No. 3, 2010


Oil of Russia magazine talks to LUKOIL President Vagit Alekperov

Q: How has the economic crisis affected LUKOIL's operations?

A: The macroeconomic situation in the world oil industry remains complicated. The volume of world trade in 2009 shrank as compared to the previous year by 12%. Most countries went over to austerity economy, and the demand for energy fell. We saw a rise in hydrocarbon prices over the course of the year, but they failed to reach the average price levels of 2008 by the end of the year. It would have been impossible for all of these factors not to have had an impact on the oil companies' production and financial performance.

During these hard times, LUKOIL successfully demonstrated its capability for overcoming difficulties. Last year, we focused on cutbacks in capital expenditures, cutting our costs, tightening up financial discipline, and strengthening our financial situation. In doing so, we continued the full financing of key development projects. Thanks to LUKOIL, we managed to lay the foundations for further growth. Yes, the Company's net profit fell by 23%; nevertheless, the Board of Directors recommended that the Shareholders' General Meeting approve dividends for 2009 in the amount of 52 rubles per share, as opposed to 50 rubles a year earlier. We refrained from cutbacks in personnel, and we cut no employee salaries.

Under the conditions of the crisis, LUKOIL reviewed the program for its strategic development over the next decade. We shifted the focus from rapid rates of growth in production to increasing our cash flow, financial efficiency, and shareholder incomes.

Q: As is well known, the foundation for the future growth of any energy company is its reserves. Why have LUKOIL's reserves shrunk relative to those of 2008?

A: What happened was that the estimates of our reserves were drawn up this time according to the standards of the United States' Securities and Exchange Commission, the SEC, which considers only those reserves that are included in an approved plan of development. We consciously took such a decision in order to ensure a high degree of transparency for our reserves and their comparability to the data of our competitors. In light of the changes to our plans and the deadlines for bringing a number of new fields on line, the Company reclassified 1.8 billion barrels of oil equivalent from being proven to reserves of lower categories. The SEC estimates have yet to consider the portion of our reserves that we have explored in Saudi Arabia, or the reserves of the West Qurna-2 field in Iraq, since the contract for this project was signed just this year.

Nevertheless, LUKOIL continues to be a leader among Russian and international oil companies in terms of proven reserves of hydrocarbons. Current reserves-to-production ratio is 21 years. That's a very high figure.

Q: In your opinion, what important events have taken place in the upstream area abroad?

A: The most important event for us was of course our joint victory with Norway's Statoil last December in the international tender for the right to develop Iraq's West Qurna-2 oil field. We really deserved to win that one. We'd been waiting patiently for that moment since 1997. We spent a great deal of time drawing up a detailed plan of development, we kept in constant contact with Iraq's Ministry of Oil, and hundreds of Iraqi oilmen underwent on-the-job training at our facilities in Russia.

West Qurna-2 is a unique oil field; there are probably none like it left in the world. Judge for yourself: in Russia, we're now producing around 92 million tons of oil from 24,000 wells, and we plan to achieve approximately the same volume of production with just 500 wells at West Qurna-2. Of course, reaching such a volume of production will demand enormous efforts and financing from us. A total of $4.5 billion will be invested in the project in just the next four to five years.

Another promising area for LUKOIL is the Gulf of Guinea. At the beginning of this year, an international consortium consisting of LUKOIL, the U.S. company Vanco, and the Ghana National Petroleum Corporation discovered substantial reserves of hydrocarbons on the Dzata offshore structure. Drilling of the first prospecting well on the Orca structure in the waters off the Cote d'Ivoire was completed in April. The results from the drilling give grounds for hoping we will discover major reserves of hydrocarbons.

Both wells were drilled in waters almost two kilometers deep. LUKOIL thereby became the first Russian company to gain valuable experience in deep-water offshore operations.

Q: What in your opinion was the event of the year for LUKOIL in Russia?

A: The most important event for the Company in Russia was undoubtedly the start of oil production at the first Caspian field in the Russian sector of the sea, the Yury Korchagin oil field. Almost 15 years of hard work and solid capital investment were needed for LUKOIL to gain access to the oil and gas fields of the North Caspian. From 1996 through 2009, we invested 56 billion rubles in the Caspian projects. The cost was worth it: LUKOIL has uncovered 8 oil and gas fields and 16 promising geological structures. From 2004 through 2009, the Company's overall expenses toward building different facilities on the Korchaginskoye oil field totaled more than 34 billion rubles.

Today we're proud that we are the first Russian company that built and erected an offshore platform, floating oil storage, and underwater pipelines, and created specialized flotilla of vessels. We're glad that a new industry for the construction of offshore facilities has been created virtually from scratch in Astrakhan, thanks to LUKOIL orders, and that thousands of Russians have been and will be provided with well-paying jobs. I saw Russian Prime Minister Vladimir Putin express a similar feeling of pride "in the hardware and in the people" when he flew out to our platform on April 28th, pushed the button that launched our production, and symbolically washed with the first Russian oil from the Caspian.

Q: What problems have you had to face?

A: As often happens when breaking new ground, our Caspian project opened up a number of new realities. Practice showed that under the existing system of taxation, investment in offshore development produces very low returns. Specialists at LUKOIL performed a number of calculations that, by order of the RF Ministry of Energy, were subsequently confirmed by independent experts.

Our analysis of offshore projects showed that investment in drilling and developing of offshore production facilities were more than six times higher than the analogous figures for land. Operating expenses for an offshore facility are eight times higher than those for a field on land, and the gross profit for an offshore field is just over half that of a similar field on land. I repeat: LUKOIL invested over $1 billion in the Yury Korchagin oil field alone. Development of the other oil fields over the next ten years will require the building of another 28 platforms and more than 1,000 kilometers of pipeline. We will need billions more in investment over a number of years to accomplish this. It's perfectly obvious that this will be beyond the capabilities of any one company.

In a situation like this, the oil companies need government support. We believe that a new system of oil industry taxation could serve as a fundamental solution to the problem. More specifically, we need to lower the oil export duties, abolish the tax on mineral resources production, and introduce a tax on additional income for new oil fields. The internal rate of return on investment in offshore projects would then be 13.5%. The introduction of a zero rate of oil export duty until planned production level is reached at the Yury Korchagin and Vladimir Filanovsky oil fields in 2013 and 2018, respectively, could serve as a temporary measure in the Caspian.

In this context, our program for the comprehensive development of the North Caspian envisions two scenarios for the unfolding of events: under the conditions of the current tax regime and under the conditions of a reduced tax load. Under the current regime, the total production of hydrocarbons from 2010 through 2039 could be a bit higher than 90 million tons of oil equivalent; with tax breaks, the figure could be higher than 400 million. Total investment in the first version could consequently be $6.6 billion, and $26.9 billion in the second. The national income under the existing taxes would be no higher than $42 billion; with tax breaks, it could be more than $165 billion. In addition, a knock-on effect of around $850 million in the form of taxes paid by contracting organizations, outside transport, and the gas and chemical complex would contribute to the growth of the national budget.

It might seem paradoxical at first glance, but the budgetary efficiency of lowering the tax burden would over the next 30 years amount to $123 billion.

It's gratifying that Vladimir Putin heard out the oil companies' appeals. The day he visited our platform, a meeting was held in Astrakhan at which the Prime Minister said he had ordered the Ministries of Finance, Economy, and Energy to examine and assess the economics of the Caspian projects. Vladimir Putin stressed that in any case, projects of this sort will be supported by the government, since the Caspian today is a unique testing ground for Russia's oil and gas industry. It's here that the oil companies are gaining experience in the comprehensive development of offshore fields, which we're going to need when we make the first large-scale moves onto the continental shelf.

Speaking of offshore projects, I'd like to mention once again a legislational problem that is important to us. Unfortunately, today's version of the Law on Subsoil limits the access of Russia's privately-owned oil companies to federal oil fields, which include offshore parts of subsoil. We think that all of this country's oil companies, whether they are privately owned or not, are national oil companies and have the finances, technology, and experience to carry out offshore projects. The most complicated of these demand the joint efforts of different companies. Let me remind you that LUKOIL has already set up joint enterprises with Gazprom and Rosneft, which are now operating successfully in the Azov and Caspian seas.

We're also quite optimistic about the recent announcements by representatives of the RF Ministry of Natural Resources and Ecology, saying that the ministry is drafting amendments to the law that would allow other Russian oil companies besides state-owned companies to participate in the development of fields on Russia's continental shelf, so long as they have the necessary financial and technological capacity.

Q: The introduction of new technical regulations on petroleum products has led to discussion of the problems of domestic refining sector. How is this segment of LUKOIL's business developing?

A: In the area of refining, LUKOIL has carried out one of its strategic tasks: the ratio of the Group's refining capacity to its production has reached an optimal and competitive level of 75%. We managed to achieve this thanks to the acquisition of a 45% share of participation in the TRN refinery from the French company Total. The refinery is located in the Netherlands and is one of the largest and most high-tech refineries in Western Europe.

Despite the difficult economic conditions, we are continuing to modernize our Russian refineries so we can go over to producing fuels that meet the standards of the new technical regulations. We're improving and expanding the production of LUKOIL's brand-name gasolines and diesel fuels. In October 2009, we began marketing new premium-grade automobile gasolines: ECTO Plus, with an octane number of 95, and 98-octane ECTO Sport. Compared to the previous generation of ECTO gasolines, the new formulas provide increased engine power and fuel economy.

Our sales territory is expanding, too. Alongside Russia, ECTO gasolines are being marketed in Lithuania, Latvia, Estonia, Ukraine, Romania and Turkey. ECTO diesel fuel is being marketed in Lithuania, Latvia, Romania and Turkey. In 2010, we plan to begin sales of ECTO fuels in Moldova, Macedonia, and Bulgaria as well.

Under the conditions of the crisis, we're taking active measures to cut costs and raise the efficiency of refinery operations. The overall effect of implementing these measures has already run to around $88 million. At the same time, utilization of the capacity of our Russian refineries has reached 99.5%, the highest figure in the history of the Company.

Q: Under the leadership of the Russian President, the efforts of commissions on the modernization and technical development of Russia's economy and issues of energy efficiency have been stepped up. What are some of LUKOIL's achievements in this area?

A: Until recently, people were of the opinion that the primary industry was quite conservative and was holding back the development of new technologies. As an oilman, I always knew that this wasn't true. The government of Russia is of the same opinion.

After his visit to our platform in the Caspian Sea, Vladimir Putin in particular made special note of its high level of technology. The platform's drilling rig allows the Yury Korchagin field to be developed using horizontal wells of extraordinary length - more than five kilometers. This is a limit achieved by world practice for drilling at sea, it is unique for Russia. Also unique is the method for monitoring drilling operations. Real-time data from the offshore platform is transmitted via a satellite communications channel to the Moscow drilling control center, whose experts are able to control the process of drilling out at sea. This year, similar centers will be set up in Western Siberia, Perm, and the Republic of Komi. They'll control the drilling of difficult horizontal wells and sidetracks.

One of LUKOIL's subsidiaries is known as RITEK (Russian Innovative Fuel and Energy Company). It's now developing and performing original experimental work on non-conventional beds of the Bazhenov formation. These innovative efforts could completely transform our understanding of the quantity of oil reserves on the territory of Russia. On a conservative estimate, our national reserves of hydrocarbons will be increased many fold if we can develop technologies for producing oil from these fields.

A special reagent, RITIN, is now being produced by the RITEK company using nanotechnologies. Just 1,200 tons of this substance will allow us to produce additionally around 850,000 tons of oil per year. Even though LUKOIL is an energy concern and not a machine-building company, we have designed and got a patent on our invention of self-controlled motors that now allow 30 to 40% savings in electrical energy in the production of oil. Such equipment is not being produced anywhere else in the world today. We're currently in negotiations with Russian firms for the mass production of pumps based on these motors.

So far as energy conservation is concerned, we have a strategic goal of reducing energy intensity by 20% in the next ten years. At the start of this year, we adopted a middle-range program of energy conservation for 2011-2012. We plan to save more than 9 billion rubles by following it.

Q: In 2009, LUKOIL finished creating a new division - the heat and electricity sector. Was this at all difficult?

A: Right; as we had planned, the Company is becoming an energy holding company. Along the way, we've encountered some problems that are new to us: the rise in tariffs on heat and electricity, the unregulated relations with consumers, the arrears of previous years, and the antiquated equipment. At the same time, we've begun the process of actively modernizing production and grid facilities, and we've embarked on the construction of modern combined cycle plants. The first of these will be installed at the Krasnodar Thermal power plant in 2011. The main task today is to bring the energy sector operation in line with our corporate standards of efficiency.

Q: Next year will be a landmark year for LUKOIL. The Company will celebrate its 20th birthday. Time to take stock?

A: Compared to the world's leading oil companies, LUKOIL is still a very young company. Nevertheless, we've been able to create an international-level energy holding company in a very short period of time. It's not only the production and financial results that characterize the Company's stability. The social aspect is very important as well. Public opinion surveys show that it's considered prestigious to work at LUKOIL. We think we've created a positive image for the Company not only in the eyes of government officials and our investors but also among the public at large. We still have no reason to rest on our laurels, though. Every day, we have to confirm through real deeds our high status as an efficient, competitive, and socially responsible company.

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Oil of Russia, No. 3, 2010
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