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. Last Updated: 07/27/2016

Alfa Marks Down Oil Producers

MT
Oil companies will not make money by developing new fields because of high taxes, while existing fields are being depleted, Alfa Bank said in report released late Wednesday.

The bank downgraded major upstream companies TNK-BP and LUKoil by 31 percent and 29 percent respectively. It also slashed 14 percent to 21 percent from the fair value of Rosneft, Gazpromneft, Tatneft and Surgutneftegaz.

In order to boost stagnating production, these companies have reported growing capital expenditures in recent years, which will reach the total of $14.5 billion this year, Alfa Bank said. The expenditures will stay about the same until 2014, the bank said in its updated projection.

A continuation of high export duties and the mineral extraction tax would make new development unprofitable in the long run, analysts Dmitry Loukashov and Andrei Fedorov said in the report, entitled "Less Taxes, Please."

Furthermore, the report advised investors to switch to oil field service companies, which stand to benefit from the greater upstream spending.

Highly integrated oil companies, such as LUKoil and TNK-BP, are more protected from growing expenditures because their refineries continue to make excellent margins, Alfa Bank said.

For companies to invest in refineries would comply with the government's drive to diversify the economy toward creating more value-added products, Fedorov said in a telephone interview. But LUKoil, which has been upgrading its refineries, has to sell the refined products at the same price as its competitors, he said.

The Alfa Bank analysts modeled 45 projects in east and west Siberia and the Timan-Pechora area in northern Russia, and "were astonished at how difficult it is to earn money in upstream nowadays." Only eight projects -- four in east Siberia, two in west Siberia, and two in Timan-Pechora -- were not loss-making.

"Only the largest and the most productive projects could be developed with significant profit for investors," Loukashov and Fedorov wrote. "The list of these projects would be limited to the most renowned names, if any at all, like the Vankor, Talakan or Verkhnechonskoye oil fields."

All other projects will most likely lose money at any oil price because high taxes would not allow companies to recoup drilling and infrastructure costs, the report said. In west Siberia, new projects will not make money even if oil prices surge to $100 per barrel, it said.

In an effort to rectify the situation, the government will have to ease the oil tax burden, but that will take time because positive stock market performance, the issue's political sensitivity and lack of a proper campaign on the part of oil firms to lobby for tax decreases blur the overall picture, they said.

"The new taxation regime has just been introduced and we do not expect any substantial changes in this election cycle," the analysts wrote. "However, in the long run ... Russia has no choice but to modify the oil industry's taxation regime to stimulate investment in greenfield projects."

The taxes have been set high because of some Russian companies ramped up production very rapidly without tapping new fields since the end of the 1990s because they targeted short-term cash returns, Alfa Bank said.

LUKoil, which wants to double production by 2016, said Thursday that its plans to invest tens of billions of dollars in the development of new fields in Timan-Pechora and the Caspian Sea area were commercially viable.

"We don't deal with unprofitable projects that provide returns of less than 15 percent," said LUKoil spokesman Dmitry Dolgov.

Capital expenditures will grow not only to increase production, but also to upgrade downstream assets, he said.

Some oil analysts disagreed with Alfa Bank's findings. UBS upgraded Tatneft on Thursday, raising its price target by 8 percent to $5.5. That represented a sharp contrast with Alfa Bank's new target price of $3, a decrease of 21 percent.

UBS based the upgrade on anticipation of increasing tax benefits reported by the company, it said. Tatneft is a major beneficiary of the new law that gives tax breaks for depleted fields.

Vladimir Vedeneyev, an oil analyst at the Bank of Moscow, said the taxes were harsh but not unsustainable. The state will change the tax regime if oil companies are really unable to develop new fields, he said.

"Oil companies feel quite confident, especially if they are balanced and have refining capacities," he said. "I wouldn't agree with the dark picture that my colleagues painted. It is over-the-top."

Shares of all the oil companies mentioned in the Alfa Bank report were up on the RTS index Thursday, except for Gazprom Neft, which lost some value.