Rationale behind my long position in Lukoil Bonds

One of the assets I bought during the recent Ruble-rout was the Lukoil 6.656% June 2022 USD bond. I managed to grab some at 80 cents on the Dollar which equates to a yield of slightly above 10 percent! The price has since recovered somewhat, despite the fact that the oil price has continued to fall. The market seems to fear that the low oil price combined with the fact that the company is at the sanctions list have increased the risk of default substantially.

In this article I will argue that the market’s fear is overdone and that the bonds represent an excellent risk-reward opportunity.

Lukoil’s balance sheet is a fortress

Let’s have a look at Lukoil’s most recent balance sheet (Q3 2014) in order to get a quick feel for the situation.

Lukoil_BS

We can see that Lukoil had about 13bn USD in financial debt outstanding at the end of Q3 2014, the bulk of which is in USD. In a first step I compare this to the book value of USD 83bn and the market cap of about USD 34bn. Regardless of how you look at the matter, Lukoil’s leverage ratio is very low.

I think if this were a not a Russian company, we would quickly agree that this is a rock-solid balance sheet – the more than 50 percent drop in oil price notwithstanding. This can easily be seen by the fact that Exxon Mobile’s bonds of comparable duration yield about 2.5% – or 600bp less – as of this writing, despite having a higher debt load (USD 23bn) and about comparable oil reserve figures (Exxon has higher gas reserves, though). So this really seems not to be just about the oil price drop, but about the fact that Lukoil is cut off from refinancing options.

Lack of refinancing options is a problem, if you do not have enough liquidity to meet liability requirements, or if you run operating losses, otherwise it is a non-issue.

Alas, let’s have a look at Lukoil’s liquidity position.

Cash stood at USD 2.8bn, working capital was positive and a crude oil inventory stood at about USD 8.6bn. Note, that there are also about USD 1.8bn in assets classified as held for sale, the bulk of which (USD 1.2) is related to a sale of an oil field in Kazakhstan to Sinopec, the Chinese oil giant. The transaction was supposed to close until the end of 2014 subject to approval by Kazakh authorities. No news about the closing have been published so far, but, if it turns out as expected, Lukoil’s USD cash would increase to USD 4.2bn over the next few weeks.

What to make of that?

Haircutting the oil inventory by a conservative 60 percent gives us liquid assets of roughly USD 7.7bn, if you include the expected proceeds from the Sinopec deal and about 6.5 if you are sceptical that the deal will close as agreed. That means that exactly 50% of the financial debt load (also including RUB debt) is covered by highly liquid FX-assets – not that bad.

Of course, there still could be problems if all the debt would be due at once. So let’s look at the maturity profile of USD denominated bonds, i.e. its external debt. Straight from the homepage we get this overview of USD bonds outstanding.

LukoilBondMaturities

We get a total USD debt load of USD 8bn, of which we have to mentally deduct the bond that was redeemed in November 2014 (USD 900bn) from the liquid assets above. In 2015 Lukoil has just one bond repayment of about 1.5bn in June, whereas nothing (!) is due in 2016 and just USD 500mln in 2017. To this has to be added the annual interest payment of around USD 500mln.

I will spare us the detailed calculation, but it is evident that the company is liquid enough to meet FX-bond redemptions as well as interest over the next few years with the existing liquid assets at its disposal. This leaves us with only two possibilities that Lukoil will not be able to meet its external debt load:

  1. The company will experience negative operating Cash Flows going forward due to the fall in oil prices.
  2. assets will be taken away by the Russian state, similar to what happened to Sistema leaving an empty shell.

Ad. 1.)

It is yet early days to gauge the impact of the oil price crash on the profitability of oil companies, at least for me as an outsider. In the case of Russian companies the case is further complicated by the fact that the Ruble has fallen even more than the oil price. Consequently, much depends on what percentage of costs is denominated in RUB. While it is clear that personnel costs are paid in RUB, I was surprised to read that most of capex spending is denominated in RUB as well. It seems that Russian oil companies have to rely on foreign technology (hence USD costs) for unconventional oil (arctic, shale oil…) only, whereas local service industries exist for conventional oil (something which is intuitive given that they were drilling oil during Soviet times when it is unlikely that they relied on foreign technology). Most of Lukoil’s reserves are conventional reserves which suggests that its operating margins in RUB even could have risen despite the oil crash, a view that this seekingalpha piece nicely lays out (you have to be a registered user to read the article).

So much for the short-term outlook, what about the long-term? After all, I intend to hold the bond for a few years, preferably until maturity.

Value investors know very well that in a commodity business, success in the long run is determined by low costs, as this is the only sustainable competitive advantage. How does the Russian oil industry and hence Lukoil, probably its best run company, rate on this score? The graph below has the answer (I saved the graph a few months ago and do not remember the source, sorry).

Oil_2014_CostCurve

Well, I would say that Russia is pretty competitive: apart from the Gulf States, which operate in a league of its own, nobody produces at lower cost (the Opec average is dragged down by Saudi Arabia). And one has to remember that the graph was compiled before the recent RUB drop, hence it is likely that its competitive advantage has only increased.

Conclusion: Lukoil and Russian oil companies in general will make operating profits, even when most other oil producers are already highly cash flow negative (and yes, that includes the allegedly well managed Exxon mobil) – good to hear!

Ad 2.)

Obviously, investing in Russia is fraught with its own risk, notably weak property rights. This is especially true for the “strategic” oil industry. The recent expropriation of Sistema’s Bashneft serves as a memorable warning-shot. Obviously, your guess is as good as mine when it comes to predicting the Kremlin’s moves, but I do think that the Sistema expropriation has been by far Putin’s dumbest move during the standoff with the west. And I think he has realized that by arbitrarily taking away assets just because Rosneft needs more cash to pay down its debt, doesn’t help his cause as it only worsens the capital flight. I think that he has learned that lesson and that a 10 percent yield is worth the risk.

Conclusion

Investing at 10% in the debt of a liquid, little levered company that is among the lowest cost producers in its industry is an excellent risk/reward proposition, as it gives equity like returns without the usual corporate governance issues that come with investing in Russian stocks. The insiders have an incentive to pay the debt in time, as a debt default would only cut them off from export trade finance and highly desired FX revenues.

Currently I am thinking about increasing my position and hedging the bond with an oil future short, as the current Contango means I get paid to hedge.

This is not a recomendation – do your own research!

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2 comments

  1. Enjoy your blog, thanks.
    Given recent history, am I right in thinking that you don’t believe expropriation risk is zero. How do you go about weighing up that probability of expropriation? It’s an issue I’ve struggled with looking at various stocks in Russia.

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