OAO Surgutneftegaz

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OAO Surgutneftegaz

1 Ul. Kukuevitskogo
Surgut
Tyumen Region 628400
Russia
Telephone: ( + 7) 346 233 4863
Fax: ( + 7)346 233 3235
Web site: http://www.surgutneftegas.ru

Public Company
Incorporated: 1993
Employees: 84,466
Sales: $5.48 billion (2001)
Stock Exchanges: Moscow (MICEX) Russian (RTS) St. Petersburg Frankfurt OTC
Ticker Symbols: SNGS; SGTZY
NAIC: 211111 Crude Petroleum and Natural Gas Extraction; 213112 Support Activities for Oil and Gas Operations; 324110 Petroleum Refineries

OAO Surgutneftegaz is one of the top three integrated oil companies in Russia, with an estimated 2.5 billion metric tons of oil and gas reserves in its West Siberian fields. The company’s production facilities are centered around Surgut, a city of about 300,000 in Tyumen Province. There the company extracts about 13 percent of all oil produced in Russia as well as approximately ten billion cubic meters of associated gas per year. Surgutneftegaz also owns a refinement facility in the city of Kirishi, near St. Petersburg. Although the refinery is far from the company’s oil fields, its location facilitates exports to Germany, Finland, Denmark, the Ukraine, and the Baltic countries. The refinery is operated by the Kirishinefteorgsintez subsidiary and has a capacity of about 390,000 barrels per day. Retail operations comprise the third branch of Surgutneftegaz’s activities. The company owns retail units in northwest Russia in proximity to the cities of Pskov, Kaliningrad, Tver, and Novgorod.

Surgutneftegaz is recognized as one of the best-managed companies in the Russian oil industry. The firm has consistently placed a high priority on capital investment, promoting stable and cost-efficient production through explorative drilling, well maintenance, and the application of new drilling technologies. Surgutneftegaz operates with a conservative, anti-debt philosophy, placing much less emphasis than its competitors on looking abroad for partners in joint ventures or for financial support. The company remains firmly rooted in Western Siberia, shielding its operations and ownership structure from outside scrutiny. Surgutneftegaz is led by President and Director General Vladimir Bogdanov.

The Development of Western Siberian Oil in the Soviet Era

The separate entities that eventually became part of Surgutneftegaz’s integrated structure began their operations as state-owned enterprises in the Soviet Union. The oil production authority “Surgutneft” was organized in the northern Tyumen region in March 1964, marking the oil industry’s first foray into Western Siberia. At the time, the region was undeveloped, inhabited only by a few thousand members of the Khanty tribe who survived by fishing and collecting berries. The Siberian climate and the ruggedness of the landscape made it nearly impossible to construct roads, pipes, and wells according to the usual methods. In the first few years, oil was extracted only during the warm season and was sent by barge down the Ob River to the Omsk refinery.

In 1967, the Ust-Surgut-Omsk pipeline was constructed, and the oil industry began year-round operations. Conditions remained primitive: in the mid-1960s there was still no paved road in the area, and power was generated by means of diesel electric plants. Nevertheless, in 1968 the one millionth metric ton of oil was extracted from the West Siberian fields. Soon other oil production entities sprang up in the area and development began in earnest. By the late 1970s, Surgut was seen as the oil capital of West Siberia, boasting huge power installations, a construction industry, a railroad, highways, and an airport.

Meanwhile, the Kirishi refinery was making a name for itself thousands of miles away in Leningrad Province. Construction of the refinery had begun in 1961 in a city that was originally founded to hold a chemical factory. World War II foiled plans for the chemical factory and left the area devastated by the effects of battle and littered with mines. After military engineers removed the mines, the area was designated as the location of a project of nationwide significance: Soviet youths and industry experts were brought in to aid with the construction of an oil refinery. The first oil reached the refinery in 1965. In 1972, the Kirishi refinery was one of the five largest in the USSR. The oil industry as a whole was nearing peak production in the late 1970s.

Privatizing Russian Oil: 1991–96

When the USSR fell apart in 1991, the oil industry was in poor shape. Drilling volume and field development had fallen sharply under Secretary General Mikhail Gorbachev, and production was at its lowest level in more than 15 years. Technical assistance for the oil industry was needed to avert an economic collapse. The former Ministry of the Oil and Gas Industry advocated swift privatization and the introduction of competition. Privatization was no simple task, however. Thirty-two separate oil production associations were left over from the Soviet era, run by managers who were sometimes more concerned about meeting targets than investing in sustainable production. Price controls also distorted the business climate, as the crude price was held low by government regulation while equipment had to be bought at free market prices.

The oil industry moved closer to privatization in 1992. Prices were freed in increments early in the year, and various decrees laid the ground for the creation of joint stock companies. Meanwhile, the directors of Surgutneftegaz travelled to Washington, D.C., to learn about capitalist operating methods. Soon they had a chance to apply what they had learned. On March 19, 1993, a decree of the Council of Ministers of the Russian Federation provided for the establishment of a vertically-integrated, open-type joint stock oil company, OAO NK Surgutneftegaz. The newly formed holding company included the Surgutneftegaz production association, the Kirishi refinery, and several retail associations in northwest Russia. State decree and the company charter both stipulated that 40.1 percent of the company would be retained by the state for at least three years, while foreign investors could hold no more than 5 percent. The Surgutneftegaz production association, which had accounted for 10 percent of Russia’s total crude output in 1992, formed the core of the new company. Vladimir Bogdanov, who had run the Surgutneftegaz oil fields since 1983, was appointed president. Two other oil companies of similar stature, YuKOS and LUKoil, were created alongside Surgutneftegaz.

The new company managed to gain control of a large portion of its equity by mid-1994. Forty percent of the company was sold to the Neftinvest oil company, which was controlled by Surgutneftegaz. Eight percent was sold to investors at cash and check auctions, while another 7 percent was acquired by the company for subsequent sale on a securities market. Meanwhile, President Boris Yeltsin made an effort to encourage oil production in the summer of 1993 when he abolished a series of punitive taxes on oil sold at high prices. Nevertheless, Russia’s crude price remained at about one-ninth of the world price, and production in 1994 at Surgutneftegaz was at two-thirds of its 1990 level. Bogdanov saw oil exports as the key means to finance capital investment in his Siberian fields, but beyond courting Western crude buyers, he showed little interest in forming partnerships with or adopting the management style of Western companies. One of Surgutneftegaz’s only foreign partnerships was with the French oil company Elf Aquitaine. Under an agreement approved in 1994, Surgutneftegaz, along with two other Russian companies, would take a 24 percent interest in the construction of a new refinery at Leuna in eastern Germany. The Russian companies would be the sole suppliers to the refinery. However, the project was slow to move ahead because of higher-than-expected construction costs.

In 1995, Surgutneftegaz became even more closely held as a result of the Russian government’s “shares-for-loans” program. Strapped for cash, the government offered shares in major enterprises as pledges against loans from financial institutions. At a controversial auction in November, Surgutneftegaz’s own pension fund received a 40.12 percent share in the Surgutneftegaz holding company in exchange for a Ru 400 billion loan to the state and the payment of a Ru 1 trillion overdue tax bill. The stake was generally agreed to be undervalued, but because the government looked favorably on the prospect of Surgutneftegaz gaining control of itself, the pension fund was able to edge out the competition. A rival oil company, Rosneft, had wanted to bid at the auction but measures were taken to strongly discourage it from doing so, including an attempt to close the airport in the town of Surgut just before the auction was to be held. As auction winner, the Surgutneftegaz pension fund technically was merely holding the stake in trust for the government, since the 40 percent share was required by law to remain under the control of the state until 1996. In reality, the state budgeted no money to repay the loans and the auction winner had de facto control of the company.

Company Perspectives:

Without question, we have achieved much in the past few years, but those achievements were merely the result of a battle for survival in difficult conditions. Today we are anticipating a whole new stage of development: the achievement of our goals and the creation of a fully-valued, vertically-integrated oil company of world stature, with a corresponding capitalization. I believe that this vision corresponds to the interests of all Surgutneftegaz shareholders, and in that we see the foundation of our unity and mutual understanding, while the corporate values of the company—professionalism, responsibility, profitability and transparency—will help us in the achievement of our shared goals.

Oil production began to show signs of a turnaround in 1995. Surgutneftegaz was the nation’s number three producer at 33 million tons, down only 2.4 percent from the previous year. In addition, the company won a tender to prospect for fields in the Khanty-Mansi autonomous area, a West Siberian region estimated to hold about 140.9 million tons in oil reserves. Surgutneftegaz exported about one quarter of its oil in 1995, which helped fund the construction of over 600 new wells and 500 kilometers of pipeline. Further capital investment projects followed in 1996. Work began on a technologically advanced system of horizontal wells, which could boost production by increasing the yield of hard-to-reach deposits. The company also gained government approval to build a harbor facility in the Batareinaya Bay on the Gulf of Finland, as well as a 200-mile pipeline from the Kirishi refinery to the port. The project was projected to be finished in 2000 but was later put off until 2004.

Profitability and Capital Investment: 1996–2002

In mid-1996, as production and revenues were improving, Surgutneftegaz loosened its self-sufficient stance slightly. The company published financial statements for the first time, showing a pre-tax profit of Ru 5.2 billion in 1995, and rescinded the regulation limiting foreign investment to 5 percent. An agreement to issue level one American Depository Receipts (ADR) was signed with the Bank of New York in November, facilitating foreign investment in the company. Still, Bogdanov emphasized that his management style remained conservative. As reported by the Moscow Times, Bogdanov stated, “We spend only what we have. We don’t have any debts, and we don’t want to take any loans. We rely on our own resources.”

Surgutneftegaz’s growing reputation for friendliness to investors faltered in October 1996 after a questionable stock deal. Specifically, the company acquired the entire 500 share issue of its production subsidiary AO Surgutneftegaz in a closed auction, at a price 30 percent below market level. Minority shareholders were alarmed at the prospect of an arbitrary dilution of their holdings. Russia’s Federal Securities Commission intervened in support of shareholder rights, saying that Surgutneftegaz could keep the stake only if it paid market price for it. The decision cleared the way for the planned ADR issue, and Surgutneftegaz stock rose on the news.

By the end of 1996, the oil industry contraction had levelled off. Profits and production at Surgutneftegaz were about the same as in 1995, but exports had risen to one third of total output. All of the company’s exporting was done through the company Nafta Moskva. In order to reduce the cost of the export middlemen, Surgutneftegaz acquired a 15 percent stake in the crude exporter in April 1997. Surgutneftegaz paid Ru 71 billion for the stake and was to invest Ru 35 billion in the company over the coming three years. In all, 1997 was a profitable year, with net profits according to Russian standards reaching Ru 1.99 billion.

Low oil prices put a squeeze on the company in early 1998. However, Surgutneftegaz had invested over $1 billion in its oil fields in the previous two years and production was consequently more efficient than at rival companies. Instead of cutting production, Bogdanov said Surgutneftegaz would reduce investment by about 10 percent. Bogdanov’s cautious leadership paid off when the nationwide economic crisis hit in August 1998. At that time, the Rule was devalued 78 percent and the government defaulted on its debts. But since Surgutneftegaz had little foreign debt and low dollar-denominated costs, it was able to weather the crisis fairly easily. The company closed the year with a pre-tax profit of Ru 6.08 billion. Crude oil and gas output had risen 3.8 and 2.8 percent, respectively.

Gas production posed a problem for Surgutneftegaz. Associated gas was extracted along with oil, but there was no profitable market for the product. The only option was to sell it to the gas refining monopoly Sibur at low government-fixed prices. The huge gas concern Gazprom, with controlled Sibur, used its influence to keep prices from being set at a higher rate. The solution, announced in June 1999, was to build gas-fired power plants for the Tyanskoye and Konitlorskoye oil fields. The plants would make use of Surgutneftegaz’s gas production while also reducing the company’s dependence on the electric power monopoly. Capital investment in the usual areas of field development and well maintenance was also a priority in 1999. Total investment more than doubled from the previous year, and overall results for 1999 showed that steady investment paid off. Crude production was up 6.8 percent and pre-tax profit increased seven times to Ru 42.7 billion, thanks to a combination of high oil prices and low costs due to the crash of the Rule. Despite this success, industry analysts criticized the company for its regional focus. They suggested that Surgutneftegaz should seek to acquire fields outside Western Siberia if it was to remain a world-class firm. Bogdanov, however, appeared firm in his belief that cutting costs and increasing production was the best was to ensure profitability.

Key Dates:

1961:: Construction of the Kirishi refinery begins.
1964:: The oil production authority “Surgutneft” is organized in northern Tyumen province.
1968:: The one-millionth metric ton of oil is extracted from the Surgut fields.
1972:: The Kirishi refinery is one of the five largest in the U.S.S.R.
1991:: Nationwide oil production is at low levels as the U.S.S.R. disintegrates.
1993:: A government decree combines several separate Soviet-era enterprises into the Surgutneftegaz holding company.
1995:: Surgutneftegaz’s pension fund buys a large stake in the oil company from the government.
1996:: The oil industry contraction levels off; Surgutneftegaz publishes its first financial statements.
2000:: Surgutneftegaz consolidates the equity of the holding company and the production subsidiary into a single share.

Bogdanov’s cautious management had made Surgutneftegaz popular with investors in the Russian stock market. The company’s equity was complicated, however, by the fact that shares in the holding company NK Surgutneftegaz and the Surgutneftegaz production subsidiary were traded separately. In January 2000, the company announced plans to consolidate its equity into the production subsidiary, thereby unifying control and creating a single share price for the firm. The specific proposal was to issue 12 billion additional shares in the production arm, which would be swapped for shares in the parent company. The plan made minority shareholders uneasy. A group of outside investors wrote a letter to Bogdanov expressing the fear that their share would be diluted from 31 to 24 percent, thus depriving them of a blocking stake in the company. Nevertheless, a February ballot on the plan won the support of 98 percent of votes cast. The results ignored the votes of holders of preferred shares and ADRs, but those groups said they would protest only if the terms of the deal were unfair. When a swap was announced at a rate of one holding company share for 1,000 shares in the subsidiary, Surgutneftegaz seemed to be carrying through on its promise not to cheat investors. After the Federal Securities Commission approved the plan in April, the consolidation moved forward.

Soon a new conflict arose with minority shareholders, this time related to low-dividend payments. In May 2001, a group of small investors prepared a suit charging that the dividend of 18 kopecks for the year 2000 violated the company charter, which stipulates that 10 percent of net income must be paid in dividends on preferred shares. Bogdanov asserted that he needed a cash reserve for a time when oil prices might fall. Extensive investment in refinery and well renovations also swallowed a large chunk of profits. Capital investment projects, including increased drilling and the introduction of new fields, led to an 8 percent rise in total crude and condensate output for 2000, totalling 13 percent of the oil produced in Russia. Both capital investment, at Ru 33.1 billion, and pre-tax profits, at Ru 86.26, were more than double 1999’s figures.

Surgutneftegaz continued cautious expansion in 2001. Through the subsidiary Kaliningradnefteprodukt, the company planned to enhance its network of gas stations around Kaliningrad by building several new stations and upgrading existing ones to multi-fuel stations. Work was also proceeding on an extensive upgrade of the Kirishi refinery in conjunction with plans to install an export terminal at Batareinaya Bay. A plan to expand production into Eastern Siberia, however, fell through when the company was denied a tender for a field in the Sakha republic after conducting a year-long feasibility study. The incident served to solidify Surgutneftegaz’s commitment to Western Siberia.

Results for the first half of 2000 showed a drop in revenues from the previous year due to lower crude prices and rising costs. But even if the stellar results of the past few years would not soon be repeated, Surgutneftegaz was still confident in its potential for growth. The company announced plans to raise output 6.8 percent in 2002 and increase refining by 7.3 percent. Capital investment would also rise 18.7 percent, the company reported, mainly to finance work on the Kirishi refinery and the Surgutneftegaz retail network. Although minority investors were still pushing for more dynamic expansion, Bogdanov was unlikely to change the management style that had kept Surgutneftegaz close to the top of its industry for nearly a decade.

Principal Subsidiaries

Surgutmebel; Insurance Society Surgutneftegaz; Central Surgut Depositary; Novgorodnefteprodukt; Retail Association Pskovnefteprodukt; Retail Association Tvernefteprodukt; Kaliningradnefteprodukt; Sovkhoz Chervishevskii; Production Association Kirishinefteorgsintez; Oil-Consulting; Oil Company Surgutneftegaz; Surgutneftegazbank; Invest-Zashchita; Surgutneftestroi; Investsibirstroi; Surgutneftegazburenie.