Lukoil accounts for almost 20 percent of Russia’s total oil production and has the largest international upstream portfolio among the Russian majors. More effort to suppress costs is necessary, especially as the price of oil remains weak.

Even so, the company doesn’t deserve to trade at such cheap valuations given that its growth potential around the world is one of the best in the industry.

Yiannis Mostrous – Silk Road Investor

In September 2008, Yiannis Mostrous, editor of the Silk Road Investor emerging markets investment service, wrote the analysis quoted above about Russian oil giant Lukoil (Other OTC: LUKOY.PK). Overall, he is very bullish on Russia, ranking it his second favorite market:

I’ve long favored Russia as a destination for investment, building my case primarily around its energy sector. But I’ve also highlighted the increase in domestic demand and the infrastructure boom taking place there.

Russia is currently in a sweet spot: It’s a net oil exporter, has good GDP growth, isn’t dependent on foreign capital flows, is relatively stable politically, boasts reasonable market valuations and, above all, enjoys solid exposure to the biggest growth story of our time, Asia.

But Lukoil, Russia’s second-largest oil company, has never made the cut for Yiannis’ “Long-Term Holdings” portfolio in Silk Road Investor. For a time, Lukoil did make his “Alternative Holdings” portfolio, which focuses on shorter-term recommendations. However, as the opening quotation from September 2008 makes clear, Yiannis had concerns about Lukoil’s cost controls. The most attractive aspect of the stock was its cheap valuation. But was it cheap for a reason?

A Prescient Sell Recommendation

The next month, in October 2008, Mr. Mostrous recommended selling Lukoil from Silk Road Investor‘s “Alternative Holdings” portfolio and replacing it with the much more diversified Market Vectors Russian ETF (NYSE: RSX).

This was a great call on multiple levels. First, the Russian ETF has outperformed Lukoil by almost 42 percentage points over the past two years, partly because Lukoil couldn’t keep its expenses in line. Second, even those subscribers that didn’t sell Lukoil came out ahead of U.S. energy investors because Lukoil’s cheap valuation allowed it to outperform its U.S. counterpart ExxonMobil (NYSE: XOM) by more than 51 percentage points:

Source: Bloomberg

Bottom line: Yiannis’ analysis of Lukoil back in 2008 was spot on! 

Lukoil is an Admirable Company

I’ve always been fascinated by Lukoil because it is a privately-owned corporation committed to Western-style capitalism in a formerly Communist country that under Prime Minister Vladimir Putin is moving back towards a state-controlled economy. Furthermore, as Lukoil’s own website states, it is “the only private Russian oil company whose share capital is dominated by minority stakeholders.”

Russia’s Political Situation is Not Admirable

An admirable thing, indeed, but it makes Lukoil an underdog in Putin country, which is famous for bankrupting a similar oil company called Yukos, jailing its CEO Mikhail Khodorkovsky, and confiscating its energy assets. Putin didn’t like Yukos CEO Khodorkovsky’s calls for greater democracy. The St. Petersburg Times described the Yukos bankruptcy this way:

The Yukos affair was and remains characterized by an almost total breakdown in legal process and judicial independence.

Yukos was expropriated through discriminatory and bogus back tax claims, and its assets were frozen to prevent Yukos from even attempting to settle the bogus claims against it or to continue operating. The company was artificially forced into bankruptcy, and its assets were sold at a series of sham auctions. There was so little due process in the whole affair that Dutch courts in 2007 refused to recognize the authority of the Russian court-appointed receiver.

So far, Lukoil has escaped Yukos’ fate. But a 2007 Rice University study outlines the challenges Lukoil faces:

In the context of the Russian oil industry, a company that is 100 percent privately owned is a member of a shrinking club. In the past three years the Russian government has steadily reasserted control over the oil and gas sector. State companies like Rosneft and Gazprom have built up their oil portfolios largely at the expense of the private sector.

The Kremlin’s advance on Russian industry has been so relentless that many believe it is simply a matter of time before more companies fall under the state’s yoke. Lukoil could fragment or merge with a state company. It seems likely that Lukoil will, even if it maintains its private ownership, increasingly act at the behest of the government.

Evidence of Putin’s harassment of the private energy sector is everywhere. The Russian government has levied large fines against Lukoil for alleged anti-trust violations and BP’s (NYSE: BP) 50-50 joint venture with Siberian oil producer TNK has been raided by Russian security services. There are constant rumors that Putin plans on nationalizing BP-TNK. In July 2009, Putin withdrew Russia from the Energy Charter Treaty, which protected the property rights of energy investors in international courts. As of now, investors in Russia’s energy markets must rely on Russian courts to enforce property rights. Yeah, that’s reassuring – NOT.

A rumor that Lukoil founder and CEO Vagit Alekperov is being forced to resign only makes matters worse. The situation in Russia has gotten so uncertain that ConocoPhillips (NYSE: COP), which owned a 20% stake in Lukoil, decided this past July to sell its entire stake. 

Lukoil’s Conference Call Frightened Me

On August 31^st, Lukoil reported that first-half 2010 profits rose 24% and debt declined by 22.5%, but all of the profit gains occurred in the first quarter; second-quarter profits declined 16% due to higher expenses. More important than the numbers was the conference call, which was hosted by vice president Leonid Fedun; CEO Alekperov was conspicuously absent. Listening to the conference call was a not encouraging. Below are a few highlights of Fedun’s comments:

• Rumors of CEO Alekperov’s resignation are a “provocation.”
• The current investment climate in Russia is “not favorable” because “in Russia the situation is not very clear.”
• The Russian government imposes two heavy taxes on Lukoil: (1) a mineral extraction tax; and (2) an export duty tax. According to Fedun, “I don’t think that tax changes can be expected in the coming years.”
• “From the perspective of taxation, the oil industry remains the milking cow of the federal budget. Most benefits of price growth go to the federal budget. The system is extremely profitable for the budget, but that system considerably limits the economic potential for development for the companies inside Russia.”
• When asked about who should be the next Russian Minister of Energy, Fedun replied:” I will never pass judgments on the positions of higher-ups in the government. I don’t think it’s smart to discuss one’s managers.”

I don’t know about you, but I found these comments very disturbing. It sounds like Lukoil is terrified of the government, and for good reason. I hesitate to invest in a company whose profits are being siphoned off by confiscatory government taxes or in a country where the investment climate is “not very clear.”

Lukoil is Cheap for a Reason

The fact remains, however, that Lukoil is a very cheap oil company. Take a look at a comparison between it and ExxonMobil:

On a price-to-earnings basis, Lukoil is almost 50% cheaper than ExxonMobil, a company that I recently wrote was itself a bargain. Nevertheless, after listening to Lukoil’s chilling conference call and given the tremendous political risks in Russia, I think this 50% discount is well deserved.

If ConocoPhillips is jumping ship, a company with many years of experience doing business in Russia, do I really want to jump on board Lukoil right now?