Wednesday, June 13, 2007

Scissors are cutting up the Russian oil & gas industry

Oil & gas companies operating in Russia have been crushed in the past few years by record-high taxation, making their business perspectives seem very unattractive. And given the fact that Russian companies now dominate the sector, courtesy of the Kremlin, Russian companies bear most of the taxation burden.

The taxation, which many have termed "Kudrin's scissors" (after Russia's Economic minister Alexei Kudrin) involves taxing 90% of the revenues (not profits) gained when Russian crude (Urals brand) trades above 25$ per barrel. Given the fact that Urals brand crude oil has been flirting above the $50 mark, the amount of taxation is huge. According to the Financial Times, Citigroup analysts have calculated an internal rate of return of under 10 per cent on a typical new Russian greenfield (undeveloped) project – lower than the hurdle rates for most majors. This means that Russian companies (which constitute the bulk of companies in the Russian oil & gas sector) are forced to pursue projects, that no other Western company would pursue outside Russia.

Investors, meanwhile, are fearful of investing into efficient independent oil & gas companies in Russia, such as Lukoil, BP or Royal Dutch Shell, due to the continuing regulatory problems these companies encounter from the Russian government. This leaves Gazprom and Rosneft as the only choices for investors, both of which have been on a spending spree; but not on investing in new fields, rather on buying out the assets of bankrupt YUKOS and other companies forced to sell their stakes to the government. Gazprom and Rosneft's shopping bonanza has ensured their debt remains at an alarming level for quite some time.

Add the two problems together, and you are left to invest in inefficient state-run companies, with huge piles of debt and little incentive to invest in new projects in Russia due to "Kudrin's scissors" (outside Russia taxation is lower but competition is fierce), and the overall picture for the Russian oil & gas industry so far is not optimistic. Profits for the two most recent quarters have been falling, as global oil prices have not been rising and as local production has been stagnant.

But the troubles in the Russian oil & gas industry may not be all that bad for the Russian economy overall. Investors have been shifting their capital out of oil & gas and into utilities and the banking sector which are scheduled for a booming growth period. The utilities sector has seen a big boost after the launch of the Russian energy trading market; the banking sector has seen a rise as well due to the recent successful IPO of Vneshtorgbank and the additional offering of Sberbank. The growth of the Russian credit market has proceeded at lightning speed recently and will continue to do so.

Overall, the trouble in the oil & gas sector may play well for the goal of diversifying the economy away from oil & gas, but taxation may have to be eased to give companies the incentive to look for new oil & gas projects; otherwise, Russia's production in the sector may begin falling in the near future.

4 comments:

daniel said...

Good article…as a matter of investment interests, people should know the full story behind Russia’s oil production, especially with the political battle-taking place until the 2008 elections. I suggest you read this report on different oil companies in Russia and their potential future growth.

http://royaldutchshellplc.com/2007/05/23/spero-news-russia-energy-profile/

Enjoy…Cheers!

nikolay i. said...

Thanks Dan!

daniel said...

Here's another one for you folks...

http://www.whiskeyandgunpowder.com/ppc/RussianOilReport2.html

Anonymous said...

Interesting...
But I think that russian oil& gas companies are set up pretty good at the moment. Returns will start to decline sharply if crude oil averages below 90 for the next 2 quarters or so. And still product prices haven´t fallen as sharply as oil price recently (gasoil avg Q3 ~1100$/t vs. avg. Q2 ~1060$/t) suggesting resilient EBIT´s. A LUKOIL trading @5 PE is pricing already lots of the dangers on the horizon....