a promising and exciting business environment by open1tup


a promising and exciting
business environment

ABN AMRO Group Public Affairs:
Economics Department:    Marijke Zewuster, marijke.zewuster@nl.abnamro.com
Sector Research:         Jan van den Berg, jan.van.den.berg@nl.abnamro.com
                         Thijs Pons, thijs.pons@nl.abnamro.com

Commissioned by:
Sector Advisory NL: Willem Rol
Commercial Client Segment / IDCC: Nico Overwijn

Finalised: September 2007


         When evaluating Russia, from whatever perspective, there are usually two
         extremes: from very sceptical or even unfavourable to nearly euphoric. From the
         perspective of a foreigner who has spent some three and a half very bright and
         intense years in the country, I can confirm the saying by the Russian poet Tutchev
         that there is no intellectual understanding of Russia, nor can it be measured with a
         standard arshin (old Russian measure that equals 0.711 metre). It can indeed be
         anything, but never dull. Russia is unique, diverse, challenging, exciting and
         promising. I could extend this list of epithets further, but the incontestable facts
         about Russia’s current economic situation and its potential, analysed in detail in
         this report, speak for themselves.

         The fundamentals are very strong. Russia’s GDP growth rate for the last five years
         has substantially exceeded that of most industrially developed countries. Growth is
         driven by high commodity prices and booming domestic consumer demand.
         Favourable prices for commodities, such as oil, gas, gold, nickel and many others
         that Russia has in abundance, have created excess cash in both the public and
         private sectors and a positive current account balance. Russian currency and gold
         reserves – the world’s third-largest – reached historical highs of over USD 420 bn
         in mid-September 2007. Inflation is coming down, the rouble is quickly becoming a
         currency to be reckoned with and the sovereign rating has increased to well
         beyond investment grade level. In summary, the Russian economy has
         transformed to become one of the largest (ranking ninth) and most important
         economies in the world. And I am convinced that this is only the beginning, given
         all the potential (size of the market, availability of high-quality labour, growth
         potential, etc.) that is yet to be tapped.

         The Russian Government is putting a lot of effort into attracting more investment
         into the country and improving the investment climate in general. It has created
         investment institutions such as the Investment Fund and the Development Bank to
         ensure investments in all sectors of the economy as well as infrastructure projects.
         “I want to note that 300 billion rubles [currently about USD12 bn] have been
         allocated to these institutions this year alone. Moreover, we have put in place a
         mechanism that ensures that these funds will increase each year, but only so long
         as they are used effectively”, - stated President Putin during his opening remarks
         at the International Investment Forum in Sochi (September 24, 2007). There is a
         clear willingness on the part of the government and the business community to
         develop a relationship, as long as it is based on mutual interests and benefits.
         International business and foreign investors are striving to increase their market
         share, strengthen their financial position, broaden their product range, ensure
         stability and find the best talent. Russia provides a solid basis for this. It may not
         happen overnight, but surely in the somewhat longer term.

         The coming year will be an exciting one for the country in general and the
         business community in particular, with parliamentary elections scheduled in
         December 2007 and presidential elections in early 2008. However, we all
         witnessed the local market’s rather limited reaction to the recent and sudden
         changes in the Russian Government. The market overall is very focused on

         2                           Economics Department/Sector Research, September 2007

         business and trusts that the new government will continue the on-going projects,
         policies and reforms.

         The liquidity crisis in the international financial markets is having a much greater
         impact on the Russian business environment. Until now the country has been
         enjoying a boom in the capital markets across all sectors, with one of the fastest
         growing equity markets in the world (up over 1000% during the “Putin era”), and
         stable growth in the fixed income market. Further developments in that area will
         greatly depend on overall international market conditions. But of course this by no
         means stops many foreign companies from coming to Russia as they see much
         greater opportunities here than elsewhere in the world. And bear in mind that of all
         the BRIC countries, Russia enjoys the highest percentage of satisfied foreign
         investors. Over 80% of foreign businesses indicate that they are generating very
         attractive returns on their investments in Russia, a statistic that cannot be matched
         by other countries.

         Russia should be more and better promoted. I trust this report will give you
         valuable insight into the country from which it is sometimes argued that doing
         business is, despite its challenges, the best kept secret in the world.

         Henk Paardekooper, Country Executive Russia

         3                          Economics Department/Sector Research, September 2007



         Chapter 1: Economic Overview .......................................................6
                Economic structure and trade....................................................................................... 6
                Economic developments .............................................................................................. 9
                SWOT analysis ........................................................................................................... 13

         Chapter 2: Russia’s Minerals & Mining Industry............................18
                The importance of the sector to the Russian economy .............................................. 18
                Exploration spending in the global mining sector ....................................................... 19
                Growing demand for mining equipment...................................................................... 20
                Medium-term outlook.................................................................................................. 20
                Opportunities in mining equipment, services and systems......................................... 21

         Chapter 3: The Russian Oil Industry .............................................22
                Oil reserves ................................................................................................................ 22
                Oil production ............................................................................................................. 22
                Oil exports .................................................................................................................. 22
                Oil production and export outlook ............................................................................... 23

         Chapter 4: The Russian Natural Gas Sector .................................25
                Natural gas reserves .................................................................................................. 25
                Natural gas production ............................................................................................... 25
                Natural gas exports .................................................................................................... 26
                Natural gas production and export outlook................................................................. 27
                The China option ........................................................................................................ 29

         Chapter 5: Opportunities in Russian Oil and Gas..........................31
                Investment climate...................................................................................................... 31
                Resource nationalism increasing................................................................................ 31
                High investments needed ........................................................................................... 32
                The E&P momentum .................................................................................................. 33

         Chapter 6: Agrifood .......................................................................35
                Exports from the Netherlands to Russia..................................................................... 35
                Dutch companies are investing in Russia................................................................... 37

         Chapter 7: “Doing Business is People’s Business” .......................39
                1. Campina in Russia: ‘Ask for support from the local authorities’ ‘Establish a good
                relationship with the local authorities’ ......................................................................... 39
                2. Jørgen de Ree, Managing Director of De Ree Holland BV ‘The Russians are loyal,
                reliable customers’...................................................................................................... 41
                3. Mammoet in Russia A good business contact is based on friendship................... 43
                4. Ottevanger Milling Engineers is successful on the Russian market ....................... 45
                5. Gebroeders Van den Berk B.V. ‘With patience and respect, you can do good
                business in Russia’..................................................................................................... 47
                6. For Econosto, Russia is a top market in the making .............................................. 49

         4                                       Economics Department/Sector Research, September 2007

         5   Economics Department/Sector Research, September 2007

                                                                          Chapter 1: Economic Overview
                   Strong growth and…
                                                                          After the roaring nineties, which began with the collapse of the Soviet Union in 1991
                             % GDP
                                                                          and ended with the rouble crisis in 1998, the start of this century was characterised by
                                                                          a much more stable and prosperous development. The year 1999 was one of
   8                                                                      adjustment, and since president Putin took power in 2000 the Russian economy has
   4                                                                      shown an outstanding performance. The period of uninterrupted decline over the first
                                                                          eight years of the transition period were followed by a period of prolonged strong
                                                                          growth following the rouble crisis. And in fact, the end of this sustained growth is not yet
                                                                          in sight. The year 2006 was a milestone as it was the first year in which Russia was
  -8                                                                      able to make up for the large decline in the real value of GDP during the years of
    1995    1997      1999    2001    2003         2005      2007
                                                                          transition prior to the rouble crisis. 1
Source: Thomson Financial

                                                                          With a population of over 140 million people, a nominal GDP of almost one trillion USD
                                                                          and rising wealth levels, Russia is not only attractive because of its rich natural
                                                                          resource base and related industrial investments and services, but has also become an
                                                                          interesting consumer market with a rising middle class.

                       …a strong rouble                                   Although the positive economic developments since 1999 are mostly attributable to
                                                                          high energy prices and the much improved competitive position due to the sharp fall in
  40                                                                      the rouble at the end of 1998, sound macroeconomic management also played an
                                                                          important role. Fiscal surpluses became the rule and debt levels were reduced to the
                                                                          point that the government became a net creditor. The currency started to strengthen
  32                                                                      and inflation was brought under control. The much improved macroeconomic stability
  28                                                                      also enhanced the inflow of foreign investment, which rose considerably over recent
                                                                          years. There is, however, a flipside to these strong growth levels and the inflow of
                                                                          foreign capital. The central bank is having a hard time balancing the need to keep
   Jan-05     Jul-05       Jan-06    Jul-06        Jan-07       Jul-07
                                                                          inflation in check and the risk of a strong loss in competitiveness due to the resulting
                       —— RUB per EUR
                          RUB per USD                                     strong currency. A loosening of fiscal policy in the run-up to the parliamentary elections
                                                                          at the end of 2007 and the presidential elections in March 2008 makes this balancing
Source: Thomson Financial
                                                                          act even more difficult.

                                                                                Economic structure and trade

                                                                          Service sector has become more important
                                                                          The transition from a centrally planned economy towards a more market-oriented
Russia                                  2006 2007 2008
                                                                          economy has led to far-reaching changes in the country’s economic structure. During
                                                % changes
                                                                          the Soviet era, the focus was on heavy industry which was where most people were
GDP                                       6.7             7.3       6.5
Inflation (average)                                                       employed, while the service sector was underdeveloped. Already in the first years after
                                          9.7             8.2       8.0
                                                                          the collapse of the Soviet Union, the economic structure changed dramatically. The
Current account (% GDP)                   9.6          5.9          4.9   share of agriculture in GDP fell from 17% in 1990 to 7% in 1995 and continued its
Budget balance (% GDP)                    7.4          6.0          2.5   gradual decline in the years thereafter to a current share of 5%. At the same time, the
Government debt (% GDP)                   9.0          5.0          5.0   agricultural sector’s productivity declined strongly, as is evident by the fact that while its
Foreign debt (% GDP)                          29          28        24    share in GDP has declined, the share in total employment has hardly changed and now
                                                   year-end               stands at around 12%, against 13% in 1990. Furthermore, much of the activity in the
Short interest rate (3m)                 11.0        10.0           9.0   informal economy likely takes place in the agricultural sector, which implies that even
RUB per USD                              26.3        25.3        25.5     more people are making a living of farming as the statistics indicate. Estimates for the
RUB per EUR                              34.6        36.7        34.4     informal economy vary between 25% and 40% of GDP.

Forecasts ABN AMRO Economics Department
                                                                          1 The cumulative decline in GDP in the period from 1991 to 1998 was 52%, while the cumulative growth
                                                                          in the period 1999 up to 2006 was 54%.

                                                                          6                               Economics Department/Sector Research, September 2007

                     Economic Structure                                The share of industry also showed a declining trend, with the share of industry to GDP
                                                                       falling from 48% in 1990 to 38% in 1995, where it still stands. Sixty percent of this
                        Share of GDP
                                                                       continues to be heavy industry, the sector is dominated by large industrial enterprises.
                                                                       These statistics are not completely reliable, however. During the Soviet era, output
                                                                       figures were more likely overestimated while now, given the fact that tax evasion is
                                                                       considerable, output figures are likely to be underestimated. Services, on the other
                                                     Industry          hand, increased its share from 35% of GDP in 1990 to 55% in 1995, and has remained
                                                                       around this level ever since. If we look at the other sectors, employment has developed
                                                                       more in line with the contribution of these sectors to total production. Industry’s share in
                                                                       employment fell from 42% in 1990 to 30% currently, while services increased its share
Source: EIU                                                            in that period from 42% to 55%.

                                                                       The oil and gas sector contributes over 50% of industrial output and represents around
                                                                       25% of GDP, including other oil and gas-related activities. It also generates 65% of
                                                                       total exports and 35% of state revenues.

                                                                       Due to the concentration of economic activity in the capital intensive energy sector, the
        …real growth agriculture and industry                          current government has dedicated various measures to stimulating investments outside
   20                                                                  the resources-based industries. These measures include special zones, tax incentives,
                                                                       and export promotion. Meanwhile, the government is concentrating its own influence on
                                                                       what are called the strategic sectors of the economy, of which the oil and gas sector is
    0                                                                  obviously the most important component.
                                                                       Strategic sectors
     1996     1998     2000    2002      2004         2006      2008
                                                                       At the start of 2007 the Russian government finally published the long-awaited draft law
                         —— Industry
                           Agricutture                                 on the limitation of foreign investment in the country. The law designates 40 industries
                                                                       as "strategic" for Russian development. Predictably, the list includes the production of
Source EIU
                                                                       military equipment, aircraft, spacecraft, ciphering tools, treatment and trade of
                                                                       radioactive and nuclear materials. This "strategic" status will also be assigned to fields
                                                                       highly endowed with natural resources, with thresholds of some 70 million tonnes for
                                                                       oil, 50 billion cubic metres for gas, 50 tonnes for gold and 500,000 tonnes for copper.
                                                                       The list of strategic industries also includes natural monopolies and arms-related
               Savings and investment rate                             metallurgy. Moreover, the regulation stipulates eight criteria for evaluating any
                            % GDP                                      particular company, which effectively enables any type of production to be classified as
  40                                                                   "strategic". The regulation sets up a special inter-departmental commission uniting
  35                                                                   economic and security officials to approve deals involving "strategic" companies. Its
  30                                                                   permission will be necessary for purchases and other deals related to the controlling
  25                                                                   shares of strategic companies, even if they do not belong to the state. Foreign states,
                                                                       their subsidiaries or international organisations will have to seek approval for deals
                                                                       above the 25% share threshold, and will be completely prohibited from acquiring
                                                                       control over "strategic"' companies.
    1993 1995 1997 1999 2001 2003 2005 2007
                                                                       The long list of strategic industries and the provisos for potentially classifying
                      —— Investment rate
                           Savings rate                                companies beyond them as strategic, reflects the government’s increasing control over
                                                                       economic issues. On the other hand, the fact that there is now a policy for considering
Source: Thomson Financial
                                                                       foreign involvement could lead to less uncertainty and is hence an improvement over
                                                                       the earlier non-transparent ad-hoc decisions.

                                                                       7                            Economics Department/Sector Research, September 2007

                                                                EU most important trading partner
               Main export markets (2006)
                                 USD bln         % of total
 EU-25                              177.2              61
                                                                Since the collapse of the Soviet Union, Russia’s imports from non-CIS countries have
 o.w Netherlands                       35.9            12       grown rapidly, with especially strong growth in trade with the EU. The EU is by far
        Germany                        24.5             8       Russia's main trading partner, accounting for around 50% of its overall trade. Total
 USA                                    8.9             3       exports from Russia to the EU amounted to USD 177 billion in 2006. Of this total,
 China                                 15.7             5
                                                                around 65% involved energy and fuels, making Russia the EU’s single most important
 Ukraine                               15.0             5
                                                                energy supplier. Imports from the EU amount to USD 61 billion. They include
 Total                              291.3
                                                                machinery (36%), chemicals (14%), manufactured goods (11%), transport equipment
 Source Datastream/IMF direction of trade statistics            (10%), food and live animals (7%). Although the EU is clearly the most important
                                                                trading partner, trade with China is quickly increasing in importance. China is now
                                                                Russia’s fourth export market and the second most important source of imports. And
                      Major exports (ITS)                       Russia is China’s 10th leading trading partner. For the EU, however, trade with Russia
 Agricultural products                                 6.1%     is less important, given that most trade is of an intra-regional trade. Exports to Russia
 Fuels and mining products                             67.7%    account for less than 5% of total EU exports, comparable to the share of exports from
 Manufactures                                          23.2%
                                                                the EU to China.
 Source WTO
                                                                Exports to the Netherlands have also grown strongly. In 2006, exports to the
                                                                Netherlands accounted for 12.3% of total exports, while this was only 4% in the period
                  Main import markets (2006)
                                                                from 1995 to 2000. This makes the Netherlands Russia’s largest export destination. If
                                   USD bln         % of total
                                                                we look at the import side, Germany is still number one, with a share of 14% of total
 EU-25                                 61.3            46
  o.w Netherlands                       2.7             2       imports. However, China is catching up quickly and has become the second largest
         Germany                       18.4            14       supplier of imported goods, with a share of almost 10%, while the Netherlands doesn’t
 US                                     6.4             5       even appear in the top 10. However, if we take a closer look at the figures regarding
 China                                 12.9            10       trade between Russia and the Netherlands, there is a huge gap between the figures
 Ukraine                                9.2             7
                                                                the IMF provides for Russia and those provided by the IMF for the Netherlands.
 Total                             132.5
                                                                According to IMF statistics for Russia, the value of imports from the Netherlands is just
 Source Datastream/IMFdirection of trade statistics             USD 2.7 billion, representing a share of 2% of total imports. However, if we take the
                                                                same statistics for the Netherlands, the value of Dutch exports to Russia amounted to
                                                                USD 7 billion. This would mean the Netherlands takes fifth position as a source of
                      Major imports (ITS)                       imports for Russia. The same discrepancy can be seen if we compare Dutch imports
 Agricultural products                                 15.4%    from Russia (USD 21 billion) with exports from Russia to the Netherlands (USD 36
 Fuels and mining products                             3.9%     billion). According to the IMF, the principal reason for this is related to differences in 1)
 Manufactures                                          80.2%    classification concepts and detail, 2) time of recording, 3) valuation, 4) coverage, and
 Source WTO                                                     5) processing errors.

                                                                Relations with both EU and US remain difficult
                   Value of import and export
                             USD bln
                                                                Given the growing importance of trade relations and because they have become
 400                                                            neighbours, both the EU and Russia have a shared interest in a stable and prosperous
 300                                                            Europe. So far, however, the EU and Russia have not found a way of working together
                                                                constructively. In fact, collaboration between Russia, the EU and the US seems to have
                                                                become even more problematic.

    0                                                           EU policy towards the east currently consists of three types of strategy; the
         1993 1995 1997 1999 2001 2003 2005 2007                enlargement process, the European Neighbourhood policy (ENP) and the Four
                     —— Import          Export                  Common Spaces with Russia.

Source: EIU
                                                                Plans to build the four 'common spaces' [in economics, education and research and
                                                                internal and external security have made little headway. The EU-Russia summit in

                                                                8                            Economics Department/Sector Research, September 2007

                                                          Samara on 18 May on a new EU-Russia treaty failed to achieve a breakthrough. The
                                                          summit underlined that further delays should be expected to the start of talks on
                                                          replacing the partnership and co-operation agreement (PCA) that is due to expire at the
                                                          end of 2007.

                                                          The failure to reach an agreement has a great deal to do with political tensions and
                                                          differing values. Where Russia insists on strategic partnerships among peers, the EU
                                                          aims at making the country more responsive to EU standards and values with respect
                                                          to issues like democracy and human rights. The EU is also concerned about Russia's
                                                          autocratic tendencies, its use of energy resources for political purposes and its bullying
                                                          of smaller neighbours, but has so far not been able to formulate a common policy.
                                                          Moscow, on the other hand, sees this as unacceptable interference in its domestic
                                                          affairs and prefers to work directly with the big member-states like Germany.

                                                          The ENP, the vehicle for stronger engagement of the EU with the CIS member
                                                          countries, is also a source of tension between the EU and Russia. This is especially
                                                          true for the relations with Georgia, Ukraine, Azerbaijan and Moldova – the so-called
                                                          GUAM countries – which seek a closer connection with the EU but are seen by Russia
                                                          as the “near abroad”. Furthermore, although many former CIS countries would like to
                                                          be absolutely independent from Russia, they are not prepared to lose the economic
                                                          benefits, such as cheap gas, which they continue to enjoy. This has resulted in the “gas
                                                          wars” with Ukraine, Georgia and Belarus, for example. On the one hand, the EU
                                                          supports the more independent position of these countries while on the other, it is
                                                          concerned about the security of its own oil and gas supplies. Energy is hence one of
                                                          the most pressing topics for discussion between the EU and Russia.

                                                          Strong economic differences also play a role in explaining the difficulties in achieving
                                                          economic and political cooperation. Despite Russia’s current strong economic
                                                          performance, the EU is still far larger than Russia in terms of economic size, population
                                                          and wealth.
                                                          In fact for Russia, even trade with the EU is much more important as a share of total
                                                          trade than it is for the EU. Nevertheless, now that its economic situation has improved
                                                          on the back of high oil prices, Russia's international political interest has become
                                                          increasingly geared towards renewing its status as a world power, which doesn’t make
                                                          cooperation any easier.

                                                          In addition, the forthcoming Duma elections (December 2007) and presidential
                                                          elections (March 2008) cast further uncertainty on future relations, as is evidenced by
                                                          the increased rhetoric from Moscow concerning both the EU and the US. Examples are
                                                          the strong negative statements from Moscow regarding the US ambition to implement a
                                                          military missile defence shield in Poland and the Czech Republic, and its reaction to
                       Different in size                  the request by the UK to extradite the main suspect sought by the UK in the Litvinenko
                            US        EU-25      Russia   murder case. Given all this, we therefore expect that relations between Russia, the EU
                                                          and the US will remain wobbly in the coming years.
Nominal GDP
(USD bln)                  13247       14550       985
                                                               Economic developments
Population (mln)             299           490     142
GDP per capita (PPP)       44244       28420     12162
                                                          Domestic demand will remain the sole driver behind economic growth, while the
Source EIU                                                contribution of the external sector will become increasingly negative. A looser fiscal
                                                          stance in the run-up to the presidential elections in March 2008 will further add to

                                                          9                           Economics Department/Sector Research, September 2007

                                                               growth. Higher import demand will only partly offset the increase in domestic demand.
                 GDP per capita at PPP
                                                               We therefore predict that although the high growth level of 7.8% seen in the first half of
                                                               2007 might not be sustained, growth for the full year will remain robust at 7.3%, up from
 12000                                                         6.7% in 2006. In 2008 we expect growth to remain strong, albeit slightly lower, at
 10000                                                         around 6.5%.
  6000                                                         2000-2006, years of rising prosperity
      1991           1995     1999      2003          2007     The strong growth performance over the last eight years has resulted in an even
Source: EIU                                                    stronger increase in per-capita GDP. Measured at purchasing power parity, per-capita
                                                               GDP fell from USD 8,400 in 1991 to a low of 5,800 in 1998 and has since risen to over

                                                               Driven by domestic demand, the economy grew by an average of 6.7% per year
                                                               between 2000 and 2006. Consumer demand is fuelled by a strong increase in
                                                               disposable income. Real wages have increased by more than 10% a year since
                                                               president Putin came to power. This has given rise to a consumption boom and a rapid
                                                               growth in the retail sector. Private consumption grew by 9.5% annually between 2000
                                                               and 2006. Investments accelerated by no less than 12.6% per year. The growth in
                                                               domestic spending drove up import demand by over 20% a year, while export demand
           Growth of real disposable income                    jumped by an average of just 9% per year. Despite the strong growth in the value of
                              %                                imports, the current account remained in surplus thanks to the high oil prices.
  10                                                           Windfall oil revenues were channelled into a stabilisation fund, which was used in 2005
   5                                                           to repay the IMF obligations and the former Soviet debt to the Paris Club (the club of
   0                                                           debtor nations). Despite the debt repayments, the fund now has a balance of over USD
  -5                                                           100 billion. The Stabilisation Fund was also an important tool of macroeconomic policy,
                                                               as it helped prevent an even stronger appreciation of the rouble and kept the economy
                                                               from overheating.
    1996      1998     2000   2002   2004      2006     2008
Source: EIU
                                                               Recent developments 2006-2007

                                                               Gross investments, which dipped below 10% growth in 2005, bounced back strongly in
                                                               2006. In the first quarter of this year, gross fixed capital formation was up 19.8% yoy,
                                                               compared to 17.4% in the last quarter of 2006 and just 5.7% in the first quarter of last
                                                               year. Including inventories, the rise was even more impressive, amounting to 34.2% in
                                                               the first quarter, against 19.7% in the last quarter of 2006 and 4% in the first quarter of
                                                               2006. Foreign direct investment increased by USD 16 bn to a total of USD 81 bn. This
                      Government debt                          contradicts fears that investment would suffer from the government’s renationalisation
                            % GDP                              efforts and a worsening political climate. The bulk of investments, both domestic and
 140                                                           foreign, is directed to the energy sector, construction, transportation and services.
 120                                                           Foreign direct investment is also increasingly directed towards the financial sector.
  60                                                           Private consumer demand also remained robust, growing 10.9% in 2006. Private
  40                                                           consumption growth accelerated during the second half of last year to 12.6% in the
  20                                                           final quarter of 2006, slowing slightly in the first quarter of 2007 to 11.9%. Domestic
                                                               demand is not only stimulated by the continuing increase in real disposable income but
    1995         1998         2001      2004          2007
                                                               also by increased access to consumer credit. Overall credit rose 46% in 2006. Loans to
Source: EIU/Economics Department
                                                               individuals were up 75% during that year, while credit to the corporate sector increased
                                                               by 39%.

                                                               10                          Economics Department/Sector Research, September 2007

              Industrial production growth                        Booming consumption market
                              % yoy
                                                                  Table: Top 20 of private consumption expenditure, at current market prices in billion US dollar
  15                                                              ranked by 2008
                                                                  Country                   2000     2001    2002    2003    2004    2005    2006    2007     2008   place
                                                                  UNITED STATES             6739     7055   7351     7704    8211    8742    9271    9640   10087      1
   5                                                              JAPAN                     2624     2340   2259     2431    2629    2600    2495    2814    3102      2
                                                                  GERMANY                   1122     1127   1194     1451    1621    1644    1684    1878    1924      3
   0                                                              UNITED KINGDOM             944      946   1035     1183    1394    1439    1520    1689    1731      4
  -5                                                              FRANCE                     743      751     819    1019    1166    1213    1279    1439    1483      5
                                                                  CHINA                      554      595     635     687     771     865     988    1146    1294      6
 -10                                                              ITALY                      656      657     715     888    1007    1032    1075    1193    1226      7
    1996      1998     2000     2002     2004     2006     2008   SPAIN                      347      360     402     510     605     652     713     815     847      8
                                                                  CANADA                     401      401     418     490     553     627     709     719     758      9
Source: EIU                                                       RUSSIAN FEDERATION        120      151     177     218     289     367     476      594     688     10
                                                                  INDIA                      296      308     318     371     419     474     536     601     666     11
                                                                  MEXICO                     389      433     448     439     465     525     570     596     613     12
                                                                  KOREA, REP. OF             276      266     305     327     351     415     474     530     592     13
                                                                  BRAZIL                     366      309     267     287     333     442     533     563     585     14
                                                                  AUSTRALIA                  228      218     244     308     374     407     421     428     418     15
                                                                  NETHERLANDS                185      201     220     270     300     308     321     362     371     16
                                                                  TURKEY                     143      105     122     160     200     245     265     281     295     17
                                                                  INDONESIA                  102      101     132     160     171     184     229     253     276     18
                                                                  TAIWAN                     195      181     181     183     198     215     220     236     259     19
                                                                  SWITZERLAND                148      151     166     195     216     221     224     250     258     20
              Real import and export growth
                                                                  Total top 20             16579    16656   17408   19280   21274   22617   24002   26028   27471
                              % yoy                               Total World              19279    19374   20145   22437   24903   26652   28448   31056   32824
                                                                  as % of total world         86       86     86       86      85      85      84      84      84
  40                                                              source EIU

                                                                  Not only has private consumption shown remarkable increases in recent years
                                                                  compared to the pre-Putin era, but is also impressive when compared to other
 -20                                                              countries. This is illustrated in the table above, showing the nominal amount of national

                                                                  income spent on private consumption from 2000 to 2008. These countries rank as the
    1991        1995           1999        2003          2007     top 20 in 2008 and, over the years, have represented around 85% of total global

                  —— Export            Import
                                                                  private consumption expenditure. Given current growth prospects, Russia is expected
                                                                  to move from 19th place in 2000 to 10th in 2008, outranking countries like India,
Source: EIU
                                                                  Mexico, South Korea and Brazil. This will make Russia an increasingly attractive
                                                                  market for both retail and other consumer-related activities.

                                                                  Construction and manufacturing show strongest growth

                                                                  Looking at the supply side, it is the construction and retail sectors that showed the
                                                                  strongest growth. In the second quarter of this year, growth in the construction sector
                                                                  was 22% yoy. Overall GDP grew by 7.8% yoy in the second quarter, just below the
                                                                  7.9% growth level recorded in the first quarter. Other sectors registering growth above
                                                                  the GDP average are trade, financial activities, real estate and transport and
                                                                  communication. The state administration sub-sector also showed remarkable Q2
                                                                  growth at 8.1%. This merely reflects sharp increases in public sector salaries in the
                                                                  run-up to the elections. Growth in the manufacturing sector was below average at 6.2%
                                                                  following a very strong performance of 11.8% in the first quarter. Resource extraction
                                                                  remains sluggish due to a lack of investment in new fields and infrastructure. The
                                                                  sector grew by just 1.4% in the second quarter, after recording a lacklustre 2.4%
                                                                  growth in the first quarter. Another sector which continues to underperform is the
                                                                  agriculture sector, which grew 2.6% in the second quarter and 2.9% in the first quarter.

                                                                  11                               Economics Department/Sector Research, September 2007

                                                             The construction and retail sectors are expected to continue to outperform due to
                      Current account
                                                             further increases in overall wealth levels. The manufacturing sector might slow down
                          % GDP
                                                             furhter over the coming period, as the sector will eventually be negatively impacted by
                                                             the loss in competitiveness caused by the continuous strengthening of the rouble. This
                                                             will particularly affect those areas of manufacturing that are oriented to the export
  15                                                         market or compete on the domestic market with imported goods.
   5                                                         Current account surplus will diminish
       1993       1997            2001          2005         Despite strong import growth and a slight decline in oil prices in the second half of last
              Trade balance         Current account          year, the current account surplus rose further in 2006 to USD 94.5 billion, compared

Source: EIU/Economics Department
                                                             with USD 83.3 billion in 2005. For 2007 we expect a small decline in the nominal value
                                                             of the surplus as imports continue to swell. This trend will continue in the coming years,
                                                             but we do not foresee a current account deficit, at least up until 2010.
                                                             Strong inflows of foreign capital will more than compensate for the lower current
                                                             account surplus and foreign reserves will hence continue to swell. Figures for the first
                                                             half of 2007 indicate that foreign capital continues to pour into the country. To a large
                                                             extent, this is related to foreign borrowing by Russian corporates, but foreign direct
                                                             investments are also surging. Total FDI inflows more than doubled in the first half of
       Real effective exchange rate against USD
                                                             2007 compared to the year-earlier period. FDI inflows amounted to USD 16 billion2,
                                                             bringing the total amount of FDI to USD 81 billion. The Netherlands is the most
                                                             important source of direct foreign investment with over USD 30 billion invested in
 100                                                         Russia. Most of this is invested in the extraction industries. Cyprus, which is the major
                                                             offshore banking centre for Russian corporates, is the second largest source of FDI.

                                                             Rouble remains strong and inflation subdued
    1995       1998        2001          2004         2007   The net capital inflow has led to a continuous strengthening of the rouble, which had a
                                                             dampening effect on inflation, despite strong consumer demand. In March 2006,
Source: EIU
                                                             inflation fell below 10% for the first time since the start of the rouble crisis in August
                                                             1998. Inflation ended 2006 at 9%, precisely at the upper end of the central bank’s
                                                             target. It fell to a low of 7.4% in March, but has since risen above 8%. We expect
                                                             inflation to end 2007 around 8.5%, above the official inflation target, which is set
                                                             between 6.5-8.0%. Interest rates were lowered by 50 basis points in mid-June to 10%,
                          % yoy
                                                             but there is little room for further cuts.
                                                             In July 2006, the rouble became fully convertible, meaning that the remaining
                                                             restrictions on capital account transactions were removed. As the balance of payments
                                                             (current account plus capital balance) will remain in surplus, there will be continuous
                                                             upward pressure on the exchange rate. Therefore, the central bank needs to continue
    0                                                        maintaining a balance between efforts to reach its inflation target and heeding political
     1995      1998        2001          2004         2007   pressure to keep appreciation of the currency in check. Clearly this is a difficult
Source: EIU                                                  balancing act. Raising interest rates to stem inflation will only lead to more capital
                                                             inflow and hence probably to even stronger upward pressure on the currency. The
                                                             appreciation of the currency itself also attracts additional capital inflows and could thus
                                                             lead to further appreciation. Another option is to further increase its reserve
                                                             requirements as a loosening of fiscal policy in the run-up to elections makes it even
                                                             more difficult for the central bank to achieve its inflationary targets. The one thing that

                                                             2 According to figures from RosStat

                                                             12                              Economics Department/Sector Research, September 2007

                                                could exert downward pressure on the currency could be political uncertainty in the
                                                period surrounding the coming elections. However, the chances that this will lead to
                                                strong and prolonged currency volatility are small given the country’s huge international
              Short term interest rate          reserves and substantial current account surplus.

 70                                             Elections could pose some risks to our positive outlook
                                                Uncertainty about Russia’s political outlook after President Putin steps down at the end
 30                                             of his second term in 2008 represents a major threat to our forecast for the coming two
 20                                             years. Infighting among rival factions in the Kremlin that are competing for influence
                                                could give rise to political turbulence, and might even trigger some capital flight.
   1996       1999     2002      2005    2008   However, the most probable scenario, given Putin’s formidable power base and his
                                                tremendous popularity, is that whoever he appoints will win the elections and carry on
Source: EIU
                                                his policies. Although it is unclear whether this new president will be able to maintain
                                                the same powerbase as Putin, the very favourable current economic developments –
                                                particularly the extremely favourable external liquidity position – strongly mitigate the
                                                political risks. Therefore, as long as the oil price continues to prop up the economy and
                                                create growing prosperity among broader sections of the population, the current power
                                                base in the Kremlin is unlikely to be seriously threatened.

                                                The more relevant vulnerability, in our view, is therefore the fact that the government is
                                                using its oil wealth to avoid painful reforms and to expand its presence in the economy.
                                                Given the inefficiency of state-owned firms, this could constitute a long-term structural
                                                constraint on growth. Further, because both the institutions and the legal framework are
                                                very weak, many approved reforms are not being implemented. This, together with high
                                                and increasing levels of corruption, could become a serious constraint to further

                                                      SWOT analysis

                                                Though Russia is an extremely attractive market for investors, it is also fraught with
                                                pitfalls. The most common problems concern the complexity of the tax system,
                                                corruption, regulatory volatility, the lack of regulatory transparency, government
                                                bureaucracy, weak contract legislation, the absence of a commercial market and
                                                business ethos as well as the absence of a commercial law system. This means that
                                                deals must often be made on the basis of trust. Investors also frequently encounter
                                                financing difficulties and have problems obtaining payment from Russian companies3.
                                                Despite these problems, businesses and investors are increasingly finding their way to
                                                Russia. Western exports to and investments in Russia are steadily rising. Every day,
                                                new products and services are launched in the Russian market. The most important
                                                reason for this is the tremendous scope for entrepreneurship in this country.

                                                In the table below we have summarised the most important strengths and weaknesses
                                                as well as the respective opportunities and threats these may give rise to. As the
                                                economic strengths have already been addressed in our outline on the current
                                                economic situation and prospects, we will only very briefly summarise the strengths
                                                and emphasise the risks to our overall very benign picture of the Russian economy.

                                                3 The Institute of Direct Investments Foundation has been set up by the Russian government to assist
                                                investors in Russia.

                                                13                              Economics Department/Sector Research, September 2007

          Table : SWOT analyses of Russia
          Strength:                                      Weakness:
              rich resource base                            fragile political situation
              growing wealth                                state interventionism
              large domestic market                         weak institutions and corruption
              sound economic policy                         demographics, infrastructure,
              Low sovereign debt levels                     education, and health

              Sound external liquidity situation            low degree of diversification

          Opportunity:                                   Threat:
              deepening of financial markets                losing competitiveness
              diversification of the economic base          Lower oil prices

              development of SME sector                     shrinking population
              to improve transparency and corporate

          Source: ABN AMRO


         Russia’s current strength is related to the fact that its rich resource base and
         favourable commodity prices – in combination with sound economic policies – have
         enabled the country to lower its sovereign debt to less than 10% of GDP and
         dramatically improve the external liquidity situation. This makes the country much less
         vulnerable to adverse internal or external developments. Although we expect that both
         the fiscal and the current account surplus will diminish rapidly in the coming years, the
         low levels of government debt and huge international reserves will cushion the
         economy for a long time from a possible change in investor sentiment. The oil boom
         has also led to a strong increase in wealth, which, given the size of the population, also
         makes Russia very attractive as a retail market.


         Fragile political situation
         The country’s present political stability has, in part, been achieved at the expense of
         progress in democratic development, which could in turn set the stage for longer-term
         instability. The biggest short-term threat to the benign risk environment is related to the
         question of what will happen after president Putin's second term ends in 2008. The
         concentration and centralisation of power in the hands of the president could result in
         instability in the longer run, regardless of who wins the elections. This is even more
         likely if the relationship between politicians and the private corporate sector further
         deteriorates as this could hamper future investment growth. This scenario could also
         have a strong negative impact on the allocation of scarce resources, impeding healthy
         economic development and leading to strong inefficiencies. But as we stated
         previously, as long as oil prices stay high and the economy continues to grow, the
         political risks are strongly mitigated. Another risk related to the concentration of power
         among only a few individuals is that the sudden death of the president could have a
         strong negative impact, especially if it leads to political infighting among different
         factions in the Duma and the country’s different regions, which now are firmly under
         state control. These risks range from increased fiscal instability in the regions to a rise
         in terrorist activities.

         14                               Economics Department/Sector Research, September 2007

         State interventionism
         In the long run, the increasing discretionary role of the state in society and the economy
         has several distortionary impacts. Inefficiencies in state-controlled sectors are likely to
         grow and corruption will rise. In addition, private business that is no longer supported
         by the government could suffer strongly.

         Weak political, legal, and economic institutions
         There has been rapid legislative reform since the election of President Putin, but
         enforcement is still a major problem due to weak institutions and a weak legal
         framework. This is also true for the intellectual property legislation that was passed in
         2002 as Russia makes its bid to join the WTO. The lack of enforcement severely
         hinders the investment climate, which is also negatively impacted by the high and rising
         corruption levels. Russia currently ranks 121 out of 158 countries in the Transparency
         International Corruption index 2006.

         Demographics, education, health, housing and infrastructure
         Years of underinvestment have resulted in a dilapidated infrastructure and inadequate
         education and health system. Decent, affordable housing remains an important issue
         as well, as it hampers the movement of labour from the agricultural sector to more
         productive sectors of the economy. Government investments are still clearly
         insufficient, and increased spending in these areas is urgently needed in order to
         maintain a strong human capital base. This should diminish the risks related to the
         negative demographic trend of a rapidly declining, and rapidly aging, population.
         Now that the foreign sovereign debt levels have declined to the extent that Russia has
         become a net creditor, it could be argued that part of the stabilisation fund could be
         used for such government investments. This would help further bolster political stability.

         Russia’s poor infrastructure is a major impediment to trade. Several major projects are
         being carried out to improve its infrastructure with financial support from the World
         Bank and the European Bank for Reconstruction and Development (EBRD). The aim is
         to upgrade the road network as well as modernise the ports and airports.
         Only 9 per cent of the total freight volume is transported by road, as most of the
         reasonably good roads are located in the European part of Russia and only in the
         proximity of its larger cities. In the rest of the country, the road network is less
         developed. Nearly 40 per cent of the villages have no access via paved roads. The rail
         network is also in very poor technical condition, while the numerous ports and
         waterways are often poorly located or lack facilities for the transshipment of large
         volumes of goods4.


         Deepening of financial markets
         The financial sector is developing rapidly. The market for consumer credit and
         mortgages as well as the rise of the corporate bond market are particularly
         encouraging. The reduction in borrowing costs was very helpful in enhancing credit
         growth as were improvements in the regulation of the banking sector in recent years
         and the introduction of deposit insurance. Nevertheless, the sector is still far from

         4 For example a large portion of agri-food products destined for West Russia is transported via ports in
         Western Europe or the Baltic states because the ports in Russia lack the required facilities.

         15                               Economics Department/Sector Research, September 2007

         offering the full range of modern instruments needed to support a dynamic corporate
         sector. The Russian banking sector also remains relatively small, weak, and
         segmented. Given continued scarcity of skilled bank personnel and substantial non-
         transparency with respect to the operation and ownership of domestic corporations,
         there is inadequate means to assess the creditworthiness of clients. This increases the
         share of bad loans. There is no legislation to protect the banks against delinquent
         customers. Meanwhile, the public—the potential customers—still distrust banks, but
         instead prefer to keep their savings in cash. This hampers the proper working of
         financial intermediation in the economy.
         Development of the sector would clearly further enhance the economy’s growth
         prospects. The development could be facilitated by eliminating inconsistencies among
         different laws and codes, and clarifying responsibilities among the various agencies
         charged with overseeing the sector.

         Diversify the economic base
         To further broaden the base of economic development it is important to stimulate
         investments in other sectors as well as development of the SME sector. The latter is
         especially important, as a well-developed SME sector increases competition and is an
         important source of jobs and a generator of innovations. This would also be a better
         stimulus for achieving the government’s aim of stimulating innovation than the current
         trend towards more centralisation.

         Improve transparency and corporate governance
         More and more Russian companies are listed abroad. Although there are no
         guarantees, this will very likely expose Russia more to "international" standards
         (including increasing transparency and corporate governance) and will create a certain
         integration between Russian and Western(-European) Financial Markets.


         Sharp fall in world oil prices
         A sharp drop in world market oil prices would severely slow the pace of the Russian
         economy’s expansion and increase all other risks. But as long as oil prices remain high
         and above USD 40 a barrel, most short and medium-term risks remain limited.

         Dutch disease development
         A sharp fall in the oil price is not the only risk; high oil prices also pose a threat to
         sound future economic development. Oil dependence makes the country vulnerable
         and creates uneven development. During the Soviet era the economy was relatively
         well diversified. But since the fall of the centrally planned communist system, import
         demand has started to rise at the expense of domestic production. This process
         accelerated when the oil boom began. Russia’s strong currency has worsened its
         competitive position, which was greatly enhanced by the mega rouble devaluation in
         1998. As a consequence, diversification has diminished at the expense of the energy
         sector. So far, the shift in concentration of economic activity out of the labour-intensive
         manufacturing sector into the capital-intensive oil and gas sector has largely been
         compensated by strong employment growth in the services sector and construction, but
         this could come to an end when the country’s development reaches a more mature

         16                               Economics Department/Sector Research, September 2007

         The Russian population is dwindling and – due to low birth rates in the late Soviet and
         transition eras – is rapidly aging as well. This could lead to labour shortages and
         pension problems. In addition to this negative demographic trend, the technological
         basis of higher education has been depleted since the fall of the Soviet Union, resulting
         in a lack of good technically skilled employees.

         17                          Economics Department/Sector Research, September 2007

         Chapter 2: Russia’s Minerals & Mining Industry
         This chapter describes Russia’s non-fuel mining industry, i.e. excluding coal, oil,
         natural gas and uranium mining. Oil and natural gas will be discussed in the next

              The importance of the sector to the Russian economy

         The non-fuel mining industry (including the further processing of ores) is of vital
         importance to Russia’s economy. Russia has a long mining tradition and is currently
         one of the world’s leading producers and exporters of minerals and mineral-based
         products. Blessed with vast resources, the country is a major producer of aluminium,
         cobalt, copper, diamonds, gold, iron ore, mica, nickel, platinum, potash, tin, titanium
         and zinc. In addition, many other metals and various industrial minerals are mined. The
         country’s most important regions for metals mining are East Siberia, the Kola
         Peninsula, the North Caucasus, the Russian Far East and the Urals. Mining conditions
         in some of these regions are harsh.

         Following the collapse of the Soviet Union in 1991, it became clear that the Russian
         mining industry – which is almost exclusively state-owned – was in a poor state due to
         years of underinvestment and lack of maintenance. Low labour productivity, high
         energy use and, at times, low product quality resulted in decreasing competitiveness in
         the world market. The transition from a centrally planned economy to a free market
         system in the early 1990s affected domestic demand for many basic metals and
         industrial minerals. By 1998, Russia’s industrial production had fallen to 45% of its level
         in 1990. One positive effect of the slump in domestic demand was that substantial
         volumes became available for export, resulting in a rapid increase in the export of
         minerals and metals.

         The sector’s poor performance and the free market economy caused the collapse of
         several large state mining companies, while private mining companies began to
         emerge. Meanwhile, small mining and metals companies closed down or merged,
         thereby creating larger and financially stronger companies. This reconstruction was
         necessary in order to survive against a backdrop of lower global commodity prices at
         the end of the 1990s and the 60% depreciation of the Rouble in 1998. However, the
         resulting capacity rationalisation was a major positive effect of the turmoil hitting the
         industry. The transition of the Russian mining industry also brought about major job
         losses and many miners left their regions to find work elsewhere.

         Privatisation was used to bring in Western know-how, technology and the much-
         needed foreign capital to upgrade the industry. However, many Western companies
         were still reluctant to invest in the Russian mining sector as a result of its negative
         image due to the unreliable legal system, problems with subsoil licensing, doubtful
         reserve classification and high federal and local taxes. Although some of the problems
         were overstated by the media, the Russian Government has recognised the need to
         improve foreign investment conditions and bring legislation up to world standards.

         18                          Economics Department/Sector Research, September 2007

                                                              Exploration spending in the global mining sector
     Worldwide nonferrous exploration spending
                      USD bln, 1994-2006
                                                              Exploration is the key element in unlocking new reserves and increasing a mining
                                                              company’s reserve base. Data from the Metals Economics Group (MEG)5 show that,
                                                              after the peak in 1997, global exploration spending in the non-ferrous mining sector
                                                              started to decline. The reasons for this decline were the low price environment and

 4                                                            falling investor confidence in the mining sector. As a result, less capital was available
                                                              for the mining sector while the more promising dot.com sector attracted huge capital
 2                                                            flows. At the turn of the century, the combined market value of quoted mining and
                                                              metals companies (representing real ‘bricks and mortar’) is said to have fallen to only
 0                                                            about half the value of Microsoft.
         1995                  2000                    2005

Source: Metals Economics Group                                After bottoming out in 2002, global exploration spending began to boom once again
                                                              from 2004. This type of boom-to-bust cycle is typical for the mining sector. Key drivers
                                                              for the sector are global economic growth and, in particular, demand growth in the
                                                              manufacturing, construction and infrastructure sectors. The current boom is based on a
                                                              combination of:
                                                              •     years of underinvestment since the Asian crisis in 1998;
                                                              •     lagging reserve replacement, a key issue for the mining industry;
                                                              •     surging demand, particularly from the emerging economies of India and China.

                                                              Metals and minerals consumption per capita in India, China and other developing
                                                              countries is still low compared to consumption levels in developed countries. This
                                                              implies that there is considerable scope for sustained high demand growth over the
                                                              medium term as long as economic growth in these countries remains relatively high.

                                                              Total global exploration spending was estimated at USD 7.13 billion in 2006, up by
     Distribution of worldwide exploration budgets            USD 2.2 billion (45%) from 2005. Although gold and diamond exploration spending still
                 in 2006, USD 7.13 billion
                                                              represents a major part of total spending, most of the increase can be attributed to
                                                              base metals exploration spending. Canada, Australia and the US traditionally head the
                                      Canada                  list of top ten countries, together accounting for 38% of total global exploration budgets.
                                                              Since 2004, Russia has quickly moved up the top ten list, jumping from seventh place
                                           Australia          in 2005 to its current fourth place spot. In 2006, Russia accounted for 5% of global
           China                       United                 exploration spending.
           Brazil                         Mexico
                    South         Russia                      Expansions are usually the preferred method of reserve replacement over grassroots
                                                              discoveries. A major reason for this is that grassroots projects take an average of 7-10
Source: Metals Economics Group                                years from initial discovery to production. According to MEG’s survey, there is currently
                                                              a clear trend towards late-stage/feasibility exploration budgets, which outpace the
                                                              increases in grassroots projects. In the present price environment, with most metals at
                                                              15 to 20-year highs, several dormant, abandoned or technically difficult projects are
                                                              now being re-assessed for near-term development.

                                                              5 The 2006 data collected by MEG are based on an analysis of 1,624 international nonferrous mining
                                                              companies with exploration budgets of at least USD 100,000.
                                                              MEG is a world leader in mining industry intelligence and a provider of information and analysis on global
                                                              nonferrous metals exploration, development and production. MEG’s data are widely used by the mining
                                                              industry and by governments to analyse trends and formulate policies.

                                                              19                               Economics Department/Sector Research, September 2007

                                                                 The data collected by MEG show that over the past few years the so called ‘junior
                                                                 exploration companies’6 have significantly outpaced larger mining companies in
                                                                 exploration spending growth. Although this can partially be explained by the focus of
                                                                 junior exploration companies on gold mining, they are also looking for opportunities in
                                                                 other commodities. In 2006, the junior exploration companies accounted for about 50%
                                                                 of total global exploration spending.

                                                                 It is becoming increasingly difficult to find economically viable metal ore and mineral
                                                                 deposits as most of the ‘low-hanging fruit’ has already been discovered and developed.
                                                                 Therefore, it will take considerably more capex to discover, explore and develop new
                                                                 grassroots deposits than in the past, particularly when local infrastructure is lacking. As
                                                                 a result, the expansion of supply will continue to struggle to keep pace with the
                                                                 expected continuing growth in demand.

                                                                       Growing demand for mining equipment

                                                                 MEG’s survey of exploration budgets indicates a sustainable revival of the global
       Acute shortages constrain the equipment
                     supply side                                 mining industry. However, one should realize that a substantial part of the increase in

Item                     Normal delivery      Current delivery   exploration spending over the past few years can be attributed to cost inflation. Since
                          time (months)        time (months)     the trough in 2002, there have been significant cost increases in wages, services and
Grinding mills                   20                   44         mining equipment. Therefore, the amount of real capital invested in 2006 may be much
Draglines                        18                   36         smaller than the survey indicates.
Barges                           24                   32
                                                                 The revival of the exploration market and the development of new deposits will be key
Locomotives                      12                   26
                                                                 drivers for mining and processing equipment market. According to a recent study7 by
Power generation                 12                   24
Wagons                           12                   24
                                                                 The Freedonia Group, global demand for specialised mining machinery and equipment
Rope shovels                      9                   24         is forecast to increase 9.3% per year through 2009 to USD 27.5 billion. Freedonia
Reclaimers                       18                   24         expects Eastern Europe to offer the best regional prospects due to the long period of
Tyres                           0-6                   24         underinvestment and the region’s extensive mineral resources.
Large haul trucks               0-6                   24
Crushers                         15                   24
                                                                 Despite the recent turnaround in the fortunes of the global mining industry, the sector
Ship Loaders                      8                   22
                                                                 still faces many challenges. Considerable equipment cost inflation and the lack of
Source: Rio Tinto, Outlook for Metals and Minerals               human resources are not the only problems hindering production and capacity growth.
                                                                 Some projects are encountering environmental oppositions, technical problems or cost
                                                                 overruns. In addition, the availability of equipment is currently causing stress in the
                                                                 mining sector, leading to project delays.

                                                                       Medium-term outlook

                                                                 The medium-term outlook for Russia’s minerals and mining industry looks rather
                                                                 promising, considering the global supply/demand trends. The industry has profited from
                                                                 increasing global demand and rising prices since 2002, which has stimulated increased

                                                                 6 Junior exploration/mining companies are small to medium-sized companies involved in early-stage
                                                                 mining projects. Their exploration expenditures vary from USD 50,000 to 1,000,000. Because they have
                                                                 no cash flow (i.e. no income from an operating mine) and their assets consist of exploration properties,
                                                                 their capital needs cannot be satisfied through normal financing channels. The capital for mineral
                                                                 properties, exploration, plant and equipment is raised through the issuing of shares. Investors consider
                                                                 junior mining companies ‘high-risk/high-reward plays’. Many are listed on the Canadian TSX Venture
                                                                 (TSX-V) Exchange or London’s Alternative Investment Market (AIM).
                                                                 7 World Mining Equipment, World Industry Study with Forecasts to 2009 & 2014. The Freedonia Group,
                                                                 Inc., April 2006.

                                                                 20                              Economics Department/Sector Research, September 2007

         Like many of their competitors elsewhere, Russian companies are also being
         confronted with the depletion of their high-grade ore deposits. They will have to
         develop new deposits in order to meet both increasing indigenous demand from the
         manufacturing sector and from exports.
         The potential for mineral exploration in Russia has been recognised by several large
         Western companies, such as Anglo American, AngloGold Ashanti, BHP Billiton and Rio
         Tinto. In recent years, several alliances and joint ventures have been announced with
         Russian companies to explore and develop attractive mineral deposits. Most of these
         joint ventures will develop greenfield mineral deposits in certain areas, such as western
         Siberia and the north-western part of Russia. Junior exploration companies are also
         likely to play a role in the development of these deposits. The successful development
         of a deposit could make these junior mining companies more attractive for acquisition
         by larger (‘senior’) mining companies, as this increases their reserves and production

                 Opportunities in mining equipment, services and systems

         Despite its production potential, the Russian minerals and mining sector still faces
         major problems, such as ageing equipment. In 2000, about 80% of Russia’s mining
         machinery was near the end of its operable life and in need of urgent replacement.
         Although there have been some improvements since, many mining companies are still
         using outdated technologies from the Soviet era. According to estimates, 30-70% of
         Russia’s minerals reserves are not economically exploitable. Major investments will be
         needed to reach Western standards of product quality, pollution control, energy use per
         unit of output and labour productivity. Moreover, new mineral deposits will have to be
         developed to meet the ever-increasing demand and compensate for the depletion of
         existing deposits.
         Vast investments will therefore be required in the coming decade, offering significant
         opportunities for Western companies involved in exploration and development, and for
         suppliers of control systems, logistics, mining technology or mining equipment.
         Medium-sized companies will be particularly interested in optimising mining and plant
         operations through advanced process control systems, and minimising the idle time of
         mining equipment through better coordination with the transport system. Even large
         mining companies tend to contract specialised companies for services that require
         certain expertise.
         Automation of mining equipment is also an important issue in modern mining
         operations, particularly in underground mining. Automation considerably improves both
         productivity and safety. Some Russian mining companies have poor safety and
         environmental records, and automation could surely help them improve safety, health
         and environmental (SHE) conditions. A consistently good SHE performance is
         increasingly becoming a prerequisite to sell to Western customers.

         21                          Economics Department/Sector Research, September 2007

       Regional distribution of proved oil reserves
                                                                 Chapter 3: The Russian Oil Industry
                 at year-end 2006, 1,208 bln bbl

             North                         Saudi
            America Iran                   Arabia                     Oil reserves
            Europe                                               Russia’s proved oil reserves amounted to about 79.5 billion barrels as at year-end
            Russia                                               2006, accounting for 6.6% of the world’s total proved reserves (BP estimate). Most of
               Africa                                            these oil reserves are located in four oil provinces: Western Siberia, Volga-Ural, Timan-
             Asia                           Middle               Pechora and Northern Caucasus. In addition, the country has roughly the same level of
            Pacific                          East                probable and possible oil reserves, putting this non-OPEC country in the top league of
                                                                 oil-producing nations that includes OPEC members like Saudi Arabia, Iran, the UAE
Source: BP Statistical Review of World Energy June 2007
                                                                 and Venezuela. According to BP, Russia’s R/P ratio was 22.3 at year-end 2006, i.e. its
   Regional distribution of oil production in 2006
                                                                 proved reserves can sustain its 2006 production level of 9.77 million bpd for 22.3 years.
                           81.66 mln bpd
                     S&C               Saudi                          Oil production
                   America             Arabia
             Pacific                         Iran
                                                                 In the 1980s, the Soviet Union became a major world oil producer due to the
             Africa                             Middle           development of the Western Siberia region (also known as the ‘Russian Core’). Peak
                                                 East            production reached 11.4 million bpd (barrels per day) in 1987. Following the
             Europe                                              disintegration of the Soviet Union in 1991, Russian oil production fell over the
                      Russia                                     subsequent years to bottom out at 6.1 million bpd in 1996. Oil production then
                                                                 stabilised at this level for several years. The production decline can be attributed to
Source: BP Statistical Review of World Energy June 2007          several factors: the collapse of the central planning system, the depletion of major
                                                                 fields due to excessive production targets and insufficient attention to matters such as
               Russia’s major oil producers                      infrastructural development, enhanced oil recovery techniques, maintenance and
                 (production x mln tons)*
                                                                 energy-saving measures.
  Company                        2005                2006
                                                                 The turnaround for Russia’s oil production came in 1999. In 2000, Russian oil
  Lukoil                         87.81                90.42
                                                                 production showed an increase of almost 360,000 bpd, a rise of 5.8% over the previous
  Rosneft                        74.42                81.71
  TNK-BP                         75.35                72.42      year. This turnaround can be attributed to the introduction of Western technologies and
  Surgutneftegas                 63.86                65.55      the re-engineering of oil fields in Western Siberia. Another driver was the sector’s
  Gazprom Neft                   33.04                32.72      privatisation, leading to better management and new field developments. Yukos and
  Tatneft                        25.33                25.41      Sibneft played an important role in the production increase by using Western-style
  Slavneft                       24.16                23.30
                                                                 production methods.
  Yukos                          24.52                21.53
  Russneft                       12.18                14.76
  Gazprom                        12.79                13.40      Russia’s oil production (crude oil plus condensates) amounted to 9.77 million bpd in
  Others                         36.44                39.31      2006, with the ‘big four’ Lukoil, Rosneft, TNK-BP and Surgutneftegaz accounting for
  Total                         469.90               480.53      64.5% of total production. Oil production in 2006 showed an increase of 2.2% over
 * incl. gas condensates                                         2005, the lowest growth rate seen since 1999 when oil was still at USD 10 per bbl
 Source: Gazprom Neft
                                                                 (barrel). This represents a marked slowdown from the 8-10% annual growth rate seen

  Oil production and consumption in the Russian                  in the 2001-2004 period. In fact, Russia was the motor for global oil supply growth in
               Federation (mln bpd)                              2001-2004, accounting for 50-75% of non-OPEC supply growth during those years.

                                                                      Oil exports

   6                                                             Russia has a vast integrated oil transportation system, which handles both crude oil
                                                                 (mostly Urals blend) and refined products. The pipelines, which were in urgent need of
                                                                 repair in the 1990s, have since been substantially upgraded. The pipeline network
   0                                                             consists of more than 60,000 km of long-distance pipelines, local oil pipeline networks
    1985         1990           1995         2000         2005
                                                                 and several export pipelines, the most important of which are ‘Druzhba-1’ and
               —— Production           Consumption               ‘Druzhba-2’.
Source: BP Statistical Review of World Energy
                                                                 22                          Economics Department/Sector Research, September 2007

                                                                 Over 70% of Russia’s crude oil production is directly exported, while the remaining
           Sources of crude oil exports in 2006
                                                                 30% is refined locally. Most of Russia’s oil exports are transported via pipelines
                          38.81 mln bpd
                                                                 (overland to other countries or to export terminals at ports). About 35% of Russia’s
                          Rest of
                           world                                 crude oil exports are still shipped via higher-cost railroad tankers and river barges due
                 Africa                                          to pipeline bottlenecks. Some of the crude oil export capacity deficit is handled by
                                            Middle               exporting refined petroleum products to Europe, mostly fuel oil and diesel fuel.
           Europe                            East                Traditionally, exports are primarily transported overland via the Druzhba trunk pipelines
              FSU                                                into Central Europe and by sea via the Black Sea ports of Novorossiysk, Tuapse and
                                                                 Odessa, and via the Baltic port of Ventspils and several other ports in the Gulf of
                       North                                     Finland. The Baltic Pipeline System (BPS), which came on stream in December 2001,
                                                                 transports oil from the West Siberian and Timan-Pechora oil fields westward to a new
Source: BP Statistical Review of World Energy June 2007
                                                                 terminal at the Russian Baltic port of Primorsk, diverting the flow from the Latvian port
                                                                 of Ventspils. The final stage of the BPS was completed in 2006.
      FSU net exports* of crude oil and petroleum                In 2006, about 85% of Russian crude oil exports went to non-CIS countries. Major
                products (million bpd)
                                                                 destinations were Germany, Italy, France and the Netherlands. The remaining 15%
                                    2004    2005          2006
                                                                 mainly went to CIS countries.
  Crude oil seaborne                3.96    4.05          4.07
  Druzhba pipelines                 1.10    1.15          1.20
  Other pipelines                   0.23    0.25          0.38   The Russian oil pipeline system is very inefficient due to inept management, and is
  Total crude exports               5.29    5.45          5.64   often troubled by reliability and environmental problems. Over 90% of the system is
  - of which Transneft              3.76    4.04          4.09   owned and managed by Russia’s state-owned monopoly Transneft. The tariffs charged
  Exports petroleum products        2.19    2.38          2.51   by Transneft for use of its pipelines are based on distance. In order to maintain control
  Total exports                     7.48    7.83          8.16
                                                                 over oil exports, Transneft has so far opposed deregulation of the pipelines.

 Source: IEA Monthly Oil Market Report
                                                                 In October 2005, a new export tax system was introduced to stimulate crude oil
                                                                 production growth by capping the export tariff rate. The unintended side-effect was a
   Differential Crude oil Urals Med. vs dated Brent              shift toward exports of refined products at the expense of crude oil exports. This was
                           USD per bbl                           mainly due to the fact that under the new tax system, the tax on refined products has
  2                                                              declined relative to the crude oil tax. For Urals at USD 40/bbl the difference for light
  0                                                              products is about USD 2.8/bbl, but for Urals at USD 60/bbl, the difference is about USD
 -2                                                              7/bbl. The differences in taxation have more than offset the higher transportation and

 -4                                                              other costs involved in the export of refined products.

                                                                      Oil production and export outlook
      00    01       02     03      04     05      06      07
                                                                 Russia’s oil production is forecast to continue its upward trend. The International
Source: Thomson Financial
                                                                 Energy Agency (IEA) expects Russia’s oil production to rise by 2.4% in 2007, slightly
                                                                 higher than the production growth of 2.2% seen in 2006. For the medium term (2007-
                                                                 2012), the IEA expects Russian oil production to continue to grow, albeit at a slower
                                                                 pace compared to the period 2001-2006. This lower growth rate reflects the fact that
                                                                 several major oil fields are showing signs of maturity as well as the difficulties
                                                                 encountered in compensating for the decline by developing new fields.

                                                                 As domestic demand is expected to increase less rapidly than production, this leaves
                                                                 room for increasing exports of crude oil and refined products. According to the IEA,
                                                                 Russia’s exports will start to gradually decline soon after 2010 when domestic demand
                                                                 outstrips the increase in production. IEA’s overall conclusion is that these production
                                                                 and export trends will remain highly sensitive to politics and taxes and may, therefore,
                                                                 differ substantially from the current scenario.

                                                                 23                           Economics Department/Sector Research, September 2007

                                                                 The medium-term outlook for Russia’s oil production growth is highly uncertain, mainly
   Pre-peak Russian oil fields (1,000 bpd), 2004
                                                                 due to the fact that seismic data are neither transparent nor made externally available.
Field               Owner              Production Depletion*
                                                                 Oil analysts have also pointed out the lack of exploration in potential production areas
Priobskoye          Rosneft                437.5         8%
Tevlin-Russinkoye Lukoil                   241.0        45%      over the last decade. The key factor determining Russia’s future level of oil production
Tyanskoye           Surgutneftegaz         191.1        20%      essentially depends on how long Western Siberia’s current production can be
Sugmutskoye         Gazprom                191.5        44%      maintained while new reserves are meanwhile put into production to offset the decline
Sporyshefskoye      Gazprom                107.5        44%      in maturing or post-peak fields.
 Total                                   1,168.6
                                                                 According to a study by John Grace ‘Russian Oil Supply’ (Oxford Institute of Energy
* cumulative depletion
Source: EIA, Country Analysis Briefs, Russia April 2007, based   Studies) about 20% (1.8 million bpd) of Russia’s oil production in 2004 came from
on John Grace’s study Russian Oil Supply
                                                                 fields that had cumulatively produced 80% of their total recoverable reserves.
                                                                 Attention is therefore likely to shift to less mature basins such as Timan-Pechora, and
  Post-peak Russian oil fields (1,000 bpd), 2004                 to frontier areas such as Eastern Siberia and Sakhalin. However, the development and

Field               Owner              Production Depletion*     production costs for such ‘greenfield projects’ are expected to be much higher than for
Samotlor            TNK-BP                 974.1        71%      existing ‘brownfield projects’ in Western Siberia. Government taxation and the lack of
Romashkino          Tatneft                295.5        84%      clarity regarding subsoil resources ownership will continue to create uncertainties. In
Momontovskoye       Rosneft                251.5        82%      this type of environment, it will be quite difficult to achieve sustained production growth.
Federovskoye        Surgutneftegaz         456.3        67%
Lyantorskoye        Surgutneftegaz         168.2        81%
                                                                 The key to Russia’s future oil production growth will be the availability of viable export
Pravdinsko-         Khantymnasiysk-        119.4        27%
Salymskoye          neftegaz                                     routes via pipelines. Alternative methods of exporting oil (by rail or barge) are far more
Povkhovskoye        Lukoil                 112.1        95%      costly than shipment via pipelines. Both Transneft and the Russian government have
Arlan               Bashneft                75.0        91%      acknowledged the future capacity problem and have introduced incentives to develop
 Total                                   2,452.0                 new export infrastructure. This export infrastructure will also take into account the
* cumulative depletion
Source: EIA, Country Analysis Briefs, Russia April 2007, based   growing demand for oil in the North East Asian market, which has so far been a limited
on John Grace’s study Russian Oil Supply                         target for Russian oil exports.
                                                                 A major project aimed at increasing oil exports to the North East Asian market will be
                                                                 the 4,200-km Eastern Siberia-Pacific Ocean (ESPO) pipeline, which was approved in
                                                                 December 2004.
                                                                 Many problems had to be solved before construction could start, such as the possible
                                                                 connection with China, the sourcing of the oil and the financing of the pipeline with an
                                                                 estimated cost of USD 7.0 billion for the first section and USD 6.0 billion for the second
                                                                 section. There were also environmental concerns related to Lake Baikal (a UNESCO-
                                                                 protected site) and Perevoznaya Bay (a sensitive area for whales). In the meantime,
                                                                 environmental and safety problems have been solved, but total construction costs may
                                                                 be double the initial estimate when both sections are completed.
                                                                 The first 2,800-km section of the ESPO pipeline, owned by Transneft, is expected to be
                                                                 completed by December 2008, with the second section to be finished in 2010. The
                                                                 route has been amended and the pipeline now passes 200 km from Lake Baikal. The
                                                                 pipeline is designed to deliver 80 million tons/year (1.6 million bpd) of Siberian oil to
                                                                 China and Asia-Pacific countries.

                                                                 24                           Economics Department/Sector Research, September 2007

    Regional distribution of proved gas reserves                       Chapter 4: The Russian Natural Gas Sector
                     at year-end 2006, 181.5 tcm
              North          S&C                                            Natural gas reserves
            America         America Qatar
            Europe                                                     Russia has the world’s largest proved natural gas reserves, totalling 47.65 trillion cubic
                                                                       metres (tcm) at year-end 2006 or 26.3% of the world’s total proved reserves (BP
                                                Other                  estimate). Russia‘s R/P ratio was 77.8 at year-end 2006, i.e. its proved gas reserves
                                                Middle                 can sustain its 2006 gas production level of 612 billion cubic metres (bcm) for 77.8
                            Asia                                       years. Gazprom’s reserve estimate for Russia at year-end 2006 was 47.85 tcm. These
                           Pacific                                     reserves are in the Russian A+B+C1 ‘proved’ or ‘commercial grade’ category of reserve
Source: BP Statistical Review of World Energy June 2007                classification, comparable to the international ‘proved plus probable’ or 2P category.
                                                                       Iran, which has the world’s next largest reserves, has about 28.1 tcm.
                                                                       In addition to these proved reserves, Russia has more than 30 tcm of undiscovered
     Gas reserve structure in Russia at end 2006
                                                                       gas resources (U.S. Geological Survey estimate, 2000). Some 20 giant fields have
                                      Volume (tcm)         Share (%)
                                                                       been discovered, each with more than 500 bcm in gas reserves; so far, only seven of
  Gazprom (controlled reserves)               29.85           62.4
  Independent producers                       10.20           21.3
                                                                       these fields have been brought into production.
  Undistributed fund                           7.80           16.3
  Total                                       47.85         100        Around 80% of Russia’s gas reserves are located in Western Siberia, mainly in the
                                                                       Nadym-Pur-Taz (NPT) region where several giant fields were discovered in the 1960s.
 Source: Gazprom
                                                                       Three major fields Urengoye, Yamburg and Medvezhye (the ‘Big Three’) still account
                                                                       for the majority of the country’s gas production, although these mature fields are now in
                                                                       decline. Significant natural gas reserves are also found offshore on the shelf of the
                                                                       Barents Sea and Pechora Sea, in Eastern Siberia and in the Timan-Pechora region.

          Regional distribution of gas production
                                                                       Natural gas production
                         in 2006, 2,865 bcm

                            Indonesia                                  In 2006, Russia accounted for 21.3% of global natural gas production. Russia’s gas
                 Algeria                  Russia
                                                                       production is largely controlled by state-owned Gazprom, the world’s largest gas
                                                   Iran                company. Gazprom owns and operates the 156,900-km network of high-pressure gas
                                                   Saudi               trunk pipelines. The company also owns 25 underground gas storage facilities in
                                                                       Russia, with a total of 63 bcm of gas stored in 2006/07. These storage facilities are
                                              USA                      important in matching supply with seasonal demand fluctuations. Via its ownership of
                                                                       Gazprom, the Russian government controls about 85% of the domestic gas production.
             Norway        UK    Canada
                                                                       However, the Russian gas sector has largely retained its centralised Soviet structure
Source: BP Statistical Review of World Energy 2007                     dating back to the 1980s. Although the restructuring of the gas sector has been high on
                                                                       the government’s agenda for some time, the move was blocked by President Putin.

     Russia’s gas production by oil majors, bcm                        After the collapse of the USSR, domestic gas production fell sharply in response to
  Company                             2005                 2006        lower domestic demand. Russian gas production peaked in 1991 at 600 bcm and
  Surgutneftegas                      14.36                14.62       bottomed out to 533 bcm in 1997. Production was flat for several years, but the
  Lukoil                               5.80                14.11       turnaround came in 2002.
  Rosneft                             13.05                13.56
  TNK-BP                               6.45                 8.65
                                                                       In 2006, Gazprom accounted for about 85 % of total gas production in Russia, while oil
  Gazprom Neft                         1.99                 2.05
  Yukos                                1.97                 1.89       companies and independent gas producers accounted for the remainder. The recent
  Others                               4.37                 2.01       increase in production can be largely attributed to the independent gas producers, the
  Total oil majors                    47.99                56.89       largest of which is currently Novatek (with gas production of 28.6 bcm in 2006). These
  Independents, Gazprom              545.04               599.34       ‘independents’ are mostly private companies that – unlike Gazprom – have managed to
  Total Russia                       641.02               656.23
                                                                       increase their gas production, filling the gap between domestic gas supply and
 Source: Surgutneftegas

                                                                       25                          Economics Department/Sector Research, September 2007

                                                                   Nearly a quarter of the gas production by independents is still being flared. This is
  Gas production and consumption in the Russian
                Federation (bcm)                                   largely attributed to the unprofitable gas processing and sales conditions for these
                                                                   producers compared to Gazprom. In most cases, these other producers have to sell
                                                                   gas to Gazprom, or Gazprom has to provide access to its Unified Gas Supply System
 600                                                               (UGSS) to enable them to deliver gas to non-Gazprom buyers. Gazprom’s control over
 450                                                               the Russian gas market is likely to change due to the long-expected policy shift towards
                                                                   gas market deregulation, necessitated by growing market imbalances.

 150                                                               In November 2006, the Russian government approved proposals for the liberalisation
        1985        1990        1995         2000           2005   and price deregulation of the domestic gas market. The proposed system should result
               —— Production        Consumption                    in a better supply/demand balance for the domestic gas market due to the introduction
                                                                   of a new pricing system and the introduction of long-term pay-or-take contracts.
Source: BP Statistical Review of World Energy June 2007
                                                                   The regulated market segments (households and utilities) will see quota-based
                                                                   deliveries with inflation-adjusted prices. Gas prices for industrial consumers and power
     Increase in Russian domestic gas prices in                    generators (about 70% of the domestic market) will be determined by export netback
           2007-2011, USD per 1,000 cu m                           parity, which is scheduled to be reached by 2011. These price hikes will create an

 140                                                               economic incentive to improve energy efficiency, offer opportunities for independent
 120                                                               gas producers and the monetisation of associated gas that is often still being flared.
 100                                                               In addition, the new gas policy encourages non-regulated gas trading. Mezhregiongaz
   80                                                              (a wholly-owned subsidiary of Gazprom) has set up an electronic trade board, which
   60                                                              enables Gazprom and independent suppliers to sell gas at free market prices. Trading
   40                                                              has been conducted on a monthly and ten-day-period basis since February 2007. Spot
   20                                                              prices have often exceeded the regulated gas prices by 30-40%, reflecting the
    0                                                              increasing dynamics of the Russian domestic gas market.
        H1 2007 H1 2008 H1 2009 H1 2010 H1 2011

Source: Institute of Energy Policy, Moscow                              Natural gas exports

                                                                   Gazprom has a monopoly on all gas exports outside the Commonwealth of
                                                                   Independent States (CIS). Via its subsidiary Gazexport, the company is the leading
                                                                   supplier of natural gas in the European gas market. Russian gas supplied to Europe is
                                                                   mainly sold on the basis of long-term contracts. In addition, Russia exports significant
                                                                   volumes of natural gas to customers in the CIS.

                                                                   CIS republics, such as Belarus, Georgia, Moldova and Ukraine have been offtakers of
                                                                   Russian gas for many years. These supplies were paid for at the expense of Russian
                                                                   citizens, who sometimes experienced supply disruptions due to these exports.
                                                                   Moreover, the CIS republics were charged only a fraction of what European offtakers
    Gazprom’s natural gas sales to CIS and Baltic
          countries, 2005 and 2006 (bcm)                           paid for Russian gas despite the serious non-payment problems with the CIS republics.

  Country                       2005                 2006
  Ukraine                       37.6                 59.0          The Western CIS states (especially Belarus and Ukraine) are still important to
  Belarus                       19.8                 20.5          Gazprom as transit countries to Central and Western Europe, its main markets. In
  Kazakhstan                     4.0                  6.5          2006, Western Europe imported about 25% of its gas needs from Russia. Other major
  Azerbaijan                     3.8                  4.0
                                                                   non-EU suppliers are Statoil/Petoro (Norway) and Sonatrach (Algeria).
  Lithuania                      2.8                  2.8
                                                                   Gas exports to Europe provided 60% of Gazprom’s gas revenues in 2006, but
  Moldova                        2.8                  2.5
  Georgia                        1.4                  1.9          represented only 28% of its gas sales volumes. This was due to the continuing marked
  Armenia                        1.7                  1.7          difference between the gas prices realised in the European export market compared to
  Other                          2.7                  2.1          Gazprom’s other markets.
  Total                         76.6                101.0          The European gas price in 2006 was RUR 5,238.5 per 1,000 cubic metre (excluding
                                                                   excise tax and customs duties), compared to only RUR 1,125.4 per 1,000 cubic metre
 Source: Gazprom Annual Reports
                                                                   (excluding VAT and excise tax) in the Russian market.

                                                                   26                          Economics Department/Sector Research, September 2007

          Gazprom’s natural gas sales to European                    In 2006, Gazprom’s gas sales revenues in the CIS and Baltic states increased by
              countries, 2005 and 2006 (bcm)                         93.5% compared to 2005, mostly due to the 46.7% increase in the average sales price
  Country                           2005               2006          to RUR 2,077.4 per 1,000 cubic metre (excluding excise tax and customs duties). This
  Germany                           36.0             34.4
                                                                     price increase forms part of Gazprom’s strategy to adjust the contractual terms and
  Italy                             22.0             22.1
                                                                     conditions to levels similar to those for exports to the European countries. In exchange
  Turkey                            18.0             19.9
  France                            13.2             10.0            for a gradual transition to more market-related prices in these countries, Gazprom has
  Hungary                            9.0               8.8           stated its goal of gaining access to ultimate consumers through participation in gas
  United Kingdom                     3.8               8.7           assets.
  Poland                             7.0               7.7           Gazprom has ambitious plans to expand its activities in Europe as well, via joint
  Czech Republic                     7.4               7.4
                                                                     ventures (for instance in gas transport companies) and the acquisition of distribution
  Slovakia                           7.5               7.0
                                                                     companies. Over the past few years, Gazprom has acquired shares in over 40
  Austria                            6.8               6.6
  Romania                            5.0               5.5           European gas transport and distribution companies, but this strategy has sometimes
  Finland                            4.5               4.9           met with strong opposition. One example was Gazprom’s bid for Centrica, the UK’s
  The Netherlands                    4.1               4.7           biggest gas supplier. When several European countries expressed concern about
  Belgium                            2.0               3.2           Gazprom’s take-over plan, the company warned that it could redirect supplies to other
  Greece                             2.4               2.7
                                                                     markets, such as North America and China.
  Bulgaria                           2.6               2.7
  Other                              4.8               5.2
  Total Europe                     156.1            161.5                  Natural gas production and export outlook

 Source: Gazprom Annual Reports
                                                                     Over the next few years, Gazprom and independent producers will need to bring
                                                                     several new fields on stream to compensate for declining production from the ‘Big
                                                                     Three’. Gazprom expects production from these fields to decline by 7-8% a year over
            Average gas prices FSU and Europe                        the next few years. The company has indicated that it prefers to develop new fields
                  (RUR per 1,000 cu m)                               rather than trying to sustain the production levels of the ‘Big Three’.
 6000                                                                The cost of developing new gas fields, all of which are located within the harsh Artic
 5000                                                                zone, is estimated at USD 30-40 billion excluding the necessary infrastructure. This is
 4000                                                                the major reason that Gazprom will give priority to the development of a number of
 3000                                                                smaller fields in the NPT region. As these fields are in the vicinity of the super-giants,
 2000                                                                the existing pipeline infrastructure can be used.
 1000                                                                This allows Gazprom to take advantage of the spare capacity in the existing pipeline
                                                                     system running from the NPT region. Recent exploration in the region has indicated
         2002       2003           2004         2005          2006
                                                                     that there is still a large number of smaller fields with substantial potential. Although
                    —— FSU            Europe
Source: Gazprom                                                      some of the gas reserves are in the ‘yet-to-find’ category, the gas reserves with
                                                                     economic potential in the NPT region could add another 100 bcm to the annual supply
                                                                     in the near future.

                                                                     Gazprom’s production is forecast to show only modest growth (1.0-1.5% per annum)
            Gazprom's production outlook (bcm)                       over the next few years. This reflects the change in the company’s medium-term
                                                                     strategy. Gazprom is shifting its focus away from increasing its overall upstream
                                      uncertainty range              production toward investments in midstream and downstream, both at home and
                                                                     abroad, moving closer to its European customers. Most of Russia’s gas production
                                                                     growth will therefore have to come from other companies (oil companies and
                                                                     independent gas producers), giving them a substantial window of opportunity as
                                                                     Russian domestic demand is also expected to increase. Supply from these
 100                                                                 independents is forecast to increase from 105 bcm in 2006 to over 200 bcm in 2015.

    0                                                                European gas demand is forecast to continue rising by about 3% (12-15 bcm) per
           96       1      2   3      4    5    6         10F 20F    annum. As European domestic gas production is soon likely to enter a phase of
Source: Gazprom                                                      decline, the EU’s dependency on gas imports will rise from 57% in 2005 to 83% by
                                                                     2030. This provides considerable scope for increasing Russian gas exports, which will

                                                                     27                           Economics Department/Sector Research, September 2007

                                                          necessitate the construction of new Russian export pipelines. In addition, growing gas
  Forecast of gas demand and supply by sources
                                                          demand in Asia (driven mainly by the power sector) will present opportunities for
 1000                                                     Russia to export gas from Eastern Siberia to several Asian countries. This will not only
  800                                                     necessitate the development of new gas fields, but the export pipeline infrastructure
                                                          and underground storage facilities as well.

  400                                                     In 2006, the State Dume adopted the Federal Law ‘On gas export’ which grants

  200                                                     exclusive rights to Gazprom to export gas. This allows Gazprom to pursue a
                                                          coordinated production and export strategy (‘the unified export channel’), forming an
                                                          additional guarantee for the reliability of Russian gas exports.
          2005              2010          2015
                                                          Europe will remain dependent on Russian gas for the foreseeable future. European
            Russia demand          Gazprom supply         offtakers will therefore be forced to work with Gazprom on the security of the gas flows.
            Europe demand          Imports Central Asia
                                                          There are currently no signs that Gazprom is unwilling to cooperate. This is clear from
            FSU demand             Independents
                                                          the agreement on the 1,200-km Nord Stream pipeline (formerly referred to as the North
Source: IEA,TNK-BP
                                                          European Gas Pipeline, NEGP) through the Baltic Sea, which was signed in
                                                          September 2005 by Putin and Schröder.
                                                          Nord Stream consists of two parallel pipelines with a total capacity of 55 bcm per
                                                          annum. The first part of Nord Stream is expected to come on stream in 2010 and
                                                          transport up to 27.5 bcm of gas a year. Initially Nord Stream will supply Germany, but
                                                          further expansion is possible to the UK, Belgium, France and the Netherlands.
                                                          The Nord Stream pipeline is a new channel for Russian natural gas exports and is seen
                                                          as a major infrastructure project, which sets a new benchmark in the co-operation
                                                          between Russia and the EU. Nord Steam is regarded as a clear sign of Gazprom’s
                                                          willingness to cooperate and find solutions to the transit risk problem. As a result,
                                                          Gazprom can avoid negotiating transfer fees, in this case by bypassing Belarus,
                                                          Poland and Ukraine.

                                                          The International Energy Agency expects Russian gas production to rise from 598 bcm
                                                          in 2005 to about 900 bcm in 2030. Despite this impressive production growth, there is
                                                          limited scope to increase exports as domestic demand is also expected to rise
                                                          substantially. However, imports from the Central Asian republics will enable Gazprom
                                                          to increase its exports to Europe. In addition, improving domestic energy efficiency can
                                                          redirect gas from the domestic market to the more lucrative export markets. Energy
                                                          inefficiencies across Russia currently account for about 100 bcm of wasted gas.

                                                          Gazprom has control over more than 60% of Russia’s natural gas reserves. This
                                                          reserve base gives the company ample opportunity – albeit currently mostly from
                                                          relatively smaller fields – to increase its future production. Gazprom can also purchase
                                                          additional gas from independent producers. So far, Gazprom has used its transport
                                                          monopoly to prevent these producers from getting direct access to the European
                                                          Recent meetings between President Putin and Central Asian leaders may help shift the
                                                          tense geopolitical relations and Gazprom’s policy. Given its problems with increasing
                                                          its gas production, Central Asian gas is very important in filling Gazprom’s looming
                                                          supply gap.
                                                          Gazprom has already concluded future gas supply contracts with the Central Asian
                                                          republics Turkmenistan, Kazakhstan and Uzbekistan. The additional volumes would
                                                          have to come on top of the volumes already allocated by Gazprom to Ukraine. The
                                                          supply contract with Turkmenistan (80 bcm/year by 2010) appears to be particularly
                                                          challenging. Turkmenistan has substantial reserves of natural gas, said to be over 20

                                                          28                          Economics Department/Sector Research, September 2007

                                                                                 tcm of recoverable reserves. However, there is lack of reserve transparency and so far
          Development of satellite and new fields
                                                                                 all their production targets have failed.
  Field                   Launch Year of peak Peak production
                               date     production             (per annum)
                                                                                 These three Central Asian countries have significant gas reserves, but up to now the
 Pestsovoye                2004               2006              27.5 bcm         (current) inadequate throughput capacity of the pipeline linking Central Asian gas
 Kharvutinskoye            1996               2008              25.0 bcm         reserves with Gazprom’s network have limited their supply. Gazprom’s recently
 Ety-Purovskoye            2004               2006              15.0 bcm         developed satellite fields will soon – or have already – reached their peak production. If
 Aneryakhinskoye           2004               2006              10.0 bcm
                                                                                 Gazprom wants to meet its targets, the company will have to improve pipeline access
 Yen-Yahinskoye            2003               2008               5.0 bcm
                                                                                 for these Central Asian producers and the gas sales conditions for Russian
 Yuzho-Russkoye            2007               2009              25.0 bcm
 Shtokmanovskoye           2010+            after 2012          67.5 bcm
                                                                                 independent gas producers and oil companies.
                                                                                 In addition to cooperation with Central Asian producers, Gazprom will need to develop
 Source: Gazprom
                                                                                 more resources, which are presently inaccessible, posing immense challenges for the
    Major uncommitted FSU natural gas reserves                                   company. Considerable investments will be needed in greenfield projects to
                  as of 31 December 2005 (tcm)
                                                                                 compensate the declining production from existing fields and prevent a future gas
 700                                                                             deficit. This will make the timing of new projects essential.
                                                                                 Gazprom has indicated that after 2010, new strategic gas fields will be developed on
 400                                                                             the Yamal Peninsula, the shelf in the Barents Sea, the shelf in the Kara Sea (including
 300                                                                             the Obskaya and Tazovskaya bays), Eastern Siberia and the Russian Far East. This
                                                                                 will be a challenging task, given the severe climate conditions in these regions and the
   0                                                                             environmental sensitivities.
          Nadym Pur   Yamal*      Barents     Kara Sea     Central     Eastern
             Taz                   Sea                      Asia       Russia
                                                                                 The U.S. Geological Survey (USGS) is very optimistic about the potential of the Arctic
                     Undiscovered resources
                     Uncommitted resources                                       offshore as well as the opportunities in the Central Asian republics and Eastern Russia.
* Yamal Peninsula undeveloped resources combined with
Nadym Pur Taz                                                                    A large part of the undiscovered resources are located in the Arctic, where Russian
Source: Jensen Associates                                                        explorers planted a flag on the seabed just below the North Pole in August 2007. The
                                                                                 flag is a symbol of Russia’s claim to the vast Artic territory, where an estimated 25% of
                                                                                 the world’s undiscovered oil and gas resources lie.
 Russia’s ‘gold rush’ for the North Pole

 Russian explorers have planted their country’s national flag on                 One of the gas fields that is very likely to be developed in the near term is the giant
 the seabed 4,200 m below the North Pole to confirm Moscow’s                     Shtokman field (or Shtokmanovskoye) in the Barents Sea, a ‘world-class gas project’
 claim to the Arctic.
 Canada, which also claims territory in the Arctic, has criticised               with reserves of 3,700 bcm and additional volumes of gas condensate. Shtokman will
 the mission. “This isn’t the fifteenth century. You can’t go                    be developed by a consortium consisting of Gazprom, French oil company Total and
 around the world and just plant flags and say ‘We’re claiming
 this territory’ ”, Canadian Foreign Minister MacKay told a TV                   other foreign companies. Starting in 2013, Shtokman should deliver 22 bcm of gas to
 Melting polar ice, said to be the result of global warming, has
                                                                                 European consumers and later – in the form of liquefied natural gas (LNG) – to US
 opened the possibility of new shipping routes in the region (the                consumers as well. The investment required to develop Shtokman are estimated at
 Northwest Passage). As exploration of offshore oil and gas
 also becomes easier, this has led to competing claims over                      USD 20-30 billion. This huge amount reflects the difficulties that will be encountered in
 Arctic resources.                                                               developing this gas condensate field, situated 600 km offshore in 350 metres of
Source: BBC News, Financial Times, 2 August 2007.                                dangerous Artic waters.
                                                                                 Shtokman is just one example of the huge investments needed. The IEA expects that
       Russia’s gas production and looming gas
                     deficit (bcm)                                               Gazprom will have to invest USD 330 billion over the period 2005-2030 (the amount
                                                     2004              2010      was not further specified) to meet both future domestic and European gas demand.
  Gas production by Gazprom (a)                          545            550      Ruhrgas has indicated capex needs for the Russian gas sector of USD 227 billion to
  Gazprom’s exports to Europe/CIS                        191            312      2020. This total includes USD 85 billion for upstream, USD 55 billion for new Russian
  Deliveries to domestic customers                       354            238
                                                                                 pipelines, USD 67 billion to upgrade existing pipelines and USD 20 billion for new
  Russia’s domestic demand (b)                           402            469
                                                                                 pipelines to Europe.
  Supply gap (b / c)                                      48         231 / 202
  Deliveries from Central Asia                             -            105
  Total supply gap (b / c)                                 -         126 / 97          The China option
 (a) Optimistic estimate without output from Yamal
 (b) Probable scenario, annual demand growth of 4.3%                             For many years, natural gas in China was mainly used as feedstock for nitrogen
 (c) Reduced scenario, annual demand growth of 2%
                                                                                 fertilizer production. Natural gas for other uses was limited to those areas near gas
 Source: CEPS Policy Brief, October 2006
                                                                                 producing fields. However, given the environmental benefits of using natural gas in

                                                                                 29                             Economics Department/Sector Research, September 2007

         power generation, China is currently undertaking a major expansion of its gas
         infrastructure. China’s gas pipeline system, which is currently still rather fragmented,
         needs more interconnections between networks. Only Sichuan province in the
         southwest can boast a sophisticated natural gas distribution network.
         Natural gas consumption (58 bcm in 2006) accounted for only 3% of China’s total
         energy consumption that year, but gas consumption is expected to increase to 100 bcm
         per year by 2010. Although China has its own substantial gas reserves, its future
         supply will increasingly depend on imports via pipeline and in the form of LNG.

         Given the fast-growing gas market in China, a widely discussed option for Russian gas
         companies is to export gas to China. The giant Kovykta gas condensate field (2,000
         bcm of natural gas) in Eastern Siberia was discovered in 1987. Kovykta, operated by
         RUSIA Petroleum (until recently,8 63%-owned by TNK-BP), could provide China with
         natural gas in the next decade. However, this is a medium-term option as the project
         will initially supply 2 bcm/year of natural gas from 2007 to households and industrial
         consumers (power stations and chemical plants) in Russia’s Irkutsk Region.

         In March 2006, Gazprom and China National Petroleum Corporation (CNPC) signed an
         outline agreement to deliver 60-80 bcm/year of Russian gas to China. This involves the
         construction of two pipelines, to be completed by 2011 at a total cost of at least USD 10
         billion. One of the pipelines is to carry West Siberian and the other East Siberian gas. It
         is still unclear which fields will supply the gas, although Kovykta and Sakhalin-1 are the
         most likely choices.
         When successfully completed, the ‘China option’ will be a crucial step in Gazprom’s
         strategy of becoming a global energy player and – as a consequence – will increase its
         bargaining power as Europe’s major gas supplier. However, Gazprom recently asked
         the Russian Government to annul the agreement of ExxonMobil to supply China with
         gas from Sakhalin-1, arguing that it needs the gas to supply its domestic customers.
         Although Russia seems to be the most logical supplier of gas to China, there are other
         options from neighbouring countries. Kazakhstan’s KazMunai Gas (KMG), for instance,
         has conducted a feasibility study in cooperation with CNPC for the construction of a
         pipeline to supply gas to China. In the longer term, this pipeline could also transport
         gas from Turkmenistan and Uzbekistan to China.

         Given the many uncertainties surrounding Gazprom’s agreement with China, the
         potential competition from Central Asian producers, the routing of pipelines and the
         sourcing of gas, it is crucial that the Russian government develop a master plan for the
         eastern Russian gas sector. This plan should cover the financial issues, which fields
         should be developed first, supplying the domestic market versus export markets (given
         that gas demand in Eastern Siberia is also increasing), and the potential role of foreign

         8 In June 2007, TNK-BP was forced to sell its stake in RUSIA Petroleum to Gazprom. BP announced
         that, in connection with the deal, a strategic alliance with Gazprom will be formed to invest ’jointly in major
         long-term energy projects or swap assets around the world’. Given the Russian regulators’ threat to
         withdraw the licence for Kovykta, BP had in fact no real choice and would be well-advised to accept

         30                                 Economics Department/Sector Research, September 2007

         Chapter 5: Opportunities in Russian Oil and Gas

               Investment climate

         The current political, fiscal and regulatory climate negatively impacts the development
         of marginal fields, particularly relatively high-cost fields. The fiscal reforms process is
         unlikely to be resolved before the 2007/08 national elections. In the meantime, ad hoc
         changes to the tax system are likely to continue. The uncertainties in the investment
         climate complicate the task of long-term project planning for all investors in the Russian
         oil and gas industry. The lack of tax holidays for new fields and reduced taxes for
         maturing fields (i.e. more tax differentiation) is seen as counterproductive.
         The Russian government has acknowledged the need to reform the current tax system.
         Incentives will be introduced to stimulate oil production growth in Russia’s ‘periphery’.
         However, Russian companies are likely to remain reluctant to invest their money in
         Siberian greenfield projects, as they would have to redirect their scarce financial
         resources from fields that are already producing.

         The regulatory framework governing the licensing of subsoil use is still under revision.
         The government submitted a draft of a new law on Mineral Resources to the State
         Duma in June 2005. The draft bill included several reforms recommended by the
         Ministry of Natural Resources (MNR), such as the creation of full-cycle licenses
         (combining exploration and production rights) and the replacement of the current
         administrative legal regime with subsoil licenses with a civil law framework.
         However, the draft bill contained some controversial proposals. In particular, the new
         rules for direct foreign participation in bidding for ‘strategic fields’ would put restrictions
         on potential foreign investors. Strategic fields are legally defined as oilfields with more
         than 1.0 billion barrels of oil, or gas fields with more than 1.0 trillion cubic metres of
         gas, or any fields located near military installations.
         Although several amendments have been made since the draft bill was introduced, the
         formal adoption of the new bill on Mineral Resources has not yet taken place. It
         therefore remains unclear how attractive the outcome will be to foreign investors and
         how it will impact their appetite.

               Resource nationalism increasing

         Several international oil and gas companies have recently been faced with increasing
         ‘resource nationalism’. Resource nationalism basically consists of changes in fiscal or
         operating regimes by oil and gas producing countries. These changes are used to
         maximise their returns or change ownership in upstream assets, often in reaction to
         domestic social unrest. The re-emergence of state control can have unwanted side-
         effects as history has shown: increasing inefficiencies, resulting in deterred upstream
         investments that are essential for sustained output in the long term.

         Bolivia, Ecuador and Venezuela are prime examples of how terms and contracts have
         recently been renegotiated to use their energy resources to press for their political
         interests. Bolivia nationalised its oil and gas fields, state-owned Petroecuador took over
         the former production assets of Occidental Petroleum and Venezuela doubled the
         taxes levied on oil production by the foreign operators in the country.

         31                            Economics Department/Sector Research, September 2007

                                                                     Some fear that Russia is moving in a similar direction, putting foreign participation in
                                                                     the oil and gas industry at risk. “Greater state-ownership of oil-producing assets is likely
                                                                     to distort the incentives facing the remaining private oil companies, because they fear
                                                                     unfair treatment when competing with large state-owned producers” (The World Bank).

                                                                     After the privatisation and restructuring of Russia’s oil industry in the 1990s, the sector
                                                                     became the most rapidly developing part of the Russian economy, contributing
                                                                     significantly to the country’s growth. However, since 2004 the Kremlin has taken steps
                                                                     to restore the government’s control over the oil and gas sectors, revising some of the
                                                                     deals made in the 1990s. Moreover, Russia has used its energy supplies as a political
                                                                     weapon, bullying its former Soviet neighbouring states.

                                                                     The gas dispute between Russia and Ukraine in early 2006 caused considerable
                                                                     upheaval in Western and Central & Eastern Europe. While Russia’s actions were
                                                                     based on a combination of political and economic motives, the result was that the
                                                                     security of energy supply was once again put high on the EU agenda.
                                                                     Russia’s political agenda for its oil and gas industry seems to be driven by increasing
     Putin’s views on Russia’s energy policy:                        state influence, particularly when ‘key strategic energy assets’ are involved. The
            nothing new under the sun                                developments involving Shell’s Sakhalin-2 project – and more recently TNK-BP’s
                                                                     forced sale of its Kovykta gas field to Gazprom – are clear signs that the Kremlin wants
Putin’s views on state planning and the importance of energy
policy for Russia’s foreign relations date back to the time when     to retain control of access to its natural resources.
he was still a senior official. His views can be found in his
dissertation for St. Peterburg’s State Mining Institute, which he
defended in June 1997.                                               Tighter control on its energy resources has become the Russian government’s
In an abstract, which appeared in 1999, he laid the foundation
for Russia’s current energy policy. Putin outlined that Russia’s     unwritten policy, which is said to be sustained by President Putin. This reversal of the
oil, gas and mining base should be used to secure the                Kremlin’s earlier policy of privatisation is evident: in 2003, state-dominated companies
country’s international position. In order to use the energy
factor in international politics, state control over the country’s   controlled only 16.5% of Russia’s oil production, while in 2006 this had increased to
energy resources must be ensured.
                                                                     32%. Lukoil is currently the only major Russian oil company that is not under state
When Putin met Gerhard Schröder in October 2003, he told
him: “The gas pipeline system is the creation of the Soviet          control.
Union. We intend to retain state control over the gas
transportation system and over Gazprom. We will not divide
                                                                     This new policy will clearly benefit state-owned companies (in the form of favourable
Gazprom. And the European Commission should not have any             licensing and regulation) or those companies that are politically well-connected. The
illusions. In the gas sector, they will have to deal with the
[Russian] state”.                                                    clear winners of the Kremlin’s policy to secure greater control over the country’s oil and
                                                                     gas industry will be the state players Rosneft and Gazprom. Their desire to expand
Source: Gazprom in Crisis; Conflict Studies Research Centre
                                                                     their operations will also trigger further consolidation in Russia‘s energy sector.

                                                                           High investments needed

                An OPEC-like Gas-PEC?                                Russia, with its vast proved reserves of oil and gas, will remain one of the world’s

A major source of uncertainty among gas-importing countries
                                                                     largest producers and exporters of oil and gas for several decades to come. In August
is the possibility that major gas-exporting countries will           2003, the Russian government confirmed ‘Russia’s Energy Strategy to 2020’ (ES-
coordinate their investment and production plans in order to
avoid surplus capacity and keep gas prices up.                       2020), sketching the key trends and parameters for Russia’s energy sector. The
The Algerian national oil and gas company Sonatrach and              starting point is that the energy sector forms a fundamental element in Russia’s foreign
Russia’s Gazprom signed a memorandum of understanding
(MoU) on cooperation in upstream activities in August 2006.          policy. A major objective of ES-2020 is to align the energy strategies of Russia with the
This move has raised concerns among European gas                     EU and other major energy players, such as OPEC, to make a contribution to global
importers about its implications for competition and prices.
Such a coordinated action will put Europe at the mercy of two        energy security.
of its three largest gas suppliers.
                                                                     Aside from the recent changes in the Kremlin’s energy policy, there are doubts about
Source: IEA, World Energy Outlook 2006                               Russia’s ability to meet its future production targets. Several new fields, some located
                                                                     in harsh environments, will have to be brought on stream to compensate for the decline
                                                                     of maturing fields, while at the same time production must increase. This will
                                                                     necessitate considerable capex in upstream production, the upgrading of existing
                                                                     systems and new pipelines to markets in Europe and Asia.

                                                                     32                           Economics Department/Sector Research, September 2007

                                                            In its World Energy Outlook 2006 the International Energy Agency forecast that Russia
                                                            needs to invest USD 478 billion in its oil sector and USD 440 billion in its gas sector
                                                            over the period 2005-2030. Although the Russian government would prefer to raise the
                                                            necessary capital domestically, external sourcing will be inevitable.
                                                            In order to be able to attract foreign capital, financial investors have indicated that
                                                            several critical issues must be resolved, such as the definition of ‘strategic fields’.
                                                            Another major issue is the current Russian reserve classification system A+B+C1 (for
                                                            proved + probable reserves). This system will have to be brought into conformity with
                                                            international reserve classification standards such as US/SEC and SPE9, and
                                                            sustained by a reserves audit by external renowned consultants.
                                                            However, despite these issues, Russia’s potential is so great that the major
                                                            international oil and gas companies cannot afford to stand aside and wait for a more
                                                            favourable investment climate.

                                                                  The E&P momentum

                                                            The Oil Field Services (OFS) industry supplies products and services to all kinds of
                                                            companies involved in the Exploration and Production (E&P) of oil and gas in onshore
                                                            and offshore areas. Drilling is the industry’s most important activity. In its broadest
                                                            sense, the OFS industry involves many other activities: seismic survey, installation, well
                                                            testing and completion, maintenance, pipelay, heavy lift and construction. In offshore
                                                            areas, in addition to several types of drilling rigs and ships, a host of other types of
                                                            vessels service the oil and gas industry.
                                                            The key challenge for oil and gas companies is meeting their production growth
                                                            targets. As the development of new resources have long lead times, oil and gas
                                                            companies therefore have to take a long-term view on their supply base and depletion
                                                            rate, allocating their E&P (or upstream) spending accordingly. During the oil price
                                                            plunge of 1998/1999, E&P spending was cut drastically due to the reduced level of free
                                                            cash flow.

                                                            Driven by the continuing strong global economic growth, oil and gas demand has
          World E&P investment 2004-2007
                                                            increased considerably over the past few years. Limited E&P spending in the period
                          USD bln
                                                            1999-2002 has narrowed the gap between global oil and gas demand and production
 400                            uncertainty range           capacity. High energy prices combined with poor reserve replacement ratios at several
 350                                                        oil and gas majors have created a strong impetus to increase E&P spending. Leading
 300                                                        indicators in the oil field services industry, such as day rates, rig counts and seismic
 250                                                        crew counts, have shown a positive development since 2003.
 150                                                        According to a study by IFP (Institut Français du Pétrole), world E&P spending in 2006
 100                                                        was estimated at USD 267 billion, up 25% from the amount spent in 2005. As the
                                                            search for new oil and gas fields continues, IFP expects E&P spending in 2007 to grow
                                                            by 20-25% to USD 320-335 billion. Although part of the increase can be attributed to
              2004       2005       2006F           2007E   cost inflation, there is surely growth in volume as well. It is believed that the Middle
              North America          Latin America          East, West Africa, Southeast Asia and Russia will show strong growth in E&P spending
              North Sea              Other                  in 2007 and beyond.
              Russia & China         Total 2007

Source: IFP

                                                            9 The current most widely used standards for the classification of oil and gas reserves are those
                                                            developed by the US Securities and Exchange Commission (SEC) and by the Society of Petroleum
                                                            Engineers (SPE).

                                                            33                              Economics Department/Sector Research, September 2007

                                                                     Organic production growth and reserve replacement have become important issues for
      The structure of the Russian OFS market,
               USD 11.4 billion in 2006                              Russian oil and gas companies. Vast investments will be made over the coming
                                                                     decade, which will make the oil field services sector very important to Russia. The size
                            WF Integra
                                    SSK                              of the Russian oil field services market was estimated at USD 10 billion in 2005, with
                                       Small /                       an expected growth of 20-25% from 2006 to 2007.
                                                                     The Russian oil field services industry currently consists of several hundred local
           Oil                                 BK
        company                                                      companies, offering a wide range of services. These local companies vary considerably
        in-house                                                     in size, from one-product SMEs to the internal services departments of the large
                                   SB                                Russian oil and gas companies. In the past few years, some oil and gas companies
                                                                     have outsourced their oil service activities.
WF = Weatherford, HB = Halliburton, SB = Schlumberger
                                                                     There are also many international companies active in the Russian OFS sector. These
Source: Douglas-Westwood/Integra                                     can provide the quality, reliability, sophistication and know-how that most of the local
                                                                     companies are not able to deliver. Foreign companies accounted for about 15% (USD
                                                                     1.5 billion) of the total Russian OFS market in 2005. US-based oil service companies
                                                                     are currently the major foreign suppliers to the Russian market, and are mainly active in
                    Russian OFS market                               the high-end part of the market. But they are facing increasing competition from
                          USD million                                suppliers from Canada, Japan, France, Germany, Italy, Norway and the UK.
 20,000                                                              The ageing production base and the potential growth of Russia’s oil and gas sectors
 15,000                                                              offer significant momentum for upstream development and rehabilitation equipment

 10,000                                                              and services. According to consultant Douglas-Westwood10, the Russian OFS market
                                                                     is set to double in value over the next five years: from USD 11.4 billion in 2006 tot 22.5
                                                                     billion by 2011. “The sector will be driven by increasing use of outsourced services and
                                                                     a move to western business models”, the consultant concluded.
           2005 2006 2007 2008 2009 2010 2011
                                                                     Western companies can profit from the Russian oil field services boom, as modern
              Logging and Seismic
              Drilling, workover, technology services, etc.          technology is often lacking. A major problem is the lack of unified norms and standards
                                                                     in the Russian oil field services sector, such as the internationally used ISO, API and
Source: Douglas-Westwood/Integra
                                                                     CEN certifications. Russian companies are therefore actively seeking collaboration with
                                                                     foreign partners to import expertise, technologies and technical advanced equipment.
  Russia - Expenditure on facilities by component                    Foreign participation will be particularly needed as Russian projects are likely to
                                                                     become more complex and challenging, and will move to frontier areas. A prime
                                                                     example is the Shtokman field in the Barents Sea that will need operational partners
                                                                     with expertise in LNG transport and deep water gas production, the kind of expertise
 20                                                                  Gazprom does not currently have.

                                                                     Contracts for oil services in Russia are usually awarded through tenders, with
  0                                                                  price/quality the major competitive aspect. Working with local companies via
       2004     2005     2006     2007    2008     2009       2010
                                                                     partnerships or joint ventures is often the best strategy to gain access to the market.
        Oil & Gas Production       Refining & Gas Processing
        Pipelines                  Maintenance & Modifications
        LNG Terminals

Source: INTSOK Annual Onshore Market Report 2006

                                                                     10 Douglas-Westwood, The Russian Oilfield Services Market Report 2007-2011, “the first publicly
                                                                     available report detailing the multi-billion dollar opportunity in this high-growth sector.”

                                                                     34                              Economics Department/Sector Research, September 2007

                                                  Chapter 6: Agrifood

                                                  The Russian market for food and beverages was worth about EUR 160 billion in 2005.
                                                  It is Europe’s third-largest market in terms of size after Germany and France. Russia is
                                                  one of the fastest-growing markets for food and beverages in the world, expanding by
                                                  20 to 25% in 2004/05. Russian consumers spend about 40% of their income on food
                                                  and beverages. Favourable economic developments, higher disposable income,
                                                  improving market access, new players in the market and a more stable political climate
                                                  have expanded the consumer market and triggered a change in consumer patterns in
                                                  Russia. In the coming years the market for food and beverages will grow further as real
                                                  incomes continue to increase.

Top-10 Dutch exports of Agrifood products 2005    The rise of food retail
                 x USD 1 mln                      One important factor in the growing food market is the rise of food retail in Russia.
Germany                                  13,461   Though food is still largely sold in Russia through traditional distribution channels such
United Kingdom                            6,242   as weekly and daily markets (known as the ‘rynok’), Russian food retail is rapidly
France                                    5,686
                                                  coming to the fore. The first supermarket in Russia dates back to the late 1980s.
Belgium                                   5,114
                                                  Hundreds of supermarkets are now being opened each year in Russia, particularly in
Italy                                     4,096
United States                             2,297   the large cities. Foreign retail chains are buying local chains and existing stores. Small
Spain                                     2,035   independent retailers are increasingly making way for multiple chains and large
Sweden                                    1,111   shopping centres while hypermarkets are springing up around the country. This trend is
Russian Federation                        1,019   set to continue in the coming years. The rise of the supermarkets is particularly crucial
Denmark                                    945
                                                  for manufacturers of branded articles. Supermarkets carry a larger product assortment,
                                                  which mainly draws people with higher disposable incomes. However, the growth of the
Source: UN/Comtrade
                                                  retail sector is mainly confined to the major cities such as Moscow and St Petersburg,
                                                  where supermarkets virtually account for all food sales. In the more remote areas, food
                                                  is still largely sold via markets and roadside stands.

                                                       Exports from the Netherlands to Russia

                                                  Alongside the consumer markets, the local food industry has also grown rapidly in
                                                  Russia over the past years, with annual growth running at about five per cent per year.
                                                  This growth in local food production was made possible by the expansion of production
                                                  capacity and the Russian government’s policy of stimulating home-grown produce.
                                                  Nevertheless, local food production is not growing fast enough to keep pace with
                                                  accelerating demand. A sizeable share of the products (over 40% in 2006) is therefore
                                                  sourced from abroad. The most important exporting countries are Brazil, Ukraine,
                                                  Germany and the United States. The Netherlands is among the top-10 suppliers to

 Dutch exports of flowers and plants to Russia    Russia. Total agricultural imports from the Netherlands amount to about EUR 1.0
                 x EUR 1 mln                      billion. The most important product groups are flowers and plants, fruit and vegetables,
2000                              46.4            meat and dairy.
2001                              73.8
2002                              86.9            Flowers and plants
2003                             103.6
                                                  Russian consumers love flowers, especially roses. The Netherlands is the most
2004                              93.4
                                                  important supplier to the Russian market. Dutch exports of nursery flowers and plants
2005                             101.0
2006                             128.4            to Russia increased by 27% to EUR 128 million in 2006. Russia has thus climbed to
                                                  become the ninth largest purchaser of flowers and plants from the Netherlands.
Source: HBAG                                      Phytosanitary requirements sometimes impede nursery exports.

                                                  35                           Economics Department/Sector Research, September 2007

         Fruit and vegetables
         Dutch fruit and vegetable exports to Russia grew by over 50% in 2006. However, this
         percentage does not accurately reflect the greater demand for Dutch products. In the
         first two months of 2005, exports were at a standstill due to an import ban on vegetable
         products from the Netherlands.
         Per capita fruit and vegetable consumption is small. Russians do not have a great
         culture of eating fresh vegetables and consumption is largely limited to the rougher
         (and cheaper) types of vegetables such as onions, various kinds of cabbage and
         carrots. However, interest in a more varied diet is increasing and, as a result, demand
         for fruit and vegetables such as tomatoes and peppers is growing strongly.

         Per capita meat consumption showed a steady decline in Russia until 2004, then
         received a strong impulse in 2005. The consumption of mainly pork and poultry
         continued to grow thereafter, while beef consumption decreased.
         Domestic production in Russia is not sufficient to meet demand. Additional imports are
         therefore necessary. Russia imports about three million tons of meat annually, and the
         EU is an important trading partner. The Russian market for meat is a particularly
         interesting one because the Russians tend to purchase parts of pigs and cattle that are
         less in demand in the EU. This often concerns meat with a higher fat content. Russia is
         constantly threatening to impose an import ban on European meat.

         The Russian market for dairy produce is rapidly expanding. Russians traditionally
         consume lots of dairy products. Russia is the most important export destination for
         butter from the EU.
         After a dip in 2004 and 2005, butter exports to Russia rebounded in 2006. In the first
         ten months of 2006, 38,600 tons of butter were exported, an increase of one third
         relative to the entire previous year. The main beneficiaries of this increase were
         Poland, Lithuania and the Netherlands. One of the reasons behind the increased
         exports to Russia is that butter exports from Ukraine have largely ground to a halt due
         to the Russian import ban on dairy products from that country.

         Netherlands AgriBusiness Support Office
         In 2004, the Netherlands Agribusiness Support Office (NABSO) was set up in Moscow.
         This is an initiative of the Dutch Ministry of Agriculture, Nature and Food Quality and is
         supported by several industry and marketing organisations from the Dutch horticultural
         sector. This support office is entrusted with the task of improving and expanding
         exports of flowers, bulbs and trees from the Netherlands to Russia. In addition, the
         office provides information to Russian entrepreneurs and establishes contacts between
         Russian and Dutch entrepreneurs who are active in horticulture.

         Import tariffs
         Certain products are subject to import tariffs. Meat imports that fall within the set import
         quota attract an import duty of 15%. Imports of products in excess of the quota are
         subject to duties varying between 60% and 80%. Some products, such as sugar, are
         taxed at extremely high rates.

         36                           Economics Department/Sector Research, September 2007

                                                                   Food and beverages that are exported to Russia must be accompanied by a certificate
                                                                   confirming that the products have been tested and meet Russian food safety
                                                                   standards. Institutions that issue such certificates must be recognised by the Russian
                                                                   Federal Agency for Technical Regulation and Metrology (FATR).
                                                                   Some products are subject to further requirements in addition to the aforementioned
                                                                   mandatory certification. The ‘Federal Service for Veterinary and Phytosanitary
                                                                   Supervision of the Ministry of Agriculture’ is the body responsible for food products.

                                                                         Dutch companies are investing in Russia

                                                                   Opportunities for foreign investors
    Russian demand for agricultural and food                       Two trends are visible in the Russian food industry. Firstly, a consolidation process is
      machinery and equipment increasing
                                                                   taking place, and smaller companies are being bought by the larger players. Secondly,
Due to the reform and modernisation in the food industry, there    the sector is undergoing vertical integration, with processing companies acquiring
is a large demand for machinery and equipment. In the
agricultural sector the demand for modern machinery is also
                                                                   interests in their suppliers.
significant, but supply is lagging. By 2006, Russia had 572,500    Due to the rapid growth in the food market, the Russian food industry is in great need
tractors (shortfall of 36%), 156,600 harvesters (shortfall of
48%), 40,300 forage harvesters (shortfall of 37%), 199,100         of investment, both on a small and large scale. Many production processes are
cultivators (shortfall of 47%) and 248,200 seeders (shortfall of   obsolete and are incapable of meeting the rapidly rising demands in terms of both
32%). Annual demand for new agricultural machinery and
equipment is estimated at USD 3.0-3.5 billion. As financing in     quantity and quality. About half the production facilities in the food industry are ripe for
the agricultural sector remains a major problem, commercial        replacement and only an estimated 20% of all facilities meet international norms. The
leasing has become an important alternative financing tool.
                                                                   Russian government has made an effort to improve the investment climate, but
The increase in disposable income has resulted in higher
demand for more variety in food products. The domestic
                                                                   investments are mainly being made in the energy sector and raw material sectors,
poultry sector, for example, has seen explosive growth of 15-      while investments in the Agrifood sector are lagging.
17% per annum due to stimulation by the Russian government
in the form of soft loans. The domestic industry is incapable of
meeting the huge demand for equipment and machinery from           Opportunities abound for foreign companies interested in investing in Russia. It is
the poultry sector and is unable to compete with foreign
suppliers, which can offer a full range of higher quality          therefore not surprising that foreign investments in Russia have risen sharply since
products. This offers opportunities for Dutch companies to         1999. The best prospects for investments within the food sector are offered by the dairy
supply the Russian market with high-quality machinery and
equipment.                                                         sector, the poultry sector, the beverages sector and the confectionery sector.

Source: U.S. Commercial Service, Agrarisch Dagblad
                                                                   Dairy sector
                                                                   The dairy industry is the least developed branch of the Russian food industry.
                                                                   Productivity is very low and the sector is inefficiently organised. Dairy production fell
                                                                   particularly sharply after the collapse of the Soviet Union. Milk production has not
                                                                   increased in recent years and is unlikely to show growth in the near future. As
                                                                   previously noted, the Russian market for dairy products is growing fast. Russians
                                                                   traditionally consume a lot of dairy products and the expanding range of choices gives
                                                                   the market great growth potential.
                                                                   The most important Russian dairy player is Wimm-Bill-Dann. Foreign companies that
                                                                   have invested in local dairy factories are Danone, Ehrmann, Arla and Campina.

                                                                   Poultry sector
                                                                   The poultry sector constitutes the most important sub-sector in the Russian Agrifood
                                                                   industry. Demand for poultry products is set to increase further in the coming years.
                                                                   Russia imposes quotas on meat imported from abroad and strict veterinary
                                                                   requirements are in force. An increase in domestic production is therefore necessary to
                                                                   meet demand. There are plentiful opportunities for Dutch companies to invest in
                                                                   Russian poultry processing companies.

                                                                   37                              Economics Department/Sector Research, September 2007

         Beverages industry
         Within the beverages sector, the beer market holds the greatest potential for the
         coming years. The beer market currently accounts for about 40% of the total alcoholic
         drinks market in Russia. Beer consumption is increasing at the expense of vodka,
         which is set to experience a decrease in demand in the coming years.
         The most important beer brewers and their beer brands are: Baltika with Baltika 3
         Klassicheskoye, Sun Interbrew with Klinskoye and Ochakova Moscow Beer, and
         Softdrinks Enterprise with Ochakova. Heineken is the third-largest brewer in Russia
         with a market share of 15%.

         In the soft drinks category the consumption of fruit juice is rising rapidly. The Russian
         company Wimm-Bill-Dann (with a subsidiary in the Netherlands) is the largest producer
         of fruit juices followed by Lebedyansky and Multon. Jointly, these companies hold
         about 75% of the total fruit juice market. Growth in this market is being achieved thanks
         to a modernised and increased production capacity, but the marketing of fruit juices
         has also improved compared to the past. Russians’ growing health consciousness is
         another factor boosting demand for fruit juices.

         The confectionery sub-sector is experiencing rapid growth. Russians traditionally have
         a sweet tooth. Russia is Europe’s fourth-largest market for confectionery in terms of
         size and has already attracted many western investors. More than half the market is
         dominated by foreign companies. Nestlé and Mars are examples of western producers
         that have established a presence in the Russian market.

         Advisory organisations
         There are also opportunities for advisory organisations in the field of technical advice
         and project development in the agricultural sector. There is a lack of experience in this
         field and the demand for knowledge of new-build projects is strong. Advisory
         organisations that open locations in Russia can respond quickly and efficiently to this

         38                          Economics Department/Sector Research, September 2007

         Chapter 7: “Doing Business is People’s

         In this chapter we have included interviews with a number of Dutch companies active in
         the Russian market to place the findings of the report in the perspective of the day to
         day reality of doing business with Russia.

         We thank the representatives of these companies for their time and willingness to
         participate in these interviews. We are convinced that their expressed views constitute
         a valuable contribution to this report.
         In this context we would also like to thank the interviewers, Mrs. Mar Oomen and Mr.
         Joep Auwerda, who made these interviews possible.

         1. Campina in Russia:
         ‘Ask for support from the local authorities’
         ‘Establish a good relationship with the local authorities’

         If you want to set up a business in Russia, first you have to establish a good
         relationship with the local authorities. This is the advice of Bob Steetskamp, who for
         two years has been Campina International’s managing director for Russia and the
         former Soviet states. And, he adds, it’s best to do business the Russian way. There are
         a lot of restrictions initially, but ultimately anything’s possible.

         Over seven years ago, in 2000, Campina built a dairy plant 80 km south of Moscow in
         the city of Stupino. It was a ‘slimmed-down’ operation, as Steetskamp describes it,
         speaking from Moscow. With 80 employees and one yoghurt line to ‘limit the risks’.
         Now the company has 400 staff and there are three yoghurt lines, two ‘dairy drinks
         lines’ and a ‘coffee cup line’. Steetskamp: ‘We’ve designated Russia as Campina’s
         fourth home country. The other three are the Netherlands, Belgium and Germany,
         where 70 percent of our turnover is generated.’
         In 1992, Campina began exporting yoghurt from Germany to Russia. That developed
         very favourably: every year more trucks full of yoghurt travelled east. Until the rouble
         crisis hit in 1998. From then on Campina sold nothing at all to the former East Block
         country. Steetskamp: ‘Exports fell to zero. Then we decided to launch our own
         production operation. Given the financial crisis, this was an extremely courageous
         decision. But everyone realised there were also significant opportunities for Campina.
         The home markets were saturated, so in order to grow, we had to go abroad. It was a
         logical step to expand our activities in Russia given that our success with exports had
         proven there was a market for Campina products there. Moreover, Russia is relatively
         close, it is a big country with a huge potential for growth.’

         Enormous sales market
         It quickly became clear that we had to build the plant near Moscow. With 16 million
         inhabitants, the region is an enormous sales market. And there is enough good quality
         milk in the area. There were various large cattle farms, Steetskamp explains; former
         kolkhozes with 1,000 to 1,600 cows. The choice was made for the city of Stupino, a
         former military and industrial city where unemployment was high due to the collapse of
         industrial activities. ‘When we started, the only entertainment was a petrol station
         where you could buy a beer. Now it’s a thriving city with shops and restaurants, and

         39                             Economics Department/Sector Research, September 2007

                                                                   unemployment has fallen to zero. The local authorities have done their best to attract
                                                                   foreign investors. The governor of the region made a personal effort. Without the
                                                                   support of the local authorities, we wouldn’t have made it. We would never have been
                                                                   able to comply with all the bureaucratic rules that are so typical of Russia.’
                                                                   The region’s farmers were also pleased with Campina’s plans. When the Soviet
                                                                   economy ground to a halt, so did the agrarian sector to a large extent. The farmers
                                                                   were happy to supply milk to the Dutch plant. However, things didn’t always run
                                                                   smoothly. Steetskamp: ‘The Russians were and are very adept at breeding cows but
                                                                   the quality of their milk was poor. The milk wasn’t refrigerated, for instance, and there
                                                                   were problems with hygiene. This prompted us to set up a development programme
                                                                   and train people locally. We gave the farmers favourable loans so they could install
                                                                   cooling tanks. Now there are around 16 farms in all, which supply us with a total of 200
                                                                   tonnes of milk a day.’

                                                                   Campina in Russia is not a cooperative, as is the case in the Netherlands and the rest
                                                                   of Europe. Instead, the milk is purchased from the suppliers. The company in Russia is
                                                                   an LLC and a wholly-owned subsidiary of Campina, which leases the land the plant is
                                                                   built on from the Russian government for 49 years. The staff are nearly all Russian,
                                                                   with only three expats among the 400 employees. Initially, there were more Dutch and
                                                                   Germans on site, primarily to supervise the Russian staff, but they have since left.
                                                                   ‘Business must be conducted with Russians by Russians,’ says Steetskamp. ‘And it
                                                                   should be conducted the Russian way. In other words: nothing is a given, but anything
                                                                   is possible. You have to be flexible. Including when it comes to credit terms. We can’t
                                                                   require a client in Vladivostok to pay within the same timeframe as one in Moscow –
                                                                   our products take a lot longer to get there. And in fact the payment morals in Russia
                                                                   are an important point of attention. We need to be careful with credit limits, so if an
                                                                   invoice remains unsettled for too long, we need to get right on it. And we won’t make
                                                                   another delivery until the last invoice has been paid.’

                                                                   Red tape is the biggest headache
                                                                   The biggest problem in Russia continues to be bureaucracy and regulations. Every
Some tips...
                                                                   product has to be inspected and certified. Every new investment must be reviewed by
1. If you want to set up a business in Russia, first you have to   the local authorities. If a new machine has been purchased, it can only be used if the
   establish a good relationship with the local authorities.       authorities have checked it for safety, hygiene and so on. And every new product the
2. Business must be conducted with Russians by Russians,’          machine produces is required to undergo extensive certification before it is sold.
   and it should be conducted the Russian way.
                                                                   Steetskamp: ‘If you don’t comply with the rules, production can be shut down. When it
3. Be careful with credit limits.                                  comes to this, the law is very complex. But there are plenty of people in Russia who
                                                                   can advise you on such matters.’
                                                                   Campina would greatly benefit if Russia joined the WTO. Ninety percent of Campina’s
... and some comments.
                                                                   sales are generated locally and 10 percent are imported. Imports are subject to an
• The biggest problem in Russia continues to be bureaucracy        even more complicated procedure. ‘For instance, they want to know the origins of the
  and regulations.
                                                                   raw materials in every product, which is sometimes unfeasible for us. If the laws and
• Campina would greatly benefit if Russia joined the WTO.’         regulations are harmonised, we can supply products to Russia that are accepted under
• Russia will be the largest food market in Europe in 2010.        European regulations.’
                                                                   Despite the quirks involved in doing business in Russia, the plant in Stupino was an
                                                                   excellent investment. It is showing profitable growth. And the market for Campina
Website                                                            products – ‘products with added value’ – is expanding. Russia will be the largest food
                                                                   market in Europe in 2010, Steetskamp predicts. Russian consumption patterns are
                                                                   very similar to those in Europe, particularly in comparison to Asia. That makes Russia
                                                                   very attractive. ‘In Russia, they eat cheese sandwiches too.’

                                                                   40                           Economics Department/Sector Research, September 2007

         2. Jørgen de Ree, Managing Director of De Ree Holland BV
         ‘The Russians are loyal, reliable customers’

         Sometimes he receives a simple letter from a consumer in Siberia, addressed equally
         simply to: De Ree, Lisse, Holland. ‘The tulips have come up beautifully; you supply
         good bulbs.’ Apart from demonstrating that the Dutch postal services can still find an
         address without a postal code or even a street name, Jørgen de Ree, managing
         director of De Ree Holland BV in Lisserbroek, likes to recount this anecdote chiefly to
         show that his products can cope in temperatures of minus 15° Centigrade. Provided
         they’re planted deep enough, that is.

         De Ree Holland hasn’t been active in Russia for long – only since 2000 – yet Russia
         has already become an important market for the Dutch bulb exporter. Jørgen de Ree:
         ‘We export to 35 countries and Russia has climbed to fourth place. The United States,
         UK and France are in first, second and third place respectively, and they each take
         roughly the same volume of goods from us. The other top ten countries are Germany,
         Canada, Sweden, Austria, Switzerland and Norway.’

         De Ree’s Russian sales account for approximately EUR 5 million. In 2006/7, all the
         Dutch bulb exporters together posted a turnover of EUR 18 million in Russia. This
         illustrates how important Russia is for De Ree. ‘It may not happen in the first ten years,
         but I’m firmly convinced that the Russian market will become just as important for the
         bulb sector as the American market.’ On his office desk stands a bottle of vodka. The
         label features a photo of Jørgen de Ree together with the words The Best Partner. It
         was a gift from a good customer whom he looked up in Moscow just a week before
         giving this interview. While he was out there, Jørgen became more convinced than
         ever that Russia is becoming a consumer economy like the West. ‘I visited an
         enormous supermarket at ten o’clock at night and there were at least 15 people
         queuing at each of the 100 checkouts. Just think of that: 1,500 people all ringing up
         their purchases, with 5,000 additional customers walking round the aisles. It looked like
         someone had announced happy hour.’
         ‘Initially we thought that Russian consumers would only really be interested in our
         cheaper lines. But that’s not the case at all. In fact, our high and medium-priced bulbs
         are the first to sell out. Russia takes as much of our most expensive and luxurious
         products as the rest of Europe. As an exporter, you’ve got to understand what people
         want. Don’t think you can simply fob the Russians off with lower quality goods if they
         haven’t asked for them. They know what quality is, and they won’t settle for anything
         less. That’s my number one tip: make sure you deliver quality.’

         Get yourself a good website
         In fact, Jørgen de Ree didn’t have to do much to attract customers in Russia: they
         came to him. ‘In 1999 and 2000, we knew that we were supplying to Russia through a
         German and a Polish distributor. But we didn’t know exactly who we were supplying.
         We found out when they came and looked us up. The Russians always want to go
         directly to the source. I would estimate that in the past couple of years we’ve had
         around 25 potential Russian clients visit us. Nine eventually placed orders. You can
         often identify the serious customers as soon as you meet them. To begin with, they
         take the trouble to make an appointment; they don’t just drop in. You very soon notice
         that they haven’t got much time and have no problem meeting our payment conditions,
         which is settlement in full prior to delivery. I won’t do business with would-be customers

         41                          Economics Department/Sector Research, September 2007

                                                                  who aren’t prepared to meet those terms. Serious potential business partners usually
                                                                  come well prepared. They’ve done their homework on the Internet and elsewhere. So
                                                                  that would be my second tip: get yourself a good website: one that’s transparent, up-to
                                                                  date and in English; it doesn’t have to be in Russian.’

                                                                  De Ree was incidentally cautious before doing business with his new customers. Just
                                                                  as his prospective clients conducted research on his company, he also investigated
                                                                  them. For that, a network in Russia is crucial, and it can often be built up simply by
                                                                  visiting the right trade fairs in Russia. De Ree: ‘I’ve always been able to talk very openly
                                                                  with the Russians at these fairs, because I’m very open about my own company.
                                                                  They’re happy to share their knowledge.’

                                                                  The Russians, says De Ree, are reliable, loyal business partners who aren’t going to
                                                                  switch to a competitor just to save one tenth of a per cent. They understand that
                                                                  everyone in the chain from grower to consumer has to get their fair share. Loyal
                                                                  customers of De Ree with a proven track record of creditworthiness can often pay only
                                                                  half the invoice in advance and the rest 14 to 30 days later. ‘Sometimes I’ll be happy
                                                                  with a fax for a banker’s order, and so far, I’ve never been let down. Once or twice,
                                                                  though, I’ve had to postpone a delivery until the funds have cleared.’

                                                                  Russians are just like the Dutch
                                                                  The Russian way of doing business is very similar to that in the Netherlands. De Ree:
                                                                  ‘In terms of directness, they’re just like us. They may appear a bit more surly at first, but
                                                                  they can become very relaxed once you get to know them better. They’re also efficient
                                                                  and keen to learn. For instance, one of our Russian customers had registered 50
                                                                  complaints about our shipments. That was an awful lot, especially when you consider
                                                                  that the total number of complaints we’d received from all 35 of the countries we export
                                                                  to came to just 85. When I visited the customer to look into the matter, we found that
                                                                  only two complaints involved substantial amounts. He was a bit embarrassed about this
Some tips...                                                      and immediately told his secretary to raise the lower limit of complaints.’
1. Make sure you deliver quality.
                                                                  ‘It’s well known that the Russians can sometimes be rather blunt and like to hammer
2. Get yourself a good website: one that’s transparent, up-to-
   date and in English; it doesn’t have to be in Russian.         their fist on the table for what in our view was no apparent reason,’ says De Ree. One
                                                                  of his customers once did this, even though De Ree only speaks two words of Russian
3. When you go to Russia, take a mobile phone with you,
   because if you don’t you’ll be completely stuck.               (‘yes’ and ‘cheers’) – and he noticed that the female interpreter was leaving many
                                                                  phrases out of her translation so as not to upset him too much. ‘She knew her boss
                                                                  didn’t need to take things to that level, and everything worked out fine in the end.
… and some comments
                                                                  Russian businesswomen really are the top. They seem to beaver away quietly in the
• Russia is becoming a consumer economy like the West.            background, but in fact they often hold very senior positions with lots of responsibility.

• Russian businesswomen really are the top. They seem to          What’s more, they’re perfectionists. I’ve got at least three Russian companies as clients
  beaver away quietly in the background, but in fact they         with all-woman management teams – and they’re a joy to do business with.’
  often hold very senior positions with lots of responsibility.
  What’s more, they’re perfectionists.
                                                                  De Ree’s third and final tip is this: ‘When you go to Russia, take a mobile phone with
                                                                  you, because if you don’t you’ll be completely stuck. When I’m in a taxi with a driver
                                                                  who speaks no English, I’ll call the hotel reception and ask them to explain where I
www.deree-holland.nl                                              want to go. And don’t forget: the traffic in Moscow is so often gridlocked that you can
                                                                  usually only manage one or two appointments a day.' That’s the downside of the ‘new,
                                                                  open, liberal West’.’

                                                                  42                           Economics Department/Sector Research, September 2007

         3. Mammoet in Russia
         A good business contact is based on friendship

         Even if you or one of your employees speaks impeccable Russian, you need to hire a
         native if you want to do business in Russia. This is the firm belief of Roderik and
         Patrick van Seumeren, president and vice president of the Schiedam-based company
         Mammoet, which specialises in solving heavy lifting and transport challenges. Patrick
         van Seumeren: ‘Only a Russian knows the language and culture so thoroughly that he
         (or she) can help you manoeuvre through all the rules and regulations.’

         Mammoet (the Dutch word for mammoth) is a specialist in moving – ‘both vertically and
         horizontally’ – any large structure including factories, bridges, refineries, drilling
         platforms, reactors and, of course, submerged submarines. In 2000 Mammoet
         managed to successfully salvage the Russian submarine Kursk. Roderik van
         Seumeren: ‘This gave a tremendous boost to our reputation in Russia. My brothers
         were personally decorated by Putin himself. The salvage operation was extremely
         important to Putin, who had promised Russia that the drowned marines would be
         properly buried.’
         Roderik and Patrick are cousins. Over 40 years ago Jan van Seumeren, Roderik’s
         father and Patrick’s grandfather, laid the foundation for Mammoet with Van Seumeren
         Kraanbedrijf SKB. The company has since grown to become world leader in its sector
         and employs around 2,500 people in over 50 countries. In Russia, Mammoet has
         operations in Moscow; on the island Sakhalin off the Russian east coast north of Japan
         and in Saint Petersburg. ‘Of course we are also present in some former Soviet states
         like Kazakhstan, Azerbaijan and Turkmenistan,’ Roderick van Seumeren explains while
         sitting in his office in the middle of the office block on the Schiedam port, with a view of
         several sky-high red cranes with the mammoth logo.

         Two major orders a year
         It all started back in the early 1990s with the purchase of a Russian crane. The Van
         Seumerens met the Russian Slava Zakharov, who was then a crane sales
         representative and is now Mammoet’s managing director in Russia. Shortly thereafter
         Mammoet was awarded a contract for the construction of the Olympic stadium.
         Mammoet opened a branch office in Moscow and quickly established a joint venture
         with Staal Constructia. Roderik van Seumeren: ‘Slowly but surely we developed a
         name and gained increasing trust. The Russians saw what we could do, we were given
         increasingly large orders and then the Kursk sank. Now we have an average of two
         orders a year, primarily in the oil and gas processing industry. For example, we
         transported an entire factory for both Shell and Exxon to Sakhalin.’
         The Van Seumerens may not say it directly, but without the help of their current
         managing director they wouldn’t have got to where they are in Russia. And if the Van
         Seumerens hadn’t dedicated as much time to the relationship with the managing
         director, he wouldn’t have offered to help them. According to Patrick van Seumeren, it’s
         all about gaining trust, which doesn’t happen by itself. Patrick van Seumeren:
         ‘Russians have been oppressed all their lives. They’ve always had to watch what they
         say. They couldn’t speak freely because an eavesdropping colleague might be a KGB
         spy. At the same time, they are very emotional people. In order to gain their trust you
         have to talk a great deal, explain, tell, communicate and, of course, drink – a lot.

         43                           Economics Department/Sector Research, September 2007

                                                                      For traditional Russians – like their managing director – a good business contact is
                                                                      based on friendship, brotherhood, mutual enjoyment of a successful project. This
                                                                      means there is one person at Mammoet in the Netherlands – Patrick van Seumeren –
                                                                      who maintains the contacts with the Russians. While the Mammoet office in America
                                                                      contacts the appropriate department for each specific problem, the Russians only call
                                                                      Patrick. And they call him for everything, from a flat tyre to a broken crane, which is
                                                                      also typically Russian. ‘Every day I get calls about little and big things, the contact is
                                                                      very intensive. And they always feel their problems should top the list. They don’t much
                                                                      care that I’m busy signing a multi-million contract. They should come first.’

                                                                      Russians are unfamiliar with depreciation
                                                                      Another noteworthy fact about Russians is that they don’t think much ahead. Perhaps
                                                                      because Russia is a former communist country. In any case, many decisions are taken
                                                                      ad hoc. And they are unfamiliar with depreciation. ‘How do you buy a new crane,’
                                                                      Patrick van Seumeren once asked a Russian colleague. ‘That’s your job,’ was the
                                                                      response. An attitude reminiscent of life under communist rule. Some time ago the Van
                                                                      Seumerens wanted to sell two used cranes and two old trucks. But this wasn’t allowed
                                                                      because these items were considered ‘capital under the articles of association’. In
                                                                      order to carry out the sale, the articles of association would first have to be amended.
                                                                      Van Seumeren: ‘These types of rules are starting to change. As is tax legislation.
                                                                      Taxes on profits used to be so high that you ended up in the red. That’s no longer the
                                                                      case. And they’ve got more realistic about granting permits.’

Some tips...                                                          Patrick van Seumeren explains that, until recently, it took six months to get a permit for
                                                                      special transport but the delivery date was often just two months away. Van Seumeren:
1. Even if you or one of your employees speaks impeccable             ‘That meant you had to be really creative.’
   Russian, you need to hire a native if you want to do
   business in Russia.
                                                                      The nouveau riche
2. It’s all about gaining trust, which doesn’t happen by itself. In
   order to gain trust you have to talk a great deal, explain,        Mammoet only carries out a project after it has the money in hand. ‘Incidentally,’ Patrick
   tell, communicate and, of course, drink – a lot.
                                                                      van Seumeren adds, ‘Russians always pay up.’ The company doesn’t work with bank
3. Only carry out a project after you have the money in hand.         guarantees or LCs. ‘It’s coming though.’ And Russians prefer to pay in dollars. ‘But the
                                                                      euro is quickly gaining ground.’ As far as the Van Seumerens are concerned, Russia

... and some comments                                                 doesn’t necessarily have to join the WTO. ‘We already know how everything works in
                                                                      Russia, which gives us a competitive edge.’
• For traditional Russians, a good business contact is based          Roderik and Patrick feel Russia has changed a lot over the past ten years. Particularly
  on friendship, brotherhood, mutual enjoyment of a
  successful project. The nouveau riche on the contrary               as a result of the emergence of the ‘nouveau riche’, as they call the 30 and 40-
  aren’t interested in helping you, they’re very impressed with
                                                                      somethings who have gotten very rich very quickly. Their mentality is very different from
  themselves, they’re only interested in dollars.
                                                                      that of the older generation. Patrick van Seumeren: ‘The nouveau riche aren’t
• Russia doesn’t necessarily have to join the WTO. ‘We
  already know how everything works in Russia, which gives
                                                                      interested in helping you, they’re very impressed with themselves, they’re only
  us a competitive edge.’                                             interested in dollars.’
• The Russian economy is still growing and for now, the               The differences between urban and rural areas have also increased, particularly
  possibilities seem endless.                                         between Moscow and the rest of Russia. Meanwhile, Moscow has become the most
                                                                      expensive city in the world.

Website                                                               The Van Seumerens don’t yet know what their future plans are in Russia. Roderik van
                                                                      Seumeren: ‘Our ambitions are undefined. We’re staying in any case. We have some
www.mammoet.com                                                       big Russian clients and the Russian economy is still growing. For now, the possibilities
                                                                      seem endless.’

                                                                      44                             Economics Department/Sector Research, September 2007

         4. Ottevanger Milling Engineers is successful on the Russian

         In 2009 it will be precisely a century ago that Dirk Ottevanger, a miller’s son, founded a
         regional windmill manufacturing company, laying the foundation for Ottevanger Milling
         Engineers BV. This globally operating company is located in Moerkapelle, not far from
         the windmill that once belonged to Dirk’s father. This company, with over 60
         employees, designs and manufactures large machinery for the grain processing and
         animal feed industry. It took on its first Russian projects back in the early 1990s.
         Ottevanger is currently involved in five projects and has successfully completed 15
         ventures, many of them of major size.

         Dick Ottevanger is third generation and no longer the company’s chairman, but is still
         closely involved. He has been to Russia at least 20 to 25 times on business. ‘It’s not an
         easy place to work, but certainly not an unpleasant country either. Culturally, the
         Russians aren’t so very different from us. I think the Asians, for example, are much
         harder to fathom. You can more easily build up a close – at times even friendly –
         relationship with Russians. Anyone wishing to do business there must take their time. I
         remember one of my first visits when I was invited for a birthday celebration where
         drink was flowing freely. The Dutch wouldn’t have been so quick to include a business

         A reference makes all the difference
         Ottevanger Milling Engineers started its pioneering work in Russia in 1989 and 1990
         when opportunities for foreign companies improved. Dick initially focused on winning
         contracts via a government agency that had contacts with state-owned companies.
         “The agency wanted to promote us, but nothing came of it. We still have a staff
         member in Moscow, Nicolaï, who worked for the now defunct agency.”
         For the very first project, which was carried out in Lindovskaya in 1994 and 1995,
         Ottevanger was approached by Euroconsult in Arnhem. Euroconsult was working on
         the Eastern Europe Cooperation Programme for the Agency for International Business
         and Cooperation, a branch of the Dutch Ministry of Economic Affairs. Ottevanger: “In
         any market completing your first project is good for your reputation. It gives you a
         reference. That makes a huge difference.” In 1995 business appeared to be picking up.
         Ottevanger: “Stork’s Peja Export BV, which had hundreds of people working in Russia
         and did a lot of business with state-owned companies, closed its doors. Ten people
         kept the branch office going and approached us. Which brings me to our most
         important tip: make sure you have an agent in Russia who is active in the local market
         or you won’t get anywhere. Once we had a serious agent, our business in Russia got
         off the ground.”

         Rouble crisis
         Unfortunately, Ottevanger’s success was short-lived as the rouble crisis threw a
         spanner in the works in 1998. “Big projects were scheduled but they all fell apart.
         Business didn’t pick up again for another five years.” And that highlights Ottevanger’s
         second tip: have patience and staying power; both are indispensable.
         At times, Dick Ottevanger flew specially to Russia to sign a contract with a business
         partner. Upon arrival he occasionally discovered something had gone amiss with the
         permits, or the client had key questions about the quote. Sometimes he came home

         45                          Economics Department/Sector Research, September 2007

                                                                  empty-handed. Other times, the issues were resolved. And there were also instances
                                                                  that the competition managed to steal the contract out from under them.
                                                                  Tip three: “You’re often well-advised to work with women in Russia, who can be more
                                                                  serious than the men. They are keen workers, often have a good command of foreign
                                                                  languages and are well-educated. It’s clear that there has always been a large
                                                                  proportion of females in the Russian workforce.”
                                                                  Erik Ottevanger, manager of the Moerkapelle branch (fourth generation and Dick’s
                                                                  son), doesn’t have to think long before remembering a project in Russia that didn’t
                                                                  quite go according to plan, to put it mildly. “I remember quite well that the client put a lot
                                                                  of pressure on us to deliver on time. So we did. Then it emerged that the Russians
                                                                  hadn’t done anything to prepare the location where the plant was to be built. There was
                                                                  nothing at all, not even a hangar to store the goods. For two winters our equipment was
                                                                  buried under a thick layer of snow. That made it difficult to get it up and running again;
                                                                  the worst part was figuring out which electrical components had broken down. Then
                                                                  there were endless discussions about the extra costs. We had to prove that the
                                                                  problems with the equipment were the result of being left outside. The client probably
                                                                  wasn’t all that interested in this project. It was a gas company that had invested in the
                                                                  agricultural sector under pressure from the Russian government.” We were, however,
                                                                  paid without a problem. As has been the case with nearly all Ottevanger’s Russian
                                                                  clients, this gas company paid the entire purchase price up front.

Some tips...
1. Make sure you have an agent in Russia who is active in the     Erik: “Normally, we don’t design and manufacture the equipment until we’ve been paid.
   local market or you won’t get anywhere.
                                                                  In a limited number of cases, we allow a 10 percent down payment with the remainder
2. Have patience and staying power; both are indispensable.       covered via a letter of credit. In such cases, a large percentage is due upon shipment
3. Work with women in Russia, who can be more serious than        and the rest three to four months after delivery. But we only do this if we have a very
   the men. They are keen workers, often have a good
   command of foreign languages and are well-educated.
                                                                  solid relationship with the client and we are nearly sure they can pay. We’ve never had
                                                                  payment problems with the Russians. It is often very difficult for Russians to get a bank
                                                                  guarantee. Usually they can get an LC, but the amount may be limited. One of our
... and some comments                                             customers wasn’t able to procure an LC for three million euros. So we allowed them to

• In any market completing your first project is good for your    arrange three successive LCs for one million euros each. Another noteworthy fact
  reputation. It gives you a reference. That makes a huge         about Russians is that they are very trusting. Sometimes they pay us 600,000 to
                                                                  800,000 euros in advance for a project and never ask for a bank guarantee even
• In a limited number of cases, we allow a 10 percent down        though we could easily arrange one. Something could actually go wrong on our end,
  payment with the remainder covered via a letter of credit. In
  such cases, a large percentage is due upon shipment and         but the Russians don’t lose much sleep over it.”
  the rest three to four months after delivery. But we only do
                                                                  Ottevanger has numerous success stories in Russia. For some three million euros,
  this if we have a very solid relationship with the client and
  we are nearly sure they can pay.                                entire feed plants were set up for a Russian chicken producer listed on the London
                                                                  exchange. Erik: “It went very well, despite a slight postponement of the delivery date.
                                                                  But that’s actually common in Russia. Russians are capable of a great deal, are well-
Website                                                           educated and have a high opinion of themselves, but their organisational skills are
                                                                  lacking. They’re frequently overoptimistic in their planning. Getting permits often takes
                                                                  a great deal of effort. We leave that to the client, who routinely hires a local project

                                                                  46                           Economics Department/Sector Research, September 2007

         5. Gebroeders Van den Berk B.V.
         ‘With patience and respect, you can do good business in Russia’

         Why does Russia have so much bureaucracy? Why do new, seemingly avoidable,
         practical problems arise every day? These are questions you often hear from Dutch
         entrepreneurs gaining their first trade experiences in Russia.

         Russian-born Svetlana van Son, who has lived in the Dutch province of Noord-Brabant
         since 1996, works for Boomkwekerijen Gebroeders Van den Berk in the town of Sint-
         Oedenrode. She is an advisor and sales manager for the Russian market, on
         permanent contract since 2005. Before that she worked as a freelancer, translating
         brochures and other documents for Van den Berk.
         Commenting on the frustrations experienced by Dutch businesspeople she says: ‘It
         works best if you have patience and respect for Russian customs and practices. You
         shouldn’t try to understand everything; some things won’t make sense. If a deal with a
         Russian client seems to be more or less finalised and the client then goes silent for
         weeks on end, don’t get emotional,’ she says. ‘Keep your cool. Consider it from a
         rational, business perspective.’
         ‘It’s not so difficult to do business if you don’t buy into all the talk and stories about
         fickle Russians who are incapable of planning and said to be incredibly curt and
         stubborn. Just be yourself and draw your own conclusions. Not only do countries differ,
         so do people. You might run across Russians who are more Dutch than the Dutch. And
         vice versa: Dutch who more than fit the cliché image of the curt Russian.’

         130-year-old plane tree
         Svetlana speaks fluent Dutch; at most you’ll hear a pleasant Flemish accent as she
         learned the language in Belgium. She started out as a German and English teacher, a
         legal interpreter and certified translator. Pieter van den Berk, an engineer, is the
         general manager of the family-owned business. Its beautiful, vast plantations, where
         thousands of trees are cultivated, are reminiscent of a park. Van den Berk is
         specialised in street and park trees as well as ornamental shrubs. The nursery can
         deliver over 800 varieties of trees and shrubs and excels at somewhat larger and older
         trees. Pieter van den Berk: ‘We have a huge plane tree that’s over 130 years old and
         even a batch of Taxus bonsai that have been looked after for over 100 years. You can
         buy trees from us that cost to EUR 30,000 and are so big you can only fit one in a huge

         Pieter: ‘During our 2002-2003 financial year we completed our first real sales
         transaction with a Russian client we met at the German IPM Essen trade fair. It’s still
         an important fair for us, as is Moscow Flowers. Now we have quite a few Russian
         clients; it’s an important market for us, which is why we work with Svetlana.’
         Svetlana: ‘We are often approached at trade fairs by Russians who are eager to set up
         a joint venture, even before they’ve purchased anything from us. In the case of a joint
         venture they usually want us to furnish the capital and products, while they provide
         knowledge of the local market.’
         Pieter: ‘This doesn’t interest us just now. I consider the cultural differences too great for
         this type of venture. We recently set up a nursery in Germany. It is a neighbouring
         country, but the differences with the Netherlands are significant. Moreover, Russia’s
         climate isn’t as suitable for a nursery.’

         47                            Economics Department/Sector Research, September 2007

                                                                    Solid market research is key
                                                                    Svetlana: ‘Our first tip: anyone interested in doing business in Russia should seek
                                                                    advice from Dutch people with experience in Russia and Russians familiar with Dutch
                                                                    Svetlana: ‘Tip two: do thorough market research at trade fairs, on the internet, and by
                                                                    following the Russian trade press. Make no mistake: Russians are very familiar with
                                                                    western products. They’re price conscious and are quite capable of assessing the
                                                                    quality of merchandise. They have more and more money to spend, they travel a lot,
                                                                    they know what’s for sale in the world.’
                                                                    Pieter: ‘We still have our very first client. That’s the delightful thing about doing
                                                                    business in Russia: the moment someone becomes a client, they’re a true client. They
                                                                    seriously examine the company they’re getting involved with, and don’t jump to a
                                                                    competitor for any little thing. It may take a little longer to build trust, but once you have,
                                                                    it’s unwavering.’
                                                                    Svetlana: ‘There’s a Russian saying: if you take your time to properly harness a horse,
                                                                    he’ll ride fast. You need to thoroughly prepare and cultivate good relations.’

                                                                    Of course this doesn’t mean everything will go perfectly. Pieter: ‘We once met with a
                                                                    potential Russian client who seemed to have everything in order. We were lavishly
                                                                    received, given a video presentation of the company, lots of grandstanding. The man
                                                                    was an incredible show-off but, in practice, not a good trading partner. So we walked
Some tips...                                                        away.’
                                                                    ‘Another time a group of Russians came to our company who were interested in placing
1. Anyone interested in doing business in Russia should seek
   advice from Dutch people with experience in Russia and           a sizeable order for birch and fir trees. It was July so I said: these trees are still in full
   Russians familiar with Dutch pitfalls.                           bloom and it doesn’t make sense to deliver them in August because they might not
2. Do thorough market research at trade fairs, on the internet,     survive. But they were in a hurry. I turned down the deal and they bought their trees
   and by following the Russian trade press.
                                                                    elsewhere. Indeed, the trees died and they came back to us. It’s important to properly
3. Don’t talk about politics. The Dutch applaud perestroika,        inform your clients.’
   but Russians might feel differently.

                                                                    Put clear agreements in writing
... and some comments.                                              Svetlana: ‘Russians like trees with colourful leaves. They also like large crowns. But big
                                                                    crowns mean a lot of water evaporation so it’s best to trim back the crown prior to
• Not only do countries differ, so do people.
                                                                    transport. Sometimes you need to thoroughly explain that to people.’
• The moment someone becomes a client, they’re a true               Pieter: ‘Everything should be crystal clear. For instance, we explain in no uncertain
  client. They seriously examine the company they’re getting
  involved with, and don’t jump to a competitor for any little      terms that it can be a problem if the trees are picked up from us later than scheduled,
  thing. It may take a little longer to build trust, but once you
                                                                    even if they’ve been paid for in advance as is the case with 90 percent of Russian
  have, it’s unwavering.’
                                                                    clients. (Ten percent – these are longstanding Russian clients – have a credit limit.) If a
• It works best if you have patience and respect for Russian
  customs and practices. You shouldn’t try to understand
                                                                    lot of trees are picked up late, quality can be lost. You need to thoroughly explain such
  everything; some things won’t make sense.                         things in advance and put it all in writing. If you don’t, your Russian partner might
                                                                    misinterpret. Communication is a challenge. Such misunderstandings are often
                                                                    inadvertent and due to inexperience. Svetlana always accompanies me to meetings
Website                                                             with Russian clients. This is an enormous help. It’s not just the language barrier, but
                                                                    the cultural subtleties, which she understands perfectly.’
                                                                    The third and final tip comes from Pieter: ‘Don’t talk about politics. The Dutch applaud
                                                                    perestroika, but Russians might feel differently.’

                                                                    48                            Economics Department/Sector Research, September 2007

         6. For Econosto, Russia is a top market in the making

         Econosto is still a relatively new player in the Russian market. And yet, this wholesaler
         in valves and seals landed a contract in May 2006 to supply all the seals – a total of
         18,000 – for the construction of a new oil refinery in Saint Petersburg. The order is
         worth a whopping 40 million euros. Project manager Tim Hogervorst and financial
         manager Otto de Vries are still amazed at how the negotiations proceeded. ‘It was like
         being at an auction. We had to write figures on paper and wait out in the hall.’

         It all started a few years earlier. Billionaire Vladimir Bogdanov, the owner of Russia’s
         second-largest oil company Surgutneftegaz, wanted to construct a hydrocracker in
         Kirishi near Saint Petersburg using the latest techniques. It was to be a plant where
         hydrogen would be used to convert heavy distillates into diesel and kerosene, for
         example. The international engineering firm ABB Lummus Global BV in The Hague
         would provide the necessary technology, design the equipment and draw up a short-list
         of western suppliers. Tim Hogervorst: ‘It took AAB years to land that contract.’
         In order to realise the project, ABB organised several information sessions for suppliers
         like Econosto and launched a tender round. Hogervorst: ‘Of course we listened very
         closely to AAB and negotiated with them intensively. We realised that participating in
         this project would be a wonderful way to gain access to the Russian market. Moreover,
         this project would enable us to learn a lot about that market in a short period of time.’
         De Vries: ‘Econosto was already doing business with Russian shipping companies and
         we were working with Russian agents, but we didn’t yet have a strong foundation in
         Econosto is a supplier of valves and seals. Seals are rings or discs of various shapes
         and sizes that prevent leaks. Valves are like faucets or open-and-close-systems; these
         can be heating faucets that cost a couple of euros or earthquake-proof sealant systems
         that run into hundreds of thousands of euros. In the over 12,000 m² distribution centre
         in Capelle aan den IJssel, the company has the largest European stock of DIN, ANSI
         and JIS appendages, instrumentation, seals and hoses of its own brand as well as a
         wide variety of products from international, renowned manufacturers.

         An amazing atmosphere
         For its Russian client, ABB was looking for a company that could supply all the valves
         needed for the refinery’s equipment. This made Econosto an attractive candidate. It
         was a major advantage to Econosto that the technical negotiations regarding the parts
         to be supplied were conducted in the Netherlands with ABB. This meant all the risks
         could be mapped out in detail. Hogervorst: ‘If we were awarded the contract, we would
         officially supply to ABB, which would be the exporting party. They are responsible for
         the technical equipment. Still, the big boss in Russia wanted to meet all the parties
         involved. ABB was not to be involved in the commercial side.’
         During the tender round, there were five major contracts to be assigned and three
         similar companies in Russia were invited to bid per contract. Negotiations were
         conducted with 15 companies over a three-day period, with each company represented
         by four to five senior staff members. De Vries: ‘The atmosphere was amazing. We were
         there with 15 companies that all knew one another in their market.’
         According to Hogervorst and De Vries, the owner, Bogdanov, wants the refinery to be a
         liberal organisation, ‘a professional global player that delivers the best products.’ De
         Vries: ‘Bogdanov wants everything to run as cleanly and objectively as possible. Every
         potential for corruption must be eliminated. Which is why he prefers to work with

         49                           Economics Department/Sector Research, September 2007

                                                                 Western companies. And we think it explains why he organised the auction in the last
                                                                 phase of negotiations.’
                                                                 Econosto’s biggest concern was the financial risks. It was determined at the beginning
                                                                 that Econosto would not be paid until after delivery. As we went along, we managed to
                                                                 cover all the risks with confirmed L/Cs.’
                                                                 The red tape involved with the customs certificates continues to be bothersome. ‘You
                                                                 have to dot all your i’s and cross all your t’s.’ In addition, every product Econosto
                                                                 supplies to Russia must undergo a thorough technical inspection. Russia works with
                                                                 different technical standards than the rest of the world. De Vries: ‘Even though we have
                                                                 ABB as our contact, we still have to meet the Russian requirements. All our products
                                                                 must be inspected by the authorities in Moscow, which takes six months. It would make
                                                                 a big difference if Russia joined the WTO; if it harmonised its regulations with those of
                                                                 other countries. We still consider this a learning experience. We’re getting to know a
                                                                 great deal about the Russian market in a short period of time.’

                                                                 Physically present
A tip...
                                                                 One of the things Econosto has learned is that doing business in Russia is much easier
1. Doing business in Russia is much easier if you are            if you are physically present. Then, it seems, anything is possible. The Econosto group
   physically present. Then, it seems, anything is possible.
                                                                 has Russian-speaking staff and has opened a small office in Moscow. All kinds of
                                                                 requests for products are now also coming from Russia. Occasionally Econosto is
                                                                 asked to enter into a joint venture with a Russian company. De Vries: ‘So far we
... and some comments.
                                                                 haven’t further explored any of these requests. They always involve companies that
• The red tape involved with the customs certificates            spread their funds among a number of firms for tax purposes. Then, six months later,
  continues to be bothersome. ‘You have to dot all your i’s
                                                                 they allow them to go bankrupt. The Russians were very open and honest about this.
  and cross all your t’s.’
                                                                 They showed us exactly how they did it and let us see their accounts. Of course as a
• It would make a big difference if Russia joined the WTO; if
  it harmonised its regulations with those of other countries.
                                                                 listed company, we cannot take part in this type of thing, which perhaps limits our
                                                                 options during this start-up phase.’
• The Russians would rather do business with Western
  companies than with Chinese or Indian firms. Sometimes         Nonetheless, according to Otto de Vries Russia could very well be a top market in the
  the motto seems to be “the more expensive the better”.         making for a company like Econosto. ‘It is a very big country with an enormous market
                                                                 and tremendous reserves. The Russians would rather do business with Western
                                                                 companies than with Chinese or Indian firms. Products from China and India are taboo.
                                                                 Sometimes the motto seems to be “the more expensive the better”.
Website                                                          We hope we can also profit from all the current investments in infrastructure. In the
                                                                 Netherlands, our market is limited; everything has already been built, everything is
                                                                 finished. Here, we only supply replacement parts or upgrades. In Russia it’s about new
                                                                 projects. Once they’re up and running, things move quickly.’

                                                                 50                           Economics Department/Sector Research, September 2007

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