2011 hasn't been a good year for BP. One year after Macondo, the ailing oil giant has failed to seal a signature deal with Rosneft that would have boosted its reserves and long term production outlook. It remains stuck with its TNK partners of old, unable to broker an amicable divorce in favour a more attractive (and better endowed) Russian bride.
To many, this will not come as a shock when we consider the whirlwind choreography of the proposed wedding: Two years ago Bob Dudley was chased out of Russia as chairman of TNK-BP because he entertained a similar deal with Gazprom; this January, he sat down with Eduard Khudainatov, the president of Rosneft, to sign the world's first ever equity alliance between a national and international oil company.
The oligarchs behind TNK-BP, never to be stilted lightly, not only stopped BP and Rosneft from walking down the aisle; they also forced Deputy PM Igor Sechin to backtrack. As the deadline for the share swap agreement has lapsed, BP's affair with Rosneft is hanging by the thinnest of vows.
Washington has reason to be smug about this of course. It didn't like the engagement in the first place. 'Bolshoi Petroleum' was the quip from the Hill still chaffing from BP's Macondo mishaps. No matter how impressive the rhetoric, the analysis was poor. The 'Bolshoi' label was certainly misleading. What Dudley proposed was 'Petroleum Business' through and through, a bellwether for a new generation of upstream M&As between supermajors (IOCs) and national oil companies (NOCs).
'Big oil' has learned 'big lessons' from the Gulf disaster: what were once deemed high risk ventures in hostile environments are fair game, while supposed 'safe bets' in friendly jurisdictions—such the Gulf of Mexico—are treated with trepidation.
This new appetite for unpalatable risks is not just a concession to the Kremlin's way of (un-)doing business, or an attempt to dodge corporate responsibility. It reflects the belated reckoning that oil is a political and intrinsically 'toxic' commodity and not for the squeamish.
It is also one of the few sensible bets for a company that does not believe in the demise of crude: irrespective of the Rosneft deal, BP—and its major league peers—will seek out similar deals with other NOCs both to bolster their balance sheets and to meet global demand. The party is still on.
Political risk and seismic trumps
BP's proposed $16bn deal with Rosneft was indeed 'seismic' in scope, but it was hardly surprising. BP knows better than most that Russia is no bed of roses, and as embarrassing as recent headlines may seem, the embattled giant would have been foolish to not to discount the political risk associated with a once-in-a-chairmanship chance to up the game and deal directly with the Kremlin, rather than keep walking the TNK-BP tightrope.
St. James's Square has long hinted that it considered Rosneft a better long-term foundation for its Russian operations than its erratic partnership with Alfa-Access-Renova (AAR), the Russian consortium behind TNK-BP. Call it a 'leveraged hedge' if you want, but the wager was straightforward: doing business in the US is not what it used to be, and business in Russia might change.
Indeed, the fundamentals suggest that Moscow needs a partner like BP at least as much as BP needs new oil fields to keep the energy market—and the IOC business model—afloat.
Russia accounts for roughly 13% of global oil production, but holds less than 6% of proved reserves. Recent depletion rates suggest that domestic producers will struggle to maintain output above 10mb/d in the coming years, let alone ramp it up beyond 11mb/d.
For a state that relies on oil and gas for two thirds of its exports, 20% of GDP, and over half of federal budget revenue, this should be a cause for concern were it not for the 100bn barrels of oil equivalent believed to sit under Russia's continental shelf.
The only hitch is that the NOCs that have been granted access to Russia's 'strategic' reserves lack the capital, the technology, the experience and the personal to bring them online. Offering BP a 33% stake in the estimated 12-15 billion barrels of recoverable crude locked in Rosneft's three South Kara Sea blocks would have been a cheap fix, as well as a smart investment, assuming the partnership would have taught the NOC a few new tricks.
Into the Russian maelstrom: Pricey but worth it
BP's political bet was only marginally bolder; the Kremlin's plan to match Rosneft with an IOC bride served not just for the incremental barrel or additional economic growth, but to demonstrate that it retained the power to structure the energy sector on its terms.
With the spectre of the Yukos breakup fading, Sechin, the man who shaped Russia's energy landscape, was itching to remind AAR that the Kremlin could still allocate the most fungible source of wealth and influence to those it deemed most suitable. Moscow had long hinted that BP could, and indeed should, be doing business outside the TNK-BP partnership. From BP's end, the prospect of a significant stake in Rosneft, and the Arctic shelf, made that offer simply irresistible.
Good plan, poor execution. AAR predictably refused to sell the 'Russian' half of TNK-BP on Moscow's terms, even though that meant standing directly in the line of Kremlin's line of fire. The fact that the Mikhail Fridman and German Khan had to turn to a London High Court to seek a first injunction against the deal indicates that AAR knew it was punching above its weight.
But it has proved to be a nimble boxer. For all the Deputy PM's bluster that he 'would take action on any party the delay of the implementation of a major project of its [Rosneft's] cooperation with BP', it was the oligarchs that dealt Sechin the knock-out blow.
In one of the most intriguing surprise twists in recent Russian politics, the government turned against Putin's point man. In late March, Medvedev ordered ministers to leave state enterprise boards, noting that 'state meddling' was holding back Russia's economy. The motives behind the move are hotly debated. But the fact that the Kremlin has been unable or unwilling to make AAR budge leaves BP with a problem, and a pretty big one at that.
There is no doubt that Rosneft's refusal to extend the 16 May dateline to conclude the $16bn deal is a major setback for BP. But as anyone used to M&A deals knows, deadlines come and deadlines go, giving the British company a small window of opportunity to act before Moscow starts looking for a new suitor.
If anything, the game has just got serious. Whether BP will continue to play depends on whether it thinks the brinkmanship is worth it, or whether it's time to cut losses. But if it gets back on the pitch, it must be ready to pay the price for playing fast and loose with AAR.
TNK-BP accounts for a fifth of BP's reserves and a quarter of its production. Since 2003, the company has pulled in earnings of $16bn from a $9bn investment. Depending on what criteria you use in terms of production, reserves, discounted cash flows and earnings, that equates to a price tag of anything between $32-68bn.
Including markups, this is well beyond BP's last offer of $32bn, and a serious chunk of change for any IOC, let alone one still facing undefined legal bills in the US. BP must decide whether the operational freedom in Russia offsets the constraints that would come with a cash infusion from Moscow, the City, or Middle Eastern and Asian investors. All pools of capital that BP could potentially tap.
Breaking BP's TNK shackles will be costly, but the political dynamics in motion still suggest that a premium might be worth paying. Rosneft has already hinted it would consider equity swaps beyond the initial 5%, and despite BP's recent commitment to focus on oil, Gazprom might jump in.
The prospect of pushing BP into a Russian bear hug should give even the most bellicose Congressional folk pause for thought, and might give it some much needed leeway to expand operations in the Gulf, as well as a buffer against advances from the likes of ExxonMobil. Unlike the oligarchs, IOCs have few reasons to worry about the Kremlin. If anything, BP might be in for considerable political gains should it reinvent its 'Anglo-Iranian' past and opt for a truly 'hybrid' NOC-IOC model.
Ambitious bellwether or reckless bet?
Should BP still take this arguably farfetched leap of faith, the usual caveats do of course apply, and then some. Even if a deal is struck, the political risk associated with doing business in Russia remain formidable.
The closer the Arctic fields come to production over the next decade, and the more Rosneft learns about cutting edge exploration and production, the more expendable BP will be. Past experience suggests that 'obsolescing bargains' have far from 'obsolesced' when it came to cutting IOCs out of the loop at the critical juncture when oil starts to flow and receipts come rolling in.
But here's the rub: the much bigger risk in play still is not entering the game at all. Having drifted downstream over the years and dabbled in renewables, big oil must get back to what it knows best: upstream oil.
IOCs too cautious to play will perish, and perish fast. If nothing else, Macondo has acted as a wakeup call. The frantic blanket ban on offshore drilling and the lumping of BP's exploration liabilities with its refinery operations told big oil all it needed to know: stop playing vertical integration in developed markets and get back out into harsh and hostile frontier environments.
BP has already dumped two of its four US refineries and the spotlight cast on its 100bn barrel 'onshore' Liberty development in the Beaufort Sea is a strong incentive to let things cool. Shell decided to stall Alaskan exploration pending regulatory clarifications, while Exxon Mobil and Conoco have both been knocking on numerous foreign upstream doors to get their fix of reserves.
They all know that they have to venture into NOC territory to get juicier finds, higher returns and political sway. NOC territory is also where political risk can be balanced between 'old' and 'new' production streams.
BP's biggest mistake was that it was too eager to dump its IOC past with TNK-BP in favour of an IOC-NOC future with Rosneft. That was always going to come with a major price tag once the Kremlin failed to make AAR yield.
No-one expected Sechin's fall, but Dudley of all people should have known that the people behind AAR were masters at their game. In the market for upstream mergers, those with tickets for the main loges can afford to wait for the encore. BP has been burnt, and burnt pretty badly.
But if BP holds its nerve and saves the deal, tactical mistakes will be exactly that. Strategic victories are what really matter in the long term. The City might still greet Dudley with a standing ovation, and politicians might admit that going 'Bolshoi' has considerable merit.
The 'Arab Spring' is a reminder that the wagers are getting higher and higher for upstream players. To keep the global markets afloat, the IOCs have to add capacity to meet rising demand and even out supply disruptions. OPEC's official '6'm b/d buffer simply won't do the trick if one more of the larger producers go offline.
In short, there has never been a better time to be upstream, but getting there, let alone staying there, is not for the fainthearted. BP has been strategically wise, but tactically stupid. It's not quite game over yet on Rosneft, but even if it is, expect BP - and others littering IOC ranks - to keep going upstream.
The one piece of the puzzle Asian energy majors have long understood is that going 'upstream' and going 'national' is the way of the future; on that note, China might well be the next bride willing to go down the Russian aisle. Who knows, PetroChina might even decide that BP would make for an attractive bridesmaid to take along as well."