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. Last Updated: 07/27/2016

Alfa Report Sees Trouble Looming in Oil Sector

Alfa Bank warned on Monday that "production stagnation is unavoidable" at the country's oil fields and further downgraded its target prices for shares in most Russian oil companies.

The dramatic worsening in its outlook was the result of the government's reluctance to consider lowering taxes on oil firms and a higher proportion of water in the declining output, the bank said in a research report.

Alfa has led the way in cautioning investors about oil sector profits over the last six months, with other brokerages following suit in reducing expectations.

Alfa analysts reduced their recommendation for LUKoil, the country's second largest oil producer, from "hold" to "sell," and reduced its target price for shares in the company by 19 percent to $58.23.

The biggest loser in the report was TNK-BP, with the bank lowering its share-value estimate by 26 percent, to $1.50. The bank maintained its "hold" recommendation on the company's shares.

The only company in the sector to be upgraded was Rosneft, which saw a modest gain in its target price from $6.86 to $6.94. The report, attributed the rise to Rosneft's "unique" downstream opportunities. The bank maintained its "hold" recommendation for the company, which is the sector leader both by production and refining capacity.

The bank maintained its "sell" recommendation for shares in Surgutneftegaz, Gazprom Neft and Tatneft.

Alfa Bank first downgraded its projections in the sector in March, saying that oil majors were depleting existing fields while heavy taxes on the industry were preventing the development of new fields. In Monday's report, the company described the situation as "substantially more dangerous" than it had suggested four months ago.

The increasing proportion of water in total output was a major source of concern, the bank's analysts wrote. This causes a quickening in the rate of natural production decline at most fields.

"The growing decline rate simply means that more and more new wells need to be drilled just for output levels to stay flat," the report said. "This fully explains why rapidly accelerating drilling activity in Russia resulted in smaller and smaller production increases."

Since 2003, companies have lost 76 million tons of oil due to the rising water component, and have had to drill 5,000 new wells just to offset the lost production, the report said.

The bank said it was unlikely industry tax rates would fall, as the government has not even acknowledged the current rate as a problem, and identified inflation and loosening of cost controls as contributing to falls in production.

"Combining these observations, we now think that a period of stagnating production against the backdrop of soaring capital expenditures can hardly be avoided," the analysts wrote.

Alexander Mikhailov, an analyst at VTB, agreed that the taxes in the oil universe were high, but said it was unrealistic to expect the government to lower them in the run up to State Duma elections in December and the presidential election in March. He said companies would continue to generate solid profits despite the taxes as long as world oil prices remain at their current high levels.