COMMENT DECREE TO CHANGE SHAPE OF RUSSIAN OIL INDUSTRY

Sheldon Stoughton
Vice President Energy Merchant Bank Bankers Trust Co.
London

A decree just approved by Russian President Boris Yeltsin sets out the proposed new shape of the Russian oil industry.

Essentially, the industry is to be divided among four holding companies: Rosneft, Yukos, Surgutneftegaz, and Lukoil. Each of these holding companies is to be loosely integrated, with a stake in exploration and production as well as refining and distribution enterprises. Rosneft is also likely to have control of the country's crude and product pipeline system.

The proposed reforms are likely to disappoint those who have argued for a more fundamental reconstruction of the industry along less centralized lines, with devolution of decisionmaking authority and autonomy to lower level units to encourage greater competition and efficiency.

There is little doubt that the Russian oil industry is in need of some sort of overhaul. Production has undergone significant decline. For example, in 1987 total Russian production was about 580 million metric tons (11.6 million b/d). This year, while estimates vary, the general consensus appears to center on output of 380-400 million metric tons (7.6-8 million b/d).

Equally worrisome is a slowdown in exploration activity and a deterioration in the country's production facilities. Recent studies have found that a third of Russia's 33 oil associations had more than a fifth of their producing oil wells idle due to technical problems. The main reason is deterioration in surface equipment as well as unsatisfactory downhole completion and maintenance work.

THE NEW HOLDING COMPANIES

The new decree envisages grouping virtually all oil and oil related enterprises under the four holding companies.

Even before this proposed consolidation, several of the country's upstream enterprises (production associations) were of world class size. Moreover, the industry was already fairly concentrated.

According to 1991 data, based on output, 16 Russian production associations would have ranked in a list of the world's top 30 oil companies-excluding 100% government owned companies outside Russia. Last year, the biggest, Nizhnevartovskneftegaz, alone produced about 12% of Russia's oil. As such, it rivaled the worldwide oil output of Exxon Corp. According to 1991 data, the five largest Russian production associations accounted for about half of the country's total oil and condensate output.

Based on the proposed groupings and using 1991 data, Rosneft will account for about 287 million metric ton (5.7 million b/d) of crude and condensate production. Lukoil, a grouping of three associations-Langepasneftegaz, Uraineftegaz, and Kogalumneftegas-will account for about 66 million metric tons (1.32 million b/d). And Yuganskneftegaz, the upstream heart of the proposed Yukos), and Surgutneftegaz will each represent just less than 50 million metric tons (1 million b/d).

LOWER LEVEL PRODUCTION UNITS

In some instances, even lower level production units (NGDUs), which combine to form production associations, are also very large.

For example, in 1991, the biggest of the 111 Russian NGDUS, Mamontovneft, would have ranked among the top ten world oil companies on the basis of output-again, excluding state owned companies outside Russia. The next six biggest NGDUS, while not qualifying among the world's top ten, nevertheless account for the bulk of the next ten.

The magnitude of the NGDUs becomes even more apparent if they are compared with nonintegrated western producers, to which they are more closely analogous. Looked at this way, Russian NGDUs would account for 18 of the world's top 20 independents. The comparison is all the more striking since most of the western independents operate in numerous countries. By contrast, the NGDUs produce from relatively small geographical areas.

ASSESSING VALUE

These statistics show how vast each of the four new holding companies will be, even at currently-and, it is hoped, temporarily-depressed rates of production.

It is obviously hard to put a value on them now.

The most reliable method, of course, would be to perform a complete discounted cash flow analysis, but this is complicated by the paucity of dependable data, an issue we are just now beginning to address.

A more basic approach would be to try to apply a cash multiple to each metric ton of oil that an association claims as proven reserves. A price of $2/bbl of oil equivalent (BOE) is assumed for now.

This is a hefty discount from the roughly $4.50/BOE applied as a rule of thumb in most western reserve transactions, and is adopted to account for currently low but rising Russian oil price realizations, high but soon to be moderated tax burdens, and operating problems.

Using such admittedly rough figures, even the upstream components of the two smallest proposed holding companies could each be worth in excess of $25 billion.

DECREE UNCERTAINTIES

There is some question about when or if the decree will become law, depending upon the outcome of the December meeting of the Congress of People's Deputies (still under way at presstime last week), which has been convened to debate the entire economic reform program.

Yeltsin's interpretation is that decrees can be automatically implemented, while some parliamentarians argue that measures of this nature will have to be approved by the legislature. Oil industry reform may therefore be another subject of debate between the two branches of government.

The structure of the oil industry as envisaged in the decree is quite complicated. Each of the four holding companies will be 45% owned by the central government's Federal Fund for at least the next 3 years. According to the decree, 40% of each holding company may be sold to any buyers during the next 2 years. Foreigners may purchase as much as 15% of that 40%. The remaining 15% of each holding company will be sold to other investors-intended to be primarily members of the public-at auction prices.

Each holding company will maintain a 38% stake in its constituent upstream and downstream entities. With as much as 25% of the capital stock of the constituent companies made available in the form of outright gifts of nonvoting preference shares to workers, the holding company will thus exert 51% voting control over its constituent companies. Stakes of voting common stock of 10% and 5% will be sold to workers at concessionary prices and managers at full nominal prices, respectively. The remainder will be available for more general distribution, and can be purchased at auctions through the use of a combination of vouchers and cash. A stake of as much as 17% would be directed to the general public, and a further 5% would be reserved for transport workers, such as pipeline employees, and/or ethnic groups in certain areas-the Khanty-Mansiysk region in western Siberia, for example.

FOREIGN INVESTMENT PROSPECTS

It is unclear whether foreign investors can be persuaded to purchase minority stakes in the enormous holding companies.

It appears more likely that foreign participation will continue primarily as it has to date, through targeted ventures with specific production associations and geophysical organizations.

The decree makes no specific mention of this, but the clear consensus is that there is no intention to discourage these sorts of transactions. Moreover, the general interpretation appears to be that the production associations will continue to hold sway over their current properties, which offer a considerable number of potentially attractive opportunities.

For example, Yuganskneftegaz alone has more than 40 fields that are proved but undeveloped, and its current exploration acreage rights extend from its main sites just south of the Ob River at Nefteyugansk right down virtually to the border with Khazakhstan, more than 700 km away. As before, it is at this level that most of the concrete deals will be struck, regardless of how shares of the various Russian entities are to be distributed.