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.

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SUMMARY
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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.

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TAX REFORM ESSENTIAL
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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
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

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the value of private production assets that many believe were
corruptly privatized in the 1990s.

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OPEC, PRODUCTION PLANS
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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.

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OIL PRICE
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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.

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TRANSPARENCY AND EFFICIENCY
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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.

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BIOFUELS AND GAS FLARING

MOSCOW 00003712 003 OF 003


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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.

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RUSSIAN INTEGRATION INTO WORLD ECONOMY
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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