Not financial advice, full disclaimer available here.
With Russia out of the SWIFT system and various other sanctions imposed on the country, it’s best to assume this idea went to zero. The post below includes the initial Lukoil investment thesis together with subsequent updates:
Original thesis: Feb. 28, 2021
Why $60? 1
From 0 to 100 2
Q3 earnings & SPR release 3
Black Friday sales 4
A contrarian sign 5
What now? 6
GAME OVER 7
The Russian economy relies heavily on energy. The sector has a 50% weighting in the country MSCI index. With oil prices in a long term downtrend and natural gas prices depressed, the Russian Ruble has lost nearly 70% of its value against the US dollar since the global financial crisis. Consequently, Russia now has one of the cheapest stock market in the world. This setup presents an interesting opportunity for contrarian investors who don’t mind the geopolitical risk. In this issue, we are going to focus on Lukoil (LKOH.MM) – one of the largest oil producers in the world.
Quality
Lukoil, much like Russia itself, has very little debt. In fact, it’s the balance sheet that really stood out to me when analysing the oil majors. The company has a net debt to income ratio of less than 1 (802 – 489 / 401*), a debt to equity ratio around 19% (802 / 4,218) and a current ratio of 1.5 (1,442 / 951). *All figures are in billions of Rubles; 401 is the average free cash flow for the fiscal year 2015-19; balance sheet data as of 30/09/2020.
This is a much stronger financial position than the other oil majors. Take Shell and Exxon for instance, two of the biggest names in the industry. Shell has a debt to equity ratio of 69% and a debt to income ratio of more than 5. That’s at least 3 times more leverage than Lukoil.
With current liabilities exceeding current asset, Exxon’s balance sheet is also challenged in my view. The company pays out more dividends to shareholders than they generate in free cash flow. In other words, Exxon is borrowing in an unsustainable fashion just to maintain their blue chip image in the investment community.
2020 showed that it pays off to have a fortress balance sheet. While Exxon was taking on debt to save face and Shell was cutting their dividend, Lukoil returned roughly the same amount of capital to shareholders than in 2019. This is another feature of Lukoil which I find compelling: the stock has offered a competitive dividend yield historically. But, in contrast with its north American and European counterparts, the payout ratio is much more sustainable. Management seems committed to maintaining an attractive dividend policy going forward.
Lukoil’s business also appears to be more resilient. Operating cash flows year on year are down 32% versus 50%, 61%, 40%, 19%, 52% for Exxon, Chevron, Total, Shell and BP, respectively (Shell did better than Lukoil thanks to changes in working capital but on a revenue basis Shell is down 47% while Lukoil is down 28%). This makes sense given that Lukoil is one of the lower cost producers. Another indicator of resilience is that all 6 companies but Lukoil reduced their capital expenditures in 2020.
One more key metric of quality is return on invested capital. ROIC tells us how efficient the company is at allocating capital. The higher the ratio, the better, because it means that management is looking after investors’ money. I calculate it as follow: free cash flow / (total debt + total equity). Lukoil’s ROIC for the past 5 year averages out to 9.4% compared to 3.1% for Exxon, Chevron, Total, Shell and BP (Shell scores the highest at 4.9%). This metric suggests that Lukoil is significantly more capital efficient than its peers.
What about Russian competitors? Gazprom and Rosneft are similar in size but more levered and less profitable. Lukoil generated more free cash flow in 2019 than Gazprom did in the last 5 years. Gazprom is state-owned and, as its name suggests, is more of a play on natural gas than oil, we will come back to that later. Rosneft did better with total profits only 13% below that of Lukoil but lost money in 2 out of the last 5 years on a free cash flow basis. I also feel more comfortable with Lukoil’s numbers because the correlation between earnings and free cash flow is much higher than the other two, which seem to carry a lot of accounting noise.
All of the above points to a well-managed business. This is not surprising given that management has significant skin in the game. The CEO, Vagit Alekperov, owns nearly 30% of the stock and has been leading the company from day one. He describes Lukoil as his life’s work and even bought a few more shares during the march 2020 sell-off (not a meaningful amount though). Insider ownership generally has a positive correlation with the fundamentals of a business and its share price overtime.
Valuation
Lukoil is cheap by any valuation metric. At RUB 5,700 per share, the free cash flow yield is 12%. I define free cash flow yield as: the average operating cash flow minus capital expenditures for the last 3 years (a proxy for $60 oil per barrel) divided by total debt, minus cash, plus market capitalisation (FCF/EV). 12% seems very reasonable given that the 10-year Russian government bond yields around 7%.
Price to book is 0.9 so the assets of the company are selling for less than historical cost according to the accountants. The dividend yield is about 5%, I use 2019 distributions + 10% (as a growth rate for D t+1) rather than 2020 to be conservative.
An alternative way to value the company is to use its proven oil & gas reserves. According to the latest fillings, Lukoil has 15,385 million barrels of oil equivalents. At $60 a barrel, that’s $923 bn. Now, we still need to multiply that by the ROIC to get an idea of how much of that nearly 1 trillion dollar of reserves would be left for shareholders once everyone else has been paid (employees, taxman, ect…).
This calculation (923 x 9.4%) gives us a net asset value of $87bn. At an exchange rate of RUB 74 / USD 1, that’s a 37% discount to the current market cap. And, the higher the oil price, the higher the discount.
In the appendix of the annual reports, oil & gas companies give an estimate of the net present value of their reserves. Using a 10% discount rate, Lukoil’s valuation comes at RUB 4,227bn in 2019, slightly above the current market cap of RUB 3,949 bn. Note that this discounted future net cash flow calculation only includes the oil & gas exploration and production activities and not the refining, marketing and distribution segment. So, you are getting the midstream and downstream assets for free. Free is a great price! Take this estimate with a grain of salt though, because the model uses the 12-months average price for oil and gas, so 2020 should be significantly lower.
If you are reading this thinking: “yes, but it’s Russia; the stock deserves a low price multiple”, I would push back and say that the oil equivalent proven reserves of Lukoil and Exxon are virtually identical while Exxon’s market cap is 4 times higher than Lukoil’s. Maybe investing in Russia is riskier and the stock does deserve to trade at a discount, but the valuation gap seems way too large in my opinion. I would go even further and add that Russia is one of the best jurisdiction for investing in the natural resources sector.
Macro considerations
At a micro level, Lukoil appears to be a sound investment; that is, a high quality business trading at an attractive valuation. But what about the macro environment? Do investors really want exposure to the oil & gas industry? It certainly has not been the place to be for the past 10 years. In that time, brent prices went from $128/bbl to $18/bbl while natural gas prices hovered around $3/mbtu. This negatively impacted the producers as illustrated by the chart below (oil price in orange and energy stocks basket in blue).
As is often the case with commodities, high prices eventually led to an oversupply and brought about the bear market of the last decade. Thanks to advances in technology, the United States - the world’s biggest oil consumer, was able to double its production capacity which drove prices lower. Unfortunately, most of the capital that went into exploiting those previously inaccessible resources has been uneconomic. So, the question is: can the trend continue?
In the late stages of the last commodity bull market, US shale producers enjoyed a very low cost of capital. Easy money led to a lack of discipline and malinvestments. According to a Deloitte report, the US shale industry registered net negative free cash flows of $300 billion, impaired more than $450 billion of invested capital, and saw more than 190 bankruptcies since 2010. With that track record, investors won’t throw money at those offenders for quite some time.
In addition, environmental, social & governance (ESG) investment mandates are impacting the flow of funds to the sector. It means that companies will need to be a lot more sensible with their cash going forward. As management teams focus on paying down debt to stay alive, we are likely to see a period of underinvestment in the next few years. This is bullish for the price of oil and good for Lukoil’s bottom line.
Although investments mandates are legitimate concerns for fossil fuel investors, one needs to appreciate the importance of oil & gas in the current energy mix. According to Exxon, they make up about 55% of global energy use today. By 2040, the company projects that oil and gas will continue to be the largest markets, supplying more than 50% of global energy. Therefore, investment in oil and natural gas is required to replace natural decline from existing production and meet future demand.
The chart below shows the supply and demand dynamics for oil over the next 20 years.
As you can see, demand is not going away. Oil remains essential for transportation and chemicals with consumption projected to stabilise above 100 millions barrels per day while natural gas is expected to contribute the most to meeting growth in electricity demand.
Because we live in a very western centric world, the general misconception is that new energy sources like wind & solar will replace prior energy sources like oil & gas. On a global scale, history suggests it is far more likely that we will just add new sources on top of the old ones. In other words, the energy mix might change in percentage terms but consumption of all energy sources will increase. So maybe wind & solar go from 2% to 5% while oil & gas go from 55% to 50% but we still end up using more oil and gas on an absolute basis.
As long as global demand for energy increases, this relationship is likely to hold. The reason is simple: having access to “dirty energy” is better than having no access to energy at all. In emerging markets, energy use and C02 emissions will rise alongside population growth, increased access to modern energy and improving living standards. It does not mean those countries won’t adopt green energy-related innovation, only that economic prosperity will be the priority.
Oil vs Gas
Based on the projections from the IEA, oil supply looks more challenged than that of natural gas in the years ahead. Natural gas resources are abundant and geographically widespread. According to Exxon, there is about 200 years of supply at the current demand level. Plus, estimates keep on rising as advances in technology expand recoverable resources. Therefore, the natural gas market is highly competitive.
The oil market is tighter which is another reason to like Lukoil. The company has high quality assets and oil accounts for over 75% of its annual hydrocarbon production. This is rather unique as most of its vertically integrated peers rely heavily on gas production. Even better, the Europeans are actually not keen on replacing their depleting reserves. Instead, they prefer to reinvest the proceeds of their oil operations into renewable energy.
Here is an excerpt from BP’s website:
The cash generated by hydrocarbons will be key to supporting the transition into our two growth areas – low carbon electricity and energy, and customer convenience and mobility. We expect to be directing 40% or more of our investment into these areas by 2030.
The key words are “supporting electricity” because it leaves room for natural gas. BP is really talking about phasing out oil since it only accounts for a small percentage of electricity generation.
This is a positive development for firms like Lukoil because less competition means more market share.
Risks
I don’t foresee a lot of risk with Lukoil as a company. The only thing I’d like to draw your attention to is that the share price already had a nice bounce from its 2020 lows. The stock is up 43% since October so don’t be surprise if we see a pull back from RUB 5,700. Actually 2 things, the second is that the CEO is 70 years old and therefore likely to retire at some point during our holding period. We might need to reassess when leadership changes.
The main risk with the thesis is geopolitical. Not at an operational level because virtually all of Lukoil’s assets are in Russia, but more as it relates to holding the shares. If tensions between the west and Russia were to escalate, I could imagine a scenario where the company has to de-list from foreign exchanges which would significantly reduce the bid for those shares.
At the more extreme end of the risk spectrum, the Russian government has actually shut down its capital markets before, wiping out equity investors. That’s why you hear people say things like: do you really own a piece of a business or is it all Mr Putin’s? However likely that is to occur today is up for debate but it’s a risk worth highlighting.
Another risk is the energy transition. I think emerging markets drive demand for oil higher as quality of life improves. I also suspect the West keeps on using more oil than the market is pricing in. But, maybe I am wrong and renewable energies do replace oil rather than just add capacity. In that case oil demand would only be subpar and supply decrease might not be an issue.
Lastly, the oil market is huge and has created massive amounts of wealth over the years. As a result, the industry gets a lot of coverage. Some analysts have made careers out of following this market. Therefore, I don’t have any edge when it comes to investing in this sector. I am more confident that the market is mispricing uranium, for example. See the January newsletter for the thesis on this niche commodity. That said, I trust my bottom up analysis and I am positive that not many investors even consider Russian equities.
Investment profile
Lukoil is well-managed business with a strong financial position trading at an attractive valuation. At $60 per barrel, oil is cheap and so is Lukoil. It is a low cost producer and its high quality assets offer equity investors more oil exposure than other stocks.
The energy sector is out of favour and Russia even more so (judging by the price multiple versus the broader market). This presents a great opportunity for contrarians looking to capitalise on a decrease in western supply over the next few years.
It’s not in the interest of Russia or other emerging markets to move away from oil; therefore, the ESG movement is unlikely to negatively impact Lukoil’s fundamentals. If anything, it might provide a tailwind because of reduced competition.
Jun. 15, 2021: Why $60?
As oil is approaching $75 a barrel, it's worth revisiting the thesis for Lukoil and clarify why I used $60 to value my preferred oil producer. Where does this number come from?
It starts with a chart of oil going back 20 years:
As you can see the price of oil for the last boom and bust cycle averages out to about $60. We can also see 3 periods when the price dipped below the average line in the last 15 years. These coincides with the global financial crisis in 08/09, peak US shale production in 15/16 and the lockdown crash of 2020.
Looking at the financials of the oil majors during those periods, we find that many of the biggest names in the industry did not make money. Excluding the state-owned companies, here is a list of 10 vertically-integrated oil & gas leaders which I believe give a fair representation of the market: Exxon, Chevron, Shell, Total, BP, Conoco Philipps, Suncor, Imperial Oil, Rosneft and Lukoil.
Out of those 10 names, 6 lost money in 2020 on a free cash flow basis. 7 lost money in 2016. 5 lost money in 2009 and 2 more were almost unprofitable as well.
This suggests that the marginal cost of production for oil is somewhere around $60, meaning that if we stay below this level for too long companies are not incentivised to produce. Therefore, $60/bbl strikes me as conservative way to value the commodity producers.
Oct. 5, 2021: From 0 to 100
Over the last few weeks, it has become clear to me that I have not been aggressive enough with my energy positions. From a fundamental standpoint, the news just keeps getting more and more bullish for energy-related commodities.
I won't waste time parroting the stories which you can read in the mainstream media but, just in case you haven't caught on to what's happening, here is a couple of links to short-form articles on the topic:
Europe’s energy crisis is coming for the rest of the world, too
China orders top energy firms to secure supplies at all costs
From a technical perspective, the momentum is also very strong. As you can see on the chart below, oil just broke out to the upside.
Same thing for Lukoil:
Even the ETFs have been outperforming the major US indices for a while now. You can play around with the duration on google finance: 1 year? energy has beaten the S&P 500. 6 months? Idem. 1 month? Energy wins again.
That's all well and good but I thought Twenties Research was about buying stocks when they are cheap, not when they are at all time highs! Correct, and it feels awful adding at this level, but I am because I think Lukoil is still attractive.
The company is on track to earn the same amount of profits this year as it did in 2018 & 2019, when oil was trading in a similar price range. This implies that the market is still valuing this blue chip business at a single digit multiple of free cash flow.
In addition, I think the risk of not being long enough is far greater than the risk of being too long. What if oil goes up another $60 a barrel in the next few months? Sounds crazy right? Yet, it happened before. Between the fall of 2007 and the summer of 08, oil went from $80 to $140. And let's not forget the crisis of the 1970s.
I am not saying history will repeat itself but it sure as hell would not surprise me if we saw triple digit oil again. When you look at it this way, the asymmetry is still interesting. I think I am risking $20 = 80 - 60 (see previous update) to potentially make $60. While the odds of the underlying commodity differs from that of the producers, I don't think it's unreasonable to expect the share price of Lukoil to triple if oil goes wild. The stock did just that in rubble terms between 2013 and 2020, and this was not exactly a bull market!
One of the risks of adding to the trade now is that the overall stock market is losing strength. Although the fundamentals point to sustainably high oil prices, oil might go down in sympathy with other markets if we have another broad sell-off. Commodities are volatile; we don't need another Covid-like event to trigger a major correction, just go back to the last quarter of 2018 when prices went from $77 to $45 in less than 3 months.
If this happens, I will be happy to double my position again - current allocation is 3%, up from 1.5% in February.
Nov. 25, 2021: Q3 earnings & SPR
In the last update, I wrote about why I was getting more bullish on Lukoil and referenced a few articles to make my case. Since then the stock went down 10% and the RUB/USD cross is down 5%. Terrible timing!
While my views on the company and the oil market have not changed, I should have known better and waited for a pullback. The reason is this:
When you see some scary/bold headlines in the mainstream media, it's usually a pretty good contrarian indicator
The Economist is infamous for getting it wrong time and time again.
The good news is: the fundamentals are just so strong that I don't think this small but noteworthy mistake will matter.
Lukoil released their earnings yesterday and the numbers are still very compelling. In the first 9 months of 2021, Lukoil produced 2.1 million barrels of oil equivalent (boe) per day and generated $12 of free cash flow (FCF) / boe. That's over $9bn of FCF per year and the current market cap is about $60bn.
Since I first wrote about Lukoil in February, the share price is up and so is the oil price. But the price multiple an investor would pay for the company has actually gone down. Originally, I estimated the FCF yield to be about 12% but the above suggests that the stock is now trading at a 15% = 9/60 yield.
Savvy investors will point out that, in the natural resources business, companies look the cheapest when the underlying commodity is the most expensive. And they are correct. But I would argue that the oil bull market is far from over.
First, let's not forget that Lukoil is still trading at around book value, which is a rare feat in today's market even for unloved oil majors.
Second, Lukoil has not enjoyed oil prices much above the marginal cost of production just yet. In the last 9 months, the average realised price was $67/bbl, only $7 above what is required for the industry to operate at a profit as a whole. Also, if we factor in all the monetary inflation that took place (and is still taking place) since March of 2020, then the marginal cost of production has probably risen.
Third, supply looks extremely challenged while demand is still subpar. Before OPEC + agreed to cut production, Lukoil was producing more than 2.3m boe / day. Add in those extra barrels to the above calculations and we get another billion dollar of FCF per year at current oil prices.
On the supply side, the DOE just offered 50m barrels of crude from their strategic petroleum reserves (SPR) to the market in an attempt to suppress prices. Not only is this reckless behaviour, but it also did not work. The market shrugged it off and oil actually rallied on the news. This goes to show just how tight supply is.
The world is short energy, demand is inelastic and producers are being told by government officials to stop drilling. This is a recipe for much higher oil prices.
There are 8bn people in the world, 1bn of which live in the West. The West needs more energy, NOT less, to transition away from hydrocarbons. The other 7bn live in what Balaji Srinivasan calls the ascending world. An ascending world does not sound like a place where people consume less energy to me!
Who is going to supply the ascending world with energy? If your answer is Exxon or any of the westerns producers, I suggest you watch this clip. My money is on Russia and specifically Lukoil. I believe the company will be worth $100bn in the next 5 years and potentially a lot more by the end of the decade.
So, I have added to my position again. Current allocation is 5% and I am not done yet.
Nov. 27, 2021: Black Friday sales
Oil is down $10 in one day! Maybe the SPR sale is having an impact after all. Maybe a large player got a margin call. The reason for the move doesn't really matter. It happened. And once again, my entry has been very ill timed. Fortunately, I am in it for the long run so time will tell whether Lukoil was a good investment or not.
Feb. 17, 2022: A contrarian sign?
If you own Lukoil or any other Russian equities, you may have received an email like this from your broker in the last few days:
Dear Client,
As you are likely aware, the elevated tension between Russia and Ukraine has led to increases in regional and global risks. The situation is fluid and no official sanctions have been announced.
We remind clients holding Russian securities traded on the Russian exchanges that these assets are particularly exposed to economic and political events, including governmental decisions to restrict activity or access to accounts, the inability to close positions, restrictions on the movement of funds in and out of Russia or the Ukraine, and other serious disruptions.
We cannot guarantee the accessibility to our liquidity in these assets and clients concerned with such impacts should consider appropriate steps to mitigate these risks.
The following might be affected:
Assets denominated primarily or secondarily in Ruble (RUB, Russian securities/debt or security linked derivatives).
Energy sensitive assets (energy commodities, energy companies, etc.).
Impact on European and/or Global markets deriving from interruptions in commodity and energy supplies.
General market risks resulting from events with large volatility and uncertainty for economies.
Regards,
The above is a good reminder of the risks associated with investing in controversial countries and they should not be ignored.
However, the contrarian in me can't help but wonder if this is a buy opportunity. Lukoil (red line in chart below) is still very cheap at current oil prices. Therefore, it would not take much of a shift in investors' sentiment for the stock to rerate dramatically.
The same thing can be said for Russian equities at large. Since December, ERUS (Russian ETF, blue line) has significantly underperformed the XLE (US energy ETF, yellow) and the oil price (USO, light blue).
Feb. 24, 2022: What now?
The Russian stock market has fallen A LOT. As highlighted in the latest update, Russian equities have been trending down for a while. But today, they crashed. Big time.
The Russian index is down 33% on the day and Lukoil was not spared. According to the company's website, the closing price was RUB 3,861 and USD 41 in Moscow and London, respectively. Meanwhile oil hit $100/bbl earlier today.
Again, I am not a geopolitical analyst. So, if you want a professional take on the Russia/Ukraine situation, watch this interview with Marko Papic from Clocktower Group (filmed before the invasion).
All I know is that Lukoil is extremely cheap right now and if it weren't for those crazy politicians, it would be a safe stock to own. Unfortunately, this has become a binary bet. So, existing shareholders are faced with three choices: 1) sell 2) hold 3) buy more.
For me, option 1 is no good because the best case scenario is to avoid a 2.5% loss (position was 5% of portfolio and got cut in half). What's the point of that? The time to reduce risk was 10 days ago.
#2 is hold. Again, what's the point? Initially, Lukoil was an investment; now it's a speculation. Either, the position is worth zero; or, it's a multi-bagger from here.
So, there is only one option left: buy a little. 1% is all it's going to take to repair the position if the market turns. If not, then it becomes a 6% loss (versus 2.5% if realised now).
What about prospective investors? Well, if you like the idea of buying panic, it does not get any better than that. However, I'd be the first to admit that I have traded this position very poorly from the start. Let's review the timeline.
Feb 27, 2021: original thesis
Here is an excerpt:
Start with half a position and buy the second half if and when the share price pulls back from current levels
Oct 5, 2021: the FOMO update
This next one goes against one of the old saying of traders:
The risk of not being long enough is far greater than the risk of being too long
versus:
It's far better to be out of a position wishing you were in, than in a position wishing you were out
Whatever. Been to conservative. Gotta add.
November 25, 2021: Mea culpa
Acknowledge stupid timing of previous trade:
... should have known better ... when you see some scary/bold headlines in the mainstream media, it's usually a pretty good contrarian indicator.
Add again. Oil drops $10 the next day!
Feb 12, 2022: comment on Ukraine situation
If world war 3 is upon us, oil will go crazy but I don't know that it's bullish for Lukoil, at least in terms of share price
Does not reduce risk anyway.
Feb 17, 2022: maybe it's all priced in already
Note that Russian equities have been underperforming US peers and the oil price since December. Broker warns about rising risks;
Is this a contrarian sign?
Clearly it was not.
Alright, maybe it's a little harsh taken out of context. But it seems like a good way to remind readers to make their own trading and investment decisions. Sometimes I get it right though :)
Mar. 4, 2022: GAME OVER
A week ago, I was highly critical of my own trading in Russian oil & gas stock Lukoil. No need to go over the full story again; but it’s important to acknowledge what a disaster this investment, turned speculation, has become.
Lukoil global depository receipts (GDRs) have been suspended from trading on the London Stock Exchange, with immediate effect from March 3rd, 2022. Click here to view the London Stock Exchange announcement in full.
So, if you were invested via the LSE, you lost everything.
For MOEX investors (Russian market), chances of getting your principle back aren’t much better. Here is a recap:
MOEX has been closed since the 28 of February and is expected to remain closed until March 9, 2022.
Once the market reopens, all MOEX products will be available for closing transactions only;
BUT, non-residents of Russia are blocked from selling securities on MOEX per central bank of Russia regulation.
The last quote I have for Lukoil is RUB 4,921. But who knows what the actual clearing price is (if there is one). In the OTC market, the last trade was $6.96 and the exchange rate is… 120?
So, it’s best to write-off this position completely.
To anyone with exposure to Chinese equities: be careful, you could be next.