Fitch: Struggle with Oil Production Drives Lukoil M&A

Lukoil's acquisition of a small Russian oil producer is out of step with recent merger and acquisitions (M&A) activity, and indicates that it may be struggling to sustain domestic oil output, according to Fitch Ratings. The ratings agency said that Lukoil's ability to reverse declining output and stabilize crude production in Russia is a critical rating factor.

Lukoil spent nearly $7.3 billion on M&A between 2009 and 2012, and it acquired large stakes in a number of upstream and downstream assets abroad, but only $452 million of that was spent on Russian upstream acquisitions, Fitch pointed out.

"This week's deal clearly bucks the recent trend. Lukoil will pay $2.05 billion to acquire Samara-Nafta, an oil-producer based in the Volga-Urals region with 2.5 million tons of annual oil production," Fitch said.

Unlike Rosneft and TNK-BP, Lukoil has posted declines in Russian oil production every year since 2010. By 2012, its total oil production from Russian fields had fallen by 7.7 million tons, or 8 percent, from 2009.

"We therefore consider this latest acquisition as a sign that Lukoil is willing to engage in costly acquisitions to halt the fall in oil production," Fitch said.

The company has sufficient rating headroom to finance this all-cash transaction with borrowed funds only, if needed, Fitch highlighted, adding that an aggressive acquisition program or other spending could lead to negative rating action.

"On the other hand, stabilization of crude production in Russia, and the completion of key upstream projects while maintaining solid credit metrics, would be positive for the rating," Fitch said.

At the end of 2012, Lukoil had $2.9 billion in cash and cash equivalents; its gross total debt was $6.6 billion.

"Lukoil's falling production in Russia results mainly from the depletion of the company's brownfields in Western Siberia and lower than-expected production potential of the Yuzhno Khylchuyu field in Timan-Pechora. The company managed to slow the decline in crude production in Russia to one percent in 2012 from five percent in 2011 through enhanced recovery techniques in Western Siberia (mainly horizontal drilling and hydraulic fracturing) and the development of new upstream assets in the Ural and Volga regions," Fitch said.

Lukoil's exploration and production capex in Russia increased from $3.9 billion in 2010 to $7 billion in 2012, and Fitch estimates it may average $8 billion per annum over the next three years.

Fitch also highlighted that Lukoil is considering large-scale investments in unconventional oil production from the Bezhenov Shale, Russia's colossal shale deposit in Western Siberia, which is estimated to contain up to two trillion barrels of oil. Production costs for the shale deposit are estimated at several times that of conventional oil, so oil producers would need new tax breaks from the Russian government to make production economic.

"We estimate that the contribution from Samara-Nafta to Lukoil's total output will be fairly small – equivalent to around  three percent of the 83.8 million tons it produced in Russia in 2012, excluding its share in production of equity affiliates," Fitch said.

LUKOIL's total hydrocarbon output in 2012 reached 2.17 million barrels of oil equivalent per day (MMboepd), second only to Rosneft's 2.43 MMboepd.


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