Alexander Temerko in London -

Alexander Temerko, a former vice president of the oil company Yukos, now lives in London where he invests into energy

There is nothing like the threat of losing energy supplies to make Europe sit up and take notice of its neighbour. What is surprising is that the West seems rather shocked that the Kremlin would do this. It seems that in their rush to embrace Russian resources, Western political leaders have forgotten that they are dealing with a regime very different to their own.

The same note of caution applies to the Western business and investor community. In their enthusiasm for the Russian stock market, many Western investors also seem to have deluded themselves into believing that, with a few improvements in disclosure and the addition of some foreign managers and non-executive directors, the companies they are investing in will be just like any other.

They could not be more wrong. Russian capitalism is not just an imperfectly evolved version of contemporary capitalism practiced in the developed countries. Russia has evolved something new, a form of capitalism never seen before. The usual market disciplines simply do not apply.

The ultimate corporate authority

Unless you have your own private mole in government, you will never be able to predict your returns with any confidence. Because, directly or indirectly, the state is where ultimate corporate authority rests in Russia, and not solely in what it has chosen to classify as "strategic sectors."

In those sectors - hydrocarbons, aviation, autos, defense, etc. - the control is very visible, through share ownership.

Take Rosneft, the recently floated oil giant, as an example.

Attentive readers will recall that I was a strong critic of the Rosneft flotation. Many might even think that my warnings then were ill-founded, and that the IPO was a great success. Far from it.

In order to get the offering away, and to meet the pricing range set, Rosneft had the full support of the government to strong-arm BP and other strategic investors eager to operate in Russia into buying large blocks of shares. As a consequence, Rosneft has a free float - tradable shares not owned by insiders and direct investors - so thin that, were it a UK instead of Russian company, it would be in serious breach of UK trading rules.

In the UK, trading rules require a free float of at least 25%. Shockingly, Rosneft's free float is a fraction of 1%. How can this be? London's rules apply only to shares which can be traded in London. In Rosneft's case, and that of nearly all other London-listed Russian stocks, the shares traded outside Russia are in the form of Global Depository Receipts, which represent a small sub-set of total shares issued. The 25% rule is applied only against GDRs and, on that rather meaningless measure, Rosneft manages to pass the test.

As a consequence, Rosneft's share price is almost entirely insulated from international investor sentiment. The only shareholders who count are in Russia. And of those, the overwhelmingly dominant players are the state-controlled Russian banks, especially Vneshtorgbank (VTB) and Sberbank.

Daily trading in Rosneft shares in Russia and the UK averages just a few million US dollars. It is plain from the trading history that there is considerable deliberation behind this, with regular increases in buy transactions adjusting the company's share price upwards from time to time, regardless of external factors.

If you had $2m to play with, you could have a significant impact on Rosneft's market capitalization. And if you devoted just $5m to the task, you could - in theory - hold the massive company's destiny in your hands, artificially boosting the company's capitalization at will. But this, of course, would not be permitted. You would quickly find there are obstacles to your trades in Russia. Trading in any stock at this level in Russia requires permission from the Kremlin.

In short, the state, an "insider" to almost any major share transaction imaginable in Russia, can do virtually whatever it chooses to do with share prices.

Kremlin connections

A key player in this less-than-virtuous circle is VTB, the state-owned bank, which is the largest trader in Rosneft shares and is the company's largest single creditor and financial services provider. VTB has announced plans for a London listing.

Every year, VTB winds up with a significant loss on its business. And every year, the bank's owner - the Russian state - elects to raise VTB's chartered capital or issue additional shares, effectively writing off the losses at the expense of the Central Bank.

But the state's influence does not stop at state-owned and controlled companies. Surgutneftegaz and Severstal, both widely condemned by international analysts for opacity and poor governance standards, nonetheless perform remarkably well on the Russian stock market, largely because of close relationships in the Kremlin, relationships through which favours flow both ways.

And these relationships are regularly emphasized by Russian (state-controlled) TV channels and newspapers, reporting on the Russian president's frequent meetings with the CEOs of these companies and his approvals of their business plans.

Any major transaction requires political authorization to proceed. Witness for instance the recent merger announcement by RUSAL and Sual, the owners of which were careful to indicate they had sought approval for the deal at the highest levels in government. Similarly, before he began his ultimately unsuccessful move to merge steel giant Severstal with Arcelor, Alexei Mordashev secured state support first.

State involvement does not stop there. Indeed, corporate governance itself is directly supervised by the state, with all board and senior management appointments in companies with state participation requiring governmental vetting.

Rosneft's controversial IPO is a clear illustration of the fulfilment of state interests. It was designed to effectively re-nationalize the assets of Yukos and also to satisfy short-term borrowing needed to restore majority state ownership of Gazprom. Gazprom's deployment as an instrument of foreign policy - in Ukraine, Georgia, Belarus, Germany and elsewhere - is obvious.

Much overlooked by international investors are the smaller "tasks" - investments in ski and holiday resorts by state-controlled companies nudged by political whims, the financing of football and hockey clubs, and the acquisition of media assets for which the state seeks reliable ownership.

The aluminium company RUSAL's generous treatment by the state - on taxes, electricity tariffs and, occasionally, loans from Sberbank - is in effect guaranteed by its ownership and maintenance of another large but far less successful business, the auto manufacturer GAZ. GAZ is a major employer in Nizhny Novgorod. It takes little imagination to spot the "deal" there - you continue subsidizing thousands of jobs in Russia's third largest city and we'll protect your core business.

Major companies have become cash cows for political purposes. State ministers and leading bureaucrats are also the actual bosses or at least board members of the biggest companies under direct or indirect state control and are all paid supplementary stipends. Even the Nashi ("Ours") movement - the youth organization recently blamed for harassing the British ambassador in Moscow - is financed by what it has described as "patriotic Russian business". Translation: Companies reliant on the state for favorable treatment.

As an outsider - and, from the government's point of view, all investors are classed as outsiders - it is impossible to predict which state interest or whim might prevail at any given moment. Perhaps the asset you have bought into is one on which insiders are expecting their own capital gain. Or - perhaps not; perhaps they will wish to use it for some other purpose, one which will ultimately ruin your investment.

Such are the dilemmas thrown up by Russian investments.

And if the past is any guide to the future, investors cannot rely on the international bankers and securities analysts to apply much prudence to this sorry picture. The deal fees are just too attractive. The cancelled Uralkaly flotation of last autumn and the postponed IPO of pharmaceuticals company Pharmstandard highlight the problems, as have the worried reactions recently to Severstal's high offering price.

Uralkaly, the fertilizer company, acknowledged it had over-priced itself (or, rather, said the market had failed to value it appropriately). But how many flotations already completed were based on overvaluations? Recently, ratings agency Standard & Poor's issued a report on corporate transparency which indicates that Russian companies collectively have made little or no progress in the area of financial disclosure over the past year. Why? Because good governance and full disclosure do not translate into market capitalisation for Russian companies. Political relationships mean far more.

And behind all this - the self-dealing, the political games, the shuffling of shares and loans and funds among state entities - there lurk all sorts of fundamental business deficiencies. Did you know that in the fourth quarter of 2006, Russian oil industry growth came to a halt? Capital expenditures in the Russian oil industry are at a five-year low. First, the state takes everything above $27 per barrel to the treasury in the form of taxes. Secondly, the companies are investing money in purchasing other assets - which have been already explored and developed - instead of investing in developing existing oil and gas fields and in exploring and developing new ones. These short-sighted strategies demonstrate that a future decline in production is inevitable.

All this should be of grave concern to international investors. Having raised over $17bn this year - an amazing 50% more than was raised throughout the past five years - Russian companies coming to market in London should have been heralding bigger and better opportunities. Instead, they represent the Russian ruling elite's bet that "Russia Plc" can exploit capitalism for its own purposes.

Russia's unique market model continues to be of interest to two types of investor: Relatively small speculative investors prepared to absorb high political risks in exchange for high potential returns, and large strategic investors whose stakes can be guaranteed by state protection and promises of future preferential treatment.

For the rest - portfolio investors large and small, including institutional investors - Russia should be regarded as off limits.

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