Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Besides invention, necessity is the mother of bromance.

At least when it comes to oil, that is. The Russian and Saudi Arabian energy ministers were unusually chummy in Vienna last week, when OPEC, Russia and some other oil exporters agreed to continue their supply cuts for another nine months.

This is, to put it mildly, a little unexpected. Besides Russia's reputation for free-riding on prior OPEC cuts, the two countries are at odds over some not-so-minor topics such as Syria and Iran. Yet now, there is talk of their temporary alliance becoming "institutionalized."

It is amazing what an oil crash can do. 

Some interested parties that aren't quite feeling the love, however, are Russia's oil majors. State-owned national oil companies across OPEC, such as Saudi Arabian Oil Co., naturally cut supply when their government shareholder demands it.

Russia's oil companies, though, are listed, commercial entities. Even state-backed champion Rosneft Oil Co., half-owned by the Russian government, has all the trappings of a listed company, with shares traded in London, quarterly results, guidance and the rest of it. Rather than being told by the Kremlin to cut, the country's oil majors are doing so on, y'know, a voluntary basis.

In theory, they will benefit, not merely by doing the patriotic thing, but also from the increase in oil prices due to the cuts. But that isn't really showing up where it counts for investors: valuation.

Cut Back
After an initial pop, Russian oil stocks haven't performed better than their peers under the cuts
Source: Bloomberg
Note: Indexed to 100 prior to the announcement of supply cuts by OPEC, Russia and others in November 2016.

Rosneft's surge late last year had something to do with the government's sale of a 19.5 percent stake in the company to Glencore Plc and Qatar's sovereign wealth fund, as well as hopes (unfulfilled thus far) that the Trump administration would lift sanctions on Russia.

Rosneft has closed its valuation discount to global peers somewhat since November, but it remains wide and has been opening up again in recent months. Lukoil's is actually wider:

Still In Siberia
Russian oil majors' discounts to international peers have shifted since November, though it's hard to be positive on the whole
Source: Bloomberg
Note: Discount to the average 2017 enterprise value-to-Ebitda multiple for Total, PetroChina and Statoil, weighted by market cap.

Cutting supply to juice the oil market isn't as helpful to Russia's oil companies' bottom lines as you might think.

When oil crashes, the companies are shielded somewhat because a weaker ruble cuts their domestic operating costs, and Russia's tax structure means the government's take falls faster than the price.

When oil prices rise, though, they tend to take the ruble up with them -- it's risen about 15 percent against the dollar since November -- and the government takes most of the gain. Russian oil producers typically capture only $1.60 out of every $10 increase in the oil price, according to brokerage Renaissance Capital.

Plus, of course, in this instance, the number of barrels they can sell is capped or cut.

This hasn't been a big problem thus far. Russia's cuts arrived in stages, only reaching the 300,000 barrels-a-day target in the past month.

But the longer the cuts are in place, the more they mess with growth plans, impacting profits, operations, and relations with contractors and investors. Before November, Russian production was expected to keep rising, due in part to the start-up of several dozen new projects:

Escalation
Prior to the cuts, Russian oil companies had a large slate of new projects planned
Source: Morgan Stanley (report published in July 2016)
Note: Actual and projected production from 24 new Russian oil projects.

There is an implicit bargain underlying these cuts, of course. Russia's oil companies have an interest in complying, as Moscow controls access to resources, as well as the levers of taxation (among other things).

The crucial test comes next March, when the cuts are currently due to end. By then, if the cuts hold, most of Russia's oil majors will have clocked up a full year of lower production, and their timetables for new development could be put at risk if the agreement with OPEC is extended. 

Crucially, however, Russia's presidential election will also be out of the way, taking some immediate pressure off the government in terms of managing the budget. Meanwhile, over in Saudi Arabia, the planned IPO of Saudi Aramco should be imminent.

While both energy ministers denied these two factors had anything to do with the extension to the cuts, the timing is remarkably convenient.

"Incentives for the Saudis and the Russians are aligned" says James Henderson, a director at the Oxford Institute for Energy Studies. He warns, however, that beyond next March they will diverge again and "the voices of Russian companies will become louder."

This tension between commercial and national interests within OPEC's crucial ally is one more complication weighing on the longevity of the cuts, as well as the long-term relevance of the organization itself and Saudi Arabia's relationship with it (see this).

And the Russian majors' situation offers one last salient point for Riyadh.

These companies trade at a discount precisely because while investors can clearly see the scale of their resources, their importance to the government is a double-edged sword.

Expect some questions along those lines when Aramco's IPO roadshow comes to town.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in New York at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net