Russia's Oil Companies Reap Little Benefit from High Prices

Despite high crude prices Russian oil production growth may be damped because the country's tax regime deprives producers of the bulk of export revenues while rising costs mean companies struggle to invest in new fields.

"We don't gain much from high oil prices," said a spokesman for Rosneft (ROSN.RS), Russia's largest oil company by volume and his counterpart at second largest company Lukoil (LKOH.RS) agreed: "High oil prices have only a marginal positive effect on the company. In reality it's the Stabilization Fund which gains from the high price of crude".

The state funnels most of the profits from oil prices above $30 a barrel through export and extraction taxes into its Stabilization Fund. Russian oil companies pay 24% income tax and then production taxes based on the market price of oil. As a result the companies are left with about 10% of their upstream profits. Still, both Lukoil and Rosneft are better off than some since they refine 40% of their output.

The strengthening of the ruble against the dollar is also denting their profits as oil producers pay their taxes and capital costs in local currency but sell oil on international markets in dollars.

In Lukoil's case, production is rising at 4% a year but its capital expenditure almost doubled between 2005 and 2007 to around $9bn.

However profits can be better for those companies that also have greater refining capacities. With the tax burden highest on crude being exported, subsidies for domestic refineries leaves companies with higher downstream capacity much better placed.

"Internationally refinery margins have little to do with oil prices but because in Russia export duties on crude and refined products are set differently, with a 30% gap, this gap goes up in dollar terms as oil prices go up," said Ronald Smith, chief strategist from Alfa-Bank in Moscow.

At $80 per barrel the companies (with refining capacity) are making $18-20 a barrel just out of the taxation differential. It's four times higher than what would be considered good in the West."

This differential divides Russia's major oil companies into two categories - Lukoil and Rosneft which refine about 40% of their oil are much better positioned than Surgutneftegaz (SNGS.RS) and Tatneft (TATN.RS) with TNK-BP somewhere in between. But even so, as the companies are working their refinery capacities flat out they find it difficult to finance new projects. The taxation regime was developed many years when oil was at $35-$40 a barrel and the assumption that it costs $2 to develop a barrel of reserves - a ratio of the total cost of oil field exploration divided by the volume of reserves. "With $80-90 a barrel it costs $7-$8 dollars a barrel," Smith said.

"The only way the companies are still making money is by extensive development of existing fields, because this doesn't require them to build oilfields from scratch including oil and pipelines," said Smith."Because the upstream profitability is so low, if you are going to develop a new greenfield project in, say, western Siberia you are going to lose money whatever the oil price is."

Sergey Donskoy, director of the Economy Department of Russia's Natural resources ministry didn't agree. "The companies still have enough money to invest in new projects," he said.

Last year Russia gave tax holidays to the companies developing new projects in Eastern Siberia, in order to fill a planned 1.6 million-barrel-a day pipeline to China. The region's crude production stands now at 20 thousand barrels a day.

Donskoy also said that the ministry is studying the possibility of easing taxation for oil deposits on the continental shelf. He also pointed out that the current tax regime gives tax breaks for some depleted fields and heavy oil projects, where oil production is more expensive.

Lukoil is already producing heavy oil and Tatneft signed a deal with Royal Dutch Shell (RDSA.LN) in September to produce heavy oil in the Volga region.

However Alfa-Bank's Smith doesn't see that as enough.

"The current tax regime is unsustainable and will change sometime over the next three years", he said.

It won't be easy to change though. The current taxes are easy to collect and cutting the tax burden for oil companies might prove to be politically difficult ahead of parliamentary and presidential elections, due in December and March.

Copyright (c) 2007 Dow Jones & Company, Inc.