Lukoil Is Firing On All Cylinders

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About: PJSC LUKOIL (LUKOY)
by: Joshua Hall
Summary

I share some thoughts on long-term energy headwinds and tailwinds.

Lukoil has the tailwind advantage of a relatively longer reserve life.

Lukoil has the highest free cash flow return on invested capital of all the integrated oil & gas majors.

Lukoil has been outperforming its peer group. I see the stock taking out the $100 barrier within 2 years.

Please note that Lukoil was not discussed in my Industrial Minefinder™ Marketplace service.

Energy Headwinds And Tailwinds

There are essentially 2 modes to the world’s energy situation but this is now morphing into 3 modes. Historically, the energy picture has included (1) refined oil products powering air, land, and sea transportation and (2) natural gas, nuclear, oil, thermal coal, and renewables powering electric utilities. Energy to power our transportation and energy to power our homes. Now we have an energy picture emerging where (1) refined oil products will continue to power transportation, (2) natural gas, nuclear, oil, thermal coal, and renewables will power both transportation and our homes, and (3) industrial metals will be used to power the batteries of electric mobility and store energy, including energy produced by renewables that also rely on increased amounts of industrial metals. To the extent that nuclear and renewables increase their share of grid generation, industrial metals (aluminum, uranium, silver, etc.) could take energy market share away from hydrocarbons.

For reference, here is a projection of global energy demand growth from the Shell LNG Outlook 2019:

Having framed my view on energy from a high level - with both eyes fixed on Asia - my strategy is to focus on investing where the tailwinds are. For now, I think the long-term tailwinds are behind companies that are involved in the current and future production of industrial metals, natural gas, and uranium and the long-term headwinds are in the face of companies that are involved in the current and future production of crude oil and thermal coal. (Given this, I thought Shell’s (NYSE:RDS.A) (NYSE:RDS.B) acquisition of BG during the depths of the last oil downturn was wise as this strengthened their future in natural gas.) There is more under the surface here though.

There are opportunities for companies whose past capital investments have mostly already been sunk in crude oil and thermal coal to invest their future cash flows from these past investments into the tailwind category going forward. These companies will have the luxury of time to analyze their future strategic direction and then also the cash flow to make sizable investments for the future. Companies that have to continue to invest significant capital in the headwind category just to tread water could ultimately be left behind as they lack the time to prepare for and the cash flow to invest in the tailwind category. The former group of companies will remain well positioned to return capital to shareholders, especially through dividends.

With this in mind, let us take a look at Lukoil (OTCPK:LUKOY):

Reserve Cushion

The following table compares the proved oil & gas reserves, 2018 production, proven reserve life, and 2018 natural gas share of production for the peer group of publicly traded integrated oil & gas majors:

BOE = Barrels of Energy

Proved Oil & Gas Reserves

(Million BOE; as of Dec 31, 2018)

2018 Production(Million BOE)

Life of Proven Reserves

Natural Gas Share of 2018 Production

BP (BP)

10,557

927

11.4

50%

Chevron (CVX)

9,764

1,069

9.1

39%

Exxon Mobil (XOM)

24,293

1,399

17.4

41%

Lukoil

15,931

857

18.6

23%

Petrobras (PBR)

11,957

959

12.5

20%

Royal Dutch Shell

11,578

1,338

8.7

51%

TOTAL S.A. (TOT)

12,050

1,013

11.9

50%

Combined Total

96,130

7,562

12.7

Lukoil has the largest life of its proven reserves - almost 19 years - to support its current rate of annual production. This data point is important when we ponder the role of electric mobility several decades from now. Compared to its peers, Lukoil may have to invest less in reserve replacement in the coming years, freeing up more cash for shareholders and new ventures in the tailwind category.

Lukoil and Petrobras derive more of their production from crude oil versus natural gas whereas the Western Majors tend to derive half of their production from natural gas. This is a reflection of the fact that it has been harder for the Western Majors to access new crude oil resources that meet their profit objectives.

Given the relatively low Reserve life that Chevron has, it is not surprising that they bid for Anadarko Petroleum (APC) earlier this year. Expect more acquisitive activity from both them and Shell

Financial Implications

Lukoil’s huge Reserve cushion has enabled it to be more stringent when it comes to capital reinvestment. Management has informed investors that they are committed to only investing in new projects that are expected to generate an internal rate of return ("IRR") of at least 15% when crude prices are at $50 per barrel. The execution of this strategy is starting to hit the bottom line as their free cash flow return on invested capital almost doubled from 2017 to 2018. In 2018, the average Brent crude price was $70.90 per barrel. Lukoil’s free cash flow per barrel of energy production was $10.60, giving them a 15% margin for each barrel of production. Here is how Lukoil compares to its peer group with respect to these 2 key metrics:

2018 Free Cash Flow per Barrel of Energy of Production Margin*

2018 Free Cash Flow Return on Invested Capital Margin

BP

9.6%

2.7%

Chevron

22.4%

7.2%

Exxon Mobil

16.9%

5.4%

Lukoil

15.1%

11.3%

Petrobras

20.0%

6.7%

Royal Dutch Shell

32.1%

9.1%

TOTAL S.A.

10.8%

3.7%

*Free cash flow per barrel of energy of production margin = (free cash flow/barrels of energy of production) / $70 (assumed price of crude oil per barrel)

Lukoil’s free cash flow per barrel of energy production is in the middle of the pack while their free cash flow return on invested capital margin is the highest. This suggests that management has done a relatively good job of allocating capital in the past.

Free cash flow ("FCF") is calculated by taking a company’s net cash from operations and subtracting out its capital expenditures. This is essentially the actual cash that a company can use to either (1) pay dividends, (2) repurchase shares, (3) pay down debt, or (4) make acquisitions. The more free cash flow per barrel of production, the more cash each of these oil majors has to reward shareholders.

Royal Dutch Shell had the highest FCF per barrel of energy, however, it also has the lowest Reserve life at only 8.7 years. Similarly, Chevron has the second highest FCF per barrel of energy, but its Reserve life is the second lowest at 9.1 years. This means that going forward these 2 companies may have to invest more capital versus their peers to maintain their Reserve lives. This could reduce their future free cash flows. Lukoil has strong free cash flow and the longest Reserve life so it is more likely to be able to sustain this margin level going forward.

FCF Return on Invested Capital tells us how well the cash invested in a business is making real cash returns for shareholders. Lukoil was the leader last year and management’s discipline to only invest in 15%+ IRR projects at a conservative $50 per barrel is likely going to support and increase its capital returns going forward. Again, the company’s long Reserve life enables management to be more strict with capital deployment.

Other Catalysts

Under the surface, Lukoil’s profitability is also getting a boost from 2 other factors: ruble depreciation and an increasing number of higher margin barrels.

5 years ago, the average US dollar/Russian ruble exchange rate was in the 30s. Now it has settled at a level that is more than twice that, as shown on the following weekly chart:

US dollar / Russian ruble exchange rate chart Chart courtesy of barchart.com

Lukoil’s revenue is mostly in U.S. dollars whereas its costs are mostly in Russian rubles. The depreciated ruble has helped boost the company’s profit margins over the last several years. Absent a rising oil price, a risk to Lukoil’s profitability is a strengthening ruble.

What Lukoil calls “higher margin barrels” are those produced outside the Russian Federation or those from certain fields within Russia with associated tax advantages. Standard oil fields in Russia are subject to mineral extraction taxes ("MET") and export duties that have a significant impact on the margins from this production. The following investor presentation slide shows Lukoil’s net realized price after MET and export duties for different types of fields, assuming a $50 per barrel crude price:

At $50 per barrel crude, Lukoil’s conventional oil fields located in Russia yield only $21 per barrel whereas offshore projects in the Baltics and the Caspian Sea yield $35 and $43 per barrel, respectively. The Russian Federation provides incentives for the development of harder to extract oil and for the development of fields in new locations. More of Lukoil’s new projects are coming from these lower tax jurisdictions and this is helping to boost profit margins.

One of Lukoil’s largest new fields is Filanovsky in the Northern end of the Caspian Sea. Filanovsky was one of the largest oil discoveries in the world over the last few decades. Lukoil now derives about 7% of all of its production from Filanovsky and this is taxed at a much lower rate, as the following presentation slide shows:

Lukoil’s share of overall production from higher-margin barrels is now approaching 30%, up from 20% just a little over one year ago.

All the before-mentioned factors are combining to boost free cash flow at Lukoil which continues to support exceptional growth in dividend payments, as shown in the following investor presentation slide:

From 2014 to 2017, Lukoil had the highest dividend yield out of all the integrated oil & gas majors.

Notably, Lukoil is also now repurchasing shares which is a significant development because the valuation of the company has been depressed for years. Share repurchases have a greater impact when companies are trading for lower valuations. These repurchases began in September 2018 and you can see on the following weekly logarithmic chart that this has helped the boost the share price from $70 to $90 before it more recently receded to around $80:

LUKOIL weekly price chart Chart courtesy of barchart.com

The following chart shows how Lukoil has vastly outperformed its peer group of integrated majors (Exxon Mobil, Chevron, BP, Shell, and Total) over the last 3 years, more so since the initiation of these share repurchases:

Chart Data by YCharts

Even after this strong run, Lukoil is still trading for only 5.5 times my 2019 earnings estimate and 5.2 times my 2020 earnings estimate. Both of these estimates assume a USD/RUB exchange rate of 65 and $70 per barrel Brent crude. At present, Brent crude is right at my long-term price. The following weekly logarithmic chart of Brent crude shows that it is at the lower end of the current rising price trend:

Brent crude oil weekly price chart Chart courtesy of barchart.com

I see $55 to $85 as a reasonable trading range for Brent crude. All else being equal, I see the current Brent price of $61 per barrel as undervalued and supporting an environment to buy oil producers on the cheap.

Given where crude is currently trading, I have a moderate outlook for Lukoil which means I am using a multiple of 11 on 12-month forward-looking free cash flow. I estimate free cash flow per share (FCFPS) of $12.11 over the next 12 months which gives me a target price of $133 per share. Lukoil’s current share price implies a forward-looking multiple of 6.6 on FCFPS which may also reflect a geopolitical discount for it being a Russian company. I see a forward multiple of 11 as more appropriate, given a moderate outlook and a long-term crude price of $70 per barrel.

The Russian Situation And Other Trade-offs

Lukoil was founded by oilman Vagit Alekperov who is from Azerbaijan. Alekperov has been the President and CEO of Lukoil since its inception. He essentially founded the company as the Soviet Union collapsed. He also owns 23.3% of the company and is the largest shareholder. He wrote a book called, Oil of Russia, and is an expert on the history of the oil industry in the Soviet Union. He is a respected oilman in Russia and not a political player. He once told a New York Times reporter:

  • “My mission,” he said, “is to show the world that Lukoil is as important as all other big oil companies, equal to them in the global market.” He did not smile and impatiently tapped a finger on an armrest. “My company is the first to break the attitude that a Russian company is second-rate,” he continued. “I have felt this responsibility for my entire life.”

Alekperov said that 15 years ago. It is safe to say that he has succeeded.

Lukoil is the largest privately held company in Russia. Unlike Gazprom (OTCPK:OGZPY) and Rosneft (OTCPK:RNFTF; OTC:OCRNL), it does not have any state ownership. Its Chairman and CEO are outside of the Kremlin web. When it comes to geopolitical entanglements such as sanctions, etc., Lukoil tends to avoid issues because of this.

The geopolitical situation always adds an element of risk for Western investors, however, I would add that this is counterbalanced by the fact that Lukoil faces little to no opposition from climate change groups unlike Western oil majors such as Exxon Mobil who seem to constantly be in their crosshairs.

Strategic Conclusion

Lukoil is a good long-term bet for oil & gas exposure. Its significant amount of reserves provide a tailwind that should continue to boost free cash flow going forward. I see the stock taking out the $100 barrier within the next 2 years.

Lukoil is also a strong dividend payer for those seeking income or who just generally prefer dividend payers. The company will likely pay out about $3 billion in dividends this year which would put its expected dividend yield at about 5.5%.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: LUKOIL is a holding in client and family portfolios that I manage. I have an economic interest in the stock. I'm an investment advisor and owner of True Vine Investments, a Registered Investment Advisor in the State of Pennsylvania (U.S.A.). I screen electronic communications from prospective clients in other states to ensure that I do not communicate directly with any prospect in another state where I have not met the registration requirements or do not have an applicable exemption. Any investment advice or recommendations involving securities referenced in this article is general in nature and geared towards a readership of sophisticated investors. This article does not involve an attempt to effect transactions in a specific security nor constitute specific investment advice to any particular individual. It does not take into account the specific financial situation, investment objectives, or particular needs of any specific person who may read this article. Individual investors are encouraged to independently evaluate specific investments and consult a licensed professional before making any investment decisions. All data presented by the author is regarded as factual; however, its accuracy is not guaranteed. Investors are encouraged to conduct their own comprehensive analysis. Positive comments made regarding this article should not be construed by readers to be an endorsement of my abilities to act as an investment advisor.