Download Closing case: Chapter 6 (Daniels)

Closing case: Chapter 6 (Daniels)
LUKOil CASE
LUKOil CASE Russia’s GDP grew by 7 percent in 2004, which marked five straight years of
growth. The growth was also higher than that of any other G8 country. Russia’s oil and gas
sector has fuelled the growth, accounting for about 25 percent of its oil production and exports
the other 70 percent. This dependence on petroleum exports makes Russia quite vulnerable to
what happens in global petroleum markets. When the price per barrel of oil changes by $1,
Russian revenues change by about $1.4 billion in the same direction.
In recent years, so much oil has been discovered in Russia that the country now has 15 percent
more proven reserves than Saudi Arabia. In addition, diplomatic negotiations to solicit Russian
support for the war against the Taliban and Qaeda in Afghanistan gained Russian control over oil
exports from oil-rich Azerbaijan and Kazakhstan in Central Asia. Russian supplies are so large
that the Moscow bureau chief of a New York-and London-based energy intelligence group said,
“The country is choking on the crude it produces.” However, because of fierce rivalry in the
global oil industry, Russian control of so much oil is no guarantee it can sell at an acceptable
margin. Thus, Russia depends on its oil companies to export sufficient oil to pay for imports,
primarily machinery, to spur its economic development needs. The economic development is
essential, both because Russia GDP per capita in 2004 at purchasing rice parity of $8,900 was
well below that of any other G8 country and because Russia’s oil sector (a capital-rather than
labor-intensive industry) employs less than 1 percent of it population.
LUKoil is Russia’s largest oil company and is either the world’s largest or second largest private
owner of proven reserves. (Analysis disagree as to whether LUKOil or ExxonMobil is larger.
Some of the world’s largest oil companies such as Saudi Aramco for Saudi Arabia and Pertroven
from Venezuela, and their reserves are government owned, rather than privately owned.) It
controls 19 percent of Russian oil production and refining. In addition to its large investments
with Russia, it has been making extensive investments abroad. Map 6.2 shows the location and
types of LUKoil’s foreign operations. For instance, in 2001 it acquired 100 percent of Getty
Petroleum in the United States, which gave it a retail network in the mid-Atlantic and
northeastern states of about 1,300 gasoline stations. In 2004, it acquired another 800 U.S.
stations for ConocoPhillips. These are being rebranded as LUKoil need to export, many analysis
have wondered, “Why does a Russian company see advantages in investing abroad?” Before
answering this question, we’ll examine LUKoil’s competitive situation and strategy.
LUKOil must sell in foreign markets if it is to use its capacity adequately and earn sufficient
profits. Since the beginning of the twenty-first century, Russia’s export situation has been
generally favourable. Between January 1999 and September 2000, oil prices tripled because of
production cutbacks by the Organization of Petroleum Exporting Countries (OPEC), which
Russia never joined; bad weather; and strong demand. Oil prices lost about half this gain because
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of economic uncertainty after 9/11, but they have since increased to all-time highs as a result of
such factors as unrest in Venezuela, the war in Iraq, Chinese economic expansion, and
production curtailment by OPEC. The result is that LUKoil has been able to sell more oil outside
Russia and at a higher price than it could a few years earlier. This favourable market situation
enabled LUKOil to have enough capital to invest abroad if its management reasoned that such
investment would help its strategic position.
LUKOil was one of several companies created in 1991 out the Russian state-owned petroleum
monopoly. Since then, the Russian government has gradually reduced its LUKOil holdings. It
sold three-quarters of its remaining 10 percent holding to ConocoPhillips in 2004. Yet LUKOil
remains close to the Russian government. Russian President Vladimir Putin even cut the ribbon
to open a new LUKOil filling station in New York City during his state visit to the United States.
LUKOil became the first Russian oil company to integrate “from oil well to filling station.” It
has over 120,000 employees and about 1,100 Russian filling stations.
In addition to exporting to use its capacity, LUKOil’s management has wanted foreign expansion
to get bigger margins and more assurance of full on-time payment than it can get within Russia.
However, why doesn’t LUKOil simply export rather than make foreign investments? The answer
lies in a combination of factors.
First, oil prices have fluctuated widely in the past in spite of their general upward trend since the
beginning of the twenty-first century; so has the ability to market Russian oil abroad. On several
occasions, oil prices have jumped over 100percent in one year and then have plummeted to lower
levels than when the jump in prices began. In fact, in the late 1990s, a global oil glut and
depressed world oil prices hampered LUKOil’s ability to be profitable. So LUKoil emulated its
larger Western competitors and embraced the ideal of forward integration into ownership of
foreign distribution. Its first foreign investments were of formerly state-owned oil facilities in the
former Soviet statellite countries of Bulgaria and Romania, because these countries were close,
familiar, and long-time customers of Russian oil. It has since expanded into other countries,
almost entirely by buying existing companies rather than through greenfield (start-up)
operations. Simply stated, when producing companies invest in distribution, the capture markets
that better enable them to sell their crude oil when there are global oversupplies. Further, this
integration could potentially reduce LUKOil’s operating costs because LUKOil will not have to
negotiate and enforce agreements by selling oil to other companies in these countries.
Second, despite having huge reserves in Russia and being a successful exporter, political
relations could impair LUKOil’s future export sales. For instance, an importing country could
lower it purchases of Russian oil to protest some Russian political policy or simply to diversify
its own sources of supplies. Further, within Russia the government owns the pipeline system
through which virtually all Russian oil exports pass. Because it allocates quotas among oil
companies to use the pipeline system, a competitor might gain influence with Russian political
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decision makers to pre-empt part of LUKOil’s quota. Thus, LUKOil sees the need to develop
foreign oil supplies and aims to make them about 20 percent of its total supplies.
Third, to be a major global competitor, LUKOil must become as efficient as the major Western
oil companies. To do so, it needs the latest petroleum technology, marketing skills, and operating
efficiencies. For example, its administrative expenses and cost of capital have been high
compared with Western competitors. Within Russia, these needs have created only minor
problems because LUKOil’s competition has been other Russian oil companies that also
inherited operational inefficiencies from the former state-owned oil monopoly. However, new
competitive threats within Russia have been gaining momentum. BP and TotalFinaFlf bought
interests in Russian companies. Thus, LUKOil sees advantages in acquiring skills from foreign
companies to help it compete better, both at home and abroad. With this outcome in mind, it has
put independent directors from Western oil companies on its abroad. The 7.6 percent purchase of
LUKOil by ConocoPhillips was partially brought about by LUKoil’s interest in tapping
ConocoPhillips’s management expertise. It also sees foreign acquisitions, such as the Getty
acquisition in the Unites States, as a means of gaining experienced personnel, technology, and
competitive know-how
In summary, both Russia and LUKOil need to export to meet their economic objectives. They
see foreign investment and ties to Western oil companies as helping to meet these objectives.
QUESTIONS
1. What theories of trade help to explain Russia’s position as an oil exporter? Which ones do
not, and why?
2. How do global political and economic conditions affect world markets and prices of oil?
3. Discuss the following statement as it applies to Russia and LUKOil. “Regardless of the
advantages a country may gain by trading, international trade will begin only if companies
within that country have competitive advantages that enable them to be viable traders-and
they must foresee profits in exporting and importing.”
4. In LUKoil’s situation, what is the relationship between factor mobility and exports?
5. Compare the role of the Costa Rican government in the chapter’s opening case with the role of
the Russian government in their use of trade to meet national economic objectives.
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