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A victim to short-term ambitions

When Mikhail Khodorkovsky set out to turn Yukos into a western-style company, he was also adopting a strategy that provided him with the largest personal return in the shortest possible time.
/ Source: Financial Times

When the Russian oil tycoon Mikhail Khodorkovsky set out four years ago to turn Yukos into a western-style company, he was also adopting a strategy that provided him with the largest personal return in the shortest possible time.

Yukos’ aggressive approach to maximizing its oil output and minimizing its tax bill made it the darling of international investors and set it apart from its Russian rivals. Only Sibneft, with which it is merging, was more aggressive.

It was a management style that divided foreign as well as Russian oil specialists, irritated the federal finance ministry, and may have helped trigger the criminal charges of more than the $1 billion in fraud and tax evasion he now faces.

Since 1999, when oil prices began to rise sharply and Mr. Khodorkovsky had full control over Yukos and its subsidiaries, he began to hire expatriates to key positions. He also shifted from French advisers to Americans.

The philosophy of Bruce Misamore, the U.S. citizen he chose as chief financial officer, fitted perfectly with his philosophy. “My approach is to make cash quick and generate dividends to maximize return on investment ... maybe that’s heartless, but it’s at the center of what we do. Our job is to keep costs low.”

One aspect was to maximize oil output, drawing on other U.S. experts such as Joe Mach, senior vice-president for production. Crude oil output has risen by far more than its peers, from 890,000 barrels a day in 1999 to 1.4 million last year. It was achieved through acquisitions and investment focused on raising productivity at existing wells rather than new exploration at “greenfield” sites.

It allowed Yukos to take advantage of the sharp rise in oil prices. It lobbied hard to cut bottlenecks in exports against the state’s interests for cost-effective, privately managed pipeline projects, including one proposed to Murmansk in the northwest, and another from Angarsk in Siberia to China.

But its focus on rapid output rises raised concerns of short-termism elsewhere in the industry. “We are the only company that has invested in new production,” says Leonid Fedun, senior vice-president at Yukos’ rival Lukoil.

“All the other companies are using fields developed in the Soviet period and have not invested in expanding their reserve base which they will have to do in five to seven years.”

Paul Collison, an energy analyst at Brunswick UBS, says Yukos’ approach is to minimize the amount of new drilling and maximize the use of existing wells. “The company is driven by its financial performance.”

A second aspect of Yukos’ strategy has been tax minimization. The company paid $3.8 billion in taxes last year. But its corporate income tax rate was just under 20 percent, compared with a statutory rate in Russia of 24 percent.

One reason is the use of tax loopholes. Yukos actively used structures, called Zatos in Russian, or “onshore-offshore” regions, offering low or zero tax rates, including Mordovia, Udmurtia and the Evenk autonomous republic, where it had a political presence.

It created oil trading companies to buy oil from its production sites at low cost and then “sold” them on to the parent via a network of intermediaries. The profit was taxed at very low rates.

One specialist who has studied Yukos says the company has one of the most complex legal structures he has ever seen, with more than 600 subsidiaries. Some are in Zatos, others abroad, including Armenia. The 2002 accounts show deferred taxes of $962 million, suggesting as much as $5 billion in unremitted and untaxed assets may be held through foreign subsidiaries and affiliates.

Most loopholes will disappear from the start of next year, and others by 2006. But Yukos was also accused by officials of lobbying aggressively in the parliament to limit the effect of new taxes. It overturned ministry of finance proposals for a unified petroleum tax linked to the value of the oil each company exploited — which would have affected it disproportionately.

That, as much as Mr. Khodorkovsky’s other broader political ambitions, helped alienate the Russian authorities. He was the greatest beneficiary of the reforms at Yukos, with his wealth increasing to more than $8 billion, and his income from dividends alone since 2000 totaling $540 million.

Additional reporting by Arkady Ostrovksy