LUKoil’s future still open to possible workable concession in Iraq

Jun 11, 2003 02:00 AM

The path to profits in post-war Iraq may run through Russia, specifically giant petroleum producer LUKoil. But not surprisingly, it's a risky route. While the Bush administration has given assurances that companies outside the US -- even those of erstwhile allies that opposed the American-led war to rid Iraq of Saddam -- would get a piece of the rebuilding of Iraq, LUKoil’s payoff won't be quick or certain.
When Russian President Vladimir Putin met in St Petersburg with President George W. Bush, he won reassurances that Russian firms would be given a fair chance for contracts in post-war Iraq, whose huge oil reserves are being eyed by oil majors around the world.
Bush told Putin it was up to the Iraqi people to decide on the sensitive issue of energy contracts. Russia fears US firms could snatch big Russian contracts signed with the government of ousted Iraqi President Saddam Hussein.

The United Nations Security Council's recent vote to lift sanctions on Baghdad could help Russia (which opposed the war) hold on to its stake in Iraq. But the UN warned that long-term oil contracts are held in abeyance and cannot be negotiated until a permanent and internally recognized Iraqi government has been installed.
What's at stake for LUKoil? Its biggest potential prize is a $ 3.7 bn contract for the West Qurna oilfield. LUKoil held the contract until mid-December, when Baghdad pulled the plug on the pretext that the Russian company allegedly had failed to meet the terms by delaying development.
A consortium including LUKoil (68.5 %), ZarubezhNeft (3.25 %), Mashinimport (3.25 %) and the Iraqi Oil Ministry (25 %) signed a production-sharing agreement for the West Qurna field in March 1997. The agreement lasts until 2020. Spending on the development of the field, with possible reserves of 20 bn barrels, is estimated at $ 6 bn.

But total forecasts of Iraq's oil riches are even more grand: Some put LUKoil’s contract to drill the West Qurna as high as $ 20 bn, and ZarubezhNeft’s concession to develop the bin Umar field at up to $ 90 bn. The total value of Iraq's foreign contract awards could reach $ 1.1 tn, according to the International Energy Agency's World Energy Outlook.
Iraq sits atop the world's second-largest oil reserves after Saudi Arabia. Without the constraint of production quotas from the Organization of the Petroleum Exporting Countries, Iraq potentially could produce about 6 mm bpd of oil by 2012. Some observers speculate Iraq's daily quota could be close to Iran's 3.6 mm barrels.
Before the most recent conflict, Iraq produced about 2.6 mm bpd, and exported 1.7 mm bpd, according to UN estimates. LUKoil’s West Qurna oilfield could have the capacity to produce up to 600,000 bpd of oil. Few -- if any -- investors and analysts are factoring the Iraq project into LUKoil’s earnings; some even consider it worthless.

But if LUKoil does reclaim the concession, the stock could serve as a handy way to cash in on a post-war recovery -- even if it takes years for the oil to be pumped out of the ground.
"Russian interests in Iraq include past and future trade, debt and oil," says Stephen O'Sullivan, oil and gas analyst at United Financial Group. "LUKoil is the major Russian company involved and the one most at risk of any backlash against non-American companies benefiting from the rehabilitation of Iraq."
He adds, "The risks are genuine, but we believe that LUKoil will retain its place in Iraq's oil sector, although the impact on the company's financials will take some time to become evident." As a result, "the impact on its share price will not be significant in the short term."

And what of LUKoil’s fundamental situation? The share price has roughly doubled in the past two years, but has lagged behind its Russian peers, such as giant Yukos, now in the midst of a mega-merger with Sibneft. LUKoil is still cheap compared with Russian oil companies and the international majors, as measured by the ratio of its enterprise value (equity and net debt) to operating cash flow (earnings before interest, taxes, depreciation and amortization, or Ebitda).
That's without any contribution from Iraq. Adam Landes, oil and gas analyst at Renaissance Capital, holds a price target for LUKoil American depositary receipts of 87, up about 20 % from the current price.

Then there are management worries at LUKoil. Witness the kidnapping last fall of LUKoil Vice President Sergei Kukura, who was snatched off the streets of Moscow, held for ransom, then set free a week later without explanation. Kukura's kidnapping remains a mystery, hinting at murky dealings among business factions within LUKoil. No one was ever charged and the case was closed this year.
"The whole affair is bullish," contends Harvey Sawikin with the Firebird Management in New York. "It means unpleasant people are being discomfited; change is being forced upon them. Getting rid of them is a cost of doing business."
And in another reflection of peculiarities in the Russian market, LUKoil’s CEO, Vagit Alekperov, only recently hascome around to the notion of increasing shareholder value, following the Yukos-Sibneft deal. (In 1993 LUKoil formally became an integrated oil company; it offered shares to investors a year later.)

Finally, LUKoil reported earnings conforming to US generally accepted accounting principles that were roughly in line with expectations -- $ 3.57 bn for 2002, down from $ 3.99 bn in 2001. That was despite a 14 % rise in revenue to $ 15.33 bn, which the company attributed to a larger portion of its sales being refined products instead of crude oil. In the fourth quarter, LUKoil’s Ebitda rose to $ 893 mm from $ 721 mm a year earlier, on sales of $ 4.30 bn, up from $ 3.03 bn.
The results were hit by a $ 103 mm tax charge in the third quarter and included a one-off pension expense of $ 82 mm. The GAAP earnings highlighted persistent concerns about LUKoil -- namely, the efficiency of its capital spending and control of its operating costs. LUKoil Vice President Leonid Fedun told investors at a conference in Moscow that the company had realized more than $ 109 mm in cost savings through a program started in April, adding that the company planned to sell non-core assets such as rail cars and financial-services subsidiaries. It still has to complete a sale of its drilling unit, LUKoil Bureniye.

Unlike other large Russian oil companies, LUKoil forecasts its output to be modestly higher this year, which will likely leave it the country's second-largest producer behind Yukos. LUKoil and Yukos were neck and neck, but Yukos on its own has already produced 1.52 mm bpd and its merger with Sibneft will pull into the No. 1 producer spot.
Otherwise, LUKoil remains one of the few public companies with a possible workable concession in Iraq and an improving relationship with Washington. If LUKoil doesn't win back its contract, it's a neutral for the stock. But if LUKoil does succeed, think of it as a cheap long-term call option on Iraqi oil.

Source: Dow Jones
Market Research

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