It was a slightly surreal experience, because the presentation was right across the street from the Pentagon.  So the Russian immigrant who until 1987 believed Americans were horrible people (read the story of how my family emigrated from Russia) was lecturing Americans on the virtues of capitalism at the doorstep of the Pentagon!

Here are some random thoughts on subjects unrelated to investing.

DC, Wright Flyer, Blackbird…

I had been in DC a few times before but never really had time to see the city.  I took my almost-ten-year-old son Jonah with me on this trip, and we had an amazing experience.  It was father-and-son, embrace history, see new things, eat donuts every morning for breakfast at Dunkin’ Donuts time (mother was not there to set us straight).  Here are some pictures from this trip.

We spent a lot of time browsing Smithsonian museums – Air and Space, American History, and the Air and Space Udvar-Hazy (giant hanger with over a hundred planes, by Dulles Airport).  The Wright brothers’ first plane (the Wright Flyer) was really a shocking exhibit.  The Wright Flyer looks like an oversized wooden kite, with strings and a few levers.  It barely looks like a plane.  In its first flight it only went 120 feet – that was it!  If  you look at the planes that came out a decade or two later, they were real planes – metal wings, wheels, a pilot’s seat, etc. But the Wright Flyer was the paradigm breaker, it proved that an object heavier than air, powered, and operated by a human, could fly.  It unleashed the imagination of the generations who followed.

Fast forward six decades, and you find us standing in front of the plane that impressed the most: the Blackbird.  The Blackbird is a reconnaissance plane; it has no weapons, just cameras.  It was the first plane to use stealth technology, though it wasn’t until decades later that that technology was perfected. The Blackbird’s engines are each the size of a small plane.  Despite being developed 47 years ago, it is still the fastest plane today, flying at Mach 3, over 2,100 miles an  hour!  It flew from LA to DC in 64 minutes.  It flew so high, at 80,000 feet, and so fast that if it was detected by radar the pilot’s strategy was not to go to evasive maneuvers but to push on the throttle.  Not a single Blackbird was ever shot down. What’s ironic about Blackbird is that it was discontinued not because the US came out with a better or faster plane, no, but because of the development of satellites.  Satellites don’t cause international incidents, don’t put pilots at risk, and don’t cost $85,000 an hour to operate.

Productivity is very difficult to observe in the short run, but in the long run it is really incredible how we manage to do ever more with ever less.  In the American History Museum there was an exhibit on ports and ships, where I found this remarkable statistic:  “1960: 25 million tons handled by 15,000 longshoremen at the West Coast ports.  2000: 250 million tons handled by 10,000 longshoremen at the West Coast ports.”  Two-thirds of the people did 10 times more – that is productivity!

I was really reluctant to go to the Holocaust museum, as I did not want to subject myself to the pain I knew would come with it, but my wife convinced me and Jonah to go.  I am glad we listened to her.  There are two things that stuck with me.

There was a wall of photos, five hundred or so family pictures and portraits from a small Lithuanian town that was home to 4,000 Jews for 900 years.  I was magnetically attracted to the photos, but it took me a few minutes to figure out that these people looked like my relatives.  A young fellow in his thirties looked just like my uncle at that age, a 15-year-old kid looked like Jonah will look five years from now, a Hassidic gentleman looked just like my cousin who is a rabbi in Rego Park, Queens, and so on.  These pictures impacted me a lot more than the pictures of dead bodies, pictures from the concentration camps, that I’ve seen so many times over the years, which my brain has learned how to dehumanize.  I could relate to these photos a lot more.  Nazis killed ALL the Jews in that village, including women and kids, in two days.  900 years of history and tradition were wiped from the face of the Earth in just two days!  I have to admit I could not keep my eyes dry after.

A quotation on the wall at the very end of the exhibit really underlined why this museum is so important.  It was written by a German pastor, Martin Niemoller:

First they came for the Socialists, and I did not speak out —
Because I was not a Socialist.

Then they came for the Trade Unionists, and I did not speak out —
Because I was not a Trade Unionist.

Then they came for the Jews, and I did not speak out —
Because I was not a Jew.

Then they came for me — and there was no one left to speak for me.

As a parent you try to instill values into your kids that you may not always possess; but you want your kids to have them, and your children inspire you to be better people.  Jonah and I had a long discussion about how, when we see injustice that doesn’t really touch us, we should not sit still.

Jonah had a blast in DC, but the culmination for him was our trip to the Pentagon.  I had a meeting at the Pentagon, and to keep Jonah occupied while I was busy, he received a private tour of the place from a lieutenant colonel.  Jonah was absolutely stunned – a few days later his eyes are still glowing when he talks about it.

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here or read his articles here. .

Copyright Vitaliy N. Katsenelson 2011.  This article may  be republished only in its entirety and without modifications.

We are pleased to invite you to an upcoming International Executive Roundtable on Thursday, April 15, 2010 to be held from 12 noon to 1:30 PM.  Vitaliy Katsenelson will address the topic “China—The Mother of all Bubbles and Japan—Past the Point of No Return”.   

Vitaliy Katsenelson is director of research and a portfolio manager at Investment Management Associates, Inc., a value investment firm based in Denver. He is the author of the book “Active Value Investing: Making Money in Range–Bound Markets”.  He also taught the graduate business class, Practical Equity Analysis, at the University of Colorado Denver for seven years.  A native of Murmansk, Russia, he holds undergraduate and graduate degrees in finance from the University of Colorado Denver.  

This roundtable will be held in the XMBA Auditorium in the CU Building, located at 1250 14th Street, Suite 150.  Lunch will be provided by the Institute for International Business.  Please RSVP for this event by Tuesday, April 13 via email to melanie.ellison@ucdenver.edu or by calling 303-315-3710.  Space is limited, and reservations will be taken on a first-come, first-served basis. 

Facebook

I created a new Facebook profile where I only have a few dozen friends, and I’d like to keep it that way.  However, if you just want to follow my random thoughts and have a discussion online, I created a new page on Facebook just for that: http://bit.ly/vnk-fb .  Also, here is my Twitter page: http://twitter.com/vitaliyk . 

Vodafone

Vodafone (VOD) stock is finally starting to show signs of life.  I’ve discussed it a few times in the past (in these interviews with TechTicker and Barron’s); also here is a one page summary of our thinking on the company.   In short, Verizon (VZ) has two businesses – a wireline business and Verizon Wireless.   Verizon owns 55% of Verizon Wireless and Vodafone owns 45%.   Verizon Wireless has not paid dividends to Vodafone since 2005 and thus the street puts almost zero value on Vodafone’s stake in Verizon Wireless.  There is the misperception that Verizon, the majority shareholder, is trying to royally screw a minority shareholder.  This perception is utterly wrong.  

Verizon Wireless was building out its network aggressively since 2005, thus tens of billions in cash flow were reinvested back into the wireless business for which it is reaping rewards today.  Also, a few years ago Verizon Wireless bought Alltel and borrowed around $30 billion to finance it, a good chunk of which came from the Verizon in intercompany loans.  Verizon Wireless did not pay dividends to Vodafone because it was paying down debt, which will be done within a year or so.  

The street is missing a very important factor: VOD has a veto power over Verizon/Verizon Wireless intercompany loans and large acquisitions;  thus Vodafone’s acquisition of Alltel and the intercompany loan that followed to finance acquisition were approved by Vodafone, and were in Vodafone’s best interests.  

But even if “evil” Verizon wanted to screw minority shareholder Vodafone and hoard the dividend forever, it could not.  After the Alltel intercompany loan is paid off, the only way for Verizon to get a hold of Verizon Wireless cash flows is for Verizon Wireless to pay a dividend to Verizon and Vodafone. 

 Verizon does need the dividend from Verizon Wireless, as Verizon’s wireline business doesn’t generate enough free cashflow to cover Verizon’s (the public company) dividend payments.  Verizon Wireless is the cash cow, generating about $10 billion of free cashflow a year, and is responsible for a large portion of Verizon’s free cashflow.  

VOD’s stock came to life yesterday after it was reported that Vodafone was putting pressure on Verizon to either pay out a dividend, merge with Vodafone, or spin off Verizon Wireless.  Every one of these scenarios would put appropriate value on Vodafone’s stake in Verizon Wireless.

 Russia

A friend found the very first interview I ever gave. It is very short, less than one page long (here is a link to PDF).  In 1997, I worked for a few months at Lipper Analytical.  Lipper interviewed some of their new employees in the company’s newspaper. 

 What it is interesting to me is how wrong I was about Russia in the interview.  I thought Russia had great potential in the 21st century because of its highly educated workforce and natural resources.  What I did not realize at the time was that natural resources are not a blessing but a curse for a developing economy, even if it is commodity-rich.  Capital gravitates to the highest, most efficient use.  Since return on capital in the Russian oil and gas industry when commodity prices were high far exceeded the returns in non-commodity industries,  capital was sucked out from non-commodity industries and flew to oil and gas.    

Although through government efforts defense industry production increased, most other industries either stagnated or weakened over the last ten years.  On top of that, commodity exports drove up the price of the Russian ruble, making non-commodity industries less competitive in the global market.  The software or other high-technology industries I fantasized about in 1997 never meaningfully developed.  Russia is a trick petrochemical pony.

 A joke comes to mind here, especially appropriate today since we are in the middle of Jewish Passover:  It took Moses 40 years to find a place in the Middle East that has no oil.  Now, if you think about that in the context of Russia, the lack of natural resources was a blessing for Israel, as it was forced to develop a high-technology industry.    

Randoms

•  I had an article (re)published in Financial Planning Magazine (here is a link).  In the article I make a case for strenuous regulation or breakup of too-big-to-fail financial institutions. 
•  If you did not see it, here is my article in the Christian Science Monitor: “China: the coming costs of a superbubble.”
•  An excellent article in BusinessWeek describes what is taking place in Venezuela (here is a link).  If you had hopes that government intervention could make things better for the economy, read this article.  I was reading and vividly recalling images of supermarkets in Soviet Russia: the government was the economy, prices for everything were centrally set, grocery store shelves were empty, there were long lines to buy poultry, meat, and even toilet paper, etc.  I remember my mother running to another part of town on a tip from a neighbor that a store had a delivery of chickens.  So if you think government will do a better job in the US running healthcare, I wouldn’t be too sure about that. 
•  And here’s a terrific white paper about the Chinese bubble, by Edward Chancellor of GMO (here is a link to the PDF).

My firm, Investment Management Associates, is looking to partner with financial planners/advisors to offer our unique portfolio management services to their clients.  We don’t do any financial planning, all we do is value investing.  You may contact me here.

I’ve received so many emails about the WSJ front page article in which the Russian expert, a professor and ex-KGB agent predicts that the US will falter and be split up into five zones (see map below, here is a link to the original article and here is a link to his video interview) and each zone will be controlled by another country like China, Canada, Mexico, and EU. Alaska would go to its rightful (more like wishful) owner Russia. You get the gist. I could not contain myself, I had to respond with a letter to Mr. Ex-KBG.

Dear Mr. Ex-KGB,

Desperate times call for desperate measures. No kidding. I understand why you took the collapse of the Soviet Union model added some wishful thinking and applied it to the United States.

The Great U.S. of A is not the Soviet Union, this analogy doesn’t work on this country. The Soviet Union was a collection of loosely assembled countries that shared little in common except … well, actually with the exception of common borders I cannot think of a single thing that united them. Flag? Hymn? No, they were quick to disembark from the Soviet Union, turn the red flag into a doormat and erase the lyrics of the Soviet hymn from their memory.

Ukrainians, Belorussians, and Russians had something in common, but Georgians, Armenians, Tajikistanis, and Uzbekistanis were always looked at by Russians as secondhand citizens. Estonians disliked Russia, but don’t blame them, they did not join the Soviet Union voluntarily. The former soviet republics were happy to return to the pre-Soviet Union state.

Unlike the Soviet Union, in the U.S. we share similar values, goals and traditions that developed over more than two hundred years. Geographic state borders have little significance with the exception that in some states you are allowed to carry a concealed weapon; in some, until recently, you could not buy alcohol on Sunday. That is just plain wrong, but I still remained in Colorado and did not announce my allegiance to the California Republic as you would call it. In some states food is very spicy — and that is alright. In some gambling and prostitution are legal — and this is alright too. America is a melting pot. Sure we make fun of the New Yorkers’ fast talk or the Texan’s drawl. But tolerant we are.

Due to the ease of mobility of employment, we constantly migrate from state to state, thus our geographic loyalties don’t go further than our Alma Matter’s football team. Our geographic preference of habitation is a function of climate, employment, proximity of mother-in-law — it has to be at least two hours away, by a very fast plane if possible — and pure randomness. We have no allegiance to a specific state — we are citizens of the United States. Culture doesn’t divide us, like it did the Soviet Union, it unites us.

You discuss the return of Russian dominance. I don’t know anyone who takes it seriously, except Russia, of course. Russia’s recent dominance is a blip in time (sorry). Unlike the U.S., Russia has a very narrow economy that has mostly been driven by natural resources and was brought to life, for a short moment, by a global commodity bubble. If Russia did not have nuclear weapons and a large army, we’d spend as much time talking about it as an election in Mozambique.

Take high commodity prices away and you find … well, Russia today: limited property rights, corruption, bribery, semi-dictatorship, and government control of the press. Newspapers and television are controlled by the government, journalists are dropping like flies.

No, Russia is not the United States. The United States has its problems, but these problems are not structural and time will heal them. Despite all of our problems, the U.S. is still the best economic and most stable political system, period. We have peacefully elected our president every four years for over two centuries. I bet you if every country in the world opened its borders to unlimited migrations in and out, you’d find the U.S. population balloon and Russia’s shrink. People from all over the world want to live here.

Dear Mr. Ex-KGB, the Russian economy is crumbling. To divert attention from the internal problems (and more importantly from him) Mr. Putin is redirecting attention onto the “evil” United States. After all, we created the global economic crisis, sabotaged the oil market, and whatever else is wrong taking place in the world, we must have had a hand in it. Now it is even a common belief in Russia that the CIA was responsible for the September 11th attacks.

Anti-Americanism is on the rise in Russia. You made an America-fall-apart prediction public almost ten years ago, but it was only recently picked up by Russian (predominantly government-owned) media. You are a superstar in Russia — you get two interviews a day. Unfortunately predictions that would have been taken as lunacy by most Russians in the past are now turned into wishful thinking. And wishful thinking has disappointed the Russian public since forever.

Sincerely,

Vitaliy Katsenelson, CFA

Central North-American Republic, formerly known as Colorado

Note: Here is a link to read the story of my childhood in Murmansk, Russia and emigration to the US.

Russian economic growth in this decade was completely driven by rising commodity prices, mainly of oil and gas. As the global economy goes into recession and commodity prices either decline or remain at today’s levels, Russia will relive the horrible 1990s when it defaulted on its debt and suffered from a severe inflation. Think of Russia as a very large oil and gas producing company that is run for the most part by a government that makes General Motors’ (nyse: GM – news - people ) and Ford’s (nyse: F – news - people ) management and autoworkers’ unions look like progressive thinkers.

Over the last five years, Russia de-privatized (a clever euphemism for “stole”) oil assets from private investors and has been milking petro cash flows from now state-owned oil companies. The government is simply not equipped to manage projects that have a multidecade life. Russia underinvested in exploration and development of oil and gas in the last decade and that is why its oil and gas production is declining.

Communism failed for a reason: Government is a horrible capital allocator. The time horizon and time in office of a government bureaucrat is much shorter than the horizon of an oil company, therefore when choosing between drilling holes in the middle of nowhere that will increase oil production years down the road or raising benefits to retirees, retirees win.

But it gets worse. As oil prices rose, the Russian government decided that it did not need the West anymore. It felt that the contracts it signed with BP (nyse: BP – news - people ) and Royal Dutch Shell (nyse: RDSA – news - people ) in the 1990s–when oil prices were much, much lower and no one wanted to invest in Russia–were not advantageous anymore. Using deceptive legal practices, it unilaterally renegotiated those contracts muscling away lucrative projects from these companies.

It is just amazing how things changed in six months. Declining oil prices will likely force Russia to come back to foreign investors begging for investment, but this time it will not receive it. Would you blame them?

Yes, it gets even worse. The return on capital in oil and commodity-related industries was much higher than in any other industry. This siphoned capital from other industries, which caused investments in these industries to decline. The rise of commodity exports drove up the Russian currency, making noncommodity industries even less competitive in the world market. Once you take high commodity prices away, Russia is worse off than it was before.

On top of this, when Russia did well, it acceded to pressures to increase social programs. While the revenues were flowing, Russia paid off its foreign debts and created a Stabilization Fund, a multihundred-billion dollar savings account. But it is hard to say how long this fund will last as Russia spent (wasted) $57.5 billion on defending the ruble in September.

Russia is strong on a balance sheet basis, but that is a reflection of the past. The future, as reflected in its future income statements, looks horrible. To some degree it is almost a mirror image of the U.S.; our balance sheet is weaker but our earnings power is strong. Despite all the problems we have in the U.S., we have the most diversified economy in the world. Unfortunately, that is not the case with Russia.

The Russian currency will decline substantially over the next several years as Russia will try to print itself out of the problem. Despite the intervention, the ruble already declined close to 20% versus the U.S. dollar since July, but the decline has only started. Money is leaving Russia, which is why the ruble is collapsing.

Construction projects big or small came to a halt in September and October. People took their money and ran. I called my childhood friends in Russia last month and advised them to move their ruble denominated savings out of ruble into dollars and/or euros (either should be better than the ruble), preferably also taking their savings out of Russian banks and either transferring into big European banks or just putting them into a safety deposit box.

Yes, unfortunately, I believe the Russian ruble will collapse.

Vitaliy N. Katsenelson, CFA, is director of research at Investment Management Associates in Denver, Colo., and he teaches a graduate investment class at the University of Colorado at Denver. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).

If you would like to receive my articles by email (usually couple days before I post them to this website), drop me a line (click here).

Why would somebody ever give a loan or buy airline bonds of any country?  I can understand buying distressed bonds or maybe a stock as a trade. Not my kind of thing, but I can respect that. But a buyer (an investor) of fully priced (at par or close) airline bonds usually intends to hold them to their maturity, or for a long time. It is well documented that the airline industry as a whole has lost money over its cumulative existence. Thus, uneconomical, low fares that consumers have been enjoying over the years were subsidized by bond and equity investors. This is great for consumers, not so good for providers of capital. I almost want to say “Fly, don’t buy.”

One could argue, “but wait, Southwest (LUV) and Virgin have done well.” And maybe this is where the answer is, at least in part. We look at these very rare success stories and think that this time is different and the industry can reinvent itself and start making money. It’s rarely different.

Or maybe the answer lies in our forgetfulness? We forget that the deck (the industry structure) is stacked against us, that for every Southwest and Virgin there are dozen airlines that went through several bankruptcies, at least once. We look at glamorous, sophisticated, electronics-laden airplanes and forget that this is a very cyclical, capital intensive (planes cost hundreds of millions of dollars), low return on capital, highly unionized, debt burdened industry that is exposed to the gyrations of commodity prices. And to top it all, the industry has marginal pricing power and surprisingly low barriers to entry (i.e. new entrants compete with major airlines on one route at a time, it is similar to a death by one thousand cuts. Virgin Air was started with just couple million dollars and leased planes).

Russian airlines are even worse as they are forced to compete with a semi-government and thus not-for-economic-profit entity – Aeroflot. Also, the Russian government is predictably unpredictable. One day it may decide that it wants to control the airline industry and suddenly we’ll discover that airlines were ruining the environment, not paying taxes, scratching runways or whatever else it’ll need to say to justify ripping off equity and bond holders. It did this with many BP PLC (BP) and Royal Dutch Shell (RDS-A) holders a few months ago, so why would this time would be any different?

I suggest the rating agencies rethink their rating scale to accomodate for airline bonds: (A) – High Quality, (B) – Investment Grade, (C) – Junk, (FBJ) – Far Below Junk – domestic airline bonds, and finally in the Nuclear Waste (NW) category – Russian Airline bonds.

Why are banks not seeing this and what happened to risk (credit) spreads? My cousin mentioned that several large Russian oil companies just received loans from American and western banks (i.e. Citigroup (C), Goldman Sachs (GS), Barclays (BCS)) at or around Libor plus 25-50 basic points. Let me put it into perspective, this about 1% premium to risk (default) free US Treasury bills. In other words banks are thinking that Russian oil companies are just a bit riskier (1%) than the US Government – the entity that can print money, raise taxes and has nuclear weapons. Is this another case of selective amnesia, similar to sub-prime lending? Will they think it’s not a problem until suddenly (it is always sudden for them) it becomes one? Did banks forget about Russia’s near death experience of the late 90s or the Yukos debacle from 2004?

Lending at a slight premium to a risk free rate made very little economic sense. Any rational entity would have been better off taking the money and buying higher yielding (much higher quality), AAA rated U.S. corporate bonds. But see, big (money center) banks are in the business of making loans. To be more precise, they are in the business of making dumb loans. When the global economy is roaring, all loans are good loans, the risk is a four-letter word that only a few can spell.

As a man with a hammer is looking for a nail, a banker armed with cheap funds is looking to make loans and generate fees. Every time a recession shows its ugly face, the “dumb” loans float to the surface and huge write offs are taken, shareholder equity is lost. During the last recession of 2001, big banks were writing off billions in loans made to South America. In the next recession it will be Russian loans.

Again, why would western banks give loans to Russian airlines that never generated positive cash flows (and probably never will) or Russian oil companies at an almost risk free rate? The answers are very simple: global liquidity and syndication.

An abundance of global liquidity coupled with low interest rates has compressed spreads between investments of various risks. Investors hungry for any yield are garbling up bonds of any risk just to increase the yield of the portfolio. Also, more and more large loans are syndicated among dozen of banks, the risk is assumed to be diversified away. Syndication sounds great in theory, but it increases the system risk as it breeds indifference and a lot of bad loans – just wait a year or two.

This article was originally published on Minyanville.com

Royal Dutch Shell‘s $7.5 billion sale to Gazprom may have been coerced by the Russian government. Vitaliy Katsenelson looks at the Sakhalin-2 sale and examines the long-term implications if Russia disregards Western investment.

[I had a different title in mind for that article Russia: Screw the West, We Don’t Need Them Anymore, but my editor decided against it, you can see why]

I can’t say I was surprised to see that Royal Dutch Shell Plc (NYSE: RDS.A) will be “selling” 50% plus one share of the Sakhalin-2 project to Gazprom for $7.5 billion. Several months ago, the Russian government wanted to take Royal Dutch Shell to court because it was ruining the environment. I suppose when the Russian government referred to the environment, it meant the economic environment, not Mother Nature. The “environmental” issue was very simple: Product sharing agreements (PSA) signed by the Russian government with Shell were not considered advantageous to Russia — at least not anymore.

The 7.5 billion-dollar question comes to mind: Did Gazprom buy a controlling stake in the Sakhalin-2 project at a fair price? It’s hard to say. $7.5 billion is not chump change, but Shell didn’t sell a controlling stake in the project — which, by the way, insured a replenishment of its dwindling oil reserves for years to come — at its own will. You don’t have to be a genius to figure out that after “selling” (I use that term loosely because it assumes willing participants on both sides) its stake in the Sakhalin project, the environmental issues will not be issues any more.

I’ll be blunt: The Russian government manipulated its environmental/legal levers to muscle an ownership stake in the project out of Shell, possibly at a significant discount. I understand that it’s so much easier to be sympathetic to the poor children and elders that this oil money is supposed to go to, than to a multibillion dollar, impersonal, foreign (Dutch to be exact) oil company.

It sounds like a Robin Hood act, taking money from the rich and giving it to the poor. It’s certainly not the first time this has happened in Russia. In 1917, on Nov. 7 (still a widely celebrated holiday in Russia), under the leadership of Mr. Lenin, the masses took from the rich and gave to … themselves. We all know how that story ended. You cannot have government thievery be a part of the free market system and expect the market to function normally.

The original Sakhalin deal
Eric Kraus who runs a Nikitsky Fund, a mutual fund that invests in Russia, pointed (opens PDF) out a study done by Alfa Bank Research, showing that the terms of the original Sakhalin PSA signed in the 1990s were unusually advantageous for Shell and its partners. For instance, usually PSAs are signed for 20 years. The Sakhalin deal was signed for 25 years and renewable at five-year increments at Shell’s discretion, forever — a very unusual clause. There were no caps on costs, and only after Shell was firmly in the black would Russia see anything from the project. According to Kraus, these favorable PSA terms are very uncommon. Cost overruns on the project did not help the issue, but if anybody ever tried to do business in Russia, they wouldn’t be surprised; The country is infested with bribe-hungry bureaucrats who make doing business in Russia prohibitively expensive and inefficient.

From today’s $60 per-barrel oil perspective, it appears that Royal Dutch Shell got a great deal in the original PSA, at Russia’s expense. However, in the 1990s when this deal was consummated, oil prices were much, much lower, and thus the breakeven point and risk for the project was a lot higher. Also, at the time, Russia was cash-poor and desperately needed foreign investment and the exploration and development know-how. Royal Dutch Shell is one of the best in the field and was willing to commit billions of dollars. And unlike Shell selling one of its best assets to Gazprom (a public company which is 39% owned by — and managed in the interests of — the Russian government), nobody forced Russia to sign the original contract in the 1990s.

Who needs the West?
Similar to Al Capone — a mafia boss sent to jail, not for his murderous crimes but for tax evasion — Mr. Putin & Co. went after Shell for “environmental” violations. However, in this case, Shell’s crime is its profitability in the face of the Russian government’s lust for oil money and control of natural resources. I don’t know if the environmental problems were really problems or not. Every time you drill for oil or gas in the middle of a wilderness, “environmental” issues could be found. But few things in Russia get done because of the environment, and this was no exception.

This very transparent act of renegotiating the terms of the contract that was signed more than a decade ago abusing the government-controlled legal system didn’t go unnoticed by foreign companies. Interestingly, even if Gazprom paid more than a fair price for the Sakhalin-2, since Shell was forced into the deal, the market perception of the whole affair will still be negative.

This isn’t the first time the Russian government has done something that has abridged the law. Using similar tactics, Russia stole (for lack of a better word) Yukos from its shareholders in 2004, sending its largest shareholder to jail, and has been gradually consolidating (deprivatizing) oil resources under the government (Gazprom) wing.

Ironically, the Russian government doesn’t care about foreign investment. It’s swimming in cash and doesn’t feel like it needs the West (or the East — two partners in the Sakhalin-2 project were Japanese) any longer. However, despite the appearance of economic prosperity, Russia is a one-trick pony. It’s blessed with natural resources (i.e., oil, natural gas, steel, timber, etc…), and that pony has been in popular demand for the last three years. Take the high commodity prices away, and Russia is back in the post-Cold War Stone Age: poor infrastructure, marginal rule of law (which is even more apparent now), and corrupt local governments.

So will this commodity-pony be in demand forever? Who knows? Predicting commodity prices is very difficult. But may Russia’s soul rest in peace if commodity prices take a dip.

Considering the recent deprivatization trends of the energy industry in Russia, oil and natural gas production is likely to face a long-term decline. All governments are ill-equipped to allocate economic resources, and the Russian government is no exception. There’s a significant mismatch between the duration of time politicians spend in office and the multidecade payoff of exploration and development expenditures of the oil and gas industry.

Faced with the allocation of Gazprom’s abundant cash flows, even a well-intentioned politician has tremendous incentives to divert the funds toward social programs (i.e., paying pensions to retirees, increasing teachers wages, etc…) that have a more apparent, immediate social impact (read re-electable) than exploration and development projects that require a tremendous outlay of capital upfront and have a payoff decades in the future.

Private enterprises such as foreign oil companies (not covert, government-controlled entities such as Gazprom) have the appropriate time horizons, the needed capital, and the know-how to get the oil and gas out of Russia. Unfortunately, in lieu of recent developments, they’ll be committing less capital to Russia rather than more.

After seeing the current developments, CFOs of foreign companies that were contemplating doing business in Russia are increasing their required return on capital assumptions in their models. As the required rate of return goes up, fewer projects become profitable — and less foreign capital will flow to Russia. Companies that have already invested in Russia — ExxonMobil (NYSE XOM), BP (NYSE BP), Conoco Phillips (NYSE COP), and others — are wondering if they’ll be the next “environmental” culprits and may be trying to find a graceful way out. Can you blame them?

P.S. If after this article gets published, I receive an invitation for dinner in a British hotel, I’d have to decline.

Russia feels like it has an upper hand in any negotiation as commodity prices and demand are on its side, plus it is becoming less dependent on the rest of the world as it is swimming in cash. This arrogance raises a political risk premium that foreign companies have to factor into their models by raising the risk premium when deciding to invest or not to invest in Russia.Since commodity prices are very high, rates of returns are high enough to cover the increased cost of capital. But commodity prices will not be scratching the sky forever.

Maybe I am just too cynical and TNK-BP really is trying to pollute poor mother-Russia… nah, if Gasprom was doing this the government would be laying a red carpet under its pipelines to make sure that its executives don’t get their feet wet.