“Neo-Oligarchical” Ownership Regime in Putin's Russia

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ABSTRACT

THE “NEO-OLIGARCHICAL” OWNERSHIP REGIME IN PUTIN’S RUSSIA: IMPLICATIONS FOR OIL SECTOR

by Mariia M. Semykoz

This paper analyses specifics of the private property system, established in the Russia oil sector in the period of Vladimir Putin’s political leadership. The model of “neo-oligarchical” ownership regime is proposed as a conceptual tool aimed at capturing the basic features and effects of the state’s dominance vis-à-vis the private economic actors. An overview of the political sources, which might have led to the emergence of this system, as well as its relationship to the broader theoretical understanding of Putin’s regime in Russia is provided. THE “NEO-OLIGARCHICAL” OWNERSHIP REGIME IN PUTIN’S RUSSIA: IMPLICATIONS FOR OIL SECTOR

A Thesis

Submitted to the

Faculty of Miami University

in partial fulfillment of

the requirements for the degree of

Master of Arts

Department of Political Science

Mariia M. Semykoz

Miami University

Oxford, Ohio

2012

Advisor: ______Dr. Gulnaz Sharafutdinova

Reader: ______Dr. Venelin I. Ganev

Reader: ______Dr. Ora John Reuter Table of Contents

Putin’s Promise: Oil Industry as a Locomotive for Russian Economy ...... 1 Puzzle: Efficiency of Russian Private Oil Firms ...... 3 Model of the “Neo-Oligarchical” Ownership Regime ...... 8 “Neo-Oligarchical” Ownership: Did Russia Move Away from Political Capitalism? ...... 17 Concluding Thoughts ...... 23 Bibliography ...... 25

II ACKNOWLEDGMENTS

I am grateful to Dr. Gulnaz Sharafutdinova, Dr. Karen Dawisha, Dr. Venelin I. Ganev, Dr. Philip Hanson, and Dr. Ora John Reuter for the support, guidance, comments and valuable criticism they provided in the course of this research. Nevertheless, all mistakes are mine only.

III Putin’s Promise: Oil Industry as a Locomotive for Russian Economy

In 2000, incoming Russian president Vladimir Putin’s popularity was based on Russians’ trust that this well-fit and disciplined man was able to deliver on his promise to “lift the country from its knees.” Many hoped that Putin’s security service background, experience in state management and a graduate degree in economics would help him to cope with this task successfully. The latter seemed to be especially relevant given the state of post-Soviet Russia’s long- troubled economy. Still suffering from the effects of the halfhearted post- communist reforms of the early 90s, the Russian economy soon found itself sinking in the rapid waves of the 1998 financial crisis, devaluing whatever thin savings and destroying whatever unsecure jobs many had. The business environment was almost unbearable by any Western standards. Pervasive corruption, massive ineffective bureaucracy, widespread organized crime and insecure property rights were just a few challenges plaguing post-Soviet economic actors. The remedy Putin publicly proposed for the Russian economy was fairly simple: the strong state must be able to enforce the “rules of the game” on everyone, including the infamous mighty business tycoons – the oligarchs. Secondly, the state must carefully and effectively guide the development of the country’s most important economic sectors. Arguably, thus far, Putin has failed to achieve the first goal. Under his leadership, the state was not able to successfully combat the blatant corruption corroding its bureaucratic apparatus and the judiciary since Yeltsin’s era; nor was it able to limit the scope of bureaucrats’ burdensome, and often arbitrary, power. (Holmes 2005, 86, Arbatov 2007). But what about the second part of his economic program, the state supervision of the development of certain economic spheres? In his first address to the Russian parliament, Putin stated: It must be admitted that the state will not be able to stop participation in several sectors of our economy for some time yet. I mean direct participation by the state. It will not be able to, and should not stop - in sectors such as the defense and industrial complex, for example. Strategically important industries will remain under the constant attention of the state (Putin 2000).

If we are to trust his opinion, expressed in his 1997 kandidat dissertation, Putin believed the natural resource industries could push Russia’s economy forward to modernization, growth and international competitiveness. In order for them to fulfill this function, the state must mobilize its resources to shape, direct and control the sector’s development. This would ensure the industry would be capable of taking “the lead in building up the economy, providing revenue and employment, and promoting economic integration across Russia, with the CIS and with the world economy.” (Balzer 2005, 216-217). In line with this position, Putin consistently refered to Russia’s natural resource industries, as well as to the military-industrial complex, as the “strategic” sectors. In essence, deeming an economic sector as “strategic” in Russian state’s discourse implies that the government considers it has a right to intervene in its development to the extent it considers it necessary. With regard to the mining industries, in 1999 Putin claimed that “[r]egardless of who’s property the natural resources are and in particular the mineral resources might be, the state has the right to regulate the process of their development and use.” (Cited at Balzer 2005, 218). Most observers would agree the actual policies Putin implemented within the first 12 years of his reign were consistent with this early statement, with the oil industry taking the top of the “strategic” sectors’ list. This became apparent after 2003, when, following the infamous Yukos affair, the state gradually increased its direct ownership in the oil sector, making the government-controlled Rosneft the world’s largest oil company in terms of proven reserves by 2010, with Gazprom’s oil-producing division exhibiting potential to become a close follower (Rosneft 2010). While simultaneously increasing the state’s direct stake in the industry, the government also developed legal and administrative mechanisms to control the activity of privately owned oil producers. As Reynolds and Kolodziej (2007) suggest, the state’s legislative policy since 2003, on balance, seemed to be aimed at reestablishing government control over the oil industry. In particular, the new legislation introduced during Putin’s leadership severely restricted opportunities for foreign investment in the petroleum sectors. It also broadened the state’s powers regarding uncompetitive administrative allocation of mining licenses, and cleared the way for nationalization of companies, through the selective application of penalties, envisaged for tax-evading firms. With regards to the latter, as experts suggest, nearly every Russian company that operated during the 90s could have been charged with tax evasion, due to the contradictions present in the pre-2001 tax

2 laws. (Reynolds and Kolodziej 2007, 946-947, Morozova 2009). Additionally, as far as restrictions on foreign investment are concerned, the analysis of the various Russian legislative provisions lead Reynolds and Kolodziej to conclude, …private ownership cannot be restricted to a single nationality of the owners in a globalized world market. If at any point in time a ‘‘Russian’’ owner is deemed to be ‘‘foreign’’ due to his investments abroad or due to foreign participation in his businesses, then the government can immediately take control of that business. Indeed, the only sure way to know if a business is fully Russian-owned is if it is owned by the government (Reynolds and Kolodziej 2007, 945). Thus, we might conclude that all the tools, Putin considered necessary to turn the Russian oil industry into the locomotive of the country’s economic integration into the competitive global environment, were at the state’s disposal. But what are the results? How competitive is the Russian oil industry on the global scale? The next section attempts to provide some answers to these questions.

Puzzle: Efficiency of Russian Private Oil Firms

For several decades, analysts have regarded the question of oil industry efficiency (and, thus, competitiveness of individual firms) in conjunction with the growing trend of greater government control over petroleum production worldwide. Since the 1970s, the National Oil Companies (NOCs) – state-owned firms, often holding a monopoly or at least exclusive status in oil production in a given country – have increasingly become key players in the world oil industry, ousting even the powerful international oil majors to the margins. For instance, in 2008, the NOCs took up almost one half of all positions in the Energy Intelligence Top 100 Ranking of the World’s Oil Companies (KPMG International 2008, 1). Similarly, in 2007, fourteen out of twenty top world oil producers were NOCs (Hartley and Medlock 2007). But why do an increasing number of analysts find the trend alarming? Their concern is based on the theory, first outlined by economist Harold Hotelling in 1931, known as “Hotelling’s rule”. (Hotelling 1931). The model implies that a finite resource, under market conditions, is likely to be depleted as a result of the physical exhaustion, but as a result of reaching a point when economic costs of the resource extraction become prohibitive. With regards to oil reserves, economists refer to this situation as “economic peak oil” (Skrebowski

3 2011). Since Hotteling’s rule was introduced, its basic assumptions have been incorporated into economic models aimed at explaining outcomes of the dynamic world oil market. In 2007, Hartley and Medlock developed a model specifically tailored to incorporate specifics of the state-controlled oil producers. The model’s results are troubling: peculiarities of the economic calculus of NOCs’ managers and shareholders, who are usually represented by politicians, discourage the firms’ investments in innovation and technological development: … NOC is likely to forgo investments that would be considered profitable if the firm were a private corporation. The funds that otherwise would have been invested are available for other purposes, including increasing the amount currently flowing to the Treasury (Hartley and Medlock 2007, 22). Underinvestment is likely to hinder efficiency of resource production, and this, in turn, leads to the situation, in which the costs of further oil extraction become too high for the economy to bear. Thus, if this theory’s assertions are correct, we should expect the greatly feared peak oil crisis faster in the world where the oil production is under control of the state-run firms. Given this gloomy prognosis of the effects of the NOCs-expansion trend, the petroleum industry situation in Russia, which has recently become the leading oil producer in the world, at first glance encourages some optimism (McInnes 2012). Though Russia, the holder of the world’s largest known natural gas reserves and the eighth largest crude oil reserves, has developed inline with the aforementioned trend of increasing state control over petroleum production, it is still far away from being considered the flagman of the world’s oil and gas industry nationalization (U.S. Energy Information Administration 2010). In 2007, already after the wave of nationalizations following the Yukos affair, the share of state-controlled petroleum producers in Russia’s output of oil and gas condensate accounted for around 37% (Hanson 2009, 15). Thus, private actors control the majority of oil production industry in the country. In the recently published study by Luong and Weinthal, the authors even consider post-Soviet Russia, prior to 2008, to be one of the rare examples of a country that opted a private ownership model for its petroleum assets, desirable from an economic and political standpoint. In fact, in light of the earlier discussion of the developed mechanism for the governmental guidance of the industry, one might argue that Putin achieved the conditions designated by him in 1999 as the most desirable for Russian oil sector development:

4 Unfortunately, when market reforms began the state lost control of the resource sector. However, now the market euphoria of the first years of economic reform is gradually giving way to a more measured [vzveshennomu] approach… A contemporary strategy for rational use of resources cannot be based exclusively on the possibilities of the market. This applies even more… to the Russian economy… In Russia, as a consequence, it is necessary to implement this principle of rational resource use by an organic combination of market mechanisms of self-regulation and [state] support for rational resource use and conservation. (Putin, cited at Balzer 2005, 218). No matter if we believe in the notion of “organic combination” of the market and state regulations, taking into consideration the above-mentioned economic theories, based on Hotelling’s rule, we can expect the Russian oil sector to perform well against the background of the NOCs-dominated world industry. Empirical evidence, however, contradicts this expectation. The study of the operational efficiency of the world’s 80 largest oil companies for the years from 2002 to 2004 by Eller et al. (2007) presents an intriguing unintended finding: An interesting regularity … is that the Russian firms (regardless of the amount of government ownership) tend to be ranked with low levels of technical efficiency. This suggests that systematic features of doing business in Russia apart from government ownership negatively affect the ability of Russian firms to generate revenue from a given level of reserves and employment (33). Indeed, the authors’ analysis suggests that all Russian petroleum companies are significantly below the world average in the measure of technical efficiency. 1 Though the key predictors of an oil company's efficiency, according to the empirical model by Eller et al., are the share of government ownership, the subsidized domestic prices for gasoline and vertical integration of a firm, a significant part of the level of Russian petroleum companies’ efficiency underperformance, compared to other industry participants, remained unexplained when these three factors are controlled for. 2 Eller et al. (2007, 2) measure the oil companies’ efficiency as an amount of revenue per employee and per unit of oil and gas reserves. The researchers use Data Envelopment Analysis (DEA) to create an indicator of technical efficiency, understood as maximization of output production given the firm’s inputs. The

1 Among the rest, the database includes Novatek, Rosneft, Gazprom, Surgutneftegas, Sibneft and TNK 2 Greater vertical integration of a company can influence the indicators of the technical efficiency due to the cheaper trade in oil between a single company’s subunits

5 index runs from 0 (indicating complete inefficiency, a waste of resources) to 1 (the outputs are maximized). According to the model, the technical efficiency indicator for Russian petroleum companies ranges from 0.02 to 0.17, which indicates 2% and 17% respectively of the technically possible output, with the industry average being 0.40 and the average for major international oil firms and national oil companies being 0.73 and 0.28 respectively (Eller, Hartley and Medlock 2007, 19-21). Accounting for vertical integration and government ownership share, Russian companies’ performance ranges approximately from 0.10 to 0.56, with the industry average being 0.77, and the average for the international oil majors and national oil companies being 0.98 and 0.76 respectively (ibid.). It is clear both models imply drastic underperformance in the Russian oil and gas sector in terms of technical efficiency, both for privately and state-owned firms. In fact, Russian companies represent the least efficient part of Eller et al.’s sample of the 80 petroleum firms worldwide. One can, however, rightfully criticize far-reaching conclusions drawn from the model. First of all, DEA produces indicators, in essence, comparing a given firm with the most efficient ones in the sample. Thus, the method does not account for the difference in the stages of business development between companies in the sample. For instance, it is likely, that a firm being in the investment stage would appear to be less efficient than companies who are already reaping the results of their previous investments. Secondly, the units of inputs, which the model assumes to be equal for all firms, are far from being the same in reality. Obviously, the same amount of barrel of oil equivalents (boe) of the easy-to-recover Saudi reserves is de-facto larger output than the same amount of, for instance, Russian East-Siberian oil. In fact, Russia belongs to the group of expensive oil producers. Its geological and geographical conditions make the natural production costs, that is the costs occurring when the production is organized in the efficient manner, higher than in other regions (Gaddy 2004, Gaddy and Ickes 2005). In other words, the oil producers in Russia appear to be inefficient when compared to producers in the “easier” oil regions, while in fact they may not be. The same might be true for Eller et al.’s other input variable, number of employees, as it might, in fact, be efficient for a firm located in an area of cheap labor force to hire more employees with lower productivity, than in areas of expensive, but more productive, human resources. However, given the scarcity of population in Russian oil-producing regions, it is highly unlikely to be the case.

6 Overall, there are grounds to believe that the significant limitations of Eller et al.’s model do not negate their finding on the profound inefficiency of Russian oil firms, as the country’s oil industry insiders’ accounts confirm this conclusion as well. For example, according to a cable by the US Embassy in Moscow, revealed by Wikileaks, then TNK-BP COO Tim Summers told the US ambassador in 2009: The inefficiencies in the system "are so huge," according to Summers, that it would take a very long time to modernize the Russian oil and gas sector. For example, Summers pointed out that a well that would take 10 days to drill in Canada would take 20 days to drill in Russia. He said moving a drilling rig from one site to another, a process that might take 7 or 8 hours in Canada, takes 28 days in Russia -- "multiply that by hundreds or thousands and you can start to imagine the costs to the economy." (US Embassy Moscow 2009) An interesting addition to the puzzle of Russian private companies’ inefficiency is the fact that oil-producers seem to be somewhat exceptional among the other Russian industries. In general, Russia is known to be a difficult place to conduct business. Many observers highlight that the sources of Russian businesses’ inefficiency can be found in high hidden costs of doing business in this country. These hidden expenses include compliance costs with the labyrinthine taxation, accounting and licensing rules, bribes, quasi-voluntary social contributions and risks induced by insecure property rights. It is reasonable to assume that in Russia, occupying the 143rd position in the Transparency International Corruption Perceptions Index (Transparency International 2011), the 120th position in the World Bank’s index on the ease of doing business (International Finance Corporation; The World Bank 2011) and the 81st position in the Economic Freedom of the World ranking (Fraser Institute 2011), all of those hidden costs’ components are likely to be substantial. However, Russian business in spheres other than petroleum production have proven to be reasonably efficient, given these unfavorable conditions. For instance, studies indicate that Russian privately owned mobile operators are closer to the median in operational efficiency in the sample of companies from other BRIC countries (Liao and González 2009).3 Therefore, on top of the generally harsh business conditions in Russia, additional factors must contribute to the inefficiency of the country’s private oil companies. In the following section I attempt to provide an explanation to this puzzle. I propose a theoretical model of the “neo-oligarchical” ownership regime,

3 In the oil industry, Brazilian and Chinese oil firms leave their Russian counterparts far behind

7 as I believe a special conceptual framework is needed to capture the specifics of the relationships developed between the major owners of Russian private oil companies and the state under Putin. I will, then, argue the “neo-oligarchical” ownership regime is likely to impact the decision-making calculus of economic actors, leading to firms’ lower efficiency in comparison to companies, assuming the classic model of the secure private property rights is in place.

Model of the “Neo-Oligarchical” Ownership Regime

By employing the term “neo-oligarchical” ownership regime I am referring to a simplified model of the system of relationships, which have been established between major private owners of businesses in “strategic” economic sectors and the state elites in the period of under Putin. Traditionally, due to the high concentration of economic property in post-Soviet Russia, coupled with the close relationship of assets’ owners with the state, the latter are referred to as “oligarchs” (Guriev and Rachinsky 2005). However, I believe the position of these large-scale owners vis-à-vis the state changed significantly with Putin’s rise to power. In order to highlight this distinction from the system in place in the 90s, I label the concentrated private ownership in Russia during the 2000s as “neo- oligarchic.” Though I assume this model might capture the key characteristics of the state-owners relationship in Russia’s other “strategic sectors”, this paper deals exclusively with its application to the situation in the country’s oil industry.4 Under the conditions of the model I refer to here as “neo-oligarchic”, the state enjoys ultimate control over economic resources, even though the assets formally belong to private owners. The two key features of the state-owners relationship allow the state to exercise such control. These features are: 1) ownership of economic assets in the petroleum sector is a privilege, not a right;5 2) this privilege is conditional on the holder’s fulfillment of the tasks, set out by the privilege-granter, that is the state elites. Let us start with discussing each of these characteristics in greater detail.

4 According to the Law “On Strategic Industries” from 2008 there might be as many as 39 of the “strategic” sectors 5 If the latter is understood as a socially protected and recognized opportunity, granted in accordance with the formal and known impartial rules

8 As Ganev (2009) suggests, the clear conceptual distinction between rights and privileges, especially applicable to studying post-communism, was offered by Max Weber in the context of political capitalism. In the Weberian tradition, the concept of privileges, juxtaposed with rights, implies the former “rest on ad hoc arrangements involving identifiable personalities (some acting as economic entrepreneurs and some acting as rule-enforcers) rather than on general legal rules and impersonal enforcement mechanisms that guarantee property rights under the conditions of modern statehood.” (Ganev 2009, 667-668). In other words, the state uses its law-enforcement power with regards to property in such a selective manner that it de facto acquires the ultimate power to control economic assets. It is important to note this power goes far beyond the initial stage of post- communist privatization of state assets, as selective law-enforcement allows state elites to acquire an important, if not a final, say in a variety of the assets-related matters, including, for instance, their transition from one private owner to another. I would argue the ownership regime in Russia’s oil sector is based on the principle of privileges, where the state is clearly perceived as the ultimate privilege-grantor, and the non-state actors are left with no other choice than to reconcile themselves with the position of grateful privilege-recipients. These “new rules of the game”, as researchers refer to the new state of affairs in Russian big business, were crystalized by the Yukos affair, when the state pointed out the illusory nature of the property rights in the oil industry, and clarified, who is the ultimate owner of Russian natural resource riches. As Hanson comments on the significance of Yukos affair, “everyone got the message: the rules of the game had changed.” (Hanson 2009, 17). While the case of Yukos’ expropriation is demonstrative of the basic principles of the system, the example of the shareholders’ dispute within Russia’s third oil-producing company, TNK-BP, which happened in 2008, is illustrative of its details. The joint venture between the holdings of three Russian oligarchs and the international oil major BP was born in 2003, when both British prime-minister Tony Blair and Russian president Vladimir Putin witnessed the ceremony of the deal signing (BP signs historic Russian deal 2003). This happened one week before the start of the Yukos affair, when the Yukos’ executive Platon Lebedev was arrested (Tavernise 2003). Thus, it can be assumed that at the time, the publicly-perceived meaning of Putin’s presence at the ceremony was not so different from the perception of Blair’s attendance. Although it is possible to speculate Russian petroleum industry insiders might have already perceived Putin’s approval as the essential security guarantee for any kind of oil sector

9 investment. Five years later, when the conflict exploded between the Russian and British partners, it was obvious who would be an arbiter in the dispute. One of the Russian TNK-BP shareholders, Mikhail Fridman, for instance, stated the British partners should not hope for the Russian shareholders to step back, as “[i]t is not the intention of Putin or Medvedev, despite all these rumors.” (Stott 2008). Interestingly, not only the Russian side appealed to the Russian state for arbitration. The TNK-BP CEO Tony Hayward, according to press reports, interpreted (albeit, arguably, mistakenly) an angry call of Igor Sechin, a deputy prime-minister, to one of Fridman’s representatives as a clear sign of the balance tipping in favor of the British shareholders (Stott 2008). Overall, what strikes one is the openness with which the oil industry insiders admit the decisive role of Kremlin in property-related disputes between the two private actors. Additionally, as the case demonstrates, a privilege granted to hold an asset in Russia’s oil sector does not necessarily imply the freedom to dispose of it without the state’s approval. The second aspect of the “neo-oligarchic” ownership regime is the conditionality of the privilege to possess an economic asset, tied to the privilege- holders’ fulfillment of tasks, set for them by the state elites. Western scholars of Putin’s regime agree the first condition for controlling “strategic” economic assets, is to avoid from politics unless asked by the regime itself to intervene. Mikhail Prokhorov’s, one of Russia’s richest men, role in Kremlin-supported center-right party formation in 2011, as well as his participation in the 2012 presidential elections as a “pocket opposition” candidate for Putin, most likely, exemplifies the latter situation. However, though there is little doubt this condition holds the number one spot on Russian oligarch’s “How not to repeat Khodorkovsky’s fate” guide, there are likely to be others. Even the publicized behavior of Russia’s leaders during the recent global recession suggests additional requirements exist for oligarchs to retain their privileges. For instance, in 2009, during Putin’s meeting with billionaire Oleg Deripaska, staged for national TV broadcast, the casually dressed prime-minister, in a rather humiliating fashion, insisted the businessman sign a document, stating his company’s new social obligations to its workers. The billionaire signed, and has never publicly expressed any wish the disputes with his company’s workers were handled in courts, where they are supposed to be handled, according to the state’s constitution (Barry 2009). This televised event was probably just the tip of the iceberg. As Thornton suggests, Russian state capitalism as a whole “is a world in which Putin requires Roman Abramovitz [sic.] to subsidize remote Chukhotka,

10 forces Oleg Deripaska to pay wages to unemployed workers at Pikalevo, and compels the largest industrial firms to construct infrastructure for the Olympics in Sochi.” (Thornton 2009, 6). But how might these aspects of the “neo-oligarchic” ownership regime in Putin’s Russia, its privilege-based character and conditionality, influence the operational efficiency of Russia-based private oil firms?

Possible Effects of “Neo-Oligarchical” Ownership Regime on Private Oil Firms’ Efficiency

I argue the most obvious, and, possibly, the most consequential effect of the “neo-oligarchic” ownership regime is it severely inhibits competition. Before developing this claim, I would like to note some of the specifics of the competition structure in the current international oil market, which Russia is a party to. During the 2000s, excepting the short period during the global economic recession, a majority of market participants have anticipated a rise in oil prices in a short- to medium-run (Barnes 2010). No matter whether the reasons behind these expectations were based on the spike in the demand for physical oil or paper oil, this continuous trend in anticipations conditioned the world oil market to be supply-driven (Doherty 2011). As a consequence, the front line of competition for vertically integrated oil firms is not so much the fight for consumers, as competition over oil reserves.6 The globalized mechanism of oil price formation reinforces this situation. The major effect of this on the Russian petroleum industry is straightforward: state protectionism with regarding oil reserves allows Russian oil firms to acquire a relative immunity from competition from the international oil majors, as long as the domestically-based companies’ monopoly on Russian petroleum riches is not questioned. Thus, despite the globalized oil market, Russia’s oil producers compete in a relatively closed environment, and, predominately, with each other. Though it ought to have a negative effect on Russian producers’ efficiency, compared to a situation of a non-protective environment, it does not necessarily doom them to the bottom of world rankings. Even the imperfect competition in such a closed market stimulates businesses to

6 As the currently ongoing saga of the US-led attempt to introduce international economic sanctions against Iran’s oil trade demonstrates, consumers’ desire to buy petroleum products no matter the producer is indeed robust.

11 find ways to minimize their costs of production in order to secure additional capital needed to outbid their competitors for new reserves acquisition, as well as to innovate, both with regards to increasing the cost-effectiveness, as well as to advance the firms’ exploration and development capacity. There are no reasons to believe these incentives are completely absent in the case of the Russian oil industry, where multiple producers aspire to control the country’s petroleum reserves. At the same time, the specifics of the ownership regimes in the oil sector, outlined above, is likely to restrain those aspirations. The privilege-based ownership regime implies the resources can be allocated not on the base of impartial and objective criteria, like firms’ possession of capital or know-how, but in accordance with other non-economic factors, such as political connections, loyalty or kleptocracy-rooted motives, as the process of allocation itself is left to the state elites’ discretion. If non-economic criteria dominate state elites’ calculus on resource allocation, incentives for firms to invest in cost-effectiveness and innovation decrease. Instead, they start competing with each other for closer ties with political elites. Some of the Russian state’s decisions regarding allocation of new oil fields in the 2000s, suggest the competition is often decided by non-economic advantages of the participants. For instance, in 2001, the government sold three lucrative new oil fields in the Tymano-Pechora region to a small oil producer, Severnaya Neft, owned by Andrey Vavilov (it is speculated that Vavilov’s interests would later become the reason for the first public conflict between Putin and Khodorkovsky). Severnaya Neft offered 7 million US dollars for the fields, while the other bids (including those from Surgutneftegaz, Yukos and Sibneft, TNK and Rosneft) started at 60 million (Ivanitskaya and Malkova 2012). The assertion it was not economic logic guiding the state officials in their decisions over the disposal of Russia’s petroleum riches, finds a symbolic confirmation in the words of the former minister of natural resources, Vitaliy Artyukhov, who occupied this position from 2001 to 2004. According to press reports, the former minister liked to reiterate during ministerial meetings: “The ministry is not a store selling the licenses [for the oil fields’ development].” (Andreev 2003). Journalists suspect this phrase was meant to be interpreted by the industry insiders as a suggestion to seek informal ways of building relationships with the ministry, rather than hope for making the highest bid at the license- distributing auctions. During the first months of his ministerial term, Artyukhov drafted the “black list” of companies under threat of termination of their current licenses’, and the prospect of a ban on their acquisition in the future. Information

12 about the list was open to journalists. Apparently, the list included a majority of Russian oil-producing firms, on the grounds that some of the oil fields, for which the companies held licenses, were not being developed at the moment the list was created (Reznik, Priroda vozmet svoye 2001). The ministry’s next step was inviting the leaders of the selected firms on the list (mainly, the largest vertically integrated ones) for a meeting, after which, according to journalists’ accounts, all of the invited companies were cleared from the list, while those that remained on the list had many of their licenses revoked (Andreev 2003). These examples of state elites’ exercising their power of privilege- granting, and withholding, demonstrate how the system can protect the privileged from the competition emanating from their less fortunate counterparts. However, after the Yukos affair, it became increasingly apparent that there is a ranking within the system of privileges as well, and the private actors are locked in the lower levels of the hierarchy. Thus, they should be prepared to lose if competing with state-controlled producers. Managers of Russian private firms seem to be well aware of this situation and prefer to avoid any competition with actual state- owned companies. For example, Gorst suggests the private Russian oil giant, Lukoil, withdrew from competition with Gazprom in transportation of gas from the Nakhodkinskoye field, readily accepting profit losses, as companies like Lukoil “understand that it is inadvisable to compete against Gazprom in the gas market” (Gorst 2007, 35). A Moscow-based investment analyst confirms this account in his assessment of Lukoil’s 2012-2024 development strategy: Lukoil’s resource base in West Siberia is decreasing gradually … and the company needs to develop new fields. But it is hard to get new fields in Russia for the company (lately, the state vertically integrated companies were getting the lucrative licenses). (Tkachuk 2012). The risks associated with competing with the state for private oil firms might have grown even higher after the unexpected outburst of public opposition after the fraudulent 2011 parliamentary elections. This can urge the state elite to be increasingly cautious regarding their potential political rivals with resources to fund opposition campaigns. Overall, the “neo-oligarchical” ownership regime seems likely to have a double negative effect on the competition between oil producers in Russia, and, consequently, to affect their performance in terms of operational efficiency. Under the condition that state elites possess the power to arbitrarily allocate petroleum-producing assets, firms’ incentives to improve their cost-effectiveness and to innovate decreases, while the incentive to seek closer relationship with the

13 government goes up. Additionally, as state-controlled producers enjoy a decisive advantage in the access to the most lucrative resources, the private firms’ potential to meet efficiency standards set by the international oil majors drops as well. The second possible impact of the privilege-based system of ownership on private oil firms’ efficiency relates to the need for state elites’ approval for significant transactions involving petroleum-producing assets. This obviously can inhibit the firms’ potential to grow, and prevent the pursuit of economic strategies they consider to be optimal. The example of the company Russneft illustrates this point. In 2007-2008, many predicted that company’s founder and CEO Mikhail Gutseriyev would repeat the fate of Mikhail Khodorkovsky. Just like the history of Yukos, the company was charged with astonishing backdating tax fines, and then a warrant was issued to arrest its CEO. (Kramer 2007). According to journalists, one of the most plausible reasons for this attack on Russneft, in addition to Putin’s ally Oleg Deripaska’s interest in buying the company, was its aggressive growth strategy, and especially, its interest in the former Yukos’ assets, the distribution of which then head of the presidential staff Igor Sechin, allegedly, considered to be the domain of his personal power (Malkova, Igumenov and Berezanskaya 2012). Another key effect of the “neo-oligarchical” ownership regime relates to the shortened time horizon of the firms’ shareholders and managers, resulting, mainly, from the ownership privileges’ conditionality. In the model of NOCs’ operation, developed by Hartley and Medlock (2007), one of the key explanatory factors for state-controlled firms’ lack of efficiency, if compared to their private counterparts, is the higher discounts on future profits, which characterizes the time-horizon of the NOCs’ managers and shareholders. This situation occurs mainly due to politicians’ preference for immediate use of the earned profits, as well as other firms’ resources for social spending and subsidies, as it secures their political power. Additionally, though politicians de facto possess a shareholder- like power with regards to NOCs, unlike private shareholders, they do not have an incentive to care about the firms’ market capitalization, and thus, future profitability, as they usually cannot dispose of their influence freely (i.e. sell or pass shares for inheritance). I would argue the conditionality of the “neo-oligarchical” ownership regime compels the shareholders and managers of the Russia-based oil firms to act in a way somewhat similar to NOC managers’ behavior. As discussed above, the principle of conditionality of the ownership privilege implies that private

14 firms are required to fulfill the tasks, set for them by state elites, be these tasks related to government social obligations or personal political and economic interests of the elites. Obviously, the fulfillment of these tasks is unlikely to be cheap, and, consequently, can divert the resources needed for firms’ capital investment. The other aspect is the exact conditions, on which the privilege of ownership is granted by state elites, are not likely to be spelled out for recipients, and, even if specified informally, these conditions are subject to sudden unilateral changes. As a result, private owners are unsure about their prospects to hold and to dispose of assets, and this uncertainty, similar to the case of NOCs, sharply increases their discount for firms’ future profits. The example of oil producer Sibneft, prior to its nationalization in 2005, provides a perfect illustration of the two drivers behind the shortened time horizon of the “neo-oligarchical” owners. One of the key indirect ways to assess the amount of the discount on future profits a company’s owners and managers have, is to look at the profit reinvestment rate, or, in other words, to estimate what percentage of the net income is being paid out as dividends, as opposed to being reinvested into the company’s development. The greater amount reinvested, the lower one can expect the company’s managers’ and owners’ discount on the future profits to be. On the contrary, the higher percentage of the net profits paid out as dividends, the more myopic one can expect the perspective of the company’s leadership to be. The dividend payout ratio for a major publicly traded oil and gas companies ranges approximately from 17% to 40% of a company’s net income (Smith 2011). One can assume this ratio to be close to the market efficient one. Unsurprisingly, Sibneft’s dividend payout ratio has been higher throughout the company’s history as a private firm. According to media reports, a new record in the company’s dividend payout was set almost each year throughout the 2000s. Until the company was sold to Gazprom in 2005, the dividend payout ratio was maintained at as high as 90% of the company’s net profit (Reznik and Yegorova , Dividendy podozhdut 2005, Saperov 2006). 7 The greatest beneficiary of these

7 While another large Russia-based oil producer TNK-BP followed the Sibneft’s suite with regards to the dividends’/net profits ratio (in 2009-2011, the company paid out from 60% to 80% of its net profits in the form of dividends), in the same period Lukoil paid out only 15% to 26% (author’s calculations, based on the companies’ GAAP reports). I, however, would not consider Lukoil’s behavior as a contradiction to the claim advanced here, as the company’s capital investments, made during the period, are concentrated mainly outside of Russia.

15 payments was Roman Abramovich, whose offshore company controlled Sibneft (Hope 2005). However, not all of this money ended up in Mr. Abromovich’s private accounts. Forced to maintain his position as the governor of Chukotsk Autonomous Area, even despite his numerous resignation attempts, he described his job to be “too expensive” (US Consulate Vladivostok 2008). The 7-fold increase in the budget revenue of the Area from 2000 to 2008, as well as the completion of a “broad array of social, cultural, medical, and educational programs,” is mostly attributed to Mr. Abramovich’s direct involvement. In fact, one may legitimately say that Mr. Abramovich, not as the governor, but as Sibneft’s owner, was simply commissioned by the Russian state to fulfill the latter’s functions. Overall, the insecurity of private ownership in the Russian oil sector vis-à- vis state elites’ claims, captured by the “neo-oligarchical” ownership regime model, as demonstrated above, does have a potential to inhibit efficiency of privately controlled petroleum companies. The “neo-oligarchical” ownership is based on that state’s ultimate control of the economic assets through the system of privileges and the principle of conditionality of their allocation. These two features have several effects on the operational efficiency of the private firms. First of all, the privilege-based character of the ownership regime inhibits competition between the private firms protecting them from the challenges coming both from inside and outside of the “privileged” circle. Additionally, the special position of the state-controlled firms in the market compromises competitiveness in the industry as a whole. Secondly, the conditionality, associated with the privilege-allocation, apart from imposing significant direct costs for the private actors and, thus, diverting resources needed for capital investment, decreases the incentives for private firms to care about their market capitalization and long-term profitability. It should be noted, however, this research does not attempt to provide sufficient evidence to suggest the accuracy of the “neo-oligarchical” ownership regime model, but rather to illustrate the plausibility of its empirical confirmation. In the remaining part of the paper, I will expand on the possible sources of the “neo-oligarchical” ownership regime, as well as try to place the proposed model in a wider context of theoretical discussions about the nature and specifics of the regime, established in Russia under Putin’s leadership.

16 “Neo-Oligarchical” Ownership: Did Russia Move Away from Political Capitalism?

Origins of the “Neo-Oligarchical” Ownership in Russian Petroleum Sector

One of the most obvious explanations for the rise of the “neo-oligarchical” model is rooted in the concept of resource nationalism. This term usually describes the complex of ideological and policy-related positions that societies and states adopt with regard to ownership regime for natural resources. Conceptually, resource nationalism can be juxtaposed to the “capitalist” model of property rights for subsoil and offshore riches. The latter is based on the classical understanding of private property rights, applied to fossil resource assets. In other words, private economic actors have a right to own oil fields in almost the same manner they own other assets such as production equipment, land or buildings. Under this regime, private actors exercise ultimate control over their subsoil or offshore assets, and they determine the order of the resources exploitation, or lack thereof, in the conditions of limited government interference (such as environmental, licensing or other generally applied regulations). The classic examples of this type are the ownership regimes over petroleum production assets in the United States, Canada, Netherlands and Great Britain.8 Resource nationalism, on the other hand, dominates in the overwhelming majority of oil-producing countries today. The doctrine of resource nationalism grants the state de facto unalienable rights to control oil reserves, even when formal ownership rights belong to private actors. The legal mechanism for such control is a constitutional provision that attributes the ownership rights over the mineral riches to the people as a whole, thus making the state the only possible legal legitimate claimant of the resource. As Luong and Weinthal (2010) point out,

8 For Canada - at least, prior to the launching Alberta’s provincial government policies to tighten the control of the oil sands reserves in 2007 (Bremmer and Johnston 2009). For Great Britain - with the possible short exception during the existence of the British National Oil Corporation and, later, the Britoil. The exclusion of the period of the British National Oil company from the “capitalist” type depends on one’s assessment of the impact of the uneven playing ground between the NOC and private oil firms, as it could be argued that the mere participation of the state in the competition for the petroleum resources results the former’s dominance over the private actors.

17 … [The state] has increasingly assumed the role of the protector of the public interest vis-à-vis the exploitation of mineral resources even when it does not own these resources outright. While not wholly a twentieth-century notion, the view that a country’s mineral wealth ultimately belongs to the people who inhabit it was elevated to the international level during the postcolonial era when it was codified by United Nations… (Luong and Weinthal 2010, 10) The policies of international legislators (predominately, the United Nations) in the natural resource sphere, aimed at liberating the postcolonial societies from economic exploitation of their former parent empires, in the second half of the twentieth century had significant unintended consequences, which to a large extent shaped the world’s energy landscape of today. The 1962 UN Resolution on the Permanent Sovereignty over Natural Resources started the creation of the legal tool, which was subsequently effectively used by states all over the world to establish their exclusive control over the subsoil and offshore riches, not only vis-à-vis the claims of foreign governments, but also the private owners, including their own citizens as well. 9 In practice, it means that in countries, whose governments embrace the principle of resource nationalism, the state de facto leases fossil resource assets to economic actors and is in a position to terminate or demand amendments to “leasing” or “concession” contracts. The wave of oil industry nationalizations in OPEC countries in the 1970s, as well as the series of renegotiations of production-sharing agreements between states and private oil firms in the 1990s demonstrates exactly that (Bremmer and Johnston 2009). In extreme cases, a government takes full control over natural resources exploitation, establishing a monopolist national oil company. After the break-up of the Soviet Union, Russia quickly joined the numerous group of states, which adhere to resource nationalism. The principle of state’s ultimate ownership on the subsoil mineral resources was established in the early 90s with the adoption of the Subsoil Law of 1992, subsequently amended in 1995. The same pattern was introduced for the offshore resources in the same year (Locatelli and Rossiau 2011, 4). As was discussed above, under Putin’s leadership, the Russian state acted even more decisively in implementing the principle of the resource nationalism in its energy policies. However, I believe that the internationally embraced principle of the resource nationalism simply provided a convenient legal and ideological tool for Russian state elites to advance their interests in the oil industry, rather than

9 For a detailed discussion of the role of the United Nations in paving the legal ground for resource nationalism see (Schrijver 1997).

18 constituted an immediate cause for the government’s ambition to establish its control over the sector. The resource nationalism “tool” was there for the Yeltsin’s administration as well, but his government did not choose to employ it to the same extent Russia’s next president did. Then, why did Putin choose to do so? His economic viewpoint, discussed in the introduction to this paper, might shed some lights on his personal motivation for such a move. However, as we know, a leaders’ desire alone is insufficient to bring about a coherent state policy. Even if a task is set politically, the government needs to have sufficient capacity to implement it. Some of accounts on the situation, which developed between the Russian state and the large businessmen, who controlled most of the country’s economy in the early 2000s, can help to provide some answers to the question what might have helped Putin’s regime to succeed in putting private oil companies “in check”. In their recent work, Gaddy and Ickes (2011) suggest, on the eve of Putin’s rise to power, the mighty oligarchs of Yeltsins’ era came to the point when their intestine wars for economic assets became too costly for them to sustain productive activities. Thus, an impartial arbiter was needed to resolve the collective action problem so that every one of them would comply with certain rules of the game. Putin in the position of Russia’s president might have appeared to them to be a suitable actor for this arbiter’s role. Gaddy and Ickes believe there must have been a pact concluded, in which Putin promised to assume a role of the impartial arbiter, who would be sufficiently powerful to guarantee oligarchs’ compliance with the “mutual disarmament” agreement, but would not become the oligarchs’ rival himself. (Gaddy and Ickes, Putin’s Protection Racket 2011). Indeed, such an agreement must have been beneficial, at least initially, both for the state and for the oligarchs. The former sought control and the larger share of the rents, generated by the richest industries, while the latter were interested in protection of their privileged economic position, first of all, from the ownership claims of each other, and, secondly, vis-à-vis other economic actors outside of the established current elites’ circle, including both potential international and domestic competitors. However, it is likely that the new president’s function have gradually shifted the balance of power between the government and the oligarchs to the critical dominance of the former. Institutionally empty, this informal agreement, if happened, provisioned no barriers for the state’s power to adjudicate oligarchs in their internal disputes to grow into its ability to decide outcomes in conflicts

19 between the oligarchs and the state itself. As a result, as Guriev and Rachinsky notice, soon, Russian oligarchs became “too vulnerable” in the face of Kremlin (2005, 147). Indeed, as the Yukos affair of 2003, as well as the subsequent, more quiet state acquisitions of oil sector assets from private domestic and foreign firms had demonstrated, Russia’s government under Putin became capable of taking the countries’ most lucrative industries under its firm control, spurring discussions among scholars and observers of Russia, whether or not the regime will resort to a full-scale expropriation of private holdings in the richest sector of the economy – the petroleum sphere. Until now, it is clear, despite the noticeable expansion of state ownership in the Russian oil sector, private actors continue to exercise at least a formal control over the lion’s share of the industry. How this situation relates then to the assertion, becoming increasingly popular with the students of Russia, that the state elites’ policies are driven by their hunt for private enrichment and political power maximization? If the state elites’ goal is to maximize their political and economic power using resources of the country’s oil industry, and the state capacity is sufficient for the elites to do so, why would not the political leadership attempt to acquire a full direct control over the sector by means of a full-fledged nationalization? It seems logical to assume that direct state ownership of economic assets minimizes risks for political elites, associated with employment of state power for leveraging their private interests. As Hanson notices: …[I]n particular, direct state control may offer opportunities to allocate natural resource rents in a less transparent way—whether they are allocated to self-enrichment by the political elite or to other projects (Hanson 2009, 19). I believe that the fact that Russia’s government tolerates private ownership in the petroleum sphere alone is not sufficient to reject the above- mentioned bitter assessment of Putin’s regime. Hanson (2009) suggests if we assume that the aim of the current Russian government policies in the oil sector is to serve the interests of the political elites’ themselves, then, both the direct state ownership and the private one, exercised by the state-approved individuals, can advance this goal equally well. Using the 2007 case of Russneft’s suspicious change of ownership from its well politically connected founder to another and, probably, even better politically connected businessmen as an illustration, Hanson argues that the Russian regime is able to achieve its goals with regards to favorable rent distribution without resorting to the direct ownership. (Hanson 2009, 14-17). Instead of nationalizing the industry, arguably, the Russian state

20 developed mechanisms of indirect control over the “strategic sectors”. This allows it to use the rents, earned by these sectors, in order to achieve its tasks without the risks of assuming responsibility over the industry’s performance in public eyes. It seems the “neo-oligarchical” ownership, described above, is capable to serve this exact function. Now, I suggest we take a step back and look at a more general picture of Russia’s political and economic system, as have been established since 2000. What does the “neo-oligarchical” system of ownership adds, if anything, to our understanding of Putin’s regime? On the one hand, it clearly points onto the increase of the state’s strength and capacity with regards to the extent it is able to formulate, and, more importantly, implement coherent policies in the key sector of Russian economy – the oil industry. On the other hand, the tools the state elites use to implement their policies strikingly resemble the features of the “lukhie devyanostye”: it is the selective law enforcement, alleged corruption links between the state officials and businessmen, compromised judiciary and labyrinthine bureaucracy. Following the insights, generated by the application of Weberian economic sociology to East-European post-communist realities, suggested by Ganev (2009), the final section of this paper will offer a framework with a potential to reconcile conceptually these two rather distinct features of the political economy of Putin’s Russia.

Putin’s Regime: Dangerous Mix of Political Capitalism and Socialism?

Max Weber’s economic sociology, as Venelin Ganev (2009) suggests, offers a concept, very well fitted to capture some of the distinct features of the post-communist political and economic systems, and applicable almost universally across the East European societies, at least, throughout the 90s. According to Weber, when a state, which includes a well-developed bureaucratic apparatus, looses its capacity to implement coherent policies from the top to the bottom, a system of political capitalism is likely to emerge (Ganev 2009). For Weber, political capitalism describes one of the two types of modern state bureaucracy’s malfunctioning, with the socialism, characterized by dictatorship of state officials, representing the second type. The both types emerge as a result of a lack of mutual insulation between the government and private economic actors:

21 In sum, a symbiosis of state and non-state agencies may result in the absorption of the latter by the former, in which case there will be a socialist regime with too-powerful state actors and too-weak private capitalist agents. But it may also lead to the absorption of the former by the latter, in which case there will be a political capitalism with too-powerful private agents and too-weak public institutions. (Ganev 2009, 655) As Ganev convincingly demonstrates, during the 90s, the post-Communist societies of the Eastern Europe, almost without an exception, and, certainly, including Russia, found themselves trapped in the system of political capitalism, where the recently reborn state bureaucracy, enjoying significant security with regards to mechanisms of public accountability, is, at the same time, strongly “embedded” into the new economies. This situation allowed post-communist bureaucratic apparatus to acquire a dispersed “power of control and disposition” (Weber’s term) in economic sphere. (Ganev 2009, 660). The above discussion of situation in the oil industry, as developed under Putin’s regime, suggests that though Russian political economy’s major features (such as corruption, selective law enforcement, insecure property rights) continued to fall under the rubric of political capitalism, starting with 2000, the state’s capacity to implement coherent policies in selected sectors had obviously increased. More than that, these policies seemed to aim at weakening private economic actors vis-à-vis the state. A clear outlier from the results, expected from a system of political capitalism, this latter development, however, strikes with its resemblance of Weber’s second nightmare of a modern state’s malfunctioning – socialism, understood as the profound weakness of private economic actors vis-à- vis the state. So can it be then that Putin’s Russia is a dangerous mix of both political capitalism, which continues to dominate most of the country’s economic sectors, and socialism, taking ground in industries, the political regime was able to designate as “strategic”? Though the answer to this question goes beyond the ambition of this paper, I believe that an argument can be made for an affirmative reply. Seemingly contradictory, political capitalism and socialism can form a symbiotic system. The two share the same necessary condition – the insulation of state institutions, be the latter unified with a capacity for coherent-policy making, or, on the contrary, fragmented, from mechanisms of public accountability. In fact, at least theoretically, it seems an unaccountable state can develop both the symptoms of political capitalism and socialism, as state capacity, which is the key parameter of distinction between the two, is likely to be not uniform across all the spheres of state involvement in a society’s life (Skocpol 1985).

22 Putin regime’s peculiar policies in the oil sector, discussed in the previous sections, clearly hint at the possibility of such a symbiosis as well. As Hanson (2009, 14) suggests, state elites exercise control over the industry with help of the “corrupt relations between big business and the state”. In other words, it was the features, lying in the core of a system of political capitalism (i.e. corruption), that allowed the state to establish its dominance vis-à-vis private economic actors in the oil industry without resorting to the full-fledged nationalization (that is the state “socialized” the petroleum sector). For instance, the Yukos affair, representing the key benchmark of the reestablished state control over the industry, would have been unimaginable without such attributes of the political capitalism as selective law enforcement or compromised judiciary, being at the disposal of the suddenly strengthened state.

Concluding Thoughts

The idea that political factors, defining specifics of ownership regimes, matter for a society’s economic development is anything but new. Political economists are well aware of the fact insecure property rights almost necessarily hinder economic growth, and the two decades of the post-Soviet history of Eastern Europe serves as an additional convincing confirmation for this assertion. But what the analysis of the situation in the Russian oil industry in the 2000s, undertaken here, reveals is that the effects of unsecure private property rights are likely to be distinct for systems, which compromise private ownership in a different manner. In other words, paraphrasing Leo Tolstoy’s aphorism, one can claim that, though all secure property rights regimes resemble one another, each insecure one is insecure in its own way. In particular, the “neo-oligarchical” ownership regime model, proposed in this paper as an analytical tool, capturing the specifics of the state-business relationship in Russian oil sector in the 2000s, suggests the privilege-based character and the conditionality of the private ownership regime might have direct implications, undermining efficiency of the Russian petroleum industry. Hindered competition, shortened time horizon in the calculus of the firms’ managers and shareholders, as well as additional costs, caused by the necessity to fulfill state- commissioned tasks, - these are the major mechanisms, which are likely to mediate the effects of the “neo-oligarchical” ownership regime on oil companies’ operational efficiency.

23 Besides its potential to explain the nature of some of the factors, contributing to inefficiencies in the “strategic” sectors of Russia’s economy, the model of “neo-oligarchical” ownership can help our understanding of Putin’s regime in a broader sense. The symbiosis of the political capitalism practices and the strengthened state capacity to implement coherent policies, apparent from examining the development of the oil sector under Putin’s political leadership, points on the necessity for greater theoretical attention to the institutional, ideological and structural sources, that can make such a peculiar symbiotic system functional.

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