Those in the energy market are up against a range of challenges at the present time, and without first adopting the correct corporate governance controls and strategy to match, key industry names could fall by the wayside. Lukoil, the country’s second-largest oil producer is testament to the fact that there are still pockets of opportunity in a market rife with challenges.
By committing to international best practices of corporate governance and comprehensive qualitative and quantitative measures to analyse risk, disclosure and compliance, Lukoil has the necessary internal controls in place to shield it from external shocks. World Finance spoke to Andrei Gaidamaka, Vice President of Investor Relations at Lukoil, about the country’s changing energy market and how the company is equipped to weather the storm.
Another advantage for Lukoil is our broad portfolio of overseas assets both up and downstream
How have Western sanctions and falling oil prices impacted Russia’s energy market?
Thanks to the tax system, Lukoil faces fewer decreasing netback prices. At the same time, domestic currency depreciation has reduced our ruble-nominated costs and liabilities in USD terms. Increased competition between subcontractors in Russia allows oil producers to exploit the situation and obtain better prices from suppliers. This is primarily why we expect lower lifting costs and capital expenses in dollar terms for this year. Also, domestic demand for petroleum products remains strong, especially for high margin streams such as high-grade gasoline, low sulphur diesel, jet fuel, and lubricants. So we remain cautiously optimistic and plan to be free cash flow positive in 2015.
The company has several major green-field projects in Russia, which enable us to maintain stable and growing production in the short and medium terms. The shortlist of such projects includes the Filanovsky field in the Caspian, mid-size discoveries in the Timan-Pechora region – our two largest gas fields in Yamal – shale and tight oil developments in Western Siberia, and many more.
Another advantage for Lukoil is our broad portfolio of overseas assets both up and downstream. Up to 30 percent of our total assets are located outside Russia, and in the nine pre-crisis months of 2014 our international businesses generated over $3bn in operational profit.
We continuously monitor the effect of the sanctions on our financial position and operations, but there has been no direct impact to the company on the technology side. Since we don’t have projects in the Arctic offshore, deep production, or significant production from shale fields, the limitations do not currently affect us. An indirect impact of the sanctions however, is to increase the cost of our financing. Our current priority is to reduce capital spending to a level that is in-line with our cash flow generation at current prices, in order to ensure that we live within our means. We have done this successfully before: when oil prices fell in 2009, our operating cash flow fell by more than $5bn from the previous year and we reduced our capital spending budget by approximately the same amount, resulting in positive free cash flow for the year.
How do you see the decline in oil production playing out in the coming years?
As our top management noted before the current crisis, we are expecting a decline in Russia’s oil production if there are no changes to the tax regime before 2017 to 2018, in that it is unprofitable to implement tertiary methods on mature oilfields. Even still, the outlook for Russia’s oil production has worsened recently following the oil price collapse, and I think oil production may begin to decline before 2017. The government has recognised the likelihood of production declines in the absence of new major green-field projects, and is implementing changes to the tax system to focus on support for oil production. There is still time to arrest the impending decline with changes to the fiscal system, and, of course, a higher and more stable oil price environment would result in more investment as well.
What is your strategy to stay competitive?
We constantly monitor the markets and our competitors’ actions in order to maintain our competitiveness. In order to be cash-positive in the low oil price environment we are cutting our capital budget programme. However, this reduction will not affect important and strategic projects. In 2015, we will begin production on new multibillion assets in upstream (Filanovsky oilfield) and downstream (Burgas Hydrocracking Unit in Bulgaria, Catcracking Unit on our refinery in Nizhniy Novgorod, Coking Unit on our refinery in Perm).
Why was the sale of Lukoil’s stake in NPC necessary, and what benefits will this bring?
Our participation in NPC was as a minority, non-operating investor. The project is at an early stage and our incurred cost was only for the purchase of a 20 percent stake. This heavy oil mega-project would require a substantial financial commitment from Lukoil, and, at this point, we think that the project does not fit into our plans. The company prefers to be an operator of projects, so we decided to sell the stake to a partner and focus on other existing opportunities.
How will Lukoil’s investment in the Burgas refinery improve the business?
This year we are planning to complete the construction of a hydrocracking unit at the Burgas refinery with a capacity of 2.5 million tonnes per year, and after commissioning the unit we will reduce the output of low-value fuel oil by 0.9 million tonnes per year.
The refinery will increase the output of light and middle distillates by 0.8 million tonnes per year – up 20 percent – and high-sulfur fuel oil will be replaced by low-sulfur content, which will increase the profitability of the refinery. The project will also reduce our environmental footprint .
What are your current priorities, and have they changed at all in the past year?
Given the dramatic changes in 2014 we are revising our long-term strategy. We do not want to under-react to the changes we are seeing, but we do not want to over-react either.
Our goal is to earn a return that is higher than our cost of capital on every barrel produced over the life of a project, so that we can then pay that return to shareholders and be free-cash flow positive.
Our corporate priorities have not changed over the last year, and our top priority is the maintenance of competitive returns to shareholders and investors. The dividend policy is not being revised despite the turbulence on the markets, and we intend to keep a comparatively high dividend yield.
What differentiates Lukoil from rival oil companies in the region?
Lukoil is a global Russian private energy company with substantial international assets. We have a long and successful company history, respect for shareholders, and a solid dividend record, and as one of Russia’s largest national taxpayers and investors, Lukoil places large-scale orders with key parts of the national economy. As a responsible corporate citizen and an honest participant in the market economy, the company commits itself to socially responsible participation in the life both of the local population in the regions where it operates and in society as a whole. We consider it our duty to pay our taxes in a timely manner, which helps the state to solve social challenges in the regions where our company has a presence.
We also consider it important to be a socially responsible company internationally. For example, Lukoil is hiring local people to work on construction of the West Qurna-2 field in Iraq. More than 11,000 workers were employed at the height of construction, and more than two thirds of them were local people, working for both Iraqi and local companies.
Lukoil has also established standards of corporate governance in Russia with specific keystones to best represent the company’s success in the area that include being independently audited by KPMG since 1994; receiving independent audit of reserves from Miller & Lents since 1997; preparing financial statements under the US GAAP standards since 1998; being listed on the LSE and including independent board members into the board of directors (BoD) since 2002; investment ratings from all three leading international rating agencies since 2007; with the majority of the board of director’s independent since 2009.
The BoD plays a crucial role in Lukoil’s system of corporate governance, exercising overall control of company activities in the interests of investors and shareholders. In accordance with Russian legislation and the Lukoil Charter, the BoD defines priorities for company development and ensures the efficient functioning of the company’s executive bodies.
At the end of 2013 there were six independent members of the board out of 11 total, whose presence enabled objective opinion to be formulated on matters discussed and, therefore, to strengthen confidence in the company.
