Lukoil's ambitious plans face execution risk
Russia’s second-largest oil producer has high hopes for its future growth, but there are difficulties ahead
Lukoil may have seen its profits rise 15% in 2011, but to continue doing so Russia’s second largest oil company will have to execute an ambitious programme of upstream investments both at home and abroad to offset declining production at its older fields in western Siberia.
In March, Lukoil announced that its net income in 2011 rose to $10.36 billion, up 15% from the previous year, as its revenues grew 27.3% to $133.65bn and earnings before interest, tax, depreciation, and amortisation (Ebitda) grew 15.9% to $18.61bn.
The company put the rise in profits down to higher global oil prices. However this masked the negative impacts stemming from an increasing tax burden, the appreciation of the Russian ruble and, most worryingly, a big slide in oil production.
Lukoil’s total hydrocarbon output was down around 4% as the fall in oil production by 5.5%, to 90.7m tonnes, was only partially offset by a 3.2% rise in natural gas production to 22bn cubic metres (cm). As its oil output fell, so too did exports: Russian crude exports fell 14.5% to 254.34m barrels during the year.
The culprit for this decline is clear: West Siberia, home to its ageing oilfields, which are responsible for over half of total oil production. “Lukoil's full-year financial and operational performance confirms the trend that has seen the company’s hydrocarbon growth stall and begin to decline as existing fields in Russia go into decline, with output from new projects not able to offset this loss,” noted IHS Global Insight following the results release.
To stem this slide, Lukoil needs to stabilise production in West Siberia, expand into neighbouring producing regions at home, increase its overseas production, and shift further into gas. On 13 March, Lukoil set out how it plans to do this.
Stand and deliver
At a capital markets presentation in London, Vagit Alekperov, Lukoil’s president, and his senior management team set about convincing investors that this oil company is poised for a new phase of growth that will see output rise by “at least” 3.5% a year over the next 10 years as it invests more than $150bn between now and 2021.
The subsequent 8%-a-year rise in profits over the coming decade will enable the company to mark itself out as one of the few Russian companies to pay out meaningful dividends to shareholders. Alekperov pledged to increase dividend payouts from an average of 15% of Lukoil's net profit to 25% this year, rising to 40% of profit by 2021. The plan, he said, would see 2021 dividends increase 300% compared with 2011 payouts.
These numbers are certainly eye-catching. But the almost 9% fall in the company’s share price in the month following the presentation bore out the prediction from Daria Kozlova of Rye, Man and Gor Securities that the massive capital expenditure plans would have investors “running scared”.
That's not to say investors don't welcome Lukoil's dividend and strategic plan, just that there is palpable scepticism about the firm's ability to deliver given previous gaps between stated strategy and operational and financial performance. “While the long-term targets are gigantically ambitious, we think that the prize 10 years from now is equally illusive, with lots of risk and incredibly optimistic assumptions embedded in between,” analysts at Moscow investment bank Troika Dialog said.
The bulk of the $150bn will be spent on upstream projects, and most of those will be abroad due to perceived – real or imagined – discrimination against it by the Russian government when it comes to developing domestic projects. This focus on international E&P in places like Iraq, central Asia and West Africa (by 2020, about 17% of Lukoil’s production will be from foreign assets) rather than domestic brownfield or downstream projects is correct, says Alexei Kokin of Uralsib Capital – but risky.
Look at one such major project, the giant 13bn-barrel West Qurna-2 field in Iraq, in which Lukoil is the operator with a 56.25% stake at present. Lukoil vice-president Leonid Fedun said capex on that project alone would reach $25bn between 2012 and 2021, with a return expected by 2015. West Qurna-2 is scheduled to reach 1.8m barrels per day (b/d) of production in seven years, and the development consortium will earn $1.15 per barrel of output after cost recovery.
However, Lukoil is in talks that it hopes to wrap up in May to buy out Statoil's 18.75% stake in the field (Iraq's South Oil Company has the remaining 25%) after the Norwegian firm said it wanted out earlier this year. Alekperov says Statoil wants to sell its stake because it has other, bigger projects that are more lucrative than the service contract terms available in Iraq. However, analysts question whether the Iraq project will deliver the required internal rate of return, 15% in Lukoil's case, as security in the country deteriorates following the withdrawal of US forces. Statoil’s pullout could mean significant risks for the project given that the additional stake would increase capital investments by at least $1bn in 2012–2013 and $5bn over 2012–2017.
As such, analysts like Kokin of Uralsib hope Lukoil will be able to find a new partner to replace Statoil rather than it increasing its stake in the project. Alekperov talks vaguely about there being “other players willing to join”. Lukoil won't take part in Iraq's fourth bidding round, saying it wishes to concentrate investment on West Qurna-2.
Gas will become more important in the coming decade than it has been. Uzbekistan is expected to add 18bn cm per year (cm/y) by 2020. Lukoil expects the share of gas in its total production to grow from 20% in 2011 to over 35% in 2021, mainly owing to the Southwest Gissar and Kandym-Khauzak-Shady projects in Uzbekistan. In March, Lukoil said it found additional reserves at the Kandym Block, boosting the total resource base by 12m tonnes of oil equivalent (toe) from the original base of 255m toe, while it plans to increase its spending on the South-Western Gissar project by 67% to $25m in 2012. On 30 March, Lukoil said it had signed a deal with a consortium of banks for a loan of up to $500m to develop the Kandym-Khauzak-Shady-Kungrad project.
Lukoil also has an ambitious programme in place to grow its domestic gas production, with rising volumes set to come from three fields: Pyakyakhinskoye (due to start in 2016), South Messoyakhskoye (2018) and Khalmerpayutinskoye (2019). This rise in domestic gas production is underpinned by a five-year sale agreement with Gazprom, inked in March, that will allow Lukoil to sell up to 12bn cm/y of gas from its Nakhodkinskoye field in Yamal-Nenets. “Lukoil is only producing around 8bn to 9bn cm/y from the Nakhodkinskoye field, so the five-year supply agreement leaves room for Lukoil to increase its gas production from the field,” said IHS Global Insight.
Lukoil plans to spend $25bn to 2021 in West Siberia maintaining oil output and its ageing fields there, which many analysts believe should be enough to plug the fall. "When a half-decent oil company pumps enough cash into the ground, oil is bound to come out eventually," say analysts at Renaissance Capital.
The focus here is drilling new wells and producing from previously untapped zones, as well as employing enhanced oil recovery techniques to lift its oil recovery factor from 25% in the 2010-2019 strategy outline to 40% in this new one.
In the downstream segment, Lukoil is planning relatively modest capex of $25bn in 2012-2021, mainly for renovation and modernisation. Of all the segments, it's here analysts have the least fears, believing that the average payback period from the start of operations is just under four years, which has allowed Lukoil to quickly recoup its investment and lowered its potential exposure to negative changes in Russia's regulatory regime. Outside of Russia, Lukoil expects a recovery of European refining margins after the bankruptcy of 15 refineries ended market oversupply.
Vertical integration, Alekperov said at the presentation, has been a successful model for Lukoil, as it allows cash flow to grow faster than any rise in the price of oil. That may be so, but what worries investors like those at Troika is that this latest strategy highlights "plenty of investments with some potentially large and yet highly uncertain prizes at the end… [while] very few meaningful catalysts for the stock price in the short term".