Restructuring, consolidation top solutions for Russia's major oil companies' woes

March 13, 2000
How does a country with such a vast natural resource base as Russia find itself on the verge of fiscal and economic insolvency?

How does a country with such a vast natural resource base as Russia find itself on the verge of fiscal and economic insolvency?

A pumpjack, shown in supergiant Samotlor oil field in Western Siberia, is operated by Nizhnevartovskneftegaz, a subsidiary of Russian oil major Tyumen Oil Co. Russia's oil majors could face a period of restructuring and consolidation as they cope with integration with world markets and the country's fiscal woes. Photo by Mikhail Dychliuk.
Click here to enlarge image

Will the Russian oil and gas sector ever attract the large-scale financing required to develop its infrastructure and a capital base to allow the industry to achieve levels of international competitiveness and sustainable profitability?

Will tax burdens placed on private enterprises and used to fund Russia's social system ever be legislatively alleviated? Will passage of production-sharing legislation stimulate exploration and development activities in an unsettled price environment? Or will the government choose the alternative route of returning to its former protectionist ways and thus destroy any possibility of attracting foreign investment?

We will attempt here to explore various options available to Russian oil managers as they begin navigating through the uncertainties of managing oil and gas enterprises in the 21st century. The primary focus will be on some fundamental structural issues faced by the Russian oil and gas sector and their impacts on managerial decision-making. Fundamental changes in the industry's dynamics will determine how managers accept these challenges-or risk failure in the next century.

Cash-strapped or insolvent?

It should come as no surprise to the international financial community that the most pressing business issue facing Russian general directors today is economic survival.

With the present liquidity crisis and forced bankruptcy proceedings, Russian enterprises are in dire need of generating hard currency earnings to sustain operations and remain viable commercial entities in a period of political uncertainty, economic turmoil, and financial instability.

To make matters worse, the Russian oil and gas sector must raise vast sums of money, both short and long-term, to undertake neglected capital expenditure programs to arrest production declines, rehabilitate existing wells, upgrade inefficient refineries, increase refining complexity, develop a service station network, alleviate export bottlenecks, and repair or replace an aging pipeline system.

The scope of these capital programs does not even be- gin to envisage funding required for environmental protection and remediation initiatives that are estimated to be significant.

The environmental issues alone represent a significant barrier to obtaining investment capital from international oil and gas firms seeking market entrance in Russia, as socially conscious and risk-averse companies are extremely reluctant to fund existing projects with unknown environmental exposures.

Another major cash drain is social costs. Presently, the Russian oil and gas sector bears a disproportionate share of the country's social responsibilities because national, regional, and local administrations are unable to pay for their share of social obligations. Oil and gas producing provinces in Western and Eastern Siberia, for example, lack the economic diversity to support the fundamental social requirements of their primary constituents. This places tremendous monetary strains on oil and gas enterprises in assuming these social liabilities in times of severe fiscal crisis (OGJ, Mar. 6, 2000, p. 25). One thing is certain: Russian oil managers and their governmental counterparts must devise a workable solution to this social funding problem. The energy industry should not be unduly penalized with heavy tax burdens to fund the country's social safety net.

Simple solution?

It is unrealistic to assume the present liquidity crisis will abate in the near term without assistance from international lending agencies (ILAs), together with drastic cost-cutting measures initiated internally by Russian oil enterprises.

More than likely, ILAs will eventually respond to the present economic crisis by providing financial assistance in the form of soft and concessionary loans, thus allowing commercial creditors to restructure current debt obligations that are staggering relative to gross domestic product.

In fact, a mutual consensus on far-reaching economic imperatives has been imposed by the International Monetary Fund (IMF), but, unfortunately, the capital infusion affected by these loans will not suffice, as new loans will only be used to roll over existing obligations.

No new money is expected to circulate to the country-and thus the oil and gas sector-until after the presidential elections in June 2000.

Another lingering issue that must be addressed before capital flows back into Russia involves how government intends to control the flight of capital that has plagued this country since the fall of communism.

Conservatively speaking, Russia has been a net exporter of more than an estimated $100 billion of capital that has found its way to the US, Switzerland, and obscure offshore banking havens. This represents a significant hemorrhage of potential capital that could be recirculated throughout the Russian economy in the form of credits to industrial sectors such as the oil and gas industry. Conservative estimates indicate the present level of capital flight offsets Russia's positive trade surplus of about $3 billion/month.

Russia suffers from capital flight because the country's risk-to-reward ratio is unfavorable, the political and economic system is unstable, the banking system has collapsed, the tax regime is punitive, the disparity of income and wealth levels among the population is high, and the country's economy over the past few years has been hyperinflationary.

Unfortunately, the country's reaction to problems has been to introduce excessive administrative controls and bureaucratic red tape, rather than tackle systemic causes.

The negative implications to the domestic economy are many, with one specific and noticeable impact-the low level of foreign direct investments (FDI). Since 1993, Russia has attracted FDI aggregating about $10 billion, leaving Russia in the company of countries such as Peru, which has only a fraction of the people and natural resources. In 1998, according to the Moscow Times, Russia's FDI averaged a paltry $1.5 billion (out of a total foreign investment of $18.6 billion), equivalent to 1% of gross domestic product or $10 per capita. This compares with world FDI of $450 billion in 1998. During 1989-98, FDI in Central and Eastern Europe and the Commonwealth of Independent States totaled $74.5 billion. Russia's low-level of FDI relative to its former Eastern Bloc satellites Hungary, the Czech Republic, and Poland further magnifies the ineffectiveness of its economic approaches.

Within the oil and gas sector, this trend is quite disturbing when one analyzes the low equity valuations placed on Russian oil companies. This point is illustrated by reviewing and contrasting the recent surge in mergers and acquisitions in the international oil arena. The US petroleum mergers, acquisition, and divestitures (MAD) market is a good yardstick for measuring the relative levels of activity in world oil markets. In 1998, the volume of US MAD activity exploded to about $82 billion from a previous record of $24 billion in 1997. These deal flows translate into acquiring oil and gas reserves at market valuations of $4.50-5.75/boe (excluding the Exxon Corp.-Mobil Corp. and BP Petroleum Co. PLC-Amoco Corp. transactions, which would skew this range upwards).

Russia has not experienced the same levels of oil and gas reserve acquisitions that are common to international oil markets to determine a readily available price barometer. But according to industry estimates, perceived acquisition values of Russian reserves are about $0.05-0.50/boe, implying a significant market discount per barrel relative to international market transactions.

To validate this low range of reserve acquisition values, another valuation methodology was used, based on a market capitalization per boe basis. Even under this market measure, the implied equity valuations of Russian oil companies based on market data have averaged roughly $0.16/boe. Again, this market measure indicates a substantial discount attributable to Russian reserves relative to those implied for international oil companies. This market approach somewhat normalizes the disparities between international and Russian reserve classification schemes (proven, probable, and possible vs. A, B, and C1 and C2, respectively). Differences aside, even with low implied equity valuations, the level of direct investment in the Russian oil and gas sector has not increased, which tends to support the fundamental structural issues already outlined.

So, what is needed to enable Russia to stimulate this key industrial sector? What steps should be initiated by Russian oil managers to facilitate a favorable investment climate?

Desperately seeking solutions

What is desperately needed to stimulate the Russian oil sector is an influx of direct financial investment from international oil companies.

Unfortunately, the government's internal debates over the commerciality of passing PSA legislation conservatively cost the oil industry billions of capital-investment dollars, let alone lost revenues in tax collections to the country's national and local coffers and missed opportunities to create much-needed employment. Many significant oil and gas projects earmarked for PSAs stalled in the bureaucratic web of self-interest and reactionary debates.

With recent passage of PSA enabling legislation, many individuals have argued that activities relating to stalled PSA projects may increase, but that is probably more wishful optimism than market reality (OGJ, Mar. 6, 2000, p. 26). Why? Fundamentally, the oil and gas sector's competitive dynamics have changed drastically since the Duma passed initial PSA legislation in late December 1995. Most important among these changes are the initiatives by key oil exporting nations, such as Saudi Arabia and Venezuela, to attract foreign investment to their upstream petroleum sectors.

Some may rationally argue that these moves do not directly affect the Russian oil and gas sector because it is characterized by completely different market and socioeconomic factors. Others will take notice of these strategic market moves and assess the overall impact on their business strategy and competitive position in the market. Decision-makers would probably opt for the latter position by quantitatively and qualitatively assessing the strategic impact on their business. Questions such as "Why would an international oil company want to invest in Russia, or for that matter, why would anyone want to invest in my company?" need to be addressed. Without a convincing story to tell, the investment community will turn a "blind eye" to Russia's oil markets until market conditions improve and shareholder rights are observed. Further, international oil companies will invest only limited E&D capital in territories offering favorable market fundamentals, such as stable governments, low geological risks, low finding and extracting costs, proximity to market, established infrastructures, and workable regulatory and tax re- gimes.

Shifting tides

First, it is important that both the Russian government and the Russian oil industry take notice of the shift toward corroborative efforts by government and industry in promoting the interest of infrastructure and regional sector development.

The theory underlying this rationale is straightforward: Create necessary economic incentives to promote and attract investments in regional development, and necessary capital will follow. This economic rationale has not yet been fully accepted by the Russian government, as shown by the long procedural delays in passing legislation conducive to foreign investment. Moreover, the symbiotic relationship between the government and the oil and gas industry in promoting regional development initiatives for large-scale energy projects is almost nonexistent in Russia, except for activities to promote exploration and development on Sakhalin Island.

The Sakhalin administration, led by its governor, Igor Farkhutdinov, has been a strong advocate in promoting oil and gas PSA projects on Sakhalin Island, soliciting enough interest from major industry participants to begin multibillion-dollar oil and gas projects prior to full legislative ratification of the PSA law (OGJ, Mar. 6, 2000, p. 30). These projects, despite setbacks in oil prices and the long legislative delays in passing PSA legislation, have significantly aided the Sakhalin region by providing aid to regional development projects principally funded through E&D efforts.

It is highly unlikely that either the Russian government or the regional and local administrations of Sakhalin Island would have the financial resources to undertake such large-scale development initiatives without funds contributed by Sakhalin PSA consortiums. Therefore, Sakhalin Island should serve as a positive model of potential regional development opportunities resulting from full-scale oil and gas development in Russia, as the Sakhalin region will continue to see residual economic benefits, such as job development and improved local infrastructure.

Another large-scale oil and gas development project that would foster regional economic development in Russia is the potential construction of an export oil and gas pipeline network that serves the growing energy demands of the Chinese, Japanese, and Korean peninsula markets. Russia's proximity to this growing market and its huge hydrocarbon reserve potential should logically translate into massive growth opportunities for those individuals with the vision to see beyond present obstacles.

Massive oil and gas reserves in the Eastern Siberia region, such as those in the Republic of Sakha and the Irkutsk basin, together with the full-scale economic development of this region, will not be fully exploited until such time as a comprehensive national energy strategy is pursued. This project is considered expensive and will take years to fully develop, and Russia will miss a major opportunity to exploit a comparative advantage if a concerted effort by government and industry is not undertaken to develop these resources.

The Russian government must perform necessary feasibility studies to determine commercial and economic impacts of this regional development project. This project will probably not be fully developed without the financial assistance of ILAs, intergovernmental mandates, and Russian and international oil and gas industry participation. To further support this project, the Russian government could also establish an oil and gas fund earmarked to cover the project's debt service and improve the standard of living for individuals in the region.

The individuals responsible for mandating energy policy in Russia should take notice of sector benefits accrued through cooperative efforts. Any cooperation between federal and regional governments and the oil and gas industry must be made within the context of a grand scheme: the future vision and direction of the Russian oil and gas sector. If practice were any indication of reality, it would appear an overall energy mandate does not exist for Russia.

During the past few years, the Russian oil and gas industry has endured a proliferation of ill-advised and ill-timed mandates from various governmental ministries (e.g., excise tax increases and decreases, export quota restrictions, currency conversion requirements, custom duties, etc.) that send conflicting and confusing messages to the industry. Also these messages retard much-needed foreign investment. These irrational policies impede, rather than foster, industry development. The oil and gas sector's importance to Russia and the Russian economy is undisputed. It is crucial that governmental policy formulation facilitate sector growth, yet at the same time promote healthy competition.

The Ministry of Fuel and Energy, with assistance from other relevant ministerial bodies and industry participants, must define a clear, concise, and comprehensive national energy policy that facilitates exploration and production growth, stimulates foreign and domestic sector investment, creates competitive market conditions, and optimizes energy efficiency and utilization while concurrently promoting sustained economic growth, federal, regional, and local development and improving the social and economic welfare of the Russian citizens and those of its territories. These broad-based policy mandates should be no different from those already approved by former President Boris Yeltsin in 1995.

Market challenges

The challenges and complexities confronting the Russian energy policy-makers have increased significantly with the oil and gas industry's changing market forces and the country's macroeconomic and socioeconomic problems during the past year.

The temptation to extract maximum petroleum rents in the form of taxation has never been more compelling. These temptations must be avoided at all costs. Russia's national budget coffers and hard currency earnings are primarily dependent on oil and gas revenues for economic survival. Significant efforts must be directed to expanding this economic base through efficient exploitation of the country's mineral base, rather than the simplistic view of "milking the cash cow" today at the expense of future generations.

A few examples of broad-based oil and gas themes that could provide guidance to Russian policy makers follow.

Redefine state role

The Russian government's role in managing the sector's productive assets should shift from operational to making rules and formulating policies.

Moreover, the Russian government should continue to divest itself of shareholdings in oil and gas companies by promoting an open and transparent privatization of remaining state shares. Recent market competitiveness for Gazprom's shares should clearly demonstrate the government's coffers are best served through an open-tender process, rather than the skepticism and bargain-basement sales that characterized the infamous loans-for-shares debacle.

By focusing solely on overall industry regulation and policy decision-making, the government will allow the private sector to navigate through market complexities to determine the most efficient and effective means of supplying oil and gas products and services. This will be a big challenge for the Russian government to accept.

Gas fuel of choice

Natural gas will be the fuel of choice in the 21st century as the world begins the slow process of crude oil depletion around the year 2050.

In the near term, Russia will continue to have a comparative advantage over its competitors with regard to natural gas, as the country has the world's largest gas reserves. But this alone will not ensure continued economic success. A global shift in exploratory activities will occur as more companies begin to search for and develop gas-prone prospects to meet increasingly stricter environmental regulations. To maintain its advantage, the Russian government should continue to support efforts to promote competitiveness in the natural gas sector to fully exploit the country's vast gas reserves.

Moreover, access rights to Russia's gas transmission system should be on a nondiscriminatory and cost-reflective basis similar to common-carrier gas networks found in Western nations. Unbundling of the supply and distribution value chain will ensure attainment of these goals.

On a related matter, as the lines between the natural gas and power sectors become increasingly blurred, opportunities to exploit the growing trend of "btu convergence" have never been better for Russia, as the country is still in its infancy in terms of privatization and industry consolidation.

Energy trading, risk arbitrage

With increased pricing volatility in the global energy markets, proliferation of risk-management tools and derivative financial instruments will continue.

These risk-management techniques have not been used extensively in the Russian oil and gas markets, but they are primary tools used by international oil and gas companies to manage price risk and physical commodity exposures.

With eventual integration and linkage of the Russian oil and gas market to global energy markets and increasing sophistication of risk-management techniques used by Russian companies, the move toward financial transactions will begin to underscore the actual physical movements of crude oil, petroleum products, and natural gas.

This move toward hedging and speculative transactions will increase the need to provide regulatory oversight in the market to avoid financial disasters. Moreover, legislative changes will have to be introduced to ensure enforceability of these financial contracts. Russia cannot afford another financial embarrassment and the worldwide indignation that resulted from the unilateral abrogation of forward-currency contracts.

Merger mania

So what are some options available to the Russian oil industry?

For starters, there is a familiar trend in the oil sector-the merger wave. Mergers and acquisition (M&A) activity flourishes in times of market discontinuities, such as a precipitous drop in crude oil prices, supply and demand imbalances, the Asian contagion, Middle East tensions-not to mention the economic and political crisis that has plagued Russia over the past year.

But why merge? This option is definitely appealing for Russian oil companies, given the haphazard privatization program and clear financial and operational synergies to this approach. It is paramount the Russian oil sector embrace this trend and begin merging or consolidating vertically integrated companies (VICs). At the outset, industry consolidation would reduce redundant operations and eliminate excessive workforces-both prudent cost-reduction measures-but unfortunately, this option is time-consuming and may not have immediate impact on resolving the present liquidity crises. M&A activity in Russia will probably be greeted with heightened suspicion and legislative barriers.

Alternatively, an acceleration toward meaningful corporate restructuring that has largely been ignored may occur. Many VICs were left with ancillary divisions, such as retail shops, farm and dairy cooperatives, and construction divisions that are neither core business activities nor strategic imperatives.

These noncore businesses should be immediately privatized or divested to enable management to concentrate on what they do best: explore, produce, refine, and market oil and petroleum products.

The need for drastic organizational solutions has never been more apparent. To survive, Russian oil managers must make tough managerial decisions to trim bloated internal costs and rationalize discretionary capital expenditure programs. Tough austerity measures will no doubt have social ramifications.

Many workers will be displaced as unprofitable operations are closed and abandoned. Unpopular tradeoffs between an entity's commercial viability and its social responsibilities must be made to ensure future economic survival. This equates to a formidable challenge for an industry sector held in high esteem in the former Soviet Union.

However painful and daunting these tasks may appear, they pale in comparison with industry dynamics that must be proactively managed to ensure economic survival. The oil price collapse, followed by an equally dramatic recovery, aptly illustrates this point. Russian oil and gas companies burdened with excessive operating and debt-service costs found it extremely difficult to compete in a low-price environment. Absent the ruble devaluation and subsequent oil price rise, the Russian oil sector found itself in dire straits during the past year, calling upon the government to decree stopgap measures to ensure survival. These are knee-jerk reactions that must be avoided at all costs. Competitive market forces are much better regulators of market inefficiencies than governmental intervention. Instead, Russian managers should pursue cost-reduction programs and prudent risk-management techniques that ensure economic continuity in any market price environment.

Market realities

Another important point often overlooked is market perception. The financial community must come to grips with major structural issues faced by Russian enterprises to appropriately assess their financing needs.

Russia is still an economy in market transition. Seventy years of communist rule left the basic infrastructure, including the energy sector, in disarray, from a market perspective. While incremental change is possible, a truly successful transformation to a market economy will involve substantial enterprise restructuring, rebuilding of basic oil infrastructure, and imposition of a workable legal and regulatory framework. This full-scale transformation process has barely begun to materialize. Any workable solution to market transformation must be undertaken with a long-term view toward sustainability. In hindsight, it was totally unrealistic to expect Russia's market transformation to occur overnight. What Russia needed was a structured investment program aimed toward achieving a balance between financial performance and social stabilization-not shock therapy.

However, here is a final thought-provoking issue to those individuals capable of implementing change: It should now be evident that financial investment from international capital markets will not occur until Russian enterprises undertake projects to improve corporate governance, promote financial transparency, and eliminate excessive social burdens. The Russian oil enterprise that effects these changes first will be rewarded with financial capital and technological know-how. The few Russian oil enterprises that maintain reactionary tendencies and clamor for the "good old days," despite prudent market advice, will face eventual extinction or forced bankruptcy proceedings.

For individuals who work every day in Russia, the difficult times and operating conditions that Russian enterprises are presently experiencing are evident.

However, this country possesses immense natural resources and a highly educated workforce to weather the storm. Understanding these crucial facts puts Russia's present financial troubles in proper perspective.

In the oil price collapse of 1986, oil company managers had to make tough choices that directly affected the lives of many people. Unfortunately, the same tough choices now confront the leaders of Russia's crown jewel-the country's precious mineral resource base. Progressive managers in Russia's oil enterprises will make the necessary decisions to overcome present financial difficulties so that their companies can take their rightful place among the premier international oil companies. Others will ignore change and languish in obscurity until it is too late. These market dinosaurs will die a slow, painful death.

Those oil companies that undertake necessary measures must exercise utmost patience as they embark on a tough road to economic survival. There are no quick-fix solutions. It will take time to undo an economic model that has stymied industry growth and created unwieldy organizations. Fortunately, the Russian oil industry has been granted a brief reprieve from disaster following last year's low oil prices. The time to act is now.

The Author

Click here to enlarge image

Mark Gyetvay is a partner with PricewaterhouseCooper's Global Energy & Mining (GEM) group based in Moscow. He has been engaged in the oil and gas industry internationally for more than 19 years. Prior to PricewaterhouseCoopers, he held various positions with Champlin Petroleum Inc., Ensource Inc., MAG Enterprises, and Amerada Hess Corp. His areas of expertise include assessing and evaluating financial, operational, and economic issues affecting the upstream and downstream sectors of the petroleum and mining industries. As a partner in the GEM practice, Gyetvay is responsible for practice management activities, including developing business opportunities, maintaining client relationships, formulating marketing strategies, coordinating thought leadership initiatives, and participating in international energy activities. He is also the engagement partner on GEM clients providing overall project management, financial and operational expertise, and maintaining and supporting client service relationships.