Russia's king of crude
Lukoil, the country's largest independent company, has become the face of Russian business abroad. But can it be the next Exxon?
Last Updated: February 26, 2009: 4:56 PM ET
(Fortune Magazine) -- There are many things that simply can't be known about Russia's largest independent company, Lukoil. How did its president come to control the oil and gas giant in the first place? How do the founders get away with buying company assets through a bank they own? And, perhaps most important, can it survive if oil prices stay as low as they are?
AN APOLOGY: Since this story was published in Fortune's Feb. 2, 2009, issue, we have discovered that several passages were lifted from "The Triumph of the Quiet Tycoon," written by Peter Maass and published in the New York Times Sunday Magazine on Aug. 1, 2004. Fortune apologizes to Mr. Maass and the New York Times Sunday Magazine.
But one thing is clear about Lukoil: It's a company that mirrors Russia right now. Back in the summer it looked as though it was on top of the world. In less than 20 years after a clever young bureaucrat put it together from the remnants of the Soviet oil industry, the company had managed to become not just a global player in petroleum but also the face of Russian business abroad. Among the world's independent oil companies it controlled the second-largest reserves, behind Exxon Mobil (XOM, Fortune 500). It had operations in more than 40 countries. Its president was the first Russian citizen to win the prestigious Woodrow Wilson Award for Corporate Citizenship. Americans did a double take when Lukoil's red and white gas stations started popping up on the East Coast a few years ago. The sight was perhaps not as jolting as a Chinese car on the New Jersey Turnpike would be, but it signaled to many - especially to the Russians themselves - the beginning of a new world order.
When the credit crisis took hold in the fall, Russians - and even some Western economists - thought it was mostly a U.S. problem. They thought the new Russia, an energy powerhouse that produces more oil than Saudi Arabia, would be spared. But when the prices of commodities, including oil, collapsed, so did Russia's economy. Economic growth, which averaged about 7% the past five years, may drop below 2% this year. Foreign capital continues to flee. The ruble is under pressure. And for the first time since the collapse of the Soviet Union in 1991, the threat of large-scale unemployment looms.
Lukoil finds itself short of cash and, some analysts fear, at risk of needing a government bailout. Its stock is down 68% since its peak last May - underperforming most of its international peers - and rumors of involuntary vacations have rippled through the company. The situation has gotten so bad that Lukoil's partner, ConocoPhillips, is expected to take a write-down as large as $10 billion on its investment in the company, analysts say.
No one doubts that oil prices will rise again - and that the spike this summer was only a foretaste of what will occur when the economy rebounds. When that happens, Lukoil may be the oil company best suited to take advantage. The reason is simple: Much of the world's remaining energy resources are located in countries off-limits to most Western oil companies.
"It's very difficult to see where Exxon or Shell or BP finds new oil in the next few years," says Mattias Westman, the founding partner of Prosperity Capital Management, a London-based hedge fund that owns $100 million of Lukoil stock. "The same cannot be said about Lukoil. They have the best chance of acquiring and developing more reserves and growing more than any other oil company on earth."
That's why Lukoil president Vagit Alekperov, a tough-minded former bureaucrat with a permanent scowl, still plans an ambitious expansion - albeit slightly toned down since the summer - and insists his company will soon be mentioned in the same breath as Exxon Mobil, Shell (RDSA), and BP (BP). The challenge, he says, will be surviving until then.
'Almost everything was perfect...'
A few minutes befoer my first meeting with Alekperov, his aide, a large older man with thick shoulders and a soldier's stride, walked up, looked me up and down, and put his face near mine. Then he started yelling in Russian. My petite translator jumped. "He says, 'No small talk,'" she translated. "'Mr. Alekperov doesn't like small talk. Do you understand? Ask your questions one after another. Do you understand? Mr. Alekperov is very important and very busy. Do you understand?'"
The aide took one step backward, turned around, and led me into a small meeting room in Lukoil's imposing glass and steel Moscow headquarters. Inside was a bronze statue of cowboys lassoing a bull, a gift from ConocoPhillips (COP, Fortune 500) CEO Jim Mulva, whose company owns 20% of Lukoil. A shelf held photos of Alekperov with President Dmitry Medvedev, Orthodox Patriarch Alexy II, and Prime Minister Vladimir Putin - Russia's holy troika.
At exactly ten the door whirred open and Alekperov entered. He is 58 years old - he was 41 when he took over Lukoil - and has short, spiky gray hair. Maybe it was the collapse of the price of oil or the meltdown in the Russian stock market, but on this day Alekperov looked extremely annoyed. "Almost everything was perfect in the whole world, and then this happened," he said through a translator. "There are these great chances to develop and acquire new assets and to expand and develop our business. But we have to be careful. We could become bankrupt as well."
Alekperov was born in Baku in Azerbaijan, then under Soviet control and the capital of its petroleum empire. He graduated from the Azerbaijan Institute of Oil and Petrochemistry and soon went to work on the Oily Rocks, a storied offshore city on the coast of the Caspian Sea. The conditions there were famously treacherous. Once, during a storm, a blowout on his drilling rig sent him flying into the high seas, and he had to swim for his life. Years later he was supervising an oilfield in remote western Siberia when a fuel pipe ruptured. His repairmen refused to go near it, fearing an explosion, and legend has it that Alekperov walked up to the pipe, sat on it, and told the men to get to work.
He wasn't just brave - he was smart. And soon the Kremlin recognized it, appointing him, at age 40, the youngest deputy oil minister in Soviet history. The timing couldn't have been better. It was 1989, and Mikhail Gorbachev was opening the door to Western investment. Oilmen from around the world flocked to Moscow, hoping for their share of the prize. (The country's proven reserves are estimated at 80 billion barrels today, according to BP, and Russia is thought to have triple that still to be discovered - another Saudi Arabia.)
While the international petro-giants were circling the imploding Soviet Union, its top bureaucrats were looking ahead to its demise. Alekperov flew around the world, taking notes from the top executives at companies like BP and ENI (E), the Italian giant. He came to believe the only way Russians could compete against Western companies was to copy their business model. That meant vertically integrating the three branches of the industry - exploration, refining, and distribution - that were strictly separate under the old Soviet system. (Alekperov's official biography is aptly titled Vertical.)
Lukoil (pg. 2)
Last Updated: February 26, 2009: 4:56 PM ET
The Kremlin's Council of Ministers formed Lukoil in November 1991, just weeks before the USSR collapsed. The company combined three of the largest fields of the Soviet industry - Langepas, Urai, and Kogalym - as well as several refineries. (Its name derives from the first letter of each field.) Alekperov, stepping down from his evaporating job as acting Soviet oil minister, became its president.
At first Lukoil remained the property of the state. But in 1993 it was "privatized," and ownership vouchers were distributed to Lukoil employees, among others. It wasn't until 2002, when the company began trading on the London Stock Exchange, that Alekperov disclosed he owned a 10% stake. (No one is really sure how he accumulated it.) Today he holds 20%.
Almost two decades later, Alekperov, who was said last year to be worth more than $10 billion, is one of the few oligarchs still in business. How did he stay in control of Lukoil when other ambitious Russian CEOs found themselves in jail? One clue is his office. It's large, but sparsely furnished with understated red and white leather chairs. (Red and white are the official corporate colors.) Behind his glass desk is the double-headed eagle, which is Russia's coat of arms, and photos of Medvedev and Putin. Replace the eagle with a hammer and sickle and substitute a photograph of Nikita Khrushchev, and you could be back in the USSR. "We are first and foremost a Russian company," he says. "I am very thankful to both the president and the prime minister. They provide great support to our business."
They also seem to look the other way at the company's penchant for self-dealing. It is well known in Russia that the company's senior management owns many of Lukoil's suppliers and contractors. But sometimes the self-dealing seems obvious. Last March, Lukoil bought 30% of the TGK-8 utility from IFD Kapital for $1 billion. In November, Lukoil acquired an 82% interest in another Russian power company, South Generation, from IFD Kapital, for an estimated $2.8 billion. IFD's majority owners are Alekperov and Leonid Fedun, a Lukoil vice president.
Asked about allegations of corruption at Lukoil, Alekperov told me "everything the company does is transparent." He added, "But this is Russia. And in Russia there is a problem called corruption. We are trying to create obstacles to corruption. In Russia, our company is the least corrupted. Of course, I am not going to say that we are not corrupted at all, but we know these problems and we fight them."
A sea of steel
From Moscow, the 1,000-mile journey north to Russia's newest oilfield requires two Aeroflot flights and a ride on a Soviet-era cargo helicopter with dangling cables, rusty benches, and a survival kit consisting of a shovel, a ladder, and a pair of wooden skis. About an hour into the rattling, vibrating, chilly hop, the pilot banks left. It's early November, well inside the Arctic Circle, and at 1 p.m. the sun is already beginning to set. But outside the fogged-up windows, the rivers of snow that crisscross the barren Russian tundra blend into a sea of steel.
The chopper slams down on a gravel pad near what looks like a metal scrap yard. In the distance small armies of oilmen bundled in thick black coats are welding and bolting and banging on the snow-covered facility's tangled web of gleaming pipes, drilling derricks, and fire-spewing towers. It's 2°F outside, warm for this time of year. Thousands of feet below the frozen earth are some of Russia's most promising oil and gas reserves: the Yuzhno Khylchuyu field, on the northern edge of the Timan Pechora petroleum basin, a New Mexico-sized triangle of land located below the Barents Sea and just west of Siberia.
While Soviet geologists discovered hydrocarbons here back in 1981, nothing started flowing at Yuzhno Khylchuyu until last June. Vladimir Tsoj, an oval-faced man with an unbreakable frown, is the project's deputy director in charge of thermoengineering. "We're developing this whole facility from scratch," he says through a translator, "and in this country that is not normal." That's an understatement. This project is one of Russia's first new major oilfields since the days of Leonid Brezhnev.
But the very things that make Lukoil work in Russia are holding it back in the rest of the world: Lukoil remains a very Russian company, with all that has come to imply, from its complex structure and opaque finances to its inefficiency and dependence on the good will of the Kremlin. And while it buys up assets in the West to gain favor with investors, it also uses its Eastern connections to enter countries like Venezuela and the former Soviet republics, where other oil companies generally aren't allowed for political reasons. Alekperov says Lukoil will double its oil and gas production outside Russia by 2010, and expects international wells to generate 20% of the company's production by 2014, up from 5% currently.
But when oil dropped below $70 a barrel, Lukoil began losing money. While changes in Russia's export tariffs allowed the company to make a small profit in January, with oil at $45, capital expenditures like new exploration and expanded production must be cut or delayed. Because the majority of its oil comes from aging fields in western Siberia, the company needs to spend more each year on expensive, enhanced oil-recovery methods just to keep production in those fields stable. Lower oil prices also dampen the company's ability to explore for Russia's undiscovered oil, most of which is located in inhospitable places like Yuzhno Khylchuyu. "But if Lukoil doesn't invest enough at home," says Jonathan Perlman, an analyst at IHS Herold, a Houston-based energy-consulting firm, "when global oil prices rebound, they might not be able to capitalize on higher prices."
While there are rumors that Lukoil has delayed paying some of its contractors - something the company denies - Alekperov says he doesn't plan to lay off any employees. He also seems to be continuing an international spending spree. Lukoil recently acquired a $1.8 billion stake in Italian refiner ERG and is reportedly interested in buying a $13.5 billion share of Spanish refiner Repsol. But Alexander Burgansky, an analyst at Moscow's Renaissance Capital, worries that the company's bond rating could go into junk territory if the company keeps buying assets. In early December, Standard & Poor's lowered the company's credit rating from positive to stable. "They will have to forget about their global ambitions for a while," Burgansky says. "They don't have the skills or the funding at the moment to do it. Priority No. 1 should be managing their operations in Russia."
But that hasn't stopped Alekperov from exploring abroad. He recently traveled with President Medvedev to Venezuela, and plans more trips soon to evaluate other potential investment opportunities. And he still insists his company will soon be the biggest producer in the world. "The most important thing is that we have an objective," he says. "If there were no goals, then what would we do?"
If Lukoil survives the downturn, Alekperov will certainly enjoy the image of Americans going to Russian-owned gas stations to fill up their government-subsidized GM cars. And that is how the world turns. 
First Published: January 26, 2009: 10:39 AM ET
