Hugh C. Beck and Dr. John R. Griffin, Political Science

The oil industry is crucial to the Russian economy. Approximately 5 percent of Russia’s GDP, 20 to 30 percent of its hard currency export revenues, and about 10 percent of it tax revenues come from the oil industry (1). Since 1988, however, oil production in Russia has steadily declined (at a rate of 7-14 percent annually) (2). Perhaps more than anything else, in order to rejuvenate itself, the Russian oil industry needs capital and foreign expertise.

While change in Russia’s tax-system is the most talked about area of reform necessary for bringing greater capital and foreign expertise to Russia’s oil sector, corporate governance issues in the industry are perhaps equally important. In a drive to construct massive business empires, Russia’s largest banks acquired large chunks of the country’s newly privatized economy. The huge Soviet oil industry was especially attractive to these banks and through a series of murky deals with the government several of them grabbed majority ownership stakes in some of the most prized oil companies. My research suggests that the large Russian banks’ majority ownership in the country’s oil companies has been a key stumbling block to good corporate governance practices in the oil sector.

In acquiring majority ownership stakes in the Russian oil companies, the banks have become control-oriented investors. Under arms-length finance arrangements, investors are generally portfolio-oriented and thus focus on diversifying their investments to minimize business-specific risk. Control-oriented investors, on the other hand, forgo the benefits of diversification in order to concentrate their shares in individual firms over which they can then exercise a degree of control.

Banks made poor use of their control over the oil companies they acquired because they sought to maximize the size of their empires more than the profitability of their acquired companies. This inattention towards profitability was compounded by the severe under capitalization of these banks which led them to pass up expensive interventions which would have increased the long-term profitability of the oil companies. Scholar Juliet Johnson, concerning these two related problems, notes that banks “have been so concerned with putting their limited resources into the acquisition of new companies that little has remained with which to improve the affairs of the enterprises that they already hold” (3).

The most harmful and long-lasting effects of banks’ control-orientation towards the oil companies they acquired are related to issues of raising the capital necessary for the restructuring of these companies. This becomes clear when the ability of oil companies controlled by banks to raise capital is compared to that same ability of the Lukoil company, a Russian oil behemoth which managed to escape majority control by the banks.

Investors in Lukoil are much more portfolio-oriented than the banks which control Russia’s other large oil companies. The more portfolio-like investment in Lukoil provides this company’s management with direct incentives to focus on corporate governance issues such as transparency, profitability, and minority shareholders rights. Lukoil knows it must focus on these issues in order to maintain the interest of portfolio investors which determine Lukoil’s stock price and thus its ability to raise additional capital through future share issues. The bank-controlled oil companies, on the other hand, which rely mostly on the decisions of their banks for funds to pursue new projects, have less incentive to cultivate the interests of portfolio investors by improving transparency and corporate governance.

Descriptions of the differences between Lukoil and the bank-controlled oil companies appear regularly in the financial press. For instance, a recent Financial Post article noted, “…Lukoil Holding, Russia’s most progressive oil company, has boosted its stock market value to US$ 12 billion by treating shareholders with respect. That far outstrips the market value of several rival companies, which have similar asset bases but less transparent management” (4). While banks do provide limited short-term credit to the oil companies and some long-term financing, they cannot meet the oil companies’ full financial needs and thus cannot compensate for their oil companies’ diminished abilities to raise arms-length external capital.

References

1. McPherson 1996, Policy Reform in Russia’s Oil Sector, Finance and Development (June) and Rinaco-Plus 1997, Russian Oil Industry: A Focus for International Interest, RinacoPlus Research (August).
2. McPherson 1996, Policy Reform in Russia’s Oil Sector, Finance and Development (June).
3. Johnson 1997, Russia’s Emerging Financial Industrial Groups, Post Soviet Affairs 13 (4).
4. The Financial Post, February 17, 1998