The investment case for Lukoil (OTCPK:LUKOY) is straight forward. Based on both a stand-alone and peer analysis, Lukoil is probably the cheapest integrated oil firm in the world. Lukoil is an unleveraged low-cost producer with ample reserves, has a collection of profitable downstream assets, and a long-documented history of returning capital to its shareholders. All of the above makes Lukoil a compelling value play and an investment opportunity.
Lukoil is an integrated oil behemoth with one of the finest collection of assets in the energy sector. The firm has a sizable low-cost upstream operation that produces around 2% of the world’s oil, which is responsible for most of its earnings.
Moreover, Lukoil possesses an impressive group of downstream assets that includes four refineries in Russia, another three refineries in Europe, and a 45% stake in a refinery in the Netherlands. These refineries combined throughput refines around 1.38 million barrels a day.
Finally, Lukoil owns and operates more than 5,000 gas stations, mostly located in Russia and Europe. Lukoil has additional insignificant operations, but due to their lesser importance, I will not address them.
In 2019 the exploration and production segment ((E&P)) accounted for more than 71% of the firm’s profit, and refining and marketing ((R&M)) were responsible for the remaining 29% of the total profits.
(Source: Lukoil’s annual report 2019)
Peer analysis and financial valuation
The peer analysis includes eight firms. All the companies on the peer analysis are either integrated oil producers (i.e., have a downstream operation) or highly tilted towards E&P. My screening process emphasized low leverage (debt to equity > 50%), Mid to high enterprise value (EV > $10B), and having a positive free cash flow over the past five years, not including 2020.
The firms on the peer analysis are ConocoPhillips (COP), Chevron (CVX), Exxon Mobil (XOM), CNOOC (CEO), Gazprom Neft (OTCQX:GZPFY), PetroChina (PTR), and Tatneft (OTCPK:OAOFY). In a peer analysis, there is a great importance of comparing “apples to apples.” Lukoil earnings stem mainly from its E&P operation, and it is essential to compare Lukoil with similar upstream firms.
Below, I present the income breakdown by segment, a peer analysis that presents financial data from 2019, and valuation metrics. Because of the cyclical nature of an E&P operation, the valuation metrics are based on five years of data.
(Source: Image created by the author with data from Bloomberg LP and annual reports)
One insight I borrowed from Ben Graham is that an investor does not need to precisely value a company to know it is selling below its fair price. In the same way that you do not need to be knowledgeable of someone’s height or BMI figure to conclude that he is tall or overweight.
Building upon this reasoning, when examining all standard valuation figures from the peer analysis, we can conclude that Lukoil stock is selling at an abnormally low price. This statement is true both in comparison to its peers and intrinsically.
Take, for example, the contrast of Lukoil to Exxon Mobil or Chevron. Lukoil is selling at a normalized EV/EBIT of 6.1x, the cheapest on the list. Exxon and Chevron are trading at much higher multiples of around 100-400% premium to those of Lukoil. There is simply no apparent justification in fundamentals to explain why Lukoil will sell at such a discount.
What is important to note is that no one figure can provide the full picture, but such a substantial discount from its peers on any valuation metrics should correct itself. The fact that Lukoil pays virtually all of its earnings and does not destroy shareholder value reinforces the idea that Lukoil sells at a bargain price.
Not all reserves are created equal
Before comparing the reserves of the companies in the peer analysis, there are some caveats that a prudent investor should watch out for when researching a firm with a significant E&P operation.
A future shareholder will be wise to carefully evaluate the prospects of oil and gas companies by examining their reserves. Specifically, the investor should inspect how much reserves the firm has, how much of those reserves are proven vs. probable, and finally of the proven reserves how much is developed vs. those that need further investments.
I will emphasize that the most valuable reserves in terms of future cash flow generation are the proven developed. Proven developed reserves are composed of active wells, and as such, do not need new large capital investments.
The next point of focus should be how much oil there is actually in a reserve. A barrel of oil is considerably more expensive to extract and is also more valuable in the commodity market than other materials. For example, due to the difference in the value and cost of extraction, measuring natural gas in a barrel of oil equivalent (BOE) can be misleading. As of the date of writing this article, a WTI barrel of oil was selling for about $43. On the other hand, a Henry-Hub natural gas measured in BOE was worth around $15. With such a difference between the price of a barrel of oil and a BOE of natural gas, investors will be wise to make adjustments.
I am highlighting the difference between a barrel of oil and a BOE of natural gas since it is a small but crucial detail that can materially distort the valuation of an E&P operation. This point seems to slip some investors’ minds during the shell boom.
The third item that may confuse investors is PV-10. PV-10 is a standardized industry measure of future cash flow from proven reserves less future expenses of developing and operating the wells from these reserves, discounted at a 10% discount rate. Needless to say that the final figure is a very rough approximation of the value of estimated future cash flows.
The PV-10 final number is inherently subject to many managerial biases and strong assumptions regarding the future. Not only the management assumes that the previous year price of oil will remain constant in the long-run, but it has to estimate the future expenses many years into the future. The PV-10 also completely ignores probable reserves which should have some value.
However, taking PV-10 together with other valuation metrics may prove to be useful. I measured the EV/ PV-10 against industry peers and attached additional data that should give investors a more complete picture as to the value of the peer list reserves. In theory, any firm that is trading at a ratio of less than one is a bargain. Such a ratio means that the firm is selling for a price lower than its proven reserve value, discounted at a 10% rate.
Reserve peer valuation
Below I present a peer analysis of the reserves:
The reserve peer analysis highlights Lukoil’s competitive strengths and undervaluation. Lukoil has the highest oil proven developed reserve, which in its current rate of production should last for more than 8 years. In theory, Lukoil can choose not to explore or develop existing reserves, and it will still be able to maintain current levels of production for a long time.
Additionally, Lukoil is selling for an EV/PV-10 ratio that is less than 1, whereas the median EV/PV-10 valuation is 1.2. This figure implies that the market largely ignores Lukoil’s downstream operation, which I remind the readers, is responsible for 30% of the income.
Finally, Lukoil’s EV/Proven developed oil reserves ratio is 5-6 times lower than the median/average firm. The lower this ratio, the less enterprise value each barrel of oil receives, which makes it intrinsically cheaper. The difference of Lukoil from its other peers is overwhelming and strengthens the investment thesis that Lukoil is selling at a deep discount.
(Source: Company’s annual report 2019)
Corporate governance and returns to shareholders.
Lukoil is known as the “dividend-king” in Russia. This title is well-earned in light of Lukoil’s constant dividend increases over the years. Additionally, Lukoil bought back shares worth $4.6 billion in 2018-2019 alone (~10% of the current market cap) while it maintained ultra-conservative financial leverage. Indeed, Lukoil is a “dividend king.”
Lukoil pays 100% of its adjusted free cash flows. Lukoil defines adjusted free cash flows as net cash from operating activities less capital expenditures, interest paid, repayment of lease obligations, and expenses on purchasing the Company’s stock.
(Source: Company’s annual report 2019)
Focusing on corporate governance, Lukoil’s largest shareholder, Vagit Alekperov, is also its CEO and chairman. A manager-owner situation should be a plus due to the alignment of interests between the leadership of the company, and shareholders. However, I believe that Lukoil overcompensates its top management with stock options. My way of dealing with what I consider “overblown” compensation plans is recognizing them as a cash outflow that reduces free cash flows.
I want to highlight that the compensation plan alone should not significantly distort the value of the Lukoil’s equity. Many companies in the US have similar compensation plans, and it does not appear to impact their market capitalization in any substantial way.
You can find details of the compensation plans below:
(Source: Company’s annual report 2019)
There are, of course, risks attached to investing in Lukoil. Some are industry-related, such as an extended period of low oil price environment or low refining margins. Others are company-specific, such as a complicated geopolitical environment, the concentration of assets in Russia, and the risk of poor corporate governance in the future.
The industry-related risks are an inherent feature of the energy business, and probably cannot be fully mitigated. Yet, purchasing a stake in an unleveraged low-cost producer at a price that is substantially lower than its intrinsic value should offer protection to the prudent investor.
Mitigating Company-specific risks is possible with moderate diversification. I will point out that the concentration of assets in a specific region is not a Lukoil –specific issue. In its recent filings, Chevron noted that 70% of its worldwide reserves are concentrated in three countries: the U.S., Australia, and Kazakhstan.
At current prices, Lukoil offers an asymmetrical bet, where the upside potential is much greater than the downside risk. Taking into account its current valuation, I can strongly argue that if Lukoil had been an American company, it would be selling at a price that is at least 2-5 times higher than its current valuation. In my opinion, this discount is extreme. A catalyst for the stock is the end of the pandemic and the subsequent normalized oil market environment. This event with Lukoil’s fundamentals should unleash some of its captured value.
Therefore, I would recommend investors with a mid- to long-term time horizon to initiate a position.
Disclosure: I am/we are long LUKOY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long on Lukoil and plaining to remain so in the foreseeable future. I do advocate my readers to come up with their own opinion as to how much Lukoil is worth.
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