ZAO KREMLIN: Russian shipping - homeward bound

By bne IntelliNews August 29, 2007

Graham Stack in Berlin -

This is the second in a series of pieces by bne that look into the development and structure of ZAO Kremlin, the Russian state conglomerate.

In the 1990s, as the Soviet economy sank with all hands, shipping was one of the few sectors to bob to the surface. Buoyed by international demand for its tonnage and operating under flags of convenience in the murky waters of offshore subsidiaries, Russian shippers were not Russian enough to get caught up in the maelstrom. Now, if the state gets its way, Russian shipping is homeward bound to become the transport arm of ZAO Kremlin.

The Soviet merchant fleet was built up in the 1970s to ship foreign grain back to Mother Russia. These days it is sailing in the other direction, carrying Russian oil and liquefied natural gas (LNG) to foreign markets. With the pipelines full to bursting, and offshore projects under development, the Kremlin - and many in the shipping sector - want to see Russian energy resources moved by Russian ships sailing under a Russian flag and built, if at all possible, by Russian shipyards.

"There's a patriotic element, a real desire to bring Russian ships back to Russia," says Tom Mundy of Renaissance Capital. "In the 1990s, less than 10% of Russian fleets' business was done in Russia. Now with increasing value being created here, there's the chance to bring it home."

The market has changed as well. A decade of international competition has forced Russian shipping companies to become sophisticated, although hardly transparent, entities.

Shipping has become another arm of ZAO Kremlin - the gargantuan financial-industrial-military company President Vladimir Putin has been building. As with most of ZAO Kremlin's divisions, the various assets are being collected together in a new national champion, which in this case is a holding company created by merging the state's 50.3% share in Novorossisk-based Novoship, the world's 20th largest carrier, into 100% state-owned Sovcomflot, the world's 16th largest. The result is the world's fifth largest shipping company.

The business of government

ZAO Kremlin is investing into virtually all sectors of the economy, though all these investments are united by links to either energy or Russia's military power. This year state-owned companies have secured control over the most significant offshore gas and oil reserves; namely the Stokmann field in the Barent's Sea and Sakhalin-2 in Russia's Far East. The idea is to now link these assets to other sectors in the domestic economy, something the multinationals working in Russia have been accused of neglecting. Shipping services were the obvious next step, closely followed by control over shipyards.

The Kremlin has studied Western economies closely and decided to go their own way, paraphrasing Milton Friedman's maxim: the business of government is business, not politics. In a typical example of this, the former minister of transport Sergei Frank - who used to run the Vladivostok shipping company FESCO - "left" the government in 2004 to become CEO of Sovcomflot and represent ZAO Kremlin in a hostile takeover of Russia's other major shipping company Novoship.

Novoship management had built up de facto ownership of Novoship by using subsidiaries to cross-own shares in the company - a standard dodge. They saw no reason why they should surrender control over the company's cash flows. Novoship was growing nicely and expanding its fleet at a rate of knots. But they had exposed the company to the volatile shipping spot market and were suspected of transferring assets offshore.

As in many other cases, the complex financial structures set up by insider management to control their companies ultimately proved to be their Achilles' heel: when company President Tagir Izmailov openly expressed opposition to the proposed merger, he found himself charged with abuse of position and money laundering, and fled to London. In December 2006, the ex-chairman of the subsidiary Novoship-Invest, holder of 6.5% of Novoship Invest, shot himself after being summoned for questioning. And days before the merger between Novoship and Sovkomflot was finalized this year, management tried to offload a 14.41% stake held by Novoship's Liberian-registered subsidiary to Gazprombank - to retain some independence from the new bosses - but the deal was blocked by the Kremlin at the very last minute.

In an eery repeat of recommendations during the 1990s when analysts were flogging the "olgiarch stocks" as index beaters, in Putin's Russia many have picked up the baton of ZAO Kremlin; analysts are generally mildly optimistic about the shipping merger:

"If it increases liquidity and creates economies of scale, it'll be a good thing," says Mundy. The merger should produce both synergies and diversification: Novoship is a classic tank oil carrier working the placid Black Sea routes, while Sovkomflot concentrates on the ice-bound Arctic and hi-tech transport of liquid natural gas.

Oleg Sudakov of Ak Bars Finance says, "the Kremlin believes that size matters when it comes to international competitivity. And to some extent they're right. The new company will obviously have considerably more pricing power."

One of the axioms of the state shipping doctrine has been to move away from the spot market and time charters - where everything is short term and subject to oil price fluctuations - towards establishing long-term contracts with direct customers, just as the Kremlin has done with the gas business.

The other axiom is for Russian ships to operate under the Russian flag - and here potentially the size and political backing of the merged company could help. You can't build a Great Russia if the companies that make it great are all registered in Cyprus.

"Shipping companies leverage their vessels to raise funds to buy new ones, and this is easier to to do with an international fleet," explains Mundy. But the giant company with its impeccable Kremlin contacts should experience no trouble in raising capital.

Ironically, for all the charges brought against former Novoship management, Sudakov sees Novoship as having been considerably more transparent than Sovkomflot. "Novoship is a public company and discloses its results on a quarterly basis. Sovkomflot discloses very little and has a strange freight pricing policy. It needs an independent audit and assessment."

Still, Sovkomflot management's desire to IPO next year could bring about change. "We have to wait for the united company's IPO," says Sudakov, adding that Sergei Frank, "likes the idea of bringing the company to the public market, and will lobby this idea."

Shipping energy

Sovcomflot and Novoship both stand to gain from Kremlin assertiveness in the energy sector. Sovcomflot's focus on offshore projects is looking good now that fellow champions Rosneft and Gazprom are dominant forces in Sakhalin and Shtokman. Arctic shipping is forecast to quadruple over the next 10 years, as development of the Shtokman field gets going.

"There is almost no shipping in this area at the moment, and so there will be no real competition," says Sudakov.

Sovcomflot is also looking to gain from Rosneft's and Gazprom's move into the Sakhalin projects. In 2003, it lost out on a $150m long-term contract for Exxon Mobil to the smaller, privately-owned and highly efficient Primorsk Shipping Company. State-owned national champions are, in contrast, likely to favour one another for political reasons, thus elbowing out private competitors.

Similar pickings loom for Novoship in connection with the planned Burgas-Alexandropolis oil pipeline, in which the Kremlin is involved. According to Renaissance Capital, the company is set to become a preferred partner for shipping Russian oil to the port of Burgas in Bulgaria. This alone would bring an increase in 35m tonnes, or 52%, on the amount shipped in 2006.

In return for these privileges, Sovcomflot-Novoship will be asked to start flagging in their fleets, and Sovcomflot to place orders with Russian shipyards for ice-class vessels, while Novoship, operating Aframax and Panamax tankers only realistically available from Korea or Japan, might focus on port infrastructure, which is suffering from, according to Mundy, "huge underinvestment."

Sovcomflot spokesman Nicholas Fairfax even envisages the merged company "effectively acting as a catalyst for the development of maritime clusters similar to the role played by Maersk in Denmark, NYK in Japan, Stena Bulk in Sweden or COSCO in China."

A third vector is international expansion. Sudak sees funds from next year's anticipated IPO going to buy a smaller foreign shipping company. Last year saw Sovcomflot and Novoship team up to acquire the Spanish chemicals carrier Marpetrol. Partly, such moves reflect the Kremlin's wish to see Russian companies swallow rather than be swallowed. Partly, they reflect a sector-specific advantage created by size - instead of ordering and waiting for new ships, it is more economical to simply buy entire existing companies.

Few analysts see Sovcomflot pursuing further domestic acquistions. Murmansk Shipping Company is financially moribund and owned by Lukoil, while Sergei Frank's old stamping ground, the Far East Shipping Company (FESCO), owned by former energy minister Sergei Generalov, is mostly involved in container shipping.

The one company that would be interesting is the Primorsk Shipping Company, which has already taken some biscuits from ZAO Krmelin's plate. It has already made a name for itself in the same niche Sovcomflot is looking to dominate - ice-class shipping for offshore oil and gas development.

But Primorsk, says Sudakov, is not for sale - it is fully private, and its owners are doubtless greatly enjoying its current profitability and golden prospects. "Unless, of course, the Kremlin asks them to sell," adds Sudakov thoughtfully.

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ZAO KREMLIN: Russian shipping - homeward bound

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