Crouching bear, leaping dragon

By bne IntelliNews October 30, 2009

Ben Aris in Moscow -

Six years ago in October, Russia's security services crept up quietly to a private jet parked on the tarmac of Novosibirsk's airport where it had stopped to refuel. The militia climbed the ladder and burst into the plane brandishing Kalashnikovs to arrested Russia's richest man, Mikhail Khodorkovsky, the majority shareholder of oil major Yukos.

He was hauled back to Moscow and locked in the overcrowded Matrosskaya Tishina prison, where he was charged with seven counts of fraud and tax evasion before eventually being sentenced to eight years in jail.

Khodorkovsky's arrest on October 25, 2003 set off a firestorm of international criticism that hasn't really abated since. A cause celebre, he is held up any time anyone feels like putting the boot into Russia's democratic credentials - and with some justification.

But while Khodokovsky was nominally imprisoned for cheating the state out of tax revenue, the real issue that got him into such trouble was trying to hijack Russia's foreign policy by pushing for the construction of an oil pipeline from Yukos oilfields in Angarsk in Western Siberia to Daqing in Northwest China.

The pipeline makes perfect economic sense: it is short and the Chinese have an insatiable appetite for Russian oil. Trouble is, building a pipeline from the middle of nowhere to the middle of nowhere commits Russia's Siberian oil exports to just one customer. Pipelines are intensely political beasts before they are built, but once built they are the geo-political equivalent of a marriage. The Kremlin wasn't ready to settle down and preferred a much longer pipeline that ends on Russia's Pacific coast at Primorsk, which makes less economic sense but has the advantage that cutting off shirty customers is as easy as saying "hard to starboard."

Now fast forward six years to this October. Prime Minister Vladimir Putin has just returned from a trip to China where he signed off on a landmark deal to build the Altai natural gas pipeline from - you guessed it - Western Siberia to northwest China, committing a substantial proportion of Russian gas to the Chinese market. Gazprom will increase exports of gas from Russia from the current nothing to 70bn cubic meters a year (cm/y) between now and 2014-2015, and inexorably tie the economies of the two emergent powers together in the process.

So what has changed? China and Russia have been on poor terms since Sino-Soviet relations floundered in the 1950s after the death of Chairman Mao and the subsequent ideological split over just what "socialism" means. But Khodorkovsky must have been choking on his brown bread and black tea as early as 2004 when the Kremlin did an abrupt volte-face and began to send all the oil it could in trains (that used to belong to Yukos) to its southern neighbour.

West put on notice

"For decades Russia has had rocky relations with its powerful eastern neighbour, but now Russian strongman Putin has decided to set these aside and embrace closer economic co-operation," says Lilit Gevorgyan, a China-analyst with IHS Global Insight. "It is a pragmatic partnership that comes out of necessity. Russia had long-term plans to develop and invest up to a trillion dollars into places like Siberia, but the crisis has destroyed its resources. The Russians can offer the Chinese what they want (resources) and the Chinese can offer the Russians what they need (investment)."

Improving relations with China is also politically expedient, but the stakes rose when Putin put the West on notice with an aggressive speech in Munich 2007, warning that Russia was losing its patience with the lack of western cooperation. Russian President Dmitry Medvedev followed up with a similar message during his first foreign trip to Berlin in 2008, arguing that Russia and Western Europe "should" be natural partners, but calling on Brussels to step to the mark with some friendly action. If anything, the hysterical Russian coverage has only got worse since then.

Former German Chancellor and now a Gazprom employee Gerhard Schroeder added that same summer that Europe should embrace Russia now as, "there is a window of opportunity to partner with Russia, but that window will close and another power is waiting in the wings to take up the role of strategic partner - namely China." That window has now closed.

"Russia has been promoted to strategic partner and the two countries are united in that they want to build a post-Cold War multiple polar world to break the US hegemony over political power," says Professor Noesselt, a China expert at the University of Goettingen in Germany.

Gas for cash

Russia's best salesman arrived in Beijing on October 14 in what was his most successful trip yet. Putin is a man of commerce who routinely closes billion-dollar-plus arms deals on the sidelines of state visits, but he surpassed himself this time.

The Sino-Russian gas deal was the headline grabber, but Russia's prime minister closed about 40 deals in all worth an estimated $3.5bn - and these are only the ones that have been reported. Following one of Putin's recces abroad, news of deals typically dribbles out for another six months after he has left. This trip brings to conclusion many deals that were set in motion during Putin's last trip in March 2006 when the then president flew a convoy of 25 planes carrying 800 Russian businessmen to Beijing to do deals with Chinese President Hu Jintao, which is when talk of the gas deal first surfaced.

Rising Russian oil exports to China already accounted for a big chunk of the $29bn trade turnover between the two countries in 2005, which grew to some $50bn by the end of 2008 and is supposed to reach $80bn by 2010, say experts. A new phase in this Moscow-Beijing partnership will be the planned 2,000-kilometre 30bn cm/y Altai pipeline, which will carry Russian gas from the West Siberian fields to China and will cost $13bn to build. There are also plans to sell Russian gas to China from Sakhalin, Yakutia and Irkutsk via the Russian Far East corridor, but these pipelines will be even more costly to build.

The deal has already made Europeans nervous (see related piece) and many European companies have already extended their long-term purchase contracts for 25-30 years to lock in Russian supplies before China starts eating into Russia's limited supply capacity. Analysts say the chances of any more long-term contracts in Europe are now low, so in this sense Europe's recent attempts to warm relations with its prickly cousin to the east seem too little, too late. Russia's deputy prime minister responsible for the fuel and energy sector, and the Russian government's chief negotiator with China, Igor Sechin, said during the Beijing trip: "We have the gas and we'll give China as much as it needs."

Natural partners

And the energy ties are just the beginning. Of all the countries that China does business with, Russia is in a uniquely strong position; China sees the industrialised countries as markets for its cut-price goods and has already become "the factory for the world," says Professor Noesselt.

Multinational companies have rushed to set up shop in China to tap its billion-strong market as well as take advantage of low labour costs, but with Russia the investment is increasingly flowing the other way - from China into Russia, as unlike the developed world, Russia has all the inputs China needs to capitalise on its competitive advantages.

At the same time, Russia's physical proximity to China means Russian companies are in a better position than anyone to re-orientate their production away from the west and toward the east. The upshot is that the Russian economy is perfectly placed to ride on China's GDP growth coat tails. "The Sino-Russia team has the best synergy on the planet. China needs Russia's resources and Russia needs China's capital. China provides a growing market, financial resources and macroeconomic stability. Russia can provide oil, gas and coal that are needed for the next stage of Chinese industrialization," Kingsmill Bond, head of strategy at Troika Dialog, said in a recent note.

Troika, therefore, recommends buying companies with hard assets near to China. Rosneft is an obvious China play, as it owns oilfields - some of them formerly of Yukos - in Eastern Siberia and Sakhalin, which are both close and eventually will supply a third of Chinese demand for oil and gas. The tax breaks and short delivery route mean the company should earn three times more profit for a barrel sold to China than it would from shipping Siberian oil to the West.

Potash producer Uralkali is another winner, as it is already the largest supplier of fertilisers to China, which the agrarian economy is heavily dependant on. Peter Hambro's iron ore company Aricom is perfectly placed to serve China, as it is exploiting untouched ore fields just over the border in Russia's Far East. Moreover, there is already a big steel mill complex on the Chinese side of the border that has used up all the ore in the Chinese part of the same fields and so is a captive customer. Exceptionally low transport costs only sweeten the deal. Raspadskaya Coal should be able to establish itself as a major coal exporter to China. The company already has the lowest production costs in the sector and is keen to diversify from its traditional markets by looking for new customers in Russia's Far East and Asia. And cargo company Globaltrans is very well positioned to benefit from growing traffic flows between China and Russia - the company is focused on exporting bulk commodities to China and thus would largely benefit from rising demand as the Chinese economy improves, says Troika.

So should the West be scared of a Sino-Russian alliance? Sorta - but there is not a lot the rest of the world can do even if it is.

China hasn't replaced the US as an engine of global growth, but the crisis has clearly shown it can, and probably will pretty soon. However, despite the harsh rhetoric, Russia remains open to western investment and the EU remains Russia's most important trading partner. Both countries want to trade with everyone and while both want the respect they believe is due to them, trade also demands they maintain civil relations with everyone. "The improved relations with China is not about Russia switching sides, but building a more balanced relation with the rest of the world," argues Gevorgyan. "Will they succeed in becoming world powers? It is not an easy question, as both countries do not have a stable government and they are still dealing with regional protests, and they need to solve these problems first."

Putin's Chinese takeaways

Prime Minister Vladimir Putin remains Russia's best salesman. He regularly concludes arms deals during his foreign trips or actively pushes telecommunication deals on behalf of Russian oligarchs. However, he outdid himself during his week in Beijing in October, overseeing a total of $3.5bn of deals. Amongst the most important were:

• Gas is by no means the only Russian energy export to China. The Kremlin agreed to a 20-year oil supply deal for China in return for $25bn in credit for state oil company Rosneft and state oil pipeline monopoly Transneft;

• China Development Bank extended a $500m credit line to Russia's Vnesheconom Bank (VEB), while the Agricultural Bank of China will refinance the Russian state-controlled VTB Bank with another $500m. Securing the credit line is important for cash-strapped Russian banks severely hit by the global economic crisis.

• A joint Russian-Chinese venture for production of high-speed train locomotives that will eventually boost the construction of railroads across vast swathes of China and Siberia. The details of this deal have yet to be clarified;

• Chinese construction company Gu & Lun together with Russian Central Trade Company will invest $630m in building a Trade and Exhibition centre in Yekaterinburg, Russia;

• A VEB-Chinese Export-Import Bank deal to invest $52.34m in developing a cement plan in the central Russian region of Penza;

• The United Ship-Building Corporation (OSK) and Yantai (China-Singapore) intend to build a mega-shipyard in the Russian Far East to produce oil and gas rigs. The project is estimated to cost a total of $1bn, with VneshEkonomBank (VEB) acting as the chief investor. There are no shipyards of this kind in Russia at present; several such projects have been announced, but none have secured state financing so far;

• China Investment Corporation, a $200bn sovereign investment fund, made its first investment in Russia during Putin's visit, investing a total of $300m for a 45% stake in junior Russian oil company Nobel Oil Group, plus debt extended to the company. Simultaneously, Hong Kong-based Oriental Patron acquired a 5% equity stake of Nobel Oil, with the 50% remaining under the control of the original Russian shareholders.

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Crouching bear, leaping dragon

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