Here's what Vitaly's Contrarian has to say about the recent Kremlin moves against foreign oil companies (in short, foreign investment in Russia is doomed, and with it Russia's last best hope to become a civilized nation). Note in particular how he exposes the outrageous propaganda of Russian stock broker Eric Kraus, who will do and say anything to get the unwitting to plonk their money into Russia so he can take a cut of it by convincing them that all is bright and rosy in Russia. He's one of the lowest forms of reptilian life in the venal Russophile universe.

I can’t say I was surprised to see that Royal Dutch Shell (NYSE: RDS.A) will be “selling” 50% plus one share of the Sakhalin-2 project to Gazprom for $7.5 billion. Several months ago, the Russian government wanted to take Royal Dutch Shell to court because it was ruining the environment. I suppose when the Russian government referred to the environment, it meant the economic environment, not Mother Nature. The “environmental” issue was very simple: Product sharing agreements (PSA) signed by the Russian government with Shell were not considered advantageous to Russia — at least not anymore.

The 7.5 billion-dollar question comes to mind: Did Gazprom buy a controlling stake in the Sakhalin-2 project at a fair price? It’s hard to say. $7.5 billion is not chump change, but Shell didn’t sell a controlling stake in the project — which, by the way, insured a replenishment of its dwindling oil reserves for years to come — at its own will. You don’t have to be a genius to figure out that after “selling” (I use that term loosely because it assumes willing participants on both sides) its stake in the Sakhalin project, the environmental issues will not be issues any more.

I’ll be blunt: The Russian government manipulated its environmental/legal levers to muscle an ownership stake in the project out of Shell, possibly at a significant discount. I understand that it’s so much easier to be sympathetic to the poor children and elders that this oil money is supposed to go to, than to a multibillion dollar, impersonal, foreign (Dutch to be exact) oil company.

It sounds like a Robin Hood act, taking money from the rich and giving it to the poor. It’s certainly not the first time this has happened in Russia. In 1917, on Nov. 7 (still a widely celebrated holiday in Russia), under the leadership of Mr. Lenin, the masses took from the rich and gave to … themselves. We all know how that story ended. You cannot have government thievery be a part of the free market system and expect the market to function normally.

The original Sakhalin deal

Eric Kraus who runs a Nikitsky Fund, a mutual fund that invests in Russia, pointed (opens PDF) out a study done by Alfa Bank Research, showing that the terms of the original Sakhalin PSA signed in the 1990s were unusually advantageous for Shell and its partners. For instance, usually PSAs are signed for 20 years. The Sakhalin deal was signed for 25 years and renewable at five-year increments at Shell’s discretion, forever — a very unusual clause. There were no caps on costs, and only after Shell was firmly in the black would Russia see anything from the project. According to Kraus, these favorable PSA terms are very uncommon. Cost overruns on the project did not help the issue, but if anybody ever tried to do business in Russia, they wouldn’t be surprised; The country is infested with bribe-hungry bureaucrats who make doing business in Russia prohibitively expensive and inefficient.

From today’s $60 per-barrel oil perspective, it appears that Royal Dutch Shell got a great deal in the original PSA, at Russia’s expense. However, in the 1990s when this deal was consummated, oil prices were much, much lower, and thus the breakeven point and risk for the project was a lot higher. Also, at the time, Russia was cash-poor and desperately needed foreign investment and the exploration and development know-how. Royal Dutch Shell is one of the best in the field and was willing to commit billions of dollars. And unlike Shell selling one of its best assets to Gazprom (a public company which is 39% owned by — and managed in the interests of — the Russian government), nobody forced Russia to sign the original contract in the 1990s.

Who needs the West?

Similar to Al Capone — a mafia boss sent to jail, not for his murderous crimes but for tax evasion — Mr. Putin & Co. went after Shell for “environmental” violations. However, in this case, Shell’s crime is its profitability in the face of the Russian government’s lust for oil money and control of natural resources. I don’t know if the environmental problems were really problems or not. Every time you drill for oil or gas in the middle of a wilderness, “environmental” issues could be found. But few things in Russia get done because of the environment, and this was no exception.

This very transparent act of renegotiating the terms of the contract that was signed more than a decade ago abusing the government-controlled legal system didn’t go unnoticed by foreign companies. Interestingly, even if Gazprom paid more than a fair price for the Sakhalin-2, since Shell was forced into the deal, the market perception of the whole affair will still be negative.

This isn’t the first time the Russian government has done something that has abridged the law. Using similar tactics, Russia stole (for lack of a better word) Yukos from its shareholders in 2004, sending its largest shareholder to jail, and has been gradually consolidating (deprivatizing) oil resources under the government (Gazprom) wing.

Ironically, the Russian government doesn’t care about foreign investment. It’s swimming in cash and doesn’t feel like it needs the West (or the East — two partners in the Sakhalin-2 project were Japanese) any longer. However, despite the appearance of economic prosperity, Russia is a one-trick pony. It’s blessed with natural resources (i.e., oil, natural gas, steel, timber, etc…), and that pony has been in popular demand for the last three years. Take the high commodity prices away, and Russia is back in the post-Cold War Stone Age: poor infrastructure, marginal rule of law (which is even more apparent now), and corrupt local governments.

So will this commodity-pony be in demand forever? Who knows? Predicting commodity prices is very difficult. But may Russia’s soul rest in peace if commodity prices take a dip.

Considering the recent deprivatization trends of the energy industry in Russia, oil and natural gas production is likely to face a long-term decline. All governments are ill-equipped to allocate economic resources, and the Russian government is no exception. There’s a significant mismatch between the duration of time politicians spend in office and the multidecade payoff of exploration and development expenditures of the oil and gas industry.

Faced with the allocation of Gazprom’s abundant cash flows, even a well-intentioned politician has tremendous incentives to divert the funds toward social programs (i.e., paying pensions to retirees, increasing teachers wages, etc…) that have a more apparent, immediate social impact (read re-electable) than exploration and development projects that require a tremendous outlay of capital upfront and have a payoff decades in the future.

Private enterprises such as foreign oil companies (not covert, government-controlled entities such as Gazprom) have the appropriate time horizons, the needed capital, and the know-how to get the oil and gas out of Russia. Unfortunately, in lieu of recent developments, they’ll be committing less capital to Russia rather than more.

After seeing the current developments, CFOs of foreign companies that were contemplating doing business in Russia are increasing their required return on capital assumptions in their models. As the required rate of return goes up, fewer projects become profitable — and less foreign capital will flow to Russia. Companies that have already invested in Russia — ExxonMobil (NYSE: XOM), BP (NYSE: BP), Conoco Phillips (NYSE: COP), and others — are wondering if they’ll be the next “environmental” culprits and may be trying to find a graceful way out. Can you blame them?