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Interview

with Edward S. Verona, President and CEO, U.S.-Russia Business Council (USRBC)

08.04.2010 / Energyboardroom

Mr. Verona, you have been here in Moscow over the last few days to announce a new report commissioned by the USRBC and published yesterday. In this white paper, Norman Anderson says that Russia should be one of the largest and most dynamic infrastructure markets in the world over the next fifteen years, worth between $830 billion $1 trillion in the next decade. What could this white paper mean for America and US business, at a time when the US is looking to rebuild its economy?

Those numbers that you cited are the most optimistic estimates. Mr. Anderson stated in his research that in the next year, Russia’s capacity for absorbing infrastructure investment will be $36 billion dollars. Even this is a substantial expenditure, and in comparison to what has been spent in the last few years on infrastructure in Russia it is a vast difference.

What does it mean for American companies? It means there are opportunities for software designers and engineering contracting companies . There are opportunities for American financial institutions, which can provide long-term capital for these projects, or help to mobilise private equity. There are opportunities for US equipment manufacturers, in all areas of infrastructure.

There will also be opportunities created by that infrastructure for American firms that want to invest in Russia. This is especially important in the area of high technology, which is currently the focus of a great deal of attention, and particularly high on Russia’s list of priorities.

As part of President Medvedev’s plans to diversify and modernise the Russian economy, a senior Russian government delegation visited MIT in January, and in February hosted a delegation in Moscow from Silicon Valley. However, rather than allowing free market economics to stimulate innovation, Mr. Medvedev is convinced that modernization will come through the intervention of the state. What can the US share with Russia, as one of most technologically advanced economies in the world?

The Russians have adopted the term Silicon Valley in relation to this new scope of research and development. As an American I am very flattered that my country has provided such an attractive example of how to stimulate the growth of these innovative industries.

My only cautionary remark, based on what I hear from other people who are more closely linked to sphere is that Silicon Valley did not come about as a result of large government expenditures, a national development policy or selection of ‘national champions’. It was something that grew more spontaneously. It was nurtured by private equity and venture capital funds that provided just enough capital to small entrepreneurs who had an interesting idea to keep them going, but not so much as to “over-irrigate” them.

There also needs to be a legislative environment that is conducive to the growth of high technology-based industries, and with robust protection for intellectual property. The essence of an innovative industry is an intangible, intellectual product; and if entrepreneurs cannot protect that product with a patent, and resolve disputes over ownership, then it will be very hard to stimulate investment.

I am encouraged by the fact that the Russian government is asking for the views of venture capitalists and private equity investors. It suggests that they understand the role that those individuals play in fomenting growth in that sector. As I understand it, in order to foster such development, strong financial discipline is required. Investors should look to every company in their portfolios to reach a certain stage of maturity and development, and hold the recipient of their funds accountable to concrete results. This is the way that a tech sector can be developed that is both stable and sustainable.

Technology is one area where Russia is particularly focused at the moment, because of the aim to modernise the economy, but US-Russia trade is far more diverse from that, from aerospace to automobiles, and consumer goods to commodities. However, trade dropped significantly between the Russia and the US between 2008 and 2009 – from $34 to $23.5 billion USD. January 2010 saw increased figures for imports to the US from Russia, almost back to 2008 levels, but exports were significantly down, even from January 2009 figures. What do you think might be causing this? Is this just a result of the economic slowdown, or are there more factors at play?

That’s a good question, but let me preface my answer by saying that in 2001 total bilateral trade between Russia and the US stood at around $9 billion USD. Trade was up to $34 billion USD at the end of 2008, even though the latter part of that year the global economy was already in recession. The growth rate in over the 2001-09 period was a phenomenal 20% per year.

The US mostly imports oil and refined petroleum products from Russia, and the demand for these commodities is much more consistent and predictable. US exports to Russia include aeronautics, automotives, fast moving consumer goods and other discretionary items. These exports tend to be high-value products, the purchase of which can be postponed in times of economic difficulty. It’s reasonable to expect that in a very significant downturn – what some are calling the “Great Recession” — we see a very steep drop off in the purchase of those types of goods. Difficult lending conditions have exacerbated this situation.

The question now is this: As the Russian economy recovers and trade in general improves, will the earlier pattern of growth resume? Will we see the demand for those goods and services grow the way they did before? I am optimistic, but not naïve. There is a certain sensitivity in the Russian economic policy establishment to allowing the ruble to appreciate. It would make it increase the demand for imported goods and impded efforts to diversify the economy and stimulate non-traditional exports.

Although exports to America are up, the US has actually been a bit of a disappointment for Russian companies – Gazprom were looking to the American market as a major source of income in the years to come, but developments in the US shale gas market have meant that the US has now actually overtaken Russia as the world’s biggest gas producer. What opportunities are there for Russian oil and gas companies in the US today?

There is absolutely no question that the dramatic increase in unconventional gas production in the USA has turned the global gas market on its head. Thanks to advances in drilling technology, it is now possible to access gas located in horizontal layers of low-porosity shale economically. Some of the technological advances that made this possible were developed on Russian projects, such extended reach drilling, which was used with great success in the Sakhalin-1 Project, an Exxon-Mobil led consortium on Sakhalin Island.

It doesn’t appear likely that the US is going to be a significant importer of LNG in the foreseeable future, though that doesn’t preclude spot market purchases and arbitrage opportunities for LNG cargoes. The physical infrastructure is in place for receiving cargoes in the USA, and there are more cargoes moving around the globe, a situation conducive to the development of a spot market. This will work to keep the US shale gas market very competitive, which is a good thing. You’ve seen the price come down, and it’s a very beneficial development for American consumers and industry.

Less than a year ago, Gazprom opened its trading floor in Houston, and the company is now actively involved in trading in the North American market. Their aim was to get a feel for the market and understand the dynamics of US pricing and commodities trading. I assume that this move to North America was part of Gazprom’s long-term strategy. I don’t know whether at the time they made the decision, they anticipated the changes that have occurred as a result of the so-called “shale gale”, but being in the US allows them to experience these changes first-hand.

Gazprom has very ambitious plans for the North American gas market, and senior company officials have stated the objective of having a 10% share of it by 2020. I believe that rather than acquiring an American shale gas producer, Gazprom will instead seek to gain market share through organic growth: perhaps by bidding on federal leases and acquiring land in shale gas belts. That would be a bold move, and one that I think would be a positive development in US-Russia relations.

Would it be feasible? At times, it seems as if the US is as more conservative in its approach to granting market share to foreign companies than it claims to be.

Russia adopted the Law on Investment in Strategic Sectors in May 2009. At the time, the percentage allocations given to various industries with respect to foreign ownership (for oil and gas it was 10%) were seen as ceilings by people in the industry, and the government did nothing to dispel that assumption. However, after the financial crisis and the economic downturn, and a careful evaluation of the effects of that legislation, the government clarified that these percentages were just thresholds for vetting, not ceilings. Russian officials compared the Russian law to legislation in other countries, such as CFIUS in the US, which limits foreign participation in key strategic sectors.

Foreign investment has had a positive effect on the oil and gas industry in Russia. No one would argue, for example, that Russia would be better off today without the Sakhalin I and II projects, especially not the island’s inhabitants. The proof of the argument can be seen in those offshore regions where only Russian companies have been allowed to operate: the level of investment has not reached expected levels there, and so these regions remain largely undeveloped. In comparision, having foreign companies working at Sakhalin has meant that Russia today is part of global LNG market. That opportunity would not exist today without the investments made in Sakhalin by foreign investors.

I would equally encourage Russian investment in the USA: no Russian company has had an unfavourable CFIUS ruling. Although a review process exists, it is rarely invoked as a reason for stopping investments coming into the country. The only platinum producer in the US, Stillwater Mining Company, for example, is owned by Norilsk Nickel; Severstal is the fourth-largest integrated steel producer, and Russian companies account for around a quarter of the US steel industry today. This is not a problem for the workers in these companies. In many cases, if Russian companies had not come in, their jobs would have disappeared. Whilst the American companies that once owned these factories could not see a future for them, the Russian companies could, having been successful at turning around their own domestic steel industry. They understood what was entailed in taking a moribund steel plant and turning it into a modern facility.

One of the things that makes the US different from other major trading partners of Russia is that there is no physical infrastructure link; we don’t have a natural complementarity based on natural resources, in the way that Germany does, for instance. It is these energy links that allow a symbiotic relationship to develop between Russia and its largest trading partners.

The success that German companies have had in Russia is largely because the two countries have such a large bilateral trade balance. This is true of many countries in Europe: there is that energy link, and significant trade levels follow naturally.

Until recently, there was not a single molecule of Russian LNG or pipeline gas in the US. Diversifying America’s source of supply to more countries makes us safer; but if we had a larger presence of a Russian company like Gazprom in the United States, investing in the downstream, it would probably be a positive development in with respect to improving bilateral relations.

Do you see German-Russian relations as a good model for cooperation? Historically, both countries have had serious political issues with Russia, but today both are looking to increase trade.

I believe that trade tends to make better relationships. Countries that have strong trading and investment relationships understand each other’s interests better. A case in point is the China-US relationship. The two countries face a lot of serious political differences, but the trade relationship means that their leaders think carefully before they take rash actions, and tend to see things from the perspective of the other side a little better.

The rationale for creating the U.S.-Russia Presidential Commission was that the relationship has been too focused on military, foreign policy, and geopolitical issues, which tend to separate us, and very little in other areas: business, trade and culture. I like the analogy of putting ballast in the ship, so that when the winds blow we don’t get thrown up on the rocks.

Our bilateral trade in the best year with Russia accounted for about 1% of total US trade worldwide. Our trade with China in the same year was around 12%. There is a very strong preference in Russia for US goods and services. Many American companies have been very successful here – generally the larger companies with a long term perspective, that have the financial resources and the global reach, that really makes it possible for them to cope with a lot of the challenges of doing business in Russia.

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