Photo source: RBC; image edited by Author Being a shareholder of Rosneft (OTCPK:RNFTF) has never been boring: the company practices value-destroying acquisitions, walks on a razor’s edge in politically unstable countries, and lobbies projects with high execution risks. On the other hand, Rosneft pretends to be a shareholder-friendly company by paying dividends without any cuts and buying back shares. Despite some positive points the company has to offer to the shareholders, I find the management’s track record too questionable to give a bullish recommendation on the stock. What The Management Achieved In The Recent Decades In the last decade, Rosneft has become unimaginable without its intimidating CEO – Igor Sechin. Recently, Rosneft’s Board of Directors approved Igor Sechin’s appointment as Chief Executive Officer for another five years. Without too much modesty, Sechin himself asked Vladimir Putin for reappointment. Before he was appointed as Chief Executive Officer of Rosneft, Sechin was Chairman of the Board of Directors from 2004 to 2011. The results of the multi-decade reign of Sechin and its management team are quite mixed for Rosneft: 1. Rosneft became the biggest oil company in Russia. Back in 2004, Rosneft was a small, insignificant company with a minor share of nationwide oil production. Unlike many other O&G companies, Rosneft had an extravagant way to grow – through a couple of hostile takeovers which took place after the Russian authorities put some unloyal, tax-avoiding, and too ambitious oligarchs into jail. This way, Rosneft acquired assets of the biggest Russian oil producer Yukos, namely, a division called Yuganskneftegaz. Yuganskneftegaz now accounts for around a third of all oil production of Rosneft.
In 2014, the purchase of Bashneft by AFK Sistema owned by Vladimir Yevtushenkov was challenged, a criminal case appeared about embezzlement and legalization of shares of the oil company, Yevtushenkov spent three months under house arrest, then the charges were dropped from him. Sistema’s stake in Bashneft was seized, transferred to the state, and included in the “privatization” plan. In 2016, Rosneft bought a 50.08% stake in Bashneft for 329 billion rubles. In 2017, Rosneft and Bashneft demanded that Sistema and its subsidiaries must compensate for the damage from the reorganization of Bashneft in 2013–2014 in the amount of 106.6 billion rubles. The Arbitration Court of the Republic of Bashkiria upheld the lawsuit, awarding Rosneft 136.2 billion rubles. It all ended with an agreement under which Sistema paid Rosneft 100 billion rubles. 2. Rosneft became the most indebted Russian oil major. Growth often comes at a price, and in the case of Rosneft, this price looks disproportionately huge. In 2013, Rosneft bought TNK-BP based on an estimate of $55 billion. Part of the amount was paid for by Rosneft shares – BP received 12.84%. Subsequently, BP acquired another 5.66% of Rosneft and became the second shareholder of the company, now its share is 19.75%. Now the capitalization of Rosneft is close to the amount paid for TNK-BP: 3.86 trillion rubles, or $55.8 billion. Today, with over thirty billion dollars of the net debt, Rosneft is the most indebted company in Russia. Data by YChartsData by YCharts
It should be noted that Gazprom isn’t in a hurry to publish its Q1 results, so it’s debt revaluation hasn’t been reflected yet and its debt will be lower than Rosneft’s. 3. Rosneft participated in risky ventures in Venezuela and now finally left the country. According to Sberbank CIB estimates, over the course of several years, Rosneft spent $8.5 billion in Venezuela, of which more than $6 billion was received by the Venezuelan state-owned company PDVSA as an advance payment for future oil supplies. However, it took only a month for Rosneft to leave Venezuela after facing sanctions from the US. As a result, Rosneft terminated its operations in Venezuela and sold all its assets to a company 100% owned by the Russian government. Who actually controls Rosneft? Now that’s a question not so easy to answer. Rosneft has de jure turned from a state-controlled company into a company with state participation. According to Rosneft materials, Rosneftegaz reduced its stake in the company from 50% plus one share to 40.4%. Thus, the fully state-owned Rosneftegaz is no longer a controlling shareholder of the company. At the same time, 9.6% of shares were transferred from Rosneftegaz to Rosneft’s subsidiary RN-NeftCapitalInvest. During a conference call at the end of the first quarter, First Vice President Pavel Fedorov said that Rosneft will keep the 9.6% stake obtained from the sale of the business in Venezuela, as it is a valuable asset for capitalization. In fact, the Russian government just gifted Rosneft with a stake worth over $5 bn for risky (and futile) operations of the company in Venezuela. 4. Rosneft becomes increasingly dependent on tax benefits. Every large company, sooner or later, faces a pressing issue – it becomes more and more difficult to grow or even just to sustain the current level of production. This issue is more relevant than ever before for Rosneft. In the last few years, the company got two major tax benefits for its two key oil deposits – Priobskoye (46 billion roubles/year for 10 years) and Samotlor (35 billion roubles/year for 10 years). Overall, in 10 years, the company will save 810 billion roubles ($11.7 billion) on taxes from the deposits. These tax benefits were provided because these two mature oil fields become barely profitable due to the high content of water in oil.
In the meantime, Igor Sechin is full of desire to conquer the Russian Arctic with the Vostok Oil project. The problem with conquering the Arctic is that it doesn’t have any infrastructure for developing oil deposits and transporting oil; therefore, it requires a substantial amount of capital expenditures. I think it’s okay to ask for some help from the government, but Sechin went full throttle on this matter: he asked for tax benefits in the amount of 2.6 trillion roubles ($37.6 bn). If this tax benefit is adopted (I very much doubt, though), the overall sum of tax benefits for this decade will amount to $49.3 billion dollars. It’s a clear trend that the company will continue to ask for more support from the Russian authorities in order to stay profitable. The question is where the company will meet the limit of the government’s generosity. What The Company’s Past Means For Its Future The biggest challenge Rosneft is going to face this decade is, for sure, the Vostok Oil project. It’s arguably the most ambitious project the Russian oil industry has ever had. The project will require the construction of large-scale infrastructure in the Arctic from scratch; it will be necessary to establish year-round oil transportation along the Northern Sea Route and cope with many other challenges. On paper, Vostok Oil production growth potential is immense: 25 million tons of oil in 2024, 50 million tons in 2027, 115 million tons in 2030. Nonetheless, since the company grew mostly through mergers and acquisitions, the management didn’t have an opportunity to gain experience in developing projects of such scale and complexity. The company’s debt load also means that the company has little margin of error, and the government likely won’t be able to help the company much because it already gives more benefits than to any other Russian O&G company. Weighing Pros & Cons Even though I’m concerned regarding the management’s competence, Rosneft still has something to offer to its shareholders. At the moment, I see the following bullish points for Rosneft:
The company pays relatively generous dividends with a yield of over 8%. Rosneft paid full dividends for 2019 and will try to avoid dividend cuts in 2020. Rosneft has a stock buyback program in the amount of $2 bn. This provides some support to the stock price in the medium term. Sanctions risks have subsided, at least for now. As I’ve already mentioned earlier, the government supports Rosneft a lot. The huge asset base provides flexibility in cutting production. The risks shouldn’t be underestimated, though: The debt load is quite high. The long-term secular decline in production rates of mature oil deposits will affect the company’s profitability. The Vostok Oil project has high execution risks. The company may get involved in new risky joint ventures in politically unstable countries. To sum up, I think the risk profile of Rosneft suggests an investor’s tolerance to the aggressive expansion of the company, high debt load, and dubious moves across the world that may provoke new sanctions towards the company. The Bottom Line For me, the quality of management is a crucial factor when picking a stock because a fish always rots from the head. After all the cuts, Rosneft will have to try hard this year to stay profitable, and perhaps the income from the sale of Venezuelan assets can come to the rescue. The second quarter will say a lot about the management’s ability to adapt to a rapidly changing market environment, so stay tuned for updates. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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