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Market looks down on Lukoil

Despite a slump in its share price, many analysts believe Lukoil is undervalued, their optimism is based on substantial Caspian resources, writes NJ Watson

THE MARKETS can be unforgiving, so when Lukoil's first-quarter revenues fell short of analysts' expectations, the firm's shares took a substantial fall. First-quarter revenues at Russia's largest privately owned oil company were up by 59% on the year to $25bn, but about 8% below the consensus forecast. The company's stock fell by 6% on 4 June, the day the results were published.

However, many analysts believe the shares are undervalued in the low $100s, where they were trading following the results, and the prospect of tax reform in Russia and new production expected from Lukoil's fields in Timan-Pechora and the Caspian Sea basin are reasons for optimism. Some believe the shares should trade up to $125-150.

Falling oil output

Lukoil fell short of the market's revenue target because of a disappointing upstream performance. First-quarter oil output was down by 4.5% to 1.92m barrels a day (b/d), with production in western Siberia, where the company produces 62% of its crude, declining by 5.5%. Fields there are "maturing'', Lukoil said ominously. The company missed its own first-quarter crude-output target by 3% and its production performance is likely to be the single most important factor in defining its fortunes over the rest of the year.

The problem is shared by many other Russian oil companies. In April, government data showed that Russian oil production had declined for the fourth month in a row, falling by 0.4% from the March total and by 1.0% from the level of April 2007. April's figures showed a 4.1% drop in western Siberia, suggesting that the first-quarter decline experienced by Lukoil in the region is likely to continue at a similar rate.

Lukoil blamed a significant amount of the fall in western Siberian production to its inability to provide enough power to its operations there, something Alexander Burgansky, an analyst at Renaissance Capital, says will not be fixed for another two or three quarters.

Even so, following the release of its first-quarter results, the company told analysts that it is still aiming for a 2.3% annual increase in hydrocarbons production this year. It refused to differentiate between oil and gas, but Deutsche Bank's analysts say that given their assumption of 20% growth in gas production this year, such a total growth figure suggests Lukoil's oil production will be flat or may even decline slightly.

That may be too pessimistic a view. Deutsche Bank also points out that the expected start-up of the 150,000 b/d South Khylchuyu oilfield in Timan-Pechora, in the middle of this month, should boost output in the near term. Indeed, on 27 May, Standard & Poor's raised its outlook for the Russian oil and gas major to positive from stable, based on the increasingly strong cash flow generation it expects to see coming from new regions such as Timan-Pechora.

In addition, Lukoil said in May that TsentrKaspneftegaz, a joint venture with Gazprom, had discovered a large oil and gas field in the Russian sector of the Caspian Sea while testing a well at the Tsentralnaya structure – near the Russian-Kazakhstani maritime border. A few days later, the firm's chief executive, Vagit Alekperov, said the newly discovered Caspian Sea field contains an estimated 2.2bn barrels of oil equivalent.

This find provides more proof, if any were needed, of Lukoil's far-sighted decision to invest heavily in the Caspian region. That is certainly how Alekperov sees it: "We took a risk, invested in exploration of the north Caspian and discovered a new oil and gas province."

Lukoil has said it will invest more than $2bn by 2012 in the construction of onshore facilities as part of the development of the north Caspian, where combined reserves at the six fields it has discovered exceed 2bn barrels of oil and 0.71 trillion cubic metres (cm) of gas. Another 10 prospective structures have been identified in the north and central Caspian, the drilling of which will make it possible to increase the resource base of the Caspian project to over 7bn barrels of oil and 0.8trillion cm of gas, says Lukoil.

Bringing all of its Caspian resources on stream, including expected discoveries, will make it possible to raise oil production in the region to up to 0.6m b/d by 2023, general director of Lukoil Nizhnevolzhsknefteprodukt, Nikolai Nikolayev, told Interfax in May. Lukoil's Russian oil output in 2007 was 1.9m b/d.

And the outlook for gas production is more positive. Lukoil plans to become Russia's second-largest gas producer, after Gazprom, with a target of lifting output from 16bn cm/y to 70bn cm/y and increasing its share of gas production from about 10% to 33%. In the first quarter, the firm reported good growth in this area, with production of marketable gas increasing by 19.8% to 4.3bn cm.

Downstream, Lukoil's business has also been helping the bottom line. The company attributed the increase in its first-quarter profits to high refinery margins and an increase in throughputs. Runs at the group's refineries rose by 9.8% to 1.1m b/d, with the Volgograd refinery accounting for most of the growth.

The trouble with tax

But the rate of investment in domestic exploration and production depends to a large extent on the government's ability to make good on its promise to reform the punitive tax regime, which takes 75-80% of oil firms' profits in the form of taxes and tariffs. During the presentation to analysts that followed the first-quarter results, Lukoil "specifically noted that its – and the whole sector's – ability to grow is heavily dependent on the scale of the continuing oil taxation reform", says Deutsche Bank.

In May, in one of his first announcements as prime minister, Vladimir Putin surprised the markets by announcing his intention to reduce the tax burden "to encourage oil production". During his time as president, Putin shied away from attempts to cut taxes on oil and gas extraction, as it would not have been popular with the public, which tends to view the industry as the cash cow of rich, corrupt oligarchs.

"That Putin used what was effectively his first speech as prime minister to commit his government to reduce oil taxation marks a highly significant shift in attitude towards the sector," says Roland Nash, head of research at Renaissance Capital.

Finance minister Alexei Kudrin has said his ministry plans to amend the formula for the oil mineral extraction tax by raising the minimum price threshold for calculating it from $9 a barrel to $15/b. The effect would be to save the oil industry about R100bn ($4.2bn) per year. "That R100bn represent about 7-8% of our forecasted mineral-extraction tax collection in 2009. This implies about $25bn-30bn of extra market capitalisation transferred to the oil sector," says Deutsche Bank.

 

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