Comparing Russian, Western major oil firms underscores problems unique to Russian oil

Tina Obut
Ryder Scott Co. Petroleum Engineers
Houston

Avik Sarkar
Brown & Root Energy Services
Houston

Sankar SunderSterling Consulting Group
Houston

• Reserves, Oil Production, Exports [175,503 bytes]
• 1997 Financial Performance [64,394 bytes]
• Debt Status [61,609 bytes]
• Market Capitalization, Reserves [109,143 bytes]
• Operating Efficiency [87,388 bytes]

This second of two parts provides an analysis of four Russian vertically integrated companies (VICs) and compares their performance on key operational parameters with their Western counterparts.

The four companies-Lukoil, Yukos, Sidanco, and Surgut-represent some of the largest players in Russia's oil industry and account for almost half of Russia's oil production.

The operations, finances, and strategies of these companies help define the environment for private enterprise in the Russian oil industry, while a comparison of these VICs with Western oil companies helps highlight problems unique to Russia.

It is useful to first present a brief background on the current state of Russia's oil industry followed by a summary of the key policy problems faced by VICs. Each of the four Russian VICs is then analyzed.

Russia's oil industry today

The collapse of oil prices and the resulting Russian economic crisis have had a devastating effect on a country that is very heavily dependent on the oil industry for tax revenues and hard currency earnings from exports (OGJ, Jan. 25, 1999, p. 27).

The financial crisis was initiated when Russian banks were unable to meet debt payments, forcing the inevitable devaluation of the ruble. The crisis has sent foreign banks and investors fleeing, caused the Moscow stock and bond markets to plummet, and rendered most of Russia's financial industrial groups (FIGs) technically insolvent. The government's decision in August 1998 to suspend foreign debt payments has further alarmed investors.

Meanwhile, the persistence of low oil prices has forced international oil companies, such as Royal Dutch/ Shell, Amoco Corp., and Elf Aquitaine, to begin pulling out of Russia, preferring to invest their diminished capital budgets in lower-cost operating areas such as West Africa and the Middle East.

The simultaneous flight of foreign capital and the collapse of the Russian banking system has meant a near-total drying up of capital for Russia's VICs. For a short while, VICs saw ruble devaluation as a boon, since they earn most of their revenues in hard currency but incur most costs in rubles. Increasing inflation in ruble-denominated goods and services has, however, quickly eroded this benefit.

Government's predicament

The rash of non-payments and tax arrears that began with the collapse of the Soviet Union continues unabated.

The government, desperate for revenues, has targeted the energy industry as its principal source of revenues (from arrears) by using threats ranging from halting export rights to seizing company shares. In connection with this, the government has recently suspended the issue of export documents to Lukoil, Yukos, Eastern Oil Co., and Sidanco. Privatization of the remaining state-owned oil properties also suffered a blow in 1998 from the complete lack of enthusiasm exhibited by private investors for the government's auction of a majority stake in Rosneft.

Since then, in a bid to raise cash, the Russian government has announced plans to sell a 5% stake in Gazprom (for a minimum bid of $1.6 billion) and a 9% stake in Lukoil for $170 million. Preliminary reports indicate that the government has successfully sold a 2.5% stake in Gazprom to Ruhrgaz for $660 million (OGJ, Dec. 28, 1998, News- letter).

It remains to be seen if the government will be successful in attracting buyers for the rest of these assets, since most domestic financial institutions are insolvent, while foreign investors are likely to steer clear of Russia, at least for the short term.

A brief list of problems discouraging international oil companies from investing in Russia include:

• High and poorly structured taxes. Russian oil producers are taxed on revenues rather than profits. The largest of Russia's many taxes is an excise tax that is levied at a flat rate of 55 rubles/metric ton and that adversely affects the economic viability of many projects in expensive operating areas.
• Lack of consistent and reliable legislation. Foreign oil companies are particularly eager for progress in production-sharing agreement (PSA) legislation, which will allow them to "lock in" on cost and tax structure, and other terms in an otherwise unpredictable fiscal climate.
• Unstable government. The past few years have seen several changes in Russia's top leadership team. The most recent shakeup has resulted in the appointment of a government staffed by politicians with an inclination to slow reforms and monetarily inflate Russia's way out of trouble.
• Fears of nationalization. Preliminary reports indicate that the government may form a single state-owned oil company, to include ailing state entities Rosneft, Slavneft, and Onaco. It remains to be seen whether the government will go so far as to reverse the privatization of other oil companies.
• Low oil prices. As a result of low oil prices, foreign oil companies have slashed their budget expenditures and are focusing on lowering costs through mergers and downsizing. As long as oil prices remain at current levels, these companies will shun expensive operating environments such as Russia.

Profiles of Russian VICs

Russian VICs Lukoil, Yukos, Sidanco, and Surgut provide a representative cross-section of Russia's oil sector.

While all VICs operate under the same political, legal, and economic backdrop of current-day Russia, with its many problems discussed in this article, each is unique in its ownership composition, asset portfolio, political connections, and management strategy.

Some of these characteristics may be related to a VIC's level of operational and financial success. In addition, these differences may affect the attractiveness of a particular VIC to different categories of foreign investors.

Lukoil

Lukoil, Russia's largest VIC, was established as an open stock company in 1993 out of the state-owned Langepas-Urai-Kogalymneftegaz oil company.

Lukoil's reported reserves of 16.8 billion bbl of oil and 1.1 tcf of gas make it the largest private owner of oil reserves in the world, while Lukoil's production of 1.1 million b/d makes it the fourth largest private producer of oil (behind Royal Dutch/Shell, Exxon Corp., and BP Amoco plc).

With two major refineries, Lukoil has a refining capacity of 470,000 b/d, making it a leader in Russia's downstream sector as well.

Lukoil was one of the few large Russian VICs that managed to avoid ownership by FIGs under the loans-for-shares scheme. Almost a third of the company is still owned by the Russian government, while another third of the company is foreign-owned. About a tenth of the company is owned by its pension funds. Lukoil is also the first VIC to have its shares listed in the U.S. (LUKOY: OTC).

Due to the company's foreign institutional ownership, employee stock equity, and American Depository Receipts (ADRs), Lukoil's management has tended to keep its focus on shareholder value. The decision of Lukoil subsidiary Lukinter Finance to pay coupons due in November 1998 on $350 million of its bonds due 2003 attests to the company's financial prudence.

Lukoil is the most outward-looking of Russia's VICs, with plans for at least 20% of its oil production to come from outside the country within 5 years. It is a leading member of Azerbaijan International Oil Co. (AIOC) and Caspian Pipeline Consortium (CPC).

Lukoil and ARCO (a 7.99% owner of Lukoil) have a joint-stock company known as Lukarko for E&P operations in the former Soviet Union, while a joint venture of Lukoil and Agip SpA focuses on Western Siberia and the Mediterranean Sea. Lukoil has also been named the operator in the Western Qurna field in Iraq, where it hopes to begin production after United Nations sanctions on Iraq are lifted. The current crisis in Russia's economy and persistent low oil prices have forced Lukoil to reduce capital outlays and scale back its plans for growth.

Lukoil Chairman Vagit Alekperov is a former Soviet minister of oil and is still well-connected to the upper echelons of government. Because Alekperov is an ethnic Azeri in charge of Russia's largest oil company, Lukoil's participation in Caspian Sea projects is often seen as an endorsement of these projects by the Russian government.

Alekperov, an outspoken critic of Russia's economic policies, is a leading proponent of reduced taxation, increased money supply, and an increased role for the state in the regulation of Russia's financial sector.

It remains to be seen whether Alekperov's influence persists under the new government.

Yukos

Yukos, established in 1993 as a joint-stock company, has emerged as the second largest VIC in Russia from the standpoint of its audited reserve base.

After the Russian government's default on loans under its "loans-for-shares" scheme, Bank Menatep (founded by the ex-Soviet Communist Party youth wing activist-turned-business-tycoon, Mikhail Khodorkhovsky) acquired a controlling interest in Yukos, whose shares were used by the government as collateral for the loan. Thus, Yukos became the first VIC in Russia to be fully privatized. Two of its major E&P subsidiaries are Yuganskneftegaz and Samaraneftegaz.

After consolidating its position as a major VIC in the Russian oil sector, Yukos went on an aggressive acquisition spree to add to its reserve base and gain efficiencies associated with economies of scale. In December 1997, Yukos acquired Eastern Oil Co. (VNK), thanks in large part to the $800 million loan Khodorkovsky secured from Western bankers. In early 1998, Yukos announced another megamerger, this time with Sibneft (another major Russian VIC) to form a giant that was to be known as Yuksi. Together, the combined company would have controlled 22% of Russia's oil production, would have been better capitalized, and would have been in a strategic position to increase the market share of its products. The merger was also believed to be strategically beneficial, because the combined refineries (Yukos's three, Eastern's Achinsk, and Sibneft's Omsk) and Yukos's producing areas were geographically compatible. However, the merger unraveled later in 1998 as a result of the dissatisfaction of Yukos with the financial viability of Sibneft and an alleged power struggle between Khodorkovsky and Boris Berezovsky, the powerful head of the banking group that owns Sibneft. The dissolution of the merger also meant an effective end to Yuksi's much-touted $2 billion, 5-year life-of-field service contract with Schlumberger.

Despite these problems, Yukos shows promise. Its huge reserve base (its own estimates are 14.9 billion bbl, although other estimates vary significantly, from 7.3 billion bbl to 14.9 billion bbl) can be unlocked with good management, capital, and technology and more investor-friendly legislation. The four refineries, with a total throughput of 360,000 b/d, rank among the most efficient in the country. The company's finances are audited, a rare phenomenon in the Russian private sector.

There is also a current emphasis to streamline its management. The company is focused on segmenting its operations into business units; creating internal markets between producing and refining units; investing $200 million in modernization programs, including installation of information technology (IT) tools such as enterprise-wide software systems; embarking on aggressive cost-cutting efforts; and outsourcing noncore services. As a result of these efforts, Yukos's cost of producing a barrel of oil has fallen to $5.50 from $9.50.

However, this cost-efficiency gain may just be a paper estimate caused by the greater than two-thirds devaluation of the ruble since August 1998.

On the other hand, Yukos is saddled with a severe cash shortage and is heavily debt ridden, partly due to the low solvency of its customer base and its limited hard currency-earning export quota. Wage arrears for its employees were running at over 3 months as of December 1998. Shareholder rights are quite primitive, with the company facing several high-profile shareholder lawsuits.

Yukos has also suffered a steady production decline, the rate of which has outpaced the general decline of Russian oil production. The company's promise can only be fulfilled by a good management team committed to shareholder value, financial discipline, adequate technology, and capital infusion.

Sidanco

Sidanco was established in 1994 with the objective of supplying eastern Siberia and the Russian Far East and Far Northeast with oil, gas, and oil products originating from the same region. However, most of Sidanco's current production comes from fields in Western Siberia and the Volga-Urals region. The development of oil reserves in eastern Siberia remains a long-term goal for Sidanco.

Sidanco comprises 28 subsidiaries, including 7 production associations ranging from one of the most successful and progressive producers, Cherno- gorneft, which accounts for 30% of Sidanco's total production, to the troubled Kondpetroleum.

Sidanco also originally held Purneftegas, but lost it in 1995 in a dispute with Rosneft. (Purneftegas is the subject of a recent scandal involving Rosneft's 38% share in the company, which, authorities allege, has been surreptitiously transferred by Dialog Optim Bank to an unknown buyer at the bargain price of $10 million.)

In 1995, 51% of Sidanco was transferred to Oneximbank-MFK in the loans-for-shares auction for $130 million. Oneximbank is run by the powerful financier Victor Potanin and has reported ties to Anatoly Chubais, former First Deputy Prime Minister.

Since the Oneximbank acquisition, Sidanco's leadership has been struggling to gain control of its many subsidiaries. Sidanco's "federalist" style of management, under which subsid- iaries were allowed to run themselves (poorly or otherwise) as independent entities, has resulted in a weak organizational structure and poor company-wide performance.

In early 1998, in an attempt to revamp Sidanco's operations, Potanin named Chernogorneft's chief Boris Volkov as interim president. (Cherno- gorneft is somewhat of a pioneer in the contemporary Russian energy industry. In 1994, it became the first enterprise to invite foreigners to audit its reserves. In 1996, it became the first Russian independent company to receive an international loan.)

In 1997, BP acquired a 10% stake in Sidanco for $571 million. The presence of a major Western oil company is expected to bring a positive element to Sidanco's management. Because of its size and stature in the international energy industry and its 10% stake, giving it a seat on the board, BP should be a positive influence.

Sidanco supplies oil to captive markets in the Russian Far East. However, because most of its production originates in Western Siberia, transportation costs are high.

Sidanco also holds significant reserve potential in eastern Siberia and the Russian Far East, but developing these resources will require significant capital infusion. Once developed, however, Sidanco could be in a strong position, due to the proximity of its marketing and refining operations, to serve the currently stagnant but potentially promising energy markets of the Asia-Pacific region. One such project centers on Kovykta gas field in eastern Siberia, which Sidanco plans to develop jointly with BP; the gas would be shipped to China.

Surgut

Surgut Oil Co. is a unique VIC in many aspects. Established in 1992, Surgut VIC holds 51% of only one producing association (PA), Surgutneftegas; 100% of the Kinef refinery in the St. Petersburg area; and some marketing affiliates. Surgutneftegas is the largest PA in Russia in terms of oil production.

Surgut is also one of the two large VICs not controlled by a bank. In 1995, when the Russian government offered 40.12% of the company in the loans-for-shares auction, the Surgut pension fund successfully acquired the stake for a total of 1.426 trillion rubles (about $300 million).

Surgut is the first VIC to use the same team to manage both the VIC and its PA, a model later adopted by Sibneft.

Unlike other VICs, Surgut does not maintain a Moscow office, but, rather, is headquartered in Surgut. However, putting management closer to the heart of its oil production operations in the Khanty Mansiysk region of Siberia has also meant reduced exposure to the financial hub of Russia (and easier access to Western banks).

A unique feature of Surgut is that its PA, Surgutneftegas, is run as a profit center, while the PAs of most other VICs are regarded as cost centers. This means that a good bit of the value of the company is still held at the PA level. Eventually, Surgut VIC plans to consolidate its books through share swaps but has not yet announced the timing or the swap ratio.

Surgut can be characterized as having a lean corporate structure and efficient management. It has enjoyed high export rates relative to other producers in return for financing the construction of an oil products terminal near St. Petersburg. Surgut has traditionally chosen to maintain a rather cold relationship with foreign investors but has recently shown signs of warming up to foreign investment.

Surgut's subsidiaries are well-suited for each other, for most of Surgutneftegas's products are refined and distributed by Surgut's own downstream subsidiaries. However, Surgut's downstream business has some major weaknesses. It suffers from a high share of non-cash sales, with 65% of its product sales bartered for crude oil and electricity. Although the Kinef refinery boasts a high utilization rate (60% vs. the Russian average of 16% in 1997), its principal product is fuel oil, which is likely to face declining demand as electric utilities increasingly switch to natural gas-fueled power generators.

A planned hydrocracking facility to reduce this dependence on fuel oil will require a hefty capital investment, and is therefore not likely to be built anytime soon, given the current economic conditions. Due to its focus on exports, the company did not develop its marketing business in the St. Petersburg area, where it would have enjoyed a strategic advantage, given the close proximity of its refinery operations.

VICs, Western firms Pitfalls of evaluation

A meaningful comparison of a Western oil company with the VICs just profiled would typically entail a technical analysis of the finances, audited reserves, and economic analysis of the companies' current capital projects.

Unfortunately, such an analysis is very difficult to do for Russian oil companies, given the constraints of data availability and financial transparency. In addition, there is no guarantee of accuracy for the information that is available. For example, most Russian oil companies do not report reserve figures that have been audited by reputable international reserve consultants.

Reserve estimates found in company reports (which are not always available) can be expected to be overstated. Financial reporting is also often inconsistent and unreliable, rendering many cross-company comparisons meaningless.

To date, most Russian companies do not employ generally accepted accounting principles and continue to report unaudited financial results.

Transfer pricing

Another issue that is problematic when evaluating Russian oil companies is the relationship between a VIC and its subsidiaries.

While most VICs control their PA subsidiaries, they generally hold less than 100% of the shares, with the balance held by the PA itself or by other private investors.

There are various levels of consolidation among the VICs, with most moving toward full ownership of their PAs. Generally, this is done by swapping shares, with shares in the PA being exchanged for equivalent VIC shares.

Many VICs have been accused of "transfer pricing" to deflate the value of their PAs in order to obtain favorable swap ratios.

In fact, many parent companies treat PAs as cost centers on an accounting basis. To get an accurate assessment of VICs, PAs need to be bundled together with their parent VICs.

Methodology of comparison

Our comparison of Russian oil companies focuses on four broad categories: size, growth, financial performance/strength, and operating efficiency.

Given the difficulties of obtaining reliable data on Russian VICs, it is appropriate to focus on a relatively short list of broad metrics that are less likely to be error-prone than a large list of detailed metrics. Where possible, it was preferred to use data from a single source.

To provide some sense of the strengths and weaknesses of Russian oil companies, their performance metrics were compared with Exxon and Chevron Corp., because these two companies represent a large Western oil major and a (relatively) small oil major, respectively.

Size

The table on p. 21 shows selected financial statistics for the four Russian oil companies and the two Western oil companies. It is obvious from this table that the Russian companies are smaller (financially) by an order of magnitude or more than their Western counterparts, in spite of having reserves and production that are comparable to Western oil majors (see charts on p. 20). Indeed, on the basis of reserves, three of the four VICs-Lukoil, Yukos, and Sidanco-would be considered among the top oil companies in the world.

In spite of these large reserves, however, Russian VICs produce considerably less oil than their Western counterparts. This can be explained, in a large part, by a lack of adequate capital and export infrastructure and low Russian domestic demand for oil.

Relative to current production rates, the reserves of Russian VICs have longer lives than those of their Western counterparts. Sidanco, for example, has a reserve life index of 93.6 years, which is almost four times that of Exxon. The large reserves and low valuations of Russian VICs represent the double-edged sword that Russian oil presents to foreign investors-incredible opportunity coupled with the very real threat of financial collapse.

Most Russian VICs have experienced a general decline in production over the past 4 years, with Sidanco leading the pack. Two of the firms, Yukos and Surgut, look to be reversing the trend with reported production increases in 1997 vs. 1996. Data for estimating reserve replacement ratios were not available.

Financial performance

On an absolute basis, Russian VICs have debt levels that are considerably lower than that of their Western counterparts. Nevertheless, these companies are highly vulnerable to debt overhang, because of their high levels of debt relative to their net income and their current revenues (see charts on p. 21).

The debt-to-revenue ratio helps determine the vulnerability of a company's operations to declining production and/or low commodity prices. From this perspective, Yukos is especially vulnerable with a debt-to-revenue ratio that is almost seven times that of Exxon's. The high debt-to-revenue figure for Surgut is biased upwards by the inability to distinguish Surgut's long-term debt from other items that were reported in summation with debt. Indeed, Surgut is believed to have the smallest debt overhang of all the Russian VICs, an advantage that is further boosted by its relatively high export levels. On the basis of debt overhang and hard currency earnings (from exports), Lukoil and Surgut are the strongest Russian VICs, while Yukos is the weakest.

A look at the market capitalization per barrel of reserves reveals that the market views Russian reserves with a heavy risk premium, with even the relatively strong Lukoil being valued at less than $0.25/bbl of oil, compared with over $10/bbl for Exxon and Chevron. And there is a striking contrast regarding investors' perceptions of Russian oil companies vis-?-vis their Western counterparts (see charts, p. 22).

Operating efficiency

A look at a few operating parameters illustrates the inefficiencies of Russian producers compared with their Western counterparts.

The Russian VICs are grossly overstaffed, as demonstrated by their low levels of oil production per employee (see charts, p. 23). While a Western oil company produces 10,000-18,600 bbl/ year/employee, the VICs produce 1,700-3,600 bbl/year/employee. Russian oil companies also have a high number of idle wells due to a lack of capital and technology to restore production. Of the three VICs reporting such data, Surgut has the lowest percentage of idle wells, while Sidanco has the highest.

In addition, the VICs' annual production per well (with the exception of Surgut) averages much less than that of Western oil companies.

Conclusions

The most obvious strength of Russian oil companies is the large size of their reserves. This strength is greatly diminished by the current high-tax, low-price environment in which Russian oil companies are forced to operate.

Russian oil companies have major financial vulnerabilities and gross operating inefficiencies relative to their Western counterparts. Their vast reserves, financial collapse, and low base of technological sophistication mean that Russian VICs offer different levels of attractiveness to different classes of investors.

Strategic investors that are looking to acquire partnership and equity interest in Russian companies are likely to find Lukoil attractive for its clout, Sidanco attractive for its low value, and Surgut attractive for its relatively well-managed operations. A strategic investor with a high risk tolerance may even find Yukos attractive for its high reserve base.

Portfolio investors, on the other hand, will find only Lukoil attractive due to its liquidity, high profile, and status as one of Russia's blue chips (if, indeed, such a term could be applied to any Russian company).

While Surgut is relatively well managed and financially strong, it is not likely to appeal significantly to foreign portfolio investors because of the illiquidity of its shares.

The desperate need for Western technology in Russia's oil sector means that Western oil service companies are likely to find a large market for their services in Russia.

However, the current liquidity crisis in the country means that only contracts struck with creditworthy parties are likely to be honored, thus effectively limiting the market to projects with Lukoil or to projects with foreign partners.

In summary, Lukoil and Surgut look to have the soundest financial and operating profiles, with Yukos having the weakest financial picture and Sidanco the weakest operating picture. While Yukos and Sidanco look to be ideal candidates for contrarian investors, all Russian oil (including Lukoil) is fraught with risk and continues to remain the domain of Western investors with deep pockets and strong stomachs.

Acknowledgments

The article was produced from research conducted through an MBA course sponsored by the Energy Institute, University of Houston-College of Business Administration.

The authors thank Prof. Paul Gregory, Dr. Michelle Foss, and Dr. Gurcan Gulen of the Energy Institute at the University of Houston for their guidance; Mike Wysatta of Ryder Scott Petroleum Engineers for editing; and our respective employers for their support.

For part two of this article series, we also thank Giorgi Bedineishvili of Salomon Smith Barney for providing financial information on Russian vertically integrated companies.

Bibliography

1. Platts Oilgram News, Dec. 2, 1998.
2. Petroleum Economist, "Turmoil in Russia," September 1998.
3. Petroleum Economist, "Scandal erupts over sale of Purneftegaz," November 1998.
4. Petroleum Economist, "News in Brief," November 1998.
5. Petroleum Economist, "Oil companies protest over Moscow's tax policy," November 1998.
6. Petroleum Economist. "Survival of the fittest is the name of the new game," October 1998.
7. I.H.S. Energy Group, Nov. 30, 1998.
8. Integrated Exploration & Development Services Ltd., Nov. 2, 1998.
9. Integrated Exploration & Development Services Ltd., Nov. 23, 1998.
10. Russian Petroleum Investor Appendix: March 1996, March 1997, March 1998 (converted to barrels using 7.3 bbl/1 metric ton.)
11. Lukoil 1997 Annual Report.
12. Yukos 1997 consolidated financial statements.
13. Sidanco January-September 1997 Interim Report.
14. Salomon Smith Barney, Global Equity Research-Russian Oils, July 1998.
15. Salomon Smith Barney, Global Equity Research, 1996.
16. U.S. Energy Information Administration; www.eia.doe.gov; Country Analysis-Russia.
17. Khartukov, Eugene, "Incomplete privatization mixes ownership of Russia's oil industry," (OGJ, Aug. 18, 1997, p. 36).
18. The Economist, "Oily Charm," Dec. 6, 1998.

This article is the second in a two-part series that provides an overview and analysis of the Russian oil industry from the Soviet era to present-day Russia. The first part of the series presented a history of the Russian oil industry and a discussion of the policy framework in post-Soviet Russia. This second part focuses on a comparison of vertically integrated Russian oil companies with their Western counterparts and what that suggests of the state of the Russian oil sector today.

The Authors