The long-term strategy of Surgutneftegaz

by Heiko Pleines

Analysts from Moscow-based United Financial Group (UFG), one of Russia's leading investment companies, met with managers of Surgutneftegaz. At the meeting, the oil company outlined its general strategy for expanding and diversifying its production base and rationalised the hoarding of its cash.
The managers also outlined their plan for ensuring that Surgutneftegaz has two main production areas -- one located in western Siberia (the company's original base) and the other in the Irkutsk/Sakha region of eastern Siberia -- within the next three to five years. Development of the eastern Siberian area will, according to the company, be driven by rising oil demand in China and other Asian countries.
Since there is virtually no infrastructure in place at present, Surgutneftegaz estimates that capital expenditure needs in the region come to about $ 10-25 bn. The company does not plan to invest that entire amount on its own, and it is willing to involve the Russian government and other oil companies -- perhaps including Western ones.
The company's medium-term production target is 60 mm tons of oil and 25 bn cmpy of gas, compared to 40 mm tons of oil and 12 bn cm of gas at present. At the meeting with UFG analysts, the company noted that gas, in particular, would require support from the government to ensure that the domestic gas pipeline network was opened to third-party shippers.

The situation of the company's single oil-processing plant was also discussed. Expansion and upgrading at the Kirishi refinery is effectively on hold because of the launching of construction work on the Baltic Pipeline System (BPS).
The refinery uses the pipeline from Yaroslavl to Kirishi to transport oil but will lose 60 % of this capacity when the new BPS terminal at Primorsk is constructed. The company is arguing that its throughput at Kirishi should not be reduced as a result of work on the BPS project and, while it believes it will be successful in persuading the government, it is not willingto countenance investment until this is confirmed.
As the UFG analysts commented: "[This] is yet another justification for investment not proceeding. Interestingly, the company also noted that it might construct a new refinery in eastern Siberia when production in that region warranted it. We consider this a very long-term possibility and investors should not focus on it at this stage. The costs involved in any project in eastern Siberia are now advanced as one of the reasons why the company requires such a large cash and shares reserve."

UFG also commented: "With oil prices at current high levels, the company believes that better opportunities will be available when prices are lower. However, this conveniently ignores the fact that prices have been lower -- in the immediate aftermath of the crisis [that began in August of 1998], when Surgut was one of the few firms with hard cash available to it but signally failed to take advantage of this. We still have a serious concern about the company in that, while caution was appropriate around the time of the 1998 financial crisis, Surgut may now be missing opportunities by being excessively cautious."
In summary, the UFG analysts came to the following conclusion: "Surgut acknowledges that it may appear somewhat pedestrian in comparison to LUKoil but appears to revel in its mould-breaking image of a low-key oil company with a focus on costs and a cautious -- yet successful -- approach to its business. We maintain our HOLD recommendation in the short-term on valuation grounds but believe that the company offers solid growth prospects in the long-term."

UFG's analysts for the oil industry are Stephen O'Sullivan and Dmitry Avdeev.