No. 1, 2005

Vladimir Akramovsky


Strategic partnership between LUKOIL and ConocoPhillips: Russian-American energy dialogue being a reality

JSC LUKOIL and ConocoPhillips are making ambitious plans for the realization of joint projects including the development of the Timan-Pechora oil- and gas-bearing province and oil production in Iraq. The two majors' strategic partnership is likely not only to strengthen the companies' positions on the international arena but to give a new impetus to the Russian-American energy dialogue.

Growth prerequisites

Cooperation between LUKOIL and the U.S. company ConocoPhillips had its start in the late 1990s. In 1997, LUKOIL launched the Northern Territories project in which ConocoPhillips took an active part. In March 1998, Vagit Alekperov, LUKOIL's President, and Archie Dunham, President of Conoco, signed a Memorandum on Mutual Understanding in Washington whereby the Russian party got a 60%, and the U.S. party, a 40% stake in the project. Negotiations on the setting up of a JV for project development on the basis of a product sharing agreement began. However, the project was put on ice then owing to the vagueness of its legal status.

The current change for the better in Russia's legislative approach to the product sharing principle has livened up the two parties' cooperation in the region. The LUKOIL-ConocoPhillips cooperation has been backed by Russian President Vladimir Putin and U.S. President George Bush. Within the framework of the energy dialogue, Russia reckons on American investments in the oil and gas industry and seeks an extensive access to the North American petroleum product market. The United States intends to diversify its oil export as part of its energy security policy. The newly-formed alliance between LUKOIL and ConocoPhillips will go a long way toward achieving these objectives.

The day of September 29, 2004, became, without exaggeration, a turning point in the history of cooperation between the two world oil industry giants - at a Moscow auction ConocoPhillips acquired 7.59% of state-owned shares in LUKOIL. On the same day, LUKOIL President Vagit Alekperov and ConocoPhillips CEO James J. Mulva announced the formation of a major strategic alliance. The deal, worth $1,988 billion, set a record in the history of Russian privatization.

Over the 45 days that followed, ConocoPhillips consolidated control over 10% of LUKOIL's stock. Further on, in pursuance of the Corporate Agreement signed by the parties, ConocoPhillips is to increase its stake in LUKOIL to 20% and will have no right to sell it during four subsequent years. On the other hand, LUKOIL will have the preferential right to redeem its stock if put up for sale by the American company.

The participants of the alliance obviously stand to gain by it. The American company has secured an access to one of the world's largest resource-rich regions thus adding substantially - over two billion barrels of oil equivalent - to its oil and gas reserves by early 2005 alone. Moreover, extra profits derived from the Russian company's dividends will add to its per-share equity value. In its turn, LUKOIL will consolidate its positive image in the international arena, gain access to the latest in American high technology and draw upon Western managerial experience.

Keys to Timan-Pechora

Within the framework of their strategic alliance, LUKOIL and ConocoPhillips are setting up a joint venture (JV) for the development of the Timan-Pechora oil- and gas-bearing province. The JV will develop 16 fields, their hypothetical reserves totaling 10 billion barrels. The joint Timan-Pechora oil and gas province development project embraces a territory of 16,289 km2 as against the Northern Territories project's 4,700 km2.

In January 2005 a special meeting devoted to the plans of the JV for the year 2005 was held in Naryan-Mar. Vagit Alekperov, President of JSC LUKOIL, Ravil Maganov, First Vice-President of LUKOIL, and Sergey Gnatchenko, Acting JV General Director, took part at the meeting, along with representatives of the American company.

The JV, named RusCo, has been set up on the basis of JSC Naryanmarneftegas, a subsidiary of JSC LUKOIL, and is to be managed along parity lines. In the JV's executive management body, ConocoPhillips and LUKOIL will be represented by five members each. The Russian and American companies' executives will alternate as JV General Directors every five years. The JV's budget, investment program, amendments to its Charter and decisions on increasing its authorized capital are to be adopted by consensus only. The Russian company's stake in the new joint venture is 70%, and its U.S. partner's, 30%. In 2004, LUKOIL invested about 10 billion rubles in the development of the JV-controlled fields. Because investments are made by partners in proportion to their stakes in the venture, ConocoPhillips is to compensate 30% of the amount. Joint capital and operating investments to be made in the project over the decade are to add up to an estimated $5.5 billion. The venture's original circulating capital has been set at 19 billion rubles.

Today, the oil fields belonging to the JV RusCo produce a mere 400,000 tons of oil per year. By the year 2008, the partners are to bring the figure up to 10 million tons. The peak daily production - 200,000 barrels - is to be attained by 2010-2011.

Oil produced at the RusCo's fields will be piped to LUKOIL's Varandey marine terminal on the Barents Sea shore. By that time the terminal will be reconstructed to accept tankers of up to 80,000-tons deadweight which will take crude oil to a trans-Atlantic accumulating tanker. The JV intends to restrict its oil deliveries to U.S. and West European markets only.

The new export route offers an indisputable competitive edge: delivering crude oil to America's North-East Coast from the Barents Sea shore rather than from the Persian Gulf will cut the distance down to a third.

ConocoPhillips has two large refineries in the north-east of the United States, and a lion's share of LUKOIL's gasoline filling stations is also found there. In May 2004, LUKOIL acquired 308 gasoline filling stations and signed contracts for fuel deliveries to 471 more thus expanding its North American retail network to 2,000 gasoline filling stations. According to Vagit Alekperov, "synchronizing the management of all these assets will raise their cost effectiveness substantially".

At present, the capacity of the Varandey marine terminal is about 1.5 million tons of oil a year. Toward the end of 2007, its throughput will be increased to 12 million tons, with ConocoPhillips taking a hand in carrying out and financing the expansion scheme.

The Timan-Pechora oil- and gas-bearing province is the world's second hydrocarbon-richest natural treasure trove. However, the development of the fields found in that northern region with its rigorous climate involves tremendous physical exertion, heavy expenses (about $15-20 billion) and calls for sophisticated modern oil-winning techniques and equipment capable of minimizing production costs.

The joint development of the Timan-Pechora oil- and gas-bearing province will enable LUKOIL and ConocoPhillips not only to share financial outlays but also to make the most of the work experience both partners have gained under severe climatic conditions.

The Iraqi puzzle

The LUKOIL-ConocoPhillips alliance presupposes the U.S. company's joining Iraq's Western Qurna-2 project. The West Qurna-2 field was explored by Soviet specialists way back in the 1980s. This enormous oil field, located in the immediate vicinity of Iraq's primary ocean port Basra, contains 7-8 billion barrels of actual high-quality easily recoverable oil.

In March 1997, LUKOIL concluded a 23-year contract with the government of Iraq for the development of that oil field with a proviso that it may be prolonged for another five years on product sharing agreement terms. Besides the Iraqi State Oil Company and LUKOIL, the contract was signed by Russia's joint-stock companies Zarubezhneft and Mashinoimport. By April 1999, all the planned topographic and land allotment operations had been completed, seismic and geophysical survey agreements signed and all the necessary well drilling and surface field facilities construction projects drawn up. All that cost LUKOIL tens of millions of dollars. The realization of the project was put off, however, owing to U.N.-imposed sanctions, which, in turn, angered Saddam Hussein on whose instructions Iraq's Oil Ministry unilaterally disrupted the agreement with LUKOIL in obvious violation of international law.

Last year, LUKOIL's top management took steps to bring the relations with the new Iraqi government back to normal. In March 2004, LUKOIL President Vagit Alekperov and Iraqi Oil Minister Ibrahim Bahr al-Ulum signed a Memorandum of Understanding and Cooperation whereby the Company is to finance the training of engineering personnel for the Iraqi oil industry. In 2004, one hundred employees of the Iraqi Oil Ministry did a spell of field training here, and in 2005 the number of Iraqi trainees will be increased to 150.

Today, LUKOIL and ConocoPhillips are jointly negotiating the resumption of oilfield development with the government of Iraq. If the negotiations are a success, LUKOIL's stake in the project will constitute 51%; ConocoPhillips', 17.5%; the Iraqi State Oil Company's, 25%; other Russian companies' (Zarubezhneft and Mashinoimport), 3.25% each. Both parties expect the Western Qurna-2 oil field to produce 0.5 million barrels a day (0.6 million after production has reached its peak). Its lifetime production is to amount to about 550 million tons. Over its validity period, the contract will account for $45 billion of Iraqi budget revenues.

The top managers of LUKOIL and ConocoPhillips have admitted that participation in the Western Qurna-2 project is one of the most important elements of their respective companies' Mideastern strategies.

Horizons of cooperation

LUKOIL Extraordinary Shareholders Meeting took place on January 24, 2005, to put Kevin O. Meyers, ConocoPhillips President of exploration and production operations in Russia and the Caspian Sea region, on the list of the Board of Directors of JSC LUKOIL and to introduce amendments to the LUKOIL Charter, which enhance the role of minority shareholders in decision-making process in connection with major transactions with the Company's assets.

The early months of cooperation between the partners have shown that they get along very well together. Leonid Fedun, LUKOIL's Vice-President, pointed out that the two companies "are mentally compatible". ConocoPhillips is the world's No.1 refining company, and LUKOIL takes the lead in Russia' refining industry. Moreover, the partners are among the world's major oil producers.

Leading analysts agree that the mighty alliance will hardly be content with the development of the Timan-Pechora and Western Qurna-2 oil fields. Prospects for their cooperation in the spheres of natural gas production, liquefaction and liquefied natural gas (LNG) marketing look good. LUKOIL has gained an access to high LNG technologies and 35-year experience gathered by ConocoPhillips which has LNG liquefaction facilities in Alaska from where liquefied gas goes to Japan.

ConocoPhillips plans constructing several gas receiving and regasification terminals in North America with a view to meeting a steadily rising demand for LNG in the U.S.

LUKOIL's and ConocoPhillips' active presence in Kazakhstan promises to materialize in their joint projects in that region before very long. It is not unlikely that they may launch joint ventures in North Africa and South America.

Another important element of the two oil majors' cooperation is an exchange of 15-20 experts in key production spheres scheduled for the first quarter of 2005. This program will be expanded with time. The example of Richard Karplus, ex-Vice-President of ConocoPhillips, who was offered the post of LUKOIL's Strategic Planning Department Director in 2002, proved the usefulness of enlisting the services of top-notch American managers having an experience of working with international oil companies.

According to Gennady Krasovsky, Head of LUKOIL's Investor Relations Department, strategic partnership between the two companies will make for a further rise in the LUKOIL share price in the mid-term. LUKOIL's ten-year development program provides for a 60-70% production increase and for the doubling, at least, of its average financial performance results, which, without a doubt, will push its stock up.

LUKOIL President Vagit Alekperov emphasized the advantages of the alliance. "New strategic partnership with ConocoPhillips", he said, "offers us a unique opportunity of using the experience and resources of the two companies in their stock-holders' best interests".

The early months of 2005 have witnessed new substantial headway toward the attainment of the targets set. The two leading oil and gas producers are proceeding to further important stages of their sweeping cooperation program on the implementation of which their own prosperity and the intensity of the Russian-American energy dialogue in general depend.

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Oil of Russia, No. 1, 2005
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