Chris Weafer of UralSib -

On Friday, the second of this year's Russia-EU summits will take place in Portugal. While few deals are expected, the tone of the meeting should be a lot better than that of the previous meeting held in Samara in May. In recent weeks there appears to have been significant movement towards compromise on both sides. The issues of greatest importance for the investment case in Russia are a new trade deal, investment access for Russian companies looking to expand in the EU, the "Gazprom clause" in the EU's energy plan, and Russia's stalled energy projects. The headline issues will still mainly be about energy, US missiles, disputes with Poland and Finland, and the question of Kosovo's future. The outcome of the election in Poland will, it is assumed, be helpful going forward, but it is too soon to assume any immediate improvement in relations with Moscow.

Improved relations would be positive for Russian equities

Investors will hope for less confrontation and more pragmatism this time, particularly given the recent softening of dialogue on Kosovo and energy cooperation. If so, more substantive progress on key trade and energy issues could be made before the end of Putin's presidency. Any evidence of improved relations would help allay investor worries about Russian economic and political risks. That would help asset valuations by easing the risk premium. Progress in cross-border investment issues and in the energy talks would directly benefit Gazprom and would improve the outlook for the country's largest enterprises harbouring ambitions to expand globally. The major deal to be signed on Friday will raise the 2007 quota for Russian steel imports to the EU by 28% to 2.7m tonnes - a net positive for Russian steel producers and yet another encouraging sign of greater pragmatism in the relationship.

Catching up with Portugal

It is appropriate that President Vladimir Putin's last Russia-EU summit should take place in Portugal. In a mission statement posted on the government's internet site on December 29, 1999, then-prime minister Putin talked of the need to make great efforts to expand and diversify the economy. He noted that even if growth could be sustained at 8% per year, Russia would only catch up with the EU's poorest country in terms of GDP per capita by 2015 at the earliest. At that time Portugal was the EU's poorest country, with a GDP per capita of $10,901 versus Russia's $1,343. Since then, Portugal's GDP has doubled from $109bn to $212bn and Russia's economy has expanded six-fold (from $196bn to an estimated $1.2 trillion). In terms of GDP per capita, Portugal is today at $19,900 while Russia is at $8,300. Using average GDP growth, and assuming some success in reaching targeted CPI, and taking the rate of population change into account, then Russia should reach Portugal's 1999 GDP per capita in 2009 and catch up with Portugal's prevailing GDP per capita in 2019.

Russia-EU relations have been very strained

There is clearly no warm relationship between Moscow and the EU as a single entity. Within the EU there are varying degrees of friendliness, with some countries falling into a more pragmatic camp and others in the "when hell freezes over" camp, and the rest occupying a sort of neutral space. During the Samara summit it was difficult to place any of the larger European countries into the pragmatic category, other than perhaps Italy. The UK was in the midst of political change and then- PM Tony Blair was openly anti-Russian. France was also in the process of changing leaders, while German Chancellor Angela Merkel and Putin had a major row in late 2006 over investment access. That period marked a low in relations between the EU and Moscow and represented a major turnaround from only 12 months earlier, when Putin had enjoyed a good personal relationship with the leaders of Germany, France and Italy. In the strongly anti- Russian camp were countries such as Poland, Estonia and Finland.

Against that backdrop, it was no surprise that the May summit in Samara was perceived as difficult and made little obvious progress. However, evidence of improved relations has appeared over the past few weeks. UK Prime Minister Gordon Brown has toned down the aggressive rhetoric of his predecessor and at a recent Russia-UK investment forum, major British companies openly talked of their wish to invest more heavily in Russia, albeit on acceptable terms. The recent visit of French President Nicolas Sarkozy to Moscow, while not producing anything specific in terms of deals, did at least convey the message that there is an open dialogue between the two governments under which business can be done. That was probably the main objective in any event. Finally, the recent meeting between Putin and Merkel at a summit between both countries in Germany was also viewed as less emotional and more businesslike.

Major EU energy companies are now heavily engaged in Russia

The backdrop to these improved relations is that Russia has included some of the EU's major energy companies in a strategic partnership role in several major energy projects or has allowed EU companies to buy strategic stakes in Russian companies. Total, France's biggest oil company, is Gazprom's strategic partner on the Shtokman gas deposit, while BP has an option to acquire a similar role in the Kovykta gas deposit, Shell has such a role in Sakhalin-2 and BASF is operating a joint venture with Gazprom on the Nord Stream pipeline. ENI is close to extending its relationship with Gazprom, while ENEL paid $1.5bn for a 25% stake in OGK-5 in June. E.On is a shareholder in Gazprom and is also active in the electricity privatization process. The upshot is that Europe's major energy companies are already well represented in major Russian energy projects. But many of those projects, such as Shtokman and Kovykta, have yet to be given the go-ahead for development from the Kremlin and that next phase is likely dependent on progress in securing a new trade and investment deal with the EU. Effectively, the Kremlin now has several major companies in each of the major EU capital cities that have access to their respective governments and in whose interest it is now to lobby on behalf of the Kremlin. Otherwise those potentially lucrative energy deals might just stay on the drawing board.

Recent compromises

In the lead-up to this summit, various Russian officials have indicated a softening of the Kremlin's position on a number of issues considered to be major obstacles to improving trade relations between the two sides. Moscow is keen to resolve the trade issue and establish new parameters for international expansion by Gazprom and Russia's other major companies before the end of Putin's presidency so as to avoid dragging out any legacy issues into the next presidential term.

--Moscow has proposed a sort of early warning system to alert its European customers of any impending problems with gas flows. Last year, the problem concerning Russia's dispute with Belarus was less to do with the threat of a gas shortage and more because no advance warning was given.

--Russia's ambassador to the EU, Vladimir Chizhov, has indicated that Moscow may be softening its stance on Kosovo, and that Russia might be able to back the idea of an independent Kosovo if it were part of a negotiated settlement agreed to by Serbia and ethnic Albanians. He said "we would not like it, but we would not oppose it."

--Following a special meeting on energy cooperation in mid- October, EU Energy Commissioner Andris Piebalgs said the European Commission was studying proposals made by Moscow and was committed to reaching a solution. There is a sense that some of the original proposals in the EU's new energy charter, such as the Gazprom clause, were pushed by certain member countries while the Commission itself is more interested in a compromise.

--After the recent meeting between Putin and Merkel in Germany, the German chancellor was quoted as saying that "Russian investment is always welcome." This marked a major improvement from the tough stance that Germany adopted after VTB acquired a stake in EADS in 2006.

--Russia and France have started cooperating on space launches (eg. Russia will supply a rocket to launch a French satellite from French Kourou early next year).

--The EU raised the import quota for Russian steel for 2007.

--There were statements about hopes for a better relationship with Poland after last weekend's election.

Key agenda items

There are some very contentious issues to resolve. The main issue for Russia is to try and seal a new partnership and cooperation agreement (PCA). The existing 10-year deal expires in December. The main issue for the EU is energy security. We are unlikely to see any substantive progress on either of these issues at this meeting and probably not until other items on the agenda are either resolved or displaced in importance. These issues include:

--Access for Polish meat to the Russian market

--Moscow's proposal to substantially hike export tariffs for timber

--Russia's WTO entry negotiations

--US missiles in the EU

--Iran

--Kosovo

--Human rights and democracy in Russia.

Relations with Poland

Poland has been a major source of problems since Russia banned the import of meat from Poland in November 2005. Since then, Warsaw has used its veto to block progress in talks over a new PCA. Moscow made a concession in allowing some meat imports to resume from next month albeit under strict terms (the meat must come from processing facilities inspected and approved by Russian inspectors). This of course has not satisfied Poland, and the threat of a veto remains. Political change offers better hope. October's election in Poland saw the outing of the incumbent government and its probable replacement with the Civic Platform party led by Donald Tusk. It is too early to say whether this change will prove to be a catalyst for improved relations between the countries, but statements from both sides in recent days show a willingness towards compromise, in our view. How far that goes will only be evident in the coming weeks and months, but for now it can be considered a positive event in terms of breaking the deadlock between Moscow and Warsaw. On October 24, the president's advisor on EU relations, Sergei Yastrzhembsky, said he expected relations with Poland to become more "pragmatic" and gradual normalize.

Timber export tariffs

Russia wants to slow timber exports. Finland has objected to Russia's plan to raise the export tariff on unprocessed timber by 80% over the next four years. The government in Helsinki has threatened to veto Russia's entry into the WTO in retaliation. Finland imports a substantial amount of timber from Russia to feed its processing industry and to extend the life of its softwood forests. Russia has identified the timber industry as one that should seek to better balance the export of cheap raw material (logs) with a greater content of products made from the timber, ie. to move up the value chain. This is an important aspect of the Kremlin's plan to diversify the economy and reduce exposure to the volatile commodity price cycle. Plans to process more into products. The Russia Timber Group, a UK-based company with operations in Russia, recently announced plans to list its shares on London's AIM to raise around $200m. The company said the bulk of the money would be used to finance the construction of processing facilities and other infrastructure with a view to exporting wood panels to be used in flat pack furniture. This, of course, is an industry in which Finland is currently very big. Russia Timber Group noted that Russia has about 50% of the world's soft wood timber but only processes about 3% of the world's total.

Partnership & Cooperation Agreement

The existing 10-year PCA deal expires in December and Moscow is looking to negotiate a new deal with improved trade terms, ie. fewer restrictions on manufactured goods, and also greater investment access for Russian companies looking to expand abroad. As part of the next phase of its plan to develop the economy and industrial base, the government wants to process more goods from the country's raw materials and export these to the EU and elsewhere. The country's major trading partners are in Europe and that is unlikely to change, hence the need to smooth out the trade relationship going forward.

An equally important priority is to agree cross-border investment access. It is well known that Gazprom would like to establish a greater presence in downstream gas distribution in the EU's major countries, but has regularly run into criticism. The proposed new energy access legislation being considered by the EU is clearly designed to curtail the involvement of state-controlled companies such as Gazprom. Hence it is referred to as the Gazprom clause (see below). But apart from Gazprom's ambitions, the government also wants to see a greater internationalization of the country's major industries and enterprises. Therefore, the Kremlin wants investment access cleared not just for the gas sector but also for other major industries. That was made clear late last year when VTB acquired a 5% stake in EADS and provoked a flurry of criticism. As a reaction to that criticism, the Kremlin cancelled the Shtokman deal as it then was and Putin held a reportedly tough meeting with Merkel in Berlin. It was after that meeting that Putin was quoted as saying, "European [regulators] will have to accept that it is not the Red Army coming, but Russian businessmen with money to invest."

The issue of further energy cooperation is directly inked to progress in trade, particularly progress in establishing ground rules for cross-border investment. The reactivation of the Shtokman project and the inclusion of Total as a strategic partner for Gazprom (ie. with a 25%+1 stake) is a major carrot dangling in front of the EU, but it is unlikely to progress further until there is reciprocation in other areas.

In this regard the recently agreed higher quota of Russian steel exports to the EU is very encouraging, albeit the EU badly needs the product and some categories remain restricted to protect EU producers. But nevertheless the quota for 2007 has been raised to 2.9m tonnes from 2.27m in 2006. That is an increase of 28%, and the agreement is expected to be signed at the summit on Friday.

Energy security

The EU would like to reduce energy dependency on Russia. A new energy relationship and a new trade/investment deal will also be near the top of the summit agenda. Europe currently gets about 25% of its gas requirements from Russia. Europe's appetite for gas is growing and will grow substantially over the next five to 10 years even if alternative energy sources are agreed upon and funded (unlikely given the environmental issues surrounding nuclear and coal powered plants). The EU has pushed a plan to secure energy from Caspian countries that will not provide any significant new source of gas, ie. even if the pipeline routes can be agreed. And that is a long way from being resolved also.

The reality is that because the status of the Caspian remains unresolved (ie. is it a sea or an inland lake?), it will be impossible to build a pipeline across it from either Turkmenistan or Kazakhstan. In any event both of those countries have committed future gas supplies to either Russia-bound pipelines or, possibly, to China. There is none spare to fill a Western pipeline. Iran has sufficient gas export potential to fill the EU's incremental demands, but so long as that country remains internationally isolated, that is not an option. Neither is using Iranian territory to build new Central Asian gas pipes to the EU (even if gas was available). Azerbaijan does not have enough gas, nor is it likely to have, to fill any major new Western pipeline (eg. Nabucco), and its existing production is already committed, for example to Turkey. Therefore, no matter how you cut it, rising EU demand for energy will have to be satisfied for most of the next decade, and imported gas - from Russia - is the only realistic option. The question of energy security therefore boils down to getting Russia to commit to a programme of more rapid development of its known resources, such as Shtokman, and the inclusion of EU companies as part of the JVs. The latter part is mainly in place with Total, ENI and BASF/E.ON, but the go-ahead for development is still a political decision dependant on progress at summits such as this week's.

Kosovo

This is a highly dangerous situation. The so-called troika (Russia, EU and the US) nominated by the UN to review the options for Kosovo's future status has to report to the Security Council by December 10. The government in Pristina has said it will declare unilateral independence after the deadline if the UN does not endorse a plan for EU-supervised autonomy that the UN-appointed inspector has proposed. Serbia has said it will oppose that, and Russia may have to side with it just as the EU would have to side with Kosovo. That is the worst-case scenario and would likely cause a serious rift between Moscow and both the EU and the US. That would delay any deal on trade, WTO entry and a new energy deal with the EU. It would be damaging for the investment case for Russian equities and provoke a response similar to that seen in April-May when a worsening of international relations caused the RTS to drop sharply against other emerging markets. But a major row over Kosovo would be just as unwelcome in Brussels as in Moscow, so we expect governments in the major EU countries to work with the Kremlin to ensure the issue stays on hold until (hopefully) both Serbia and Kosovo can work out a mutually acceptable deal (under pressure from both Russia and the EU). This is the line recently adopted by Russia's ambassador to the EU and by various EU officials.

Chris Weafter is analyst for strategy & politics at UralSib Financial Corporation in Moscow

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