Russian oil: The death knell for easy downstream profits

Context

Regulatory drivers for Russian oil: All eyes on tax, but competition policy also matters

Since the global financial crash and the onset of recession in 2008, domestic regulation has comfortably beaten world oil price movements as the most important top-down earnings driver for Russian oil companies. This would have seemed a surprising conclusion when the oil price plummeted in late 2008 as well as when it staged its almost equally striking recovery in Q2/09.

Even before the start of that recovery from the trough of US$34/bbl (Brent), the negative effect of the price collapse on company earnings had been quite considerably offset by the 30 per cent ruble devaluation and the turnaround in galloping cost inflation in oil services and equipment, which had been the rule during the pre-crisis period. The subsequent erosion of those gains (ruble strengthening again, oil service deflation ending) has been offset, in turn, by the Russian government’s various measures to reduce – from a very high base – the tax burden on oil companies. Given Russian oil stocks’ year-to-date underperformance of the domestic benchmark indices, in which they retain large weightings, developments in oil sector taxation have become a major issue not only for oil company shareholders but also for the Russian equity market as a whole.

This report focuses on another live issue in domestic oil sector regulation: how to establish for the purposes of competition regulation a benchmark “market” price for oil products. The issue has been brought to a head by the country’s competition regulator, the Federal Anti-Monopoly Service (FAS), which since July 2008 has waged a relentless campaign against the major oil companies for alleged violations of competition law. So far, it has handed down fines totalling more than Rb20 billion (US$673 million) or 2.5 per cent of consensus forecasts for the Russian oil majors’ aggregate 2009 earnings (see table below).

Sources: FAS and “Vedomosti”.

Of these two main regulatory drivers for Russian oil stocks, taxation has attracted by far the most attention. This must reflect perceptions that earnings prospects and valuations now hinge, above all, on decisions about extending, maintaining or reversing the various reductions and “holidays” in the mineral extraction tax and crude oil export duties. While that is arguably true, any new hard-hitting regulations on oil-product pricing would also have a material impact on valuations, given that the domestic downstream has long been the highest-margin segment of Russian oil companies’ business.

The market’s comparative indifference to this issue also looks unjustified when viewed from the perspective of predictability. Imponderables are a dubious basis for investment strategy, and there can be few more unpredictable situations than the one now grabbing the headlines: namely, the future of the “holiday” from export duty on crude oil produced in East Siberia, which was introduced in 2009. The main beneficiary of this tax break has been Rosneft, whose Vankor field, located in the Krasnoyarsk region, is in full-scale production of around 1 mbd. The issue boils down to a tussle between Rosneft’s chairman, Igor Sechin (who is also Deputy Prime Minister with overall responsibility for the energy sector), and Finance Minister Aleksey Kudrin.

In marked contrast to the lack of transparency on that front, the FAS published its final determination on oil-product pricing on 27 February. This recommendation, based on several months of consultations with the oil companies and other government agencies, will go to the full government for a final decision before the end of Q2/10. With the parameters of that decision looking clear, investors now have plenty to go on.

The cosy, high-margin downstream business comes to an end

The FAS has long been gunning for monopolistic pricing of oil products at the refinery gate. Its scrutiny is motivated by the way that competition is hampered by the very structure of the Russian oil industry, which dates back to the formation and privatization of the main vertically integrated companies in the 1990s. As a result, each of the majors has its refining and product marketing subsidiaries concentrated in particular regions. With little or no local competition, oil product consumers intent on shopping around must seek price offers from distant refineries, which are discounted sufficiently to offset transport costs. An example cited by the FAS in its analysis of the market published in February 2010 is Gazprom Neft’s Omsk refinery, which is the largest in the country; lacking sufficient captive regional demand for its output, it competes with refineries thousands of kilometres away (see map below).

The political scope for the FAS to follow its natural inclination to go after the oil companies was constrained by the federal government’s bad habit, formed during the years of rising oil prices after 2004, of pressuring the oil companies into “voluntary” restraint on petrol prices. The oil companies prudently played along with this approach, recouping margin in periods of steadier crude prices when the government’s back was turned and all the while retaining margin on the sales of products other than petrol. These economics are reflected in the industry trend of rising refinery throughput (in other words, increasing downstream capex) and higher shares of refined products in total output (see Charts 1 and 2 below). The investment case for Rosneft pre-Vankor hinged on the integration and upgrading of its backward refineries with the huge upstream capacity acquired from Yukos.

The empowerment of the FAS dates back to the federal government reorganization of 2004 and the strengthening of competition law – the “first anti-monopoly package”, which has been in force since 2006. Under that legislation, the FAS can impose fines of 1-15 per cent of turnover on companies participating in cartels or otherwise held to have abused their dominant market position (legally defined as a 35 percent market share, or less for certain products, at the regional as well as the national level). Over and above the usual desired effects of competition policy (such as more efficient resource allocation and productivity gains), the political priority throughout this period has been to help bring down stubbornly high inflation. Under the leadership of Igor Artemyev (who had previously been elected to the State Duma on the liberal Yabloko party ticket), the FAS has set vigorously about this task – with an early highlight being its battle against Eurocement (see our July 2007 research note Construction materials: A core story).

The informal restraint on similar action against the oil companies was removed in 2008 when, amid intensifying inflation pressure, Vladimir Putin took to publicly lambasting price surges in various key industrial inputs. In the case of aviation fuel, FAS officials found that they, too, were on the receiving end of the prime minister’s invective (“It’s time for them to wake up if they want to keep their jobs”). The FAS swung into immediate action against the oil companies and quickly extended the campaign from aviation fuel to petrol and other products.

Political pressure for downstream capex while squeezing downstream cash flow

In their public and private lobbying, the oil companies have tried various defences. They point out, reasonably enough, that the government was happy to see them restrain product prices in the face of sharply rising world crude prices and started to complain only when falls in domestic product prices lagged the global price crash in Q4/08. More seriously, the companies face the challenge of coping with the transition to more environmentally friendly motor fuels that are in line with European emission standards. Under Russia’s 2008 technical regulation on fuel standards, the production of 92- and 95-octane petrol based on the Euro-2 and Euro-3 standards was to be phased out by the end of 2008 and 2009, respectively, while the manufacture of Euro-4 (95-octane) petrol is to be prohibited from the end of 2012 onwards, by which time all Russian refineries are supposed to be producing petrol compliant exclusively with the Euro-5 standard. These changes require continuing costly refinery upgrades to increase refining depths.

At the same time, increasing the scale and depth of domestic refining is part of the government’s wider agenda of moving up the value chain. As an additional economic incentive, the government plans to equalize export duties on heavy and light oil products – the unified tariff is to be 55 per cent of the export duty on crude (compared with the current tariffs of 35-40 percent and 70-75 per cent, respectively). A bid by the Ministry of Economic Development to introduce this measure at the beginning of 2010 was quashed to prevent the likely resulting increase in light product exports, which would cause a spike in domestic petrol prices at a time when the economic crisis is far from over. So this change now appears unlikely to materialize before 2012.

Faced with these conflicting pressures, the industry view – evident from the materials published by the Energy Committee of the Russian Union of Industrialists and Entrepreneurs (i.e., the big business lobby) – is that the downstream capex required and desired by the government will produce adequate returns only if high margins on domestic oil product sales are maintained.

The same mindset is evident in some ill-advised representations from oil company managers that high domestic downstream margins are justified by inelastic domestic demand underpinned by surges in car ownership. The continuing reality of those high margins is clear from a study commissioned from a domestic industry consultant by the Ministry of Economic Development on the difference between the actual price of the best-selling petrol grade on the domestic market and the export netback price (that is, the prevailing price quotes in liquid European exchanges minus transport costs and the export duties levied by the Russian government – see Chart 3 below).

Here is the whole point of the FAS campaign: the impact on consumers of oil companies’ natural pricing power should not be aggravated by monopolized markets, and there should be no tacit understandings which enhance returns to oil company shareholders at the expense of consumers and the wider economy.

This fighting spirit was very much in evidence in a major newspaper interview with Artemyev published on 3 March 2010. While admitting that the courts had so far upheld only Rb128 million out of fines totalling billions of rubles that have been imposed on the oil companies (he repeatedly cites a Rb25 billion number, despite the reported total on the FAS website being around Rb20 billion), Artemyev emphasized that the FAS arguments on pricing had not been struck down; rather, questions had merely been raised about the demarcation of regional markets. Thus the FAS could return to the charge and would have ample time to do so under the three-year statute of limitations for competition law violations. Artemyev predicted that the Russian public would recall the FAS campaign against the oil companies a hundred years hence – just as the breakup of Standard Oil is remembered in the US to this day.

A formula for determining the ‘market price’ of oil products

This sounds overblown – or at least might be better applied to Artemyev’s (for now) quixotic desire to break up Gazprom – but the basis for his big talk is clear nonetheless. Taking advantage of recent changes in competition law, the FAS is confident that it has now come up with an ironclad approach to identifying the monopolistic pricing of oil products.

Russian competition law stipulates two criteria for determining whether the price of a product is monopolistically high or low. The first is estimated production costs – based on analysis conducted solely by FAS officials. Serious critics of the FAS have pointed out that for all its liberal rhetoric, the logical outcome of its campaigns conducted on this basis is a return to Soviet-style price controls.

The second criterion is the price of the same product on a “comparable market”. Until recently Russian competition law provided that only markets inside the country were eligible comparables. With the entry into force of the “second anti-monopoly package” in the summer of 2009, the concept of the “comparable market” has been broadened to include markets abroad.

The FAS has now applied this provision to its work on domestic oil product markets. It establishes an indicative “market” wholesale price for each Russian oil refinery by taking the Platts quote from the international oil market closest to that refinery – that is, Northwest Europe (Rotterdam), the Mediterranean or Singapore – and deducting the costs of export duties and transport. The results of this exercise are given a reality check by applying variations of this method, and the bottom line is that actual domestic prices are inflated by 15-20 per cent. The lower end of that range reflects a “generous” approach in which the highest netback price – enjoyed by Surgutneftegaz’s Kirishe refinery, near St Petersburg – is applied to all other refineries.

On the basis of its work, which was made public on 27 February 2010, the FAS is recommending that indicative “market” prices arrived at in this way should become the official basis for competition regulation. Perhaps the most interesting feature of the FAS press release is that this recommendation is presented as no more than an interim solution – that is, “until such time as objective market price indicators become available inside Russia, in particular in the form of trading quotes on liquid exchanges”.

The development of domestic commodity exchanges

Here the FAS is latching onto the development of domestic commodity exchanges, which is the subject of a government initiative that stemmed neither originally nor even largely from competition policy considerations. The main motivation is the desire that Russia, as a major world oil producer, should have its own exchanges trading significant volumes of crude oil and oil products – with the long-term goal of establishing a new (ruble-denominated) global benchmark. In addition, the creation of a viable domestic futures market is correctly seen as a prerequisite for the development of onshore financial hedging opportunities for producers and consumers of major commodities (such as hydrocarbons, metals and grains).

These objectives were evident in the political initiative for commodity exchanges announced in Putin’s annual “state of the nation” address in 2006. As with so much new policy in Russia, implementation was slow; and Putin was about to leave the presidency by the time the St Petersburg International Mercantile Exchange (SPIMEX) was established in April 2008. Several state-controlled companies were corralled into becoming founders of this closed joint-stock company: the oil companies Rosneft, Gazprom Neft, Zarubezhneft, Surgutneftegaz; the oil and oil products pipeline monopolies Transneft and Transnefteprodukt; the financial institutions Sberbank, VTB and Gazprombank; and the transport monopolies Sovcomflot and Russian Railways. In a recent discussion with Trusted Sources, a senior manager of SPIMEX described this development as an instance of the “market economy being forced into existence”.

Apart from being registered in St Petersburg, SPIMEX has no links with that city: its operations and management are all based in Moscow. The same goes for its only serious rival in oil products trading, the Interregional Oil and Gas Exchange (MBNK), which, like SPIMEX, started trading in 2008. So far, the MBNK has recorded a higher trading volume in oil products than SPIMEX (around 875,000 tonnes and 300,000 tonnes, respectively, in 2009).

However, those tallies reflect qualitative differences between the two platforms which point to SPIMEX eventually becoming the dominant player. Electronic trading at the MBNK amounts to little more than a price discovery mechanism that traders can access free of charge. A seat at SPIMEX, by contrast, costs money, and the exchange supervises financial and physical settlement of all trades (providing force majeure protection on all open positions). This requires pre-payment from brokers, which is a tough hurdle for many of them. Clear rules for market makers (absent from the MBNK) are designed to ensure that futures prices are constantly quoted.

In addition to these structural factors, the status of SPIMEX as the leading national commodity exchange was reinforced by Rosneft’s announcement in February 2010 that it planned to suspend separate sales tenders of uncontracted oil products and instead put all these volumes – now including petrochemical products and lubricants – through the recently introduced daily trading sessions on SPIMEX (this despite Rosneft having had a close association to date with the MBNK). The Rosneft press release speaks of exchange-traded volumes increasing “tenfold”. That may be true coming off a near-zero base; but the reality is that these volumes remain negligible at around 1-2 per cent of total domestic sales of oil products (which, moreover, includes Russia’s 40 or so other commodity exchanges).

According to various official proposals doing the rounds since late 2009, this share would have to rise to 10-15 per cent before exchange prices could be taken as the “market” price. Reaching this target will not be helped by unnecessary regulations in the “second anti-monopoly package”. Under this legislation, companies are required to give advance notice of selling more than a specified volume of a product on a commodity exchange and (rather absurdly) empowering FAS to approve procedures for determining the starting prices of exchange auctions.

But the main challenge is to attract more buyers. Government action could make all the difference by obliging public sector consumers – starting with the ministries of defence and agriculture, which together account directly or indirectly for around a quarter of all domestic fuel consumption – to purchase minimum quantities on the exchanges. The fact that this has not yet happened, despite the strong political interest in developing a national commodity exchange, reflects bureaucratic resistance to replacing existing corrupt procurement practices with transparent exchange auctions. The FAS accordingly recommends amending the federal law on state procurement.

Our trusted source at SPIMEX pointed to one other regulatory change which would be necessary before prices agreed at auctions on the exchange could have “market” status. Since a government regulation could not grant such status to prices set on SPIMEX, as opposed to any of the country’s other licensed commodity exchanges, there would have to be inter-agency agreement on the criteria which exchange auctions (conducted in theory on any licensed exchange but in practice on SPIMEX) would have to meet for the resulting prices to be recognized as true “market” prices.

Conclusion

Imminent FAS victory

In our view, the FAS agenda on competition regulation of domestic oil product markets will prevail. In other words, the Russian oil majors – all of which have a “dominant market” position in one or more of the country’s regions – will be unable in practice to raise their refinery gate prices above a “market” price defined initially with reference to international exchanges and, over time, to average prices quoted on SPIMEX. The reason for this is that once the “market price” formula has been approved by the full government, the FAS will have the strongest possible grounds for imposing fines and getting them upheld in the courts. From a company perspective, the risk of any attempt to maintain their existing downstream margins would be all the greater since the “second anti-monopoly” package establishes criminal liability for repeated violations of competition law.

This prediction will play out by mid-2010, when we expect final decisions to emerge from the government. Meanwhile, the oil companies will continue rearguard lobbying. Their fallback position – already being advanced by friendly Energy Ministry officials – is that companies should be allowed a 20 per cent corridor around the “market benchmark” price (in effect, legalizing the existing profitability premium in the domestic oil products market). The FAS wants to limit that above-market margin to 1.5 per cent. The final decision looks set to come out in line with the Ministry of Economic Development’s recommendation in favour of a 5 per cent margin on the grounds that this is the extent of actual price fluctuation that can be observed on international markets.

Winners and losers

Two overall conclusions follow from any such outcome to this important episode in oil industry regulation.

This is a positive development for Russia’s macroeconomy ...

The adoption for the purposes of competition regulation of a fair market benchmark for wholesale oil product prices will boost the cause of healthy disinflation – “healthy” in the sense of providing a market-based antidote (without resorting to price controls) to the structural lack of natural competitive pressures in what for any modern economy is a key product market.

The gains for price stability and economic efficiency will be enhanced by the synergy between this competition agenda and the broader political impetus behind the development of domestic commodity exchanges. This points to the necessary policy steps being taken to ensure a critical mass of oil product contracts being struck in SPIMEX. The result will be to fill an important gap by creating access to hedging opportunities for domestically oriented commodity consuming companies. Anecdotal evidence (from SPIMEX) suggests that over the last couple of years, major real-sector companies such as Russian Railways have been waking up to the need for such financial planning tools. At the same time, the existence of exchange trading in adequate volumes will drive down costs by giving commodity users direct purchasing opportunities avoiding intermediaries. In its February 2010 press release on boosting exchange trading, Rosneft mentioned the introduction for this purpose of small lots of 60 tonnes.

... but largely bad news for the oil companies

The negative impact extends to the Russian equity market as a whole since much of the market’s outperformance potential hinges on some reduction in the oil stocks’ valuation discounts. If the loss of easy profitability in the domestic downstream dampens the prospect of improved share price performance, the emergence of a transparent basis for competition regulation in this segment at least removes one risk of further de-rating, while paving the way for wider variance in financial performance between companies.

On the general de-risking point, the threat in question would be that of further large and unpredictable fines hanging over the oil companies. The market appears to have been assuming that the courts will strike down these fines, which on paper would make a noticeable dent in earnings. But that is not a safe assumption. The FAS has taken its case against TNK-BP right up to the Supreme Arbitrazh Court, where a ruling is imminent. And even if the FAS were to lose on a technicality, it can make the necessary corrections and return to the charge. In this light, it is no wonder that TNK-BP started positioning itself in public last year as a champion of exchange trading.

However, this defensive move has potential upside. TNK-BP and Rosneft, which have taken the lead in exchange trading, will be able to increase their share of the highest-margin business, even within the tighter framework of competition regulation, by directly accessing customers beyond their natural refining catchment areas and using swap deals to reduce logistics costs. Other relative winners should include companies with less integrated refining and petrochemical output (that is, producing more products than can be absorbed in their “home” regions). Such companies – Gazprom Neft and Bashneft are prime examples – stand to benefit from new domestic product marketing opportunities of the kind which will flow from higher-volume exchange trading.

Relevant Companies

Russia’s oil majors