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Lukoil caught in the crossfire

An investor favourite thanks to its Western-style management and handsome dividends, Lukoil could feel the fallout from a dispute between other major players

Dividends paid by Lukoil, Russia's largest privately held oil company, are under threat as a result of an intensifying legal battle involving Rosneft and Sistema.

Kremlin-controlled Rosneft has initiated a $3bn lawsuit against conglomerate Sistema over alleged asset-stripping at Bashneft in a case that has echoes of Rosneft's dismantling of Yukos in 2003. The case is already damaging investor sentiment in Russia and now threatens to have a wider impact, as worries grow about claims that could be made by Rosneft on the Trebs and Titov oilfields joint venture, which is controlled by Bashneft and Lukoil.

"We think the perceived risk to Lukoil's dividend has increased post the recent Rosneft-Sistema court case, as the market remains concerned about potential hostile claims from Rosneft, particularly in regard to the Trebs and Titov JV," says Ilkin Karimli, an energy analyst at Credit Suisse.

Lukoil has a 25.1% stake in the Bashneft Polus joint venture, which holds reserves of around 1.1bn barrels in the Trebs and Titov fields. Production at the two fields, which are among Russia's largest in terms of reserves, started in August 2013 and the oil is exported through Lukoil`s Varandey terminal on the Pechora Sea.

In 2016, Lukoil had been regarded as the leading candidate to buy Bashneft when it was sold off by the government, but then state-controlled Rosneft decided it wanted the company.

Lukoil's dividend policy is key to its investment strategy, especially as it is the only Russian oil and gas company increasing its pay out by at least the rate of inflation. As a privately owned company adopting Western-style management and corporate governance, Lukoil is achieving this by cutting capital expenditure to free up more cash flow to pay dividends.

Meanwhile, state-controlled companies, such as Rosneft and Gazprom, have been ignoring a decree to pay dividends worth 50% of earnings under International Financial Reporting Standards (IFRS).

The perceived risk to Lukoil's dividend has increased

In the recent earnings season, Lukoil once again topped the ranking of Russian oil and gas companies by payouts, allocating to dividends 80% of its 2016 net income under IFRS. The next best was a payout worth 46% by oil producer Tatneft, while Rosneft paid just 35%. Gas monopoly Gazprom irked investors for the second consecutive year with a low payout, increasing dividends by only 1.9% in 2016 and allocating 20% of its IFRS net income for dividends.

Lukoil has reacted to Russia's production cuts with Opec by reducing output at its least-profitable and highest-taxed fields. Debt is being paid down, while $1.45bn was raised in May by the sale of its diamond business Arkhangelsgeoldobycha to investment firm Otrkitie.

Reports in the Russian press suggest both Lukoil's chief executive Vagit Alekperov and its vice president Leonid Fedun have been buying back stock during the summer. Alekperov, with a 20% stake in the company, controls Lukoil, which he co-founded in the 1990s and turned into an operation with a presence in more than a dozen countries. His partner Fedun has a stake of just under 10%.

While Rosneft boss Igor Sechin has started building an overseas realm to complement his dominance at home, Lukoil's investment focus on new fields with tax exemptions is intended to contribute to rising cash flow and dividends.

The launch of two major greenfield developments in the fourth quarter of last year—Filanovskoe in the Caspian Sea and Pyakyakhinskoe in the Arctic—could well provide strong support to the company's profitability, while brownfield developments are likely to continue showing declining production. VTB Capital estimates that Lukoil's domestic output this year will fall to 81.6m tonnes (about 1.6m b/d) from 82.2m in 2016, which is in line with the production cuts agreed with Opec.

Lukoil's dividend policy is underpinned by strong free cash-flow generation and a relatively conservative balance sheet. Capital expenditure peaked at R140bn ($2.3bn) in the final quarter of 2016 and has been falling since. Capex in the first quarter of 2017 fell to R130bn, while the company's free cash flow rose by 17% to R67bn.

Analysts estimates show that Lukoil will be able to cover its growing dividend organically, while its balance sheet should allow for mergers and acquisitions to keep its projects pipeline replenished. Both Credit Suisse and the Russian brokerage BCS Financial have recently remarked on how a new investor relations team is significantly improving transparency at the company.

However, risks to its progressive dividend policy have clearly risen due to the precarious position of Sistema. Lukoil may suffer collateral damage and its sector-leading implied dividend yield of 6% is no longer a given.

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