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Avinash Gandhi

Amit Amin

LUKOY AT A GLANCE

 

 

 

 

 

 

Though Russian oil major LUKOIL earns 98% of its revenues through the sale of refined products, it holds the second largest set of reserves out of all the vertically integrated oil majors. In an energy market where oil prices have shot through the roof, this business strategy seems flawed: if the company were to sell crude oil to refiners, it would make a killing off the high margins afforded through high oil prices. As a refiner, however, higher oil prices just mean higher costs and lower margins, a condition exacerbated by price-competitive nature of the refined petroleum industry. LUKOIL cannot pass the increasing input costs onto customers because they would simply move to a lower-priced refiner, so the company must deal with volatile margins - as seen by its recent revenue growth and simultaneous income decline.

The majority of LUKOIL's exploratory operations occur in the Western Siberian region of Russia, where 60% of the country's oil and 90% of its natural gas reserves lay. While this affords the company a vast area of proven reserves to expand, it also means that the company is more heavily exposed to a maturing base. Western Siberia has been drilled for many years, and though it has a large quantity of oil under its surface, the speed at which the region is being exploited means that it will have a much shorter lifespan than other oil-rich regions with stricter production controls, like Saudi Arabia. In the past year, LUKOIL has had to acquire other exploratory companies in order to increase its reserves, since its own exploration has yielded fewer discoveries.

Russian oil infrastructure is controlled by state-owned conglomerates, and with the bureaucratic machine preventing efficient use of resources, they often create supply-chain bottlenecks that prevent oil companies like LUKOIL from being able to meet potential sales. However, the Russian state can also be a benefactor to LUKOIL, as it prefers to purchase its resources from domestic businesses. LUKOIL's position in the capitalist market puts it at risk of nationalization, as Russian leaders may decide that cheaper-than-market energy is more important to his country than the privatization of industry. On the international market, LUKOIL competes with the oil majors: Exxon Mobil, Chevron, Royal Dutch Shell, ConocoPhillips, and BP.

Business and Financials

LUKOIL is a vertically integrated oil and gas company, and was originally one of Russia's national oil companies though it is now entirely privately traded.

LUKOIL's upstream segment has reserves of 20,360 million barrels of oil equivalent, making it the second largest private hydrocarbon reserve holder after international oil major, Exxon Mobil; it owns 1.3% of the world's oil reserves and is responsible for 2.3% of the world's oil production.

The company's downstream segment has a refinery capacity of 58.1 tons per year, though it is significantly underutilized with 2006 production totaling just 48.9 million tons. Four of the company's seven refineries are in Russia, with the rest in Ukraine, Bulgaria, and Romania.

For the first three quarters of 2007, LUKOIL saw revenues of $57,347, with an operating income of $8,828, with revenues up from the same period in 2006's $51,803 but profits down from $8,863. Revenue increased due to higher production, but income decreased because oil prices for the period were volatile, but generally higher, causing some of the company's refining margins to shrink; given that the vast majority of its revenues come from downstream operations, the company could avoid shrinking margins despite the fact that most of the petroleum supplied to its refineries came from its own upstream segment.

In the fourth quarter of 2008, LUKOIL had a loss of $1.6 billion.^[2] Margins shrunk after oil and gas prices fell more than $100 a barrel from their peaks mid-year to below $45 a barrel in early 2009. Margins also fell because the value of the rubble has been decreasing, and Russian export duties increased.^[2]

20.6% of LUKOIL is owned by international oil major, ConocoPhillips; this ownership gives LUKOIL funding and joint venture opportunities with one of the largest oil companies in the world.

LUKOIL Owns Three of Its Own Export Terminals

LUKOIL owns and operates three major oil terminals: the Vysotsk terminal, the Varandey terminal, and the Izhevskoye terminal. Russia is the largest natural gas exporter and second largest oil exporter in the world^[3]. LUKOIL uses its terminals to cut transportation costs when exporting its crude out of the country; it also makes money by allowing other oil companies to use the terminals to export their products.

Trends and Forces

LUKOIL Produces Mostly in One Region: Western Siberia

Estimates of Russia's oil reserves vary wildly, from 60 million barrels to 200 million barrels^[4], though it is generally estimated that 60% of this is found in the Western Siberia region^[5]. Furthermore, 90% of Russia's natural gas production and 72% of its natural gas reserves are found in Western Siberia^[6] - an enormous amount considering Russia has the largest natural gas reserves in the world^[7]. LUKOIL produced 63.7% of its crude oil for the first three quarters of 2007 in Western Siberia. With so much of its production centered in one region, LUKOIL is exposed to a few unique trends.

• Russian reserves are prone to short lives, as they are heavily produced. This is even more pronounced in Western Siberia, where most of Russia's production has occurred in the past. Though the region's reserves may be high-yielding in the short-term, fast depletion will hinder long-term regional production, especially as more and more international oil and gas producers enter the region. This can be illustrated by the organic decrease of 738 thousand tonnes of oil produced by LUKOIL's existing holdings in the region during the first three quarters of 2007 from the same period in 2006^[8] (the company's overall production in the area increased due to acquisitions and new joint partnerships, rather than internal exploration and production).
• As old reserves in easily accessible parts of Western Siberia mature, LUKOIL must spend more on exploration for new wells, as well as on infrastructure to transport the oil to refineries and/or distribution centers. In the first three quarters of 2007, for example, the company's capital expenditures in the region rose $703 million from the same period in 2006 - more than the $632 million LUKOIL spent on exploration and infrastructure in regions that it had never developed before.^[8]
• Western Siberia sees crude oil production taxes increase by $0.22 per barrel for every $1.00 that international Urals blend prices increase above $9.00 per barrel. However, when a given reserve reaches 80% depletion, this tax decreases by a factor of 0.035 for every 1% of the reserve depleted, allowing LUKOIL to spend more on using expensive technology to deplete the well as fully as possible. Essentially, this gives LUKOIL the ability to spend more on fully draining mature wells, increasing reserve life and offsetting the need for the company to engage in costly exploration.

Railway Capacity is Blocking LUKOIL's Export Capacity Growth

In Russia, most petroleum transportation infrastructure is owned either by pipeline company Transneft or train company Russian Railways - both owned by the Russian state and both lacking the capacity to handle the all the natural gas and oil that is flowing out of the country. This capacity constraint prevents LUKOIL and other oil companies operating in Russia from being able to export oil as fast as they can, meaning the companies are losing potential export revenues. In LUKOIL's case, this has had a recent, material effect on its growth strategy; in October, 2007, the company canceled its plans to increase capacity at its Vysotsk terminal to 15 million barrels per year from the 12 million that the company expects to have shipped out of the port in 2007^[9]. 3 million barrels of crude at the company's average Mediterranean market price of $63.96 for the first nine months of 2007 means that the company will lose about $192 million in potential revenue from the canceled Vostok expansion alone^[10].

GDP Growth in the Former USSR Means LUKOIL is an Unwitting Player in an Economic Game of Russian Roulette

In 2007, Russia's GDP grew 8.1%, compared to the United States' 2.2% and China's 11.4%^[11]. As a fast-growing, state-controlled capitalist economy, Russia's energy demand is also growing. This presents an opportunity for LUKOIL; as a state-controlled economy, Russia's government will give preference to Russian businesses when purchasing fuel and building power stations, and LUKOIL, as the largest privately-owned oil company in Russia, is positioned to benefit. The risk, however, is that the state may not want to pay the market price. Since LUKOIL is a publicly owned company, its executives are responsible to its shareholders, so they may not agree to sell oil at lower-than-market prices. In the present political climate, where President Vladmir Putin has near-authoritarian powers, LUKOIL is taking a significant risk. While Russia provides a great opportunity for shareholders, it's possible that going against the wishes of the Kremlin would lead to LUKOIL's nationalization, especially if the Russian state decides that it would prefer cheap energy and direct state income to foreign investment.

Rising Oil Prices Treat LUKOIL Worse that Most Vertically Integrated Oil Companies

Since around 98% of LUKOIL's revenues come from refining petroleum products, the company mainly sees the bad side of rising oil prices. Most of the oil majors are heavily exposed to the upstream side of the industry, so higher commodity costs benefit more than hurt them, but LUKOIL's sales balance causes the reverse to be true, as crude oil is a petroleum refinery's primary input, and if oil prices rise then margins shrink. Despite the fact that the company can sell itself its own oil, removing the value added costs that are driving prices up, LUKOIL does not produce enough crude to meet its refining capacity, and must purchase expensive oil from other upstream producers.

Oil and gas prices have fluctuated heavily over the past few years, though the trend in 2008 is a rise in prices, with a barrel of oil trading in international market a day after the new year at just over $100. Because both are nonrenewable forms of energy (they will eventually run out), slowing discoveries of new sources combined with increasing demand has led to rising prices - and to speculation that production is approaching peak oil quantities. Whether this is true or not, oil and gas are commodities: one company's oil can only be differentiated from another company's oil based on price. At the same time, refined petroleum products are also commodities. LUKOIL doesn't have the liberty to raise gasoline prices to pass the input costs on to customers because gasoline is a price-competitive product, so consumers would simply move to lower-price refiners. Fortunately for LUKOIL, however, the profitability of the current market for crude will drive increased exploration and production. If peak oil theory is just a myth, this should eventually cause production to rise and oil prices to fall.

Competition

In Russia, LUKOIL competes with state-owned heavyweight Gazprom. Other international companies involved in all aspects of the oil and gas industry (with a focus on refining) include:

• Valero - The largest independent refiner in the U.S., Valero has a total of 17 refineries with a capacity of 3.1 million BPD, and over 5,800 retail stations around the country^[12].
• Sunoco - The second largest independent refiner in the U.S., Sunoco has a capacity of 950,000 BPD, with 5 refineries and almost 4,700 retail stations.
• The oil majors - Exxon Mobil, Chevron, RDS. BP, ConocoPhillips - All are vertically integrated oil companies that explore, extract, and refine petroleum products. Supplying their own oil allows them to keep margins down, while their immense size allows them to keep capital expenditures high to expand refining capacity and technology.
• Western Refining - Western Refining is the main supplier of refined petroleum to the Southwest United States, though the expansion of the Longhorn Pipeline threatens to shift this balance by enabling Gulf Coast refiners (like Chevron, Exxon, Valero, and Sunoco) to ship cheaper products into the Southwest distribution hub of El Paso.

(1) Latest data is for 2007 (2) Does not include reserves of equity affiliates

(1) Latest data is for 2007

Notes

1. ↑ OAO LUKOIL "INTERIM CONSOLIDATED FINANCIAL STATEMENTS, (prepared in accordance with US GAAP), As of and for the three and nine month periods ended September 30, 2007, {unaudited)
2. ↑ ^{2.0 2.1} 24/7 WallSt. - Lukoil, Profits & Losses (COP, LUKOY)
3. ↑ Energy Information Administration: Russia: Background
4. ↑ Wikipedia.com, Oil reserves: 2.7 Russia
5. ↑ Oil of Russia: "BIG STEP FORWARD"
6. ↑ Russia 2007, Slide 6
7. ↑ Energy Information Administration: Russia: Background
8. ↑ ^{8.0 8.1} "Management’s discussion and analysis of financial condition and results of operations" for the period ended September 30th, 2007
9. ↑ PortWorld: "Lukoil cancels Vysotsk expansion"
10. ↑ "Management’s discussion and analysis of financial condition and results of operations" for the period ended September 30th, 2007
11. ↑ "List of countries by GDP (real) growth rate"
12. ↑ VLO 4th Quarter and FY 2007 Earnings Release
13. ↑ COP 2008 10-K, Item 8,Page 149
14. ↑ COP 2008 10-K, Item 8,Page 152
15. ↑ ^{15.0 15.1} RDS’A 2008 20-F, Supplementary Information, Crude oil and natural gas liquids
16. ↑ ^{16.0 16.1} XOM 2008 10-K, Item 1, Page6
17. ↑ ^{17.0 17.1} CVX 10-K 2009, Item 1, Page 7
18. ↑ ^{18.0 18.1} BP 2008 20-F, Item 1, Page 16
19. ↑ Lukoil Investor Relations – Fact Book 2008, Page 11
20. ↑ ^{20.0 20.1 20.2 20.3} ENI S.p.A. – Fact Book 2007, Page 11
21. ↑ ^{21.0 21.1} TOT 2008 20-F, Item 4, Page 10
22. ↑ COP 2008 10-K, Item 8, Page 151
23. ↑ ^{23.0 23.1} RDS’A 2008 20-F, Supplementary Information, Natural gas
24. ↑ Lukoil Investor Relations – Fact Book 2008, Page 12
25. ↑ ^{25.0 25.1} COP 2008 10-K, Item 6, Page 42
26. ↑ ^{26.0 26.1} XOM, 2008 10-K, Item 6, Page 36
27. ↑ ^{27.0 27.1} CVX 2008 10-K, Item 1, Page 5
28. ↑ ^{28.0 28.1} BP 2008 20-F, Item 1, Page 14
29. ↑ Lukoil Investor Relations – Fact Book 2008, Page 13
30. ↑ ^{30.0 30.1} TOT 2008 20-F, Item 4, Page 12
31. ↑ Lukoil Investor Relations – Fact Book 2008, Page 14
32. ↑ E 2007 Annual Report
33. ↑ SUN 2008 10-K, Item 7, Page 35
34. ↑ ^{34.0 34.1} CVX 10-K 2009, Item 1, Page 24
35. ↑ VLO 2008 10-K, Item 1, Page 3
36. ↑ ^{36.0 36.1} XOM 2008 10-K, Item 6, Page 43
37. ↑ RDS’A 2008 20-F, Results, Refining Data
38. ↑ Sinopec Investor Relations, Operational Statistics for 2008
39. ↑ WNR 2008 10-K, Item 7, Page 34
40. ↑ ^{40.0 40.1} COP 2008 10-K, Item 1, Page 16
41. ↑ ^{41.0 41.1} BP 2008 20-F, Item 1, Page 29
42. ↑ Lukoil Investor Relations – Fact Book 2008, Page 15
43. ↑ Conversion factor is 1 BPD = 50 tonnes per year
44. ↑ ^{44.0 44.1 44.2} TOT 2008 20-F, Item 4, Page 36
45. ↑ SUN 2008 10-K, Item 1, Page 1
46. ↑ ^{46.0 46.1} VLO 10-K 2008, Item 1, Page 1
47. ↑ RDS’A 2008 20-F, Results, Manufacturing
48. ↑ Sinopec Refining Overview
49. ↑ WNR 2008 10-K, Item 1, Page 19
50. ↑ Lukoil Investor Relations – Fact Book 2008, Page 16
51. ↑ SUN 2008 10-K, Item 1, Page7
52. ↑ CVX 10-K 2008, Item 1, Page 25
53. ↑ CVX 10-K 2008, Item 1, Page 26
54. ↑ XOM 2008 10-K, Item 2, Page 25
55. ↑ RDS’A 2008 20-F, Results, Marketing
56. ↑ Sinopec 2008 Annual Report, Business Review and Prospects, Page 20
57. ↑ WNR 2008 10-K, Item 1, Page 3
58. ↑ COP 2008 10-K, Item 1, Page 18
59. ↑ BP 2008 20-F, Item 1, Page 30
60. ↑ Lukoil Investor Relations – Fact Book 2008, Page 60