(FORTUNE Magazine) – Even by the rarified standards of London society, it was an extraordinary event. To introduce his Open Russia Foundation, Mikhail Khodorkovsky, then the 38-year-old chairman and principal owner of Russia's second-largest oil firm, Yukos, had assembled the cream of Britain's power elite, from BP CEO John Browne to former foreign secretary Douglas Hurd. As the high-powered crowd sipped champagne, Jacob Rothschild, a board member of the charity, hailed Khodorkovsky as a modern-day Andrew Carnegie, a J.P. Morgan, even a John D. Rockefeller. The young Russian was flattered, and who wouldn't be? Those were icons of robber-baron capitalism who had bought respectability in America.

Two years later, Russia's richest man sits in a Moscow jail, his Yukos shares apparently frozen by Russia's state prosecutor. Yukos says he is the victim of an illegal political campaign waged by Russian President Vladimir Putin. But Khodorkovsky clearly provoked a power struggle, financing opposition candidates and successfully lobbying against Putin's plan to hike oil taxes. Having built Yukos through takeovers and dodgy privatizations, his next goal, he told FORTUNE in August, was to exert political power. "I'm going to try to buy a democratic future for my country," he said. "And I have enough money and energy to do that."

Khodorkovsky's ambitions have backfired, at least for now. But what happens to him is unlikely to have much impact on whether Yukos and the rest of the Russian oil industry continue to thrive. BP's Browne, who recently consummated a $7.7 billion joint venture with three other oligarchs who owned Russian oil company TNK, says "nothing has changed" as far as BP's interests in the country are concerned. Menno Grouvel, Total's senior vice president for Europe and Central Asia, says his company is "still very much interested in" expanding in Russia and doesn't see the Khodorkovsky affair affecting its exploration agreement with Yukos in the Black Sea. Marathon Oil, which bought a west Siberian oil company for $280 million in May, says Russia remains a key element of its growth strategy. Shell says it still plans to put $1 billion into a Siberian joint venture, which is set to begin drilling in March. And while talks with Yukos have halted, oil analysts say that ChevronTexaco and Exxon Mobil may want to continue exploring the purchase of a stake in the company for as much as $20 billion.

"This is a story of a fight between the Kremlin and a wealthy oligarch who overstepped his bounds," says Eric Krause, head of equities at Sovlink, a Moscow investment bank partly owned by two oligarchs. "It really doesn't mean very much for the Russian oil business, or Russia."

The reason for this optimism is simple. Russia has more oil and gas reserves than any other country--nearly 350 billion barrels, almost 50 billion more than Saudi Arabia. While the lion's share is gas, controlled by Gazprom, Russia's oil industry has been largely privatized. Led by Khodorkovsky at Yukos, these companies have poured billions of dollars into their oilfields in recent years, raising production by 40% since 1998. As they have done so, they've watched their stock prices rocket. Yukos shares traded at 55 cents in 2000, about one-twentieth of what they trade for today, turning Khodorkovsky from a multimillionaire into a multibillionaire before he reached the age of 40.

As a result of this investment enthusiasm, Russia is now the world's biggest oil producer and a potential key supplier to the U.S. "I call it production on Viagra," says Neil McMahon, Sanford Bernstein's oil analyst in London. Backed by oil, Russia's economy has been growing by 7% a year, with oil and gas accounting for 55% of exports and 15% of GDP. Putin wants to double GDP by 2013, and he needs increased oil production to do so. Should the freeze of Yukos shares signal some new policy of returning oil assets to the state, Putin could kiss that goal goodbye, oilmen say.

Russia's oilfields, particularly in western Siberia, have only begun to be tapped. The opportunity has attracted not just Russians and the Western oil majors but entrepreneurs such as Howard Cooper, who runs tiny Teton Petroleum in Denver. Over escargots and lamb at the Pushkin restaurant in Moscow, Cooper waxes enthusiastic about Teton's joint venture with Goloil, a Russian company with a 25-year license to drill in Siberia. "Russia is extremely hot for business right now," says Cooper, who raised $10 million from private investors after Khodorkovsky's arrest--double the anticipated amount. "This Yukos situation creates some short-term concern, but the smart money is looking at this as an isolated situation. People realize that at the end of the day Russia has to get these oil assets developed."

Russia's oil is equally important to the Western majors. In the last few years, their efforts to expand production in deep water offshore have failed. ChevronTexaco and Royal Dutch/Shell are particularly squeezed for reserves, analysts say. "The oil majors have looked at their exploration portfolios and scoured the world" for more oil, says McMahon at Sanford Bernstein. "It comes down to Russia or the Middle East. Would you rather go into Saudi [Arabia] or Iraq? At least in Russia you know who to bribe."

Then there is the example set by Khodorkovsky. The former Yukos CEO gained celebrity for becoming the first Russian chief to bring his company up to Western standards. Not only did he adopt U.S. accounting methods and appoint Western executives, he brought new technology and management techniques to the oilfields. Instead of drilling more wells, which cost $1 million each, he took the advice of managers such as senior vice president Joe Mach, a longtime oilman from Tulsa, to make existing wells more productive for a tenth of the cost.

Yukos's oil production exploded, rising by more than 56% between 1998 and 2002, according to Cambridge Energy Research in Boston. Production from Yukos and Sibneft, with which Yukos is merging, accounts for more than 60% of Russia's increased oil production. Yukos says it is pumping 1.7 million barrels a day this year, yet it is only producing at 27% of its wells' potential, compared with the 50% to 60% achieved by Western majors. Moreover, Yukos has about 21 years of reserves left; the majors have between 11 and 15 years. Yukos's strategy of fixing wells has brought its operating and capital costs to $3.50 a barrel--the lowest in the Russian industry.

Khodorkovsky did that not just with Western technology and managers but by creating a culture that has gotten Yukos's far-flung production chiefs to focus on boosting production. Those who didn't were summarily fired. Khodorkovsky held weekend meetings four times a year with Yukos's top 150 managers, where he made a point of talking to everyone. The entrance to Yukos's Moscow headquarters is lined with larger-than-life photos of Khodorkovsky standing with figures such as Bill Gates and Nelson Mandela. "Khodorkovsky is very, very good at running an oil company," says Teton's Cooper.

About a year ago, the oil magnate began preparing the company for his departure, initiating a search for a chief operating officer from the West and probing the oil majors for a possible investment. Selling to BP, Exxon, or Chevron would have done two things: allowed Khodorkovsky to cash out and given Yukos an international presence. Yukos executives say Khodorkovsky owns about 26% of the combined Yukos-Sibneft, making him worth about $8.4 billion.

BP backed off, choosing TNK instead, in part because it was leery of Khodorkovsky's political ambitions, say sources close to the company. Chevron wanted a share swap. Exxon's Lee Raymond wanted a majority stake, Yukos sources say, but that was quashed by Putin, who objects to foreigners owning controlling stakes in strategic assets such as Russia's big oil companies.

With Khodorkovsky awaiting trial on fraud and tax-evasion charges, Yukos executives are putting on a brave face. New CEO Simon Kukes, a Russian who emigrated to the U.S. during the '70s and has worked for Chevron and Amoco, says his immediate goal is to calm markets. After the Sibneft merger, the company will be on track to raise production 14% next year to three million barrels a day, accounting for 30% of Russian production. As for mergers and partnerships, he says, "there is no urgency." If the company were to sell out now, it would be at too cheap a price.

As for Khodorkovsky, his spokesman in Moscow says he could emerge as a figure around which opposition to Putin coalesces. He's not worried by the freeze on his shares, which are held in shell companies on Cyprus and the Isle of Man. "The prosecutors believe they have arrested the shares," says a legal expert close to the oligarch. "It's naive to think so. They are controlled by foreign entities and any attempt to go after them will result in a very nasty legal battle, something the Russian government has never seen before."

For now, Khodorkovsky, dressed in a blue track suit and jogging an hour a day in a 20-square-foot room, is mapping his future. He told FORTUNE in August that he doesn't plan to run for President, but Yukos executives say that could change. "I am much more politically influential outside the company than inside," he said at the time.

That may be so, but the oilmen who admired Khodorkovsky are scratching their heads over why he gave up his Yukos perch for a jail cell. "If my shareholders saw me running around making public statements about policy," says Teton's Cooper, "they'd think I was crazy."

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