No. 1, 2008

Prospects for growth in the refining sector of the LUKOIL Group

Oil refining is a key area in the operations of the LUKOIL Group. The Company implements modern processes and stays by right in the forefront of the Russian refining sector, swiftly responding to all changes in the world market of petroleum products. In December 2007, the LUKOIL Board of Directors met in Moscow to adopt further measures to raise the efficiency of refineries and petrochemical plants of the LUKOIL Group.

Present-day realities

The Russian refining sector holds fourth place in the world in primary refining volumes after the USA, Japan and China: in 2006, it turned out 220 million tons of refined products. In terms of refining capacity, Russia is second to the United States only, operating 27 major and more than 50 small-sized refineries. However, the depth of refining in Russia (71%) is significantly lower than in most of the industrial countries (85 to 95%).

There are many factors behind this situation in the Russian refining sector. First, more than 80% of the capital assets is worn out, second, the resultant petroleum products are often of low quality, as the use of outdated power-consuming and non-ecofriendly processes makes it impossible to come out with products that can be competitive in international markets, therefore they have to be sold at a considerable discount. Many refineries are scattered unevenly across Russian territory and far removed from both sea terminals and foreign consumers, as their geography was dictated by considerations of strategic security at the time they were built that is more than 50 years ago. Besides, the current system of government regulation stimulates the volume of output rather than the depth of refining.

The technological backwardness of most Russian refineries is in many ways due to the low amount of investment over the past 15 years. And yet, some positive trends have already emerged in the development of the Russian refining sector. Today, the RF State Duma discusses the setting up of technological standards on fuel and car engines in order to bring down demand for low quality fuel and for cars with non-ecofriendly engines. Duma deputies also consider the problem of differentiating excises on fuel to stimulate the production of more ecological gasolines and Diesel oil.

Another incentive for development of the Russian refining sector can be seen in the introduction of zero customs duties for refining equipment, which should be effective in upgrading domestic refineries. Starting trade in various energy products, including petroleum products, at the Russian Fuel and Energy Exchange, which is currently being set up, is also expected to have a beneficial effect on the situation in the refining sector.

Prior to the introduction of a differentiated export duty, the refining margin in Russia was below the European level, but the situation was reversed as soon as it was introduced. In the second half of 2006, the Russian refining margin reached its peak values due to regressively diminishing export duties and limited reductions in wholesale petroleum products prices in Russia when the world prices had dropped.

The differentiation of export duties levied on light and dark petroleum products in November 2004 helped Russian refineries step up their production levels. Whereas before November 2004 the export duty on refined products had been 90% of that on crude oil, it dropped to 65% for the light petroleum products and to around 40% for the dark ones after that date.

The present-day structure of the Russian refining sector began to evolve in the early 1990s as soon as the privatization was over. Today, the sector operates 27 major refineries, 19 of which belong to the vertically integrated oil companies.

Over the past five years, substantial consolidation took place in the sector, as Rosneft acquired the refineries of the former YUKOS company and the Slavneft refineries were divided between Gazpromneft and TNK-BP. The so-called Refiners’ club came into being, with three to five major players accounting for 80 to 90% of total petroleum products output between them.

Maintaining the position of leadership

LUKOIL consistently applies modern processes to strengthen its leading position in the Russian refining sector and to swiftly respond to all changes in the world market of petroleum products. To sustain its development, the Company has designed an intensive growth program, which provides, inter alia, for capital investment in upgrading its refineries so as to raise their production efficiency and to comply with all the current and future norms and standards.

Crude refining and petrochemical production are key lines of the Company’s business. LUKOIL owns seven large modern refineries inside and outside Russia. Its four major Russian-based refineries (in Perm, Volgograd, Ukhta and Nizhny Novgorod) and two small-sized refineries cumulatively produce 44.1 million tons of petroleum products a year. Outside Russia, LUKOIL has three refineries: in the Ukraine, Bulgaria and Romania with the total annual output of 14.0 million tons.

The total capacity of the LUKOIL Group refineries stands at 58.1 million tons of crude oil a year. Hence active development of wholesale and retail petroleum products marketing in Russia, Eastern and Western Europe, former Soviet republics, and the United States. The sales network in 19 countries of the world comprises 5,793 gasoline filling stations, including franchisees (1,658 stations in Russia, 196 in the Baltic states, 442 in the CIS, 1,654 in Europe, and 1,843 in the United States) and 200 tank farm facilities.

Like other Russian companies, LUKOIL suffers from an imbalance between upstream and downstream operations. Yet out of all Russian companies, it is LUKOIL that displays the best refining-to-production ratio. LUKOIL’s priorities include increasing the Company’s shareholder value, raising the internal rate of return in the refining sector.

Moving forward

LUKOIL is constantly modernizing its refining capacities, reacting quickly to main market trends. The Company uses the latest technologies in modernization of its refineries in order to improve quality of production and reduce environmental impact. The Company is rapidly introducing European quality standards for motor oils at all its refineries. This will offer significant competitive advantages in the future and already ensures a price premium, reflecting the environmental and functional qualities of LUKOIL’s products.

At its meeting in December 2007, the Company’s Board of Directors defined the following priorities in enhancing the efficiency of refining and petrochemical operations by the LUKOIL Group: industrial safety, profitability and sustainable development. In order to achieve these objectives, a number of target programs have been devised. For instance, the Equipment Reliability Enhancement Program is aimed at securing process plant reliability while reducing workover time and increasing the interrepair cycle of Russian refineries up to four years, and of foreign-based ones to five years. The HSE Program for Industrial Safety, Protection of Labor and Environment Protection aims at reducing to zero the industrial accident and injury rate.

On the whole, the refining business sector was set the following tasks: optimizing production-to-refining ratio, enhancing the internal rate of return and securing competitive advantages by producing premium quality petroleum products.

The 2008-2017 General Plan for the development of LUKOIL refineries, devised by the Company as part of its Intensive Growth Strategy, envisages increasing refined products output to 65.7 million tons a year and jacking the Nelson Index up to 8.2 points by the year 2017.

The bulk of investment will be made in the first five years of the Plan for the following reasons: in 2009, the Euro-5 standard will be enforced in the EU countries, which will require substantial investments in fuel quality; the ban on the use of high sulphur (over 1%) fuel oil will necessitate construction of a black oil processing unit at LUKOIL Naftochim Bourgas AD; introduction of the Euro-4 standard in the Russian Federation will call for building a catalytic cracking plant at LUKOIL-Nizhegorodnefteorgsintez and LUKOIL-Volgogradneftepererabotka.

The Company’s investments into the refining sector have been categorized as follows, with due regard for priority and the macroeconomic context: first, bridging the gap between LUKOIL refineries and those of its competitors in terms of the Solomon System (minimum investments for maximum efficiency), regardless of the market situation; second, improving petroleum products quality and industrial safety, also regardless of the market situation; third, raising the level of conversion and the share of high added value products, that is, maintaining high prices and increasing the price difference between light and dark petroleum products; and finally, boosting refining capacity and retaining an easy export duty on dark petroleum products and a high refining margin for simple configuration refineries.

Division of the investments into categories such as quality, conversion and capacity helps minimize the risks and dependence on the macroeconomic conditions. Thus, a higher conversion rate brings about a 50 percent growth in the production of engine fuels and a 20 percent reduction in the output of fuel oil and vacuum gas oil.

LUKOIL moves ahead confidently along its development path, solving complex problems one by one in the downstream sector. The Company does not intend to rest on its laurels before its principal goal of securing a firm foothold on the summit of the world oil industry is achieved.