The CEO and principal owner of Yukos, Russia's most profitable oil company, was sitting in his Moscow home on the evening of Sept. 11, thinking he was watching a disaster flick. "It took me a little while to figure out it was CNN," says Mikhail Khodorkovsky, and that the destruction of the World Trade Center was not, as he puts it, some "bad Hollywood movie." Unknowable at the time--to him or anyone else--were the ways in which that horrific event would profoundly change Khodorkovsky's world and that of the other men who run Russia's vast oil industry.
Within hours Vladimir Putin would be on the phone to George W. Bush, expressing sympathy and offering help. Within months Putin would be visiting Bush's ranch in Crawford, Texas, to talk about the war on terror--a visit that will be reciprocated this month when Bush visits Moscow. Bush and Putin, for their own reasons, embraced each other after Sept. 11 and recast U.S.-Russian relations. That embrace will have huge implications on many fronts, but one is already clear. The world is recognizing anew the profit potential and the geopolitical importance of a simple geological fact--Russia has more oil than anyone outside the sheikhdoms of the Middle East, a part of the world for which "stable" is not the first adjective that springs to mind these days. Although Crown Prince Abdullah of Saudi Arabia has assured President Bush that his nation won't use oil as a weapon, talk of a cutoff is in the air again. For that and other reasons, more than a decade after the collapse of the Soviet Union, Khodorkovsky & Co.'s time has come.
In both matters of money and affairs of state, perceptions matter. Russia has always had oil. Lots and lots of it. And because of that it has always attracted ambitious young men seeking to make their fortunes. In the late 19th century, Swedish business magnate Ludwig Nobel began developing oil fields in the Caucasus, and in doing so drove another international entrepreneur right out of the Russian market for lamp oil--a fellow named J.P. Morgan. For all the cruel economic incompetence of the Soviet regime that soon took power, Russian oil production actually peaked in the late 1980s, at around 12 million barrels per day. But to the good fortune of Saudi Arabia and other Middle Eastern suppliers, most of that production was shut up behind the Iron Curtain. Since the Soviet collapse, expectations soared that Russia would finally take its place among the world's major oil powers. But like the rest of the economy, development of the oil industry took a back seat to the rapacious chaos of the Yeltsin years, when men like Khodorkovsky, Boris Berezovsky, and Roman Abramovich focused on acquiring assets, not nurturing them.
They became known as the "oligarchs," and it was not a term of endearment. They got valuable assets on the cheap and did whatever they had to do in order to hold on to them. Consider Khodorkovsky, now 38. He bought Yukos in Russia's infamous "loan for shares" scheme in 1995; got rid of U.S. investor Kenneth Dart, a large minority stakeholder in Yukos, via a brazenly massive share dilution; then survived the economic collapse of 1998 by simply stonewalling three big Western institutions whose loans to Khodorkovsky's bank were collateralized by 30% of Yukos' shares. Despairing of their ability to prevail legally in a virtually lawless Russia, the Westerners eventually walked, ending up with a fraction of what their stakes would be worth today.
That was when the rest of the world tuned out. It was the end of 1998. Russia had devalued the ruble and, to the fury of Western investors, defaulted on its debt. The country and its businessmen were pariahs. With Internet mania at its height, no one gave a damn about the place anymore.
It is true, as Stephen O'Sullivan, chief analyst at Moscow's United Financial Group, puts it, that in the year before Sept. 11 there had been "a crawling re-evaluation" of Russia going on in inter-national capital markets. Putin had begun to impose at least a semblance of order after the riot of the Yeltsin era. Oil prices were up. More important--and mostly unnoticed except by the oil cognoscenti--so, too, was Russian production of oil. Right around the time everyone had written them off as robber barons, the men who ran Russia's oil companies started to get their act together.
By Sept. 11, 2001, when the world began looking at Russia through a different lens, they were hitting their stride. At Yukos, and at Sibneft (a company run by Eugene Shvidler on behalf of Abramovich, Sibneft's largest shareholder, who is now also governor of a remote region in northeastern Russia), management got on with the job of creating modern oil companies out of the assets they had acquired. After bottoming at six million barrels per day in 1996, Russian production has risen by more than one million barrels per day over the past two years. Exports, too, have jumped. Russia now sells five million barrels of crude and oil products per day on the international market--a number that will continue to grow, since the spread between what a barrel brings in dollars abroad vs. rubles at home has never been wider.
Under normal circumstances, Russia's emergence would have gotten OPEC's attention. Its production increases were coming at a time when the cartel was cutting its own output to prop prices up in the face of a global recession. Sept. 11 made the situation that much more complicated. It was not lost on anyone in Russia's oil establishment that 15 of the 19 suicide hijackers were Saudis. Nor did it surprise anyone when President Putin bolted so quickly to Washington's side. "He was doing what any normal human being would do at a time like that," Khodorkovsky says.
But there was more to it than just empathy. Arab fighters, many trained in Osama bin Laden's camps, have been tormenting Russian troops in Chechnya for years, and Putin quite legitimately views radical Wahhabism--the infidel-hating brand of Islam that spews forth from too many mosques in Saudi Arabia--as a source of instability along Russia's southern crescent. There is, in short, no love lost between Moscow and Riyadh. Last November, around the time of a critical OPEC meeting, several of Russia's new oil czars were infuriated when Saudi Oil Minister Ali Naimi imperiously demanded that the Russians play ball with OPEC and cut production. The Russians sent him back to what one oil oligarch calls his "Wahhabi sandbox" with a curt nyet.
By all accounts, Naimi learned an important lesson from the experience. The central point about Russian oil these days is that there really is no such thing as "Russian oil." Not only is Russia not the old Soviet Union, but it is also not Norway, Mexico, or Venezuela, where the government dictates how much oil will be produced by a state-owned company. "Russian oil" is a constellation of asset-rich companies, the biggest of which is Lukoil, with more than $12 billion in revenues, including Yukos, Sibneft, Surgut Oil & Gas, TatNeft, and TNK, all of which are major crude producers. They are fiercely competitive, boast vastly different cost structures and operating strengths, and have very different opinions about the extent to which Russia should cooperate with OPEC.
If you want to get a sense of just how competitive these companies are, consider Lukoil and Khodorkovsky's Yukos. The headquarters buildings of the two companies sit just a few blocks from each other. Lukoil's is a gleaming, newish skyscraper, Yukos' a monstrous, rust-colored old Soviet-style building that used to be inhabited by a Soviet-era defense contractor. Strung across the outside of the Yukos building is a massive banner that reads YUKOS, INDUSTRY LEADER! It's there not just to inspire Yukos employees but to stick it to Lukoil employees, in particular CEO Vagit Alekperov, who pass by it every morning on the way to work.
Lukoil, after the collapse of the Soviet Union, carried the banner of Russian oil. The government still owns 14% of the company, though it is now preparing to sell off another 6% stake to investors. It remains the biggest of the Russian majors, with 30 years' worth of proven reserves, a vast retail chain, and international ambitions. In the ferocious post-Soviet jousting over oil and gas reserves in the Caspian Sea, for example, it was Lukoil that won the day, and it is the only Russian company now producing oil there. Its sales are nearly twice the size of Yukos', but that is where the favorable comparisons end. To be fair, because it was the state-owned flagship of the Soviet Union, Lukoil carried more of the inefficient Communist-era baggage into the '90s. Even so, Yukos has dusted Lukoil as a company.
At the end of 1998, Khodorkovsky owned 92% of an oil company then worth about $300 million. He made a conscious decision that he was going to try to turn Yukos into an "international oil company" up to Western standards of management and transparency. Needless to say, the number of people who would have believed that kind of prattle back then would not have included Kenneth Dart or the three banks Khodorkovsky stiffed or, for that matter, anyone else except Khodorkovsky himself. But the fact is, says one Yukos colleague, "it was the only way to do what he wanted to do"--increase the value of the company he had, by hook or by crook, gained control of.
Methodically, he has done exactly that. Not as burdened as some other Russian oil companies by excessive national pride--the belief that Western executives can't really teach the Russians anything--Yukos settled into a stable working relationship with Schlumberger, the giant oil-services provider, and the two set out to improve the productivity of Yukos' vast number of wells in western Siberia. Khodorkovsky also included several foreigners on his executive staff. None has been more important than an American senior vice president named Joe Mach. A native of Tulsa, with a thick drawl and an easy, engaging manner, Mach is a 31-year veteran of the global oil patch, working first for Gulf Oil (acquired by Chevron in the early '80s), then for Schlumberger, and for the past three years for Yukos. Mach visited the Soviet Union on a project in 1977. Asked if he ever could have conceived that he'd be working full-time for a Russian oil company, Mach says no, but adds that he knew his work would bring him back to Russia someday. Why? "Because outside the Middle East," he says, "this is where the oil is."
Fifty-five billion barrels of it, in fact (that's just proven reserves), compared with Saudi Arabia's 261 billion. Yukos' share of Russia's reserves stands at 11.8 billion. Mach's specific task is not to find new reserves--though Russia has plenty of those too--but to better exploit Yukos' existing wells. Drilling for new reserves has always been the sexy part of the oil business, but it is, as Mach says, expensive (though less so in Russia than in the U.S., thanks to the cheap ruble). Using sophisticated new software programs, Yukos has refined the art of injecting water into wells to push more oil up to the surface. It's the oil-patch equivalent of precision targeting, and the economics of it are a no-brainer: It costs much less to draw oil from already productive wells than it does to drill for new oil. Using the new programs, Yukos identifies which wells will produce the most oil using water injection. The system it uses, Mach says, "is world class." Then, catching himself, he adds, "in fact, it's better than world class."
The result is showing up on Yukos' bottom line. The company has relentlessly driven down its cost per barrel of production, which, given the quality of its assets, was already among the lowest of the Russian producers. In terms of operating expenses alone, Yukos estimates its cost per barrel last year at about $1.86, an extraordinarily low figure. That puts Yukos within a dollar and change of the legendarily low-cost Saudi fields. In 2001 Yukos made about $9.11 on every barrel of oil it produced, by far the highest figure in the Russian industry and one of the highest anywhere. With production surging--up by nearly 20% last year--Yukos' profits have been huge--an estimated $2.97 billion in 2001, on revenues of about $7 billion. That's a stunning 42.5% profit margin. Since Sept. 11, Yukos' stock has exploded. As of April 24, the company worth about $300 million in 1998 had a market cap in excess of $20 billion.
Yukos isn't the only Russian oil company to separate itself from the pack. Sibneft has too. Though its costs are not as low as Yukos'--in part because it drills more--they are lower than Lukoil's. And Sibneft is also printing money these days. It has, in fact, become the subject of much speculation that it could be acquired by a foreign major in search of a fully integrated Russian operation. Indeed, while Khodorkovsky made it plain to FORTUNE that he had no interest in peddling Yukos to Royal Dutch/Shell or Exxon Mobil, president Shvidler said "sure'' when asked if Sibneft is for sale.
The speculation about a possible acquisition does not come out of the blue. Nothing confirmed the post-Sept. 11 Russian rehabilitation more than a late-April announcement that British Petroleum would increase from 10% to 25% its stake in a Russian company called Sidanco, which is an affiliate of TNK, or Tyumen Oil. TNK is controlled by the Alpha Group, the investment arm of two other Russian oligarchs, Mikhail Friedman and Pyotr Aven, and is run by Simon Kukes, a Russian who for years worked in the U.S. as an executive at Amoco. In the late '90s, Kukes fought a pitched battle with BP over one of Sidanco's key assets, a highly productive oil field. BP accused TNK of bribing judges in order to rig a bankruptcy auction in which control of the field was given to TNK (TNK denied the allegations). Furious, BP Chairman Lord John Browne stormed out of Russia and didn't seem likely to return anytime soon. That he and TNK have kissed and made up, and done a deal, shows two things: one, that BP thinks Russia has changed, and two, that the Alpha Group is more than willing to entertain a similar deal for the whole of TNK--a point Kukes himself acknowledges.
All this is producing huge ripple effects throughout the Russian industry, and you couldn't miss them in late April in Moscow. Lukoil CEO Alekperov held an analysts' meeting on April 22 in which he announced a restructuring plan, one aim of which is to cut costs significantly (in part by shutting down thousands of high-cost, marginally productive wells) while increasing overall production. The government wants a hefty price for the 6% of Lukoil it's about to sell and has watched in dismay as Sibneft and Yukos shares have soared while Lukoil's have lagged. Alekperov got the message. In an interview with FORTUNE, his brainy right-hand man, Leonid Fedoun, said the words that are music to Khodorkovsky's ears: "We are going to try to do what Yukos has done."
The ripple effects extend well beyond Russia's borders. A productive and profitable Russian oil industry is good news for energy consumers everywhere and bad news for Saudi Arabia and the rest of OPEC. With its low costs and fat profit margins per barrel, Yukos is not, and won't be, interested in anything other than increasing production. The more Russian companies feel the same way, the better--and right now, alas, Lukoil's Fedoun believes Moscow is better served by "cooperating" with OPEC. The only thing keeping Russia from selling more oil overseas is infrastructure--pipelines and ports--but the industry and the government are slowly addressing those issues, too, as a newly built Baltic pipeline capable of transporting 240,000 barrels per day to the West shows.
The Saudis are watching all this warily. After Sept. 11, Riyadh desperately wants to shore up its justifiably tattered reputation in the U.S. It also wants to make sure it continues to supply the U.S. with about 15% of its oil imports, as it does now, and not see its share slowly ebb away as more Russian exports come onstream over the next few years. (Today Russia accounts for a minuscule 0.77% of U.S. oil imports.) One way to do both--as Saddam Hussein beseeches his Arab brethren to slash oil production as a way of punishing the U.S. for its support of Israel--is to pledge to increase production and keep oil markets stable. And so Riyadh, in late April, said it would do just that. The Saudis can still turn their spigot on and off to serve their foreign policy goals, something Putin cannot do.
But the Saudis live in a rough neighborhood, one that could get even rougher in the next year or so if Bush attempts to rid Iraq of Saddam. And it's hard to imagine that many Americans would be loath to wean themselves just a little bit off Saudi oil. In the bad old days, the phrase "The Russians are coming!," even if used mirthfully, reminded us who the enemy was. No more. Now the Russians are coming indeed. To which SUV owners and all other energy consumers around the world should say only one thing: Thank God.