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Lukoil: bigger than Rosneft

The investors' darling is prioritising high-margin upstream activities

Lukoil overtook Rosneft for the first time in late March to become Russia's largest oil producer by market capitalisation. But it may have just put a large target on its back.

The independently-owned producer, which has been run by Vagit Alekperov since the Soviet Union collapsed, enjoyed a share price bounce in March after presenting its new long-term strategy to investors in London. Promises made by Alekperov to use revenue earned when oil is above $50 to pay investors drove its market value above those of both Rosneft and Gazprom.

Lukoil has long been a darling of portfolio investors, due to its progressive dividend policy, Western-style management and by underlining how different it is to Rosneft. The latter is regularly maligned for bulldozing mergers and acquisitions through, and woeful corporate governance standards.

The company's so-called "Strategy 2027" prioritises high-margin upstream output, but there are no plans for any substantial fresh investments in downstream. Instead, management is placing an emphasis on maintenance of capital expenditure in refining, as well as overall cost optimisation.

Lukoil plans to keep pumping 100m tonnes (roughly 700m barrels) of oil a year between 2018 and 2027, with projects at home and abroad soaking up annual investment of $8-8.5bn.

The company is banking on domestic tax reforms to help it pursue the development of unconventional reserves and intends to invest 20% of that annual $8bn overseas, mostly into Iraq, Iran and Mexico.

"The newly presented strategy effectively classifies Lukoil as a conservative and stable company with a highly predictable business that is secure in bad times thanks to a low debt burden, and very limited exposure to risky and capex-intensive projects," says Alexander Kornilov, an oil analyst at Aton Capital.

Prior to the investor day presentation, the company released solid fourth-quarter 2017 earnings that indicated a sound free cash flow (FCF). That FCF was mentioned in Lukoil's presentation 26 times—compared with four mentions in Gazprom's recent investor day presentation—reflects its position at the core of the company's new strategy.

The strategy shows Lukoil as a conservative, stable company

Investors perked up at the company's assertion that cash flow from oil prices above $50 a barrel will be "efficiently reinvested and distributed to shareholders". Analysts cheered the conservative $50/b oil price assumption, which should help smoothen the high oil price volatility and help Lukoil sustain sufficient FCF to provide a constantly rising dividend.

In the 2018-27 period, Lukoil plans to generate around $130bn of operating cash flow, assuming a $50/b oil price, which the firm says will result in aggregate FCF of $50bn.

As Lukoil's star continues to soar, the only real cloud on the horizon is the issue of succession and how that might jeopardise the company's much-vaunted independence.

Alekperov has closely guarded that independence ever since setting up Lukoil in 1991 by taking over three oilfields controlled by the oil ministry. But the wily former Caspian Sea oil rig worker is now 67 and is increasingly talking about succession. While saying that his children and close relatives would not replace him, Alekperov has yet to unveil any likely replacement nor give any timeframe for his departure.

In the meantime, Rosneft's all-powerful boss Igor Sechin lies in wait. Bid speculation first started swirling after Rosneft dropped a $55bn bid to acquire rival TNK-BP in 2013. A subsequent deal to swallow mid-sized operator Bashneft for $5.3bn in 2016 helped to revive the rumours that Sechin is just waiting to pick off Lukoil, the choicest morsel on the market.

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