No. 1, 2006

Prof. Valery Grayfer
Chairman of the Board of Directors of JSC LUKOIL, General Director of JSC RITEK


The review of the performance of JSC LUKOIL in 2005

Hydrocarbon resources, oil and gas, are of vital importance to Russia, considering its huge area and geographical and climate diversity. During the past decade, oil and gas industry has been and remains Russia's largest sector. With Russia's huge natural resources and the industry's enormous production, industrial, intellectual, and workforce potential, built in earlier decades, the oil and gas sector makes a major contribution to the national economy, providing a huge share of the country's gross domestic product and thereby helping to maintain economic and social stability in society.

Last year's weighty results

At the end of 2004, Board of Directors of JSC LUKOIL identified the Company's priorities for 2005. They included the increment in hydrocarbon resources 1.3 times the amount of expected annual production. In refining operations, the focus was on increasing the value of crude sent to Russian refineries by optimizing utilization rates and increasing the share of high-value products. In terms of corporate governance, the objectives were to implement the Heads of Agreement for a Strategic Partnership with ConocoPhillips and to pursue the restructuring program to optimize the Company's operations and to reduce significantly the number of legal entities in the LUKOIL Group, primarily non-core assets. In the field of financial performance, the Company's medium-term goal remained the same – raise the ROCE figures to the level of performance shown by LUKOIL's principal international competitors, despite the considerably increased tax burden.

As we review the Company's performance in 2005, we are pleased to note that the targets have been successfully achieved. LUKOIL remains a leader of Russia's oil industry, as evidenced by its financial strength, capitalization profile, capital market borrowing parameters, and liquidity of its securities in the market. Importantly, LUKOIL's basic investment attractiveness remains high, due to its enormous and growing oil and gas resources and effective growth of its refining and petrochemical operations and foreign assets.

During 2005, the Company's upstream operations steadily increased and its downstream sector showed adequate development, providing for an optimum mix of business operations.

In 2005, according to the preliminary results summarized at the meeting of the LUKOIL Board of Directors on January 13, 2006, LUKOIL Group produced a total of 90.1 million tons of oil, including 86.3 million tons in the Russian Federation and 3.8 million tons abroad, as compared to the total oil production in the amount of 86.3 million tons in 2004. Oil export of the LUKOIL Group in 2005 rose by 2.3% against the last year and amounted to 46.6 million tons.

It is important that LUKOIL is now in its sixth consecutive year of extensive prospecting works, which enables it to increase hydrocarbon reserves to compensate production and to have a strong reserve base for the future. In terms of proven oil and gas reserves, LUKOIL remains a leading company in the world, ranking number one among Russia's oil companies and number two among the international private petroleum companies of the world. As of January 1, 2005, LUKOIL's proven reserves of hydrocarbons, as audited by Miller and Lents, totaled 20.07 billion barrels of oil equivalent, including 15.97 billion barrels of oil and 24.60 trillion f3 of gas.

Last year, LUKOIL-owned refineries handled 47.4 million tons of oil, 37.1 million tons of it refined in Russia, with the crude conversion efficiency at 8.2%.

Gas production has been growing, too. LUKOIL's Board of Directors approved a long-term gas sector development program for 2005-2014, at a guest session held in Usinsk in the autumn of 2005. The key elements of the program are: develop an optimum gas marketing strategy, implement new gas projects in an integrated manner, and participate in the entire value chain of projects – from production to transportation to processing to marketing. The plan is increase gas production to 33% of LUKOIL's overall hydrocarbon production during the program implementation period. In 2005, LUKOIL produced over 7.6 billion m3 of gas, as compared with 6.47 billion m3 in 2004, so the Company is on the right track.

Efficient management of time and resources is key to maximizing LUKOIL's value. In 2005, the Company steadily continued to optimize its organization and corporate governance, making broad use of modern IT methods to improve planning, production, and marketing. According to leading analysts, LUKOIL, having adopted US GAAP accounting and reporting, now leads the industry as a company with an innovative approach to implementing new standards in business operations.

Consistent implementation of the corporate Budget policy and Budget regulations has significantly strengthened the link between strategic goals and current operations, investment and financial activities. The centralization of the treasury functions, along with strengthening payments discipline and implementing daily cash flow controls, has improved capital turnover rates and capital management efficiency. The internal audit system is performing well. Last year, active work continued to optimize the corporate organization and to spin off non-core and low-profit assets.

LUKOIL closely adheres to the principles of conducting its business in a socially responsible manner. Its Board of Directors sees sustainable development as a combination of simultaneous and interrelated efforts to increase the resource, production, and financial potential and to maintain social security and environmental safety. LUKOIL became one of Russia's first companies to make active social improvements by setting up an effective social welfare program for its employees. Well-targeted social welfare and charitable programs are part of the corporate strategy and constructive cooperation with legislative and executive bodies, the business community and the public. The Company's fundamental strategic documents – the LUKOIL Social Code, the Industrial, Work and Environmental Safety Policy for the 21st Century, the LUKOIL Group Employees' Health System Program, and the Corporate Pension System set high social targets, and those are steadily implemented.

Innovation is the key

In implementing its long-term strategic program, LUKOIL relies on innovations based on high technology and new management solutions, both being inevitable features of a modern petroleum company.

At present, LUKOIL Group comprises some 400 subsidiaries in about 30 countries, employing a total of more than 160,000. They are coordinated by an integrated management system using state-of-the-art software.

One essential type of innovation work has to do with introducing high-tech equipment in all operations, including upstream. LUKOIL owns one of the world's leading data visualization centers, with modern equipment and software to generate 3D models of oil and gas fields. Such models help to save on drilling and the resulting environmental impact. This is especially important in offshore field developments, as evidenced by the Kravtsovskoye field project in the Baltic.

LUKOIL gives a lot of attention to new production enhancement methods and supports the relevant research. A positive example of this is provided by the successful performance of the Russian Innovation Fuel and Energy Company (RITEK), a LUKOIL subsidiary. In the very first year of its existence (1992), the company set course at innovation and became a testing ground for innovation processes, new chemicals, and equipment providing for steady development of the core sectors of the national economy – oil and gas, engineering, and metals. Over the years, RITEK grew from a relatively small well workover service firm into a diversified petroleum company.

RITEK's strategy is focused on three major components. One is expanding the company's resource base and increasing oil production by applying innovation processes and technology, and building intellectual property. A strong resource base is essential for financial stability and dynamic growth, so the company implements prospecting works and drilling program. Industry reserves to production ratios are quite low, but RITEK's RP ratio is 2.1 to 1. At present, the company holds licenses for 25 fields with C1+C2 oil reserves currently totaling 188.1 million tons and gas reserves in excess of 2 billion m3. RITEK plans to increase oil production to 7 million tons by 2010. The company's major production regions are the Khanty-Mansi and Yamal-Nenets Autonomous Regions and the Republic of Tatarstan.

The second focus area is oil recovery enhancement through applying proprietary and licensed innovations. These comprise three categories of innovative processes and chemicals. One category is Russian and Western processes, including some developed by our company, which are widely used. The second category comprises processes and chemicals that are being field-tested; these are mostly proprietary projects, such as the RITIN polymer gel and products designed and manufactured by the company's engineering subsidiary, RITEK-ITC. Its latest product – the valve electric drive – is seen by Russian and foreign specialists as a breakthrough in oil production technology engineering. Lastly, the third category comprises future technology projects without immediate commercial applications.

Among RITEK's proprietary innovations, one high-potential project is the so-called intelligent field project – a system of production wells equipped with modern telemetric, telecom, and technical devices. The intelligent field project will enable bed engineers to monitor bed behavior on a real-time basis and optimize bed development accordingly, thereby increasing oil recovery rates to 60-70% of the oil in place.

The company now owns intellectual property worth more than 4.5 billion rubles. Our R&D projects attract the interest of oil companies in Oman, India, Venezuela, and other countries.

It is my opinion that intellectual property will drive the future of Russia's oil industry and generate high-tech solutions that will alter oil companies' attitudes to hard to recover reserves. Even today, our specialists are building a petroleum production process and technology database, to make innovation projects accessible to any company interested in using them. The database is intended to accumulate and organize information about the entire range of existing efficient solutions to developing hard to recover oil reserves. Many specialists have shown interest in the database project, so it is likely to become an industry information resource. We are convinced that the future of Russia's oil industry will be shaped by broad use of high technology, modern equipment and chemicals, and the skills of engineers and workers.

In conclusion, I wish to emphasize that LUKOIL's performance in the early months of 2006 is a promise of another successful year for the Company. It is obvious today that LUKOIL's purposeful and efficient efforts enable it to keep and consolidate its position as the leader of Russia's oil industry and will soon establish a strong position for it as a major international petroleum company.

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Oil of Russia, No. 1, 2006
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