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Transneft under fire

The pipeline company's leaders are used to doing things their way, but a new shareholder, who has Kremlin-backing, sees things differently and wants changes

Transneft, Russia's pipeline infrastructure monopoly, is under pressure to open up its shareholder base and ditch its appalling reputation in the area of corporate governance.

The long-overdue overhaul is being spearheaded by Kirill Dmitriev, the chief executive of the Russian Direct Investment Fund (RDIF), the Kremlin-controlled sovereign wealth vehicle. Dmitriev was parachuted on to the Transneft board in July after the RDIF-related vehicles took a combined stake of almost 2% in Transneft, via a purchase of preferred shares.

Of this stake, RDIF directly owns 0.43%, while the Russia-China Investment Fund, which is a co-funding vehicle for RDIF and China's state-owned China Investment Corporation (CIC), owns another 1.49%. CIC has said it may invest in more shares.

Dmitriev, a former Goldman Sachs banker, wants to boost the shareholder base by allowing investors to buy ordinary shares. They are currently restricted to purchasing preferred shares, which offer lower dividend returns and less influence over the company. The state currently owns all of Transneft's ordinary shares.

He set up RDIF in 2011, with the aim of partnering with Wall Street fund managers on Russian private equity investments. That strategy never took off due to sanctions and the poor development of the domestic private equity market. Dmitriev then turned to co-investing in publicly listed companies with sovereign funds from Asia, Europe and the Middle East.

Transneft, which transports more than 90% of crude oil produced in Russia across a network spanning 50,000 km, has the worst corporate governance reputations of any Russian blue-chip. In 2012, President Vladimir Putin called for an investigation into allegations that $4bn was fraudulently siphoned off by its executives during the construction of an oil pipeline across eastern Siberia.

Transneft's tight-fisted approach to paying dividends to preference shareholders has also been a flashpoint for portfolio investors for years. Ordinary shareholders—state entities—were paid around two and a half times the dividend received by those with preferred shares recently.

UCP, a Russia portfolio manager, last year took Transneft to court over what it claimed was "illegal and unfair" treatment of preferred shareholders. UCP argued Transneft deliberately consolidated its profits in a subsidiary to avoid paying higher dividends and is ignoring a government command for state companies to make bigger payouts.

Prosperity Capital Management, a leading Russia investor, wrote to senior Russian officials last year to complain about the dividend policy and what it asserts is creative accounting by Transneft.

The letter says Prosperity is concerned by the situation where investors in preference shares received dividends smaller than holders of ordinary stock. Typically, preferred shareholders have priority rights to dividends in exchange for diminished voting rights.

90% - Share of Russian oil handled by Transneft

In 2011, a Transneft spokesman told this journalist that paying more dividends would curtail aid to orphans and other charity work. Higher dividends would reduce money destined for "the sick, supporting sport, renovating churches and monasteries," according to Transneft. Some of the company's charitable largesse extended to an aquarium and an organisation that helps retired Russian spies.

Transneft stock has been widely held by emerging-markets and Russia-dedicated funds. Its preferred shares, issued as part of a privatisation in 1995-1996, account for 22% of its equity, while the state owns all the ordinary shares.

Dmitriev believes investors' interest in Transneft can be resuscitated by converting preferred shares into ordinary stock.

"The broader list of corporate rights that ordinary shares enjoy will improve the protection of minority shareholders' rights and, as a consequence, will be one of the key factors to raise the company's investment attractiveness for international and Russian investors," Dmitriev told Vedomosti newspaper.

If the initiative leads to an increase in Transneft's market capitalisation, analysts believe the government has a plan for a further privatisation of Transneft. Ultimately, the RDIF and its partners may seek to cash out via a listing on an Asian bourse.

Meanwhile, Transneft's chief executive Nikolai Tokarev says the company has not ruled out a conversion of its preferred shares, but for now it "would like to keep the status quo".

A former KGB officer who was stationed in East Germany alongside Putin, Tokarev has been in charge since 2007 and has previously resisted any plans for further privatisation or to improve corporate governance.

The market's reaction to the arrival of new investors and Dmitriev's proposals has been muted so far, given the wider community's scepticism about Transneft's appetite to change.

The pipeline company is also subject to US and European sanctions related to the Kremlin's interference in the Ukrainian conflict.

Dmitry Loukashov, head of oil and gas research at investment firm VTB Capital, says sectoral sanctions are "a formidable caveat" for any plans to convert Transneft's shares.

"Any conversion or share split can only be exercised via the issuance of new shares, which would be subject to sectoral restrictions and, hence, would be un-investable for US and European investors," he says. "With this in mind, we would expect the government to give careful consideration to the RDIF suggestion and its implications, but it could well take some time doing so."

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