#9 - JRL 7060
Analysis: Russia's British turning point
By Sam Vaknin
UPI Senior Business Correspondent
SKOPJE, Macedonia, Feb. 12 (UPI) -- British Petroleum PLC teamed up with the Alfa Group-Access-Renova concern in a 50-50 joint venture to form Russia's third-largest energy company. The new titan will digest Tyumen Oil Company International, Rusia Petroleum and Sidanco Oil, which produce, among them, about 1.2 million barrels per day.
The combined outfit will tap between 5 billion and 9 billion barrels of proven oil reserves as well as perhaps 100 trillion cubic feet of gas.
The mix includes lucrative exploration contracts in Sakhalin (an island in Russia's Far East) and western Siberia as well as 2,100 gas stations and five refineries in Russia and Ukraine.
Slavneft shares owned by AAR are excluded -- as are Sibneft's warrants convertible to TNK stock. BP keeps out its interests in various local businesses and its sizable oil trading operations in the Russian Federation.
BP will pay $3 billion in cash for its stake and another $3.75 billion in shares over three years. The market valuation of BP's stock is at an ebb -- but some analysts say that, in a world of rising global tensions and surging oil prices, the deal might yet turn out to be a masterstroke. BP's earnings jumped a whopping 49 percent in the fourth quarter, they point out.
But the far likelier scenario is less friendly.
BP was forced, by a series of humiliating revisions to previous figures, not to set a future production growth target, merely claiming to be in a "strong competitive position."
Moreover, when the change in the value of its oil inventories is stripped, profits last year are down by a quarter from 2001.
Its return on capital also plummeted from 19 percent in 2001 to 13 percent the next year. Dwindling margins in refining and retail, mainly in the United States, threaten the viability of these operations, although they have been improving as of late.
Only hefty reserves and a higher dividend cushioned the widely expected decline in net earnings.
BP had withdrawn from the Russian market, having been scorched by shady dealings in Sidanco, one-tenth of which it acquired in 1998. At the time, it claimed to have been defrauded by the very partners it has taken on board in the current collaboration.
But it firmly believes that its Russian re-entry is auspicious, saying: "The deal would be immediately accretive to cash flow, earnings per share and return on capital employed, and it expected to improve performance significantly over the next four years through synergies, cost reductions and output growth."
However, the situation in Russia might be more complicated.
In the proposed partnership, BP is paying about $3 per barrel for reserves. It stands to gain about 500,000 bpd in production from the joint venture.
Only two-fifths of this amount can be exported as crude and another 15 percent as refined products. The rest must be sold domestically at artificially depressed prices.
Russia is already flooded with about 170 million barrels of unsold oil, in no small measure due to an ongoing conflict among private producers and the country's state-owned pipeline monopoly, Transneft. LUKoil foresees an increase of yet another 130 million barrels by November, according to the New York Times.
With the indigenous market thus saturated, any post-war plunge in world prices could prove calamitous to BP.
As Venezuela's output recovers, the weather warms, the global recession deepens, and a regime-changed Iraq rejoins the world market, an oil glut is in the cards. Despite current high crude prices, OPEC has been talking about production cuts to sustain a level of $18 to $20 per barrel.
Russia is unlikely to support such a policy. Its dependence on oil has matured into a full-fledged addiction in the last three years. Russia's budget assumes an average price of $21.50 per barrel. Its production is also more rigid than Saudi Arabia's. It cannot turn extraction on and off at will. Output increased by 9 percent last year.
Additionally, Russia will gleefully leverage the fortuity of a crumbling and internecine OPEC into gaining the no.1 oil producer spot by increasing its market share. BP might find this policy reckless and short-sighted but still be forced to cooperate with it to the detriment of its long-term interests.
Frederick Leuffer of Bear Stearns reiterated his "outperform" recommendation for BP's shares before it embarked on the Russian joint venture. The analyst predicted "restructuring and capital expenditure reduction initiatives shortly ... the company (is expected) to redeploy proceeds and cash flow towards share buybacks and dividend increases." These seem less likely now.
BP is also involved in other costly projects in Georgia, Ukraine and the countries of the Caspian Basin. This pervasive exposure to the region is nothing short of a gamble.
BP's attempts to minimize the weight of its latest foray into Russia is disingenuous. Once concluded and cleared by competition authorities in the Russian Federation and the European Union, this single venture will account for one-third of BP's reserves and one-seventh of its production.
BP's traditional haunts in the North Sea, the Gulf of Mexico and Alaska are mature and extraction might become prohibitively expensive at much-reduced crude prices. But the company is endowed with massive -- and oft-replenished -- reserves. It is also geographically diversified. Its output is poised to grow by one fifth, to 4.3 million bpd, within three to four years.
So why risk another round of bad governance, venal bureaucracy, oil transport monopoly, obstructive local partners, corrupt judiciary, capricious legislation, restive employees, organized crime and cunning competitors? In short: why risk Russia?
Virtually all other oil majors steered clear of Russia and chose to invest in countries like Kazakhstan or Azerbaijan. BP's move is driven by an unorthodox assessment that the Caspian is overrated and black gold is to be found in the Far East.
Russia's low cost of production and its enormous reserves make it as attractive as the Gulf once was.
And Russia is changing for the better. BP implausibly claims that the country is now a stable and promising investment destination. This might be going too far. But alternative crude transport infrastructure is being put in place -- from pipelines to deep sea harbors. Corporate governance has improved. The oil sector is almost entirely private and awareness of property rights has grown.
BP's shares went up a mere 4 percent after the announcement. This cautious welcome reflects the uncertainty surrounding the company's strategy. In 10 years, its managers will be praised as visionary pioneers -- or castigated as gullible dupes who were taken for a second ride by the very same partners. Time will tell.
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