New Expectations

By Ivan Rubanov

Rosneft has come to a point beyond which explosive growth through M&A activity no longer meets the expectations of the market. From now on, its performance will be evaluated on the efficiency of its production operations and investment activity.

A decade ago, Rosneft was a pale shadow of its rivals in the Russian oil industry. In the aftermath of the Russia-wide privatization program, the company seemed to be waging a losing battle against private oil companies: it consolidated what stayed in government property after the break-up of the Soviet oil ministry, but suffered constant attacks from the more enterprising private companies. Until recently, its production was almost ten times less than that of the market leaders, and its financial and operating performance was quite poor (see Table).

Table

The situation changed dramatically at the start of this decade. A new management team headed by the current president Sergei Bogdanchikov came to usher in a new era for Rosnef where it enjoys the support of “superior forces” personified by the Russian President’s deputy chief of staff Igor Sechin. During 2000 – 2003, Rosneft licensed and started production from a number of fields in Eastern Siberia, offshore projects in Sakhalin and North Caspian, bought a number of large production and refinery assets, in particular, the Northern Oil and the Eastern Oil Terminal, and started to create its own refinery business.

The company started to grow.

However, sustainable organic growth could not bring Rosneft closer to the leaders of the market. Its main rival Gazprom, controlled by other “superior forces” in the staff of the President, remained far ahead, wielding almost ten times more financial resources than Rosneft. Time had come for explosive growth.

The year 2003 marked the start of an all-out offensive against Yukos, one of the most dynamic Russian vertically integrated oil companies. Next year became the star year for Rosneft: Yuganskneftegaz, the key asset of Mr. Khodorkovskiy, was acquired for USD 9.35 bln, at half the market value of the company. The new asset had a production capacity exceeding that of Rosneft by 2 times (45 MMT against 22 MMT), which allowed the government-owned company to soar into the top three of the market in terms of production. To quote the official Web site of Rosneft, “conditions for that historical move had been created on a planned basis since 1998”.

Rosneft against the background of the largest Russian Oil & Gas companies in 2005

Since then the industry analysts keep referring to the “administrative resource”, or political backing, as a key competitive advantage of Rosneft. Once in control of Yuganskneftegaz, the company set claims against its mother company, triggered an early bankruptcy to the rest of Yukos assets, and used the assistance of a loyal liquidation manager to assume control over those assets. In the past few years Rosneft received a number of important government preferences: a recent law disallows tax benefits to foreign-controlled companies who develop hard-to-reach fields in Eastern Siberia, and there are new legal restrictions on access for companies with foreign capital to strategically important (large) oil and gas fields.

To benchmark against the most efficient public companies in the energy sector and attract financial resources to pay off a considerable portion of its debt, Rosneft staged a triumphal IPO in July 2006. The price of shares in the IPO came close to the upper limit set by financial analysts: 15% of its equity was sold for USD 10.4 billion, which placed the company above the rivals in the Russian oil sector in terms of capitalization. Some analysts express doubts whether the IPO set a true market value for the company, considering that most of the shares had been bought by major foreign oil and gas companies (Chinese CNPC, British BP, and Malayan Petronas), and Gazprombank and Sberbank - two banks loyal to the government.

Growth does not come without problems. Rosneft’s aggressive M&A activity has resulted in an immense debt burden of USD 20 billion, which is five times the net profit in 2006. After the inventive legal arrangements applied to cause the bankruptcy of Yukos and alienate Yuganskneftegaz, the company may stay the target of legal suits on a permanent basis. Besides, experts point to a lower quality of management compared with that of its private peers, and a complex geographical structure of assets, which are spread out in clusters across the whole territory of the country.

Despite this, Rosneft announces further growth plans, and one can only suspect that such plans will again be driven by the administrative resource. The company will probably buy up the rest of Yukos production assets, for a modest price, but that would allow it to boost production by another 50%. Further M&A activity in the refining and petrochemical sectors are expected to give more balance to the company which has been relying heavily on crude production. It is further expected that the company will continue to enjoy preferential treatment from the government, get access to attractive fields and be able to acquire a number of small and medium-sized producers. If all goes as expected, the company’s strategy will continue to be aggressive growth through M&A.

Having said that, Rosneft and its management should not ignore the main thing. As a government-owned company, it should not only enjoy immense lobbying power, but should also act responsibly. The government and the companies it owns should have social responsibility. The society and economy are less interested in flowery reports about another acquisition, than in real actions, solutions to pressing problems and role models. Produce inexpensive quality gasoline, actively develop the East Siberian fields, improve oil recovery factors – these are the areas where Rosneft managers can prove to all of us that they are worthy of their positions and can meet our expectations. This would be the main criterion to assess their performance from now on.