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ITALY: Devil's Advocate

by Daniel FisherForbes
July 24th, 2007

Italian oil giant Eni has a long history of cutting deals with anyone. Now that its future hangs on Russia, has it finally met its match?

What makes Paolo Scaroni think he's so smart? The chief of ENI Spa, the world's sixth-largest publicly traded oil company, is heir to a long tradition of high-stakes dealmaking with rogues from Iran to Angola. These days Scaroni is guiding Eni into the nasty Russian energy business--and is convinced he can survive unscorched.

A lot rides on his bet. Eni already is the biggest customer of Gazprom, the Russian state-controlled gas producer that is nationalizing most domestic oil and gas production. Eni also shares control of one of the largest pipelines bringing Russian gas into Europe and recently announced plans for a pipeline across the Black Sea to Bulgaria that will solidify Gazprom's hold on the European energy market. Scaroni & Co. are also developing Kashagan--an estimated 13 billion barrels of oil reserves, the largest discovery since Alaska's Prudhoe Bay--in the former Soviet republic of Kazakhstan. The pipeline from Kashagan goes through Russia, which exerts influence over the $29 billion project. Eni has a 19% piece of Kashagan.

Eni is a formidable company. Last year it earned $11.6 billion on revenue of $108 billion. It controls Italy's main gas distribution company and its domestic pipelines; it has a 10% share of the nation's electricity. But if it is to survive on its own--and Europe's economy is to continue to grow--it needs to keep moving those hydrocarbons west. That has become difficult in a chilly geopolitical climate, where Russian President Vladimir Putin uses energy as a strategic cudgel. He has a habit of breaking contracts with foreign companies.

Scaroni says he can win at a game that has humiliated sizable competitors like Shell and BP with one-way "renegotiations" and outright expropriation of their reserves. "We are different from anybody else," says Scaroni, 60, who joined Eni two years ago after spending most of his career in the glass industry. "We've built an understanding of reciprocal trust [with Russia] nobody else has built."

Some of that trust flows from the $6 billion Eni ships east each year for the Russian gas that provides 25% of Italy's supply. Then there's Eni's famous ability to cut a deal with anyone.

Earlier this year, for example, Eni agreed to pay $5.8 billion for a collection of assets from Yukos, the bankrupt oil company founded by jailed Russian oligarch Mikhail Khodorkovsky. The agreement, reportedly brokered with the help of Italian Prime Minister Romano Prodi, contained an unusual provision: For the next two years Gazprom can buy most of the assets from Eni for $4.8 billion.

What, if anything, had Eni bought? Khodorkovsky's lawyer, Robert Amsterdam, denounced the whole transaction as a sham, designed to protect Gazprom from lawsuits by investors who have a $33 billion claim pending in the Hague over accusations the Russian government illegally stripped Yukos of its assets. "They're playing dirty, which is actually what you have to do to succeed in Russia," Amsterdam says. But he gives Eni backhanded praise for exploiting the situation. Even if Gazprom exercises all its options, the Italian oil giant will have purchased the equivalent of 1.5 billion barrels of oil for less than 50 cents a barrel.

At his office in Eni's Rome headquarters Scaroni smiles politely at the kerfuffle. The auction was fair, he says, and he's "hopeful" Gazprom won't exercise its options. Reason: The Russians need Eni's expertise in developing complex oilfields. Such logic hasn't saved his rivals from being double-crossed. But even if Gazprom snatches away most of the assets, Scaroni says Eni got "a phenomenal deal" in a world where reserves are hard to come by. "You don't find oil in Switzerland," he says.

With 6.4 billion barrels of oil equivalent in reserves--behind France's Total, with 11.1 billion, and ExxonMobil, with 13.6 billion--Eni is struggling to stay in the top tier of international oil companies. While it has investments in the U.S. and the North Sea, its biggest bets are in distinctly un-Swiss places--places known for, say, corruption (like Angola and the Congo) or tyranny (such as Iran and Venezuela).

Eni owns a 10% stake in the Bonny gas-liquefaction plant in Nigeria, for example, where troubles include kidnappings and a bribery scandal currently under investigation by the U.S. Securities & Exchange Commission. (Eni's American Depositary Receipts trade on the New York Stock Exchange.) It was the biggest foreign oil company in Libya in the years when Muammar Qaddafi was an international pariah, and it developed the massive South Pars Field in Iran, where it produces 700 billion cubic feet of gas a year for the Iranian market. (Like other foreign companies with investments in Iran, Eni has an exemption from U.S. sanctions as long as it doesn't increase its activity there.)

Dealing with scoundrels is par for an international oil company. Still, Eni's role as middleman between Russia and the West is fraught with risk. As the biggest gas broker in Europe, selling 3.2 trillion cubic feet a year (or 15% of demand), Eni is a critical player in the Continent's economy; gas consumption is expected to rise 2.4% a year while regional gas fields slowly deplete. By 2020 Europe could need an additional 11 trillion cubic feet a year of gas, more than double current imports. To get a feel for these magnitudes, note that a trillion cubic feet is worth maybe $7 billion when delivered to the end user. The U.S. burns 22 trillion cubic feet a year.

Most of Eni's gas will come from two places: Russia and Algeria. To hammer home the message of Europe's vulnerability, Putin sent his energy minister, Viktor Khristenko, to Algeria in January to discuss tighter business ties with its state-owned gas company, Sonatrach. That set off fears in Europe and the U.S. that Russia was trying to form a gas version of OPEC to extract tribute from EUropean consumers.

With 6.5 million gas customers, Eni is Gazprom's biggest collection agent in EUrope. It also has a half interest in a large pipeline connected to the Russian grid in Austria. It owns another pipeline between Russia and Turkey, and the largest pipeline to Algeria. Last year Scaroni extended Eni's contract with Gazprom from 2017 to 2035, while opening the door for the Russian colossus to begin selling gas directly in Italy as well as investing in Eni's exploration and electricity businesses. Eni has committed to buying at least 750 billion cubic feet a year, one-quarter of total Italian demand, or pay for the gas anyway (the price is a formula based mainly on fuel oil). With EUropean Union pressures to reduce its monopoly hold on the Italian gas market, Eni will have to increase its sales elsewhere to get rid of all that Russian gas. Scaroni hopes to burn some of it in electricity plants he's building in Italy.

Scaroni's willingness to cut deals with the Kremlin is not popular. Eni's Gazprom pact is "against the interests of the EU," Jean-Arnold Vinois, an EU energy-supply bureaucrat, reportedly harped at a May conference. Christophe-Alexandre Paillard, an official with France's General Secretary for National Defense, recently issued a report titled "Gazprom: The Fastest Way to Energy Suicide." His point is that Russia won't be able to deliver all the gas it's agreed to sell, because Putin's strong-arm tactics--like the recent ordeal in which Shell lost control of its Sakhalin Island project--is discouraging the $200 billion investment needed.

Scaroni shrugs. He says he's preparing to spend as much as $7 billion on the Siberian gas fields he bought in the Yukos auction, with production starting in 2011. He thinks the Russians need Eni's money and technical expertise as much as he needs their reserves. "We will remain in control and exist as long as we bring to the country something it doesn't have," he says.

Eni's long history in Russia might help. Ente Nazionale Idrocarburi (National Hydrocarbons Agency) was founded by Enrico Mattei, a self-trained businessman who made a career of defying authority. An anti-Fascist who resisted dictator Benito Mussolini, he was rewarded at the end of World War II with the job of liquidating the state-owned oil company. Still, he violated his instructions and drilled for oil--and found huge natural gas reserves in Italy's Po Valley.

With gas profits at his disposal, Mattei transformed himself into a petropopulist, promising cheap energy for consumers across EUrope. He controlled one of Italy's largest newspapers, Il Giorno, and emblazoned Eni's gas stations with a fire-breathing, six-legged dog. Operating largely without oversight, Mattei built refineries and chemical plants, and pipelines reaching as far as Bavaria. His crews were infamous for laying pipelines at night, without permission, and Mattei himself once boasted of having broken 8,000 laws and ordinances.

Mattei shook up the business by offering oil-exporting nations a bigger share of production. (He also reportedly tried to win a sweet deal by enticing the Shah of Iran with an Italian princess.) At one point British diplomats fretted that Mattei's dealmaking could "seriously prejudice the stability of the Middle East," according to The Prize, Daniel Yergin's 1991 history of the oil business.

He pioneered the oil trade with Russia, bartering drill pipe, petrochemicals and engineering services to the Soviet Union in exchange for crude. The Soviets supplied 38% of Eni's oil by the early 1960s. Mattei also wasn't above dealing with outlaws like Algeria's FLN movement, violent revolutionaries trying to overthrow French rule. Right-wing French terrorists reportedly tried to return the favor by attempting to sabotage Mattei's plane.

Fate finally caught up with Mattei in 1962, when his corporate jet crashed in a thunderstorm short of the Milan airport. A movie based on his life, Il Caso Mattei (The Mattei Affair), won the Palme d'Or at the Cannes Film Festival in 1972. Eni suffered through several decades as a corruption-laden state enterprise. The low point came in 1993 when its chairman, Gabriele Cagliari, died in jail during a scandal over bribes paid to Italian political parties to counter the power of the Soviet-financed Communist party. The cause of death was a plastic bag placed over his head. The official presumption is that Cagliari placed it there.

The Italian government sold 67% of the company to the public in the 1990s. Under Chairman Vittorio Mincato, Eni increased oil and gas production by more than 20% between 2001 and 2004 through successful exploration and acquisitions like the U.K.'s Lasmo Plc. Scaroni came in at a good time, when energy producers were enjoying handsome price gains.

Over the years Eni has developed a reputation for dazzling technical successes--and for infuriating competitors and U.S. officials. It built the Blue Stream pipeline connecting Russia and Turkey, for example, a $2.4 billion marvel that plunges as deep as 7,000 feet across the Black Sea. (Turkey later said it didn't need the gas.) Still, the project undercut rivals' plans--heavily backed by the U.S.--for pipelines directly linking former Soviet republics like Azerbaijan and Turkmenistan to EUrope.

Those countries now must export their gas through Russian-controlled pipelines, selling it for as little as $3 per thousand cubic feet at the border, while the EUropean price is closer to $9. The difference goes to "shady middlemen," says Deputy Assistant Secretary of State Matthew Bryza, in the Bureau of EUropean and EUrasian Affairs. "The gas market in EUrope is dysfunctional," says Bryza. "Somebody is reaping huge rents here."

Into this world walked Scaroni, who studied economics at Bocconi University and earned an M.B.A. at Columbia University. After a short stint in sales at Chevron he developed a reputation as a talented manager at French glassmaker Saint-Gobain and later ran the Italian manufacturing and engineering company Techint. (While there, Techint was caught paying bribes in the same political scandal as Eni's former chairman, Cagliari. "Everyone was part of the system," Scaroni says.)

He ran British glassmaker Pilkington Plc. from 1996 to 2002, cutting 10,000 jobs and reorganizing the company's international operations. "He's quite a skilled negotiator," says Sir Nigel Rudd, the British industrialist who brought him to Pilkington. The company constantly had to bargain with its then investor and now owner, Nippon Sheet Glass, over technology-sharing and other issues, Rudd says, and "we always got the best part of the deal."

Scaroni returned to Italy in 2002 at the behest of Silvio Berlusconi, Italy's prime minister at the time, to run Enel, the former state-owned Italian electrical utility company, where he sold off its water and telephone divisions. In 2005, as he was mulling a job with another foreign company (Scaroni won't say which), Berlusconi recruited him to run Eni.

Not an easy switch. Scaroni had a lot to learn, especially about Eni's most profitable business, exploration and production. "Reserves are a concept that doesn't exist in any other business," he says. The job at most companies is to reduce inventories, not increase them. But reserves are the lifeblood of any oil company and nowadays they exist mostly in unpleasant, risky places.

For all Scaroni's efforts, proved reserves at Eni have fallen 11% since 2004 to the equivalent of 6.4 billion barrels of oil. Venezuelan jefe Hugo Chávez is partly to blame: His government expropriated Eni's Dalcion field there last year, erasing 170 million barrels. Eni is seeking $830 million in proceedings before a World Bank panel. But Scaroni says he is "ready to negotiate a solution."

A bigger problem is Kashagan, where Eni won the job of building and operating the field after partners ExxonMobil and Shell--each owns around 20%, as Eni does--reportedly couldn't agree on which one of them should be in charge. Since then the project has been delayed by at least five years, with production now expected to start no earlier than 2010. The setbacks haven't done much for Eni's reputation and have hurt its stock which, at a recent $70.70, trades at a 10.3 price/earnings ratio, compared with 11.2 for Total.

Scaroni is betting that Kashagan will transform Eni into one of the best operators of big, highly complex oil and gas fields--and thereby impress the Kremlin. "EUrope cannot survive without Russia, and Russia has a deep need of Western technology," he says. Whatever the dicey politics of dealing with Russia, he insists, "I want to be their best friend."
The Power of the Spigot

Russian President Vladimir Putin has steadily tightened his grip on Europe's energy supply by taking over Russian oil and gas reserves and control of the pipelines leading west.

1997 Putin, then a rising KGB agent, awarded Ph.D. from the St. Petersburg Mining Institute, after a thesis on strategic planning and resources.

October 2003 Yukos founder Mikhail Khodorkovsky is jailed on tax charges and his independent oil company is dismantled.

January 2006 Russia cuts off gas supplies to Ukraine in price dispute; as a result, gas supplies in Hungary, France and Italy drop as much as 40%.

December 2006 Royal Dutch Shell is forced to sell majority stake in Sakhalin Island oil project to Gazprom for $7.5 billion.

January 2007 Russia cuts off 1.5 million- barrels-a-day oil supply to Belarus, triggering fears of oil shortages in EUrope.

June 2007 BP sells control of Kovykta gas field to Gazprom for a humiliating $800 million; future of TNK-BP partnership in doubt.





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