RUSSIA - NK LUKoil

LUKoil is the leader among Russia's oil companies, being the largest group and growing steadily. Its president, Azeri-born Vakit Alekperov who has good connections with the political leadership in Moscow, once said LUKoil could buy Exxon within 15 years. LUKoil's R/P ratio is 36.5 years, compared to 11 years for most Western oil majors.

Because of low oil prices and high expenses, LUKoil is producing at full capacity: 1.3m b/d of oil and 2.3 BCM/year of associated gas. Its capacity increased after the company this year acquired a 75% stake in Arkhangelskgeoldobycha (AGD), the oil producer in the Arctic north. In July 1998, it sold 15.7% of its AGD stake to Conoco, the US major which has an oil producing JV with AGD and is to become LUKoil's strategic partner in developing large fields in the Northern Territories (see Gas Market Trends). LUKoil is to increase gas production considerably in the coming years, with plans to build gas processing facilities under study.

The group's expansions outside Russia have been rapid. They include major equities in the biggest oilfields and pipeline projects in Azerbaijan and Kazakhstan (see Gas Market Trends). Turkmenistan and other CIS countries are high on its list for E&P and downstream expansions. It is also moving into Algeria, Egypt, Iraq and other countries, with Agip of Italy and Arco of the US being its partners in most cases. Chevron, its partner in Tenghiz and the CPC in Kazakhstan, has been dealing with LUKoil in more than one way. In 1993, Chevron signed an eight-year contract to buy about 70,000 b/d of crudes from LUKoil, which allowed for a Japanese bank to lend the group about $700m in a deal arranged by Mitsui.

Structure Of LUKoil: LUKoil was first structured in 1992 and its name derived from three production associations in west Siberia that were merged: Langepasneftegaz (with a production the capacity of 275,000 b/d); Uraineftegaz (cap. 87,000 b/d); and Kogalymneftegaz (475,000 b/d). In Sept. 1995, under a decree, LUKoil took from Rosneft four producers which had agreed to merge with it: Permneft (170,000 b/d); Nizhnevolzhskneft (52,000 b/d); Kaliningradmorneftegaz in the north-west of the federation (15,000 b/d); and Astrakhanneft, the Caucasus (2,000 b/d).

LUKoil began its vertical integration in 1993 by taking in one oil refining firm, Volgogradneftepererabotka (with a 188,000 b/d refinery at Volgograd whose usable capacity is about 100,000 b/d). Under the same 1995 decree, LUKoil took from Rosneft three refining companies: Permnefteorgsintez (278,000 b/d refinery in Perm being partly used); a smaller plant at Novoufimsk, the Urals; and the large Ufa refining complex in Bashkortostan (whose capacity once was over 900,000 b/d but now is about 100,000 b/d). LUKoil is modernising these refineries so that its refining capacity should reach 1m b/d by 2002. This will include a new 180,000 b/d plant, being built in an area 30 km from Russia's Black Sea port of Novorossyisk, called Southern Oil Refinery. To cost about $1.5 bn, the refinery will be a JV with Agip, KazakhOil, the regional administration of Krasnodar, Transneft, Sidanco, Tatneft, ABB Lummus Global of

the US, Mitsui of Japan, Lurgi Oil & Gas of Germany, and Sirecox of Spain. At home the refineries are generating cash, but they produce fuel oil far in excess of local demand.

To LUKoil the retail business is very important. The group has several units marketing crude oil and oil products in the regions of lower Volga, the Urals, the Caucasus and the north-west. A marketing unit is to be formed for the coastal region around Novorossyisk. The units include Volgogradnefteprodukt, Kirovnefte-produkt, ChelyaBNefteprodukt, Vologdanefteprodukt, Permnefteprodukt, Adygeya-nefteprodukt, Astrakhannefteprodukt, Abadzekhsk- nefteprodukt, Kogalymtorgneftegaz, Pokachevtorgneft, and Kaliningrad- torgmorneftegaz. It has close links with trader Taurus for marketing in Europe. It controls 75% of crude oil sales to the Czech Republic through the Friendship Pipeline. The group has 800 service stations bearing its red and silver logo. With an investment of $100m, these should reach about 2,000 by 2001. LUKoil's 10% market share in Russia would be more than doubled; and this will include Moscow, the most lucrative market in Russia.

The group is building an oil products pipeline to link its Perm refinery, on the Volga River, to Moscow and other markets including Tatarstan. This will join an existing line for products exports from Omsk refinery in Siberia to Europe, which will enable LUKoil's marketing units to expand in premium European regions. At the same time, the group is building up a fleet for its shipping units, with one at Astrakhan where barge traffic along the Volga River links Russia's refining centres to the Caspian Sea.

LUKoil is negotiating to acquire an oil refinery in Lithuania. LUKoil is that country's main crude oil supplier. Lithuania recently sold a 33.3% stake in the same refinery to a US company called Williams.

Other companies in the group include construction firms and units providing various services, such as LUKoil-nefteavtomatika, Rostovneftekhimproekt, Uraiskoe, and Volgogradnefteproduktavtomatika.

LUKoil was registered on the Russian stock exchange on April 5, 1993. It was not fully consolidated until 1995. It was the first to convert "daughter shares" into shares of the holding company and the exchange ended on Jan. 1, 1996. It was the first to enter foreign capital markets, successfully placing converted bonds which were later exchanged for a 6% block of common shares. The exchange of daughter shares for holding company shares was conducted at "market cost". Daughter shares not quoted on the market were exchanged at somewhat arbitrary ratios. This was not resisted by shareholders. The success of the conversion had a positive effect on the share price of the holding company. Now the level of consolidation at LUKoil exceeds that of the other Russian groups.

Arco in 1995 got a 6% stake in LUKoil for $250m paid by means of convertible bonds. Arco later increased this to 7.99% and formed a joint venture with the group called LukArco. The group also formed LukAgip as a JV with the Italian company. By then, 16% of the group's shares were held by US investors in the form of American Depositary Receipts (ADRs). Now the holding company is to attract bigger investment through a listing in New York, with each daughter firm seeking investors on its own. CS First Boston, a unit of Credit Suisse and a main player on Russia's stock market, is the group's financial advisor.

Imperial Bank is its main local banker and holds 5% in LUKoil, said to be on behalf of the management.

LUKoil has relied heavily on crude oil exports for revenue. But the fall in world crude oil prices since October 1997 has affected the group badly. In May 1998 the group said its pre-tax profits for 1998 would be $540m, compared to $1 bn forecast earlier. But as prices kept falling, LUKoil officials last week said the $540m figure might be optimistic.

The group made big profits in 1996, when crude oil prices were strong with Dated Brent at times exceeding $25/barrel. LUKoil's receivables to revenue ratio in the first half of 1996 was 27%, compared to 13% at Sibneft's oil producer Noyabrskneftegaz and 68% at Yukos' Yuganskneftegaz. The ratio for its oil refineries was 40%, compared to 11% for Sibneft's refinery at Omsk (the largest and most modern plant in Russia) and 8% at Achinsk refinery of Eastern Oil Co.

In July 1998, the group announced that LUKoil's production cost had been cut by nearly 20% through efforts to cope with falling oil prices. The crude oil unit cost was brought down from Rbs340/ton to Rbs270/ton. At current prices, Rbs270/ton translate into $5.98/barrel. Combined with transportation costs and pipeline fees, the total unit cost could come to $9.40/barrel. LUKoil is the only Russian company drilling 1,000 wells/year using its own money. The group's maintenance of fields and related infrastructure has improved and unprofitable wells have been closed.

LUKoil's usable oil refining capacity has declined from 450,000 b/d in mid- 1996 to about 400,000 b/d. Its four refineries - at Volgograd, Perm, Novoufimsk and Ufa - produce too much fuel oil. The group is planning to upgrade these plants and, together with the $1.5 bn JV near Novorossyisk, LUKoil's refining capacity should reach 1m b/d by 2002. The group is also upgrading and expanding its Russian retail business (see OMT).

Russia's oil refining sector is old and inefficient. The 28 refineries are mostly owned by the integrated oil groups. There are 28 major refineries and thousands of mini-plants in Russia with a usable capacity of about 6.7m b/d, in theory making the country the third largest oil refiner in the world. It once was the largest in the world. However, some of the plants date from before the 1917 Bolshevik revolution. An influx of foreign funding to upgrade the plants, expected since the oil sector was restructured in 1992, would come too late and only a limited number of independent refiners will survive. With domestic oil consumption having fallen considerably since 1991, the surplus output of fuel oil has risen. Now fuel oil production is exceeding 1m b/d, about 40% of the refineries' production, while Russian demand is limited to 800,000 b/d compared with 1.6m b/d in 1985. The surplus of 200,000 b/d of fuel oils are being exported.

Russian demand for gasoline has risen to 700,000 b/d, while local production is limited to 600,000 b/d. Russian traders have become reluctant to import gasoline in recent months after the federal government imposed a new 25% import duty. Low-octane grades account for two-thirds of local gasoline production, while the strongest growth in Russian consumption is in high- octane gasolines. The unwanted gasolines are being exported at depressed prices.