Mauled by the Russian bear

Over the last decade, the Russian oil services market has been red-hot. Russian oil and gas firms have eagerly adopted Western oil services technology, resulting in significant growth for many US services firms. The substantial rise in commodity prices over the past few years had encouraged many Russian firms to invest heavily in new technology for their fields in order to boost production and reverse decades of field mismanagement.

Due to the frozen credit markets, and the collapse in commodity prices, we think the Russian oil services market may take years to recover. We see a handful of outcomes for the firms we cover as the Russian government struggles to fix its damaged economy. We also see a variety of geopolitical factors that could serve to complicate things for years to come. As always, it comes down to the ever-shifting balance of power between the oil and gas firms, services firms, and the Russian government.

Haven't We Been Here Before?
In the early 1990s, the Russian government had essentially collapsed and capital was scarce. The state was so disorganised and capital-starved that there was no capital to support basic maintenance on oil wells. In 1993, 1.6 million barrels per day were offline that could have been fixed for a negligible cost per well. Using then-current oil prices, the cost would have been paid back within months. It was during this time period that oil firms and the state began to negotiate the first production-sharing agreements. Production-sharing agreements are generally used by oil and gas firms when they are dealing with a highly uncertain or challenging environment and want to lower their risk exposure. In typical deals, international oil and gas firms provide capital and technical expertise in exchange for reserve ownership. Both parties share any profits after the oil firm has recovered its costs.

One of the first agreements was Shakhalin-II, which is one of the largest gas fields in the world, with about 18 trillion cubic feet in reserves. Given the poor shape Russia was in at the time, the production-sharing agreements for Shakhalin-II were extremely favorable to Royal Dutch Shell and far more generous than the typical industry-standard PSA. The agreement contained no cap on capital costs, which meant the state would not receive any profits from the sale of its oil until Shell had recovered all of its costs, plus a 17.5% return on its investment. Furthermore, there was no time-limit expiration for this deal, which meant that Shell could extend this lucrative agreement into perpetuity. Unfortunately for Shell, when the project overran by tens of billions of dollars in 2006, the Russian government saw that it may not get paid for years to come, as Shell had little incentive to control costs for the projects. As a result, the government eventually forced Shell to sell a 50% stake to Gazprom and cede operational control of the project. What the Russians had given up in the 1990s they reclaimed with a vengeance a little more than a decade later.

Reclaiming control over Shakhalin-II was a key event in the relationships between oil and gas firms and the Russian state. As oil prices marched upward over the past few years, the state's confidence and exchange reserves (which eventually topped US$500 billion) grew even stronger. An example of this newfound muscle is the agreement to develop the Shtokman field in the Barents Sea. The field contains an estimated 3.8 trillion cubic feet of natural gas, and we expect it to cost well over US$20 billion to develop. In 2007, Gazprom negotiated a deal with Total and StatoilHydro to provide technical assistance; however, Gazprom would retain ownership of the reserves. Total was allowed to book its 25% share of the gas reserves for shareholders in exchange for a payment of US$800 million. In the past, the oil companies retained ownership of the reserves for no additional cost and paid merely taxes and royalties to the host countries. In this particular agreement, the oil firms were relegated to the role of a services provider, such as Schlumberger or Baker Hughes. This distinction is important, as it is a complete turnaround from the Shakhalin-II agreement in the 1990s.

Contrast Russia's coolness with the international oil firms with its fondness for Schlumberger. Schlumberger has increased its Russian revenue from US$50 million in 1999 to more than US$1.5 billion today and retains about 10% market share in the region by our estimates. When Rosneft bought some exploration acreage in Algeria, the company had little operating experience in the country. Schlumberger, relying on its decades of experience in the region, found a drilling rig, drilled several wells, and found gas for Rosneft. In addition, the company has also built a training centre in West Siberia at a cost of more than US$100 million. The centre will provide over 350 students a year with basic and advanced training in oilfield technology. However, more crucially, it will also establish a level of trust with the Russian universities and improve relations between the state and the services company.

Similar scenarios have been taking place around the world where cash-rich but technically inexperienced national oil firms have placed their trust with service firms rather than international oil firms. As the countries have built up their own financial reserves, partnering with the international oil companies in exchange for giving up ownership of their reserves (which is perceived by some as a national right) began to seem rather undesirable. For these countries, the services firms became an attractive alternative. The countries have been able to outsource the drilling management and field production to Schlumberger and other services firms without having to give up ownership of the reserves. Services firms don't want to own oil and gas reserves, which pleases the countries. Services firms are content to take cold, hard, cash. For instance, Pemex has awarded over US$2 billion in contracts to Schlumberger to drill hundreds of wells and handle tedious steps, such as obtaining permits from local authorities in an effort to get the Chicontepec field to 550,000 barrels of oil per day by 2021. This is up from today's levels of less than 40,000 barrels a day. Other services firms, such as Weatherford, have also won billions of dollars in awards for similar work.

The Current Crisis
In our opinion, the current crisis is likely to change things yet again. The collapse in oil and gas prices since the summer of 2008 has quieted the Russian bear. Gazprom chief executive Alexei Miller boasted at the time that oil prices were going to US$250 a barrel in 2009 and that Gazprom would become the world's first trillion-dollar company in the next 7-10 years. We doubt he could have envisioned the firm asking the government for funds a few short months later, as liquidity in the domestic Russian market and international markets all but dried up. The Russian banks were ill-equipped to lend money before the global credit markets froze due to undeveloped lending programmes and practices, and they are in even worse shape following the market collapse. As it stands, no Russian firm has managed to raise money on the international bond market since August, and Russian bond yields have traded at more than 100%, indicating extremely low liquidity levels. The Russian government stepped in with a US$36 billion package for the banks, as part of a US$200 billion bailout package to get capital flowing again. However, this wasn't enough, as Russian oil firm Rosneft and pipeline firm Transneft had to turn to China for capital. The two firms ended up cutting a landmark deal in which China lent the firms US$25 billion in exchange for a 20-year supply of oil.

The Russian government's position as the provider of last resort is quickly weakening. The country has spent US$210 billion, or more than a third of its foreign currency reserves, since August to defend the ruble, which has declined by 33%. It also faces a near US$200 billion shortfall on its 2009 annual budget, written when oil prices were at US$95 versus the current US$40-50 range. Finally, the state is lending money to the Russian banks, which are then using the money to short the ruble, worsening the crisis. Not surprisingly, the Russian economy contracted at an 8.8% annual rate in January.

Varying Outcomes for Oil Services in Russia
In response to the frozen credit markets, overleveraged Russian oil and gas companies have slashed capital spending budgets. For example, Lukoil has taken its capital spending budget plan for 2009 down to US$6.5 billion, versus US$17 billion in 2008. Investment opportunities cannot compete with higher interest rates, which have doubled to 11-13% for larger firms and as high as 18% for smaller firms. The lower capital spending plans will mean lower profits for the services firms in Russia. In addition, the collapse of the ruble will mean a further decline in near-term profits for the US firms, which report in US dollars. On a ruble-denominated basis, drilling pricing may only be down 10% in 2009 at 35 rubles per US dollar, but in US terms, the same services pricing could be down 36%. We believe that if things are to improve for services firms in the future, the Russian economy and the ruble must stabilise.

Once the economy stabilises (which could be a generous assumption in our part given that Russian credit default swaps were trading at distressed levels recently), there are several outcomes for the oil services sector that we think are worth considering. The first is that the Chinese/Russian relationship may be expanded to include oil services over time, as we think it is highly unlikely that credit will flow as easily as it did over the past few years for some time, if ever. China's ample liquidity would be quite useful to the capital-hungry Russian firms, who are seeking to develop fields in the Yamal Peninsula and Barents Sea. As a requirement for providing additional funds, we could see Chinese oil services firms move into Russia with potentially cheaper services and displace the incumbent in-house Russian services arms or independent US oil services firms.

A second outcome could be capital becoming much harder to obtain permanently. If oil and gas prices do not recover to their former highs for several years, cash-strapped countries such as Russia may be forced to cut deals with international oil firms to develop expensive oil and gas finds. The terms are likely to favour the international oil companies and include reserve ownership once again. Service firms do not have the capital resources of the larger international oil firms and may end up returning to a services provider role rather than remaining a partner with Russia and other countries. In our opinion, a major growth avenue may disappear for the services firms, which could hurt profitability and valuations.

A third outcome, assuming that capital is much harder to obtain and that Russia is unlikely to give up its reserves ownership, would be the Russian oil services sector consolidating significantly. Currently, about 50% of the Russian oil services market is made up of the in-house services firms of major Russian oil firms, about 35% small and mid-size independent Russian firms, and about 15% US services firms. We believe this would be the most likely scenario, as strong services firms acquire struggling players and in-house services firms could be spun out to shareholders over time. Divesting the in-house services arms could make sense for the Russian firms (it certainly did for many US oil and gas firms in the 1980s) who want to focus on developing their reserves and may not want the additional volatility and challenges of the services business. US services firms would benefit under this scenario, as they have ample sources of cash from their US and European operations to acquire competitors. By consolidating the Russian services market, the US players would gain large enough capital cushions and additional technical expertise with the Russian reservoirs to be able to handle larger projects. If this outcome plays out over the next decade or two, the international oil firms' traditional advantages of technical expertise and capital could be largely diminished, and both services firms and oil firms could be competing on an equal footing.

Stephen Ellis is a Morningstar analyst based in the US.