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Making sense of merger mania

Against a background of global economic slowdown, M&A activity in Russia’s oil sector is gaining speed, driven by acquisitive domestic companies. But international players are also viewing the country as an increasingly attractive option for reserves replacement, writes Joseph McAllen

TYUMEN OIL (TNK) and Sibneft fired the first shot in the latest round of Russian oil industry consolidation. Early this year, they gobbled up a 75% stake in Slavneft, the 320,000 barrels a day (b/d) state-owned producer, for $1.86bn - Russia's largest oil privatisation to date.

Within a month, BP announced its landmark deal with the owners of TNK - Alfa Group and Access-Renova (AAR) - creating TNK-BP (PE 4/03 p28). The $18bn merger, which combines BP's Russian assets with TNK, marks the largest foreign investment deal in the country since the fall of the Soviet Union.

Then, in late April, Yukos and Sibneft announced a merger (PE 05/03 p36). Should the transaction work this time (their first attempt failed in 1998), it would create Russia's largest oil firm, with a market capitalisation of $35bn, controlling output of 2.1m b/d and almost 2m b/d in refining capacity (Lukoil, which would become the second-largest, produces 1.5m b/d).

From rags to riches

The latest round of consolidation reflects a new level of maturity in the Russian oil industry, says Stan Polovets, vice-president, corporate development and mergers and acquisitions (M&A) at TNK. The industry was pushed to the brink during the 1998 financial crisis. As the rouble collapsed, Russian firms defaulted on foreign loans. With international oil prices below $12 a barrel, high-cost Russian producers were forced to export at a loss to avoid losing market share. 

Polovets claims the crisis taught Russian companies a tough survival lesson. Under new private-sector ownership, they began to modernise, control costs and restructure. Most of the Russian majors launched aggressive programmes of corporate optimisation, restructuring of business processes and massive application of new Western production technologies. Most of this would not have happened as quickly had it not been for the 1998 crisis. 

Over a few years, companies such as Yukos, TNK and Sibneft attained double-digit production growth and slashed production costs. The effect of the restructuring, combined with high oil prices, had a massive effect on their balance sheets (see Table 1). It also armed them with enough cash to finance aggressive expansion.

Private-sector oil firms are driving industry consolidation. While all major industry players are acquisitive, the reasons for merging vary.

Some, such as Lukoil, seek to attain the scale needed to compete internationally. Others, such as Yukos, TNK and Sibneft, are (or have been until recently) controlled by financial investors, rather than professional oilmen and see mergers as the most efficient route to growth.

These investors, who picked up distressed assets from the state in the mid-1990s, have sought to increase their capitalisation through growth, restructuring and modernisation. Their goal was an initial public offering or a sale to a strategic - presumably, foreign partner, says Polovets. They achieved the most spectacular growth in the size and value of their assets, and the most spectacular efficiency gains. 

The big three

After 2003, three firms will dominate the Russian oil sector: Yukos-Sibneft, TNK-BP and Lukoil. Lukoil, which in the mid-1990s was the largest and most powerful Russian oil firm, appears to be the least dynamic of the trio. Recently, TNK, Yukos and Sibneft have grown rapidly, while Lukoil has achieved slower output growth (2.5% in 2002) and lower returns on capital employed.

Table 1: Financial position of Russia's top five, 2002











cash flow



























*estimates Sep 2002 Jun 2002


Source: Company data, analysts' forecasts

Yukos-Sibneft will be the largest industry player, but many questions remain about the proposed merger. Although the two companies were the best industry performers individually, the effect of the merger and its synergies are yet to be explained by the management. The companies' previous attempt to merge failed because of irreconcilable difference in the corporate cultures and the egos of the principal shareholders.

TNK-BP, while smaller than its two main rivals, has the critical mass to compete. It will have production of 1.2m b/d and will control 1m b/d in refining capacity. And as the first experiment in fully integrating Western technology and management principles into a Russian company is the most interesting of the three to watch.

Fertile ground

BP's knowledge and technology will find itself on fertile ground.

Since 2001, when TNK began its corporate optimisation programme, it has demonstrated stellar upstream performance, including double-digit production growth rates and significant efficiency gains. (TNK's crude production for the 12 months to May 2003 was up by 16% on the year-earlier period.)

BP's contribution will be complemented by the local expertise and political connections of its influential Russian partners, led by the chairman of Alfa Group, Mikhail Fridman. Another advantage of having BP as a shareholder is the substantially lower cost of capital that will be available. The high cost of capital typical for Russian firms restricts them to projects with very high internal rates of return.

TNK-BP will have a wider choice of opportunities.

Other large Russian companies are increasingly likely to become targets for acquisition. Surgutneftegaz narrowly survived a hostile takeover attempt by an unknown investor in April and may not be safe yet. The company, which at one point was the highest-valued Russian oil stock, is in a perilous position.

The remaining state-owned companies could also be targets.

Zarubezhneft, a Soviet-era operator of state-owned oil interests abroad, may be put up for sale this year. Its main asset is a share in Vietsovpetro, the Russian-Vietnamese joint venture, which produces 260,000 b/d offshore Vietnam. The much larger Rosneft is not for sale.

The fate of two vertically integrated regional oil firms, Tatneft and Bashneft, hinges on politics. As producers of lower-quality crude, both are effectively subsidised by Russia's other producers when their crudes mix in the export pipeline system.

The political influence of the regional governments of Tatarstan and Bashkortostan has prevented the introduction of a quality banking system. Yet, as Russia's political climate tilts towards limiting the powers of its regions, a quality bank appears to be a certainty. Once introduced, Tatneft and Bashneft will lose the incentive to export and will probably be absorbed by other companies.

Foreign influence

Foreign companies have been relative latecomers to the latest round of Russian M&A. They arrived en masse in the early 1990s, drawn by the vast reserves and the promise of an opening economy.

But during the first post-Soviet decade, most of these projects fell victim to the unstable political and business environment and, after the crisis of 1998, most shut up shop. Only the isolated Sakhalin projects, in the far east, thrived, protected by grandfathered production-sharing agreements (PSAs).

Political stability under President Vladimir Putin has returned Russia to the attention of international oil firms. By 2002, the three supermajors were evaluating opportunities, as well as, among others, Total, Norsk Hydro, Statoil, Marathon, ConocoPhillips and China National Petroleum Corporation.

BP's was the first bold move. Following the announcement of the TNK deal, John Browne, the firm's chief executive, said: We had a tough time initially [after entering the country five years ago], but ... we have built an important, mutually beneficial relationship with the owners of TNK and learned a great deal about doing business in Russia ... Combined with Russia's greatly improved economic stability, improved legal system and increasing commitment to international rules of trade and business, BP is convinced that now is the time to deepen our partnership with AAR. 

BP's decision signalled the emergence of the country as a global oil province, where international companies must stake out a presence if they are to replace reserves and remain competitive.

By spring, Total and Shell were reportedly in takeover negotiations with Sibneft. To prevent the entry of another powerful foreign competitor, Yukos made a pre-emptive bid. The manoeuvre seems to have sidelined the large foreign companies hoping to make a major acquisition in Russia - for now.

While the government is supportive of the TNK-BP deal, the appetite for another high-profile sale to a foreign company in a pre-election year appears unclear. As a result, another major deal is unlikely in the immediate future, although the outlook may change after parliamentary elections in December and presidential elections in March.

PSAs bite the dust

PSAs are unlikely to become the common vehicle for Russian investments, as foreign firms had hoped. In 2003, anti-PSA lobbyists, driven by protectionist Yukos, pushed through legislation that renders the regime useless to investors. From mid-2003, the government will treat PSAs as a special regime to be applied selectively on a case-by-case basis. They are likely to be limited to complex and capital-intensive offshore projects.

Although new mega-deals are unlikely in the immediate future, other options for entry remain open. Direct equity investment or acquisition of medium-sized projects is the most accessible option, as illustrated by the recent deal between Marathon and Khanty Mansiysk Oil. Marathon plans to buy the 15,000 b/d western Siberia producer, with proved reserves of 289m barrels, for $275m. Similar deals are in the pipeline.

Alliances and/or asset swaps are another option. Deals that do not just sell an upstream asset, but provide additional value to the seller, such as access to a retail network, are likely to be attractive to a Russian firm. Hungary's Mol has paid Yukos $100m to acquire a 50% interest in the West Malobalyk field in western Siberia. As part of the transaction, Mol will give Yukos access to its retail network in central Europe.

Asset valuations: confusion can't hide a good deal
AS GLOBAL options for oil reserves replacement shrink, Russia looks increasingly attractive to foreign firms. It remains one of the cheapest places to acquire reserves and production (see Figures 1 and 2), and publicly traded companies trade at $1.40 a barrel of reserves, defined by Society of Petroleum Engineers (SPE) standards, or $35/b of annual production.

While Russian reserves are recognised as cheap, a lack of accurate information often complicates establishing their fair market value and can produce bewildering ranges in their estimated price.

In recent M&A transactions involving Russian firms the stated or announced price paid varies from $0.22-3.10/b, with an average price of $1.40/b.

One of the main reasons you have such a broad range of valuations is that the parties announcing transactions often don't disclose the system according to which the acquired reserves have been classified, says Stan Polovets, vice-president, corporate development and M&A at TNK. Some companies refer to all reserves, including proved, probable and possible. Others refer only to proved reserves, although the price paid often incorporates some implicit value for [probable and possible] reserves. 

But even when companies talk about the same category of reserves - for example, proved - some refer to the definition of proved reserves mandated by the US Securities and Exchanges Commission (SEC), while others use the more liberal definition of SPE. There are other factors, but if same definitions are used, the range will be much narrower, explains Polovets.

The TNK-BP transaction offers some insight into Russian reserves valuations. On completion of the deal, BP will pay AAR $3bn in cash, followed by three annual installments of $1.75bn in BP shares. This implies the price of $3.10/b of reserves as defined by SEC standards. Using the SPE's less-restrictive reserves definitions, BP paid $1.80/b of reserves. The price is at a slight premium for Russia, but a bargain compared with reserves valuations in other regions.

According to research by Goldman Sachs, the same is true for the $37/b of annual output paid by BP, which is slightly above the $35 average for the publicly traded Russian oil firms, but well below other regions.

While the discount is typically attributed to the political risk and high discount rates in Russia, there are important economic considerations that affect Russian valuations. Goldman Sachs says these include low domestic prices, export restrictions and relatively high transportation costs.

But even taking into account the factors that depress the valuation of Russian oil assets, they can still be a good deal. Most international firms see a large upside from utilising Western technology and are confident they can extract significantly more value from brownfields and greenfields than Russian companies can on their own. As a result, more transactions similar to the BP-TNK deal are likely.

Others will try to replicate what we have done with BP, says Polovets. It will take a while, but I would not be surprised to see Western majors abandon their preoccupation with PSAs and decide the best way of entering the Russian oil industry is through M&A. For some it may be the only way. 

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