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Lukoil: Russia's sleeping giant

Lukoil’s move for Bashneft suggests the company is at last ready to use its cash pile and challenge Rosneft

FIVE years ago, when ConocoPhillips sold its stake in Lukoil for close to $10bn, the US firm complained that its investment in Russia's second-largest oil producer had failed to yield the access to the vast oil and gas reserves it had hoped for. ConocoPhillips's final departure last year seemed sensible too, given the near paralysis imposed on Russia's industry by sanctions and the growing dominance of state-controlled players.

Now the US company might wonder. A joint-venture deal Lukoil agreed with Bashneft - just two months after ConocoPhillips offloaded its final shares - has brought new verve to Lukoil. It should increase its reserve base, for starters. It might also bring it out from under the long shadow cast by its main rival, government-controlled Rosneft.

Lukoil, a privately owned company committed to Western-style management and corporate governance, sat on the sidelines in 2007 as Rosneft picked the choicest morsels from the corps of Yukos, once Russia's largest oil company until its co-founder Mikhail Khodorkovsky was imprisoned. Lukoil again had to watch idly while Rosneft splashed out $55bn in 2013 to buy TNKBP, then Russia's third-biggest oil and gas company.

Such was the hubris among bankers after that deal three years ago - the biggest transaction in Russian history - that Vagit Alekperov, Lukoil's president, was forced to deny that his company would be Rosneft's next victim. How things change. Today it's peculiar to think that Rosneft, not Lukoil, is likely to be a spectator in this year's privatisation programme and the race to acquire Bashneft, which produces about 20m tonnes (about 400,000 b/d) of oil a year. Lukoil is the frontrunner and Rosneft, saddled with debt and accused of triggering a run on the ruble, has fallen foul of President Vladimir Putin.

Interest heats up

Lukoil may yet have to compete for the 50% stake in Bashneft with Surgutneftegas, a secretive company with close ties to the Kremlin, and The Independent Petroleum Company (IPC), a small energy firm set up a couple of years ago by former Rosneft executive Eduard Khudainatov. But Lukoil remains the best fit for Bashneft thanks to its five-year alliance with the-then privately held operator to develop the Roman Trebs and Anatoly Titov oilfields, located on a 2,151-squarekm plot in Nenets autonomous district, in Russia's north.

Lukoil has a 25.1% stake in the Bashneft Polus joint venture, which holds reserves of around 1.1bn barrels in the two fields. Production at Trebs and Titov started in August 2013 and the oil is exported through Lukoil`s Varandey terminal, on the Pechora Sea. Lukoil is already the largest supplier of oil to Bashneft's refinery, and the latter's president, Alexander Korsik, has backed Lukoil's bid for his company.

Bashneft remains the most attractive target on the Russian oil and gas block due to its low leverage - about 0.8x after the first quarter - and its willingness and ability to pay high dividends. A tie-up with Bashneft, Russia's sixth-largest producer, would add another 2.15bn barrels of reserves to Lukoil's existing 16.6bn. It would still leave the combined company well short of Rosneft's 34.4bn barrels.

The sanctions over Ukraine have left Russian companies struggling to raise debt from Western, and forced others to scrap stock placements

Lukoil can draw on strong liquidity to execute a deal while its leverage is stable. Short-term debt amounts to just RUB60bn ($0.93bn), while cash on hand totals RUB250bn. In fact, the company could now buy a 50% stake in Bashneft at the market price of about RUB220bn using only its cash pile - and still leave enough to cover short-term debt.

To acquire a majority stake in Bashneft, Lukoil has indicated a willingness to pay a considerable premium relative to its own multiples. Indeed, Lukoil's vice president and second-largest shareholder Leonid Fedun acknowledged Bashneft was becoming "more valuable" (by multiples) than Lukoil itself. The messages have been mixed, though. Alekperov has also said that the premium to market value sought by the state means "this asset becomes less interesting for us". A sale of Bashneft is expected in the third quarter although the Kremlin may delay the process if oil prices and sentiment drop. Lukoil could be ready to part with RUB250bn to land a 50% stake in Bashneft, which would value the company at RUB500bn.

Recent months haven't been easy for Lukoil. It reported a 59% drop in net profit in June - a hit from weak oil prices - and a $0.6bn foreign-exchange loss. The ruble's weakness has boosted revenues but weighed on the cost side, as the company's obligations, denominated in foreign currencies, became more expensive to meet.

Yet the company's fundamentals remain strong. Lukoil is the only oil company in Russia now cutting its capital expenditures, freeing up more cash flow to pay dividends. The first quarter of 2016 was likely the bottom for Russia's oil and gas firms, and growth of financial indicators in the second quarter should let Lukoil reach its target figures for 2016 and increase dividends. Management has said RUB200 per share should be paid in dividends this year, translating to an 8% yield compared with 5.2% in 2015.

Volumes also remain healthy. Lukoil, created shortly after the Soviet Union's collapse, produces as much oil - 100m tonnes a year - as Opec nations Angola or Nigeria. Its quasi-private structure gives it some flexibility: publicly listed, but co-owned by its senior management, including billionaires Alekperov and Fedun, who hold a combined 30% stake.

The sanctions over Ukraine have left Russian companies struggling to raise debt from Western, and forced others to scrap stock placements. But sectoral sanctions, which prohibit US and EU companies from providing goods and services for Russian deep water, Arctic offshore or shale oil projects, have had no real impact on Lukoil: its focus remains conventional onshore and shallow-water offshore oil and gas production.

Lukoil is also not subjected to financial sanctions and has been one of the few Russian blue-chip companies able to raise money on the international debt markets over the past two years. Since 2013, it has switched to banks for funding, which accounted for nearly half of its long-term debt at end-2015, up from 24% at end-2013. Net debt grew by 8% to $8.6bn in the first quarter of this year, and the company says it may place Eurobonds in the second half of 2016

Invest to grow

Lukoil insists its massive investment to reverse a decline in its output is starting to pay off, allowing it to compensate for weaker prices with higher volume. Oil production is rising - but at a crawl. Output increased by 0.5% to the equivalent of an average of 214m b/d oil in the first quarter, or 2.3m b/d. The company will start a drilling programme in Western Siberia in September at the Pyakyakhinskoe and Filanovskoe fields, part of an effort to slow oil-output decline rates in the region from 7% now to 2%. Western Siberian remains the company's main oil production region, representing 42% of all production and 54% of its proven oil reserves.

Internationally, Lukoil is also shuffling its deck. It is considering selling refinery operations in Italy, Romania, Bulgaria and the Netherlands. In Romania some of its managers have been accused of tax evasion and money laundering in a $1.9bn fraud case. Lukoil denies the claims. Nonetheless, these European assets are no longer strategic for Lukoil, which has made exploration and development its focus.

"Selling part of the European downstream operations might be viewed as a positive development, given that the company has experienced a number of conflicts with European authorities which have resulted in refineries being halted and assets arrested," says VTB Capital's senior oil and gas analyst Dmitry Loukashov.

The withdrawal from Europe comes as Lukoil plots a return to Iran and eyes positions in Mexico and Nigeria. Analysts wonder if these targets would add value. Its biggest foreign success has been in Iraq, where output at its West Qurna-2 field has steadily increased since Lukoil took its stake in 2009. Production is now around 450,000 b/d.

Investors have yet to be convinced that the company is doing as well as it should be. Its shares have underperformed over the past 12 months against its broad index and peers, especially Rosneft. One hit came when MSCI Russia cut its index weight in May, which subsequently resulted in outflows from the name driven by index-tracking funds. Since April, Lukoil's stock has lost 10%.

But the drop in Lukoil's valuation is probably overdone and its share price is primed to outperform its peers. "Lukoil's valuation and dividends, which are guaranteed to grow according to the recently updated dividend policy, make the company our only top pick in the first-tier among Russian oils," says Alexander Nazarov, Gazprombank's lead oil and gas analyst. "Bashneft's privatisation may be another driver."

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