OPINION: Oil taxes: Mind the gap - $20 bln tax cut but in two stages

Contributed by Chris Weafer, chief strategist at UralSib

MOSCOW, May 26 (Prime-Tass) -- $20 bln tax savings at $100/bbl oil. We believe that the government is close to announcing a mechanism to reduce the tax burden in the oil sector. Rather than devising a new formula, we believe that the tax cut will be derived from indexing the parameters of the existing Mineral Extraction Tax (MET).

Currently, MET is calculated using the formula set in 2002 and this has been adjusted for inflation only once, back in 2004. By including inflation and ruble appreciation indexation, the changes in the tax charge will result in a return of approximately $20 bln (gross) to Russian oil companies. In addition, we believe that the government will review proposals for a tax holiday in designated oil regions, and changes in excise duties and export tariffs, both for crude oil and oil products. If accepted, these amendments will increase the money “given back” to the industry beyond the $20 bln from the MET changes. A $20 bln gross tax reduction will result in a post-tax bottom line gain of approximately $15 bln.

But, potential disappointment to come with the first cut. Prime Minister Vladimir Putin recently confirmed that a tax cut for the oil industry is on the way. He said that the enabling legislation will be presented to the Duma during this spring session. However, we expect the cut in the oil sector tax burden to come in two parts.

Part one is expected to involve the indexation of the “tax free base” used in the MET formula from 2004. This will reduce the tax bill for oil companies by an annualized $5.4 bln (annualized, gross) (or $4.1 bln net of profit tax) from the fourth quarter of this year. It is also possible that during the first phase, the government might approve a seven year tax holiday for new fields in certain regions.

Part two will involve further reductions in MET. This, at the current year to date average price for Urals ($120/bbl), will result in a tax reduction of $20 bln from 1 January, 2009. In addition, there will be cuts in excise tax for oil products and export tax for crude oil and oil products.

If only details of phase one of the tax cut is released, and without clarification of the changes to come in phase two, then we would almost certainly see a sharp fall in the price of oil stocks and the market overall. When the full package is made clear we expect this to be a positive driver for oil shares, and the market, from current price levels.

Confirmation in next few days. In terms of timing, details of the first phase reduction of $5.4 bln (annualized, gross) could come in the next few days, once the government submits the proposed legislation to the Duma. Details of the second phase changes, if not made clear at the same time, will likely be made known by mid June. This is because they will have to be contained in the 2009 draft budget assumptions, and the finance ministry usually makes these known around this time.

Investment Strategy

Best placed shares. The expected changes to the MET, plus other possible adjustments in the excise duty and export tariffs that may be implemented also as part of a broad review of taxation in the industry, will mainly benefit companies operating in Russia’s new oil regions of Timano-Pechora and Eastern Siberia. In the former region, the main beneficiaries will be LUKoil and Rosneft, with Surgutneftegaz and West Siberia Resources also likely to benefit, but to a lesser extent. In Eastern Siberia, the main beneficiaries will be Rosneft and Surgutneftegaz with TNK-BP and Urals Energy also in line to benefit. The expected increase in oil field spending across the industry will also benefit the oil service companies: Eurasia Drilling, Integra and C.A.T.oil.

Long term projects. We believe that as much as 100% of the extra cash will be invested by the oil companies into long-term upstream projects with a long pay back period. There are not many large fields currently under developed that are close to production and which could avail of the tax holiday in the nearest future. Most additional growth in the long term will come from currently unexplored blocks in areas like eastern Siberia, which is planned to be the prime source of crude for the East Siberian Pipeline.

Tax holidays. It is also possible that the government might consider the possibility of introducing tax holidays for such prospective regions as Timano-Pechora and the continental shelf of the Russian Federation. It is important to stress that we expect tax holidays not only for fields under exploration (usually referred to as “new fields”) but, more importantly, for fields still in the development stage. We also feel there is a possilbility that holidays for the continental shelf will be expanded to the “sea shelf” too, which would give strong stimulus to speed up exploration and development activities on the shelfs of the Black and Caspian Seas. The winners of such a move would be LUKoil, which develops the resources on the Russian sea shelf of the Caspian Sea and Rosneft, which has three offshore projects on the Black Sea and Azov Sea.

Stay long and consider “insurance”. If only the phase one news is made known then the oil shares and market would suffer a sharp fall. But if details of the full package are made public at the same time, then shares will rise, in our opinion. Three options to consider for investors:

- If you believe the government is likely to also confirm a broad outline of more substantial cuts at the same time as it publishes legislation to approve the $5.4 bln reduction, then stay long in oils and add to positions now.

- If, on the other hand, the government follows its normal practice of not commenting on future plans and only publishes the legislation for the first phase of the cut, then we will see a very sharp correction in the oil sector and across the broader market.

- Given the short-term uncertainty and our conviction that details of the second phase, consisting of substantial cuts, will be revealed with the proposed 2009 budget changes during the summer, the best strategy is to stay long in oils and also to look at the futures and options market for insurance. The potential volatility of such a move more than justifies the premium to be paid for options market “insurance”. The RTS Index LUKoil and Gazprom derivative instruments all trade with large daily volumes on both the Futures and Options bourses in Moscow.

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26.05.2008 11:46