ROSNEFT AND LUKOIL TELL SENATOR LUGAR OIL TAX

UNCLAS SECTION 01 OF 03 MOSCOW 003712 SIPDIS DEPT FOR EUR/RUS, FOR EEB/ESC/IEC GALLOGLY AND WRIGHT EUR/CARC, SCA (GALLAGHER, SUMAR) DOE FOR HEGBURG, EKIMOFF DOC FOR JBROUGHER E.O. 12958: N/A TAGS: ECON ENRG EPET OREP PREL RS SUBJECT: ROSNEFT AND LUKOIL TELL SENATOR LUGAR OIL TAX REFORM IS COMING REF: A. MOSCOW 3649 ¶B. MOSCOW 1295 SENSITIVE BUT UNCLASSIFIED. PLEASE PROTECT ACCORDINGLY. NOT FOR INTERNET DISTRIBUTION. -------------- SUMMARY -------------- ¶1. (SBU) In separate meetings on December 17 and 18, Lukoil Executive V.P. Ravil Maganov and Rosneft V.P. for Finance Peter O'Brien told Senator Lugar that they strongly believe major oil tax reform is inevitable in Russia in order to stop the slide in production (reftels). They both suggested, however, that their own companies' production levels would likely not decline in 2009. Both said future production in Russia will be more logistically and technically difficult and thus more expensive. O'Brien and Maganov predicted the oil price would recover in the medium-term, with Maganov citing $70 - $80 as optimal. Neither described their companies as very interested or involved in ethanol production in the near future. End summary. -------------- TAX REFORM ESSENTIAL -------------- ¶2. (SBU) During his December 16 - 19 visit to Moscow, Senator Richard Lugar met separately with Lukoil Executive Vice President Ravil Maganov and Rosneft Vice President for Finance Peter O'Brien to hear their views on Russia's energy sector. A main theme for both meetings was the need for the GOR to reform the tax regime on the oil sector in order to reverse the trend of declining Russian oil production. Both Maganov and O'Brien noted that new production areas in Russia will be more difficult and expensive to tap. They said the most promising areas for future production are in the logistically and technically challenging East Siberian and off-shore regions. Given the capital requirements for developing such fields and the financial risks involved, they said, the GOR needs move toward a system of profit-based taxes. ¶3. (SBU) O'Brien explained that a tax on profits reduces much of the inflation risk (higher costs of labor and inputs) borne by companies. If companies don't know what their price structure is going to be in the future, but face high tax rates regardless, they will be very conservative with their investment decisions. If companies know that they will only �0A;face a tax on profits, then they can deploy capital more aggressively. ¶4. (SBU) Maganov told Senator Lugar that many positive steps have already been taken, and that he strongly believes more comprehensive reform is coming. Maganov said that a recent GOR decision to raise the threshold at which companies pay the mineral extraction tax, from $9 per barrel to $15, has already resulted in $1.5 billion of savings for Lukoil. He also praised a recent GOR decision that reduced the lag period for the application of export taxes -- from a tax on the oil price of the preceeding 60-120 days, to a tax on the oil price of the preceeding 30-60 days. Maganov said the GOR is also considering a proposal on accelerated depreciation that would be worth some $300-$400 million for Lukoil. His said he believes further tax reform will be approved because the government realizes that such reform would ultimately increase government oil revenues by boosting production. ¶5. (SBU) O'Brien echoed Maganov's optimism on future tax reform, saying he is "very confident" that the government understands the importance of the issue and the clear long-term benefit to state finances. He said the main impediment to tax reform right now is the Ministry of Finance's reluctance to take a short-term hit to the budget, especially given commitments to increase social spending. O'Brien welcomed the internal government debate, however, noting that decision makers are asking the right questions and weighing priorities. O'Brien said another hindrance to tax reform is that many in the government and population can't bear to take actions (like tax cuts) that would raise MOSCOW 00003712 002 OF 003 the value of private production assets that many believe were corruptly privatized in the 1990s. -------------- OPEC, PRODUCTION PLANS -------------- ¶6. (SBU) O'Brien said that with tax reform, Russian production could quickly recover to remain level, and possibly increase slightly in the coming years. In the long-term, O'Brien said, production could only increase if Russia welcomes investment by major interantional oil companies who have the expertise and technology to develop the challenging fields in new production areas. As for Russia's suggestion at the OPEC meeting in Algeria that Russian companies will reduce production by 300,000 barrels, O'Brien explained that most companies other than Rosneft already have production declines in their business plans for ¶2009. He said that given lower oil prices and high taxes, even without the credit crisis, Russian companies have reduced projected capital expenditures for 2009. Rosneft, however, plans to increase production by up to 1% in 2009 and possibly by 5% in 2010, as its large Vankor field comes online. ¶7. (SBU) Maganov said if the government of Russia enacted a policy requiring Lukoil to lower production, that "as a Russian company," it would abide by the government's policy. Without directly suggesting that the government could force compliance using its monopoly control over the transportation network, Maganov noted the government's 100% ownership of Transneft. Maganov said Lukoil does not expect its production to decline in 2009 and "it may even grow a little." He said the company will reduce certain investments, including cutting its budget for service contracts by 15% in 2009, but it would not cut production activities that would cause production to drop in 2009. To conserve cash, he said, Lukoil will cut new projects and international expansion plans. He explained that Lukoil is assuming a 2009 average price of $50 for oil, but would like to build up cash reserves to "prepare for the worst," especially in light of frozen credit markets. -------------- OIL PRICE -------------- ¶8. (SBU) Maganov predicted global oil consumption would resume its growth soon and push prices back to the $70 to $80 per barrel range, which he described as optimal "for both consumers and producers." O'Brien also predicted oil prices would rise again given increasing costs of oil production for most producers. He said that although Rosneft can produce oil for about $20 per barrel on average, including capital expenditures to replace reserves, the production cost of the marginal barrel for many producers around the world currently exceeds the oil price. He added that even for Rosneft, the capital expenditure portion of its expenses would rise as it seeks to develop new production areas. -------------- TRANSPARENCY AND EFFICIENCY -------------- ¶9. (SBU) Both Maganov and O'Brien presented their companies as having made great strides toward greater transparency and operational efficiency. Maganov claimed Lukoil is as transparent as all the major international oil companies, reporting its financial results using GAAP standards. Maganov praised Lukoil's strategic alliance with ConocoPhillips, which owns 20% of the company, stressing the benefits of exchanges of personnel that have helped modernize Lukoil management practices. ¶10. (SBU) O'Brien also touted his company's improved record of transparency and efficiency, saying it is essential to gaining public trust and support for tax reform as well as gaining preferential access to international credit markets. -------------- BIOFUELS AND GAS FLARING MOSCOW 00003712 003 OF 003 -------------- ¶10. (SBU) Both O'Brien and Maganov told Senator Lugar that their companies are not focused at all on production of biofuels. Both cited their companies' decades of reserves -- Maganov said Lukoil has 28 - 20 years, O'Brien said Rosneft has 30 years -- as why they see no urgency to diversify into biofuels or any other alternative energy supplies. Maganov emphasized that Lukoil is an oil company, focused on developing oil. He noted that biofuels not only require subsidies in most countries, but have indirectly caused mass hunger around the world by diverting food for fuel. ¶11. (SBU) Maganov cited his company's efforts to cut down on gas flaring by using the gas for power generation. O'Brien, too, noted Rosneft's development of power generation capacity (largely for its own use) run by the associated gas that it would otherwise flare. He blamed state-owned Gazprom, which owns 100% of the gas transportation network, for hindering access to its pipelines. He said given the lack of easy access to the gas transportation network and the government's plans to fine companies for flaring gas, oil companies have built power plants to use their associated gas production. -------------- RUSSIAN INTEGRATION INTO WORLD ECONOMY -------------- ¶12. (SBU) O'Brien told Senator Lugar that he is convinced that Premier Putin and President Medvedev share a desire to promote liberal economic policies, even if they are not doing enough to implement them. He suggested that Russia is "still working its way out" of the trauma of 1990s. He agreed with Senator Lugar that integration into the global economy and the global financial structures is the best path for Russia, forcing better economic policies and greater transparency and accountability. He lamented, however, that the financial crisis and the reaction of investors toward Russia means that progress on integrating Russia into the global financial system will be set back "at least" 2-3 years. RUBIN