08.03.2009
After the Oil Boom
№1 2009 January/March

Record-high oil prices in the recent years brought an illusion
with Russian oil and gas companies that their easy profits would
continue forever. The financial crisis and the subsequent recession
have taught them a harsh but useful lesson: even enormous
hydrocarbon resources are not enough for prosperity.

Five Russian majors (Rosneft, LUKoil, TNK-BP, Surgutneftegaz and
Gazprom-Oil) have more energy resources than the leading Western
companies, while Gazprom is the world’s leader in natural gas
resources. However, the Russian corporations are behind their major
rivals in terms of capitalization and stable position on the
market. Owing to their diversified investment structure,
international oil and gas companies influence the formation of the
norms that provide stability both inside and beyond individual
countries. Even their occasional performance setbacks in
underdeveloped countries do not undermine their reputation as
successful global players. Stability in the market helps them
counteract the volatility of oil prices.

When oil prices were high, Russian companies could easily
attract financial capital. Short-term profits earned them stable
credit ratings and encouraged them to take long-term loans for
large investments. However, the liquidity crisis froze many
long-term investment projects. Even such major Russian companies as
Gazprom, Rosneft and LUKoil, which increased their profits by 30 to
40 percent over the last year, have not achieved an island of
stability in the ocean of financial turmoil. The loss of
capitalization and overall profits only complicates their
investment prospects, which, in turn, will have a long-term effect
on their future development.

Russian corporations that made profits only by raising prices
ignored the need for onward development and diversification of
investment activities. Meanwhile, the latter measure must be used
to develop and improve the resource base and enter new sales
markets – especially as global economic recessions are always
accompanied by a growth of protectionism and its political
manifestations. This is why transnational energy companies usually
abide by – and help consolidate – the international practice that
protects their investments in other countries.

Moscow, however, only responds to actions of the West.

The situation for Gazprom is complicated by its long-term
commitments, whose fulfillment requires stable gas supply from
extraction sites to the European Union’s borders.

In view of the abovementioned changes in the world energy system
it is natural to ask a question: Does Russia really need an
international investment regime?

RECESSION AND POLITICIZATION OF THE ECONOMIC SECURITY ISSUE

The financial crisis has already caused countries to toughen
their economic security measures. State interference in the
economy, expropriations and forced sales of assets have become
common practice even in such liberal states as Britain.

The revision of liberal economic values was also behind the new
measures taken by the EU Energy Council for the EU internal market.
On October 10, 2008, the Council proposed allowing all EU states to
take protective measures with regard to investment in transport
facilities. National governments will be able to restrict access to
investment in gas transport networks for non-European companies; in
other words, protectionist actions by EU member-states will be
legalized. Of course, the Council’s conclusions are not tantamount
to barring access to investment, yet they justify introduction of
economic security measures.

In this context, diversification of investment by Russia must be
carried out within the frameworks of a political strategy for
protecting its investments abroad. Yet the international political
context weakens Russia’s positions – Russian actors have to operate
outside of Russia in an atmosphere of mistrust and absence of
protection means against investment risks, as well as absence of
stable relations with neighboring states, which are becoming
systemic factors of the global energy system.

The development of a long-term investment strategy in foreign
markets is a vital need, but legal mechanisms for protecting energy
investments are not always backed with foreign-policy moves. In
addition, Moscow’s demands – made with an injured air – that the
West revise its approach to Russian energy companies rarely come
home to its Western partners. Moreover, the decisions by the EU
Energy Council emphasize potential risks involved in the economic
security policy in EU countries.

THE POLITICAL PROBLEM IS NOTHING NEW

According to Immanuel Wallerstein, the bifurcation of
international relations began with changes in the rules that
regulated cross-border political and economic ties.

The global economy is now witnessing two opposite trends. On the
one hand, the increasing politicization of the economic security
issue undermines the liberal market norms. On the other hand, this
causes a pressing need for international legal protection of
investments against possible discrimination.

The liberalization of EU gas markets is a graphic illustration
of these two opposite trends on the way towards a common market.
The closure of the doors before outside investors acquired a
pan-European dimension in September 2007 when the European
Commission approved the Third Energy Package to restrict
non-European investment in EU transport facilities. This document
became part of a logical chain of the development of a common
liberalized EU energy market.

Making energy markets open to competition has always met with
political opposition. The first fights over this issue began in
1989, when the EU discussed the possibility of introducing the
successful experience of the UK in liberalizing electricity and gas
markets was. Seven years of negotiations were crowned with the
adoption of a directive of the European Council and the European
Parliament, which endorsed the main principles for opening markets.
The principles include separating transportation from production
and supply; working out transparency rules that would facilitate
access to transportation for all competing suppliers; and opening
wholesale markets for companies competing for sales networks.

However, the process of opening up the gas market has been
delayed because gas transport networks belong to suppliers, which
deny access to them for competitors. The European Commission’s
proposal, made in the autumn of 2007, was intended to increase
competition among gas suppliers. To this end, suppliers needed to
be separated from their transport networks, thus removing barriers
to markets for suppliers that do not have pipelines of their
own.

The Third Energy Package, in its original wording, was blocked
by the European Council which bowed to the demands of some of the
EU states and their companies that showed strong opposition to this
initiative. Nevertheless, the European Commission turned to the EU
competition law in order to legitimize –through legal action –
complete separation of transport companies and suppliers in terms
of property. On October 10, 2008, the EU member states sealed a
compromise based on a consensus on the exclusion of non-European
investments if this is required by security considerations. At the
same time, attempts have been made to lobby for establishing a
unified European gas transport company, where investment
limitations would be introduced. A unified gas transport system
would create real prerequisites for the emergence of a single gas
market, where networks and supplies would belong to different
owners.

The adoption of such measures to protect Europe against
“unwanted” capital should not be surprising, considering the EU’s
efforts to strengthen its economic security.

The politicization of the energy security issue began after the
events of January 2006, when a Russian-Ukrainian gas price conflict
interrupted gas transit to Europe for some time. Russian gas
supplies began to be viewed through the prism of security and
geopolitics. Subsequent agreements between Moscow and Kyiv have not
removed the threat of a crisis recurrence, which happened three
years later. In 2009, gas transit to Europe was halted on a much
larger scale; this time the termination of supply was initiated by
Russia, which has given additional arguments to those who advocate
the politicization of energy relations with Moscow and those who
propose establishing a unified gas transport company in Europe,
with ensuing protectionist measures.

The EU poses as the only effective international regime for
cross-border investment in the energy sector, which it believes
justifies its moves to restrict access to its market. Thus, the
European Union distances itself from other international investment
regimes, such as the Energy Charter.

INVESTMENT RISKS IN SAFE EUROPE

Russian oil and gas companies look at investment risks in the
European Union through rose-colored glasses. Indeed, the EU
economic space is more predictable and transparent than most of the
other regions in the world. Nevertheless, real and latent
investment risks in the EU do exist. Today they concern Gazprom,
and tomorrow they may affect Russian oil companies as well.

First, there is a risk of actual expropriation
of assets after the introduction of forced competition and
restricted access for foreign capital. The discussion of the Third
Energy Package makes this risk more tangible. In addition, pursuant
to the EU competition provisions, the European Commission is taking
steps to initiate legal proceedings against suppliers that have
transport assets. This may directly affect the investment already
made by Gazprom in gas transport networks, which are particularly
ramified in the Baltic States and Eastern Europe.

Second, investment may also be limited for
ecological reasons, and, at worst, assets may be expropriated. Many
energy investments have come under the pressure of standards of the
Kyoto Protocol and the EU directive on emission reductions. Russian
investments in oil refineries may be affected by this pressure as
well.

Third, it is not ruled out that investors from
Russia will be barred – for security reasons – already at the
pre-investment stage. Such cases are many, and the best known of
them involves Britain’s Centrica. Calls to restrict Russian
investments are heard even from such friendly countries as
Germany.

Fourth, risks emerge when partners fail to
fulfill their contractual obligations. For example, Russian gas
suppliers conclude a contract to supply gas to a distribution
market at a certain price, while local authorities amend the price
according to their political favors. Such conflicts may happen in
the Baltic States where Gazprom has a large share in heat power
distribution. It should be noted that failure to comply with one’s
contractual obligations does not entail the application of security
provisions of the Energy Charter Treaty (ECT).

Apart from the European Union, which remains the largest source
of revenues for the Russian oil and gas sector, the restrictions
may also be applied in the Balkans and Turkey. Russian investors
view that region as an alternative to the EU, but EU legislation
applies to Balkan countries, as well as they are parties to the
2005 Energy Community Treaty.

Combining competition legislation with energy security issues is
becoming a long-term tendency of the EU internal market. This
situation is not in Gazprom’s favor, although the latter has been
making great efforts, struggling against complete division
according to property. Gazprom is trying to influence the European
Council through the lobbies of its European partners. But these
efforts will it bring nothing – either in what concerns European
competition legislation or limitations on investment in the EU – as
the Russian gas giant has to rely on companies that are its rivals
in EU distribution markets.

What political and legal mechanisms are needed to protect
investors in the European Union?

NEW EU RULES VERSUS ECONOMIC LIBERALISM

The international investment regime has traditionally been
regulated by bilateral investment agreements providing for
international arbitration. However, these agreements do not always
clearly specified rules for resolving conflicts. In addition,
agreements of this kind are very sensitive to political changes in
the signatory countries.

During the years of the rapid development of energy markets, an
attempt was made to streamline the protection of private investment
within the framework of the Energy Charter Treaty (ECT). This was
the first document in economic history to include multilateral
provisions for protecting investors against discrimination and
illegitimate expropriation. In addition, the ECT mechanisms for
settling disputes allow one to initiate legal proceedings directly
against the European Community.

However, the treaty has lost its legitimacy after Moscow’s
refused to ratify it, which was the result of Gazprom’s lobbying
efforts. The corporation has objections against transit provisions
of the ECT and against its Transit Protocol, which is still the
subject of international negotiations.

In June 2006, experts of the Gazekonomika Research Institute,
which is close to Gazprom, pointed to the absence in the ECT of
provisions that would ensure pre-investment protection against
discrimination. They failed to take into account the fact that
investment arbitration rules make no distinction between pre- and
post-investment stages. Yet, the criticism by Gazekonomika was
justified because non-discrimination at the pre-investment stage
increasingly depends on relations of reciprocity, bypassing
provisions of the international treaty. These rules of reciprocity
serve as a pretext for the European Union to restrict investment in
transport facilities.

In light of these restrictions, one can assume that if the
negotiations on the ECT were held today, the treaty would not be
signed even by the EU member states themselves. But the treaty has
been in force for ten years now, while the interest of European
energy companies in it further grew after the emergence of the
Third Energy Package. These companies view the Charter’s investment
provisions as a legal guarantee against property division and as
protection against the expropriation of energy property.

Russian experts from the Russian Gas Society and the Institute
for Energy and Finance Foundation contrast European law with
constitutional rights of the EU member countries concerning the
protection of property at the national level. But their reasoning
does not take into account legal monism, by which the majority of
European countries abide: international law is integrated into
national legislation through the ratification of any treaty. The
monism means that national legislation cannot oppose decisions of a
European court or laws of the European Union. At the same time, the
ECT prevails over EU legislation, because the European Community is
a party to the Charter.

At the same time, the European Commission has grounds to deny
Gazprom non-discrimination, using the security provisions in the
ECT and those adopted by the Council. The proponents of the EC’s
position argue that the monopoly on gas exports in Russia, which
lacks economic grounds and which even Norway has given up, is the
main and only argument for justifying the security measures.

The situation with investments in the oil industry is simpler:
arbitration is possible there within the ECT frameworks, as there
is no oil exporting monopoly company in Russia.

In addition, the January 2009 crisis has confirmed that the
transit mechanisms, provided for by the ECT, can prove necessary in
situations when transit to Europe is halted. During the conflict
with Ukraine, after Russia resumed gas supply to the EU but Ukraine
did not resume gas transit yet, the Russian leadership and Gazprom
urged Kyiv to comply with ECT transit provisions. However, Moscow
refrained from resorting to the ECT legal mechanisms against
violator countries. Meanwhile, using international mechanisms for
settling disputes would have been less painful politically than
proving to be an unreliable gas supplier to consumers in the
EU.

This conflict may have consequences for direct access to
European markets for Gazprom. After the January 2009 events, the
Europeans will find it difficult to give it direct access to
investment after it has proven to be an unreliable gas supplier
unable to find a political solution to the conflict with a transit
country without halting gas supply to its clients. And on the
contrary, the settlement of the crisis using intermediary
mechanisms within the ECT frameworks would have let Russia save
face and accuse Ukraine of violating the transit provisions.

But can the Russian state and Russian companies use legal
mechanisms of the ECT which has not been ratified yet? This
question remains open and requires careful analysis of various
political and legal options.

RUSSIA AND THE ENERGY CHARTER TREATY

Russia has not ratified the ECT and applies it on a temporary
basis (that is, its provisions remain in force if they are not at
variance with Russian legislation and the Constitution). Therefore,
there arises a possibility of using its investment provisions to
oppose restrictions in the EU. Such an approach to the treaty is
practiced for the first time in international practices. According
to the Vienna Convention on Treaties, provisional application
ceases after a treaty enters into force. In case with the ECT, this
already happened in 1998.

 According to the Vienna Convention, a state can choose
either to start full application of a treaty, or revoke its
signature from it. Russia has chosen a “golden mean” of its own –
it has refrained from the full application of the ECT, yet it has
not withdrawn its signature. Thus, Moscow’s application of the ECT
to protect Russian oil companies in Europe, for example, becomes
the subject matter of an international arbitration proceeding,
without Moscow’s consent. Russia does not relish the prospect of
being ranked among Latin American regimes, such as Bolivia, so it
does not contest international arbitral awards. In particular, it
signed and ratified the New York Convention on the Recognition and
Enforcement of Foreign Arbitral Awards even when it was part of the
Soviet Union.

The situation has been exacerbated by the application of the ECT
against Russia by YUKOS shareholders, who argue that Moscow has
violated the ECT expropriation provisions, using them in a
discriminatory manner against their company. YUKOS is seeking an
arbitral award precisely over the provisional application of the
Energy Charter Treaty by Russia. An arbitration proceeding is yet
to begin but the case has already been forgotten by the public
opinion both in Russia and the West. A hypothetical decision by an
arbitrator in favor of or against YUKOS would not mean that Russian
oil companies would automatically have a similar right to defend
their interests in Europe.

Russia’s uncertain position on the ECT may backfire on the
Russian state (if an arbitral award is made in favor of YUKOS) and
on Russian oil companies (if they are denied the right to use ECT
provisions against the EU). Meanwhile, Russia recognizes
arbitration decisions, even though it does not participate in
drawing up norms and rules.

The absurdity of the situation with the provisional application
of the ECT makes one ponder what system, apart from the EU legal
system, Russian investors can turn to if problems with the EU
arise.

Moscow will have to formulate its position and choose one of the
following options:

  • Withdraw from the ECT, leaving its economic players to the
    mercy of EU legislation and renouncing high posts in that
    organization, which would limit Moscow’s influence. As a result,
    political mistrust of Russia would grow, and the spiral of security
    problems would continue to unwind. The European Union would have
    every reason to use restrictive measures not only towards Gazprom
    but also towards the Russian oil industry;
  • Accept the ECT in its present wording, renouncing its
    provisional application and reaching a compromise with the EU,
    particularly on transit issues. Difficulties may arise, above all,
    for Gazprom due to its legal monopoly on gas export and due to
    limited access to networks for other gas producers. The gas giant
    is not ready for changes that could remove conflicts between
    Russian legislation and the Energy Charter Treaty. Russia may
    ratify the ECT with a reservation that its provisions shall not
    apply to the gas industry. However, considering the importance of
    gas for the EU, it is unlikely that Brussels will consider such
    ratification sufficient. In addition, it would be difficult for
    Moscow to demand that Ukraine comply with provisions that Russia
    itself has declined to observe;
  • Offer a clear alternative that would be acceptable both to
    Russia and the European Union. It could be a new document based on
    the ECT or a possible Russian-EU Agreement, which would contain
    clear-cut provisions on non-discrimination at the pre-investment
    stage and specify mechanisms for settling transit disputes. Regular
    gas conflicts with Ukraine require a new approach for settling
    them. However, this approach involves a risk of losing new
    negotiations, whose results would have to be renounced. This is
    what happened, for example, to the Transit Protocol, which was
    initially supported and partly initiated by Moscow.

Obviously, Russia avoids making a decision for the time being. A
wait-and-see position makes sense if there is a clear political
strategy behind it. In this case, the Russian position is based on
expectations of high oil prices and on the liberal investment
regime in the EU countries. However, protectionist sentiments in
Europe are growing, while a further decline in oil prices may
weaken Russia’s positions at negotiations with the EU.

WHAT TO DO?

Russian companies have overestimated their own strength and have
been affected by the financial crisis more than their Western
partners. The dependence on European markets, finance and
technologies requires drawing up a detailed economic strategy aimed
at diversification and innovation. Only in this way can Russia move
from a policy of “protecting the weak” to the “stimulation of the
strong” and clearly formulate its position on investment and the
international investment protection system. Otherwise, Russian
actors will have to abide only by the European rules of the game in
their relations with the EU.

When entering the international investment market, Russian
companies and the Russian state must become sources for developing
international energy law. So far, Russia’s participation in this
process has been passive. Russian corporations underestimate
investment risks in the European Union, while the Russian energy
strategy lacks understanding of how this country should build its
relations with international arbitration institutions.

The conflict between EU legislation and traditional liberal
norms calls into question the possibility of protecting investment
in the EU on the basis of EU laws. The present vacuum of
international rules and regulations on investment movements gives
Russia a chance to offer an alternative of its own – a new
international investment agreement based on the ECT. It could be
concluded starting with the oil industry, which needs investment
security most. Such an agreement would also be good for the power
industry, where the liberalization process is already well under
way.

As regards the gas industry, it first needs to be depoliticized
by both Russia and the European Union. This is impossible unless
regular conflicts between Russia and Ukraine are stopped. The
transit conflicts only confirm the need for universally accepted
rules, rather than annul it. One can draw an analogy with the law
of the sea: the existence of pirates does not call into question
the Treaty’s validity but it requires additional political efforts
to combat anomalies.

To this end, Russia should start a political dialogue with
various states and regional groups in Europe, similar to the
existing German-Russian energy dialogue. But above all, this
requires a political decision by Russia to move towards an
international Energy Treaty.