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May 27, 2009 | 11:04 GMT

9 mins read

Russian Oligarchs Part 2: The Evolution of a New Business Elite

Summary

Editor's Note: Part 1 of this series examines the oligarchs' rise to power, Part 2 discusses their confrontation with Putin, and Part 3 looks at Putin's successful efforts to co-opt or defeat the oligarchs.

In the bedlam following the Soviet Union's collapse, Russian laws were contradictory and unevenly enforced. The oligarchs thrived in this environment, gobbling up corporate holdings and creating empires of disparate parts. Then the ruble crashed in 1998, and a new wave of more business-minded oligarchs reconsolidated their holdings and created real empires. One of these oligarchs, the owner of oil giant Yukos, also had political ambitions, and he was the first to go when Vladimir Putin set out to remake the Russian business elite.

The Russian oligarchs emerged from the wreckage of the Soviet Union in 1991, taking advantage of organizational, economic and political chaos to form multibillion-dollar corporate empires. They did not create their empires in the traditional way — with the idea of building something permanent and sound — but instead used a variety of underhanded methods to amass their fortunes as quickly as possible. We say "underhanded" and not "illegal" because Russian law during this period was anything but clear. Large portions of the Soviet legal code were abrogated by the new Russian state while many statutes remained in place. In the bedlam of the Yeltsin years, much of the law became contradictory and — at best — unevenly enforced.

The oligarchs thrived in this environment. Some banded together to rig privatization auctions, allowing all to get pieces of Soviet industry for rock-bottom bids. Others monopolized the export of raw materials to the West, purchasing commodities at local (controlled) prices and then selling them abroad at much higher global prices. Still others gathered stock certificates that had been issued to workers who did not understand what it meant to have an equity interest in a corporation, swindling their way to majority and often total ownership. Others provided loans to the government when it found itself in dire financial straits and seized the ownership of state-owned firms when the government defaulted. There were even rare cases when an oligarch would acquire a company and its assets merely by reproducing corporate ownership documents on a home printer and then registering them with the state.

There was no coherence to the composition of corporate holdings that emerged from the Soviet wreckage. Most oligarchic empires were hodgepodges of unrelated assets, with oil firms owning cafeteria subsidiaries or metal smelters with pig-farm units. The new oligarchs were simply grabbing whatever they could however they could, with the goal of acquiring more of anything, whether it made business sense or not. The bottom line was not wealth generation but wealth extraction. Oligarchs gave very little thought to the future. It was all about what could be obtained now.

And they had no reluctance to use "extra-legal" methods in the process, from fraudulent accounting to hiring a private army to wrest control of an asset away from its rightful owner. While using a variety of methods to build their empires, oligarchs shared a common view of the state: they saw it as an increasingly irrelevant player, an entity to be stolen from and certainly not a threat.

1999-2003: Making Empires Work

This mindset changed with the ruble crash in August 1998. Until this point, the oligarchs leeched off of their corporate empires heedless of the damage they were inflicting not only on the country but also on their own assets. When the ruble devalued and most Russians were thrown into poverty, the oligarchs faced their first collective crisis. They discovered that the companies they had been aggregating were not performing particularly well.

The oil industry is perhaps the best example of this. A well-run oil firm requires regular reinvestment to maintain or re-drill wells to keep output steady, manage reservoir pressure and find new fields to replace aging ones. In the 1990s, very little of this happened. As a rule, the oligarchs simply worked their fields harder and harder to extract as much oil as quickly as they could. After six years of such activity, many fields were failing outright and Russian oil output had dropped by over one-third. When international oil prices tanked with the ruble crisis in 1998, many oligarchs found themselves unable to break even.

Similar problems beset most of Russia's oligarchs, many of whom discovered quickly — and belatedly — that they had run their empires into the ground. The result was a massive consolidation as a new crop of oligarchs pushed aside the old. Conmen and thieves gave way to (or transformed themselves into) actual businessmen. These were all businessmen who had their roots in the chaos of the 1990s, so it would be inaccurate to think of them as kind, law-abiding citizens, but they did begin to take a longer view of things.

Industrial empires were reconsolidated based on core competencies — oil companies divested their cafeterias, for example — and standard reinvestment and asset-maintenance practices were introduced. The oligarchs' holding companies formed or acquired limited banking assets to better process their firms' collective accounts and allow for internal lending to finance everything from operations to capital improvements to takeovers. In most cases, this was the first time anything had been accomplished with legitimate financing (albeit handled within each oligarch’s own holdings).

This period's defining moment came in early 2000, when Vladimir Putin called all the oligarchs to Moscow. Putin, a former KGB officer, became prime minister in August 1999 and acting-president in December 1999, then was elected president in his own right in March 2000. At the initial Moscow meeting, Putin made it clear that the state would make few to no additional divestments. From now on, the oligarchs would have to make do with the empires they already had, and their future wealth would be determined by how much business they could grow rather than how much they could pillage.

At the time, the government was not seeking to reclaim the oligarchs' assets for the state. But Putin did have two conditions. First, oligarchs had to pay their taxes. Second, they had to stay out of politics. It was clearly communicated that refusal to do so would result in aggressive state efforts to reclaim lost property. For the next three years, the oligarchs were left to their own devices and set about actually building their businesses. An oligarch-state truce largely held, and Putin spent most of this period consolidating his government and edging the oligarchs as a class steadily out of Russian political life.

2004-2008: Oligarchs, Silovarchs and Credit

In the eyes of the government, one oligarch continued playing the political game: Mikhail Khodorkovsky, owner of the oil giant Yukos, which at the time produced over 2 percent of global oil supplies. Khodorkovsky held the loyalty of a large number of state Duma representatives, used that influence to amend laws to make his corporate empire stronger and made little secret of his intention to succeed Putin as president. In 2004, the government brought the full power of a much-reinvigorated state to bear against Khodorkovsky and soon banished him to a Siberian prison where he languishes to this day.

In addition to underscoring just how much the Russian balance of power had shifted, Khodorkovsky's fall had a critical side effect: it toppled Yukos along with its master. Deeply engrained within the state's effort to bring down Khodorkovsky was a parallel effort to seize control of his assets, particularly Yukos. In a country as energy-rich as Russia — the world's largest natural gas producer and second largest oil producer — for the state to have the opportunity to command the country's largest energy company was key to having control over Russia's most important political, economic and social lever.

Using Yukos as an example, the Russian government went after the rest of the energy industry in the country and began targeting other sectors it deemed "strategic." During the Yukos break-up, the company's senior leadership was stripped away in various ways — including being exiled and charged with murder — along with Khodorkovsky. Yukos itself was broken up and was transferred to a new breed of businessman who reported not to the head of the firm or his shareholders but to the Kremlin.

This new breed was the "silovarch" — half siloviki, half oligarch. Silovarchs constitute a highly elite class since they are within the corporate boardrooms of Russia but have the Kremlin's support and resources of the siloviki (the federal intelligence apparatus, state prosecutors and judiciaries, even the armed forces) to protect themselves and their assets and to rid themselves of pesky rivals. With the nation's leader a former KGB operative, such tactics defined the government and eventually the rest of the country, although the system remained vertically stacked under Putin alone.

The silovarch class grew very quickly during this period as traditional oligarchs either misstepped or discovered there were ambitious men in the government who wanted their firms. Government tentacles extended into energy, metals and mining, diamonds, defense, aviation, banking, automotive, shipping, retail, agriculture and telecommunications. Today, Kremlinologists estimate that 78 percent of Russia's government, business and social leadership is currently linked to the Federal Security Service, successor agency to the Soviet-era KGB.

While 2004 marked a turning point in the Kremlin's attitude toward the oligarchs, it also marked a revolution in oligarch (and silovarch) thinking. The global economy was booming, and the United States, Europe and Asia were looking for prospective markets in which to invest. The legal murkiness and sordid corporate histories of most Russian firms — state and private — frightened away investors, and Russian IPOs were at best tepid affairs. So Russian banks and firms quit trying to attract discerning investors and instead started tapping Western capital markets more directly. Some of this was done by borrowing money from Western banks while most consisted of bond offerings to Western investors.

For the first time in the post-Cold War era, Russian business reached out for credit beyond the limited scope of local corporate empires. The subsequent credit engorgement — some half a trillion dollars in all flooded into Russia during this period — provided for the country's first real economic boom unrelated to energy prices (the fact that energy prices breached $100 a barrel in this period certainly did not hurt). The oligarchs and silovarchs (the latter backed by the full faith and credit of the Russian government) used this money to invest in infrastructure, apply Western technology to their operations and fund massive industrial expansions.

Next: The Party's Over.

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