With S&P facing billion-dollar fines for defying the narrative, Goldman Sachs just dared to go even further against the US government by suggesting that the new oil order may be a blessing in disguise for Russia's oil industry. Simply put, the impact of the lower oil price and sanctions on the Russian economy increase the importance of oil industry tax reform, which could provide stimulus for upstream investments and commercialisation of the country’s vast oil reserves. An acceleration of upstream/downstream tax rebalancing could incentivise the development of substantial new basins in Russia, leading to a production capacity increase and a reduction in refining volumes to levels necessary to supply the domestic market. As a result, in Goldman's view, Russian crude exports would increase, improving the country’s current account, government revenues would grow, and upstream would attract material incremental investments.
Via Goldman Sachs,
The new oil price environment, the impact of sanctions on upstream developments, and the emergence of the Eurasian Economic Union (Kazakhstan, Belarus and Russia) are likely to lead to a major tax reshuffle in the Russian oil industry, in our view. Russia’s dependence on the oil market makes the country’s economy highly vulnerable to the new oil price reality. Consequently, we believe Russia might need to create a stimulus for new upstream developments to go ahead, otherwise it could see falling oil revenues and further deterioration in the economy. In addition to this, the formation of the Eurasian Economic Union requires the gradual unification of export duties. All these suggest a tax overhaul in the Russian oil industry might not be far off.
In this note, we outline what shape we think potential tax reform might take and what would be the implications on the Russian oil industry, Russia in general and Russian oil equities.
Why we think change is needed?
The current tax regime indirectly subsidises both the Russian refining industry and Russian consumers, via low fuel prices, while the tax burden on Russian upstream is one of the highest in the world. Effectively, refining and consumers are subsidised by upstream. Removal of this subsidy and the simultaneous reduction of the upstream tax burden could boost upstream profitability, while keeping the government’s take from the industry unchanged; consumers and refining, not the government, would therefore fund the expected increase in upstream profitability. A lower upstream tax burden would make currently-stranded reserves commercially recoverable, which would boost production and export volumes, helping the country to sell more oil on international markets and offset the negative impact of price decline.
What we think needs to change?
The tax changes, introduced on January 1, 2015, and known as the “tax manoeuvre”, indicate some minor upstream/downstream re-balancing. However, we believe the pace of the tax adjustments introduced with the tax manoeuvre is too slow to incentivise material upstream developments. We think that, with the current macro/political realities, the pace could accelerate and could lead to faster and sharper improvement in upstream profitability. Based on the direction of tax reforms over the last 3-4 years (60/66 tax reform, the tax manoeuvre) and the formation of the Eurasian Economic Union, we infer that the end point of tax reform could be the full cancellation of export duties and excise taxes, and an increase in MET. However, we expect the magnitude of any MET increase would be lower than the reduction of export duties.
What would be the outcome of potential tax reform?
We estimate such reform could lead to the following: (a) upstream profitability would substantially increase, driving up the earnings of Russian oil companies; (b) Russia would produce more oil – its vast onshore and offshore oil resources would become commercial to develop, giving a boost to accelerated production growth; (c) export refining would become loss-making and hence refining volumes would decline. Total refining throughput could decline to as much as needed to supply products to the domestic market. Under the current regime, we estimate that potential oil products export could decline up to c.50% from 2014 to 2020 (from c.3 mnbpd to c.1.5); (d) domestic oil product prices could rise by 30%, on average, from current levels, as indirect subsidy through export duties would be eliminated; (e) unconventional and offshore exploration would pick up, as profitability would improve substantially, making those areas particularly interesting for investment.
What would be the stock impact?
We believe Russian oil companies could experience an increase in earnings, but the magnitude of impact would be differentiated. Higher upstream exposure, production growth and better access to unconventional and offshore deposits would be the key for success. Companies that adjusted their strategies to increase upstream exposure would be in a more beneficial position than those investing in downstream. For portfolio managers, stock picking in the Russian oil industry would be based on the following metrics, in our view: (a) upstream vs. refining, measured by refining cover, i.e. lower is better; (b) production growth becomes important, as profitability would improve; (c) exposure to unconventional and offshore. Within the Russian oils space, we see Novatek and Lukoil as winners on a 5-7 year view, under both the current, and a reformed, tax regime.
Tax reform machine turned on; upstream to benefit
We think that the tax manoeuvre sets the foundation for upstream/downstream tax rebalancing. In its current form, we believe it implies some upstream/downstream rebalancing, but not enough to create material incentives for upstream developments; it maintains the Russian refining sector tax incentives and indirect consumer subsidies, by effectively keeping the domestic oil products price at a discount to the international price, through the use of export duties. However, we think that the new oil order and current macro/political realities could drive a redesign of the tax system to make it more favourable to upstream. We think this could be achieved by an acceleration of the tax manoeuvre, which would imply a reduction in export duties and a MET increase. We think the end point of the tax reform would be full cancellation of export duties, a MET increase and cancellation of excise taxes.
2014 and onwards: The trend is set - volume vs. price, upstream vs. downstream
After years of tweaks to the tax regime, it looks like the trend has now been set; refining taxes are going up, upstream taxes are going down. Yet we are a long way from broad tax reform; it seems the trend could be followed, not via overall reform, but rather through a continuous chain of tweaks, such as the tax manoeuvre and special tax breaks for greenfields. The chain of recently announced tax breaks for new developments, implemented over the course of 2013/2014, has also set another interesting trend, i.e. going for volume growth in production and expanding capacity in order to maintain, or even increase, market share in the global oil market; we think Russia would have benefited from pursuing this trend a long time ago. For now, it seems the government prefers to support new developments in the industry. However, with time, we are likely to see broader support for upstream, especially as budget revenues from the refining sector increase.
Conclusion: Tax manoeuvre is the beginning of a wider reform
The Russian government’s tax manoeuvre reduces export duties for both crude oil and light products, while MET (which originates at the point of production) increases. However, the profitability of light products sales remains high and the tax differential between crude and products looks set to stay in place. In our opinion, these tax regime changes are not final, and we think there could be more adjustments to follow. We believe the government is trying to maintain its subsidy to the refining industry, but we see several factors that could lead to the gradual cancellation of the refining tax subsidy and the elimination of export duties as a fiscal tool: (a) integration of the Eurasian Economic Union of Belarus, Kazakhstan and Russia; (b) the need to increase budget revenues; and (c) the need to provide more economic incentives for new upstream developments. Yet, it does not appear that the government is ready to introduce radical changes, as it appears to be proactively trying to maintain the refining industry tax subsidy. However, we think the government might gradually approach the point where reform could be economically necessary. That could be years from now and, until that time, Russian oil industry taxation is set to remain a topic of continued debate within the government, the Kremlin and company managements. Hence, we expect the Russian oil industry tax regime to continue to be subject to regular adjustments to the tax law. This would not be positive for Russian oil equities, as it would introduce a high level of uncertainty into future projections.