The Russia Conundrum

CHAPTER 4

GAMBLING BIG

Yukos was a major oil producer, but it had been run by uninterested state bureaucrats for so long that it was unprofitable, inefficient and deeply in debt. In 1996, we paid $309 million for a controlling 78 per cent of the holding company, despite knowing that it controlled only a minority of the shares in its oil production and other assets, and had debts exceeding $3.5 billion. We did so because we understood the potential that Yukos offered – and because we were sure we could bring the leadership, enterprise and commitment that would turn it around.

It worked. Under our leadership, Yukos would ultimately grow into the biggest oil producer in Russia, responsible for 20 per cent of the nation’s output, and one of the largest in the world. By 2003, its value on the Moscow stock exchange would rise to a market capitalisation of over $30 billion. But it wasn’t easy. Back in 1996, the Russian oil sector was in chaos. The major companies were in meltdown, not paying wages to their workers, not paying taxes and threatened with bankruptcy. Yukos owed $2 billion in taxes to the state; wage arrears and debts to contractors were spiralling; output had fallen from 45 million to 35 million tons per year, with the result that the infrastructure for production, processing and transportation had collapsed. The Kremlin was unhappy, the workers were unhappy and tensions were growing. When Boris Yeltsin agreed to privatise the oil industry, he knew that that was the only way to save it, and he laid down strict conditions. ‘We have to immediately ensure the receipt of taxes from the largest industrial enterprises,’ the Kremlin negotiators told us. ‘That is why we are ready to sell those enterprises to you. But, to begin with, you must go and persuade the directors of those enterprises to hand over power to you. You have to do that yourselves. And you have to start paying workers’ wages and state taxes immediately.’

I remember very clearly what Yukos was like back then. Salaries were six months in arrears and employees were either grumbling to themselves or complaining out loud. The level of theft of company property and corruption by workers and managers was staggering. Yukos was running a massive operating loss, and the company was only functioning in nine regions of Russia. When I left Yukos seven years later, however, average salaries had reached $1,000 per month; there were no delays in pay; production had doubled; and tax payments reached $3.5–4 billion per year at an oil price of just over $20 a barrel. Privatisation had allowed us to establish proper management, which simply did not exist in the era of the ‘red directors’ – the old Soviet bureaucrats who continued to run the big national industries.

We had to do it the hard way. As I mentioned before, Soviet era employment practices were based on the old mantra of ‘we pretend to work and they pretend to pay us’, with the result that Yukos was saddled with hundreds of middle managers who turned up, clocked on and did nothing. To knock the company into shape, we had to move most of them on. Many people were fired. We introduced severe penalties for drunkenness on the job, which was running at catastrophic levels. And we cracked down on corruption, showing no mercy to those workers and contractors who were seen to be cheating the company or stealing its property. After seven years, Yukos was active in a total of 50 Russian regions, with an annual production of 80 million tons and a distinct upward trend. It became the second largest taxpayer in the whole country, after Gazprom, accounting for almost 5 per cent of all federal budget revenues – and all of this was achieved in a country that had just emerged from 70 years of communism, where we had to struggle to find managers and workers able to adapt to the new ways of private enterprise.

Turning round Yukos’s fortunes meant struggling against the backwardness and mental entropy of the Russian business world. In addition, we had to contend with sharp practice from Western business as well. There was underhand dealing, a systematic failure to respect agreements and an unscrupulous Wild West capitalism at play, which helped to undermine the esteem in which we Russians had held the West, denting our admiration for the ‘shining light’ of free-market democracy.

In particular, I saw how large Western companies used their negotiating experience to exploit the business illiteracy of Russian officials, trying to bargain with the government to snap up oilfields for 2–4 per cent of their real value. And I encountered examples of economic blackmail, so-called ‘greenmailing’, by Western investors. This was done by buying a minority stake in a company and then accumulating enough shares to be able to veto its management’s plans for restructuring and modernising the business. The greenmailers would offer to lift the veto in return for the management’s agreement to buy out their shares at a price well above market value. In our case, Western investors did this to us when we were trying to integrate some of Yukos’s subsidiary companies. We eventually managed to fend off the greenmail attempt, but the underhand methods they used against us shook my faith in the West as a model to be followed.

Then, in the second half of 1998, things went from bad to worse. Following the sudden plunge in world oil prices, the rouble was sharply devalued and the energy-dependent Russian economy went into a nosedive. The stock market lost billions of dollars. Many firms that had previously appeared impregnable went to the wall and it seemed Yukos might become one of them. The price of oil on world markets plunged to $8.50 per barrel, while the cost of production remained at $12 per barrel. It meant we were producing oil and then paying out money for doing so. With bankruptcy looming, I took drastic action. I had to cut the staff by 30 per cent: tens of thousands of people in just one year. It is not something I found easy, or am proud of, but there was no alternative. Those who remained, nearly 100,000 employees, agreed to take a 30 per cent reduction in their salaries (which was softened to less than half of that because of the devaluation of the rouble).

I went to Yukos’s main oil production facility in the town of Nefteyugansk and invited representatives of all the company’s workers to a meeting in the local theatre. I spoke with them to explain why I was asking them to vote to take a pay cut. Their agreement in a formal vote was legally necessary and the initial reaction was hostile, but by the end of the meeting I had convinced them that it was better to agree a temporary drop in wages to save the company for better days ahead. I promised I would make up for their lost wages within a year, and I am proud that I managed to do so. But even more important for me was the fact that I had gained the trust of the workers.

The economic crisis of 1998 was a wakeup call, though not everyone heeded it. Many Russians complained and blamed the West, but I decided it was time to concentrate on taking practical steps. Together with my business partners, we resolved to transform Yukos into a completely open and transparent operation, adopting Western reporting standards and respecting world-class environmental, employment and ethical practices. Without this, it was evident that we could not thrive in an international business sector where competition was fierce. We invited the best specialists from around the world to help us reorganise our production processes, and we secured the buy-in of the company’s employees. It paid off: production increased, costs fell, we were welcomed into the global market and our profits grew.

Yukos became one of the first Russian companies to adopt Western standards of corporate governance and respect for shareholder rights, including the preparation of financial accounts that complied with US Generally Accepted Accounting Principles (GAAP). An independent board of directors was appointed, with a mix of Russian and Western representatives, such as the international investment specialist Bernard Lozé, the prominent French banker Jacques-Antoine Kosciusko, the Washington lawyer Sarah Carey Reilly and others. We revealed who owned what in the company, with details of all our shareholdings, and we adopted a new company motto, ‘Honesty, Openness, Responsibility’. The result was that Yukos American Depository Receipts (ADRs) were accepted for trading in the US market, and US investors – including state pension funds – bought nearly 15 per cent of our shares. By conforming to Western norms, we boosted our standing and our profits at the same time. Yukos became a poster-child company, a symbol of how the Russian economy and its shady business culture could transform itself. BusinessWeek wrote that US investors were rewarding our new approach. Yukos’s share price rose 250 per cent. ‘If Khodorkovsky can keep this up,’ BusinessWeek concluded, ‘the Russian energy industry with Yukos as its standard bearer may finally get some respect.’

My partners and I were lucky. We teamed up with consultants from the oilfield services specialists, Schlumberger, and other advisers from Western countries, who were marvellous to work with. They not only advised us on how to transform and restructure our company, they helped us to restructure our whole way of thinking. The Schlumberger team showed us the best things about Western business ethics and why integrity matters. They worked according to proper codes of conduct, honest people who commanded respect both as professionals and as decent folk with real values. Even today, I remember them with the greatest admiration. This convinced us that the conmen who had previously rushed into Russia were perhaps not the true face of Western capitalism after all.

My respect for Western values was boosted and restored but, for the majority of Russians, things seemed very different. Many had been badly hit by the economic collapse of 1998 and a substantial number of people came to blame the West. Russian government officials who had to cut public spending and imposed economic austerity measures were quick to cite the demands of the International Monetary Fund as the reason for their tough decisions. The result was a growing, generalised antipathy towards ‘Western interference’. When Russian banks failed and people’s savings were lost, the public seized on the explanation that this too was the result of conditions imposed on Russia by the IMF. They believed that the West was implementing a deliberate policy of destroying Russian banks in order to clear the way for Western financial institutions to come and take their place. Things had gone badly wrong and the West – especially its financial institutions – was a convenient scapegoat. A wave of national resentment grew, attaching itself to the ‘traitors’ in the Russian government who had ‘sold Russia out’ to foreign interests. The Yeltsin administration’s commitment to Western-style market democracy was blamed for all the nation’s ills, and the conditions were created for the coming to power of a new breed of politicians – people with a background in the security services, who would restore order with the iron grip of centralised autocracy.

It seems to me that Russia in the late 1990s was suffering from a sort of Weimar syndrome. In the 1930s, the population of the Weimar Republic had become convinced that Germany’s poverty and humiliation were caused by the harsh terms of the Treaty of Versailles, imposed on them by the victorious First World War allies. In a similar mood of national discontent, Russians now began to blame Western Europe and the United States.

The Russian people had seen living standards fall and many were plunged into poverty. After decades of artificially maintained price controls, backed by billions of roubles of state subsidies (which even then did not manage to keep the shelves filled), Yeltsin and the Chicago Boys had freed prices for all but the most essential goods. Inflation had rocketed; people’s savings were being spent on just a few days’ worth of food. Hordes of beggars appeared on the streets; people were forced to sell their family possessions to stay afloat. The collapse of the USSR and the Soviet system of central planning had left factories without suppliers and without government orders. Unable to adapt to market conditions, they could no longer pay wages to their workers or taxes to the state. In an attempt to balance the national budget, Yeltsin slashed state spending and raised taxes. When entitlement to free healthcare was sharply reduced, few could afford the paid services that replaced it. Illnesses and infant mortality increased, along with alcoholism and suicide; male life expectancy fell to 57 years. The result was that the nation felt cheated and belittled. And at the same time, Western Europe and North America seemed to be thriving. Many Russians resented the apparent decline of their country from a global superpower to an impoverished third world country. And they knew who to blame. Powerful voices in society accused malevolent foreign powers of trampling on Russia’s national interests and called for the restoration of national pride by the rejection of all cooperation with the West.

By a stroke of ill fortune, the Yugoslav crisis – following reports of Serbian ethnic cleansing of Kosovar Albanians – broke out just at the moment when revanchist demands in Russia were at their height. In 1999, the Kremlin was still actively engaging with the international community, pursuing internationalist policies and in return receiving Western financial support. With Boris Yeltsin incapacitated by a series of heart attacks, the country was effectively being led by the prime minister, Yevgeny Primakov. On 24 March that year, Primakov was due to fly to Washington to ask the International Monetary Fund for an additional $4.2 billion, and he took me with him as a member of the Russian business delegation. As we took off from Moscow, Primakov explained that he was not optimistic that the loan would be granted: the West had already pumped large sums into Russia, with little indication that it was making any difference to the crisis in our economy. In addition, there was growing popular anger in Russia that Yeltsin was perceived as going cap-in-hand to the Western ‘enemy’ who had brought us to our knees. A further flashpoint had emerged: NATO countries announced their intention to intervene in the Yugoslav conflict by bombing Serbian military forces accused of the ethnic cleansing of Muslim Albanians in Kosovo, further inflaming Russian opinion.

We were already in the air when Vice President Al Gore called Primakov to tell him that the bombing campaign was about to begin. Primakov had to decide what to do. Most Russians regard the Serbs as our historical allies, fellow Slavs who fought with us against Muslim forces threatening from the east. After hurried discussions, Primakov ordered the crew to turn the plane around in mid-flight over the Atlantic and return to Moscow, scrapping a long-scheduled round of high-level economic and security talks with the Clinton administration. It was a dramatic protest against Western military action against Serbia, but also a symbolic U-turn in Russia’s whole relationship with the West. Even though I was on that plane, I am not sure that I fully understood at that moment the fateful consequences of what was happening. There was, however, a very real sense of a historic drama being played out before our eyes. At Shannon airport in Ireland, where we landed for refuelling on the way back home, I bought a box of Irish whisky and we all shared it to drown our anxiety about the future. We didn’t know it, but in a little over six months Yeltsin would be gone, and Russia would be under the rule of a very different type of leader.