LUKoil's Q2 Net Profits Slip Despite Increase in Sales

More Mixed Signals

Russian oil major LUKoil announced yesterday that it had generated net profits of US$1.95 billion in the second quarter according to U.S. Generally Accepted Accounting Practices (US GAAP). The company's net income in the April–June 2010 period was something of a disappointment, representing a 16% drop from the same time period in 2009 and even a 5.1% decline from the first quarter of this year (see table). Not surprisingly, then, the number two Russian oil company chose to focus its presentation to investors and analysts on its overall first-half results, showing a 23.9% increase year-on-year (y/y) in LUKoil's net profits, to US$4.0 billion, with sales up 42.7% y/y to US$49.76 billion in the January–June 2010 period. Revenues from sales in the second quarter of 2010 alone were up 8.2%, to US$25.85 billion, compared to the first quarter of this year.

Still, even taking account of the miserable first quarter of 2009 in LUKoil's focus on its first-half 2010 results compared to the first half of 2009, the trends are concerning for the Russian firm. Sure, LUKoil's earnings before interest, tax, depreciation, and amortisation (EBITDA) were up 13.8% y/y, to US$7.43 billion, in the first half of 2010, but the company's second-quarter 2010 EBITDA of US$3.70 billion was still down from US$3.72 billion in the first quarter of this year. Equally worrisome is the continued trend of flat-to-downward in the company's oil production, normally the bread and butter for a Russian company: LUKoil produced 1.951 million b/d of oil in the April–June 2010 period, down from 1.99 million b/d in the same quarter last year and from 1.96 million b/d in the first three months of this year.

Perhaps even more troublesome is that LUKoil has once again reverted to type in the perception that it is not keeping a close eye on the purse strings. The company—which in past years was frequently assailed by investors for failing to keep a lid on costs before it belatedly began to address the problem—reported that its operating expenses in the second quarter alone rose by 14.8%, to US$2.03 billion, relative to the first quarter of this year, while overall operating expenses in the first six months of 2010 stood at US$3.8 billion, up 22.3% y/y. LUKoil blamed the cost inflation on a variety of factors, including appreciation of the Russian rouble, higher taxes and transportation costs, and a 25% y/y increase in lifting costs in the first half of the year.

Beyond ConocoPhillips

LUKoil's second-quarter financials are not going to win it many new friends in the investor community, and yesterday the company's stock price on Russia's MICEX exchange closed down 1.38% on the day. Nevertheless, a new day is dawning for the Russian company, as LUKoil and U.S. supermajor ConocoPhillips have decided to dissolve their strategic alliance that was formed nearly six years ago. LUKoil re-acquired a block of 7.6% of its own shares from ConocoPhillips in July for US$3.44 billion as part of the divorce agreement, and yesterday LUKoil vice-president Leonid Fedun reiterated comments earlier this week by company head Vagit Alekperov indicating that LUKoil will not "fully" exercise its option to purchase the U.S. company's remaining 11.6% block of shares in LUKoil (see "Related Articles").

Outlook and Implications

Perhaps in a de facto acknowledgement of LUKoil's financial and operational malaise, Fedun told investors in a conference call yesterday that the Russian company has no plans to take on significant new debt to finance the purchase of the full block of 11.6% of its own shares from ConocoPhillips. However, Fedun did not entirely rule out buying some of its own shares on the open market, and the LUKoil VP—like Alekperov, also a core shareholder in the company—said that the oil firm could use the 7.6% block of shares it already bought from ConocoPhillips as bonus payments for employees.

LUKoil's workers will no doubt be cheered by this comment, but investors and analysts will not be similarly enthused, as the lukewarm commitment to buying back some shares raises questions about LUKoil management's determination to improve its share price performance. Nor does the company's stagnant production growth arouse any strong sentiment. While few will shed any tears for the end of the ConocoPhillips partnership, which proved hugely disappointing to both sides, the salient question for LUKoil now is what comes next. Will LUKoil return to focus on its "home" market in Russia, shorn of the cumbersome tag as a majority foreign-owned, albeit still predominantly Russian company, or will it continue its game of hopscotch around the world in pursuit of international projects?

This question is increasingly relevant to LUKoil's long-term future, as the company has sought to move away from Russia in recent years, yet failed to really gain any traction in its international portfolio. LUKoil continues to derive the vast majority of its oil production and profits from Russia, but whether there is room for the company to grow at home in competition with state-run Rosneft will to a large extent be determined by how willing the government is to move away from the practice in recent years of tilting the playing field in favour of the state. Potential new tax breaks for LUKoil for its projects in the Russian sector of the Caspian Sea could be a hopeful sign for LUKoil's prospects at home.

Outside of Russia, LUKoil needs to reassure investors and analysts that it does indeed have a plan, rather than simply seeking to plant the Russian flag wherever a new country is amenable to the oil company. LUKoil's hodgepodge of projects in Kazakhstan, Colombia, West Africa, Iraq, and Egypt begs the question of what really is a "core'" region for the Russian oil company. Figuring this out, explaining it to investors, and proceeding to hone a strategy that allows LUKoil to demonstrate its long-term growth prospects and boosts the company's share price will go a long way towards defining the Russian oil company's identity in the aftermath of the dissolution of the ConocoPhillips alliance.

Related Articles

• Russia: 31 August 2010: LUKoil Still Undecided on Purchasing Remaining Shares from ConocoPhillips
• Russia: 17 August 2010: LUKoil Buys Back 7.6% of Its Shares from ConocoPhillips
• Kazakhstan: 16 August 2010: KPO Consortium Reportedly Consents to Make Room for Kazakhstan with 10% Stake
• World: 29 July 2010: ConocoPhillips Posts US$4.2-Bil. Q2 Net Profit, Agrees to Sell LUKoil Stake
• Russia: 22 July 2010: Energy Ministry Reportedly Targets US$2 Bil. in Revenue from Planned Auction of Two Russian Oilfields
• Iraq: 19 July 2010: LUKoil Puts West Qurna-2 Investment Programme at US$5 Bil.
• Saudi Arabia: 16 June 2010: LUKoil-Led JV Relinquishes 90% of Saudi Gas Exploration Block
• Russia: 29 April 2010: LUKoil Launches First Oil Production from Russian Sector of Caspian Sea
• Russia: 3 June 2010: LUKoil Reports US$2.05 Bil. in Q1 Net Profits; Russian Oil Firm Champions Caspian Tax Breaks
• Uzbekistan: 14 May 2010: LUKoil Begins Work on South-Western Gissar Gas Field in Uzbekistan