Tumbling Gazprom, Rising Lukoil

From its decision to defend Bashar al-Assad to legislation against homosexuals, Moscow's recent moves have been attracting endless negative press. However, the latest controversy with the Russian state's heavy-handed response to Greenpeace protests against deep sea drilling in the Arctic Ocean has brought investors' attention to more than the country's worrying record with environmental conservation and treatment of activists. The spotlight falls on a company that had frontlined Russia's status as a hydrocarbon empire and its woeful state today. This company is of course Gazprom (NASDAQOTH: OGZPY  ) .

Gazprom under pressure
Despite its current privilege of monopolizing Russia's natural gas exports, the future looks grim for Gazprom. 

In September, the Moscow Commercial Court rejected a suit filed by Gazprom Export , a subsidiary of the energy giant, against the Interdistrict Inspectorate of the Federal Tax Service. The Interdistrict Inspectorate charged the energy company of underpaying 560.1 million rubles ($16 million) in corporate taxes during the period from 2008 to 2009. The court's decision to uphold the assessment by the Federal Tax Services will cost the company a total of 4.1 billion rubles ($123 million) in tax claims and penalties, a cost that will definitely have consequences on its operations. 

To make matters worse for the company, the European Commission has begun reiterating its concerns regarding Gazprom's pricing policy in central and eastern Europe. This is a setup for a potential antitrust investigation. If the charges are found to be true, the commission could fine Gazprom up to 10% of its global turnover and limit the company's commercial activities in the European Union. Although the impending departure of the EU's current competition commissioner and the political nature of Gazprom's relationship with the commission might mean that the charges may never be pressed, many analysts see the antitrust challenge to likely happen . 

Gazprom had already been forced to amend its contract with German utility company RWE in July after a legal ruling forced the Russian supplier to adjust the gas price formula and pay back about 1 billion euros ($1.3 billion) to the German distributor. 

All this, on top of Gazprom's mounting problems with developing new gas fields, competing against other suppliers, and maintaining ties with the Kremlin, makes it seem like the whole company is in retreat. 

Halliburton to the rescue?
In August 2013, Gazprom Neft, the subsidiary of OAO Gazprom responsible for oil extraction, and Halliburton (NYSE: HAL  ) entered into a strategic agreement to "introduce new technology and improve operational efficiency." The agreement's stated aim is to increase Gazprom Neft's annual hydrocarbon production to 100 million metric tons of oil by 2020 to make up for the decreasing output from existing fields.

Gazprom expects U.S. funding and expertise to facilitate the extraction of deep water reserves and oil in other areas current technology remains incapable of exploiting.

This brings us back to the spat between Greenpeace and the Russian state. With Halliburton's safety records in doubt after the 2010 Deepwater Horizon oil spill in the Gulf of Mexico, there is considerable uncertainty about whether this massive joint project will be safe and/or reach its stated aims. So far, despite the massive technology transfer from the United States, the difficulties of operating in one of the world's harshest climates have not been overcome. Halliburton is unlikely see a lot of profit here either.

Meanwhile, there is one company that is making ground.

Lukoil primed for the market
Lukoil
(NASDAQOTH: LUKOY  ) , Russia's largest private oil company, is making headway in developing Siberian shale oil in the Bazhenov Formation. Modest calculations from the U.S. government suggest that there may be 1,243 billion barrels of risked shale oil in place , but other estimates place the figure as high as 2,300 billion barrels. This is five times the volume of the largest shale deposit in the United States. 

While companies like Rosneft, ExxonMobil, Gazprom Neft, and Royal Dutch Shell also have plans in the shale, the most promising advance appears to have been made by Lukoil.  

Lukoil is experimenting with a new thermal extraction method , heating the oil in the shale and using the fractures in the rocks themselves to filter the deposits to the wells above. Lukoil engineers claim that they are in the process of finessing the technology. Meanwhile, Leonid Fedun, Vice President of Lukoil, spoke with great optimism about development in the Bazhenov Shale. He expects the deposits to be the main source of oil for the Russian Federation in 20 years, with yields exceeding the output from the Arctic Ocean. 

In addition to these exciting technological developments and geological surveys, Lukoil has one additional feature that makes it an attractive long-term investment: it is a private company.

Global market trends in the past decade have underscored the "old rule that buying shares in state firms is investment suicide."  Downsides to having a cozy relationship with the government, the corruption and other perversions that produce inefficiencies, have surfaced all around the world, in particular among state-run energy companies such as Petrobras and PetroChina. Gazprom is not an exception, and its above-mentioned legal troubles are no doubt the tip of the iceberg.

Given these variables, the safe long-term option in Russia's hydrocarbon market is with Lukoil.

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  • Report this Comment On October 08, 2013, at 10:52 AM, 153fish wrote:

    Very good article, Lukoil is very undervalued. An intrinsic DCF valuation of $90 is conservative.

  • Report this Comment On November 21, 2013, at 6:15 AM, RVredeling wrote:

    Gazprom and Rosneft are undervalued as well, a good time to invest in these companies. Ample of price appreciation potential + healthy % dividends. Best to buy these companies on LSE

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