Russia is gradually becoming a more attractive prospect for project finance, especially in the oil and gas industry. Ben Aris reports on progress and on old problems that still blight opportunities.

Russia’s potential as a project finance market is plain to see but so are the dangers. Having set out on the road to sustainable growth, companies and investors are in the unusual position of being spoilt for opportunities. However, the slow pace of structural reform has meant that few have taken the plunge.

Although the list of potentially highly profitable projects is long, less than a handful of project finance deals have been completed. However, as confidence in president Vladimir Putin’s reforms grows, international banks are returning to Russia and have already signed off on a handful of landmark deals. Conditions are ripe for a boom in project financing.

There are a lot of problems still to overcome, though. The first is the confusion about what project financing is. If Russian managers are talking about project financing, they usually mean the financing of projects. Western bankers have egregiously confused the issue in an effort to reduce risks. Strictly speaking, the initiator of the project (the sponsor) sets up a separate legal entity, the project company, that is responsible for paying back the credits, and the sponsors are not liable. However, Western bankers who negotiate project financing deals sometimes try to make the sponsor liable for these debts, turning the deal into a structured financing agreement.

“Most project financing in Russia is actually the financing of projects, which is not the same thing,” says Mark Kirch, a lawyer at Linklaters. “These are loans to a company that are secured by the assets of the project. All the risk is concentrated in the project company with no recourse to the sponsors should it go belly up.”

This may seem like semantic nitpicking but the difference produces two radically different forms of financing, each with its own pros and cons.

Project financing involves limiting risks to well-defined boxes. This makes such deals dependent on the legal system because the responsibilities of the sponsor, creditor and project company must be clearly defined by contracts. This is a complicated and expensive process, which is made more difficult by Russia’s weak judicial system.

Main attraction

The attraction for the sponsor is that the debts of the project can be kept off the balance sheet. If the project succeeds, the sponsor earns a share in proportion to its equity stake. If it fails, the sponsor loses only the equity it contributed to setting up the project company. For the banks, the attraction is that they are insulated from problems at the sponsor company and, as they are shouldering an unsecured risk, they can charge more.

The risk is unsecured because in the initial stage, the project is little more than an idea: a green field with oil in the ground or a city nearby that needs a power station. A lot of money has to be invested to build the plant or to develop the deposit before a cent can be earned.

Sponsors often offer completion guarantees. These are promises that they will pay for the construction to get the project to the point at which the cash starts to flow. After that the creditors take on the risk and the guarantees fall away.

Oil and gas lead the way

Oil and gas projects are leading the way for Russia’s foray into project financing. The world’s stock of oil went into decline last year as, for the first time, the leading companies produced more oil than they found.

The first significant project financing deal was struck last year when Russian oil major Lukoil, at the time the biggest oil company in the country, tied up with Finnish oil and gas producer Fortum to set up and raise money for the Severtek project company that will exploit a rich deposit in the Timan-Pechora region of Russia’s northwest. To everyone’s surprise, the $200m deal sailed through the various obstacles, taking only a year to go from an in-principle agreement to the cash arriving in the bank. This underscored the rapidly improving business environment and the Kremlin’s desire to tie the Russian economy in more closely with the global economy.

This year, the combination of the economy’s return to health, Putin’s promise of political stability and a revolution in Russian corporate governance have led to the first large investments. In February, BP committed itself to a $6.1bn merger with Russian oil major Tyumen Oil, a deal that was completed at the start of September. In May, the Sakhalin Energy consortium, led by Royal Dutch/Shell, committed itself to a $10bn oil and gas project on the far eastern island of Sakhalin. This was Russia’s largest single foreign investment and equivalent to the last three years of foreign direct investment combined.

As a single-asset company that requires massive initial investment but can look forward to strong and reliable cash flows when it goes on line in 2007, Sakhalin Energy is a classic candidate for project financing, which Shell is in the process of trying to organise. But there are plenty of other projects waiting in the wings for financing.

Russia has the second largest reserves of oil and gas after the Middle East: estimated to be between 50 billion and 100 billion barrels of oil (the lack of exploration in large swathes of Russia means estimates vary widely) and 1700 billion cubic feet of gas. Oil development is concentrated in the Urals and western Siberia, but Sakhalin, the Arctic shelf, Timan-Pechora and eastern Siberia are also thought to hold significant deposits.

While the international companies salivate over Russian deposits, most Russian companies have more than enough to keep them busy. Production has been rising by about 11% a year but Russian oil fields typically have working lives of between 40-50 years, whereas those of the multinationals are closer to 15 years; the Russian companies could double production again and still be in a more comfortable position than their global competitors.

Legal problems

Investors will be watching these pioneering deals closely. Although they are progressing well, there is still room for problems.

Project financing deals are legal beasts and the weak and untried Russian legal system is a major disincentive. The laws on the book are quite good and in the past three years have been improved further with a raft of new legislation rammed through the Duma by the Kremlin. However, sensible rules are useless if no-one follows or enforces them.

“The laws are among the best in the world because so many international experts helped to draw them up. It is the implementation of the law that is the problem,” says Peter Kölle, managing director for the CIS at Hypovereinsbank, which has been actively syndicating loans to Russia. “You have a judicial system where judges earn $220 a month, which causes problems. But it is improving rapidly.”

Creditors want to lock up a project with clear contracts and title to the assets. But, having built up multi-billion dollar corporates in the legal vacuum of the past decade, Russian businessmen have learned to work without enforceable contracts.

“Russia is not about who owns what but about who controls what. The control is maintained by delivery contracts, real estate ownership, supply deals; it is not in the balance sheet or even below it. It is all in contractual obligations that don’t appear in the IAS [International Accounting Standards] accounts,” says Mr Kölle.

Russian oil and gas projects are especially difficult because, although the oil in the ground can be worth billions of dollars, it cannot be taken as security because the project company only holds the licence to exploit it.

“The company usually doesn’t own the gas and oil in the ground, only a licence that gives it the right to extract it,” says Mr Kirch. “This is a right given to the project company and, like a driving licence, can’t be transferred to another person.”

Another quirk of Russian law means that if the project company defaults on the loan then the creditors cannot take the shares in lieu of payment. Under Russian rules, the shares have to be put up for public auction, introducing a risk that the creditors will not win the auction. If the project company is put into bankruptcy, the procedures are even more problematic.

Russia’s bankruptcy laws have also been widely abused by corporate raiders, which could put an otherwise profitable company into receivership if it has a debt as small as $1000 that is more than three months overdue. A new bankruptcy code was enacted in 2002, designed to reduce these abuses, but it has not been tested yet.

Elena Anankina, an analyst at rating agency Standard and Poor’s, says: “A lot of these laws are still relatively new; they have not been tested. We are not sure that all these games have come to an end.”

BP was a victim of the bankruptcy law and had to write off hundreds of millions of dollars in an investment into oil major Sidanco after Tyumen Oil bankrupted it in 1999 over a debt of a few tens of thousands of dollars.

Because of these problems, Western bankers have been muddying the project financing water by attempting to extend the liability for the loans to the sponsors beyond the initial construction phase.

Severgal is another project finance deal in the works. It is a project company that is 75% owned by Russian steel company Severstal and 25% by western European producer Arcelor. It was set up to build a hot dip galvanised steel shop at the Severstal plant at Cherepovets, north of Moscow.

Severstal is one of Russia’s best companies and has a spotless credit history, having made good on all its debt repayments even during the height of the 1998 financial crisis.

Bankers in Moscow say the European Bank of Reconstruction and Development (EBRD) had a hard time trying to syndicate a $100m credit. Rather than accept Severstal’s completion guarantee, bankers were trying to tie the company’s other assets into a deal to cover the loans of the project’s seven-year life. Most bankers consider this a long time in Russia, as it would take the project beyond Mr Putin’s time in office.

The Severgal deal was closed in February. The EBRD granted a seven-year $90m loan, of which $33.25m was syndicated to four Western banks: ING Bank NV, Credit Lyonnais, Raiffeisen Zentralbank Oesterreich and Canada’s International Finance Participation Trust.

“The entry of the world’s number one steelmaker into the Russian market and the high-tech contribution it is bringing in the form of its patented process sends an important signal about the business opportunities that other foreign investors could find in Russian industry today,” Noreen Doyle, first vice-president of the EBRD, said at a deal signing ceremony in Paris.

Control and risk

The same weak rule of law makes Russian corporates keen to bring in foreign shareholders. Foreigners may be worried about predatory Russian raiders playing on loopholes and pliable courts but the Russian companies are as worried about expropriation by the regional and federal authorities. They see a foreign investor as a form of insurance.

“The oligarchs want foreign money but will not give up control to the foreigners. The people who control Russia do not want to share the best resources with the foreigners – and this goes for both the politicians and the businessmen,” says Mr Kölle.

The outside possibility of renationalising Russia’s biggest companies unnerved investors in July when Platon Lebedev, a senior Yukos executive and shareholder, was arrested in his hospital bed on embezzlement charges by the general prosecutor. The arrest was widely seen as politically motivated and $2bn was wiped off Yukos’s market capitalisation in two weeks. Investors were afraid that the diehard Soviet faction in the Kremlin had succeeded in persuading Mr Putin to revisit the privatisations of the mid 1990s that created most of Russia’s bluechips.

“People in the government feel that the natural resources should belong to the government and that the companies should only be paid a royalty for extractions and delivering them to the world market,” says Mr Kölle. “The businessmen feel that these resources belong to them – and legally they do – but are afraid of the state expropriating them because everyone did illegal things in the 1990s. All the laws were contradictory in those days, so it was impossible not to do something that breached the law.”

Despite the risks, investors are becoming more confident that Russia is on the right path. The leading RTS stock market index took a beating after the Yukos affair began, dropping by nearly a quarter in a matter of weeks. But by the start of September not only had it recovered, but it had also sailed through the psychologically important 530 mark and at the time of writing was a whisker away from reaching its all time high of 571, set in October 1997.

The rating agencies have acknowledged the progress by awarding a series of upgrades in rapid succession, leading pundits to speculate that Russia will reach the sought-after investment grade level some time next year, although the rating agencies are more dubious.

EBRD backing

In the meantime, the best insurance foreign creditors can get is the backing of the EBRD, which is actively promoting project finance. Loans to the oil and gas sector had exceeded $800m by August – just short of the $1bn of total credits that the bank was hoping to extend this year.

Bankers at the EBRD say that nine out of 10 of its deals are project financing, but in the loose sense of providing credits for specific projects, often secured by exports of raw materials.

“The distinction between project financing and structured finance has become blurred,” says Tero Halimari, head of syndication at the EBRD. “Of all the syndicated loans in Russia last year, only two were not pre-trade financing. All the others were secured on exports, which have a performance risk, but you have effectively removed the country risk.”

The EBRD has made the crucial difference to project finance deals so far and more deals are expected. Many of the major Western banks have sent project finance officers to Moscow but the majority of them are spending most of their time staring at the wall.

That may change in the next two years. Russian oil companies remain cash rich, thanks to high international oil prices and so are not under a lot of pressure to look for alternative forms of finance to bring their projects online. However, in September, prime minister Mikhail Kasyanov signed off on the long awaited law that lays the legal foundation for the creation of 10 wholesale electric power generation companies, known as gencos.

A crucial step in the privatisation and liberalisation of Russia’s utility sector, gencos will form the basis of a free market for power. They are being formed out of the generating assets of the regional energy companies (energos) and will be privately owned.

Initially, these companies will not produce much in the way of cash flows but in the long-term they could be highly profitable. Likewise, they will need a lot of investment in the early stages to bring them up to scratch. As power generation is basically part of Russia’s economic infrastructure, the multilateral agencies, and the EBRD in particular, are expected to be heavily involved in getting the private power sector on its feet. The combination of all these factors means that when the electricity power market is liberalised after 2006, gencos will also be ideal candidates for project financing.

In the shorter term, the attractiveness of project financing is increasing. The lake of domestic liquidity from higher than expected oil prices is starting to dry up. A run of Russian corporate eurobonds issues that began last year is also starting to slow and is being overtaken as a source of financing by syndicated loans. As Russian companies switch from relying on huge cash surpluses and begin to gear up their debt portfolios, they will explore other financing options. What would pique their curiosity is maturities of more than seven years – something that suits project financing deals.

“The only real reason why there is not more project financing in Russia is the lack of experience,” says S&P’s Ms Anankina. “Once we have had the first few, a flood could follow as there are still many projects on the sidelines due to the lack of long-term financing.”


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