Streetwise Professor

May 6, 2012

A Fish Story That Should Remind Norway That It Needs Healthy Hostages

Filed under: Commodities,Economics,Energy,Politics,Regulation,Russia — The Professor @ 7:53 am

Very interesting of juxtaposition of stories involving Norway and Russia (h/t R).

Story one-Norway’s Statoil and Russia’s Rosneft agree to exploration joint ventures in the Russian Arctic:

Statoil (OSE:STL, NYSE:STO) and Rosneft today signed a cooperation agreement. The companies have agreed to jointly explore offshore frontier areas of Russia and Norway and to conduct joint technical studies on two onshore Russian assets.

The agreement also envisages Rosneft’s acquisition of participating interests in selected Statoil projects.

. . . .

Under the agreement, Statoil and Rosneft will set up joint ventures, with Statoil holding 33,33% in each. The partners will jointly explore the Perseevsky licence in in the Russian part of the Central Barents Sea and three licences – the Kashevarovsky, Lisyansky and Magadan-1 – north of Sakhalin island in the Sea of Okhotsk. The four offshore licences cover an area of more than 100,000 square kilometres, equalling approximately 200 blocks on the Norwegian continental shelf.

Are the Norwegians setting themselves up to be the next victims of expropriation? A couple of things to note.

First, this an exploration deal.  Although this involves irreversible investments, the real risk of expropriation spikes when production begins.  This is particularly true inasmuch as even if the exploration identifies commercially attractive opportunities.  Rosneft would be in no position to try to freeze out Statoil after it had paid to discover the prospects because the Russian company seriously lacks the expertise to develop these resources itself: this is why it is so assiduously pursuing agreements with all the major western majors.

Second, it appears that Statoil is following the hostage model pioneered by ExxonMobil:

The cooperation agreement also provides Rosneft with an opportunity to acquire interests in selected Statoil exploration licences and assets in the North Sea as well as in the Norwegian sector of the Barents Sea.

This article, and all the others I’ve tracked down about the deal, are maddeningly short of details on this crucial aspect of the transaction.  But it is evident that the deal is structured so that Rosneft has a valuable asset at risk if it (or the Russian government) tries its old tricks.

Note to reporters: please get a clue and get more detail on this aspect of the agreement.  This is the crucial term in the agreement.

The hostage mechanism is an oft-used way of enforcing good behavior in transactions involving long-lived investments in specific assets.  Williamson wrote about this mechanism in detail in The Economic Institutions of  Capitalism and elsewhere.

The devil is truly in the details, though.  XOM is apparently confident that it can provide incentives for good behavior from the Russians, and apparently Statoil has taken XOM’s confidence to heart.  But how it works in practice remains to be seen.  Don’t underestimate the ability of the Russians to behave opportunistically.

A particular risk is that the values of the investment opportunities in Russia and in Norway (or in the US Gulf, in the XOM deal) diverge.  Let’s say that the Russian resource turns out to be extremely valuable, but the Norwegian (or Gulf) resource comes a cropper.  Then the hostage has no value, and the risk of expropriation rises dramatically.

That risk seems to be particularly acute in this context, given the extreme uncertainty about the commercial value of the different projects.  Much information will be developed over time about the value of the various resources.  Moreover, technologies will change, affecting the commercial prospects of each.  There is an appreciable risk of a divergence in hostage values.  Given the asymmetric risk of opportunism, that divergence is particularly hazardous for Statoil and Exxon.

This probably explains why all of the deals involve bundles of several exploration prospects.  This diversification reduces the risk of the loss of hostage value.  Only if all of the Norwegian prospects turn out badly do the hostages die, leaving Rosneft free to screw the Norwegians out of any attractive opportunities in Russia.  Note in this regard that the Norwegian prospects are in two different regions-the North Sea and the Barents Sea.  This increases the diversification.

Clever.  I hope it works out for them.

Hey, Tim Newman-your insights would be greatly appreciated.

To emphasize why such measures are particularly important in dealing with Russia, consider the second story, about Russia banning Norwegian salmon imports:

Russia temporarily halted chilled salmon imports from 13 Norwegian firms, the animal and plant health watchdog in Moscow said.

The ban followed repeated instances of microbe pollution, a spokesman for the regulator said on Saturday.

Norway’s food Safety Authority said on April 30 it had received advance notice of the ban, which does not include frozen salmon, and was working with the firms to resolve the “very serious” issue.

Russia is Norway’s biggest salmon market.

Shares in fish and seafood products company Russian Sea . rose 7 percent in Moscow on Saturday.

. . . .

The global salmon market is experiencing a glut, and many firms are struggling to shift their stocks.

There are no “microbes” in salmon caught in Russian nets?  Sure there aren’t.

No.  The last two sentences tell the real story.  A supply glut is weighing on prices, hurting Russian fishers.  So the Russians gin up (or would that be vodka up?) the “health and safety” issue to justify an import ban.  Lo and behold, Russian fishing companies (or at least one, anyways, but there is no reason to believe it is exceptional) realize a windfall.

I’ve written in the past about how Russia routinely manipulates health and safety concerns as a protectionist instrument. (Search the site for “swine flu” and a couple of posts will come up.) (And yes, I recognize and condemn the fact that Russia is not the only sinner in this regard.  The US also engages in various forms of legerdemain to protect US firms.)  That this continues even as Russia joins the WTO indicates that it is still not too keen on rules and agreements that constrain its ability to take from foreigners to benefit domestic interests.

So, this fish story should focus Norwegian minds on the risks that they assume when trawling for other riches in cold waters.  Maybe the hostages will keep the Russians in line.  But the point is that you need hostages in dealing with them, for reputation and contracts alone aren’t enough.  You just need to hope that your hostages don’t die before you need them.

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6 Comments »

  1. Hey, Tim Newman-your insights would be greatly appreciated.

    Okay!

    I’ve lost count of the number of allegedly enormous, groundbreaking deals various foreign governments or companies have signed with the Russians. I recall a few years back Eni having signed some huge deal with Gazprom, and then there was Gazprom’s grand announcement that it would take over all the foreign operations in Nigeria, then there would be a trans-saharan pipeline, etc. What happened to all of that? Nothing. It’s all piss and wind. The only major Russian project that has got off the ground is Shtokman, and that is skidding along on one wing, scraping the runway as it lurches forward in undignified hops, landing gear still down and pilots desperately trying to regain control.

    Truth is, all of these paper agreements mean nothing without production. Even if the exploration phase goes well, and it probably will, there is the project development phase to get through – and it is there where the details really matter. Thus far, the Russians have proved incapable of working with foreign entities through a project development phase – Shtokman being the prime example. Sweeping changes are made to the concept design late in the development phase, rendering existing contracts void and work done thus far obselete. These decisions are made on a whim by senior Russians who haven’t the faintest idea what they’re doing, but want to be seen to be “in control” and in charge of pesky foreigners, like they were when the Cubans or Angolans visited in the days of the USSR.

    Production will only happen once the Russians change sufficiently to enable a project to get past development, engineering, and construction. And if they change to that extent, the problem you describe will probably go away.

    Comment by Tim Newman — May 6, 2012 @ 11:37 pm

  2. Thanks, Tim. That’s pretty much as I figured. Same take on the XOM deal?

    The ProfessorComment by The Professor — May 7, 2012 @ 8:19 am

  3. The potential risk for Statoil of being the minority partner in a joint venture in which it carries the main burden of responsibility for high-cost exploration in the Arctic, with challenging technological parameters and significant environmental risks.

    Statoil is committed to shooting seismic and drilling first exploration wells across the four licences included in the Rosneft deal, which also includes the Kashevarovsky, Lisyansky and Magadan-1 licences north of Sakhalin island in the Sea of Okhotsk.

    Independent analyst Hans Henrik Ramm told Norwegian business daily DN: “The framework conditions can be changed, as Russians have done previously.

    “It is also risky to be the smaller party in a co-operation with a large international company. Rosneft has the power, while Statoil must do the work. That in itself can be a source of conflict.”

    Comment by Anders — May 7, 2012 @ 10:23 am

  4. Same take on the XOM deal?

    Yup. Although the Russians would be monumentally stupid to try to strong-arm ExxonMobil, they have means of hitting back which other companies don’t. They managed to get several billion of Chavez’s monetary assets frozen for a year or so by having a canny knowledge of how courts work.

    Comment by Tim Newman — May 7, 2012 @ 11:35 pm

  5. Thanks again, Tim. Any thoughts about this article that argues XOM’s old “strongarm” ways aren’t effective any more?

    The ProfessorComment by The Professor — May 8, 2012 @ 6:15 am

  6. Hmmm. I expect there is some truth in it, i.e. that the softly-softly approach of Shell or the shady deals of Total may in some instances achieve better results than Exxon’s abruptness, but there’s no mistaking that Exxon outperforms the rest of us by a mile and a half on any measure. And this:

    In contrast, at the neighboring Sahkalin-2 field, project-leader Royal Dutch Shell Plc took a more flexible approach to the Kremlin’s demands and agreed to sell a majority stake in its project to Gazprom. Shell executives privately accepted that the company’s original contract had been too advantageous and now brag that they are making strong returns on their investment.

    is bollocks.

    Comment by Tim Newman — May 8, 2012 @ 9:18 am

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