OREANDA-NEWS. Fitch Ratings has affirmed OAO LUKOIL's Long-term foreign and local currency Issuer Default Ratings (IDR) at 'BBB'. The Outlook is Negative and remains constrained by the Outlook on Russia's sovereign ratings (BBB/Negative) due to the company's asset concentration in Russia and the influence the Russian state exercises on the oil and gas sector through taxes and regulation.

LUKOIL has a strong business profile, in both upstream and downstream, and solid credit metrics. We believe LUKOIL has sufficient headroom at the current rating to finance its ambitious development programme and increase its dividend payout. The company's efforts to stabilise its crude production in Russia as well as its international expansion, mainly in Iraq, are also beneficial for the business profile. OAO LUKOIL is the second-largest oil major operating in Russia, with total hydrocarbon production of 2.2 million barrels of oil equivalent per day (mmboe/d) in 2013 (excluding equity affiliates).

KEY RATING FACTORS
Russian Oil Major
LUKOIL is Russia's largest private oil company, accounting for 16% of crude production and 17% of oil refining in the country. Its scale of operations is comparable with those of international majors, such as Royal Dutch Shell plc (AA/Stable), BP plc (A/Stable) and ConocoPhillips (A/Stable). In 2013 LUKOIL's hydrocarbon production amounted to 2.2 million barrels of oil equivalent per day (mmboe/d), mainly liquids, which Fitch calculates generated USD18.6bn of EBITDA.
Sovereign-Capped Ratings

Fitch cap LUKOIL's ratings at those of the Russian Federation. This reflects the influence that the sovereign exerts on Russian oil and gas (O&G) companies' operations and profitability through regulation and taxation. Fitch view LUKOIL's uncapped ratings in the low 'A' category, limited by country-specific corporate governance concerns and its oil production concentration in Russia.
Fitch revised the Outlook on Russia to Negative from Stable in March 2014. The revision reflected the potential impact of sanctions on Russia's economy and business environment. Fitch do not expect that the sanctions will directly affect LUKOIL, but the perceived risk of further measures, combined with the possibility of Russian retaliation, may impede Russian issuers' access to the international debt markets. However, any interruption should not present a serious problem for LUKOIL because of the company's healthy liquidity and moderate debt burden, as well as access to the domestic debt markets.

Russia-Focused Upstream
In 2013 Russia accounted for over 90% of LUKOIL's proved oil and gas reserves and production. We believe that the higher state presence in the oil sector potentially puts private Russian O&G companies, such as LUKOIL, at a disadvantage, as state-owned companies are likely to receive preferential treatment in licence block allocation and other support. However, this should not significantly affect LUKOIL's creditworthiness in the medium term, taking into account its 21 years of proved reserve life at end-2013.

West Qurna 2 Launched
In March 2014 LUKOIL launched its Iraq West Qurna 2 (WQ2) project, of which it holds 75% and which we believe could soon be recognised as Russia's first large successful O&G project abroad. The commercial production at the field reached 120mbbl/d at end-March, and LUKOIL will need to maintain output at this level up to end-June to be entitled to cost recovery. In 2011-1Q14, LUKOIL invested USD4bn in WQ2, and we expect the company to recover its initial costs in 2014-2015, and the project to become self-financing from 2016. Although WQ2's successful implementation will have a positive effect on LUKOIL's international reputation and may help the company secure new large projects abroad, its impact on LUKOIL's credit profile will be limited, as the USD1.15/bbl fee to be received by LUKOIL under the service contract will not substantially benefit the company's cash flows, even when the project reaches its 1.2mmbbl/d full capacity.

If LUKOIL fails to recover its initial WQ2 costs in 2014-2015 (e.g. due to lower than expected production or geopolitical reasons) its funds from operations (FFO) net adjusted leverage will still be below our negative rating guidance and we are unlikely to take negative rating action, unless the amount of unrecovered investments substantially rises.

Stabilising Russian Oil Volumes
In 2013 LUKOIL's crude output in Russia increased by 1% year-on-year (yoy), due mainly to USD2.5bn upstream M&A. This is an improvement on 2012, when it reported a 1% drop in Russian crude production, and particularly on 2011, with a 5% yoy decline. Fitch expect that LUKOIL will stabilise oil production in Russia due to continued utilisation of horizontal drilling and hydraulic fracturing on brownfield sties in Western Siberia and the development of greenfield sites, including the Caspian shelf development and Timan-Pechora, and possibly more M&A.

Rising But Still Moderate Leverage
LUKOIL has historically maintained a strong credit profile, which allows the company to finance its ambitious capex programme and pay higher dividends without jeopardising its credit strength. We expect LUKOIL's FFO adjusted net leverage to increase to 1.1x by 2016 and to 1.3x by 2018 from 0.6x at end-2013. This is mainly due to: (i) declining oil prices as per Fitch's Brent price deck, (ii) lower profitability of downstream operations because the Russian government intends to equalise export duty on crude and dark oil products from 2015; (iii) high capital expenditure; and (iv) an increasing dividend payout. LUKOIL's FFO interest cover should remain comfortably above 10x. Even if our conservative assumptions are realised and LUKOIL's debt load increases, it should still remain one of the least leveraged O&G companies both in Russia and internationally.

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- Positive rating action on Russia would be replicated on LUKOIL, as LUKOIL's rating is currently capped by that of the sovereign and the company's Outlook constrained by the sovereign Outlook. (e.g. the Outlook would be stabilised if Russia's Outlook is stabilised).
- A significant diversification beyond Russia could potentially allow us to rate LUKOIL above the sovereign. However, we do not expect this to happen in the medium term.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Negative rating action on Russia would be replicated on LUKOIL.
- LUKOIL's aggressive investment programme, acquisitions or dividends, resulting in FFO net adjusted leverage exceeding 2.5x and FFO interest coverage falling below 10x on a sustained basis could lead to negative rating action.
- Failure to stabilise production in Russia and higher production decline rates for several consecutive periods could also trigger negative rating action.
- An increasing amount of unrecovered investments in WQ2.

LIQUIDITY AND DEBT STRUCTURE
Sound Liquidity, Comfortable Maturities:
At end-2013, LUKOIL had USD1.7bn in cash and USD2.6bn in unutilised committed credit lines compared with USD1.3bn of short-term debt. We believe LUKOIL may need to moderately increase its debt level to finance its ambitious capex programme and higher dividend payout as publically committed. If the international debt markets remain unavailable for some time we expect LUKOIL should be able to raise finance domestically.

LUKOIL's debt maturities are well balanced. At end-2013 only 28% of its debt was due within the next two years.