved with the customs certificates continues to be bothersome. ‘You have to dot all your i’s and cross all your t’s.’ In addition, every product Econosto supplies to Russia must undergo a thorough technical inspection. Russia works with different technical standards than the rest of the world. De Vries: ‘Even though we have ABB as our contact, we still have to meet the Russian requirements. All our products must be inspected by the authorities in Moscow, which takes six months. It would make a big difference if Russia joined the WTO; if it harmonised its regulations with those of other countries. We still consider this a learning experience. We’re getting to know a great deal about the Russian market in a short period of time.’ Physically present One of the things Econosto has learned is that doing business in Russia is much easier if you are physically present. Then, it seems, anything is possible. The Econosto group has Russian-speaking staff and has opened a small office in Moscow. All kinds of requests for products are now also coming from Russia. Occasionally Econosto is asked to enter into a joint venture with a Russian company. De Vries: ‘So far we haven’t further explored any of these requests. They always involve companies that spread their funds among a number of firms for tax purposes. Then, six months later, they allow them to go bankrupt. The Russians were very open and honest about this. They showed us exactly how they did it and let us see their accounts. Of course as a listed company, we cannot take part in this type of thing, which perhaps limits our options during this start-up phase.’ Nonetheless, according to Otto de Vries Russia could very well be a top market in the making for a company like Econosto. ‘It is a very big country with an enormous market and tremendous reserves. The Russians would rather do business with Western companies than with Chinese or Indian firms. Products from China and India are taboo. Sometimes the motto seems to be “the more expensive the better”. We hope we can also profit from all the current investments in infrastructure. In the Netherlands, our market is limited; everything has already been built, everything is finished. Here, we only supply replacement parts or upgrades. In Russia it’s about new projects. Once they’re up and running, things move quickly.’

... and some comments. • The red tape involved with the customs certificates

continues to be bothersome. ‘You have to dot all your i’s and cross all your t’s.’

• It would make a big difference if Russia joined the WTO; if

it harmonised its regulations with those of other countries. • The Russians would rather do business with Western

companies than with Chinese or Indian firms. Sometimes the motto seems to be “the more expensive the better”.

A tip... 1. Doing business in Russia is much easier if you are

physically present. Then, it seems, anything is possible.

Website www.econosto.com

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