Russia's Trial Of The Century Former Yukos CEO Khodorkovsky is in the dock, and the company is fighting for its life. But the Russian oil industry is still pumping strong.
By Nelson D. Schwartz Reporter Associate Doris Burke

(FORTUNE Magazine) – Stretching his feet through the bars of his cage, Mikhail Khodorkovsky rarely looks up from the book he's reading on the history of authoritarianism in Russia. The former CEO of Russia's largest oil company--and still its biggest shareholder--hardly seems interested in the accusations of tax evasion, forgery, fraud, and theft being read aloud in a Moscow court this August morning. His former partner Platon Lebedev sits beside him in the cage, engrossed in a crossword puzzle. Around the dingy courtroom, with its fake-wood walls, guards in camouflage nod off as a prosecutor recites page after page of evidence. Even Khodorkovsky's lawyers seem bored: One dozes; the other sends text messages from his mobile phone.

Few in Moscow doubt that Khodorkovsky and Lebedev will be found guilty when this trial ends, or that they will face at least a few years in prison, which may explain the collective courtroom ennui. The outlook for Yukos, once the most widely held Russian stock in the West and the closest thing the country had to a blue chip, is only a little less bleak. The Kremlin has ordered the company to pay $3.4 billion in back taxes from 2000 and has signaled that Yukos may owe an additional $7 billion to $10 billion in taxes and fines.

The standoff between the Kremlin and Yukos has been more than a year in the making, but what had been a slow-motion train wreck has picked up speed recently. Yukos continues to pump about 1.7 million barrels of oil a day, even though the Russian government froze many of its bank accounts in early July, making bankruptcy a real possibility. In late August investigators raided company offices in search of documents to back up fresh tax claims. The coming days will be crucial--for Yukos, for the future of the Russian economy, for American investors who hold its stock, and for companies like Citigroup and BP that have poured billions of dollars into the country in recent years.

Within weeks the Kremlin will likely auction off Yukos's biggest subsidiary, Yuganskneftegaz, which was seized by the tax ministry in July. (The government has hired investment banking firm Dresdner Kleinwort Wasserstein to value the subsidiary, which is believed to be worth more than Yukos's tax liabilities.) At the same time the government is expected to sell a 7.6% stake in Lukoil, a rival oil giant that has taken Yukos's place as the biggest Russian company by market capitalization. In July, ConocoPhillips CEO James Mulva met with Russian President Vladimir Putin and Lukoil CEO Vagit Alekperov to discuss a deal. The Houston company is expected to snap up the shares for at least $2 billion; if the sale goes through, it will be the biggest show of support for Russia by a Western company since the Yukos affair began.

Mulva declined to comment about how the Yukos case may affect the Lukoil deal, but he has stated that he wants Conoco to be a "major player" in Russia. Exxon Mobil and ChevronTexaco are also looking for ways to increase their production there. Indeed, even though Yukos is on the edge of a precipice, the same cannot be said of Russia's oil industry--or its economy, which is expected to grow 7.5% this year. In early September, Russia announced that oil production was up 9.9% in the first eight months of the year and that exports had surged 18%. "Big Oil has to go to where the big oil is, and that's Russia," says Bear Stearns analyst Fred Leuffer.

What started out as a battle between Russia's President and its richest businessman has developed into a larger struggle between the oligarchs who dominate key industries and a Kremlin eager to reassert control over the Russian economy. "This is all about power politics," says James Fenkner, chief strategist for Troika Dialog, Russia's largest domestic brokerage firm. "The cruel lesson is that the beneficiaries of privatization, like Khodorkovsky, have to stay out of opposition politics." Khodorkovsky dared to challenge Putin directly, says Fenkner, and it's unlikely any oligarch will make that mistake again. Billionaire Mikhail Fridman, chairman of Anglo-Russian oil company TNK-BP, has clearly gotten the message. "I don't want to share my views publicly," he says, sitting in his office at Moscow's Alfa Bank, which he also controls. "We've never been associated with politicians."

The Kremlin's treatment of Yukos has many in the West worried about what it means for property rights in Russia. But aside from Fridman--who calls Khodorkovsky's jailing a "big tragedy"--local observers aren't shedding too many tears. "These guys were greedy, and that precipitated this crisis," says Al Breach, chief strategist for UBS Brunswick in Moscow. "However, in prosecuting these guys, the government is killing due process, which is hardly constructive."

While Yukos's American CEO, Steven Theede, struggles to keep the company afloat and talks about minority-shareholder rights and corporate transparency, there's a distinctly Russian character to the Yukos affair that wouldn't be out of place in a novel by Gogol, the 19th-century fabulist. Yukos executives didn't learn about the last seizure of Yuganskneftegaz until reporters called to ask for comment. And although the stock is traded in Moscow and New York City--its shares have plummeted by 75% since April--Yukos hasn't released any results for 2004; it's still sorting out its revenues and profits for 2003.

The most likely endgame is that Yukos, which supplies about 2% of the world's oil, will be dismembered by the Kremlin, and pieces will be sold off to pay the tax claims. The likely buyers? Russian energy companies like Rosneft, Lukoil, and Gazprom with close ties to the Kremlin. In what passes for optimism about Yukos these days, shareholders like Fidelity and banks such as Citigroup and Societe Generale are hoping the Kremlin will let the beleaguered company continue as a rump of its former self. That would be far better than bankruptcy, especially since the two banks arranged a $2.6 billion loan for Yukos less than a year ago.

"What certain bureaucrats are doing to Yukos appears arbitrary and extreme," says Bill Browder, who manages $1.4 billion invested by HSBC and other clients in his Moscow firm, Hermitage Capital Management. But, Browder adds, Khodorkovsky's methods of acquiring assets from the government was "far worse." The only ones that deserve any sympathy at all, he says, are Yukos's minority shareholders (his fund among them). "They're caught in the crossfire in a highly emotional fight."

Although Western observers remain focused on Khodorkovsky and Yukos, there's another question at stake: Will Russia overtake Saudi Arabia as the world's leading oil exporter and emerge as the West's most reliable source of energy? Foreign direct investment, as well as the billions Russian companies have raised in the West, has helped the country increase its oil output by nearly 50% over the past five years. If those investors were to be scared off, production growth would likely ebb. Indeed, Yukos has already cut its expected production growth for this year from 12% to 6%, a reduction of about 90,000 barrels.

With oil prices hovering near $44 a barrel and energy supplies at their tightest level in decades, this isn't a worry just for academics or CIA analysts. At slightly more than nine million barrels a day, Russia's current oil production is within shouting distance of Saudi Arabia's 9.5 million barrels a day, and Yukos has played a key role in boosting Russia's oil output in recent years. If that output doesn't rise with global demand, Americans are likely to start paying even more to fill up their tanks in the years ahead. Fears that the Kremlin's actions would interrupt production at Yukos helped drive crude prices to near $50 last month. If Yukos does collapse, oil prices will no doubt surge again. That's one reason President Bush's National Security Advisor, Condoleezza Rice, telephoned Putin's chief of staff in August to express concern about the Kremlin's handling of the Yukos case.

Sitting in a cafe on Moscow's Stoleshnikov Lane, Anton Drel seems in his element. A key member of Khodorkovsky's legal team, Drel eyes the beefy bodyguards and upscale shoppers walking by the Hermes, Louis Vuitton, Escada, and Ferragamo stores that line the street. Shoes sell here for more than what a typical Muscovite earns in six months. But for the small group of men that includes Drel's client, spending $2,000 on a pair of Berlutis isn't a big deal. As prices for oil and other natural resources have soared in recent years, Russia's new rich have prospered--Moscow today boasts more billionaires than New York City.

The vast majority of Russia's 144 million people haven't been so fortunate, of course, and the attack on Khodorkovsky and other oligarchs has tapped into deep populist resentment. But even arch-capitalists like Browder say Putin's campaign isn't motivated simply by a desire to punish Khodorkovsky for his political ambitions or stoke popular anger and cement his own power. Through rigged privatization deals in the mid-1990s under former President Yeltsin, says Browder, a few dozen businessmen ended up owning 40% of the Russian economy. "Putin wants the oligarchs to behave themselves by paying their taxes, to stop stealing assets and behave like normal business people," he adds. "A very effective way of doing that is to make an extreme example of the richest one."

And the Matrosskaya jail near central Moscow, a decrepit yellow-and-white building with barred windows and barbed wire on the roof, certainly fits the bill. Khodorkovsky, who is not permitted to talk to reporters, shares a cell here with several other inmates and is allowed a one-hour walk in the prison yard each day, according to Drel. He has plenty of time to think about why he didn't follow other oligarchs like Boris Berezovsky, Vladimir Gusinsky, or even his former partner Leonid Nevzlin into exile. Drel, predictably, says it's because Khodorkovsky wanted his four children to live in a free Russia. More likely, say observers like Browder and Troika Dialog's Fenkner, Khodorkovsky felt that his $15 billion fortune and his status as Russia's best-known CEO would protect him.

Now his status as Russia's best-known prisoner threatens to bring down the company he ran. One reason the government has frozen Yukos's bank accounts is to prevent Khodorkovsky, Lebedev, Nevzlin, and others behind Group Menatep--the entity that owns a controlling 44% stake in Yukos--from siphoning cash out of the company prior to a bankruptcy. The government also knows that any deal it cuts with Yukos would quickly boost the company's share price, benefiting Khodorkovsky and his partners. Unless these men give up their stake in Yukos, there's no reason to expect the heat on the company to let up anytime soon.

Khodorkovsky's continuing involvement in Yukos's affairs--Drel says he gets regular updates on the tax case from prison--is another reason that the company hasn't been able to come up with a compromise that might satisfy the Kremlin. "Khodorkovsky's only leverage is to say to the Kremlin, 'If you take me down, you take the rest of Yukos and the world with me,'" says Browder. "It's working--oil prices are up, and everyone is focused on Yukos." Fenkner adds that the Americans who serve as CEO and CFO of Yukos have only limited authority. "I can tell you that a foreigner in Russia is not an insider," says Fenkner, who has worked in Moscow for a decade. "The Americans are talented guys, but Khodorkovsky and Menatep are clearly in charge, and there's confusion in the executive suite."

Neither Theede, a former ConocoPhillips vice president who was tapped to be Yukos's CEO in June, nor CFO Bruce Misamore would comment on the case. But they have been racing to pay off the $3.4 billion tax claim, hoping to derail the expected auction of Yuganskneftegaz. Although the company expects to have handed over nearly $3 billion by the end of September, the Kremlin keeps tightening the screws. In early September it froze additional bank accounts, which Yukos said further endangered its ability to pay salaries and maintain operations. And even if Yukos manages to satisfy the entire 2000 claim before the auction, it's likely the Kremlin will simply hit it with an expected $4 billion claim for 2001. "Yukos believed in the integrity of the Russian court system," says company spokesman Hugo Erikssen. "We were law-abiding citizens and were confident we would win the tax cases in court." But as UBS Brunswick analyst Paul Collison notes, "This was never about the money or the Russian legal system. It's about politics and power."

Not long ago, Russia was considered the Wild East--at least as far as ordinary Main Street American investors were concerned. Those folks may still think about Russia that way, but the people who manage their money don't. According to recent filings, Fidelity owns several million shares of Yukos. Given the headlines, the Boston mutual fund giant may have already dumped some of those shares, but as recently as this spring it was still buying stock in the beleaguered oil company. The State Teachers Retirement System of Ohio made a smarter bet than Fidelity and now holds nearly half a million shares of Lukoil. Many other mutual funds, like Janus and AIM, are also big Lukoil holders.

All this shows how intertwined American investors have become with Russian oil, even grannies in Cleveland. It also underscores how Russian companies--including those, like Lukoil, still partially owned by the Kremlin--have become dependent on Western markets for capital. Western banks, too: Shortly before Khodorkovsky's arrest last fall, France's Societe Generale and Citigroup stepped in and led a loan syndicate that raised $2.6 billion for Yukos. Putin has stated that bankrupting Yukos is not in Russia's interest, but the government's often heavy-handed actions could result in just such an outcome. If that were to happen, it would be harder for other Russian companies to raise money abroad. And that would be devastating, not only for shareholders or lenders like Citigroup but also for oil consumers counting on rising Russian oil production.

With typically Slavic black humor, Troika analyst Oleg Maximov has come up with six different scenarios based on the titles of Dostoyevsky novels. Maximov says there's a 50% chance of the Possessed outcome, in which Yukos forfeits about $11 billion of assets to pay off its tax liabilities and manages to survive. The second-most likely denouement, The House of the Dead, which he rates at 30%, is that Yukos will go bankrupt and be liquidated.

Even though Yukos's fate is weeks, perhaps months, from being sealed, the House of the Dead scenario poses big risks for Putin. It took years for Russia to recover from its 1998 debt default. If Yukos collapses and Conoco walks away from a deal, capital flight would likely intensify. With foreign investors scared off, Putin would find it more difficult to fulfill his pledge to double Russia's GDP by 2010.

So far Putin has been careful to keep Yukos under pressure but not bring about its collapse. He has publicly kept his distance from the affair, letting the tax ministry and the courts fight it out. That has made for some bizarre twists and turns, such as the freezing, unfreezing, and eventual refreezing of Yukos's main assets. But it has allowed Putin and his advisors to claim they are respecting due process and private property rights, while making sure the decisions ultimately go the Kremlin's way. "Russians are expert negotiators," says Troika's Fenkner, "and brinksmanship is an art form here."

How will the chess game end? If the Possessed scenario comes to pass, and Conoco makes a deal, Putin could win the match with a flourish worthy of a grand master. Khodorkovsky, his onetime nemesis, will end up behind bars, while still-free oligarchs like Fridman pay their taxes and stay out of politics. At the same time, Putin will have helped push oil prices higher and filled Russia's coffers, while getting one of the West's oil giants to ante up billions for a small slice of a Russian company. He'll also have one less worry as he focuses on the rising threat of Chechen terrorism.

Besides reassuring investors, the sale of the Lukoil stake to Conoco could also tighten Russian-American economic relations and clear the way for other American oil companies, like Exxon Mobil and Chevron, to make deals. (Exxon eyed buying a stake in Yukos but backed away after Khodorkovsky's arrest.) The U.S. imports fewer than 150,000 barrels a day from Russia--about a quarter of what it gets from Iraq--but Oppenheimer analyst Fadel Gheit says Lukoil is eager to ship Russian crude to Conoco's east coast refineries.

More than most businesses, the world of Big Oil is as much about politics and diplomacy as about money. If Conoco can beat foreign rivals like France's Total to Russia's oil riches and deliver fresh Russian crude for American drivers, it's not just the Kremlin that will be pleased--so will the White House. President Bush hosted Putin and his wife at his Texas ranch in 2001, and Putin is one of the few foreign leaders whom Bush has embraced. Meanwhile, Conoco has been a generous contributor to the GOP, with its employees and political action committee donating more than $1 million to the party in the past four years.

Khodorkovsky's imprisonment and the Kremlin's increasing authoritarianism may make many Westerners uneasy. But most Russians will be content as long as the petrodollars keep flowing. As will major investors like Browder. "There are growing pains to becoming normal," he says. "Twenty-eight people are controlling the economy, and tens of millions of people are living in poverty and dying at the age of 57. If there's a bit of authoritarianism, but people are being paid their wages and living a better life, that's progress."

In the long run, the world's hunger for oil will trump any concerns about Putin's methods or the fate of Yukos. That may be a cynical analysis, but Russia has never been a particularly hospitable place for idealists or romantics. And drivers don't care where the crude comes from, as long as there's gas, preferably cheap gas, in their tanks. Oilmen can live with that--their motto is that you've got to go where the oil is. And that's exactly what they are doing.