This May Be Rosneft's Breakout Year

Jan.30.12 | About: Rosneft Oil (RNFTF)

Headline-grabbing joint ventures with global oil companies like ExxonMobil (NYSE:XOM) and long-awaited tax breaks are on the horizon for Rosneft (OTC:RNFTF), Russia’s state-owned oil company, potentially making 2012 the year the stock breaks out.

Rosneft produces 2.3 million barrels of oil of day, slightly more than Exxon and slightly less that Brazil’s Petrobras (NYSE:PBR), but is currently valued at $80 billion vs $415 billion and $200 billion respectively for ExxonMobil and Petrobras.

On a reserve basis, another metric to measure valuation, Rosneft looks very undervalued compared to these peers.

With 2P hydrocarbon reserves of 35 billion barrels of oil equivalent, Rosneft has an enterprise value per 2P reserves of just over $2 vs $6 for ExxonMobil and $4 for Petrobras.

The cheap valuation is due to a potent mix of Russia’s draconian oil taxation regime, one of the toughest in the world, as well as investor perceptions that Russia is just “too damn risky.”

A burdensome combination of mineral extraction tax, export tax and profit tax means the government takes 80% or more of Rosneft’s revenue. Thus, the company only generates about $12 of free cash flow per barrel vs about $30 and $25 for ExxonMobil and Petrobras Rosneft now trades at an attractive price to its consensus forecast earnings of 6 times vs 8 times for Petrobras and 10.5 times for Exxon.

Rosneft shares, which are listed both in London and Moscow — and on the pink sheets in New York — closed Friday at $7.48, below its IPO price of $7.55 in July 2006, when it was only pumping only 1.6 million barrels per day.

The Kremlin uses the oil tax to raise state salaries and pensions to keep its popularity high. However, the Kremlin’s generous spending increase – which will rise 12% this year – is, ironically, slowly giving the upper hand to the oil companies like Rosneft in their fight to lower the tax burden.

Output Peaking Nearly 90% of Russia’s oil production comes from Western Siberia, Volga and Urals region, where the first wells were drilled during Stalin’s regime. More than half a century later, oil production in those regions is declining rather rapidly.

Companies are posting anywhere from 2%-4% decline rates. Enhanced recover techniques like horizontal drilling, which helped revive Russian oil production in the 2000s, can now just help slow the decline in those three regions.

Fortunately for Russia, Rosneft and its peers, TNK-BP and Surgutneftegaz, all launched major Greenfield projects in 2009, staving off production decline.

However, the decline now looks inevitable in 2013 as the new fields peak and that will put pressure on the Russian budget, which balances at $110 under the current output volume of 10.9 million barrels a day.

The lower the production, the higher the price needed to balance the budget. While Rosneft has plenty of untapped oil fields in Eastern Siberia and the Arctic that are the envy of the likes of Exxon, the Russian government’s huge tax take has left Rosneft with little fire power to explore and develop all those reserves or even generate an acceptable return on the cash it throws at those projects.

Exxon’s Entry

Russian oil companies have been at war with the Finance Ministry to ease the tax burden since at least 2007, at times seeming to be close to victory, which spurred investors to snap up shares of Rosneft. But the Finance Ministry turned out to be more resilient, getting the Kremlin to reduce or end those tax breaks, leaving investors with loses and disillusionment and Rosneft with a low valuation.

But with no new significant greenfield production on the horizon and a drop in total output next year seeming unavoidable, the Russian oil companies can potentially force the ministry to compromise this year, with new tax breaks possibly coming into force next year.

Aside from a small reduction in the mineral extraction tax on existing fields, Russia may pass a profit-orientated tax regime for Eastern Siberia and the Arctic, where Rosneft has potentially billions of barrels of reserves.

These tax breaks – combined with joint ventures with global oil companies – would launch a new era of exploration and development comparable to what took place in Brazil in the 1990s.

And in that case, Rosneft’s stock price may just repeat the remarkable rally in Petrobras shares.

The first step to potential stock rerating was taken in August, when Rosneft announced it would create a joint venture to develop four arctic fields with Exxon.

With Rosneft to potentially receive another 24 offshore licenses in the Arctic, it can pen similar ventures with other global companies. Rosneft said this week it would like to team up with Norway’s Statoil (STO, quote) to develop several fields it will get in the Barents Sea.

The sweet part of the joint venture is that Exxon and other future JV partners will lay out the initial exploration investment, enabling Rosneft to ramp up its 2P reserves without coughing up a ruble. Talk about value creation!

Exxon and Rosneft are expected to hold a presentation as early as April to explain details of the venture, which could be a short-term catalyst for Rosneft’s shares. The partners may also announce what assets Rosneft will receive in the US.

Teaming up with Exxon and getting assets in the US will make Rosneft a better known name among US investors. Rosneft will announce Q4 results on February 1. With the background of a weak ruble and high oil price during Q4, Rosneft should post superior results.