Tax Cuts Likely to Benefit Russian Oil Service Companies

MOSCOW (Dow Jones Newswires), May 28, 2008

Russian oil-field service companies could be among the biggest winners as the government slashes oil-sector taxes in a bid to revive stagnating production, industry participants say.

After annual growth of up to 10% at the start of the decade, Russia - the world's second-largest crude producer - saw output edge up by just 2.2% last year, with oil production down 0.1% year to date as what many deem an excessive tax burden hampers investment in new fields.

But following much lobbying on the part of the industry, the government recently agreed to reduce its key extraction tax and promised tax holidays for producers developing certain regions of the country.

The proposals could boost sector profits by as much as $20 billion a year according to some estimates and could benefit local service firms like Eurasia Drilling Co. Limited (EDCL.LN) and Integra Group (INTE.LN) to an even greater extent.

"The more the Russian government cuts (taxes), the better it will be for us," said Eurasia's Chief Executive Alexander Dzphaparidze during a conference call following his company's 2007 earnings.

London-listed Eurasia was formed in 2004 on the basis of the drilling assets of OAO Lukoil (LKOH.RS), Russia's biggest independent oil producer. Focusing primarily on drilling and workovers, the company posted $1.5 billion in revenue in 2007 and still counts Lukoil as its major client.

Lukoil, whose output has fallen a touch between January and April, was among the most vocal lobbyists for a cut in taxes.

Deputy CEO Leonid Fedun said earlier this year that the recent fall in production in Siberia reflects a longer-term depletion in the older fields located in that region.

"Western Siberia is repeating the fate of Prudhoe Bay, with a time lag of five to six years," he said. "When the well's productivity falls, you have to keep drilling more and more. You've seen it in Alaska and the Gulf of Mexico, and now you're seeing it in Siberia."

The company has since suggested Russia's oil output could surge by as much as 10% annually based on proposed tax holidays in regions such as Yamal and Timan-Pechora.

Such a trend would be an obvious boon to services firms, especially coupled with the seemingly unstoppable ascent of global crude prices, which are currently hovering at around $130 a barrel, more than double the level seen a year ago.

"High oil prices, as well as the potential for reduced taxation in the oil industry even beyond that recently announced, underpin the case for strong, multiyear, double-digit growth in the Russian oil-field service industry," Moscow-based Alfa Bank wrote in a recent research note.

"Currently, oil companies in Russia are in a critical situation in which the only possible way to maintain existing production levels - let alone to sustain production growth - is to drastically increase upstream capital expenditures, which feed oil-field service companies' order books," Alfa analysts Chirvani Abdoullaev and Konstantin Batunin argue.

As well as increased capex following the planned tax cuts, they note that small independent oil producers don't have in-house service units and rely increasingly on independent service providers. Also, new regions like East Siberia are only staring to be developed and should generate huge contracts in the future.

While high world oil prices increase demand for - and pricing power at - service providers, even a sharp drop in crude prices wouldn't be critical for those working in Russia, Abdoullaev and Batunin said, highlighting the structure of Russia's tax regime, which swallows a large part of prices above $27 a barrel.

Integra, which like Eurasia is listed in London, has also said it sees scope for a better operating environment following the potential tax relief.

"But before such changes take effect, there is a risk of certain services and manufacturing demand being deferred by our customers until their cashflows actually benefit from the tax change," it warned in a statement Tuesday.

Alfa favors Eurasia's simple business model over the slightly smaller Integra, which doubled revenue to $1.18 billion last year, rating the pair at buy and hold respectively.

Operating across Russia's traditional oil regions, Integra provides services to all major domestic and international oil and gas companies as well as for more than 30 independent oil producers.

On top of drilling the company offers a wide range of oil-field services, including manufacturing of related equipment, post-sale servicing and logging.

The pair vie with international service providers like Schlumberger AG (SLBS.VI) and Halliburton (HAL) for business from Russian heavyweights like OAO Rosneft (ROSN.RS) and OAO Gazprom Neft (SIBN.RS).

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