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Friday, August 1, 2008

Rosneft: All paid up !

Strategic Forecasting, Inc.


Reports from Russia indicate that state-owned oil behemoth Rosneft might be able to repay the entire $22 billion debt it took on to finance the purchase of various subsidiaries of the defunct oil firm Yukos. No exact date for the final debt payment is known, but Rosneft announced in mid-July that it should happen in late August or September. This debt has been a point of contention between Rosneft and the Kremlin, and its payment is likely to benefit Rosneft financially and politically.

Yukos was forced to sell its main production assets in a 2004 auction due to bankruptcy caused by unpaid taxes. Moscow forced the taxes -- and bankruptcy -- on Yukos because the firm's oligarch owner Mikhail Khodorkovsky had a falling out with the Kremlin over his political ambitions and Yukos' power. Rosneft acquired most of Yukos' main production assets in the 2004 auction. Moreover, Rosneft wanted to become vertically integrated, from the oil well to the gas station, and reap the value-added profits along the way. Thus, the firm decided to purchase more Yukos assets -- five Siberian refineries and two leftover production units -- in May 2007 for approximately $24.5 billion. At this point, questions emerged about whether Rosneft would be able to pay the entire debt, and the Kremlin was displeased with the debt that Rosneft was taking on.

The state-owned Rosneft initially hoped that the Russian government would help out with the debt, since Moscow's coffers were stuffed with more than $150 billion in profits from energy sales. After all, Rosneft is overseen by Igor Sechin, one of Russia's most powerful figures. Besides serving as deputy prime minister, Sechin holds the energy industry portfolio in Putin's Cabinet; he serves to balance out the power of state-run natural gas firm Gazprom. Yet Putin -- who was president at the time -- told Rosneft to figure out how to pay off the enormous debt on its own.

And now, in just more than 18 months, Rosneft is expecting to make the final payment on a debt that initial projections showed would not be paid off until 2015. Rosneft's success is due to a combination of increased profits, eventual direct help from the government with a small portion of its overall debt, and cuts in expenditures.

Rosneft's profits have increased as a result of high global oil prices and the additional production and refining capacity the company gained from its 2007 Yukos acquisitions. Rosneft's first-quarter profits in 2008 were $2.56 billion, more than four times its first-quarter 2007 profits of $602 million. The acquired Yukos assets helped Rosneft increase its crude output in the fourth quarter of 2007 by 35.7 percent on the year to 2.23 million barrels per day. Rosneft has said its overall oil production in 2008 will be 23.9 percent higher than its 2007 output, including a 6 percent growth independent of the newly acquired Yukos units.

For its part, the Russian government slashed the Yukos tax debts that Rosneft had to pay -- a small portion of the overall debt that Rosneft incurred from the Yukos acquisitions. The Kremlin transferred only a small portion of Yukos' tax debt to Rosneft, and in February decided to give Rosneft a break and reduce that portion from more than $5 billion to about $1.3 billion, plus $973 million in fines and penalties. Now it looks as if Rosneft might avoid the fines and penalties as it plans to pay the debt before the new deadline in 2013. While this was not a huge relief, the Kremlin's decision certainly did help.

Finally, Rosneft managed to cut its upstream production and operating expenses by 1.2 percent in 2008. These expense cuts come despite the acquisition of new units and an expanded capital expenditure of $8 billion, up from $6.24 billion. Rosneft is therefore cutting costs where it should (expenses and operational costs) and expanding expenditures where it needs it (such as new field development). In short, Rosneft finally began to manage its finances and develop its medium- to long-term strategies like a real company rather than repeating the behaviors it learned as a Soviet governmental ministry.

As result of these efforts, Rosneft's debt, which peaked at $36 billion on June 2007, stood at $23.58 billion at the end of March and will be further lowered to around $16 billion as Rosneft finances the final $7 billion payment for the Yukos acquisitions.

By trimming its huge debt, Rosneft will have a stronger standing in its dealings with the Kremlin. When it originally announced it would pay $24.5 billion for the leftover Yukos assets, Rosneft had to endure rare criticism from the Russian government. The Kremlin was worried that Rosneft was overextending itself. A swift turnaround on the debt will convince the Kremlin that Rosneft is not spending unwisely and will probably give it greater room for future expansion -- particularly within Russia, but also abroad.

Internally, the three main Russian energy companies -- Rosneft, Gazprom and LUKoil -- are in constant competition with one another. LUKoil is the odd man out, as it is a private company run by oligarch Vagit Alekperov, who is doing everything he can to stave off a Gazprom takeover. Gazprom is the natural gas behemoth always looking to swallow any energy asset it can, including perhaps oil assets that normally would fall under Rosneft's purview. Getting its books in order, and consequently back in the good graces of the Kremlin, allows Rosneft to keep up with its Russian competition and go toe-to-toe with them in any acquisition and/or political maneuvering that may become necessary.

A better financial situation will allow Rosneft to dip into the resources of foreign banks more often. The financial world has already rewarded Rosneft's efforts; Standard & Poor's raising its long-term corporate credit rating to BBB- from BB+, saying that Rosneft's outlook is stable and thus raising Rosneft to investment-grade bond status. In fact, the refinancing of Rosneft's debt was accomplished with the help of a dozen foreign banks, led by Barclays and Deutsche Bank, which provided it with more than $5 billion worth of refinancing in two separate deals. This is a clear indication that Rosneft is on the right track, as it is doubtful it could borrow that much from Western banks if its books were cooked.

Expansion for Rosneft might also mean a more aggressive foreign investment plan. Rosneft is far behind LUKoil's level of foreign involvement; Rosneft only has a few uninspiring ventures in Algeria, Kazakhstan and Turkmenistan. A clean bill of financial health would help Rosneft develop arrangements with foreign companies and allow it to challenge LUKoil as the face of Russian oil industry abroad. This is something that the Kremlin will be extremely pleased about, as LUKoil is a privately owned company and Rosneft represents the state. Unsaddled by its debt, Rosneft will be able to finally earn the right to be called a Russian national champion.

Copyright 2008 Strategic Forecasting, Inc.

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