Group Members:Violetta Abramova

Dennis HwangLuba Jacobson

Valerie KritsbergGeorge Oka

Our Agenda Today:

• Introducing…• Political Conditions• Economic Climate• Valuing the Firm• Conclusion and Recommendations

Decisions, Decisions, Decisions…

Why LUKOIL?

● Given the current economic & political conditions in the world, the future of oil industry affects us all

● Large multinational & the fifth largest oil supplier in the world after Exxon Mobile

● Improvement of corporate governance control & relative financial strength of its equity shares on NYSE & LSE place the company in a strong position

Because…

Introduction to LUKOIL

The World Over!!!

• Global player and Russia’s #1 oil producer

• One of the world’s top 5 publicly traded oil companies

• Most internationally diversified with projects in the Republics of the former Soviet Union, Eastern Europe and the Middle East

• Holds up to 2% of world’s output of oil

• Emerged on Nov. 25th, 1991 from a consolidated venture of 3 production associations – Langepasneftegas, Uraneftegas and Kogalumneftegas (LUK OIL)

• Organized into an Open Joint Stock company on Apr. 5th, 1993

Making History…

• In 1999 Lukoil acquired KomiTEK oil company• First post privatization corporate merger in Russian oil and gas

industry• This strengthened Lukoil’s position in the oil sector even

further• That same year it acquired Saratov petrochemical plant• In 1999 it acquired oil refineries in Odessa and Bulgaria• In 2000 moved its operations beyond the Atlantic Ocean• Acquired Getty Petroleum Marketing Inc. American corporation controlling petroleum stations in 13 NE States, covering NY & NJ• In 2001 attained 60% voting right of the NORSI OIL – Nizhniy Novgorod Refinery

Acquisitions

LUKOIL Production

Growing…Growing…Grown

• Producing higher volumes of jet and diesel fuel, and are expanding in the petrochemical section

• Increasing its refining capacity in both Russia and Internationally

• Constantly implementing refinery upgrade to meet American and European Standards

• Believe Eastern European Markets provide for low cost and retail sales growth opportunities

• Natural gas production went up by 11% & oil refining volume increased by 18% in the last year

Caspian Exploration

Why, When and Where…• Over the past year Lukoil has been penetrating the North Caspian

Region:– Sign of company’s upstream development strategy– Shift the pressure from worn out fields in Siberia to underdeveloped

fields• As per World Bank – Caspian will be a key region for most of the

future’s oil production• In 1997 Lukoil + Atlantic Ritchfield Company (ARCO, sub of BP) = LUCARCO Agreement• Working together on the exploration and the development of the North Caspian Region• Political Union – BP’s down payment for Russia’s compliance on the war against Iraq

Gazprom and LUKOILThe Venture…

• In Nov. 2002 two biggest Russia’s gas and oil producers signed a strategic partnership agreement

• Together will sponsor the exploration and development in the North Caspian Region

• There are large deposits of gas in the North Caspian Region

• Lukoil is intending to use Gazprom’s pipelines because the tariffs on those are too high

• Lukoil benefits because it is looking to expand its gas sector

“Keep you friends close, and your enemies even closer”

West Qurna ProjectEntering Dangerous Waters

• In 1997 Lukoil and the Baghdad Oil Ministry signed a production sharing agreement (PSA) to develop the West Qurna Field

• Would have brought Lukoil $70 billion worth of oil

• Lukoil would own one of the biggest oil fields Baghdad has ever offered

• In December of 2002 Iraq’s ministry terminated the contract

• As per Baghdad Oil Ministry Lukoil failed to meet its obligations

• Main point was to develop the field, Lukoil harmed the Iraqi economy

• The true reason behind the termination was hidden

Initial Agenda• Restore Russia’s international image as a great world power

• Pro-Western stand

• Support following September 11th, 2001

• May 2002 – Signed bilateral strategic arms reduction agreement with the U.S., and agreed on creation of Russian NATO Council

Russian Federation – PoliticalRussian Federation – Political

• Implications of Impending War in Iraq– Positioning: Side with U.S.?

Side With U.S. Not Side With U.S.Maintain built-up positive relations with U.S.

Economic gains from lucrative oil contracts with Iraq

Improve chances with entrance of NATO

Implications with EU leaders – France and Germany

Greater involvement in distribution of Iraqi oil in the case of a U.S. victory

Hussein’s tactics from Gulf War could imply rise in Russian oil prices

Might not receive just proportion of Iraqi oil from the U.S.

Russian Federation – PoliticalRussian Federation – Political

•Result: Not side with the U.S. Result: Not side with the U.S. Side with French-German EntenteSide with French-German Entente

• Political Implications During the War– U.S. and the coalition forces likely to defeat Saddam

Hussein’s Regime– U.S. to take lead role of developing post-war Iraqi

government– Most outside nations, including Russia, believe the United

Nations should assume the lead role– If U.S. takes lead role, current Russian contracts with Iraq

might not be enforced

Russian Federation – PoliticalRussian Federation – Political

• Political Implications During the War

– April 6, 2003: U.S. House of Representatives passed an amendment that bars Russia, France, Germany, and Syria from participating in contracts for Iraq’s postwar restoration

– Elevated importance of U.N. Security Council meeting concerning Iraq’s oil revenues

• Oil-for-Food Program

Russian Federation – PoliticalRussian Federation – Political

• Strained Relations– U.S. accused Russia of providing Iraq with military equipment

– Russia claimed that U.S. troops shot at a Russian convoy, which was carrying Russian diplomats

– If U.S. pursues other “Axis of Evil” countries, Russian-U.S. long-term partnership could collapse

Russian Federation – PoliticalRussian Federation – Political

Russian Government’s Future Decisions• Recognize strong Anti-American and Anti-War sentiment in Russian people

• Upcoming election might force Kremlin party to play to a receptive home

• Oil industry’s reliance on political relationships with foreign countries

• Future Western retaliations to Russian opposition

Russian Federation – PoliticalRussian Federation – Political

? ?

• Russian Trading System– Created in 1994 – Energy Index

– Largest Russian Electronic site uniting investment companies and banks

– Two large movements in history:• Rise by 1000% in 1996-1997• Drop by 1000% in 1997-1998

– Based upon results of 1998, 2nd largest fastest rising index in world

Russian Federation - Economy

Russian Federation - Economy

Russian Trading System (RTS)

Russian Federation - Economy

Ruble Crisis of 1997

• Initially triggered by Asian Financial Crisis

• Government defaulted on debt and lacked hard currency to pay out to citizens

• Plan to stabilize economy via currency devaluation failed

• As a result, amount of tangible goods in stores disappeared rapidly

• Despite problems, LUKOIL pre-tax profit higher then forecasted profits and production increased

Russian Federation - Economy

Banking System

• Initial stabilization deprived banks of easy profits

• Central banks forced to keep other banks afloat

• Major banks had much capital but could not lend

• Government eager to deal with foreign banks, but they are wary

• Problems include lack of transparency and legal framework

Russian Federation - Economy

Corporate Governance• Rapid privatization led to series of scandals

• Early government attempts to fix issues have not met with success

• Managers beginning to realize benefits of Corporate Governance

• Government attempting new measures to curb issues

Vladimir Putin meets LUKOIL's President V. Alekperov.

Russian Federation - Economy

Inflation

• Post-Cold War, inflation stabilized at 11% in 1997 (compared to 2500% in 1992)

• Financial collapse led to large increase in inflation, 6.4% to 84.5% in 1998

• March 2003: Inflation has begin to return to normal, forecasts expect to be no higher then 12% for 2003

Russian Federation - Economy

• Tax System– Burdensome and Complicated

– Tax evasion high in the 1990’s

– Tax improvements have begun, but total reform still needed

– Recent changes include:• Flat Personal Income Tax – 13%• Maximum Corporate Profit Tax down to 24% from 35%

“But in this world nothing can be said to be certain, except death and taxes, even in Russia”

Russian Federation - OilRussia, Thee Oil Producer

• 10% of World’s proven reserves

• 10% of World oil production– 2001: 348m tons, up from 1999 (305m) &

2000 (323m)– LUKOIL – 78.3 million tons – 22.5% of

Russian production

• 5 major Russian companies – LUKOIL, Surgut Holdings, Yukos, Tatneft, & Sidanco

• Lack of funds caused collapse in early 90’s

• Development of new fields has increased

Russian Federation - Oil

Russia, Thee Oil Supplier

• Strong growth has made economy highly dependent

• 2nd largest exporter of oil in 2001 (Saudi Arabia)

• Importance as supplier has put in conflict with OPEC

• Volatile domestic prices caused domestic companies to slow down

• Recent developments have led to new growth

Russian Federation - OilForeign Direct Investment in the Oil Sector

• Foreign investment has been slow to despite potential

• Deterrents: Political instability, legal framework, governance, etc.

• Recent steps by government to liberalize foreign entry have improved relations

• BP Amoco Investment– 2002: Purchase of 15% more of Sidanko – USD $375m– 2003: Expected purchase of 50% of Tyumen for USD $6.75

billion

ValuationAny oil company with as large of a production capacity and world presence as LUKOIL considers two eminent factors:

•Production–Capacity and recognition of probable oil production from development projects (Caspian)

•World Oil Prices–OPEC production and reserves–Russia’s current and future presence in the oil market–Effects of the war with Iraq

Valuation

LUKOIL’s strategic plans for the next 10 years:

• Lower production costs– Improve efficiencies in existing operations– Production expansion in lower cost regions (Caspian, Middle East)

• Strengthen Netbacks:– Lower transportation costs– Increase proportion of sales in international markets– Improve quality of crude oil

• Increase Capital Expenditures to facilitate expansion Capital Expenditures, exploration and investment programs:

Project: Completion Date: Investment Amount ($m)

Neftochim burgas AD 2005 $84

Petrotel SA 2008 $86

Russian Federation 2006 $471

Iraq 2004 $495

Caspian Region: 2030 $1,008

Total Expenditures:   $2,144

“Good Things Come to Those Who Wait”

Sales Projections: Sensitivity Analysis

Production:

•Development of the Caspian Region expected to have largest effect on production

•Expected closing of 5000 unproductive oil wells

•Level of ownership of the license by Kazakhstan

Closing of promised 5000 unproductive oil wells

• Optimal cost savings• Will increase production level by 3% for 2002-2008

Caspian Production• Highest growth rate for 2002-2005 of 5% and 10% for 2005-2008• Based on successful extraction and quick extraction of 3.3 billion barrels of extractable

reserves

Best Case Production Projections:

Best Case Production

0

1,000

2,000

3,000

4,000

YearsM

illio

ns o

f Bar

rels

20012002200320042005200620072008

Overall Production Growth Rate:2002-2005 = 8%2005-2008= 13%

Closing of approximately 3,000 unproductive oil wells

• Moderate cost savings• Will increase production

level by 1.5% for 2002-2008.

Caspian Production• Moderate growth rate for 2002-2005 of 4% and

7% for 2005-2008

Intermediate Case Production Projections:

Intermediate Production

0500

1,0001,5002,0002,5003,000

Year

Mill

ions

of B

arre

ls 20012002200320042005200620072008

Overall Production Growth Rate:2002-2005= 5.5%2005-2008= 8.5%

Worst Case Production Projections:

Closing of unproductivewells is either too costlyor unsuccessful• No cost savings.• No contribution to

production level growth

Caspian Production:• Lower end of projection

growth rate for 2002-2005 of 3% and 4%

for 2005-2008• Based on slow and low

level of extraction and higher level of

ownership of the license by Kazakhstan

Worst Case Production

0

500

1,000

1,500

2,000

2,500

Year

Mill

ions

of B

arre

ls

20012002200320042005200620072008

Overall Production Growth Rate:

2002-2005= 3%2005-2008= 4%

Oil Prices

• World Bank estimates

• Prolonged war and insufficient oil supplies

• Comparison to the results of the Gulf WarNote: “Best Case Prices” refer to optimal prices for world markets, assuming

reduction and later stabilization. Under these assumptions prices are the lowest of the three scenarios, which in turn are least beneficial for LUKOIL.

“It Ain’t Over Till Its Over”

Sales Projections: Sensitivity Analysis

Based on World Bank Estimates assuming:• Short war with Iraq• Few subsequent attacks on coalition forces• Quick integration of new representative government in Iraq• Increased OPEC production• Increased growth in non- OPEC suppliers, with Russian being second largest world supplier.• Emergence of North Caspian oil

Best Case World Prices: (Worst Case Scenario for LUKOIL)

Best Case Oil Price ($/Barrel)

05

1015202530

Year

$/Bar

rel Oil Price

($/Barrel)

Comparison to the resultsof post Gulf War Oil Prices• OPEC led by Saudis, increased

production to calm oil markets but lacking reserves to offset post war non production in Iraq

• Large Iraqi oil fields will remain unproductive

• New supplies from West Africa, Caspian Sea, and Venezuela are not significant enough to affect oil prices

• New technologies fail to increase rate of production as estimated

Intermediate Case World Prices:

Intermediate Case Oil Price ($/Barrel)

0.005.00

10.0015.0020.0025.0030.0035.00

Year

$/Bar

rel Oil Price

($/Barrel)

Prolonged War andinsufficient oil supplies

• Oil stocks remain tight into 2004

• Iraqi opposition will remain strong: attacks from Iraqi forces from Syria

• Scud missiles with chemical war heads are launched at coalition forces

• Acts of sabotage and terrorism reduce oil exports from the Middle East

Worst Case World Prices: (Best Case for LUKOIL)

Worst Case Oil Price ($/Barrel)

01020304050

Year

$/Bar

rel Oil Price

($/Barrel)

– Arrived at most likely scenario for LUKOIL

– Correlated production scenarios to oil price scenarios

Sensitivity Analysis

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

Best Case Prices Intermediate LevelPrices

Worst Case Prices

Proj

ecte

d R

even

ue

Best CaseProduction

IntermediateLevelProduction

Worst CaseProduction

Sensitivity Analysis Overview:

Most Likely Outcome: Intermediate Production and Best Case World Oil Prices

• Why Intermediate Production:– The Caspian project will not be as successful as earlier predicted. – Closing of 5000 unproductive oil wells will not be successful: high

operational and environmental costs– Number of unproductive oil fields to be closed will equal breakeven

volume • Decreasing expenses and idle capacity

• Why Best Case World Oil Prices:– Lower demand for oil due to recession and slow economic growth – Higher non-OPEC oil production (West Africa and Caspian)– Release of reserves by OPEC to keep prices within target– Past 20 years shown decline in oil prices at the end of war

“History repeats itself”

Scenario Analysis Conclusion:

Scenario 4: Intermediate Production and Best Case Prices

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

2002 2003 2004 2005 2006 2007 2008

Year

Reve

nue

(in m

illio

n of

USD

)

Revenues:

Most Likely Scenario:Graphical View of Projected Revenues

International Cost of Capital (CSFB) Inputs:

International Cost of Capital (CSFB) Inputs:A (CV or RTS/ CV of S&P) -0.439

CV of RTS 0.974

CV of S&P -2.219

SY (Sovereign Yield) 0.034

Beta of RTSI 0.825

K (Adjustment Factor) 0.6

Russian Fed. Rf rate 0.17

E[r-Rf] 0.307

Brady Bond Yield-Semi-Annual 0.128

Brady Bond Yield-Annual Adj. 0.271

CV of Local Market= Standard Deviation of RTSI/ Mean of RTSI  

CV of US Market= Standard Deviation of S&P/ Mean of S&P  

Cost of Equity: CSFB Model

International Cost of Capital:

E[r]= SY+B{E[r-Rf)*A} *K

E[r]= .271+.825{(.307)*(-.439)} *.6=

20.43%

Cost of Debt:

• Credit Spread Rating: BB-– BB- rating of 4.13% is average of B+ and BB ratings (4.75%

and 3.5%)

Risk Free Rate: 10.47%

• Risk Free Rate for US 10 year T-bonds = 3.95%• Risk Free Rate of the Russian GKO Ten Year Bond= 17.0%• Average of US Risk Free and Russian Risk Free Rate:

10.47%

Cost of Debt= Average Rf + Credit risk spread : 14.61%

Cost of Debt

Weighted Average Cost of Capital

WACCCost of Equity 20.43%

Cost of Debt 14.61%

Market Value of Equity $10,412,500,000

Market Value of Debt $71,284,399,127

Market Value of Firm $81,696,899,127

Equity/Total Firm Value 12.75%

Debt/Total Firm Value 87.25%

Corp tax rate= 24.00%

WACC=(E/V)*re+((D/V)*(rd)*(1-T))

WACC= 12.29%

Net Income• Revenue: Based on production minus reserves (9% of annual production) in

Scenario 4• Operating Expenses: 1.5% yearly reduction• SG&A: 15% annual increase due to increased exports• Depreciation, depletion and amortization: 5% historical annual increase• Excise and Export Tariffs: 30% annual increase due to increase in

exports• Interest Expense: 15% historical annual increase• Corporate Taxes: Reduced from 35% to 24% in 2002 per government tax

reform.

Capital Expenditures• 30% annual increase based on projects in progress

Changes in Networking Capital• Growth in current assets and liabilities • Annual growth in current assets based on Yukos financial statements• Growth in current liabilities of 21.2% based on historical data• Reduction in networking capital as projects approach completion dates

Cash Flow Analysis (Free Cash Flows to the Firm)

• Free cash flows decrease from 2003 due to increase in Capex in short-term projects

• Revenue from short-term projects will not be realized till 2010• Revenue from long-term projects (Caspian) will not be realized till 2032• By discounting annual FCFF by Cost of Capital (11.41%), firm value

equals• 52,627 million USD.

Free Cash Flows to Firm Analysis:Major Highlights

FCFF Analysis  2002 2003 2004 2005 2006 2007 2008

Net Income 17,701 18,168 14,289 13,785 10,835 11,020 10,917

Depreciation, depletion and amortization 930 977 1,026 1,077 1,131 1,187 1,247

Capital Expenditures -1,059 -1,482 -1,927 -2,505 -3,256 -4,233 -5,503

Changes in Networking Capital -73 -149 -249 -379 -547 -761 -1,034

Free Cash Flows to Firm 15,785 15,858 11,585 10,582 6,994 6,361 5,201

Growth Rates:   0.47% -26.94% -8.66% -33.91% -9.06% -18.24%

Discounted Cash Flows at Cost of Capital (12.29%): 14,152 12,768 8,429 6,939 4,223 3,489 2,628

Value of Firm   52,627 (in million of USD)    

• Proceeds from New Debt Issues– Based on maturing debt and current debt ratio

• Preferred Dividends– As per Russian Federal Law, 10% of net income

FCFE 2002 2003 2004 2005 2006 2007 2008Net Income 17,701 18,168 14,289 13,785 10,835 11,020 10,917

+ Depreciation, depletion and Amortization 930 977 1,026 1,077 1,131 1,187 1,247

Operating Cash Flows from Operations to Equity 18,631 19,145 15,315 14,862 11,966 12,208 12,163

- Capital Expenditures § -1,059 -1,482 -1,927 -2,505 -3,256 -4,233 -5,503

- Principal Repayments 478 799 208 424 374 143 143

+ Proceeds from New Debt issues 750 1,254 327 666 587 224 224

- Changes in Networking Capital¥ -73 -149 -249 -379 -547 -761 -1,034

-Preferred Dividends 211 1,770 1,817 1,429 1,379 1,083 1,102

FCFE per year 19,824 19,462 15,792 16,559 14,603 16,200 17,680

Discounted FCFE (Cost of Equity: 20.43%) 16,461 13,419 9,041 7,872 5,765 5,310 4,812

Value per Share (estimated) $73.69

Current Price (LUKOY.PK: As of Friday close) $62.50

Percent Undervalued: 18%

New Items:• Principal Repayments

– As projected by LUKOIL, maintaining current debt ratio (87%)

Free Cash Flows to Equity Analysis:

• The Country:– Russia will experience a Renaissance, given successful

policy implementation and monitoring– Russian oil industry expected to become a dominating

force in the world markets • The Company

– LUKOIL is a lucrative long-term investment– Maintaining of its market share and strategic alliances,

probable future reserves will equal proven current profits

-------------------------------------------------------------------------What Professor Mei will realize in capital gains if he

invests $1,000,000 is $179,040 + Dividends!!!

Conclusion and Recommendation: Conclusion and Recommendation:

““Early Bird Gets the Worm”Early Bird Gets the Worm”