The rise and rise of Rosneft

by Simon Pirani

The jewel in Rosneft’s crown is Yuganskneftegaz, the west Siberian production company once owned by Mikhail Khodorkovsky’s ill-fated Yukos. In 2006, Yuganskneftegaz accounted for about 70% of both the production (total 80.8 million tonnes) and the reserves (total 2.2 billion tonnes of oil and 701 bcm of gas) of Rosneft.

It is mainly thanks to Yuganskneftegaz that Rosneft boasts the largest proved oil and gas condensate reserves among the world’s publicly-traded oil companies. Its 28-year reserves-to-production ratio is double that of ConocoPhillips, the leader among the international integrated oil companies, and substantially ahead of its nearest Russian rival Lukoil’s (24 years).

Earlier this year, Rosneft scooped up three more of the production subsidiaries that once belonged to Yukos – Tomskneft, Samaraneftegaz, and the East Siberian oil company – plus six oil refineries, a chain of 537 petrol stations in Moscow and nearby regions, and Yukos’s head office building and trading companies.

The bill came to more than $21 billion. Rosneft bought the production units at auctions by the receiver appointed when Yukos was finally declared bankrupt last year. Many of the other assets were first bought by two shadowy companies with no previous history, Unitex and Prana, who stumped up billions to the auctioneers and then resold to Rosneft within weeks.

Rosneft’s dizzying expansion over the last three years – from eighth largest Russian producer, worth an estimated $6 billion, to the first, with a market capitalisation of more than $90 billion – is a direct function of the strong support of the state, which owns 75% of Rosneft.

Conversely, support for Rosneft has been a central plank of the Putin administration’s drive to expand the state’s role in the hydrocarbons sector. It followed directly from the Kremlin-orchestrated campaign against Yukos, which was crippled with more than $30 billion of back tax demands and fines, and then bankrupted, after its main owner, Mikhail Khodorkovsky, was arrested in October 2003.

Khodorkovsky’s exile in 2005 to Siberia, where he is serving a ten-year jail sentence on corruption and fraud charges, marked the end of an era in which he and other “oligarchs” (politically influential businessmen) had set the pace in the Russian oil sector. Their vision of private entrepreneurship as the driver of development has been replaced by president Vladimir Putin’s insistence that private capital must be tied to state-directed companies and projects.

At Rosneft, Bogdanchikov, a career oil man, has teamed up with the ultimate statist in the person of Igor Sechin, who has since 2004 been both deputy head of the Kremlin administration and chairman of Rosneft. Sechin served in the late 1980s as a Soviet military interpreter in Africa and is one of the many senior state officials who in the early 1990s worked in St Petersburg in the early 1990s alongside Putin, himself a former KGB officer. Sechin is routinely categorised by the Russian media as a representative of the “siloviki”, i.e. those from a security services background.

Under Putin, state direction and control in the oil sector does not mean total state ownership. In mid 2006, Rosneft undertook an IPO that raised $10.5 billion from the international capital markets. Since then, more than 150,000 individual Russian investors have bought into the company – not a few of whom came to the shareholders’ meeting in June this year to complain of “miserly” dividends. The meeting was chaired by Sechin, making his first ever appearance in public: he described Rosneft as “a unique synthesis of two development models: that of a state company and that of an international public company”.

That synthesis has won the approval not only of Hans-Jurg Rudloff, chairman of Barclays Capital, who has joined Rosneft’s board as an independent director, but of most financial institutions and their oil sector analysts. Institutional investors have poured money into Rosneft as quickly as they have forgotten the losses many sustained from the state-sponsored break-up of Yukos. Rosneft’s prime chunk of Russia’s reserve base talks, and money listens.

Even the biggest sceptics believe that the combination of those reserves, and high oil prices, will ensure that Rosneft keeps growing for some time. It is the company’s complicated relationship with the state, industry observers say, that could frustrate Bogdanchikov’s ideal of Rosneft becoming a world leader.

Sources of growth

By outbidding rivals for former Yukos assets, Rosneft’s executives proved little more than the financial hitting power of their state backers. But by growing both reserves and production from its purchases, they have demonstrated an inspiring ability to manage. In 2006, the first year in which Yuganskneftegaz was consolidated, Rosneft not only achieved Russia’s lowest production costs, but also the highest industry increase in proved reserves per exploration well, the lowest replacement cost per tonne of reserves, the fastest oil production growth rate in Russia and the highest new well flow rates.

“Certainly, the accent has been on acquisitions in the last two years. But I wouldn’t want that to overshadow the organic growth that continued in all respects”, Bogdanchikov told a press briefing after the shareholders’ meeting. On reserves, Rosneft’s annual report points out that although the reserves replacement ratio in 2006 was swelled by acquisitions – including that of an effective 49.4% stake in Udmurtneft, a former TNK-BP production company in the Urals which brought 45.9 million tonnes – there were also big increases in proved reserves at the Vankor field (29.5 million tonnes) and in Yuganskneftegaz (59.2 million tonnes).

On production, Rosneft’s is growing “more rapidly than any other Russian oil company, and we intend that that will continue”, Bogdanchikov says. Industry analysts are confident of that, too. Konstantin Batunin, oil and gas analyst at Alfa Bank, says: “Rosneft will continue to ramp up production there for several years. At some point – and for some Russian oil companies this point has already arrived – production from existing assets will decline, and then the rate of well drilling becomes crucial.” But Rosneft is also strong in this respect: “Drilling volumes have increased. Rosneft has invested in Yuganskneftegaz at nearly twice the rate that Yukos was doing.”

Artem Konchin, oil and gas analyst at Aton bank, says: “I expect that within six months or a year, the newly purchased former Yukos companies will be integrated into Rosneft as effectively as Yuganskneftegaz has been. The company has an impressive internal control system that tracks production, refining and transport and facilitates the interconnection of assets.”

The former Yukos companies suffered from a serious lack of investment between the state’s attack on Khodorkovsky in 2003 and their purchase by Rosneft. Samaraneftegaz’s production has fallen from 12.4 million tonnes per year (tpy) to 9.5 million tpy, and Tomskneft’s from 15.9 million tpy to 11.4 million tpy. Industry sources say that Bogdanchikov has given free rein to Sergei Kudriashov, Rosneft vice-president in charge of production, to turn things around. Kudriashov is certainly cut out for the task: he was general director of Yuganskneftegaz from 2003 to 2005, and at that company brought a large number of former Yukos employees over to Rosneft.

One of Rosneft’s main sources of growth is a non-Yukos asset, the Vankor field in Krasnoyarsk, in the north-east of the west Siberian hydrocarbons field, from which oil will be exported via a new 543 kilometre pipeline to Purpe and on via the East Siberia-Pacific Ocean pipeline to serve east Asian markets. It is hoped to achieve output of 9.9 million tpy by 2009 and 32.8 million tpy by 2014. Beyond that, there are big east Siberian fields including Verhkhniaia Chona, where Rosneft has a 26% stake in a project operated by TNK-BP, and the Iurubcheno-Tokhomskoe deposit, licences for which came to Rosneft with the East Siberian oil company. It also participates in four of the six Sakhalin island projects.

This year’s shopping spree has also gone a long way to resolving Rosneft’s severe shortage of refining capacity. In 2006, it refined only 11 million tonnes of its own crude oil (13% of total production). Bogdanchikov says that this year, with the six new refineries and substantial upgrades of existing plants, that figure will rise to 50 million tonnes, “and to 90 million tonnes in the coming years”.

Rosneft’s acquisitions this year made it the Russian leader not only by reserves and production, but also by the volume of its debt portfolio – although financial analysts are pretty much unanimous that the burden is manageable, barring an unexpected and steep decline in international oil prices.

Rosneft started 2007 with $13.5 billion in borrowings, and in March took a short-term loan of $22 billion from Russia’s state-owned banks to enable it to sweep up the remaining former Yukos assets. Of that, $9.2 billion was repaid from a payment it received as a Yukos creditor. Management has committed itself to refinancing the remainder – with measures including the sale of non-core ex-Yukos assets and a $5 billion, ten-year eurobond that was introduced to investors in July – and to bringing the total debt burden down to $15 billion by 2010.

State and market

Whether Rosneft can reach the very top of the international industry will probably depend more on the strategy adopted by its largest shareholder, the Russian state, than on its spectacular exploration and production statistics. To become a super-major, Rosneft would at least need, first, to expand substantially its foreign holdings, which now are pretty modest, and, second, to show that it can rise above the limitations imposed by its unique relationship with government. And that part could be trickier.

Unlike Saudi Aramco, Petrobras of Brazil or Petronas of Mexico, Rosneft has to share the state’s affections with another energy behemoth: Gazprom, the world’s largest gas producer, which is also moving aggressively into the oil and power markets. Gazprom’s chairman is Dmitry Medvedev, the head of the presidential administration, Sechin’s immediate boss, and one of two likely Kremlin-backed candidates to succeed Putin in the March 2008 presidential election.

Rosneft’s rivalry with Gazprom has become the stuff of Kremlinological legend. In late 2004, discussions on a merger between the two companies were well advanced. But senior Rosneft managers, led by Bogdanchikov, had other ideas. They were intent not only on maintaining their independence but also on creating a state oil company parallel to, but separate from, Gazprom. When they bought Yuganskneftegaz in December 2004, the Gazprom merger plan was amended – but in March 2005 it collapsed all together.

Gazprom then established a substantial foothold in the oil sector with its purchase in September 2005 of a controlling stake in Sibneft, while Rosneft made clear its intentions of growing its gas business, particularly in the Far East. The two companies have clashed covertly on a series of issues, the latest of which is Exxon’s plans to export gas from the Sakhalin I project to China (Rosneft, a project participant, approves, but Gazprom doesn’t).

The presence of a “Gazprom party” and a “Rosneft party” in the Kremlin creates political risks for both companies – but analysts believe that those for Rosneft are greater. Konchin at Aton bank says that the presidential election in 2008 is bound to bring personnel changes, which may affect Rosneft’s position. “There is a risk that its corporate governance will not be as good as people have been expecting.” If the “Gazprom party” was to gain the upper hand, that could impact on Rosneft’s ability to move forward with strategic plans on the Arctic shelf, on Sakhalin and in east Siberia, Konchin believes.

Analyst Elena Anankina of the rating agency Standard & Poors says: “We keep in mind the fundamental economic interest of the state. Whoever is elected president next year, Gazprom will continue to supply 40% of Russia’s energy balance. Rosneft, on the other hand, is essentially a private player, whose contribution to the budget and share of exports are both lower than Gazprom’s.” This makes Rosneft more vulnerable to the impact of political changes, she believes.

Another obstruction that Rosneft faces jointly with other Russian oil producers is a high rate of tax. Both royalties on production and duties on exported oil, linked to a derivative of world prices, are a prime source of income for the state, and, along with local currency appreciation, taxation has cut into the current profitability of production. More seriously though, taxation may prove a barrier to future investment. As natural decline rates speed up, and costs of reserve replacement rise, Russian oil companies will find it impossible to undertake greenfield developments profitably: Alfa Bank recently modelled 40 possible projects and found that none of them could make money.

Russia’s shift of emphasis from private entrepreneurial initiative to a state-controlled national oil company is complete, and Rosneft is the main winner. But leaping to the top of the world industry will be a whole new challenge.