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Russia's Lukoil announced a drop in profits in 2013

The company's net profit in 2013 dropped by 29% to $7.83 billion

Lukoil's poor 2013 results sum the Russian major’s dilemma: as a privately held company it lacks ready access to the Russia’s new fields, but its riskier overseas expansion is proving disappointing. On 19 February, Lukoil announced its net profit in 2013 dropped by 29% to $7.83 billion, as it had to write off the value of investments at some major projects it once touted as the source of the company’s future earnings growth.

The impairments had a $2.1bn impact on net profits, Lukoil said, though some analysts noted that even without write-offs the company’s bottom line would have been $10.28bn, down on the previous year and worse than a Reuters consensus forecast of $10.36bn. Better news came with revenues, which were up 1.6% at $141.5bn “due to a year-on-year increase in hydrocarbon, petrochemicals and premium petroleum products production in 2013”, the company said.

And oil and gas production also rose 1.5% to 2.2 million barrels of oil equivalent a day (boe/d), with crude and liquids output reversing a prolonged decline by rising 1.2% to 1.87m b/d and natural gas output up 2.3% to 20.4bn cubic metres (cm). Lukoil blamed the $2.4bn write-off on its Yuzhnoye Khylchuyu oilfield in Timan-Pechora and several projects in West Africa, as well as losses related to refining in Italy and Ukraine.

Yuzhnoye Khylchuyu was a joint project with ConocoPhillips. However, the US major pulled out in 2012 when it became clear that reserves estimates needed revision. In 2008, when the project started, reserves were put at 505m barrels. However, “unanticipated geological reasons” forced a revision to less than 150m barrels.

As recently as two years ago Lukoil claimed its West African assets – five blocks in Ghana, the Ivory Coast and Sierra Leone – could host prospective resources of as much as 5bn to 6bn boe. However, it took a charge of almost $300m after exploration wells “showed hydrocarbons but not commercial ones”, vice president Leonid Fedun said following the earnings results.

These problems, together with the company pulling out of Venezuela and Vietnam, are raising questions about Lukoil’s plan to increase it share of overseas hydrocarbon production from 6% at present to 17% over the next six years. Lukoil said it plans to invest $27bn in all its existing foreign projects, as well as the acquisition of new assets outside Russia by 2017.

That puts the onus on Iraq’s West Qurna 2, the world’s second-largest undeveloped field with recoverable oil reserves of around 14bn barrels, to deliver. Happily for investors, the recent news is positive, with operations manager Gennady Budarin telling Bloomberg in on 29 March that the field in southern Iraq has been producing at a rate of 120,000 b/d since late March and is expected to ramp up to 400,000 b/d by the end of the year.

With peak production from the field estimated at 1.2m b/d by the end of 2017, Lukoil chairman Vagit Alekperov’s statement is certainly true that “West Qurna 2 first oil is significant to global markets” – but it is perhaps even more significant for the company itself. In 2013 Lukoil managed to stem a prolonged fall in oil production, raising average daily output by about 1% to 1.8m b/d. 

Certainly Alekperov and Fedun are putting their money where their mouths are. The two have pledged to keep adding to the large shareholdings they bought last year. In February Alekperov spent another $77m increasing his stake to over 24%, the largest shareholding. Dan Naumov, an independent trader, points out “that company management having their personal fortunes so closely tied to the company they run is a completely unique situation for a public Russian company”.

Much of this new buying can be attributed to the relative cheapness of the stock. One research analyst, who declined to be named, says the fall in the Russian stock market since the Ukrainian crisis broke in February has made valuations, normally discounted due to additional risk over transparency issues and potential governmental influence, too cheap to ignore. “Lukoil is one of the world’s largest oil and gas companies and has very good growth prospects … [yet] it currently trades at only four times its estimated 2014 earnings and offers a dividend yield of 5%,” the analyst notes. “Lukoil seems too cheap to ignore and offers a very attractive dividend yield, which gives investors some margin of safety over the long term.”

Still, the success of Iraq can’t dispel all the fears many investors have about an overseas strategy that is now focusing on opportunities in Iran, Romania and Mexico. “While the news that Lukoil is leaving Vietnam is positive, the fact that the company is planning operations in Romania and a possible return to Iran is less welcome. We continue to be cautious on the international upstream expansion of the Russian oil companies, especially given the political and executional risks abroad,” says Dmitry Loukashov of VTB Capital.

Indeed, the West is considering new, heavier sanctions on Russian individuals and companies over the Ukraine crisis. Companies like Lukoil may be at particular risk from any new measures. Given these conditions, many analysts argue that Lukoil should instead expand its domestic production, particularly reserves of hard-to-extract oil and shale gas. And recent evidence suggests this might be happening.

At the end of March, Lukoil confirmed reports that it had signed a memorandum with France’s Total to develop the Bazhenov Shale in western Siberia. The US Energy Information Administration estimates the Bazhenov formation holds 75bn barrels of technically recoverable shale oil resources. The formation covers 2.3m square km, an area 80 times larger than the Bakken Shale in the US.

The Russian government has introduced tax breaks to spur exploration of the Bazhenov and other shale plays, which have already attracted the likes of Shell with Gazprom Neft, and Exxon Mobil with Rosneft.

Alekperov said the company plans to extract 733,000 barrels from the Bazhenov this year. Given that Lukoil expects to have overseas production of at least 800m barrels by 2017, according to Andrey Kuzyaev, president of Lukoil Overseas, that’s small beer. However, it could be the start of something more significant.

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