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ConocoPhillips Buys $2 Billion Stake in Lukoil
By ERIN E. ARVEDLUND

September 29, 2004


MOSCOW, Sept. 28 — ConocoPhillips, the American energy conern, paid nearly $2 billion at auction today for the Russian government's stake in the oil giant Lukoil, a purchase the two companies said sets the stage for potentially huge oil drilling projects in both northern Russia and Iraq.

ConocoPhillips, the third-largest oil company in the United States, was widely expected to win the auction. Two other bidders showed up at the perfunctory 90-second auction, but it was unclear whom they represented. Nearly all industry analysts agreed that the process favored the Kremlin-approved winner.

James J. Mulva, president and chief executive of ConocoPhillips, insisted that the auction was "orderly and transparent," adding that "there was competition." ConocoPhillips had "a unique opportunity for a reserves increase in Russia and possibility of working in Iraq," he said at a news conference.

ConocoPhillips paid $1.988 billion, or $30.76 per share, for 7.59 percent of Lukoil. Russia's biggest post-Soviet privatization still represented a bargain — with the final price a discount to Lukoil's current market price. ConocoPhillips will raise its Lukoil stake first to 10 percent this year and 20 percent within two to three years, allowing it to book part of Lukoil's 20 billion barrels in reserves. The American company said it would buy the shares in the open market or through tenders.

Amid record high oil prices of over $50 a barrel, Russia has emerged as a key supplier to the world energy markets. Russia is second only to Saudi Arabia in reserves, and Lukoil is the country's No. 2 oil company, with reserves second only to ExxonMobil and daily production of about 1.6 million barrels.

"There's real demand for oil and gas in the world, and it makes sense for us to join forces," Mr. Mulva said.

ConocoPhillips and Lukoil said they want to jointly develop the West Qurna oil concession in Iraq, a concession Lukoil won in 1997 during Saddam Hussein's regime.

The project is highly speculative, hinging on whether Iraqi elections take place and on the country's fragile security. But if it goes forward, Lukoil would hold 51 percent, the Iraqi government 25 percent, and ConocoPhillips 17.5 percent. Lukoil's president, Vagit Y. Alekperov, estimated that the Iraqi oil fields could produce 500 million barrels per day in three years.

The ongoing attack on Russia's No. 1 oil producer Yukos rattled many foreign investors and reversed capital flows again out of Russia. Yukos is enfeebled by a $7.5 billion back tax bill, and its founder is in jail facing criminal charges.

But Mr. Mulva secured the Kremlin's blessing for today's deal this past summer, when he and Mr. Alekperov met with President Vladimir V. Putin of Russia at his summer residence. Mr. Putin assured Mr. Mulva that the American company could "count on his support."

"We view the situation differently than Yukos," Mr. Mulva said at the news conference today. Lukoil "is a leading oil and gas company and a good corporate citizen, paying its taxes." Moreover, he added, the support of Russia's president "has been of some help."

ConocoPhillips and Lukoil have worked together for nearly a decade, and their businesses complement each other: the American company has refineries and retail gas stations in the United States, while the Russian giant has huge reserves.

ConocoPhillips' production and reserves will increase by 10 percent, and the deal should be "slightly accretive" to earnings in 2005 and 2006, Mr Mulva estimated. ConocoPhillips gains one seat on Lukoil's board of 11 directors, and a proportional number of seats once it reaches 20 percent. ConocoPhillips will not sell any assets or alter capital spending plans to finance the share purchase.

Lukoil wins access to American consumers and cheaper financing for heavy investment needed to develop Russia's inhospitable, energy-rich regions. Lukoil had already purchased a chain of nearly 800 gas stations on the East Coast from ConocoPhillips.

"This means further integration for Russia in the world economy," said Mr. Alekperov. "But it requires huge investment."

The joint project in Timan-Pechora, in northern Russia, could start producing oil commercially as soon as 2007, but after investments of $3 billion. ConocoPhillips will pay $370 million for a 30 percent share in the venture. Lukoil will hold 70 percent, and costs and profits will be split along the same percentages.

For investors, the deal alters the calculus in valuing Russian oil companies, including a discount for new rules of the game in which the Kremlin makes key decisions. ConocoPhillips, for instance, will not acquire a blocking stake, or 25 percent plus one share, in Lukoil. Mr. Putin has largely frowned on deals where foreign investors acquire controlling stakes. But at 20 percent, ConocoPhillips can not only book reserves, but profits, from Lukoil, according to Steven Dashevsky, an Aton Capital analyst.

"We wanted the equity to be substantive and make sure it was something acceptable to Lukoil," Mr. Mulva said. "It was a tradeoff."

Investors priced in heavy dose of uncertainty amid a Kremlin-backed campaign against Yukos and its billionaire founder, Mikhail B. Khodorkovsky. Once the darling of investors, Yukos frequently warns of bankruptcy and has stopped shipping oil to some Chinese customers.

Many risks remain: Russia still lacks sufficient oil export pipelines, and the rule of law and property rights are shaky at best. Instead, proximity to the Kremlin has emerged as the best business guarantee.

"This deal gives investors the latest read on how risky it is to do business in Russia," said Fadel Gheit, oil analyst with Oppenheimer & Co. in New York. "But ConocoPhillips is not going to buy Russian assets at record high prices just to get their assets taken away."

As payment for $7.5 billion in back taxes, the Russian government hired investment bankers to appraise Yukos's biggest subsidiary Yuganksneftegas for sale.

Lukoil will not bid for any Yukos assets. "You can't bid for something that's not for sale," Mr. Alekperov snapped at the news conference, "at least not yet."

Russian energy deals reignited as Total SA last week bought 25 percent of an independent gas supplier Novatek for $1 billion, and Chinese government officials visited last month promising an additional $12 billion in Russian energy projects.

ConocoPhillips's purchase of Lukoil is the largest energy deal here since BP last year paid about $7 billion for 50 percent of the Russian company TNK.

Yukos last year was negotiating with Western oil companies such as ExxonMobil and ChevronTexaco to sell part of the company. But the talks reportedly angered Mr. Putin, who views Russia's oil reserves as a strategic national interest. In October 2003, Yukos's founder Mr. Khodorkovsky was arrested; he remains in prison and is fighting charges including tax evasion and fraud.