PJSC LUKOIL
Q2 2021 Earnings Call Transcript

Published: 27 Aug 2021

[Alexander Palivoda:]

Alexander Palivoda speaking. Thank you very much. Good afternoon, ladies and gentlemen. Thank you for joining us today for this conference call on LUKOIL’s Results for the Second Quarter and the First Half of 2021. On today’s call, we have Mr. Alexander Matytsyn, CFO; Mr. Pavel Zhdanov, Vice President for Finance; as well as our colleagues from the Accounting Team. Before we move on to the presentation, I would like to draw your attention, as always to the fact that some of the comments during this call constitute forward-looking statements involving risks, uncertainties and other factors that may cause our actual results to be materially different from what is expressed or implied by these forward-looking statements. You may find more detailed information on the slide in the presentation. Now, I would like to hand over to Mr. Alexander Matytsyn.

[Alexander Matytsyn:]

Thank you, Alexander. Good afternoon, ladies and gentlemen. In the second quarter, we delivered very strong financial results on the back of efficient recovery of production volumes and further improvements in the market environment. Oil prices continued to climb, thanks to reviving demand and concerted efforts by OPEC+ countries. In the second quarter, we ramped up hydrocarbon production by more than 4% year-on-year. Average daily oil production in Russia was up 3% quarter-on-quarter following amendments to the OPEC+ agreement. Considering the July amendments thereto, we plan to keep ramping up production volumes as quickly as possible. Refining margins continued to improve in the second quarter, though still staying below pre-COVID-19 levels. Quickly responding to the changing market environment, we increased capacity utilization at our refineries by 8% quarter-on-quarter. I would like to note that our Russian refineries greatly improved their margins on the back of better yields while the country’s benchmark refining margin was declining. Although, production volumes and the market environment are still below the pre-crisis levels, our financial results for the second quarter are on par with 2019, with EBITDA hitting an all-time high at RUB340 billion. Free cash flow declined quarter-on-quarter, driven by a significant increase in the working capital due to rising oil prices and implementation of international trading strategies. It should be noted that our free cash flow before changes in the working capital amounted to a record high of RUB212 billion, or nearly US$3 billion, while the first half of the year saw it reach RUB400 billion, which is twice above that in the entire 2020, implying 9% of LUKOIL’s free cash flow yield. Thanks to its highly efficient business model, LUKOIL continues to maintain a strong leadership among Russian oil and gas companies in terms of per unit financial metrics in any market environment. Specifically, we maintained our leadership in free cash flow per unit, despite a significant increase in the working capital. LUKOIL further improved its already very strong financial position in the second quarter. As at the end of June, our financial debt was slightly above RUB440 billion, while the net debt-to-EBITDA ratio declined to zero. In July, we paid final dividends for 2020 in the amount of RUB148 billion, or RUB213 per share. In October, the Board of Directors will recommend interim dividend distribution for 2021 based on the semi-annual financial statements. LUKOIL has recently released its Sustainability Report for 2020 prepared in line with the international and industry non-financial reporting standards. In preparing this Report, we strived for fuller and better disclosure on issues of greatest relevance for our stakeholders. We recognize that sustainable development is of major importance for ensuring the Company’s investment appeal and effective implementation of its strategy and keep improving our sustainable development management system, while also enhancing disclosure transparency. I would like to highlight that our efforts invested over the past year helped LUKOIL make its way through key sustainability ratings. As a result, LUKOIL is now among the industry leaders in many ratings. In wrapping up, we are optimistic about the prospects for a further recovery in global oil demand and the market environment in Downstream, and we plan to fully unlock the existing potential to ramp up production volumes and further develop our business. In doing so, we will continue to rigorously control costs and pay even more attention to managing climate risks and opportunities. Thank you. Now I would like to hand over to Mr. Pavel Zhdanov.

[Pavel Zhdanov:]

Pavel Zhdanov speaking. Thank you, Alexander. I will present our results in the Upstream segment. Let me begin with the price environment. In the second quarter, the average Urals oil price went up by 12% quarter-on-quarter. However, the Urals net ruble price remained virtually flat due to the progressive tax scale in Russia and a positive effect of the tax lag. It averaged at RUB1,840 per barrel in the second quarter, thus maintaining the all-time high. We also see the relatively favorable market environment to continue into the third quarter. In the second quarter 2021, the Group’s hydrocarbon production, excluding the West Qurna-2 project totaled 2.1 million barrels of oil equivalent per day, up 4.2% year-on-year. We continued recovering our oil output in Russia in accordance with the instructions of the Russia’s Ministry of Energy. The recovery is going as quickly as possible by restarting shut-in wells at mature fields. We also continued developing our priority projects. Their share rose by 2 percentage points in the first half of the current year to reach 27% in the total output. The quarter-on-quarter production decline in Q2 2021 is attributable to maintenance works at the gas projects in Uzbekistan. At present, our spare oil production capacity in Russia stands at 90,000 barrels per day. By now, we have recovered the output by two-thirds as compared to May 2020. Given an improved market environment and optimistic expectations about the demand recovery, we increased drilling volumes in the second quarter. This will help us keep to a minimum the use of spare capacity to offset the naturally declining production and secure the output growth to above the pre-crisis level. As for our financial performance in the second quarter, EBITDA in the Russian Upstream segment rose by 3% quarter-on-quarter to RUB193 billion on the back of growing prices and oil production, but the reduction of the positive tax lag had a negative effect on the indicator. The weaker upstream EBITDA outside Russia is due to a decline in gas production in Uzbekistan and lower EBITDA from West Qurna-2, which is associated with a decrease in capital expenditures. In the first half of the year, EBITDA more than doubled year-on-year to RUB445 billion. The growth was driven mostly by the Russian Upstream segment, thanks to oil prices, ruble devaluation and a positive tax lag. It was, however, constrained by the tax incentives being canceled for high-viscosity oil projects and oil production being cut in Russia in line with the OPEC+ deal. EBITDA in the International segment also grew on the back of higher oil prices, recovery of gas production in Uzbekistan and the ruble devaluation. Now let us move on to our high-priority projects. In the first half of 2021, we maintained production at our Vladimir Filanovsky and Yuri Korchagin fields at the project level, having commissioned three production wells. Their combined oil and gas condensate production reached 3.7 million tonnes, up 2% year-on-year. As part of the Valery Grayfer field development, shipyards continued building platforms. As at the end of the first half of the year, the fixed ice-resistant platform was 80% complete, and the living platform was 87% complete. We plan to deliver a topside of the living platform and install it on the offshore jackets by the end of the current year. Production at the Valery Grayfer field is scheduled to start in 2022. In April, we made our final investment decision on the D33 field, which we discovered in the Baltic Sea in 2015. We have been operating in this region since 1995 and have gained solid experience in oil production and transportation. With a developed infrastructure in place, we are well-positioned to roll out new offshore projects and achieve significant synergies. The D33 field is planned to be put into operation already in 2024 as earlier said and produce 1.8 million tonnes per year. For this purpose, we are going to begin drilling operations in late 2022 using a jack-up floating drilling rig. We will use a mini-platform to produce oil. The bidding for the platform has been completed, with suppliers and contractors selected, and the construction is already underway. The platform will be unmanned

[Alexander Palivoda:]

Alexander Palivoda speaking. Thank you, Pavel. In the second quarter, the refining market environment continued on the recovery path. In Europe, the benchmark margin grew more than 1.5 times quarter-on-quarter, driven by an increase in the crack spreads of light products, primarily gasoline, as a result of declining global inventories and seasonal growth in demand. Growing margins also reflected a wider Brent to Urals spread at around US$2 per barrel, which can be attributed to increased oil production in OPEC+ countries and weaker demand for heavy crude oil amid better economics of light products. Despite this growth, benchmark margins in Europe are still far below pre-pandemic levels, as crack spreads for mid-distillates remain at multi-year lows primarily due to weak demand for jet fuel. The Russian benchmark refining margin went down quarter-on-quarter due to a widened crack spread for fuel oil, which was partially offset by higher export duty differentials. As for our own refining margin in Russia, we saw it almost double quarter-on-quarter on the back of our high-quality product slate and increased light products yield. Starting 1 May 2021, an amended formula for the motor fuels damper went into effect, which was another positive factor for the economics of our Russian refineries. In the third quarter, we are witnessing a significant increase in the benchmark refining margins in Europe and Russia both driven by further improvements in light products crack spreads, increase in export duty differentials and higher export netbacks. In the second quarter, we continued to ramp up capacity utilization at our refineries, flexibly responding to improvements in the market environment. Refining volumes were up by 8% quarter-on-quarter, while utilization reached 90% of the pre-crisis level. Domestic refineries increased their throughput by 3% quarter-on-quarter, driven by higher volumes of Nizhny Novgorod and Volgograd plants. However, the growth was constrained by repairs at the Perm refinery. At European refineries, utilization grew more significantly by 20% quarter-on-quarter, mainly on the back of higher throughput at the ISAB plant in Italy. At the end of the first quarter, it underwent process optimization, enabling it to effectively process light sweet crude oil blends and maximize the yield of gasoline and low sulfur bunker fuel, thus translating into higher margins in the current market conditions. The growth overseas was constrained by lower utilization at the Zeeland refinery due to its scheduled maintenance. The increase in utilization was coupled with improvements in product slate. Compared to the first quarter of 2021, light product yield increased, while the yield of fuel oil remained flat, despite higher throughput volumes. The second quarter saw exceptionally strong retail sales of motor fuels, with the difference from the pre-pandemic 2019 levels standing at just 3%. Sales volumes recovered completely by the end of the quarter, even exceeding the pre-pandemic levels in July. Jet fuel sales were very strong, too. For sales in a form of aircraft fueling, the difference from the pre-pandemic levels tightened to 30% in the second quarter and to 20% in July, but widened again in August due to new mobility restrictions. The second quarter saw a considerable increase in Russian downstream margin, which is the difference between the netback for oil to be refined and sold in Russia through all sales channels, and export sales. Despite rising refinery utilization, oil exports also increased quarter-on-quarter due to higher production. A decrease in the exports of oil subject to a lower-rate export duty was attributable to a reduced output due to a seasonal decline in production across Group 1 TAI fields in the Republic of Komi. As for our financial performance in the downstream segment, total EBITDA rose by 6% quarter-on-quarter to RUB127 billion, mainly driven by Russian refineries, where EBITDA added 28% on the back of higher refining margins and throughput volumes, as well as strong performance in petrochemicals, lubricants and aircraft refueling segments. The growth was constrained by a weaker positive inventory effect at our refineries and lower retail margins. Downstream EBITDA outside of Russia declined due to the accounting specifics of hedging operations in international trading and a weaker positive inventory effect at our overseas refineries. In the first half of the year, downstream EBITDA more than doubled year-on-year to RUB247 billion, downstream EBITDA in Russia rose by 60% as a result of higher refining margins, a positive inventory effect at domestic refineries, and strong results of the petrochemical segment. Downstream EBITDA outside of Russia almost quadrupled year-on-year on the back of a positive inventory effect at refineries, better results in international trading, accounting specifics of hedging operations, as well as better results in the retail segment. The positive factors were partially offset by lower throughput and refining margins. This year, we are completing several refinery upgrade projects in Russia. Let me remind you that following the launch of the de-asphalting unit at the Volgograd refinery in January 2021, we increased the output of lubricants with improved features. In June, the Nizhny Novgorod refinery completed the construction of an isomerization unit with an annual capacity of 800,000 tons, which is intended to process light gasoline fraction into a high-octane blending component of commercial gasoline. This will help bring to the market an additional of some 400,000 tons of high-octane motor gasoline annually. In July, the same refinery launched a polymer-bitumen binder production unit, which is set to expand our product slate with innovative and modified bituminous materials. By the end of the year, the Nizhny Novgorod refinery plans to launch a delayed coker that’s the largest project we are currently running. As of today, the construction and installation operations are more than 95% complete, with pipeline testing commenced. I would also like to note that in March 2021, we signed an agreement with the Russia’s Ministry of Energy in relation to this project. The agreement provides for an investment increment to the reverse excise tax on petroleum feedstock and greatly improves the project economics. We have recently made a similar agreement for the construction of a catalytic cracking unit at the Perm refinery. This is a new project that we expect to complete in 2026. We have already defined the key project details and we are now preparing to start construction. The facility’s annual feedstock capacity will be 1.8 million tons. It will process vacuum gas oil into high-octane motor gasoline and propylene. The facility will have a distinctive features such as high adjustable yield of ropylene, which will be used as feedstock by our petrochemical plants. Now, let me briefly outline our financial performance in the second quarter. Starting with revenue. Higher hydrocarbon prices were the key factor driving revenue up by 17% quarter-on-quarter. Other factors contributing to the revenue growth included higher oil production and petroleum product output, as well as increased oil trading volumes. On top of that, the revenue growth was backed by higher volumes of oil exports and retail sales of petroleum products. Negative factors included lower trading volumes of petroleum products, a decrease in gas production from international projects, and a seasonal decline in power and heat sales. Now EBITDA. EBTITA was up to record high of RUB340 billion, that’s up by 8% quater-on-quarter that exceeded the record-breaking level of the second quarter of the pre-pandemic 2019 and it also featured higher production volumes and refining margin. We have already spoken in detail on EBITDA drivers for each segment. I would also like to note that inventory sales in the second quarter were a strong contributor to the increase in EBITDA, which is reflected in the Elimination line of the EBITDA breakdown. Furthermore, with the market environment back to normalcy in the second quarter, the carrying over drivers and one-off factors had a less pronounced effect on EBITDA quarter-on-quarter performance. In the second quarter of 2021, the company posted net profit of RUB190 billion, an increase of more than 20% quarter-on-quarter. The growth was supported primarily by stronger EBITDA. Items below the operating profit line saw no impact from one-off or carrying over factors. Free cash flow in the second quarter stood at RUB112 billion, going down quarter-on-quarter as the working capital expanded by RUB100 billion, which was driven by higher oil prices and implementation of international trading strategies. Free cash flow before changes in the working capital hit a record high of RUB212 billion, that’s up 13% quarter-on-quarter. The key driver behind this growth was stronger operating cash flow associated with higher production volumes and improved market environment. At the end of our presentation today, let me talk briefly about our plans for this year. Given the July decision of the OPEC+ members to increase oil output on a monthly basis, we expect hydrocarbon production to grow by about 4% excluding the West Qurna-2 project that’s compared to 2020. Depending on the market environment, we will stay flexible in managing our refining fleet utilization in Russia and abroad. We have updated our investment plans so now expect the 2021 capital expenditures, excluding the West Qurna-2 project to be in the range of RUB470 billion to RUB490 billion. Please be reminded that our early guidance stood at RUB460 billion to RUB490 billion so a mininal change to RUB470 billion to RUB490 billion LUKOIL continues to boast a very strong investment story. The company’s efficient management enables us to maximize the benefit from the market recovery while the current dividend policy transforms this benefit into higher shareholder returns. Very soon we expect our production to recover completely, and we continue to develop our business with due account for all the industry trends, including climate change of course. We see that LUKOIL's market capitalization is sound lagging behind our financial performance, so we still believe that our shares are strongly undervalued. Thank you. We conclude this presentation and we're ready to take your questions. Please go ahead.

[Operator:]

[Operator Instructions] The first question comes from the Russian line from Karen Kostanian from Bank of America. Please go ahead.

[Karen Kostanian:]

Thank you. Thank you, gentlemen, for the presentation. Good afternoon. I have a question about the working capital. Could you provide us with a quick breakdown like what percentage of the increase was driven by higher prices and which percentage was – which share was driven by the trading strategies. And please clarify what those trading strategies are? Do you expect some of the working capital to be returned as cashflow in the future as the trading strategies reversed? And one further question is the updated – does the updated CapEx guidance includes the hydrocracking unit, the catalytic cracker unit in Perm? Thank you.

[Pavel Zhdanov:]

Pavel Zhdanov speaking. Thank you, Karen, for the question. Regarding the inflation in our working cap, about a quarter of the increase comes through higher prices for oil and petroleum products while the remainder 75% is attributable to the short-term trading strategies. We expect this working capital to be released in the upcoming several quarters, but a lot will depend on the market environment. Regarding your second question, the catalytic cracker unit in Perm, while most of the investment phase goes beyond 2021. So in 2021, the CapEx numbers would only be minimal for these particular projects. They're not material.

[Karen Kostanian:]

Okay. Thank you.

[Operator:]

The next question comes from the line of – from the Russian line from Igor Kuzmin from Morgan Stanley. Please go ahead.

[Igor Kuzmin:]

Good afternoon. Thank you. A couple of questions if I may. My first question, as it relates to your CapEx and CapEx plans for next year, maybe have some sort of targets for 2021 is the CapEx and 2020 to go into the similar to the number of 2021, or are you expecting any increase? I would appreciate some color here. And one other question from my side, about your refining operations downstream segment, like regardless of the macro situation, what kind of effect would you expect from the upgrade over your refining facilities like could you suggest an estimate and dollars per barrel? What's the economic effect of the modernization program in 2021 vis-à-vis 2020 – in 2022 vis-à-vis 2021? Thank you.

[Pavel Zhdanov:]

Pavel Zhdanov speaking. Thank you, Igor. I believe it's too early to suggest any specific target for 2022. We'll have that closer to the end of the year, Q4 this year. We'll definitely be ramping up our drilling program, which will serve us the foundation for further production ramp up in line with the plans as suggested by the OPEC+ arrangement and the Ministry of Energy. So we couldn’t be looking up to about RUB500 billion. But at our next call, we’ll be providing you with some more specific guidance. Regarding your other question, while we are not prepared to give you any specific number to touch in upfront, we’ll divert to you on the effect of the modernization program. Thank you.

[Igor Kuzmin:]

Thank you very much.

[Operator:]

The next question comes from the Russian line from the line of Angelina Glazova from JPMorgan. Please go ahead.

[Angelina Glazova:]

Good afternoon. Thank you for this opportunity to ask my questions, and I have two. Early in the year, LUKOIL mentioned that it could update its mid-term strategy to include some climate targets. And do you have underlined the importance of climate change again on this call? Do you have an understanding now as to when we are to expect the strategy update? And my other question, according to media reports, you are still discussing potential tax benefits with the government for potential tax changes. You have suggested that some changes of the taxation could becoming as of the January 1 next year. Is this case now, or is there any update? Thank you.

[Alexander Palivoda:]

Alexander Palivoda speaking. Regarding our mid-term strategy, that’s currently being finalized and we expect to complete this effort before the end of the year. So the presentation of that strategy may will happen as we disclose our full year 2021 numbers in spring, 2022 most likely. Regarding high viscosity oil tax stimulus that’s currently work in progress. We have a working group set up, that’s about using the windfall profits tax or excess profits tax. And we are still working with the government and the timeline is up to them.

[Angelina Glazova:]

Thank you.

[Operator:]

The next question comes from the English line from Mitch Jennings from Sova Capital. Please go ahead.

[Mitch Jennings:]

Hi, thank you for letting me ask a few questions. My first question is, if there’s any changes to the way you’re looking at your buyback, if you plan to do anything there. And then second question is on M&A. Is there anything that you could talk – give us more color on going forward or after Mexico, could we expect to see a pause in M&A? Thank you.

[Pavel Zhdanov:]

Pavel Zhdanov speaking. No changes in our buyback approach. We have provided comments earlier and our position remains the same. The program has been announced is there, and we don’t think there is any further input on top of that. We’re waiting for the regulations to kick in, which would clarify the possibility to do the buyback and purchase the shares by the holding company PJSC, CJSC – oh, sorry, Public Joint Stock Company LUKOIL. As to the M&A strategy, we have always said our strategies opportunistic. So we can’t talk of any pauses here. We follow – the key thing is that we follow our main criteria, we would like to proceed with opportunistic acquisitions of high-quality undervalued assets that have synergy with those projects we have in our portfolio already and that reside in the regions of our strategic operations. I don’t think there is any further comments on top. Thank you.

[Operator:]

The next question comes from the English line from Henri Patricot from UBS. Please go ahead.

[Henri Patricot:]

Yes, Alexander, thank you for the presentation. A couple of questions around some of your upstream projects. The first one, I was wondering if you can give us a bit more color around the base of the ramp up for some of these projects in Iraq Block 10, how quickly do you expect that project to run in Mexico? Can you get to the targeted production? And secondly, you mentioned the low carbon intensity of the Baltic Sea project. Do you have any number to give us them to some future development [ph] for instance, and know that’s compared to address with the portfolio and some of your projects which as Mexico of the Grayfer project in Caspian. Thank you.

[Pavel Zhdanov:]

Pavel Zhdanov speaking. Let’s start with Iraq, West Qurna-2 as part of the OpEx plus arrangement we ramped up to 400,000 barrels per day. Our further plans on that project suggest that's the next step would be 480,000 barrels per day. That's the next step? So we'll be starting to produce from Yamamah formation in the amount of 30K barrel. And next year, we'll ramp up to 450 at Michrif from the current 400,000 barrels per day. Our plans remain to reach 800,000 barrels by 2030, but it's still too early to discuss that. As to Block 10, you’ve asked about it exploration at Block 10 is already completed. It's more than 400 million barrels of recoverable reserves and together with impact. So with Japanese partner, we are going to file an application for commercialization of this field and we'll finalize our plans was the Iraqi side. As far as D33, I understand you're interested in further the parameters of the project. We intended to launch production in 2024 with the shelf of 1.8 million barrels of oil a day. It would last for at least three years on that level. And that shelf has to behave in 2025. And I can give you the number of total CapEx. That's about RUB110 billion.

[Alexander Palivoda:]

Thank you. And Mr. Palivoda would like to add on Mexico. The newly acquired asset, well, first and foremost, we need to close the deal, of course, but shelf production is expected to be above 150,000 barrels of oil equivalent per day. We are already prepping for production at present. So the first phase of the project is pretty much complete in its construction side. So production is set to begin in the very near future. It's important to note here that as production begins and commercial becomes available, this project will have a cash flow of its own investment and to that project, it will be financed from that cash flow that’s our expectation. I hope I've answered your question.

[Alexander Palivoda:]

Mr. Palivoda speaking, I see no further questions from speakers on the line. I would like to thank everyone who have joined this call. See you next time. Goodbye.

[Operator:]

Ladies and gentlemen, thank you for joining today's conference. You may now replace your handsets. Thank you.