Leonid Fedun - Vice President
Andrey Gromadin - JPMorgan
Maksim Moshkov - UBS
Karen Kostanian - Merrill Lynch
LUKOIL (OTCPK:LUKOY) Q1 2013 Earnings Conference Call May 28, 2013 8:00 AM ET
Leonid Fedun - Vice President
Ladies gentlemen, welcome to the LUKOIL headquarters in Moscow. I hope you are getting the English translation. We appreciate very much that you have carved out some time out of your busy schedule to join us here. The topic of this presentation today is presenting the financial results of this company for the first quarter 2013. It has been quite a challenging quarter. But we think that the company is still moving towards its strategic goal.
The second slide is there as usual, our disclaimer. For any presentation I have to show it to you according to the law. Next slide please. These are our main financial results. Net income is $2.5 billion. Earnings per share is $3.4. Net income per BOE produced is $13.1, not million dollars, unfortunately just $13.1. EBITDA is $4.7 billion and net debt is almost $4 billion. The company in this first challenging quarter turned out to be the most efficient. Let me just look at the real operations without paper based gains or depreciations. Among Russian peers we are the most efficient company financially.
Same thing becomes visible if you look at the net income per BOE, $13.1 per barrel. A lot of analysts say that $7 to $8 per BOE is quite normal for the Russian market. You can see how we are much higher than those estimates and EBITDA per BOE is $24. And again, these indicators show that in terms of economic efficiency we are better than our peers in both oil and gas sectors in Russia. Now let us look at our comparisons to our international peers.
Even though the tax regime is rather strong, we are quite in the trends in terms of [ROACE]. And in lifting costs, even though we are drilling more, we are also quite efficient. And in terms of the net income and specific net income per BOE, we are quite within the trends of our international peers. In terms of E&P [expenditure] per BOE produced, you can see that we are quite competitive. Even though the Russian tax regime is not the most friendly, it is quite well compensated by our efficiency and by the very healthy structure of our comps.
Now let us look at our macroeconomic environment. This has been a challenging year. There were some factors that played against the oil part. First of all we have witnessed a very dramatic decrease in the diesel price in Europe and Europe is the biggest consumer of Russian diesel. And while the fuel oil price in Russia grew, abroad it fell. Since we export about 2/3rd of our oil products, those negative factors have of course affected us negatively. In the first quarter, well, if you look at year '13 compared to year '12, you need always to take into account the leap year effect. So just add one day and add 3% to performance. So you need to keep that in mind.
Also, the currency translation turned out to be not so friendly. In the Russian taxation practices, this is so called paper based income but this paper based income is quite really taxed. So while last year our effective taxation rate was less than 10%, this year it is more than 20%. And at the same, if you look at the currency gains, from LUKOIL and for Rosneft you can see that the dynamics is absolutely different because the currency settlements inside the company's are quite different, but this is just paper based money movement. But of course it is important for the taxman.
This is the net income reconciliation. As you can see, the biggest factor that was behind the decrease in net income compared to the last year was the increase in the income tax. It was $422 million higher than the year before. And of course, capital expenditures and operating expenses also increase and that these are the factors behind that. Now let's look at the main operating results.
The domestic market is premium market for this company. We have invested heavily the past years in creating internal infrastructure, domestic infrastructure, so we quite consistently decrease oil exports in the loss making destinations. Black Sea, for instance, and at the same time we capitalize on $200 per metric ton net margin on oil products in the domestic market. So we quite consistently work and increase our operations on the domestic markets in sales and marketing of end products and this plays very positively in our operating results.
Last year in our presentation we said that LUKOIL's plans were to stabilize production starting from the end of the previous year. And in fact this is what we are witnessing. Rather slowly, but surely, we are increase production even though we have not started up and ramped up any of the new fields in the past year, and this report does not include the latest acquisitions which were made in the previous quarter. So what are the factors behind the flattening of the production decline. First of all, the biggest of the factors is increasing commercial rate of drilling. Starting from 2011, we have dramatically increased the amount of drilling so the commercial rate of drilling per rig increased over 50% in a single year and since then it increased over two-folds.
And if you look at the next graph, you will see that compared to 2010, we have increased the drilling amount two times but at the same time we have not increased, we have not doubled drilling expenses. So we are much more efficient in drilling. Primarily this drilling increased production in West Siberia and other mature regions. But there is another factor that is quite important now, it is water flooding and improvement of oil recovery through water flooding in mature fields. Fighting high water cuts and sustaining reservoir pressure is also quite an important factor. We have started on this on a wide scale and I think this is going to give us 2% to 3% less production decline in mature regions and consequently it will add about 1% points in the production from mature regions. So the next step for us is going to work with hydrodynamic characteristics of the reservoir -- same pressure as long as possible.
Next slide please. One of the financial efficiency drivers is the production of high-octane gasoline in Russia. In the past years, we have consistently increased the domestic sales of high-octane gasoline. We don’t do that just because it is the right thing to do, we do that because of good business. If you look at the next slide, you will see why. The next slide describes the increase in the year-on-year production of high-octane gasoline, 7.3% plus. And now let us see how we are gaining financially from migrating from Euro 3 and Euro 4 to Euro 5 grade gasoline.
The Russian government has tried to stimulate investment in refinery so for environment friendly Euro 5 gasoline and diesel, they have introduced very serious incentives. The difference in excise tax between a metric ton of Euro 3 and Euro 5 is about $140 and is going to bring an additional $800 million of EBITDA until the end of this year. Our expectation is that this system is going to work until 2015-2016, but we think that some of our colleagues, very influential colleagues will not have enough time and will not be fast enough to migrate to Euro 5. So we think that this might be prolonged until 2017. And this will be very very good for LUKOIL financially. So the investments that we made in oil refining and that were, I might add, very skeptically appraised by some analysts and some of our peers, have actually given LUKOIL and are going to give LUKOIL more net income and very good monetization.
Sales have gone down slightly and this decrease is due to two factors. First of all the leap year effect from 2012, but there is also a second factor, the euro's price has decreased slightly and consequently the oil products prices have gone down. EBITDA is down 11% year-on-year, but it is higher than in the fourth quarter. At the end there is a leap year effect, there is the price decrease effect and 0.8% decrease in the oil production. You can see that the income before income tax is quarter-on-quarter almost zero change but the decrease is 17% year-on-year.
However, if you look at net income, I think the next slide is net income, you can see that the difference is more dramatic. And it is exactly because of the $400 million plus that we had to pay in tax, just because of the unfriendly currency translation rates. The next thing is the economic efficiency. I think we have already commented on the figures. The biggest operating expenses increased, I think it's production rates. Yes, these are production figures. So you can see that we have 11% increase during the year in hydrocarbon extraction expenses. I had said already that this has been due to our additional investment in drilling. Even though the drilling rate, the drilling volume, increased much more than the 11%.
Our own refining expenses, operating expenses, are primarily explained by increasing the quality, increasing the part of premium diesel fuels, and increasing the share of premium gasolines in our product lines. We have produced less of fuel oil and I think this quite explains the 61% growth in refining operating expenses. But I think it is more than compensated by the higher net income that we get out of it. You can see the structure of change in our operating expenses here. As you can see, it is primarily about quite objective factors that are beyond our control. So about 3% explained by the volatility in ruble exchange rates and all the rest goes into depreciation and investment in higher quality of end products.
Leasing costs have also changed but I can tell you quite frankly that it's just about the ruble to dollar volatility. The company's policy on expenses is that our expenses should grow less than the official inflation rate. It's quite a challenge but we have been trying to achieve that and all the motivation schemes and incentive schemes for our engineers and for staff are very closely related to making our cost centers more efficient than inflation. And the tenders we have organized throughout the supply chain have enabled us to buy metal pipes and all the big products at prices that have grown less than the real inflation to Russian Federation.
Next slide. Transportation expenses have been flat because Transneft rates have increased but freight cost and railway transportation costs have gone down, so the growth is -- I would say the growth is negligible. Sales, general and administration and transportation expenses put together in the past quarter have decreased because in the fourth quarter of each year all companies pay a lot of bonuses, so traditionally SG&A in the third quarter of each quarter of each year are quite low. This is exactly what this slide demonstrates. So this is the quarter-to-quarter and year-on-year changes.
The balance sheet is quite strong. I would say that the share of debt in our balance sheet is exceptionally low and I would like to ask you to take into account also that we, I think, issued $3 billion worth of euro bonds, maturity from 5 to 10 years. They were quite oversubscribed. And we got very very good interest rates on the securities which are far better than what Rosneft and Gazprom got. We were in a hurry because we knew that Rosneft was preparing to purchase a large volume of their euro bonds on the market. We were faster and I think that gave us a very very good and healthy position in our euro bond interest rates.
This our debt-to-EBITDA ratio. I will say it's quite acceptable and net debt is also quite low. And so the net cash to net debt relationship, again it's been flat for the year. There have been some fluctuations in debt but they are quite insignificant and there is quite a few of available cash on our balance sheet. Capital expenditures. The biggest item of capital expenditures is exploration and production. You can see that our CapEx is quite stable from quarter-to-quarter, $2.5 billion to $2.6 billion. It has increased compared to the previous quarter primarily because of investing in new, highly efficient and effective projects like the Caspian production in Uzbekistan, and we are expecting the West Qurna-2 to come on stream to ramp up quite quickly.
The refining and market investments are explained by the drive to retrofit our refineries in the Russian Federation. This investment remains stable. We think that retrofit will be more or less completed in three to four years with a recovery ratio increasing to 95%, which will give us over 10 Nelson index on all our refineries. So we will become one of the best refiners or one of the most efficient refiners in the Russian Federation. This is the characteristic of our investment, one of our investment projects that will grow very quickly by us. This project is the construction of a pipeline between the Kharyaga field and Yuzhnoye Khylchuyu, the transportation system that has already been built there. At about $230 million capital expenses we expect to be increasing in EBITDA alone about $500 million per year. We save on transportation cost because it is own infrastructure and also we can sell more premium oil because the quality of this oil that we can sell at the seaport is quite high.
Now let us talk about our acquisitions. I think we have made a very good acquisition in Russia, Samara-Nafta. The Samara region is a region where the growing production potential and we have paid very competitive price. May be you have heard that our American partners agreed to sell us this object at a much lower price than some others. Yesterday, (inaudible) went to the Samara region to talk to the regional government, to talk to the Presidential representative in the federal district, to negotiate for the connections of our southern and northern license areas to the pipelines.
So far we have been transporting 100% of production by truck, which means very high costs. And according to our past calculations, the net income per BOE was about $10. And we actually expect to increase that by $3 additional per BOE by going down on transportation costs, by own refining, and through other synergies which are quite visible. Which means that the value of synergy from this project is just about $150 million per year, just because of these factors.
We also think that the Samara region has not yet sold a lot of quite good license area. The American geologists who had worked there before have indicated a lot of shale oil in the so-called (inaudible) formations, which they said look quite like Bakken. So probably we will start our shale oil development in this region by trying to replicate here the technology already tested in Bakken. We have here quite a few oil rigs, we have here quite a few pipelines, so there is a lot of infrastructure here. And to drill share oil here will be much less challenging than in West Siberia where formations are quite less homogenous.
Kama-Oil is another acquisition. The acquisition that we have targeted for quite some time and finally we got it. There has been a prohibition to develop these fields because I think you know Uralkali, the potassium producer, and there is a potassium field, deposit, above those reservoirs. But we have very successfully negotiated with Uralkali proprietors itself. Our current C1+C2 reserves are about 175 million barrels and with quite good infrastructure. I think after we complete the acquisition we will ramp up the investment in the region and it will be one of our biggest factors of growth in the Perm region.
Northern Caspian is already, not distant future, for this company. We have already designated where the supporting blocks for the ice-resistant platform at Filanovsky field. We have designated where they are going to be. And on Korchagin field, we already are getting about 6000 barrels per day. This is a horizontal well with the longest reach out in Europe. On explorations, we can bring I think that good news. Now our understanding is that (inaudible) formations are one formation after all, and we think that the gas reserves can be doubled really shortly and also we have got signs of very big volumes of gas condensate. This is because of knowledge of the past ten years is very ample and in fact our knowledge suggests that this is not the last time we are going to increase our reserve, our registered reserves, in the Caspian. So we are steadily optimistic about Caspian reserves.
Very shortly, the Caspian shelf I think is going to by classified by government as so called group 2, which are going to create additional incentives and at par with arctic regions. And these incentives will mean that there much more factors in favor of faster ramp up in these fields. West Qurna-2. This is so called Mishrif Earl Oil project. It was scheduled to be on stream late last year and right now it is on on the peak of activity. We have almost completed the pipeline that is going to export our oil through Basra. The oil treatment plant and gas gathering system is completed over 50%. And I think by the end of year, we will start up for own power plant in the field. Currently, five rigs are in operation. There was a problem with migration of the Chinese drilling personal because they were actually working one month here then one month in Malaysia and so on and so forth. So we had to stimulate them to work more consistently and not lose the local skill. So right now we are quite active. And if nothing bad happens, next year we expect to get about $70 million barrels of compensation oil.
Of course it's all going to depend on oil price, but I think considering the most probable oil price, you can calculate the cash back that we are going to get next year for West Qurna. The project in Uzbekistan is also developing on a quite stable basis. We have also invested quite a lot and for the next year we are already expecting our oil production increase and we expect that gas production is going to increase dramatically starting from 2015. This project is going to perform much better than our current project in West Siberia. This is a production sharing agreement project and at this stage of cash back it is quite an effective project.
The second phase of oil pipeline to west China is successfully completing. And from our negotiations with the oil and gas ministry of Uzbekistan, we are expecting quite competitive price of exports to China. Next slide is dedicated to our dividends. Our strong financial position has allowed us to increase dividends quite persistently. That includes dividends for the previous year, for the first half, second half of the previous year. So last week the board of directors made a decision to pay 90 rubles per share, which means that this is more than 20% increase and which means that we are honoring our promise to start up a consistent multiyear program to increase dividends.
I think that the third quarter will see the full payment of dividends to all our shareholders. In conclusion, I would like to state that this company is very much focused on value creation through high performing projects and through growth of dividends. We are focused on increasing efficiency of operating activities and we are also focused on cost control and strong financial discipline. That is all from my side. If you have any questions, please let me know. Would you please give the microphone?
Andrey Gromadin - JPMorgan
I have a couple of questions on, first on gas business. Recently you published your annual report and you said that you said that [Yu. Korchagin] field was going to start up in 2016. But I think you said previously it was going to be 2014. So why or how can you explain this deal? And in Uzbekistan, your current expectation is, long-term expectation is 16 billion cubic meters but your previous expectation was 18 to 19. So is it more conservative for appraisal or something else. Then could you enlarge please on the latest acquisitions?
Unidentified Company Speaker
Well, on gas, it makes sense to produce gas when you clearly understand how are you going to sell it and who you are going to sell it to. Gazprom has encountered challenges in selling its gas to Europe which has made the domestic market much more competitive. So we just made a decision to use the money or we have intended to use in gas projects as well. Just to give an example, the investment in Imilor. We have also decided to make several hard to extract deposits which currently are classified as hard to extract but which will be quite doable. Achimov formation for instance, five years ago was considered as almost impossible. But with multistage fracturing in horizontal wells and Northern Americans have been doing that for quite some time already. This technology demonstrated that from Achimov formation one can get 500 to 1000 tons per day.
In this environment, I don’t think it would be the right thing to increase gas production. So we are operating in agreement with our license agreement and that has enabled us to prolong the ramp up for this field by another two years. And I thank Andrey for this explanation. You need to look at different figures. Standard to surface gas and overall gas production. You need to also correct for that because part of gas we produce, for example, is used to produce electricity or whatever. So we don’t sell it but it doesn’t mean that we don’t get any value out of it.
As to the acquisitions, I am very happy about Samara-nafta because we paid very reasonable money for a really good company. My conservative estimate is that we are going to double the production from the existing fields on the basis of what we know about this current reserves. We may become more optimistic in about a year or when we finish the reappraisal of all the geological data that we have. I think there is quite a big room for growth there. And the big synergy that I had been referring to, that we will connect to the Transneft oil pipeline, will decrease dramatically transportation costs and will increase the refinery efficiency. All these factors are going to create very very big synergies. Imilor was one of our largest acquisitions in the past year. It is quite a challenging field. I think we mentioned it in our annual report presentation. That was quite a challenge. Rosneft and Gazprom competed against us until the last moment. But since we have an advantage, these fields are quite well integrated with our infrastructure. We had a quite an advantage over both Rosneft and Gazprom in terms of economic efficiency.
We are also thinking about yet another one or two undeveloped assets in the Russian Federation if the price tag is reasonable. As all that is going to give us enough oil for ten years in West Siberia. And that against the background of our good performance in the Caspian. And we have made some very good discoveries in the (inaudible) trough. The (inaudible) trough is located in the Republic of Kalmy, and our latest appraisal is that the original hydrocarbons in place have doubled already. When we have finished the processing of the geological data gathered to date, I think in half a year we will be able to come up with a more precise appraisal.
Uzbekistan is quite a big project for us and it performed quite well. In fact we have a plant to gather again a group of investors to go to Uzbekistan. We have been there once and I think we will be welcoming everyone to Uzbekistan and you will see for yourself that this is quite a successful.
Maksim Moshkov - UBS
I have a question on drilling. Well, you have increased your drilling volumes by 17% current year (inaudible). However, your increase in production has not been growing very actively while your CapEx increased by 30%. So this is my first question. So when are you expecting increase in production in Russia?
Unidentified Company Speaker
Well, I will take you first question and just don’t make a mistake. There was no dramatic increase in production in any Russian company. Only Caspian and some other fields in East Siberia are going to increase production. The challenge for any Russian company now is to stop the production decline. Production decline is becoming more and dramatic so we have to drill more. Just look at what's happening North Sea. The North Sea operators are losing 5% to 7% points every year. If we don’t want to go along the same road, we have to drill more. We have to drill some more water flooding and we have to drill some other (inaudible). There are no miracles. We cannot produce the oil out of nowhere. Our challenge is to make efficient drilling. This is why the commercial rates of penetration must grow and they will grow. We will, for example, get closer and closer to, for example, North American benchmark. Of course I don’t think our drilling will cost the same here as in North America but we will get as close as possible.
Maksim Moshkov - UBS
Do you have the understanding of how many million meters per year could guarantee you that production?
Unidentified Company Speaker
I think what we are at now is quite enough. And as we go into the Achimov formation, our new acquisitions. And as we go into other yet undeveloped reserves, we will use the horizontal wells, which means that there are much fewer wells to start with. So we don’t think the volume we are drilling is going to be growing at dramatically as it used to.
Maksim Moshkov - UBS
Well, in your net cash flow considering your acquisitions, your newer acquisitions, was negative in the first quarter. I think that your policy limits you a little bit in using your free cash flow for dividend. So are you expecting increase in the leverage across the company?
Unidentified Company Speaker
Well, the opportunity opened up to acquire Imilor. And Mr. (Inaudible) actually opened you this opportunity for us and that actually took away a lot of cash. But we are quite well performing in terms of income and since we are expecting faster cash back from Qurna, I don’t think that there will be any problem with the dividend that we have promised to our shareholders.
In terms of PE, your company, let's call it, is not over appreciated. And at the same time you have very low debt level. Why shouldn’t you, for example, announce buyback and why shouldn’t you conserve the shares, the treasury shares that I think amount to about 10% of the capital. So what is your policy about the treasury shares?
Unidentified Company Speaker
That’s two questions in one. Well, the company has bought back 7%, 10% of its shares. And as ConocoPhillips sold its stake, that’s actually allowed us not to get a very sharp decline. Are we going to go to more buybacks? I think, yes. This year is going to be [peak] activity on a lot of projects but after we start up Qurna, after we start up Uzbekistan, after we start up Filanovsky field, our investment ambitions will decrease dramatically. So my position is that we are going to buy back more shares from the market and if everything goes right in Qurna, if we get to pump the initial oil in time, we will of course [extend] our license with the Iraqi government, we will be buying back more and we will be even paying more dividends without increasing leverage.
We have really said that there are several reasons behind our caution. First of all there is high volatility on the market, so this is protecting (inaudible). Secondly, so far we don’t have a clear understanding of how it's going to play in legal terms. The new mega regulator of the securities market is going to come into force on January 1, 2014. That means that the securities market is going to be supervised by the central bank. And we expect quite a few news, and a lot of news is going to relate to treasury shares, how they are vote, how they are eliminated and so on and so forth. So we are not in a hurry. So I can quite reassure you that we are not going to put these shares back into the market.
Karen Kostanian - Merrill Lynch
Last year we had a meeting with people from several ministries and agencies of government. And the ministry of economic development has said that the government is still considering admitting other companies rather than only Gazprom and Rosneft into the Arctic continental shelf. So are still retaining this ambition or are you just focusing on the Caspian? And do you think you are going to grow further into the Caspian or it is going to go as far [state] company as well?
Unidentified Company Speaker
As far as (inaudible). On the 24, we are going to present our outlook of the energy sector just like BP has done for years. And in that report, one part will be dedicated to the Arctic Sea. My impression is that the arctic story is a story that is going to last for decades. I know the (inaudible) story, I know the [stockman] story. So it is nice to have to go into the arctic but it is not critical now, Caspian is critical now. We have prolonged successfully all the licenses. On KazMunayGaz we will, I think sign the final PSA with Kazakhstan and on (inaudible) I don’t see, I don’t expect any more (inaudible) connections. And we are in negotiations with the Kazak government to explore some prospective blocks in their territory. But this is again a long term thing. So my position is, of course I am a little bit frustrated that they admit into the Arctic, but I would not bet my personal money on the arctic. So they have not admitted us, okay, it's fine. In five to ten years a lot of people will probably see that I was right. I think that Arctic is too challenging. I think in a year they will already lift all the limitations, that I can tell you that polar bears are safe. They are not going to be dirty will oil because in decades there will be no oil produced there, I don’t think so.
If there are no other questions, I would like to thank you for your attention, for the questions. The shareholder general meeting is already very close and under the new rule every vote is important to us because of the quorum requirement. I think Andrey Gaidamaka has several questions to you on this issue.
(Inaudible) I guess we would like to have a discussion about our forthcoming shareholders meeting, if you guys have any questions.
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