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Business Watch: April 1, 2003

1 April 2003, Volume 3, Number 12
Russian Deputy Prime Minister Viktor Khristenko, who heads a key government pipeline commission, announced on 25 March that state-owned oil transport monopolist Transneft will pump an extra 10 million metric tons of oil abroad in 2003, "Vedomosti" reported the next day. The news comes amid mounting frustration among Russian oilmen at a maddening combination of limited export capacity, booming production, and high prices on world markets. Much of the increase will come from filling the Kholmogory-Klin pipeline to capacity by allowing it to transport sulfur-bearing crude in addition to the sweet crude it currently carries. The plan, which will add 6 million-7 million tons annually to the country's export capacity, had previously encountered opposition from the owners of the Tuapsa, Krasnodar, and Volgograd refineries, which will now have to be refitted to handle the increased sulfur content. Those refineries will now receive an additional 240,000 tons of crude each month to pay for desulfurization facilities, "Vremya novostei" reported on 26 March. Meanwhile, Transneft Vice President Sergei Grigorev told "Vedomosti" on 27 March that the company will ask the Federal Energy Commission to raise transport fees by 5 percent pay for measures to "eliminate pipeline bottlenecks." An oil company representative told the newspaper the industry is ready to open its wallet: "Better to pay a bit more for transport so that you can be sure to export the oil." DK

LUKoil announced in a 27 March press release that it reached an agreement with Urals Energy to acquire the latter's oil assets in the Komi Republic, obtaining a 50.8 percent stake in Tebukneft, a 59.8 percent stake in Ukhtaneft, and a 58.3 percent stake in RKM Oil. The deal ends a struggle for control of Tebukneft that briefly threatened to spill over into international courts in mid-February. The dispute drew heightened attention because Tebukneft, which produces 1 million metric tons of crude oil annually, is controlled by Leonid Dyachenko, former son-in-law of Boris Yeltsin. Anonymous industry sources told both "Vedomosti" and "Gazeta" that the sum of the deal was approximately $100 million. "Kommersant" reported on 25 March that the analysts it queried deemed the presumed $100 million price tag "inflated." "Vedomosti" reported the same day that LUKoil raised additional eyebrows by choosing to acquire Tebukneft through unnamed third parties. LUKoil confirmed its operational control over Tebukneft at a 21 March shareholders' meeting that saw LUKoil representatives occupy all nine seats on the Komi oil company's board of directors. DK

Central Bank Deputy Chairman Oleg Vyugin sought to allay foreigners' fears over money transfers abroad in a 24 March letter, "Gazeta" reported the next day. New currency legislation that took effect on 15 March omitted foreign legal entities from a detailed enumeration of various legal means of transferring money abroad. Auditing firms PricewaterhouseCoopers and Ernst & Young were sufficiently perturbed by the legal implications of the omission to recommend that their foreign clients refrain from transferring money out of Russia pending further explanations, "Kommersant" reported on 25 March. Vyugin called the misgivings "far-fetched" and stressed that "the law does not prohibit this, therefore it is permitted." Not everyone was swayed by Vyugin's legal liberalism. Aleksei Kuznetsov, senior manager of Ernst & Young's tax department, told "Vedomosti" on 25 March, "The Central Bank's explanation is good only for the short term." Michinoku Bank President Yuzuru Kasio stressed to "Kommersant" that "changes to the law are definitely necessary, since the Central Bank can give one explanation today and a different one tomorrow." DK

A little-known investment fund paid $60 million for a 7 percent stake in leading Russian dairy and juice producer Wimm-Bill-Dann (WBD), "Vedomosti" reported on 24 March. Aleksandr Gorbachev, director of United Burlington Investment Limited, told the newspaper that his company bought up the stake because it believes that WBD shares will rise by at least 20 percent in the upcoming year. The shares were acquired from Aleksandras Timokhins, a private investor. WBD press secretary Kira Kiryukhina told Reuters that Timokhins, while a large shareholder, "did not have a seat on the board or influence in the company." DK

United Heavy Machinery (OMZ) announced on 27 March a significant expansion of its nuclear-power-engineering interests with the acquisition of a 19.9 percent stake in Atomenergoexport (AEE) and a 50.94 percent stake in Zarubezhenergoproekt, "The Moscow Times" reported on 28 March. Together with subsidiary Atomstroiexport, AEE has nearly $3 billion in contracts on the books, including agreements to build nuclear reactors in India, China, and Iran, "Vedomosti" reported on 28 March. OMZ was quiet about the amount of the deal but promised to make the terms known in May after an audit. OMZ-Atomic Equipment head Aleksei Shavrov told "Izvestiya" on 28 March that the idea behind the deal was to create an independent business structure capable of making inroads on international markets. Atomstroiexport Director Viktor Kozlov told "Kommersant," "Integration into a large heavy machinery corporation will get rid of our financial problems, and especially a shortage of cash on hand in the early stages of construction." Troika Dialog analyst Andrei Kormilitsyn told "Vedomosti" that while the acquisitions seem promising, more precise information is required to evaluate them. DK

Russian Aluminum (RusAl), the world's second-largest aluminum producer, has put in an application to take part in the privatization of Guinea's Friguia alumina factory, "Vedomosti" reported on 27 March. RusAl currently owns a controlling stake in Guinean Investment Company, which in turn owns the company that manages Friguia. Friguia's current annual production of alumina -- two tons of which are refined into a single ton of aluminum -- is 600,000-700,000 metric tons. Aleksandr Bulygin, RusAl chief operating officer, told reporters on 26 March that his company would consider investing up to $300 million to boost production at Friguia to 1.4 million tons, Reuters reported. RusAl, which plans to put out 2.5 million tons of aluminum in 2003, needs to improve its access to alumina if it wants to complete a plan to overtake U.S.-based Alcoa as the world's leading aluminum producer by 2012. The impending elimination of external tolling -- a system of favorable tariffs whereby raw materials are not subject to a value-added tax because they are processed under a leasing agreement -- gives RusAl added incentive to acquire its own sources of alumina and lessen its dependence on Western suppliers. DK

Norilsk Nickel came one step closer to acquiring U.S.-based Stillwater Mining Company when the latter reached an agreement with its creditors to prevent the planned acquisition from triggering the advance repayment of its roughly $250 million debt, reported on 26 March. Stillwater spokesman John W. Pearson explained that the mining company's largest creditor, Toronto Dominion Securities US Inc., reached an agreement with Nornickel that $50 million of the $100 million in cash Nornickel is forking over for Stillwater will go toward paying off a $186.9 million syndicated loan that Stillwater received through Toronto Dominion. Nornickel agreed in November 2002 to buy a 51 percent stake in the financially troubled mining company for $341 million ($100 million in cash and the remainder in platinum). In accordance with the terms of the agreement, Nornickel recently exercised its right to propose candidates to Stillwater's board of directors, reported on 31 March. The only hurdles that now remain are the approval of the U.S. Federal Trade Commission and Stillwater shareholders. If the deal goes through, it will mark an unusual example of a Russian investor coming to the aid of an ailing U.S. enterprise. DK

Representatives of five Moscow cellular operators arrived at City Hall on 28 March for a private tongue-lashing from Mayor Yurii Luzhkov, reported the same day. The meeting came after the mayor voiced his displeasure with Mobile TeleSystems (MTS), Vimpelcom (Bee Line), Sonic Duo (Megafon), MSS, and Personal Communications (Sonnet) on 24 March, lambasting the companies for cutting corners on quality while reaping huge profits, "Vedomosti" reported the next day. Cellular operators hit back, asserting that dropouts and break-ups remain below the 5 percent level stipulated by regulations, "Izvestiya" reported on 25 March. Industry analysts noted, however, that problems might arise from bottlenecks in connections between cell phones and the city's fixed-line network. "Vremya novostei" reported on 25 March that Luzhkov's remarks were likely directed at Vimpelcom, the only one of Moscow's big three cellular operators -- together with MTS and Megafon -- "whose owners are not affiliated with a state structure." speculated that the cell spat was either a "populist move" signifying the start of election season, or an attempt to help MTS, whose owners have close ties to city hall, in its long-running battle with Vimpelcom for preeminence in the Moscow market. DK

Vimpelcom announced impressive 2002 financial results in a 27 March press release, but the second-place Russian cellular operator's across-the-board gains failed to wow the market. Calculated to international accounting standards, net profit in 2002 was $129.6 million, a whopping 173.9 percent year-on-year gain. Revenues were $768.5 million, an 81.8 percent year-on-year increase. The company's subscriber base grew 144 percent year-on-year to 5.15 million by the end of 2002, with 3.71 million subscribers in the Moscow region, RosBusinessConsulting (RBK) reported on 27 March. (Vimpelcom's current subscriber base is 6.15 million, with 3.93 million in the Moscow region.) The results fell short of some analysts' predictions, however, and left the market cold. Vimpelcom American Depositary Receipts (ADRs) fell 8.39 percent on the NYSE in the first hour and a half hours of trading on 27 March, "Kommersant" reported the next day. Analysts offered various explanations for the negative reaction. ACM Consulting partner Mikhail Alekseev told "Kommersant" that everyone is looking for indications that the Moscow market is showing signs of saturation, so "any figures that can be interpreted as a growth slowdown cause a violent reaction." Troika Dialog analyst Yevgenii Golosnoi downplayed the reaction to "Vedomosti" on 28 March: "I think the market is making a mistake. Investors are looking at the details and not seeing the big picture." DK

Yurii Pavlenko has left his post as general director of third-place cellular operator Megafon, "Kommersant" reported on 27 March. Pavlenko, who will assume new duties as the vice-president of Swedish-Finnish telecommunications group TeliaSonera, will be replaced by Sergei Soldatenkov. Megafon's board of directors approved the change at a 24 March meeting. A Petersburg native, Soldatenkov was the director of North-West Telecom, the northern capital's largest phone company, until the summer of 2002, when he left to head an effort to create a next-generation CDMA-450 network in the city. Soldatenkov will oversee the company's initial public offering (IPO). "I think that the question of an IPO will be resolved in the near future," he told "Vedomosti" on 28 March. Megafon currently has 3.6 million subscribers in Russia, making it the country's third-largest cellular operator. DK

A BP-led international consortium continues to move ahead with the construction of the $3 billion Baku-Tbilisi-Ceyhan (BTC) pipeline despite rumors of war-related delays and environmental concerns, "Nefte Compass" reported on 26 March. Slated for completion in late 2004, the 1,760-kilometer pipeline will connect the oil deposits of the Caspian Sea with the Turkish port of Ceyhan on the Mediterranean. According to "Nefte Compass," military activity around the Turkish port of Iskenderun has disrupted the delivery of supplies, but a BP spokesman claimed the project's built in "contingencies" ensure that "it's not a problem." Meanwhile, a number of environmental groups recently presented the European Bank for Reconstruction and Development (EBRD), which has yet to decide whether to provide $300 million financing for the BTC pipeline, with a list of objections to the project, "Vedomosti" reported on 27 March. A BP spokesperson told the newspaper that the project, which requires $1.7 billion in external financing, will go on even if the EBRD declines to provide funding. In another reminder of the uncertainties surrounding the project, UPI reported on 27 March that the United States might halt its financial and political support for the pipeline after Ankara refused to allow U.S. troop transports across Turkish territory. DK

The skill of Russian manufacturers has rarely been perceived as a direct threat to the United States. But with thousands of Americans in harm's way on the battlefield in Iraq, and the Bush administration voicing angry protests at alleged illegal arms shipments to the regime of Saddam Hussein, the quality of Moscow's antitank missiles, electronic jamming equipment, and night-vision goggles is suddenly too high to be allowed to fall into the wrong hands.

The scandal went public on 22 March, when U.S. diplomats delivered a formal protest to the Russian Foreign Ministry for failing to take action against three Russian firms for military hardware shipments to Iraq in violation of UN sanctions, "The Washington Post" reported the next day. U.S. officials claimed that their Russian counterparts had done nothing despite clear evidence that illegal shipments were taking place. U.S. indignation, which had simmered for months behind closed doors, broke out into the open with the start of hostilities in Iraq. An unnamed U.S. official fumed to "The Washington Post," "The stuff's there, it's on the ground, and they're trying to use it against us." Another source told the newspaper that a Russian firm even had personnel on the ground in Iraq to show the Iraqis how to use and repair its equipment.

A blistering 29 March editorial in "The New York Times," which had assumed a cautious stance on Iraq-related matters before combat began, showed just how much war changes the picture. Under the headline "Supplying The Enemy," the editors stressed that the equipment involved poses no trivial threat: "Russian missiles can knock out the mighty Abrams tank, and smart weapons can be sent astray with the jamming device." They closed with a stark warning: "Many Americans may share the Russian objections to this war, but no Americans will tolerate or forgive having an American tank blown up by a Russian missile."

Moscow and Baghdad have a long history of well-armed friendship. Between 1958 and 1990, the Soviet Union concluded arms contracts with Iraq to the tune of $30.5 billion, "Izvestiya" reported on 25 March. Exports included: 4,630 tanks, 2,810 armored fighting vehicles, 2,714 armored personnel carriers, 3,279 pieces of artillery, 725 antitank rocket complexes, 325 antiaircraft rocket launchers, 1,593 portable "Igla" antiaircraft missiles, 1,145 military and transport aircraft, 348 helicopters, and 41 warships. Official cooperation came to an end in 1990 with the Iraqi invasion of Kuwait and the subsequent imposition of UN sanctions.

The latest allegations centered on two companies: Moscow-based Aviakonversiya and the Tula-based Instrument Design Bureau (KBP Tula). Both were quick to deny the charges. KBP Tula Director Vasilii Knyazev told "Vedomosti" on 25 March that his firm never supplied Iraq with antitank missiles. Knyazev did note, however, that KBP Tula-designed "Kornet" and "Metis" antitank missile systems were shipped to Syria in 1998-1999, triggering U.S. sanctions that are still in effect. Aviakonversiya Director Oleg Antonov told "Vedomosti" that GPS jammers numbering in the "tens" had been delivered to "countries in the region." While he wouldn't rule out their subsequent resale to other nations, he stressed that the numbers involved were insufficient to pose a threat to the U.S. military.

Reports in the Russian press were quick to point out that, official denials aside, military hardware flows from producer to purchaser through a number of channels, not all of them easy to track. Defense analyst Pavel Felgenhauer, who has often cast a critical eye on the Russian military establishment, detailed some of those channels in a 27 March article in "Novaya gazeta" (an abridged version of the article appeared in "The Moscow Times" in English the same day). Felgenhauer writes that in the 1990s Iraq purchased new armaments and spare parts for existing weapons systems through a Bulgarian firm called Kintex that coordinated "illegal weapons shipments to hot spots all over the world."

Felgenhauer notes that economic necessity spurred hard-pressed Russian specialists to keep their Baghdad contacts current. The author recalls that a designer from a "large Russian weapons firm" told him, "What do you want? The Russian government doesn't pay us anything, so we have to go to Baghdad to earn money to survive." After quoting a source in the Foreign Ministry that recent public allegations are "only the tip of the iceberg, no more than a third of what's really going on," Felgenhauer wonders what the Americans will find when they take Baghdad. He concludes, "No wonder our guys are so stubbornly opposed to the idea of violently deposing Hussein."

Despite their insistence that they are not themselves responsible for any direct shipments of military hardware to Iraq, Russian arms manufacturers' proud declarations of confidence in their creations seemed to lend credence to U.S. concerns. After a de rigueur denial of contacts with Iraq, Aviakonversiya's Oleg Antonov shared the following with "Vremya novostei" on 25 March: "We exhibited our first [GPS jamming] transmitter at the air show in Zhukovskii in 1997. The Americans were horrified. End of story, as they say -- their high-precision weaponry can be wrecked quite simply."

Curiously, reports from the 1997 air show that Antonov mentions hint at a link between Aviakonversiya's GPS jammers and Iraq. "Aerospace Daily" reported on 14 October 1997, "A poster from Aviaconversia shows a map of a Gulf nation and the number of jammers that would be required to cover an international boundary." Moreover, "the company has acknowledged getting expressions of interest from Libya and Iraq."

How effective are the jamming devices? "Aviation Daily" reported on 22 September 1997 that, according to FAA spokesman Hank Price, "the type of device being marketed by Moscow-based Aviaconversia is 'nothing new,' and there are 'hundreds of these devices' on the market." A 17 November 2000 article in "Defense Daily" reported that U.S. defense contractor Lockheed Martin was sufficiently concerned, however, to develop a system to counter GPS jammers. The article went on to explain: "Russia's Aviaconversia currently markets a four-watt GPS jammer that only weighs about 19 pounds but can deny GPS reception for about 125 miles." Avoiding further specifics, "Defense Daily" merely noted that Lockheed Martin's G-STAR antijamming system ended its development phase to go into testing in 1999.

Few in Russia were inclined to cast doubts on the jammers' effectiveness. In fact, a 25 March article in "Nezavisimaya gazeta" argued that it was the jamming systems' efficacy that sparked protests from the stunned U.S.-British coalition. Citing anonymous "experts," the newspaper claimed that the Iraqis' use of jamming technology "came as a complete surprise to the attackers, who above all else feared chemical and biological weapons." The effects on the coalition's weaponry were even more surprising, as "instead of high-precision direct hits, in a number of cases 'smart' bombs and Tomahawk cruise missiles struck civilian targets far from where they were aimed."

Mikhail Leontev, a pro-Kremlin commentator on the state-run ORT television channel, assembled the story's parts into a tidy political package for viewers of the evening news on 26 March:

"The U.S. State Department has accused two Russian firms of violating UN sanctions and providing Iraq with weapons, specifically, equipment to create radio interference for aviation and missiles. The Americans are making it clear that this equipment is to blame for the glaringly obvious inaccuracy of their so-called 'smart bomb' and guided missile strikes against Baghdad."

Carefully noting that Iraq must have obtained the jamming equipment through third parties, Leontev returns to the same air show that Aviakonversiya head Antonov described so glowingly to "Vremya novostei":

"Since 1997, when our jammers were shown to the public in Zhukovskii, the Americans have been fully aware that these instruments are a quiet death sentence to the Pentagon doctrine of high-precision weaponry. As for the fact that the Americans deluded themselves about the Iraqis' willingness to fight each other and about the guaranteed delivery of guided missiles to Saddam's bedroom window -- they can, of course, blame that on two private Russian companies, but that won't make the consequences of this delusion go away."

Far from the politically charged airwaves of state-run television, Sergei Oznobishchev, director of the Institute for Strategic Studies, cautioned against taking the matter too seriously. In a 25 March comment to "Vremya novostei," Oznobishchev argued, "This is a one-day scandal, an isolated incident. This always happens when political relations are strained."

Political prognostication aside, the issue of Russian military shipments to Iraq unexpectedly raises the broader question of innovation in business. "The New York Times," one might recall, wrote on 29 March that "Russian missiles can knock out the mighty Abrams tank." Despite its troubling implications for U.S.-Russian relations in their current circumstances, in the more general context of Cold War military competition between the United States and the Soviet Union, nothing about the statement is particularly surprising.

Imagine, however, a computer industry magazine writing that "Russian software can outperform the mighty Microsoft Office." Inconceivable. Impossible. Preposterous.

Perhaps. But just as the war in Iraq will eventually take its place as merely one episode in the continuing saga of U.S.-Russian relations, so could the Soviet Union's outsized military-industrial complex emerge from its post-Soviet travails as a balanced technology sector that serves as the innovative engine for a competitive Russian economy. DK