OAO LUKOIL

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OAO LUKOIL

11 Stretenski Boulevard
101000 Moscow
Russia
Telephone: +7-095-927-4444
Fax: +7-095-928-9841
Web site: http://www.lukoil.com

Public Company
Incorporated: 1991
Employees: 120,000
Sales: $9.75 billion (1999)
Stock Exchanges: OTC
Ticker Symbol: LUKOY
NAIC: 324110 Petroleum Refineries; 211111 Crude Petroleum and Natural Gas Extraction

OAO LUKOIL is one of Russia’s most successful efforts at capitalism following the breakup of the Soviet Union in 1991. An integrated oil company, involved from the exploration stage to the gas pump, LUKOIL was created when the oil and gas industry was chosen to be Russia’s first attempt at privatization. The staterun, western Siberian companies of Langepasneftegaz, Uraineftegaz, and Kogalymneftegaz were merged together to form LUKOIL, with the initials of the three combined to coin the name for the new giant company. LUKOIL, although not the largest of Russia’s new private oil companies, is unquestionably the most advanced, attracting foreign investors and partnerships, and trading on the New York Stock Exchange. Russia’s oil and gas reserves are sizeable, with eastern Siberia seen as the world’s last great unexplored territory that could add greatly to the country’s wealth. LUKOIL, which produces about 24 percent of Russia’s crude, also operates in 25 other countries. It has a presence in the United States through its purchase of Getty gas stations.

Breakup of Soviet Union and Creation of LUKOIL: 1991

For many years the Soviet Union produced more oil than any other country in the world, even more than Saudi Arabia or the United States. Its great wealth, however, was essentially squandered, used to prop up an inefficient, militarized economy and to enrich Soviet government ministers. With the collapse of Communism and the breakup of the Soviet Union, the control of oil fields, pipelines, and refineries became a matter of vital importance to both Russia and the Soviet republics that quickly broke free and sought to exploit their own natural resources. Russian production of crude oil fell steadily as the Soviet Union declined, due in large part to a lack of government investment, which resulted in rotting surface equipment, and the overall failure of the Soviet planned economy. Under Soviet rule, Russia’s oil industry was divided among 33“associations,” many of which were huge enterprises but essentially operated as fiefdoms. Based on 1991 data, 16 of the Russian associations would have been ranked among the world’s top 30 oil companies.

Efforts to privatize the oil and gas industry began soon after the fall of Communist rule. By the end of 1991, four large holding companies had been formed out of the old oil associations, the most strategically positioned being LUKOIL, led by Vagit Alekperov. The son of an oil worker, Alekperov grew up in the oil town of Baku (now part of independent Azerbaijan), where many Westerners made their fortunes—including the Nobel brothers, better known today for Alfred Nobel’s endowment of the annual prizes for peace, science, and literature that bear his name; and Marcus Samuel, who established Shell Oil. After studying engineering at a petrochemical institute, Alekperov went to work in the emerging oil industry in western Siberia, where oil was first discovered in 1964. In 1983 he became director of oil production in the town of Kogalym (its oil association, Kogalymneftegaz, would one day become a linchpin of LUKOIL), which was located in one of Russia’s richest oilfields yet only pumped a few million barrels of crude annually. By 1990 the association under Alekperov’s leadership would be producing 240 million barrels a year. In that year, at the age of 40, Alekperov would be summoned to Moscow and appointed deputy minister of oil production, at a time when not only the Soviet oil industry was falling apart, but the entire Soviet system of government was on the edge of collapse.

Alekperov was quick to recognize what the future held. He began meeting with Western oil executives to pick their brains about creating an integrated oil company, and in the process learned a great deal about the workings of private enterprise. Alekperov asked British Petroleum (BP) to form a strategic partnership, but was turned down by executives who could not fathom the possibility of valuable Soviet oil assets becoming privatized.

In Moscow, Alekperov’s foresight was seen as a threat by Communist hardliners, who were anything but receptive to his proposal that the oil industry be divided among a dozen integrated companies. On the verge of being fired, he was the beneficiary of a failed coup attempt by hardliners that included his boss, the head of the oil ministry. When the plotters were thwarted and Soviet President Mikhail Gorbachev remained in charge, Alekperov became acting oil minister. As the Soviet structure continued to disintegrate, he was able to set the future direction of the oil industry. Following a decree by Russian President Boris Yeltsin, Alekperov established LUKOIL for his own control, acquiring some of Russia’s best properties and most talented engineers, while placing loyal ministry subordinates at the head of other oil companies.

The transition to capitalism in Russia, however, was not without complications. Oil facilities that had for years essentially run themselves now resisted being merged into the new integrated companies. The Samara Refinery, for instance, had struck its own exporting deal with a Belgian company that had connections to a Russian gangster. Somehow, export earnings never seemed to return to Russia. When one of the integrated oil companies, Yukos, tried to exert control over the refinery, its appointed general manager was murdered outside his home. Three months later the head of the Belgian company was critically wounded when his Mercedes was ambushed on the streets of Moscow, and another executive of the company was subsequently killed. With that, Yukos was able to proceed with incorporating the Samara Refinery into its operations.

First Russian Company to Offer Stock: 1994

Overall, ten large integrated Russian oil companies were formed. In 1994 LUKOIL was the first to begin offering shares of stock on the new Russian Trading System, with the Russian government temporarily controlling a third of the company and retaining a long-term 5 percent stake. Because Russian law did not require disclosure, it was uncertain how much of the company Alekperov owned, but there was no doubt that he held voting control and ran the affairs of LUKOIL with a firm hand.

Alekperov began to address the problems LUKOIL faced as it transformed itself into a Western-style corporation. First, production had to be increased. Because of decaying Soviet-era equipment, output had dropped by 15 percent in 1993 and was expected to drop another 5 percent in 1994. In order to finance the purchase of equipment to put wells back into production, LUKOIL signed an agreement to sell 70,000 barrels of oil a day to Chevron, then pledged the revenues to guarantee a $700 million loan from the Japanese trading house of Mitsui. To further increase output LUKOIL also began to buy up smaller Russian oil companies.

LUKOIL also had to improve efficiency and maintain cash flow. Too many of LUKOIL’s customers, such as Russia’s collective farms, were state mandated and simply did not pay their bills. The Lukoil Financial Company was formed to deal with the non-payment crisis that was forcing the company to cut output and place workers on compulsory leave. The new company would assume control over the flow of goods and cash within LUKOIL. It also began conversations with the government about the mutual cancellation of debt.

LUKOIL’s relationship to the Russian government, due to its sheer size as well as close ties to the oil ministry, gave it a distinct advantage over its rival Russian oil companies. In some cases LUKOIL was seen as acting as proconsul for the government, or the government as the agent for the oil company. After a BP-led consortium of oil companies pursued a deal for three years with Azerbaijan to develop oil fields in the Caspian Sea, despite civil war and a coup d’état, Russia began pressuring Azerbaijan to include LUKOIL in the deal. First the Russian Minister of Energy proposed that LUKOIL should be granted a 20 percent stake in the consortium, then a few months later the Russian government sent a formal note to the British embassy to lay a claim to the oil reserves. Finally, Alekperov flew in to close the deal, demanding a 10 percent, equity-free slice of the project, which the Azerbaijan government, in the interests of improving relations with Moscow, eventually agreed to. For many observers it was more a matter of extracting oil tribute from a former vassal than negotiating a business deal.

LUKOIL received further bad press during the early days of its existence when it was sued for $660 million in U.S. federal court by a Texas unit of Frankenburg, a Liechtenstein company. Lukoil was accused of conspiracy, fraud, and money laundering. In 1991 Frankenburg had been hired by Kogalymneftegaz to repair abandoned wells, but quit work a year later when it was not paid. The suit alleged that non-payment was simply a way to drive Frankenburg out so that work could then be diverted to a new oil services company set up in the British Virgin Islands by Alekperov and other LUKOIL executives, and aided by former Frankenburg employees. The fact that one of the alleged conspirators was American was used as entree to the U.S. courts. LUKOIL heatedly denied the charges, and Frankenburg eventually elected to drop the suit, but at the very least the affair introduced the oil company to further complexities of the free enterprise system. Such embarrassment was not helpful at a time when LUKOIL was trying to distance itself from the image of Russian corruption in order to attract foreign investors.

Company Perspectives:

LUKOIL is the first Russian integrated oil company operating according to the principle“from oil well to filling station. ”

In 1995 LUKOIL made an offering of bonds that would convert to stock in the company and lead to trading in Western financial markets, but was met with less than anticipated enthusiasm. Nevertheless, the Atlantic Richfield Co. (ARCO) eagerly purchased $250 million of the bonds, which would give it a 5.7 percent stake in the company and represent the largest single foreign investment in Russia. It was also the first time that a foreign oil company had acquired equity in a major Russian oil company. The relationship made sense for both parties. LUKOIL would receive cash to upgrade facilities, as well as access to much needed technical and management expertise. ARCO, heavily dependent on the shrinking reserves of Alaska, would gain access to new reserves and was already skilled in operating under conditions similar to Siberia. Several months later ARCO upped its stake in LUKOIL and signed an 18-year agreement to commit $5 billion to jointly develop projects in Russia.

Attempting to Enter U.S. Gasoline Market: 1997

By 1997, with privatization of the oil industry far from complete, LUKOIL was generally considered an unparalleled Russian success. With a market capitalization of $9 billion, it planned to issue ten million new preferred shares of the company. The Russian government, in need of cash, also decided to sell off 15 percent of its ownership. Although the company announced strong financial results for 1996, LUKOIL still needed to bring its accounting up to international standards in order to attract further foreign investment. In the meantime, it continued to pursue its ambitious goals. LUKOIL gas stations not only spread across Russia, replacing the tanker parked on the side of the road where motorists traditionally filled up, they began cropping up in former Soviet republics and other Eastern European countries. In July 1997 LUKOIL made an attempt to enter the U.S. gasoline market when it teamed with Nexus Fuels of Irving, California, to establish 5,000 fueling centers next to the outlets of several supermarket chains, which saw the move as a way to recapture some of the revenue lost to the oil companies that had expanded their onsite convenience stores. The deal fell apart, however, when, according to Nexus, LUKOIL failed to provide the necessary cash.

The Russian oil industry experienced its first taste of merger mania in 1998 when AO Yukoa and AO Sibneft combined to create AO Yuksi, instantly becoming the third largest private oil producer in the world. Rumors then spread that Lukoil would combine with AO Sidanco, a possible move that investors questioned by bidding down LUKOIL stock by more than 10 percent. Despite a Russian obsession with size, Yuksi had little to offer. In effect, two cash-strapped, poorly run companies were thrown together. In the end, LUKOIL would remain the choice of investors even if it remained somewhat smaller than Yuksi.

With a 1998 drop in oil prices, Russia’s oil industry was hurt and the country’s economy thrown into crisis, eclipsing further talks of mega-mergers. A number of foreign oil companies, also adversely affected by low oil prices, pulled out of Russia, electing instead to invest in West Africa and the Middle East, where it cost less to operate. Companies also feared that Russia and its unstable government might create a state oil company and possibly reverse course on privatization of the industry. Moreover, Russian taxes were onerous, based on revenues rather than profits.

Nevertheless, LUKOIL was strong enough to press on. In 1998 it teamed with Conoco to develop oil and natural gas reserves in the northern territories of Russia. It also joined a consortium of oil companies, including Texaco and Exxon, to drill in the Timan Pechora region, an oil shelf that was projected to contain several billion barrels of oil. Lukoil purchased a Russian exploration company which held licenses to drill in some of the best sites in Timan Pechora, and also purchased Komitek, another company in the region with proven reserves of 1.36 billion barrels.

After annual revenues fell from $9 billion in 1997 to below $4 billion in 1998, oil prices began to rise again, so that in 1999 LUKOIL generated a record $9.75 billion. It continued its outward expansion, upgrading domestic facilities and establishing foreign refinery capacity. LUKOIL looked once more to entering the U.S. gasoline market in 2000 when it agreed to purchase a chain of 1,300 gas stations from Petty Petroleum for $71 million. The company also faced charges at home that it and the other major Russian oil companies were using offshore firms and trading schemes to avoid paying taxes, which were estimated to total some $9 billion a year. LUKOIL maintained that all its taxes were paid, but also warned Moscow that any tightening of regulations would prevent the company from continuing to upgrade its aging production equipment and soon lead to a drop in oil production that would have a dire effect on the economy. With world oil prices soaring, however, such predictions of doom for LUKOIL carried little weight.

The economic climate for Russia was also improving. In 2000 the country’s economy grew for the first time since the fall of the Soviet Union. With oil reserves that could possibly top 100 billion barrels, Russian territory was looking even more promising than the five billion to 16 billion barrels that could be realized in Alaska’s Arctic National Wildlife Refuge that President George W. Bush indicated he would allow to be tapped. Russian officials went on a road show to urge U.S. oil companies to drill in Russia, which they maintained would be faster and provide far more oil than the Refuge. With forecasts indicating that over the next 20 years the world would continue to increase its oil consumption, any supply of crude not controlled by OPEC (the Organization of Petroleum Exporting Countries) would have to be viewed as an inviting prize.

Key Dates:

1991:: LUKOIL is formed in aftermath of the dissolution of the Soviet Union, through consolidation of the western Siberian companies Langepasneftegaz, Uraineftegaz, and Kogalymneftegaz.
1994:: LUKOIL becomes first Russian company to offer stock.
1995:: Offering of convertible bonds leads to listing on New York Stock Exchange.
1998:: LUKOIL enters into agreement with Conoco to drill in the northern territories of Russia.
2000:: LUKOIL acquires U.S. Getty gas stations.

LUKOIL, with the vast potential of Russian oil reserves backing it up, appeared poised in 2001 to join the ranks of the world’s major oil companies, the so-called seven sisters. In order to be less dependent on the fluctuation of crude oil prices, LUKOIL invested widely in downstream businesses in Europe and the United States. Aside from expanding European refining capacity, LUKOIL looked to buy a gas retailer, such as Austrian Avanti. In the United States it looked to acquire an East Coast refinery to supply its chain of Getty gas stations. As long as the Russian government and economy remained relatively stable, there was no reason to believe that LUKOIL would be unable to find enough Western partners to help it continue to grow.

Principal Divisions

Refining; Supplies; Marketing; Transportation.

Principal Competitors

Exxon Mobil Corporation; Royal Dutch/Shell Group; BP Amoco p.l.c.; Total Fina Elf S.A.; Texaco Inc.; Chevron Corporation; Conoco Inc.; Repsol YPF, S.A.; Petróleos de Venezuela S.A.; Petróleo Brasileiro S.A. - Petrobras; Petróleos Mexicanos; Norsk Hydro ASA; CITGO Petroleum Corporation; Ultramar Diamond Shamrock Corporation; Occidental Petroleum Corporation; Sunoco, Inc.; Amerada Hess Corporation; 7-Eleven, Inc.; Koch Industries, Inc.; Kerr-McGee Corporation; Tatneft; Yukos.