GapromNeft — another 12 billion rubles earmarked for development

Alexander Dyukov

Interview with Chairman of Gazprom Neft’s Executive Board Alexander Dyukov

June 9, 2011 IntefaxNewsAgency.

Alexander Dyukov, headof the oil company, speaks to Interfax Petroleum News Agency before the shareholders’ meeting about the company’s acquisitions, Russia’s fuel problems and about personal plans in connection with the relocation of Gazprom Neft to St. Petersburg.

— How would you rate the company’s current operations? Are there any changes likely this year to Gazprom Neft’s production and investment plans due to the rising oil prices?

— Overall, I would rate the current results as positive and I don’t see any negative areas in the company’s operations. All production plans approved by the Board of Directors are being implemented.

Moreover, our intermediate production and financial results indicate that the planned performance targets are being exceeded. This is not only due to market conditions but also due to the management’s efforts aimed at improving performance and reducing costs.

No doubt, the current market prices have led to an increase in the net cash flow not only for us but also for other companies. Gazprom Neft’s financial performance is better than forecasted and higher than planned. Consequently, we now have additional funds that we are planning to invest.

I think that even as early as this year we will be able to allocate additional 12 billion rubles for financing new projects. We are planning to increase drilling in the existing fields, and we are also looking into the possibilities of acquiring new assets.

— Acquiring assets in Russia or abroad? And in what sectors?

— This is purchasing of upstream assets and also of chains of gas stations in the regions located close to our refineries. Naturally, for business reasons, I will not name any specific assets.

— And what about the company’s plans for potential acquisitions of European refineries? It has been reported that Gazprom Neft may be interested in the refineries in Schwedt, Germany, the Polish Lotos, in Mazeikiai, Lithuania, and in Pavlodar, Kazakhstan? By the way, are there any likely acquisitions of European retail chains?

— Such acquisitions may be possible in the Balkans. As for other European regions, it is too early to discuss acquisitions of gas stations before acquiring any new refining assets.

As I said once before, we do not regard our plans of acquiring refineries in Europe as strategic but rather as opportunistic, that is, optional. Any deal like that may be closed only if we see an interesting facility toacquire: the refining efficiency should be higher than the industry average in Europe, and the seller would agree to a price that will be acceptable to us.

As regards the mentioned facilities, the Schwedt Refinery is one of the most efficient facilities in Europe, with a high refining margin, and, hence, it could be of interest to us and may be considered as part of the asset swap with Eni.

We had an interest in the Polish Lotosas well, but we decided not to file a preliminary application for its privatization. The Mazeikiai Refinery is of no interest for Gazprom Neft. We looked into the Pavlodar Refinery but we do not consider it an option at this point.

— Could you tell us about the planned presence in Eastern Europe, which the company intends to achieve through the Serbian NIS?

— This is true. We have approved a program aimed at increasing our presence in the Balkans. This program includes plans of joining a number of exploration projects in the neighboring countries such as Bosnia and Herzegovina, Montenegro, Romania and Hungary, and of expanding the company’s retail network.

Production in this region is expected to rise from the current level of over 1 million tons to 4-5 million tons of crude by 2020. After completing the modernization of NIS facilities, their refining capacity will be increased, so our task will be to ensure the sale of the products in the Balkan region through developing the NIS distribution network.

This is our overall strategy in the Balkans, which is already being implemented in specific projects, such as the joint operations of NIS and the Canadian EWP in the exploration of four blocksin Romania and also the joint venture between NIS and Zarubezhneft in Bosnia and Herzegovina.

— Why is there no progress in the talks on joining Iran’s Anaran project? Has Gazprom Neft lost interest in it?

— Middle East is certainly an interesting area but to date we have been unable to agree on the economic conditions and to find partners for this project.

— And how is the Badra project in Iraq developing?

— We are developing this field jointly with a consortium of foreign companies. We are on schedule. Drilling at Badra will begin later this year and commercial production will start in 2013.

— Recently, Gazprom Neft and the representatives of Equatorial Guinea signed a cooperation agreement. Does the Russian company have any plans to expand its presence in Guinea?

— The ProductSharing Agreement for developing the shelf was signed between Gazprom Neft and GEPetrola year ago. In a recent meeting with Equatorial Guinea held at the Kremlin, we specified details of cooperation between the parties in implementing this Product Sharing Agreement on two sites — Block T in the basin of the Niger Delta, and Block U in the Rio Muni Basin.

In the course of our negotiations with the representatives of Equatorial Guinea, we received geological information on a number of other blocks. No doubt, some of them are quite attractive and we are currently studying them. But in any case, we will be able to state our interest only after the decision is made to join the active phases on Blocks T and U, that is, not until 2013-2014.

— What is the reason for the delay in transferring the first two oil fields from Gazprom to Gazprom Neft? Has the transferring of the remaining fields been discussed yet?

— The transfer process requires solving a tremendous number of issues. These are issues related to corporate law, infrastructure, and business. Naturally, dealing withall these matters takes time. However, we have come a long way and we expect the transfer of the first two fields to be completed by the end of this year.

Besides, I would like to point out that since the end of last year, we have been the operator of the East section of the Orenburg condensate field. The asset is being currently independently appraised, with a report due in June. The transaction details will then be submitted to the Board of Directors of Gazprom. We expect the transfer of this field to be finalized in September or October.

As for Novoport, the situation is as follows. Currently, the company, Gazprom Neft Novyi Port, is being established, so the process of re-registering the license to this company can get underway. After this, an independent appraisal can be carried out. Nevertheless, the tackling of corporate and ownership issues does not deter us from preparing the field for commercial operation. Incidentally, this year we have already began its pilot commercial operation.

Next year we will move on to formalizing the transfer of other fields.

— At the 2010 meeting of shareholders, you promised that Gazprom NeftExecutive Board members will buy company shares. Have you personally bought any company shares?

— Yes, about a year and a half back I bought close to 124 thousand shares.

— Gazprom Neft is planning to move from Moscow to St. Petersburg before the end of this year. How much will the move cost Gazprom Neft?

— Gazprom Neft will receive tax breaks from the city of St. Petersburg, which will fully offset the relocation costs.

— Are you not worried about losing some of the team due to the move?

— This is quite possible that due to the relocation some experts may leave the company. We still haven’t received final confirmations from some of our staff as to whether they will move or stay. The larger part of the senior management is also still deciding. Relocation is not a trivial issue as it involves spouses, children, parents, and friends.

— Andyoupersonally? Are you prepared to move?

— Could it be any other way?

— You spoke about plans to buy new gas stations. Due to Russia’s fuel crisis, which broke out in April, do vertically integrated oil companies now have the opportunity to expand their retail networks?

— I wouldn’t say that this situation has presented us with some additional opportunities. We made retail chain acquisitions two years ago, and a year ago at the time when the retail margin was very high and, in certain months, reached 40%. So, I wouldn’t say that we are trying to take advantage of the situation. Our negotiations with the owners of retail chains, which we may soon acquire, had begun prior to the events, which you term “the fuel crisis”.

— Was it not a crisis in Russia’s domestic fuel supplies?

— I think crisis is too strong a word to describe the current situation. I recall the crisis of the early 90s when motorists across the country were forced to stand in long lines for hours on end in order to fill their cars.

I would call what happened in the spring of 2011,certainsupply problems of a number of gas station networks in several regions.

— And what do you see as the root cause of these problems?

— The main reason is that Russia’s economy is continuing to grow and its growth is accompanied by an increased demand for motor fuels. Unfortunately, this year’s increasing demand could not be supported by the growth in supply. Moreover, due toa number of factors, high-octane gasoline shipments to the domestic market in the first half of 2011 not only did not grow but even slightly diminished.

What are those factors? First, on January 1, 2011 the ban on domestic sales of Grade 2 high-octane gasoline came into effect. As regards Gazprom Neft, we were able to convert all of our refineries to production of Grade 3 and 4 diesel fuel and gasoline. Some of our refineries even produce Grade 5.

However, not all refineries were able to switch to production of Grade 3 and higher grades of motor fuels. The refineries, which didn’t do this in time, had to export all of their output, which was below that grade.

Second, world market prices were rapidly growing at the beginning of this year. As a result, domestic prices of motor fuels in Russia have become lower than the export netbacks and exporting petroleum products has become more profitable. Low domestic prices have also contributed to the leaching of fuels from Russia’s border areas, with our neighbors buying cheap Russian fuels en masse.

On top of that, in the first and second quarters, disparities occurred in the fuel prices in different regions. In particular, the low prices in the Siberian region were not conducive to ensuring supplies there, say, from the Bashkirian group of refineries, because wholesale prices are linked to the exchange prices, which at that time were, and still remain, high, which is only natural given the shortage of supply.

— Why,during that period of supply problems,did Gazprom Neft continue to sell gasoline at prices below those at the stock exchange? It is like selling at a loss.

— It’s true that we didn’t align our prices with exchange prices. Gazprom Neft was selling fuel at much lower prices of 25-26 thousand rubles per ton. Why? Because the exchange price was subjective and caused by the shortage of supply. In such circumstances, we consider it unethical to profit from the difficulties consumers are faced with. The price at which we sold, and continue to sell, is roughly equivalent to the export netback. In general, I think it is wrong to continue trading in the conditions of panicked demand. It is a good practice shared by many exchanges to suspend trading until the situation stabilizes. An exchange cannot function effectively in the conditions of shortage of supply.

— How did Gazprom Neft deal with the problem of additional supplies? Do you think that increased export duties, which effectively made it impossible to export gasoline, are warranted?

— As for Gazprom Neft, when there was a shortage of petroleum products on the market, we made every effort possible to rectify the situation. We have increased the supply of fuels to the domestic market by an average of 20% compared to last year. All the while, our facilities operated at 100 percent loads. At the same time, our supplies to some regions, for instance to Altai, have increased several times. We have also begun shipping to areas where we previously had no presence, to Tuva, in particular.

Increasing such duties is a justified measure and I believe that the Ministry of Energy responded quickly. The Ministry also successfully coordinated the distribution of petroleum products among regions on a daily basis. And, basically, now we can see that there are no serious problems in the regions.

— What should be done to avoid similar situations in the future?

— First, the situation needs to be stabilized completely. To do this, the technical regulations banning the use of Grade 2 motor fuels in the Russian Federation should be suspended. This will help saturate the market and lower the exchange prices to 25-26 thousand rubles per ton. At this point they have already broken through the 30-31 thousand rubles mark. This measure is appropriate especially taking into account the planned transition of the customs union to common technical regulations, which Kazakhstan refineries cannot meet at this point in time.

The measures required for preventing any recurrence of such situations are obvious. First, the quality of motor fuel demand forecasts should be improved. We need to understand how demand will be changing in those industries, which are consumers of petroleum product. And this is a joint responsibility of companies and dedicated ministries.

Second, oil companies must continue to modernize their processing facilities.

Third, until the modernization of our oil processing industry is complete, it will continue to experience shortages in times of seasonal demand fluctuations. And in this respect, I think it is important ensure that reserves are created that will allow meeting the increased demand in peak seasons: in the summer — for gasoline and in the winter — for winter diesel fuel.

As far as reserves of jet fuel are concerned, it would be logical to require that fuel facilities maintaina mandatory reserve. With regard to diesel and gasoline, Rosrezerv and Transnefteproduct could deal with this task. Oil companies and motor fuel consumers could also shoulder some part of the responsibility by creating their own reserves.

— And how do you feel about the proposal by the Ministry of Energy to establish an independent refining company, which, under tolling schemes, would refine oil produced by small and medium-sized oil companies?

— Transferring an existing facility will not solve the problem of shortages. Constructing a new one may help but this would be a step in the wrong direction. Russia, in principle, has sufficient refining capacity. We are already refining twice as much as we need, with a half of the petroleum products being exported.

— What should the refining industry primarily focus on: improving the quality or the depth of processing?

— Both are important. But given the limited investment resources, it is a priority now to bring fuel quality in line with the requirements of the technical regulations. In our case, in the next 3-4 years the larger part of investment resources will go to implementing quality improvement projects. After they are completed by 2015, the oil companies will be able to launch projects aimed at increasing the depth of processing.

I once again repeat myself by saying that in Europe, the transition from Euro 2 to Euro 5 took 15 years. And the Russian companies have to do it within 7 years.

— I would like to hear your expert opinion: how would the recent legislative and fiscal initiatives in the energy sector affect the oil industry?

— We hope that the 60-66 system is one of the intermediate yet very important steps in the industry tax reform and could be introduced as early as this year. Almost everyone understands the need for it: the Ministry of Energy and the Ministry of Finance. At the same time, a certain dip in the financial results for a number of companies will be felt short-term. In the long term and strategically, everyone will benefit: the industry, the companies and the state.

The Additional Income Tax (AIT) will help make taxation of production more flexible. Everyone knows that the tax burden on production in Russia is the highest in the world. This renders development of approximately 20-30% of the reserves commercially not viable, even of those found in the existing developed fields and in the traditional production regions with developed infrastructure.

Overall, I think that initiatives such as the proposed 60-66 system and AIT together will definitely boost the efficiency of the industry and quite significantly at that, too. Reducing the tax burden on production will allow committing additional reserves to development and the alignment of export duties on light and dark oil products will, at the same time, compel oil companies to increase the depth of processing. As the saying goes, two birds with one stone.

As far as the Oil Law is concerned, it is definitely needed. However, it is not likely to be revolutionary. This is not the intention at all. This law simply allows systematizing the existing regulations governing the oil sector.