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Rosneft: scaling the heights of power

High-wire deal-making has become the hallmark of Russia's national oil champion. But are expansion plans risking too much?

Rosneft chief executive Igor Sechin, a close confidant of Vladimir Putin since the men worked together in the St Petersburg mayor's office 20 years ago, has been charting a vertiginous course for his company. Lately, he's masterminded both the acquisition of rival Bashneft, in November, and the opaque sale of a 19.5% stake in Rosneft to a consortium in January. But Rosneft built much of its oil-producing process on assets it gained after Yukos's destruction—it's a paragon of Russia's often murky oil world.

Still, investors have been stunned by events of recent months, including revelations that Sechin had been involved in a dubious sting operation to arrest the economy minister Alexey Ulyukaev, an opponent of the Bashneft sale. That deal also drew criticism from business leaders, who said selling one state-controlled asset (Bashneft) to another (Rosneft) hardly fulfilled the Kremlin's ambition of privatising Bashneft.

Analysts at Credit Suisse recently called on Rosneft to hold its first capital markets day in four years to lay out how the company plans to create value and synergies from the recent mergers and acquisitions activity, as well as its targets for deleveraging. "We upgraded Rosneft last year on the premise that the company would increasingly allocate its capital to deleveraging rather than to further M&A," says Credit Suisse analyst Ilkin Karimli. "This has not happened."

Rosneft, which is still hurting from a $55bn outlay for TNK-BP in 2013, saw its net debt jump 15% in the fourth quarter following yet more acquisitions. It paid $3.5bn in October to acquire a 49% stake in India's Essar Oil before forking out $5bn a month later for the Bashneft deal.

While by Rosneft's own estimates the net debt at the end of 2016 grew only marginally, to $31.2bn from $26.1bn in the reporting quarter, Renaissance Capital estimates that including prepayments on supplies the net debt stood at $78.3bn.

"Although headline financials came close to our consensus estimates, we are concerned by growing net debt and weaker free cash flow (FCF) generation," says Ildar Davletshin, senior oil analyst at Renaissance Capital.

Rosneft's FCF was negative by $2bn in the fourth quarter due to a jump in capital spending. The company, which has a $27.9bn cash position, still has enough to repay debt worth $25bn this year. Rosneft has been generating much-needed cash from the sale of non-controlling stakes in East Siberian upstream projects to Asian investors and has rolled some of its debt under repurchase agreements, which are due this year and early in 2018.

So far, Rosneft has managed to survive the impact of sanctions—though they have complicated the servicing of its debts and hampered access to cutting-edge technology needed to keep developing its energy resources. The company's sale in January of a stake worth €10.2bn ($10.8bn) to Glencore and the Qatar Investment Authority (QIA) looked like a great deal on paper and was heralded by the Kremlin as proof of its ability to circumvent sanctions.

But the transaction has been mired in controversy. The QIA is supposed to have paid €2.5bn while Glencore was said to have fronted €300m via a joint venture. The remainder was made up of margin guarantees from Glencore and various obscure financing deals from the Italian bank Intesa and Russian state-controlled lenders Gazprombank and VTB.

Analysts, though, question whether QIA and Glencore are the main participants in the deal, or whether it was entirely financed by state funds. The so-called privatisation is not the first time Sechin's antics have bamboozled and spooked the market. Two years ago, with a $7bn bond repayment looming, Rosneft borrowed heavily in the local market in a deal that sent the ruble crashing.

Net profit halved last year to R181bn ($3.07bn) as the company struggled with low crude prices and rising costs. Income also declined in the fourth quarter by 2%, to R52bn. These weak results came despite a rise in revenue provided by the acquisition of Bashneft.

Eastern promise

But Rosneft, whatever its cash position, has much work to do. Alongside gas giant Gazprom, it must invest heavily to bring new East Siberian fields online. Analysts have expressed concern about a decline in Russian oil output due to maturing fields in West Siberia, home to more than half of Russia's oil output.

And it must keep the existing asset base ticking along. Rosneft has ramped up drilling at Yuganskneftegaz, a former subsidiary of defunct Yukos which it now owns. The campaign has worked: Rosneft has been the exception in being able to reverse the decline across Russia's legacy brownfields. Capital expenditure for Yuganskneftegaz surged by 60% last year, and the company is aiming for what amounts to 2-2.5% average annual production growth there over the next two years.

Still, average decline rates of 4.5% at the fields controlled by its TNK-BP unit, now known as RN Holding, are too high. Rosneft is also allowing production at Vankor, its Siberian field, to decline. Output there shrank by more than 70,000 barrels a day, or by one sixth, over the course of 2016, to 370,000 b/d in December.

The recently launched Suzun field, in the Krasnoyarsk region, reached maximum output in December, which means that production should translate into 60,000 b/d more in 2017 than last year. This field will account for almost three quarters of the net growth in Rosneft's greenfield output this year, according to Sberbank CIB. The company's only new organic additions will be the Yurubcheno-Tokhomskoe field, in East Siberia, and Naul, in Timan-Pechora, which should both finally be launched in the second half of this year.

Rosneft's Bashneft unit, meanwhile, is guiding for flat output this year, including at the legacy fields in Bashkortostan as well as the Trebs and Titov project, in Timan-Pechora, and the Burneftegaz assets, in Tyumen Region, in West Siberia.

Rosneft's production, which averaged 3.8m b/d in 2016, should edge up by around 1% this year, to 3.85m b/d. This is provided its heavier drilling programme continues to perk up older assets and new fields ramp up as planned. As Russia's largest producer—and the state's champion—Rosneft might have been expected to shoulder most of the weight of the 300,000-b/d cuts Moscow pledged to Opec last year. But, despite Rosneft's 1.9% output drop in January and almost flat production in February, sustained oil-output growth, not cuts, is the company's ambition for 2017. With the consolidation of Bashneft under its belt, the company is expected to increase production by 1.3% to 1.5% this year. Sechin told Putin at a meeting in the Kremlin in January that Rosneft's investment programme will rise to 200m rubles in 2018, up to 1.3 trillion rubles in 2018. This may bring further growth.

Taking on Gazprom

Rosneft's ambitions aren't just oily. Last year, the company overtook Novatek to become Russia's second-biggest gas producer, recording a 7% jump in production to 67bn cubic metres. It forecasts that production will surge to 100bn cm a year by 2020. Success, though, hinges on gaining access to pipelines and an export outlet in the form of liquefied natural gas. Gazprom, which produces about 419bn cm per year, and so still dwarfs Rosneft's gas business, retains its monopoly over pipeline exports. So far, Rosneft's lobbying efforts to change this have largely fallen on deaf ears at the Kremlin, though it did in 2014 grant Rosneft and Novatek rights to export LNG.

Part of Rosneft's gas strategy is to attract partners for offshore projects. In mid-December, Sechin announced a deal with three Japanese companies to explore for oil and gas southwest of Sakhalin Island. Yet domestic prices remain depressed, so at some point any new successes in the upstream will have to be matched with new export capacity. It's a political battle that will run in the backdrop to Russia's gas sector over the coming years.

In the meantime, investors will be focused on Rosneft's broader corporate performance. Without any signs of deleveraging and an unlikely material impact from acquisitions over the next two quarters, the company's share price is likely to be put under pressure. Its stock has underperformed the market even after oil prices rallied in the first quarter. Rosneft shares dropped 20% to R331 ($5.80) a share in the first two months of this year—double the 10% decline for Lukoil and almost twice the 11% drop for the Micex benchmark index.

The company wriggled out of decree to pay dividends worth 50% of profits but still must accommodate an increase to 35% of earnings. Even so, investors say an implied yield of less than 4% is too low to make a difference to its investment case.

In the meantime, Sechin shows no sign of slowing down his international M&A. The company is buying a stake worth $2.8bn Eni's giant Zohr gasfield in Egypt and is expanding its footprint in the Middle East after striking new oil deals in Libya and Iraq's Kurdish region.

In Venezuela, Rosneft has hit a roadblock in the form of the opposition-controlled congress, which voted in February to reject a $0.5bn deal to almost double its share in the Petromonagas joint venture to 40%. There is a risk now that final decision will not be made in Rosneft's favour and the investment might turn into bad debt.

Even the geopolitical climate is not looking as forgiving as it did a couple of months ago. Much of the hoopla and hubris in Moscow over the appointment of Rex Tillerson, the former ExxonMobil boss, as the US Secretary of State, has faded. Sechin, a friend of Tillerson, had hoped his pal's appointment by President Donald Trump would bring an easing of sanctions this year and allow Exxon and Rosneft to return to the Kara Sea shelf. The joint venture was halted months after it started in September 2014 following the introduction of sanctions. Yet the thaw in US-Russian relations many expected under Trump has not yet begun, and suspicions around the Trump administration's relations with Moscow could have the effect of stalling that process further.

Rosneft's alliance with Exxon may have run its course anyway. The two companies recently abandoned a joint extraction development in the Gulf of Mexico. Rosneft may have to explore the Russian offshore alone—it says it still plans to reactivate several large offshore projects, including drilling in the Kara Sea and the Pacific Sea of Okhotsk. Still, Sechin's admiration for Exxon—and Tillerson's stewardship of it—is undimmed. Having transformed Rosneft from a bit player into a national champion, Sechin wants to emulate the US giant. The problem is that Rosneft is not a company designed to reward long-term private investors. Its strategy is dictated by the Kremlin's geopolitical interests. Sechin's boss regards Rosneft as a projection of state power, not a vehicle to maximise value for investors.

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