Russia: Kremlin Takeover of the Russian Oil Industry?

In Russia these days, a lot of old is new again. In fact, the Russian oil and gas sector's new paradigm can be summarized in two words: "state domination." The free market has been abandoned. For example, last December the tax authorities bankrupted YUKOS, a major oil company, for allegedly failing to pay taxes. The government sold YUKOS' main production unit, Yuganskneftegaz, to the state-owned company Rosneft, using a straw company as an intermediary. Chinese state banks apparently financed the purchase with $6 billion in loans. To top it off, Rosneft is merging with state-owned Gazprom, the largest natural gas company in the world.

And in mid-February, Yuri Trutnev, the Russian Minister of Natural Resources, has announced that Moscow will keep Western firms from bidding on major natural resources mining and drilling licenses.

Thus, the Kremlin, not the private sector, has become the key decision maker in licensing oil fields, determining the location of pipelines and approving consortia for production and transportation.

The biggest problems in the post-YUKOS Russian oil sector are the intrusive role of the state, overregulation, the violation of property rights and opaque transactions. Plus, foreign investors are made to feel unwelcome. Exxon and Total, a French firm, recently announced that they would scale down involvement in Russia's oil markets, and capital flight from Russia has increased from $2.9 billion in 2003 to between $9 billion and $12 billion last year.

There's reason for the United States to be nervous about this turn of events. And we're not alone. Vladimir Putin's economic adviser Andrey Illarionov called the sale of Yuganskneftegaz the "swindle of the year" and warned that Russia is on its way to joining the Third World economically. While Illarionov was demoted for his candor, he was not fired. Clearly, the Russian elite is deeply divided over energy policy.

But this is about more than energy. Russia's government is using energy policy to again become a major player on the international stage.

The government-owned Gazpromneft (the combined Gazprom and Rosneft) will be a huge global company, bigger than Petroleas de Venezuela and comparable to Saudi Arabia's Aramco (both state monopolies). It will function as a potent instrument of Russian foreign policy throughout the region and around the world.

Russia also wants to play a more robust role in the Commonwealth of Independent States, Europe and Asia. It is buying up strategic infrastructure companies, such as pipelines, refineries and electric grids, as well as ports in Georgia, Hungary and Ukraine.

Moreover, there are hopes in some quarters that Russia's energy, supplemented by Iran and Venezuela, can power a global coalition with China and the Muslim world to offset U.S. hegemony. Russian officials have hinted that 20 percent of Yuganskneftegaz would be sold to China. Moscow, meanwhile, is enticing Japan to pay a whopping $12 billion for the Nakhodka pipeline, a delivery system that could create competition for Russian oil between China and Japan in the Far East.

After 9/11, many hoped Russia and Eurasia would provide a welcome addition, if not an alternative, to Middle East oil. That hope is now waning. Russian oil still faces many real challenges above and beyond government re-nationalization. These hurdles include an antiquated pipeline network (which is a government monopoly) as well as high production and transportation costs.

The U.S. and Russia are still "energy compatible." One is an importer and the other an exporter. But the diminishing attractiveness of investing in Russia's energy sector will hamper the country's economic development. In addition, Russia's decision-making elite is split between those who view the takedown of YUKOS as a heavy-handed operation that caused unacceptable collateral damage and those who believe that the ends justified the means.

In order to encourage the Russians to reopen their energy markets, Washington should condition U.S. agreement to let Russia join the World Trade Organization (WTO) on the creation of transparent rules and protection for U.S. companies that invest in Russia. President Bush also should specifically request that U.S. companies participate in construction of the Murmansk pipeline and the Shtokman natural gas project.

Bush can push for those concessions during his visit to Russia in May to celebrate the 60th anniversary of the Allies' victory in Europe. He should make it clear that Russia's new state control and opacity conceal corruption, and its nationalist rhetoric covers up protectionism, backwardness, greed and graft. As a WTO candidate and G-8 member, Russia cannot afford any of these.

First appeared on FoxNews.com

Ariel Cohen, Ph.D., is Senior Research Fellow in Russian and Eurasian Studies and International Energy Security at the Allison Center of the Katherine and Shelby Cullom Davis Institute at The Heritage Foundation.