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A year of regulatory change

From a regulatory standpoint, 2019 will see a plethora of regulatory changes in Russia, following a regulatory pause over 2018. Presidential elections held in April 2018, subsequent changes in the composition of the new government, including the appointment of Finance Minister Anton Siluanov as first deputy prime minister, as well as the appointment of Dmitry Kozak as deputy prime minister in charge of the energy sector, led to a series of regulatory initiatives that will culminate in three groups of regulatory changes from 1 January 2019:

1.The commencement of the final phase of the tax manoeuvre with Federal Law No. 301-FZ On amending part two of the Tax Code of the Russian Federation, dated 3 August 2018. Another key part of this regulatory change was the adoption of Federal Law No. 305-FZ On amending article 3.1 of the Custom Law of the Russian Federation, on the same date, which officially established the export duty rates for 2019-2024 and also reviewed the list of exempt oil fields. The parameters of the tax manoeuvre were subsequently adjusted with the adoption of Federal Law No. 424-FZ On amending part two of the Tax Code of the Russian Federation and certain fiscal legislative acts, dated 27 November 2018.

2.The introduction of the excess profits tax regime with Federal Law No. 199FZ On amending parts one and two of the Tax Code of the Russian Federation, dated 19 July 2018. The parameters of the regime were subsequently adjusted with the adoption of the Federal Law No. 424-FZ On amending part two of the Tax Code of the Russian Federation and certain fiscal legislative acts, dated 27 November 2018.

3.A more structured approach to the control of domestic gasoline and diesel prices in Russia. We note that Federal Law No. 305-FZ On amending article 3.1 of the Custom Law of the Russian Federation, mentioned above, has formally enshrined in law the government’s right to impose a prohibitive 90% export duty on petroleum products if the government is not pleased with the absolute level of domestic product prices. The government aims to control domestic prices via a so-called dampening coefficient that will serve to keep the average domestic wholesale oil product price for gasoline and diesel within a 10% range of a targeted level (set as RUB56,000/t for gasoline and RUB50,000/t for diesel in nominal 2019 prices). While talked about throughout most of 2018, the concept was finalised on 27 November 2018 with the adoption of Federal Law No. 424-FZ On amending part two of the Tax Code of the Russian Federation and certain fiscal legislative acts.

We note that the grouping of these changes in the three categories above is rather arbitrary. While they seem to address seemingly unrelated regulatory or fiscal issues, many of the concepts, introduced by the related laws, are intertwined with other regulatory areas both formally (e.g. the dampening mechanism introduced to control retail prices will have a direct mathematical impact on the calculation of the mineral extraction tax [MET]) and informally (as a more strict approach in one regulatory aspect may have been compensated by a softer stance in a seemingly completely unrelated area). Still, we find this grouping useful if not for modelling purposes, but to set a framework for our discussion below.

Regulatory change 1: Final phase of the oil tax manoeuvre

The commencement of the final phase of the tax manoeuvre, which will see a gradual reduction in the export duty on crude and its replacement with a higher MET during 20192024. This process will be accompanied by a necessary suite of other tax changes, required to keep the status quo in relation to existing upstream tax breaks as well as downstream tax incentives (including negative excise tax on crude oil used for domestic refining, effective 1 January 2019). We have analysed the key parameters and effects of the tax manoeuvre here and here, viewing it as broadly neutral for the sector. The parameters of the tax manoeuvre were subsequently adjusted with the adoption of

Renaissance Capital

14 December 2018

Oil & Gas

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Federal Law No. 424-FZ On amending part two of the Tax Code of the Russian Federation and certain fiscal legislative acts, dated 27 November 2018, in two specific aspects: amendments to the dampening mechanism and the expansion of the list of refineries subject to a higher logistical coefficient.

The dampening mechanism was introduced to allow the government to control retail petrol prices in Russia. It will be used to increase or reduce the amount of negative excise tax to reduce volatility of end-prices, compensating the oil companies with 60% (in 2019) and 50% (thereafter) of the difference between the export netback and the target price within a 10% range. If the actual netback exceeds the target price, the negative oil excise will increase, reducing the tax burden for the refineries. Conversely, if the actual netback price is below the target price, the size of the negative oil excise will be reduced, thus increasing the tax take for the government at the expense of the customer. Should the positive difference exceed 10% (i.e., actual wholesale prices are more than 10% above the target prices), the dampening mechanism will not apply and we understand the government can revert to more draconian measures, such as the introduction of the prohibitive 90% export duty rate in accordance with the powers given by Federal Law No. 305-FZ On amending article 3.1 of the Custom Law of the Russian Federation. Should the negative difference exceed 10% (i.e., actual prices are less than 10% below the target price), the original version of the law assumed no action, while the 27 November 2018 version has no downside limit for the dampening mechanism, effectively meaning that retail petrol prices in Russia will never be reduced: if the oil price goes down, the government’s tax take will increase via a reduction of the negative excise tax.

Despite its superficial simplicity, the mathematics behind the calculation of the dampening mechanism is quite complex, as the government and the oil companies have each tried to negotiate a favourable outcome for themselves. Therefore there are several balancing coefficients, kickers and compensatory mechanisms, which, among other things, have resulted in an additional coefficient that will be introduced to the calculation of the seemingly unrelated MET. We calculate that this coefficient will kick in if indicative prices are below export netback, and will amount to RUB32/bl ($0.5/bl) or 2% of our estimated average 2019 statutory MET rate, on our estimates. In essence, the rationale behind this approach is to redistribute some of the cost of the damper mechanism from the government to the upstream segment when export prices are too high, relative to the target domestic price level.

The 27 November 2018 changes in the legislation also expanded the geography of the application of the regional (logistical) coefficients, which are supposed to provide additional compensation to geographically disadvantaged refineries in Russia. In particular, a coefficient of 1.1 was introduced for Kemerovo Region and Khanty-Mansiysk Autonomous Region. In our coverage universe, this will affect the smaller refineries of Rosneft (Nizhnevartovsk, Krasnoleninsk) and LUKOIL (Urai), as well as Gazprom’s Surgut ZSK. In total, the changes will generate small additional benefits for both Rosneft and LUKOIL and represent less than 1% of our current 2019 EBITDA estimates for these two companies, respectively. While the introduction of the regional coefficient in Khabarovsk Region was also widely discussed (this would have benefited Rosneft’s Komsomolsk refinery), the government decided against such move on the basis that Russia’s Far East is a premium market. Instead, the government has opted to support the region by increasing the amount of negative excise tax on the production of high-sulphur fuel oil (HSFO) used for marine bunkering (the RUB1,000/t negative excise tax on HSFO will apply to the whole industry from 2022; the government has now favoured the Khabarovsk Region by bringing this tax forward to 2019 and raising the base level by RUB2,100/t for 2019-2021 and RUB1,100/t from 2022, benefiting Rosneft’s Komsomolsk and independent Khabarovsk refineries).

Taking into account the above-mentioned changes to the Russian petroleum industry legislation, as well as our update for the oil price outlook for 2019, we review the impact of the tax manoeuvre on the budget in 2019-2024. We estimate the effect will stand at

Renaissance Capital

14 December 2018

Oil & Gas

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Figure 23 shows export margins for the three principal refined products compared with crude oil. These subtract from Mediterranean prices the high cost of displacing products and the export duties levied on the way out.

Figure 23: Crude and refined product export margins, $/bl

Note: West Mediterranean quotes.

Netback calculated after cif-to-fob adjustment, export duty, and typical transportation costs from Perm to Novorossiysk for gasoline and diesel and from Nizhny Novgorod to St Petersburg for fuel oil.

Source: Bloomberg, InfoTEK, Renaissance Capital

These margins (with some exception for fuel oil) were mostly negative in 2016 and 2017, indicating that the domestic sales channel for light products was generally more profitable than the export channel, although arguably the premium has shrunk in recent years. The situation has changed from December 2017, when the export margin for gasoline turned positive in the midst of growing government concerns over domestic prices. The situation exacerbated during the course of the year, with October 2018 seeing positive export margins for all three key refining products as well as crude oil for the first time since February 2015. So far in 2018 YtD, the average discount for the domestic gasoline price over the export netback was $2.8/bl (vs an average premium of $2.7/bl in 2017). There is less pressure on the domestic diesel price, which is a less socially-sensitive product, with the average domestic premium of $5.9/bl in 2018 YtD declining marginally from $6.6/bl in 2017. Some oversupply in fuel oil continues, but this has become a less pressing issue with recent refinery upgrades. Low domestic demand and the generally reduced availability of the product (Russia is the world’s largest exporter of fuel oil, with its export volumes down by 15% in 2017 and another 10% in 10M18) helped to maintain a positive export margin of $6.3/bl in 2017, which declined to just $0.5/bl in 11M18.

From the beginning of 2011, the government began applying pressures on domestic product prices. 2011-2012 saw the value of the domestic product basket diverge significantly from the export basket value, though trends were then largely parallel until 2014 (as shown in Figure 21). Since that time, the reduction in international oil and product prices, combined with upgrades of Russian refining capacities and the associated start of the first tax manoeuvre, has helped the domestic product basket to again equalise with its export value.

Late 2017 and 2018 saw the Russian government’s obsession over petrol prices grow, first in the run-up to the April 2018 presidential elections, and later in the face of growing oil prices and higher domestic taxes, which saw wholesale gasoline and diesel prices increase by 14% and 31% YtD, respectively. The government has tried to encourage oil companies to comply with voluntary price restrictions, with deputy prime minister Kozak suggesting that “altruism” was required, but this is an approach that is not compatible with the free market concept. Traders were immediately accused of re-exporting oil products that could be bought cheaply domestically, leading to shortages being reported in certain

Renaissance Capital

14 December 2018

Oil & Gas

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Russian regions; the oil companies themselves found other ways of increasing effective prices, such as through the reduction of previously offered discounts or even the introduction of special service charges. The government has threatened to respond with a prohibitive export duty on oil products, which is still a risk. However, we understand the government’s preferred approach is via a balancing coefficient in the negative oil excise formula, which will act to counter-balance oil price and exchange rate movements to keep domestic product prices within a desired range.

The agreement between the government and Russia’s vertically integrated oil companies on 7-12 November outlined the new indexation-based model for Russia’s domestic petrol prices, targeting a 1.7% hike to the target price level from 1 January 2019 to compensate for the increase in VAT to 20% (from 18%), followed by inflation-based indexation from 1 February 2019. As stated earlier, 60% (in 2019) and 50% (thereafter) of the difference between the actual export netback and the target price within a 10% range will be compensated by the budget through the dampening coefficient applied to the negative oil excise tax mechanism.

In addition, Federal Law No. 424-FZ On amending part two of the Tax Code of the Russian Federation and certain fiscal legislative acts, dated 27 November 2018, has created a new mechanism for the government to introduce prohibitive export duty rates on petroleum products in the event of domestic price shocks. We currently do not anticipate that this measure will be implemented, but it will act as a deterrent against unexpected domestic petrol price hikes by Russian oil producers. According to the new mechanism, the government will monitor domestic product prices on a rolling three-month basis. If price hikes exceed 15% over this period, the government will have the power to increase the marginal crude oil export duty up to 45% (if the Urals price is above $25/bl), from 30% currently, and simultaneously increase the marginal export duty on gasoline and diesel to 60%, from 30% currently, for a duration of up to six months. In such an event, the marginal export duty rate on gasoline and diesel will approach 90% of the initial marginal export duty rate on crude oil, resulting in lower crude oil and oil products export netbacks, thereby reducing the incentive to export.

To support independent retail fuel stations, the government has also introduced a binding condition for the vertically-integrated oil companies to sell a minimum share of 10% and 5% of their total gasoline and diesel production, respectively, on the domestic commodity exchange, or else risk losing their negative oil excise allowance.

Figures 24-26 illustrate the effect of the government’s approach to price regulation through the use of the dampening mechanism and prohibitive export duties:

▪Figure 24 shows the sensitivity of an oil company’s EBITDA to changes in the domestic wholesale price (for example, as international oil prices fluctuate but the Russian government keeps the domestic indicative price unchanged). In such an event, the oil companies will have a normal downside risk, but a limited upside risk as the government should introduce a prohibitive export duty if the domestic wholesale price exceeds the indicative price by more than 10%.

▪Figure 25 shows the sensitivity of an oil company’s EBITDA to changes in the indicative price. Other things being equal, the government may want to raise the indicative price to increase its tax receipts (via a reduction in the negative excise tax it pays to the refiners). This would be an example of using retail price regulation for the government’s fiscal benefit. On the other hand, should the refining industry become unprofitable, the government may decide to lower the indicative price to support the industry through a lower tax take.

▪Finally, Figure 26 shows the sensitivity of an oil company’s EBITDA to changes in export netbacks. Assuming the oil companies keep domestic wholesale prices flat to please the government, they will receive compensatory payment via the dampening mechanism if export netbacks rise (although only up to a certain limit).

Renaissance Capital

14 December 2018

Oil & Gas

Construction of catalytic cracking (1.1mn tpa), hydrotreatment (2.5mn tpa), MTBE (0.04mn tpa) and alkylation (0.158mn tpa) units.

New hydrocracker (2mn tpa) and gasoil hydrotreatment (1.6mn tpa) units.

New delayed coking (3mn tpa) and hydrocracking-hydrotreating (3.6mn tpa) units, as well as construction of the vacuum block.

Construction of hydrocracker (2.2mn tpa) in 2023. MTBE unit is scheduled. Studying the feasibility of constructing a new atmospheric-vacuum distillation unit (5mn tpa).

Ufaneftekhim

Ufa

Novo-Ufa

Upgrade of the hydrocracking unit (capacity increased by 0.6mn tpa).

Construction of a hydrotreating unit of 1.3mn tpa in 2014.

Construction of alkylation (0.448mn tpa) and hydrogen production (0.153mn tpa) units.

Construction of a hydro-aromatisation unit and new sulphur capacities. Reconstruction of distillation and renovation of hydrocracker units. Reconstruction of the aromatics complex.

Construction of the delayed coking unit (2mn tpa) and new sulphur capacities. Reconstruction of the distillation units.

Reconstruction of the distillation units. The expansion of the hydrocracker unit was cancelled.

Construction of additional isomerisation (0.65mn tpa) and gasoline Moscow hydrotreatment (1.2mn tpa) units. Reconstruction of the gasoil

hydrotreatment unit (2mn tpa).

Construction of "Euro+" refining complex including 6mn tpa of AV-distillation, 1mn tpa of catalytic reforming and 2mn tpa of diesel hydrotreating capacity to replace outdated capacities. Reconstruction of the catalytic cracker unit up to total capacity of 2.4mn tpa. Reconstruction of the primary distillation capacities. Construction of the Deep Oil Refining Complex in 2022.

Construction of the delayed coking unit (2mn tpa), hydrocracker (2.9mn tpa), hydrogen (0.1mn tpa) and high-index oils (0.25mn tpa) units. Isomerisation

TANEKO (0.42mn tpa) and naphtha hydrotreating (1.1mn tpa) units launched in January 2018, followed by diesel (1.6mn tpa) and kerosene (0.5mn tpa) HDTs in July 2018. Upgrade of the primary distillation capacities in 2013.

Expansion of the primary distillation capacity by 6mn tpa. Construction of catalytic reforming unit (0.714mn tpa) and addition of the vacuum block to the visbreaking unit in 2018, vacuum gasoil hydrotreater (0.85mn tpa) in 2019, catalytic cracker (1.1mn tpa) in 2020, aromatics production line (0.714mn tpa), middle distillates HDT (3.7mn tpa), alkylation, hydrogen and MTBE units in 2021-2022. A new hydrocracking unit is scheduled for 2026 (1.2mn tpa). A test hydroconversion unit is scheduled for a pilot run (0.1mnt pa) in 2019, to be constructed at full scale (2mnt pa) in 2026.