#22 - JRL 7004
Barron's
January 6, 2003
Russian Oils Still Look Cheap After Big 2002 Gains
By GEOFFREY T. SMITH
Geoffrey T. Smith is the Russia Bureau Chief for Dow Jones Newswires.
WHAT A LOUSY YEAR 2002 was for Russian oils: Yukos up only 81%, Tatneft up the merest fraction over 50%, Lukoil Holdings a pathetic 20%. Heck, without Sibneft's 200% rally, the sector might look positively mundane.
I wonder how many people took a long look at this sector this time last year, only to decide that the owners are still too wild; minority shareholders still are mistreated; the best part of the rally is over; oil prices can't stay this high anyway, and so on.
You could still find reasons to think that way today without having to look too hard. But the chances are you'd be making a bigger mistake now than you did last year because the best Russian oil companies' valuations still are absurdly low.
Last year was one of huge developments in relations between Russian oil companies and the West: BP spent $375 million to raise its stake in Sidanco; Yukos sent supertankers direct to Texas; Tyumen Oil, or TNK, sold crude into the U.S. Strategic Petroleum Reserve; and Yukos, Lukoil, TNK and Sibneft together initialed a plan to build $4 billion worth of export infrastructure specifically to serve the U.S. market. For good measure, they also made a mockery of OPEC's plans to restrict crude output in the first half of the year -- a performance that certainly didn't go unnoticed at the Department of Energy.
In short: a whole series of events showed the determination of the West to embrace Russia as a strategic energy partner, and the determination of Russian companies to get a firm hold on international market share.
In this context, two companies in particular stand out as being startlingly, laughably cheap: Yukos and Sibneft, majority-owned by the oligarchs Mikhail Khodorkovsky and Roman Abramovich, respectively. Even after Yukos's famous 1,500% rise in the last three years, and even after Sibneft's 187% gain in 2002, they are cheap not only by mature-market standards, but even by emerging-market ones.
The stock market says Sibneft is worth $2.12 a barrel of reserves and Yukos $1.36 per barrel -- around one-eighth of the value the market gives to Exxon Mobil or BP. Yukos trades at 5.4 times expected 2003 earnings, Sibneft at 7.1 times.
Chris Weafer, chief strategist at Alfa Bank in Moscow, contends that, sooner or later, international oil majors will buy at least 25% of both companies. After all, there are few other places on earth where the majors can replace their reserves so easily. The main aim of Khodorkovsky and Abramovich is to make sure their future partners pay as full a price as possible.
To that end, both Yukos and Sibneft are trying furiously to prove that they can run a company as well as anyone in the West. Both have raised production over 25% the past year. For 2003, Sibneft again forecasts organic output growth of 25% and Yukos is aiming for a touch under 20%, a bumper return from the concerted application of Western drilling techniques.
In the first half of 2002, both companies spent less than $2 per barrel getting the stuff out of the ground, but Sibneft sold its crude for just under $22 a barrel, Yukos for just under $20, making over $5 per barrel of net profit in both cases. Spot prices have, of course, risen another $8 a barrel, to over $30, since then, bringing extra revenues at the same time as production growth has further depressed unit costs.
Sibneft even added another string to its bow in December, proving that it can replace reserves cheaply, as well as exploit them efficiently. Together with TNK, it bought OAO Slavneft, Russia's seventh-largest producer, at an equivalent of only $1.17 a barrel. The anticipatory rally means there may be little short-term benefit to Sibneft stock from the acquisition, say Troika Dialog analysts Kaha Kiknavelidze and Valery Nesterov. Longer-term, though, the strategic benefits of this could be huge: more reserves from which to wring value, more refining capacity to guarantee markets for its crude, more presence in the affluent Moscow region, and so on.
So, why the discount for either Sibneft or Yukos persist? The most common, and most persuasive, argument has been corporate-governance risk. But 2002 proved -- and sadly not in the way one would have wished -- that the gap between Russian and U.S. corporate governance isn't as wide as was thought. And still the discount persists.
That may make sense for Lukoil, Tatneft and OAO Surgutneftegaz, which trade even more cheaply. In contrast, the corporate reinvention process is already well-advanced at both Yukos and Sibneft. Yukos, in particular, is trying to live up to its self-proclaimed commitment to shareholder value.
In December, it became the first Russian company to pay an interim dividend, with a $400 million payout for the first nine months of 2002. And earlier in the year, in what appears to be a full-scale preparation for a level 3 ADR listing, Khodorkovsky had disclosed his and his friends' full shareholdings and mapped out a gradual reduction in them to a level just over 50%. The move was widely praised for boosting the share float and offering the prospect of a blocking stake to minority shareholders.
The latter still seems a couple of steps too far for Sibneft. Abramovich shuns the limelight as much as Khodorkovsky courts it, and Western investors will never feel comfortable with secretive Russian majority owners. Moreover, his fellow shareholders still include (at least according to his own claims) the self-exiled oligarch Boris Berezovsky, the embodiment of Yeltsin-era bandit capitalism. Their influence was widely suspected behind some share-shuffling by Sibneft management only a year ago that channeled around $150 million of the company's money exclusively to "core" shareholders.
Apparently chastised by the consequent PR disaster, Sibneft's behavior toward investors in 2002 has been pretty much flawless. The syndicated loan and bond markets haven't hesitated to throw over $1.5 billion at it. Still, the rough manner of its fights for control of Slavneft and the Moscow refinery this year suggest that the stock is still a high-risk, high-return play.
Of course, all of the above invites the perennial rejoinder about Russia that it is a one-trick pony: oil, oil and more oil. And this isn't just true of its stock market -- a chorus of independent analysts this year has bemoaned the fact that the economy at large has become more, not less, dependent on natural resources.
That means that, if oil prices collapse for any reason, such telecom and consumer stocks as are out there will struggle to avoid the fallout because the economy still relies so much on recycled petrodollars.
On the other hand, lower oil prices could be a big help to the world economy and stimulate demand for both base and platinum-group metals, the main products of OAO Norilsk Nickel.
Only a year ago, it would have been perverse to advocate investing in a mining company whose reserves and sales were classified by law as state secrets, and which under its previous management had almost single-handedly ruined the market for its most valuable product, palladium.
The secrecy laws and the awful state of palladium prices disguise how much Norilsk has in common with Yukos and Sibneft: sound operational management, abundant natural resources and a desire to integrate with the global economy and capital markets. Where they differ is in the government interference in Norilsk's business.
But changes are afoot. The government appears to have recognized that the secrecy it imposes on Norilsk is self-defeating. In the past four weeks, it has agreed to a step-by-step liberalization of platinum-group metal exports, given its blessing to a new PGM trading unit that Norilsk is setting up in London and freed information on two of Norilsk's largest nickel and cobalt deposits. There is lots more to do, but the movement is in the right direction.
Norilsk is without doubt still a speculative play. A lot is riding on its planned takeover of Stillwater Mining, which it hopes will reopen the U.S. market for it. It also remains to be seen how successful its expansion into gold mining will be. But having risen only 23% in 2002, nobody need be afraid that they have missed the rally. And it arguably has the most to benefit from the continuation of common sense in the Kremlin and an upturn in the world economy.
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