Despite rosy production numbers, actions by Russia courts have cast a cloud over future growth and potential investments.

The well-publicized tax problems currently being experienced by Yukos, Russia's largest oil producer, have cast a pall over what was seen to be a burgeoning industry. In a classic "catch-22" situation, the authorities froze Yukos' assets, then demanded payment of US $3.4 billion in taxes. With the assets frozen, Yukos' daily cash flow is the only way it can pay, but the June court decision gave the company only a week to come up with the money. Seemingly solving the dilemma, the court relented and ruled in August that Yukos could pay their tax debt over time from production. However, during the same week a different tax authority said it would take charge of Yuganskneftegaz, Yukos' cash cow with estimated worth of more than $40 billion, to settle the debt. At press time, the storm in the east was still brewing.

Part of the legacy of change from Soviet times was the lack of tax codes governing private enterprise. With no clear guidelines, it was problematic to calculate taxable income, much less figure how much tax to pay. Still, most Russian companies shouldered the tax burden. On average, the Russian oil industry pays $8.62/boe in taxes (Chart 1). These taxes include export duties, royalty and mineral restoration taxes, unified production taxes, excise and fuel taxes, road-use tax, property taxes, income tax and VAT. Yukos' auditors and its tax counsel believe the company has fully met its tax obligations. Nevertheless, the company has stated publicly that it will comply with the directives of the court. All it asks is the time and the ability to do so.

Picture of prosperity

Describing his company last June, Yukos' Deputy Chief Executive Officer Dr. Yuri Beilin said, "We're solid, as usual!" Not an idle boast, Beilin has the numbers to prove it. A quick look at the scoresheet confirms that Yukos richly deserves its title of eighth largest oil company in the world. As of Dec. 31, 2003, the company listed proven reserves of 14.709 billion bbl of oil and 7.936 Tcf of gas. In 2003 it produced more than 1.6 MMbo/d on average for a total of 591 million bbl of oil, which amounts to 19.2% of Russia's oil production that year. Already this year the percentage has climbed to 21.53%. Adding Yukos' gas production of 199.7 Bcf into the mix, the company accounted for 27.2% of the total increase in Russian production in 2003.

Last year was not a flash in the pan. Yukos' 10-year compound annual growth rate (CAGR) of 19% tops all Russian companies except TNK. But in terms of total oil production, Yukos has few rivals. If the future plays out the way Beilin expects, the company will stabilize at 11% CAGR and will lead all Russian companies in the 2003-2005 time period. Assuring a sustainable market position, Yukos operates five major refineries whose total output in 2003 amounted to 16% of all oil refined in Russia. The refineries are all located in Western Siberia, close to the fields, enabling the company to save by transporting refined products.

Speaking of transportation, Yukos is taking advantage of the Russian rail infrastructure, shipping up to 70% of its product via rail. Albeit more costly, the company is benefiting from current high prices. "Rail shipment gives us a faster, more nimble response to favorable market conditions," Beilin said. "While prices remain high it makes sense to ship this way, but of course we are pursuing more economic solutions in the long term."

He was referring to a joint oil company initiative to construct new pipelines to Murmansk and China.
In sales, Yukos operates more than 1,200 branded filling stations in Russia. It exports 61% of its production to Europe via the Baltic and Black Seas and the Druzhba pipeline as well as CIS countries and China. Retail outlets are clean, modern and most often incorporate a western-style convenience store.

Profitability for Yukos is among the best in the business. According to Lambert Energy Advisory, who quote figures gathered by J.S. Herold and Associates, the company's margin per unit produced is slightly more than 43%. Beilin credits the company's production efficiency, stating that Yukos lifting costs average $1.47/bbl compared to the Russian average of $2.30/bbl, and way below the international average of $4.17/bbl. Beilin lists as one of his chief goals keeping costs at the same levels despite the devaluation of the Ruble.

It is worth noting that the majority of Russian oil and gas companies report their reserves using either Society of Petroleum Engineers (SPE) or Securities Exchange Commission (SEC) standards. While the risking of physical presence is similar, these differ from the Russian standard in one important way. Both the SPE and SEC standards reckon probability of the physical presence of hydrocarbon plus the economic viability of recovery. The Russian standard ignores the economic viability issue.

Driving the dilemma

To understand the Russian oil industry one has to understand Russia. This cannot be accomplished from Moscow. Most westerners have a very narrow and somewhat limited view of the evolution of Russia's oil and gas industry. The majority of the oil and gas, almost 75% of it, is found in Western Siberia, an area so vast it boggles the mind. For gas, the number approaches 91%. So it might be a good idea to look about the country to get a better understanding of what makes it tick. Across the vast sweeps of boreal forests of alder and birch, across the miles of taiga, endless marshy bogs, and across an infinite number of lakes, rivers and ponds, one encounters large, modern cities. Their names are all but unknown in the west. Places like Nefteyugansk, Noyabr'sk, Muravlenko, Usinsk and Raduzhny have a lot in common. They are new, most less than 30 years old, they are large (certainly by Arctic and sub-Arctic standards) cities of more than 100,000 and they are one-industry towns. Prior to the Yeltsin era, companies supported the development of these towns, building infrastructure and populating them as needed with specialists and workers.

Yukos' Deputy Chairman Mikhail Trushin explained, "We view the Dow Jones Group Sustainability Index as the most important rating." It is based on five key indicators:
• Innovative character and technology effectiveness
• High corporate management standards
• High shareholder profits
• Industrial leadership
• Level of social engagement

Yukos has achieved prominence in all of these, but it is the last indicator that helps outsiders understand the company's commitment to the land. The company is spending more than $100 million this year on such programs as education, youth programs, small business revitalization, health and social services, infrastructure support and building peoples' initiative. In all, 302 projects in 22 territories are funded. Some of the most notable include the brand new regional hospital and clinic in Nefteyugansk, the Tomsk University program that graduated 41 petroleum engineers earlier this year, the mortgage loan program that helps company personnel purchase their own homes, and aggressive never-ending training programs that improve the quality, knowledge and skills of more than 65,000 of the 105,000 workforce last year. Put in perspective, the company's goal is to develop professional employees' skills and knowledge so they can earn the equivalent of $100,000/yr within 4 years. The company negotiated a new 10-year contract with its unions in 1999. For skilled workers, the goal is to provide an average income equivalent to $1,500/month (2.5 times the national average). Presently 30% to 35% of the workforce is ahead of plan.

"Pre-Yeltsin, companies built these cities and sponsored development in the autonomous regions of Siberia," Trushin said. He explained that companies paid little tax but had huge responsibilities to pay for social development. During President Yeltsin's administration, everything changed. The government assumed the role of infrastructure building and insisted that companies pay taxes to fund it. This is true to the Russian character that recognizes historical paternalism, a well-developed sense of social justice, inefficient social policy as administered by the government and a general climate of distrust of private enterprise. Naturally, there was plenty of blame to go around. Politicians blamed the companies for failing to do enough, while companies blamed the politicians for failing to stabilize the financial system and establish the rule of law. Tax sharing is reversed today, with 65% going to the Federal government and 35% going back to the regions. So in addition to paying tax, the company's regional social program expenditures are more critical than ever.

Sword of Damocles?

While not impervious to the dilemma in which it finds itself, the company continues to grow, both in production and responsibility. Goals for 2004 include greater social focus on its employees and their future, greater focus on regional development and public image improvement, largely achieved through its retail outlets. Some examples include better living quarters in the field and in the cities, improved and diversified social activities such as sports and cultural events, the aforementioned mortgage assistance programs, a veterans program that recognizes the contribution of long-time employees and establishing the company resorts where employees can economically spend their holidays. There will be training and re-training programs where the employee only pays 5% of the cost.

Can Yukos survive? The answer, as most answers from Russia these days, is, "It depends." On the positive side, the Minister of Natural Resources recently affirmed the company's rights when he said, "We have no grounds to recall Yukos' licenses." On the negative side is the spectre of $3.4 billion in disputed taxes. Given a reasonable schedule, the company said it can pay, but if hard cash is demanded, the axe may fall.

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