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Should foreign investors in Russia be worried? Certainly it's a sign of concern that Anglo-Dutch giant Royal Dutch Shell (RDS.A) is on the verge of handing majority control of its $20 billion energy project in remote Sakhalin Island to Russia's state-controlled gas behemoth Gazprom. A deal isn't yet done but it looks like Gazprom will win after months of Russian government pressure on Shell, including the suspension of environmental permits for the project and the threat of criminal prosecutions and fines.



No doubt, the tussle over Shell's project, known as Sakhalin II, has tarnished Russia's international image. The surprising thing, though, is that the impact of the conflict on Russia's overall investment climate is likely to be limited -- for two main reasons.



The first is that, to a large extent, the case merely confirms a new energy policy that has become increasingly apparent over the last couple of years. To invest in large Russian energy projects, foreign investors need to team up with a Kremlin-approved partner. In the future, that's likely to mean either Gazprom or Rosneft, Russia's two state-owned energy companies. "The state companies, or Russian companies at a minimum, will have 51% of all major energy projects in Russia," predicts Chris Weafer, chief equity strategist at Russia's Alfa-Bank.



Different Industries, Different Rules

Investors who follow these new rules aren't likely to fall foul of the authorities. And with energy in desperately short supply globally, there is still no shortage of foreign companies eager to get a piece of Russia's energy pie. That largely explains why Russia can afford to play hardball.



The second reason the Sakhalin II case is unlikely to harm overall investment in Russia is that so far there have been clear differences in policy regarding foreign investment in various industries. The Russian government obviously regards energy as a key strategic resource -- a form of geopolitical as much as economic influence. That explains why the state has largely reasserted its influence over that sector.



But some three-quarters of all foreign investment in Russia -- a total of about $70 billion since the Soviet Union collapsed in 1991 -- has been outside the strategically important energy sector. This money has flowed into fast-expanding consumer markets for automobiles, banking, retail, and telecoms. Here, foreign investors have not encountered the pressure from the state that is so obvious to investors in energy.



Returns Over Risks

Some analysts argue that the legal concerns raised by the Sakhalin case cast a shadow over all agreements in Russia. "What it does for the investment climate generally is it says agreements are not worth the paper they're written on," says Stephen O'Sullivan, head of research at Deutsche UFG investment bank in Moscow.



But investors in Russia have long known that business there faces legal and political risks, as it does in other emerging markets. The issue is whether the returns are worth it. With many foreign companies in Russia posting annual sales growth anywhere from 25% to 70%, it's not surprising if many have figured the risks are worth the rewards.



High-profile cases such as Sakhalin also obscure the general improvement in the legal and administrative environment for business in Russia. When it comes to the day-to-day tax and regulatory issues that concern most investors, as well as the reliability of laws and the court system, investors say the situation has improved noticeably over recent years. Compared with the 1990s, "in terms of infrastructure for doing business, the business opportunities, and how businesses are doing, this is paradise," says Paul Melling, managing partner for Baker & McKenzie law firm in Moscow.



None Rest Easy

But for foreign investors in Russia, there is always uncertainty. For example, where exactly will Russia draw the line between "strategic" and "nonstrategic" sectors of the economy? Energy is clearly strategic, but how about other natural resources such as metals or forests? What about electricity, or banking? Divisions in the Russian government mean that it has never provided clear answers to these questions.



That's why, even though the problems facing Sakhalin II are a long way away for most foreign investors today, no investor can sleep entirely easily. "What happens in three years' time, with a new president? Does he say automobiles are strategic, or retailing? When does the next set of goalposts get changed?" says O'Sullivan. "That's the worry."