European oil companies operating in Russia have poor reserve valuations due to the Russian policies over oil. Russia has focused on preventing the depletion of its reserves, and thus the country’s legal framework that surrounds the oil and gas exploration industry discourages growth.

Oil

Russia’s oil and gas sector is burdened with high taxes and export duties. In the face of immense pressure from oil and gas giants, export duties on crude oil and petroleum products were reduced in 2011 from 65 percent to 60 percent. However, this is still quite significant and the government continues to dictate the activities of the exploration sector.

Furthermore, there are a number of high mineral extraction taxes in addition to a revenue-based tax system. The Russian tax law also restricts operations of foreign companies where they have to conduct their gathering and distribution of information, marketing, advertising, market research and the import and export of goods activities via a local approved agent.

Crude oil producers get the worst of the taxation

Crude oil suffers from significantly higher regulation than natural gas. The public entity Transneft’ AK OAO (MCX:TRNFP) (OTCMKTS:TRNFF) has the right to transfer the majority of Russian crude oil for exports and dominates 93 percent of the crude oil produced by Russia.

Export is a major issue in the country. However, “The duties on crude oil and oil products are adjusted by the Russian government on a monthly basis to reflect price movements in the European oil market. The flat rate on crude oil cannot exceed the maximum rate,” reports Deloitte.

As a result, international oil companies which have operations in crude oil production in Russia suffer from lower valuations. The figure below shows the companies operating and producing in Russia and their respective oil and gas production.

Table 1: Crude oil and gas production in Russia

Source: Energy Information Administration (EIA)
Source: Energy Information Administration (EIA)

Of these producers, Rosneft’ NK OAO (MCX:ROSN) (LON:ROSN) (OTCMKTS:RNFTF) and LUKOIL (ADR) (OTCMKTS:LUKOY) (LON:LKOH) have the largest stakes in crude oil production. This is also illustrated in the figure below.

Figure 1: Product mix of producing companies in terms of percent of crude oil in total production

Source: Bloomberg
Source: Bloomberg

Weak valuations result from Russian policy concerns

Due to the immense reliance on crude oil production of Rosneft’ NK OAO (MCX:ROSN) (LON:ROSN) (OTCMKTS:RNFTF) and LUKOIL (ADR) (OTCMKTS:LUKOY) (LON:LKOH), their valuations have suffered. “Most European oil-geared integrateds are Russian companies trading at a discount due to external forces, including taxation and government policy. Gas producers typically trade at a particular discount, restrained by lower natural gas prices and the limited geographical flexibility of trading,” analyzed Philipp Chladek.

Figure 2: Enterprise value as a ratio of total reserves of Russian producing firms

Source: Bloomberg
Source: Bloomberg

As illustrated in the figure above, Rosneft and LUKOIL (ADR) (OTCMKTS:LUKOY) (LON:LKOH) fall at the far end of this spectrum and investors value their oil and gas reserves at much lower than that of other firms. Companies like Moly Mines Ltd. (TSE:MOL) (ASX:MOL), Repsol SA (ADR) (OTCMKTS:REPYY) (MCE:REP), Enersis S.A. (ADR) (NYSE:ENI) (BIT:ENI), Total SA (ADR) (NYSE:TOT) and Royal Dutch Shell plc (ADR) (NYSE:RDS.A) (NYSE:RDS.B) have been able to avoid this situation because of the geographical diversification that these companies have. Rosneft’ NK OAO (MCX:ROSN) (LON:ROSN) (OTCMKTS:RNFTF) and Lukoil’s focus on Russian energy has made them vulnerable to investor concerns over the Russian regulatory system.

Geographical diversification key to sustainable values

Philipp Chladek further explores this area by stating: “Integrated EU oil companies tend to have more globally diversified exploration and production (E&P) portfolios than smaller independent E&P companies, which means that macroeconomic sentiment is usually the main driver in valuing their reserves. In contrast, reserve valuations for smaller producers, focused on specific regions, are often heavily influenced by local news or investor interest in that area.”

It is important for LUKOIL (ADR) (OTCMKTS:LUKOY) (LON:LKOH) and Rosneft’ NK OAO (MCX:ROSN) (LON:ROSN) (OTCMKTS:RNFTF) to not only increase their product diversification but also to expand their global reach to benefit from geographical diversity. Other areas of Europe should be explored such as the North Sea where companies have been observed to have much better valuations.