Why Lukoil Is The Best Oil Major To Own (?)

Perhaps surprisingly, I believe Lukoil, the Russian oil giant, is the best oil stock to own among the oil majors. Despite being a Russian company, it’s managed well due to the CEO being the biggest shareholder in the company. Management has skin in the game.

I bought shares in the fall of 2015 at 34 USD, which has produced a CAGR of 16% with dividends reinvested. I have no intentions of selling as I believe the oil price can make a solid comeback from today’s depressed levels. This article gives brief arguments for why I believe Lukoil is the best stock to own among the oil majors.

Summary:

In brief, I support my holding on these arguments:

  • Historically Lukoil has managed to stay free cashflow in any market environment due to its vast resources and low cost of conventional reserves.
  • Probably one of the best, if not the best, managed Russian companies.
  • Skin in the game, the BoD and management owns 39% of the company.
  • Have outperformed its peers.
  • Have no long-term debt, in best position to sustain low oil prices.
  • The highest oil reserves among the oil majors relative to its size.
  • Not prone to risky M&A activity. Mostly focused on organic growth.
  • Reasonably good capital allocation skills. A buyback program was not used by February 2020 and I expect buybacks during the sharp drop in the share price since then.

The easiest way to acquire shares is via the OTC-market in the US where it trades with the ticker LUKOY, averaging about 20 000 shares per day.

The company:

Lukoil is a vertically integrated oil company, meaning it’s involved in the whole value chain from upstream to downstream plus distribution. The segments are divided into three units: Exploration and production, Refining/marketing/distribution and Corporate/other. Distribution involves about 5 000 petrol stations and aviation refuelling.

  • Operates in over 30 countries, but mainly in the former Soviet.
  • 16 billion barrels of proven reserves, 76% is liquid and 24% is gas (ExxonMobil has about 22 billion). This is 1% of global reserves. In 2018 Lukoil produced 856 billion.
  • 2.2 million barrels per day in production (1.8 is crude oil and 0.5 is natural gas). This is 2% of global production.
  • 1.4 million per day in refining output.

Lukoil  has three natural “hedges” in the business model:

The business model has three natural hedges: vertically integrated, costs are mainly in RUB and Russia has progressive taxation.

An oil producer is obviously “long” the price of oil, but for the refining business this is a bit different. The refining business buys crude oil and sells refined products and pockets the difference between the cost and sale price. The relationship is in reality a bit more complicated, but as a crude assumption I believe this holds up pretty well.

Lukoil is based in Russia has most of its production there. This means most of the cost base in in Russian roubles, while the oil price is priced in USD, thus giving a hedge.

The third argument is about progressive taxation, which means taxation is less severe at lower prices.

Free cashflow positive in any environment:

Lukoil has over the last two decades concentrated their production to projects with higher EBITDA per barrel, which has made it a good play in any oil-regime. In 2017/18 Lukoil decided to divest its upstream assets in fields they consider high-risk or inefficient.

Lukoil is profitable even during low oil prices. Source: Lukoil presentation.

A clean balance sheet:

For the ancients, someone in debt was not free, he was in bondage.

The above quote is taken from Nassim Nicholas Taleb, and sums up pretty well my own personal take on debt.

Unlike many other companies, Lukoil has zero long-term debt which makes them the most antifragile oil company.

Capital allocation:

Lukoil focus on organic growth, not M&A. This of course reduces the risk for ill-fated acquisitions (overpaying, clash of cultures etc.).

The dividend has top priority and buybacks are just secondary.

Lukoil has paid a rising dividend since 1998 (in roubles). Source: Lukoil presentation slides.

For 2019 shareholders have already received 192 roubles in dividend, and later during the summer the board will decide if they are going to distribute the remaining planned 350 roubles. As of writing, Lukoil trades at 4 780 roubles on Moscow Stock Exchange, indicating a dividend yield of about 4% on the already paid out dividend. There is a 15% withholding tax on the dividend.

Back in the fall of 2019 the BoD announced a buyback program worth 200 billion roubles/3 billion USD, currently worth about 6% of the market cap. To my knowledge none of this was used as late as February 2020, thus indicating they might have repurchased after that, in which case indicates an excellent discipline in waiting for the right moment.

Management and inside ownership:

As of December 2019 39% of the shares were owned by the BoD and management. The CEO, Vagit Alekperov, owns 27.33%. He was an oil minister during the Soviet times and he got the responsibility of forming a Russian equivalent oil-integrated like ExxonMobil. He has been the CEO since its formation in 1993 and is now 70 years old. We can safely say Lukoil is owner-operated. He has a son born in 1990 but to my knowledge he is not much involved in business. As such, there is a question mark about what will happen to Alekperov’s ownership in case he retires or fall ill.

Alekperov has managed Lukoil very well, and Lukoil is his “baby”, presumably he has very few friends outside business. During the recent Covid-19 downturn Alekperov bought an additional 15 million USD worth of shares, but perhaps not significant considering his net worth.

Worth mentioning is that major shareholders will direct the dividends for 2019 to a special fund for new investments.

Leonid Fedun, Vice President of Strategic Development and a friend of Alekperov, owns about 9.91%.

The high insider ownership should ensure that management’s interests are aligned with those of regular investors. To my knowledge, the Russian Government has no ownership at all.

Even though Lukoil is not state-owned, I believe Alekperov is in good terms with Putin and they meet regularly.

The oil price:

What makes the oil companies a bit harder to value is their dependence on the oil price. The oil price is a highly cyclical commodity that suffers from very volatile swings which is impossible to forecast. We can assume that the oil price will fluctuate between 10 and 200 dollars per barrel…… No matter how good an oil company is managed, it’s still at the mercy of the oil market. This make any investment in oil tricky and I believe the safest bet are those with little or no debt.

The Covid-19 forced in April the nearest future contract to go negative when speculators sold in panic to avoid delivery of their contractual obligations (the market is in contango). Speculators are buying oil on spot prices, store it wherever they can, and sell it for a higher price in the future, and pocket the difference less storage costs. If storage costs are lower than the difference between forward and spot prices, it’s a “risk-free” arb-play. This has bid up rates for oil tankers, they are having a field day right now, but most likely only for a short period of time.

Oil production and exploration is extremely capital intensive and cyclical. Today oil companies are fighting for survival and cuts CAPEX and dividends, meaning very little is spent on exploration over the next 2-4 years. At the same it’s unlikely that demand for oil will drop significantly over the long-term. As far as I can see, oil is needed for the foreseeable future, no matter how fast renewable sources are developing. Rystad Energy, a Norwegian oil consultant, writes that exploration is cut to the lowest level in 40 years and US shale production most likely is halved.

Based on this I expect the price of oil to go up from here.

Russia has pledged to cut production and Lukoil is thus forced to cut accordingly, which amounts to 18%, or about 300K bpd.

How has Lukoil fared compared to peers?

The table below shows the P/B and average return on both equity and capital invested (ROIC) over the last ten years. Lukoil has the second highest ROE despite having practically no debt/gearing. Including the debt, by using ROIC, ExxonMobil and Lukoil is in a class of their own:

Avg. Avg.
P/BV ROE % ROIC %
RDS.B 0.66 8.6 6.4
TOT 0.75 10.7 7.6
LUKOY 0.83 12.6 11.1
BP 0.90 7.91 5.9
XOM 0.97 15.2 13.5
EQNR 1.03 10.2 7.5
CVX 1.17 10.3 9.2
ENI 1.25 4.3 3.8
COP 1.39 11.21 8.8

The share price of Lukoil has performed well over the last two decades:

Lukoil share performance and five year rolling CAGR. Blue line (left axis) is logarithmic share price, right axis is rolling five year CAGR (pink line). Source: Yahoo/finance and my own calculations.

The solid operating metrics of Lukoil has made it the best performer over the last two decades:

Lukoil relative share performance relative to peers, dividend reinvested. Source: Seeking Alpha.

Risks:

  • The oil price.
  • Operates mainly in very corrupt countries. However, I believe Alekperov is on good terms with the rulers in Moscow. This can of course turn any moment.
  • Could Lukoil be nationalized? Of course, the risk is much higher than in Western companies.
  • The focus on renewables could be a “black swan” with a sudden new innovation or government legislation.
  • Vagit Alekperov is 70. How long does he want to continue?

However, all these issues is already discounted, reflected by the low valuations:

Valuation:

Over the last two decades Lukoil has always traded at a discount to its peers, presumably because it’s a Russian company operating in the former Soviet countries. The P/E ratio has hovered between 5-10, a very modest valuation for such a big and well managed company. As of writing it’s hard to evaluate the current P/E ratio due to the sharp drop in oil prices. The forward rates of oil indicates higher prices, and Lukoil and other oil companies are valued at future prices, just as every other stock.

If we look at another metric, price to book, the valuation has gradually increased over the years.

Lukoil price to book values (P/B). Source: annual reports and my own calculations.

Conclusion:

Based on my arguments above I expect Lukoil to outperform its peers over the next 1-2 decades (I’m always a long-term investor), mainly due to its better capital allocation skills and being owner-operated.

 

Disclosure: I am not a financial advisor. Please do your own due diligence and investment research or consult a financial professional. All articles are my opinion – they are not suggestions to buy or sell any securities.  

(This article was published on the 8th of May 2020.)

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