Energy Investment in Russia: The Empire Strikes Back

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1 : The Empire Strikes Back Stephen O Sullivan Washington 8 July ited Financial Group and Deutsche Bank ited Financial Group and/or Deutsche Bank do and seek to do business with companies covered in their research reports. Thus, investors should be aware that the firms may have a conflict of interest that could affect the objectivity of this report. vestors should consider this report as only a single factor in making their investment decision. SCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED AT THE END OF THE BODY OF THIS RESEARCH 1

2 verview Valuation Political background Macroeconomic environment Commercial environment Business and the state 2

3 aluation Financial multiples P/CF April July Today Yukos today 2.0 Yukos peak European EM Supermajor EV/EBITDA 04 Source: I/B/E/S, UFG Research estimates 3

4 aluation Asset multiples European Supermajor P/Reserves EM 4.0 July 03 April Russia today Yukos today Yukos peak EV/Production 04 Source: I/B/E/S, UFG Research estimates 4

5 olitical Background Putin re-elected with substantial majority in March 2004 Compliant Duma elected in December 2003 Reformist government installed in February 2004 Limited progress on reform Attractive returns + security of investment = positive investment climate Who is really in charge? 5

6 acroeconomic Environment Supportive external environment Limited but sensible government policies Most indicators look positive: GDP 6.2 % - current account: + $ 24.7bn - fiscal surplus: 1.3 % - inflation: 11.8 % - real exchange rate appreciation: 15 % Challenge remains to avoid Dutch disease and carry through reforms 6

7 acroeconomic Environment GDP growth vs. Brent price 10% 40 8% 6% 4% 20 2% 0% F 2005F 2006F GDP growth, % (LHS) Brent, $/bbl (RHS) 0 Source: Goskomstat, Bloomberg, UFG Research estimates 7

8 ommercial Environment Reserves Production Costs Taxes Infrastructure 8

9 ommercial Environment - Reserves ussia as a proportion of world oil reserves Russia as a proportion of world gas reserves Russia 6% Middle East 35% Europe 4% America 14% Middle East 65% Russia 31% Africa 8% Asia Pacific 8% urce: BP Statistical Review Asia Pacific 4% Africa 7% Source: BP Statistical Review Europe 9% America 9% 9

10 ommercial Environment - Reserves Sakhalin Kovykta 10

11 ommercial Environment - Production Russia production profile mbd Peak production, W. Siberian giant fields are on stream Industry collapses due to lack of investment and technical failures F 2013F Source: Interfax, UFG Research estimates Oil sector privatised, production stabilises Energy Strategy forecast Future production dependent on availability of new reserves and export capacity Ownership title confirmed by Putin, tax system improves, investment flourishes UFG forecast 2020F 11

12 ommercial Environment - Production Production growth, 2003/02 Sibneft Yukos Petrobras LUKoil Total BP ChevronTexaco PetroChina Tatneft RD/Shell ExxonMobil 0% -2% -2% 2% 1% 0% 5% 9% 7% Including 50% equity stake in TNK-BP 16% 54% Including 50% equity stake in Slavneft -5% 0% 5% 10% 15% 20% 25% Source: Company data, Deutsche Bank, UFG Research estimates 12

13 ommercial Environment - Costs Lifting costs, 2002 ExxonMobil ChevronTexaco RD/Shell Tatneft BP Petrobras LUKoil PetroChina Total Sibneft Yukos Source: Company data (SFAS 69) $/boe 13

14 ommercial Environment - Taxes Average tax rate 80% 70% 60% 50% 40% 30% Norway Russia exports Gulf of Mexico UK 20% 10% 0% $15 $20 $25 $30 $35 14

15 ommercial Environment - Infrastructure Murmansk St. Petersburg Moscow Nyuksenitsa Yaroslavl Nizhny Novgorod Usa Novorossiysk Samara Almetyevsk Ufa Tobolsk Surgut Omsk Oil pipelines Gas pipelines Angarsk To Daqing Bohai Bay (Korea) Perevoznaya 15

16 usiness & the State Massive shift in balance of power from business to the state Key issue is security of investment, not attractiveness Khodorkovsky affair destabilized market & sentiment Concerns of contagion to other oligarchs not so far Criminal and civil trials closely related Appearance of due process but not the substance Legacy of mid-90s privatisation which still needs to be addressed 16

17 ussia is changing rapidly 17

18 Contact details: Stephen O Sullivan (osullivan@ufg.com) Tel: Fax:

19 isclosures Rating key Underperform: This indicates that the analyst expects the stock to underperform the MSCI Russia Index by at least 10% over the subsequent 12 months Market Perform: This indicates that the analyst expects the stock to perform in line with the MSCI Russia Index (i.e. no more than +/ 10%) over the subsequent 12 months Outperform: This indicates that the analyst expects the stock to outperform the MSCI Russia Index by at least 10% over the subsequent 12 months For disclosures pertaining to recommendations or estimates made on a security mentioned in this research, please see the most recently published company report or visit our global disclosure look-up page on our website at We use APT-based discounted cash flow valuation as our primary basis for assigning investment ratings, as we believe it provides a superior tool for estimating company-specific risks compared with the capital asset pricing model. It also enables us to account for a much wider range of fundamental factors than comparable multiples valuation, which often fails to account for differences in capex plans, capital structure and growth rates. Given that our market discount is calculated on the basis of actual share prices, our ratings are always relative and reflect our expectations of outperformance or underperformance of particular stocks against the MSCI Russia Index, rather than absolute price movements. Our fair value is taken directly from our APT-based DCF model while our target price is the fair value multiplied by (1+ROE). The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s) about the subject issuer and the securities of the issuer. In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this presentation. Stephen O'Sullivan Additional information available upon request This document is for information purposes only and does not constitute an offer or solicitation to buy or sell securities. Information and opinions contained herein have been compiled or arrived at by United Financial Group ('UFG') from sourc believed to be reliable, but none of UFG or Deutsche Bank AG or any of its affiliates (collectively 'Deutsche Bank') and their respective principals and employees make any representations or warranties as to the accuracy or completeness hereof an nor do they accept any liability for investor losses arising from their use. Investors should make their own investment decisions using their own independent advisors as they believe necessary and based upon their specific financial situations an investment objectives when investing. This document is being furnished to certain persons as permitted by applicable law, and accordingly may not be reproduced or circulated to any other person. UFG, Deutsche Bank (and their respective principa and employees) may have positions or effect transactions in the securities referred to herein, may engage in securities transactions in a manner inconsistent with the research report and with respect to securities covered by this report, may sell to buy from customers on a principal basis and may serve as director of issuers of such securities. Disclosures of conflicts of interest, if any, are found at the end of the text of this report or on the Deutsche Bank website UFG or Deutsche Bank may act upon or use the information or conclusions contained in this document, or the research or analysis on which they are based, before publication of this document. Investing in Russia an Russian securities involves a high degree of risk, and investors should perform their own due diligence before investing. Particularly important to note, is that Securities denominated in foreign currencies and ADRs are subject to exchange rat fluctuations that may affect the value of the investment. Furthermore, past performance is not necessarily indicative of future results. Neither UFG nor Deutsche Bank has any obligation to update, modify or amend this report nor to otherwise notify reader thereof in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate, or if research on the subject company is withdrawn. Prices and availability financial instruments are also subject to change without notice. The views expressed in this research report accurately reflect the personal views of the authors of this report about the subject securities and issuers and do not necessarily reflect th views of UFG or Deutsche Bank. No part of the compensation of the authors of this report will be directly or indirectly related to the specific recommendations or views contained in the research report. This report has been approved for publication the United Kingdom by UFG (UK) Limited and is also communicated by Deutsche Bank AG London, 1 Great Winchester Street, London EC2N 2EQ, a member of the London Stock Exchange. UFG (UK) Limited is regulated by the FSA for th conduct of Investment Business in the United Kingdom and is a member of the London Stock Exchange. In the U.S. this report is also approved and/or communicated by Deutsche Bank Securities Inc., a member of the NYSE, the NASD, NFA an SIPC, and also by UFG (US) Inc., a member of the NASD and SIPC. This report is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. and in Singapore by Deutsche Bank AG, Singapo Branch. In Japan, this report is approved and/or distributed by Deutsche Securities Limited, Tokyo Branch. This material is not intended for the use of private investors. Copyright 2004 by United Financial Group. All rights reserved. Please c source when quoting. Additional information relative to securities, other financial products or issuers discussed in this report is available upon request. 19

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