Research Notes

2004 Results.
Forecasts and Recommendations for 2005.

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Oil & Gas

Given the performance of the Russian stock market during the last few months of 2004, a situation emerged where nearly all oil and gas companies are undervalued. However, in framing our 2005 recommendations we have tried to pick stocks with “ironclad” growth potential, while steering clear of issuers associated with heightened political or corporate risks.

As a result, our choice does not look surprising, as we continue to be upbeat on Lukoil and Gazprom locals.

Utilities

The year 2004 was one of pivotal headway in the domestic utilities sector. Active measures were taken to reorganize regional energo companies and establish power generation concerns. Russia’s competitive power market celebrated its 1st anniversary. By the end of the year, we can safely say that the reform process is gaining momentum and there is every reason to assume that the results of the ongoing reform process will raise efficiency and, hence, improve the investment appeal of Russian energy companies.

Metals and Mining

There can be no doubt that 2004 was exceptionally profitable for metal makers. We have reason to believe that 2005 will yield more modest results owing to a slower pace in demand growth. Overall, we maintain our positive forecast for 2005 and do expect any steep production slump in the industry, as opposed to the cycles in previous years in the ferrous metallurgy where steady growth in output volumes was followed by a sharp decline.

Market Overview

Shortly before the New Year, after reviewing the major events and processes of the year, we decided to summarize the market’s overall results and issue our forecasts for 2005.

By and large, 2004 results are controversial and it is on easy matter to say whether they are positive or negative for the Russian economy and the equity market.

Looking back at the past year, we can say that the news flow was tense and the market was abuzz with a number of key events: power industry restructuring, Gazprom reform, privatization of state-owned telecom holding Svyazinvest, structural changes in the Russian oil sector, ongoing redistribution of assets, tax claims filed against Russia’s largest companies (Yukos and VimpelCom) and problems in the banking system.

On the other hand, the Russian financial system became stronger, the stock market expanded, a number of successful IPOs and major bond placements took place, while corporate governance standards improved at many companies. The favorable price climate on global raw material markets allowed many Russian companies to post stellar results, expand at a faster pace, and strengthen their operations. The presidential elections, which occurred in the first quarter of 2004, pushed Russian stock indices to all-time highs.

Russian equity market: latent growth

The first thing that becomes readily apparent is the fact that Russia’s main stock indices, which are benchmarks of investment activities, ended the year not far from the level reached at the beginning of the year: by the close of the December 24 trading session the RTS index had advanced by a mere 5.3% year-on-year (597 vs. 567), while MICEX looked a bit better, up 6.4% (547 against 514).

However, it should also be noted that Russian oil major Yukos, as one of Russian’s foremost blue chip companies (now former), which crashed 12-fold year-on-year, is to a large extent the reason behind the market’s dismal showing. However, if we were to discount the tragic chain of events surrounding the Yukos case, i.e. remove the oil company’s stocks from the list of securities tracked by market indices, the latter would have performed much more robustly.

In addition, it should be noted that trading volumes on Russian stock exchanges climbed substantially over the last 12 months. For example, volumes of stocks tracked by the MICEX index surged by nearly 70% year-on-year. While growth in both RTS and MICEX indices was more modest, this figure may also be viewed as an upswing in speculative trading.

As for sector indices, investors preferred to buy into stocks in different sectors at various times of the year and here we can single out the leading sectors and those which ended up deep in the red.

The metals and mining sector fared the worst, although there are some caveats. Shares of NorNickel account for the bulk of this sector (ranging from 60% to 80% at different times), and, consequently, a decline in the metal giant’s stocks shaped the overall picture of the sector’s performance. And if we factor in the fact that most stocks in this sector are those issued by ferrous metal producers and NorNickel is involved in non-ferrous metal output, and try to look at the metal sector’s index not counting this metals giant, the general picture will look quite different:

Thus, if we do not take into account all the negative factors attributed to specific issuers, it is plain to see that the Russian equity market ultimately posted rather strong performance.

Was the Yukos Case a Growth Catalyst or Did it Scare Off Investors?

On the one hand, the events that surrounded besieged oil major Yukos and Russia’s No. 2 mobile phone company VimpelCom and riveted investors’ attention most of all should have sent us a signal about the tightening of fiscal discipline in the country, while on the other hand the methods and modus operandi used by state authorities in this sense have demonstrated that the interests of specific financial and industrial groups can still prevail over state interests and show signs of political coloring.

At this point, it is hard to forecast whether 2005 will witness a similar case like that of Yukos. We are inclined to believe that even if similar tax claims are filed against Russian major companies, they would not have such catastrophic effects for these entities. First of all, the state must realize that the Russian stock market cannot withstand another devastating blow it suffered following the meltdown of Yukos and the idea of extensive foreign investments in the national economy cannot be laid to rest. Secondly, at present the opposition oligarchs are in the shadow. Thirdly, those who resorted to tax scams have had enough time to think over their position and smooth over controversial issues with tax authorities and settle their debts.

In the event that the Yukos affair turns out to be a one-off phenomenon, the market should be able to shake off the tremendous stress that plagued it over the past twelve months and then we should expect to see vigorous growth on the equity market.

As for those investors who are not willing to accept the risks associated with such large-scale witch-hunts, we would recommend buying into stocks of companies whose owners and management are connected with state authorities or under state control (Gazprom, Surgutneftegaz, Sberbank, Tatneft, Rosneft’s subsidiaries and Russian power companies).

The stock the above companies may be referred to as defensive stocks. Under the traditional meaning of such instruments, they include stocks of legal entities not exposed to changes in the economy (foodstuff manufacturers, utility companies, etc.). Under the current economic conditions in Russia, these companies involve those that are loyal to or controlled by the state. As political risks in Russia largely fuel market volatility, a heavier weightage of such companies in conservative investment portfolios will adequately hedge against potential negative changes in Russia’s political climate.

However, one should bear in mind that such companies, as a rule, are less efficient and marked by low or zero pace of development than privately-owned businesses, not to mention soft corporate governance standards and poor observance of minority shareholder rights.

Has Investment Appeal Been On the Rise?

For various categories of investors the investment appeal of different shares is determined by the investment horizon, risk tolerance and investment targets.

We have heard on numerous occasions that one of the government’s top priorities today is to raise Russia’s investment appeal in the eyes of investors, create conditions to draw foreign direct investments and portfolio investments into the country. A great deal has been done in this respect and we can see some positive results in this area.

Russia’s investment appeal is dependent on many factors, including stability of the financial system and its creditworthiness, investment climate, guarantees for asset preservation and economic growth prospects.

What was achieved by the end of the year? Here are some cold hard figures:

1. Russia’s GDP 2004 growth rate is expected to be roughly 6.8%. According to Russian President Vladimir Putin, this figure is equal to the annual average growth rate of the national economy over the past five years. Meanwhile, in dollar terms 2004 GDP per capita will be about $4,000 in 2004, i.e. twice as much as in 2002 and a 3-fold rise against 1999.

2. Fixed investments in 2004 jumped by more than 10%. “Slightly less than in 2003, but, overall, the figure is good”, President Putin said.

3. Commodity imports surged by nearly 25%.

4. Exports nearly doubled imports.

5. Russia’s international currency reserves rocketed 70% year-on-year and reached an all-time high of $120 bln, i.e. more than the country’s foreign debt.

6. The country’s stabilization fund topped $20 bln.

7. Since 1999 the Russian Federation has reduced its public debt by one-third and its share in GDP plunged from 60% to 20%.

8. Given 2004 results, foreign direct investments grew by 60% year-on-year to $10 bln.

9. The Russian budget ran a surplus for the fifth straight year.

Nevertheless, one cannot help noting problematic issues that remain unresolved from previous years and which have arise in recent months: a noticeable drop in direct investment growth, inability to meet the official GDP target, escalating inflation, rising capital flight and the fact that the results achieved are based on favorable climate on global commodity market (which the Russian government failed to capitalize on), and a slew of other problems, which are too numerous to count. In addition to that, Russian PM Mikhail Fradkov recently admitted that many opportunities to raise economic growth have been exhausted.

But the figures speak for themselves and we can safely say that they were pretty good.

Returning to the issue of investment appeal, it is important to note that Russia is an EM country. Due to heightened investment risks, much to our chagrin, Russia has to date mostly seen funds flowing in as venture capital, hedge fund capital and speculative equity funds, since these risks spooked major conservative portfolio investors (investment and pension funds) and the Russian stock market has not been the recipient of any of these funds.

Be this as it may, taking into account Russia’s upgrade by several international rating agencies, this situation could start to turn around.

Foreign investors believe in Russia

Russia’s strong macroeconomic performance was marked by the upgrade of its ratings by two international rating agencies, Moody’s and Fitch, to investment grade. Russia has seen no upgrade from Standard & Poor’s, the last fortress, which is more cautious about the country’s political risks and is no hurry to award the coveted upgrade.

Even today, after receiving investment grade ratings from Moody's and Fitch, Russia could theoretically attract sizeable portfolio investments, as, according to investment statements from conservative investment funds, they are entitled to allocate part of their funds to shares of countries which hold investment grade rating from two global rating agencies. Understandably, this would be a tiny amount of these funds’ assets (1-2%), nonetheless, given the size of the assets they manage, and taking into account the fact that they are larger than hedge funds and EM funds, potential investments in Russia could rise considerably in monetary terms.

Summing up the situation, here are some relevant quotes from the media:

“International rating agency Fitch upgraded Russia’s ratings to investment grade. The country’s long-term foreign and national currency debt rating was raised to BBB - from BB+, and the ceiling of the country rating to investment grade of BBB- from BB+. Short-term rating was upgraded to F3 from B, ratings of 5th and 8th foreign currency bonds were raised to BB+ from BB. All ratings hold stable outlook. Upgrade of Russia’s sovereign rating to the investment grade level underscores the fact that in recent years the Russian Federation has substantially improved its creditworthiness, according to the agency. Excellent macroeconomic indicators, sustained by record high crude oil prices and well thought out financial policy have helped the country considerably reduce its foreign and public debt, accumulate currency reserves and ramp up its stabilization fund”.

“Standard & Poor’s, international leading rating agency, also upgraded in January 2004 Russia’s ruble credit rating to BBB-“.

“This summer (2004) Moody’s, the third largest rating agency, notched up the Russian Federation’s sovereign credit rating”.

“This means that having granted investment grade rating to Russia all leading rating agencies have tacitly advised foreign investors to boost their investments in the Russian economy”.

Helen Hessel, sovereign ratings director at S&P, stressed on October 8, 2004 that an upgrade of the country’s credit rating reflects, first and foremost, its achievements in reforming the financial and banking sectors. The judiciary reform and protection of ownership rights in Russia are other determining factors. Hessel explained that while adopting rating upgrade decisions, her agency factors in the full scope of reforms, including restructuring of natural monopolies and protection of ownership rights, but the vital issue is creation of a flexible monetary policy which can give us stronger grounds for awarding investment status to Russia. At the same time she pointed out that the run on the Russian banking sector in summer 2004 looked more like a riot than a crisis. Over the past several years the possibility of upgrading Russia’s sovereign rating has been restrained by the country’s weak banking system”, she said.

“Now the rating agencies, in all likelihood, have no doubts that the reform process is in full swing in Russia. Officials of International Finance Corporation, the investment arm of the World Bank, stated in September that all in all Russia has created favorable conditions for conducting business”.

We venture to say that Western investors have already started to change their attitude towards Russia for the better and little time will pass before we will see fresh cash flowing into the country.

Summing up

Summing up the above, we would like to point out the following:

1. Overall, we can say that Russia has a stable political system, high economic growth rates, quite a reliable financial system, improved conditions for investments and positive developments in the social sphere.

2. The overall growth of the Russian equity market will depend on the macroeconomic indicators Russia will show in the future, bolstering of political stability, the state’s transparent and fair actions in relation to investors (improvement of which would lead to an upgrade of Russia’s ratings, which would undoubtedly fuel a rise in investments).

We will carefully monitor the train of events this year and for the time being we can say that we are upbeat on development of the Russian stock market in 2005.

We shall now examine the events that took place in domestic sectors and their prospects, as seen by our sector analysts.

Oil & Gas Sector

Highlights of 2004

Conducting an in-depth analysis of events that occurred in 2004, we have differentiated four events, complex consideration of which, in our view, gives a clear picture “where we are heading” or “what we are being driven to”, to be more precise.

1. Demise of Yukos. There could be endless debates on whether the tax claims and accusations filed against the oil major’s majority shareholders were fair, but the political coloring of the Yukos affair is plain to see. In the battle between Yukos, Russia’s largest crude oil exporter, and the state, represented by the Federal Tax Service, the latter came out on the winning end.

2. The Gazprom-Rosneft merger. The primary objective of this transaction is the state’s keen aspiration to gain full and unwavering control over the activities and earnings of the Russian gas monopoly and to establish a major state-owned oil corporation. The merged company will become Russia’s second-largest enterprise by oil production and could vie for first place in the years to come.

3. The deal between ConocoPhillips and Lukoil. Formation of an alliance with the US oil major will enable Lukoil not only to expedite development of oilfields in the Timan-Pechora region with crude oil reserves estimated at 10 mln bbl, but also to gain access to advanced technologies and expertise in oil extraction. Moreover, the American oil company could be instrumental in assisting Lukoil to expand its presence on international market.

4. Acquisition of a 25% + 1 share stake in Novatek, Russia’s largest independent gas producer, by French concern Total. To complete the transaction the parties need approval from the Federal Anti-Monopoly Service, which has yet to be granted. In any case, this is the first transaction in which a foreign strategic investor is attempting to acquire an equity position in an Russian independent gas producer.

As for last two transactions, Russian President Vladimir Putin gave the green light and ordered to keep these deals under tabs, despite obvious benefit for the Russian companies.

Based on the foregoing, we have arrived at the logical conclusion that Russian state authorities have become far stronger and will be sparing no efforts to solidify their role and participation in major corporations. We may therefore venture to say that this trend will spill over into 2005 and we will see state authorities intensifying their role in keeping the national economy under control, especially such high-yield sectors which are capable of putting pressure on the global community as the oil industry.

Changes in Russian Oil and Gas Companies’ Market Cap in 2004

Source: RTS, Finam estimates

What to look for in 2005

We expect FY 2005 to deliver growth to all Russian oil-and-gas stocks across the board. We are of the opinion that no matter how the Yukos affair plays out, the market appears to have priced in all negativity and is poised for growth.

Nonetheless, in the process of framing our 2005 stock recommendations we have picked the plays that are least exposed to political and corporate risks. For this reason, we stuck to our previous recommendations and .

There are two scenarios where the market could be sent into a tailspin:

• If, based on results of Yukos management or its majority shareholders’ lawsuits with European and American courts seeking to invalidate the sale of YuganskNG, judicial authorities were to issue a ruling to freeze export revenues of the oil production unit’s purchaser or those that acquired the distressed oil major’s assets, although Gazprom and Rosneft appear to have taken preemptive measures to guard themselves against such an outcome.

• If the Yukos affair turns out to be the prototype in a long chain of similar cases. In this case, investors would be well advised not to make any long-term investments in Russian stocks, as the Russian equity market is extremely sensitive to news of this nature and inevitably responds with an immediate nosedive on the part of all traded stocks.

There is still a chance for imbalance to be created on the market if Gazprom, represented by Gazpromneft-2, continues to make attempts to gobble up other oil assets. It would be quite logical, but presently, in our view, it makes no sense to set the timeframe for events of such kind. We will definitely revisit this issue when the curtains are lifted on the final results of the Yugansk auction, the sale of Gazpromneft and the final scheme and terms of the Gazprom-Rosneft merger.

2005 Forecasts

In attempting to forecast how the Russian equity market will perform in 2005, we find it reasonable to make the following assumptions:

• Urals crude oil will not fall below $30/bbl.

• We do not expect any major overhaul of the Russian taxation system or rising tax burden in the oil and gas sector.

• We refrain from conjecture on what the fate of Yuganskneftegaz, sold off on December 19, will be. No matter what legal entity finally places this oil production unit on its books, its market capitalization, not counting the synergy effect from the merger, will jump by approximately $10.4 bln to $13.3 bln (according to Dresdner Kleinwort Wasserstein’s figure of $10.4-$17.3 bln).

Companies

Lukoil is the oil company with highest transparency and strongest corporate governance track record.

• The anticipated results of Lukoil for 2004 look better than previously expected: net consolidated profit is expected to be in the ballpark of $8 bln which is double the same indicator for 2003.

• Based on 2004 operations, Lukoil is expected to extract around 86.7 mln tons, or up 6.4% on 2003. The consolidated oil production in 2005 is projected to be 90.2 mln tons, i.e. a 4% increase on the oil company’s 2004 forecasts.

Lukoil will press ahead with implementation of the joint project with US oil major ConocoPhillips to tap oil and gas fields in the northern part of the Timan-Pechora oil-and-gas region. The project is marked by high efficiency, as it will enable Lukoil to boost crude exports by rerouting Transneft’s crude export itinerary (oil will be pumped through the pipeline to Lukoil’s Varandei terminal on the Barents Sea (Nenets Autonomous District) and then tankered to international markets).

As far as foreign assets are concerned, in 2005 we expect Lukoil to continue playing an active part in implementing projects on Kazakhstan and Azerbaijan’s Caspian Sea shelf and tapping Uzbekistan’s Kandym group of oilfields and those in Saudi Arabia, Egypt and Colombia on a PSA basis.

• Consolidated gas output in 2005 is projected at 7.8 bcm (up 20%) due to the launch of commercial development at the Nakhodka field in the Bolshekhetskaya Trough (the Yamal-Nenetsk Autonomous District). Thanks to this project, Lukoil will manage not only to ramp up gas output, but also implement another beneficial project with Russian gas giant Gazprom – in 2005 the oil company intends to pump gas through the gas monopoly’s pipe (0.8 bcm) and boost gas production up to 8 bcm by 2006.

• Taking into account the refining and sales segment, the oil company should be able to considerably raise crude oil exports which, factoring in supplies to foreign refiners, are expected to be 49 mln tons, i.e. 11% above 2004 export projections.

• ConocoPhillips Inc. will most likely be taking proactive measures to up its stake in Lukoil to 20%, which will contribute to further growth of the oil company’s market capitalization;

• With US ConocoPhillips among principal shareholders, we are not looking for Lukoil to alter its dividend policy, namely issues related to payment of interim dividends as well as their amounts.

Overall, Lukoil is likely the most politically and economically stable company going into 2005. The major is marked by a clear strategy, effective investments, tough management-controlled opex and transparent financial statements. Tax claims filed against the oil firm in spring 2004 were peacefully resolved. Over the past three years (2002-2004) Lukoil has not resorted to tax optimization schemes. Lukoil management is politically loyal. Moreover, intensified foreign expansion is helping the company to sidestep and shield itself from potential clashes of interest with state-run companies.

Returning to the issue of the gas giant’s expansion, we are of the opinion that Gazprom and Lukoil have fixed their strategies both officially (by signing a cooperation agreement in 2004) and unofficially for an even longer period of time.

The companies’ powers lies within different projects and to date they have always managed to reach a compromise on issues where their interests have overlapped.

We advise investors looking to form mid- and long-term investment portfolios to pick up Lukoil stocks.

Gazprom – low political risks are decisive

In 2005, Gazprom is on the threshold of large-scale changes. We are not of the opinion that they will involve restructuring the gas monopoly. However, the following events, expected in 2005, will be crucial for the company:

1. Beginning of active development of the gas holding’s oil business, as reflected by the takeover of Rosneft

The possibility of synergetic effects exists during the Gazprom-Rosneft merger, since to date Gazprom has failed to pay due attention to crude and gas condensate extraction.

At present, while the procedure for the Gazprom-Gazpromneft-2-Rosneft-Yuganskneftegaz transaction has yet to be set in stone, we see little point in hypothesizing over multiple scenarios under which the situation could unfold and therefore refrain from quantitative comments.

However, Yuganskneftegaz’s financials will most likely be consolidated on Gazprom’s balance sheet either through the data of enlarged Rosneft (after the merger is complete) or as a result of the subsidiary’s performance (in the event that the final owner of Yukos’ asset is the gas holding). We are not of the opinion that this asset, previously owned by Yukos, will retain its efficiency after being snapped up by the state-owned company.

2. Elimination of the ring fence

In our opinion, the issue of ring fence removal is the most interesting, including the scale and timeframe of this event.

For the record, at present there is a 20% restriction on the participation of foreign investors in the gas producer’s charter capital. Non-residents are only allowed to purchase those securities of the company which are traded on Western bourses as ADRs.

In the event that foreign investors gain access to the company’s internal securities and are given the same rights as domestic players, the gas monopoly’s domestic shares should rise at least to the level of ADRs traded on international bourses as a single security.

The issue is the amount of foreign capital admissible to trading in Gazprom’s securities, i.e. whether this will result in complete removal of the ring fence (49%) or incomplete.

In the event that the liberalization of the securities market turns out to be incomplete, this, in turn, will prevent Gazprom from being listed on the global indices and will not eliminate the spread between valuation of “domestic” securities and ADRs.

At the same time, complete demolition of the ring fence will significantly drive up both Gazprom’s capitalization and the gas monopoly’s share in the country indices and push up these indices.

We subscribe to the viewpoint of Deputy Economic Development and Trade Minister Andrei Sharonov, who said that the liberalization of Gazprom’s securities market, coupled with a level playing field for access to the gas trunk pipeline system, will trigger an investment boom in the industry.

As for the timeframe for liberalization, considering the need to finalize the Gazprom-Rosneft merger (the more so including the acquisition of Yuganskneftegaz by the state-owned company), making amendments to the regulatory documents which regulate trading in Gazprom shares, we believe that the process will be complete by around 3Q 2005.

No matter how strange it may seem, given our Buy recommendation, we do not expect to see any significant improvement in Gazprom’s 2005 financials (not including Yuganskneftegaz). Most likely, costs will continue their unrestrained rise, and we expect to see lackluster operating and net profit margins.

However, the gas monopoly’s low political risks are decisive. We assign a Buy recommendation to Gazprom shares.

We would like to reassess the issue of a possible acquisition of Russian oil assets by Gazprom. For the record, in autumn 2004 Deutsche Bank, retained by Gazprom to provide consultations about strategic expansion of its oil business, submitted to Gazprom its recommendation with a substantiation of the purchase of Yuganskneftegaz, Sibneft and Surgutneftegaz, which was tantamount to an offer to renationalize the Russian oil industry.

At present, we believe that renationalization is conceivable. Although Gazprom has enough unresolved issues concerning its recent acquisitions, it is possible that Gazprom could grab other oil assets in 2005.

The Utilities Industry

Since January 2004, utilities stocks have been constantly affected by news about details of utility sector reform.

Investor demand for utilities assets has been initially determined by the aspiration of strategic investors to obtain monopolistic profits which emerge in the process of managing power assets and the intention to minimize risks associated with uncertainty over utility sector reform. Meanwhile speculative investors have spawned high volatility of stock quotes, while the overall uncertainty factor has prevented the most liquid stock in the industry from posting significant gains. The exception to the above rule has been Mosenergo, which was up by 110% as of December 27, 2004. UES shares remained flat, down 4%, during the same period.

Less liquid stocks posted the highest yields. In particular, HPP stocks posted excellent results in 2004. Common shares in Zhigulevskaya GES surged by 240%, Volzhskaya GES commons by 185%, and Votkinskaya GES by 188%.

We believe that 2005 will be the year of most crucial decisions in the utility sector reform. However, the most important of these decisions - the one on the WGC privatization - will be adopted, in our opinion, in 2006, at the earliest.

What to look for in 2005

Reorganization of regional energos will continue

Over 50 out of 72 regional energos, which are owned by UES, are being restructured at present. In line with the timeframe for utility sector reform, in 1Q 2005 33 regional energos will be spun off by business activities. By ear-end 2005, the spin off by business activities is to be complete in all reorganized regional energos. At least 60 regional energos are to be restructured, not including 10 isolated power companies.

TGC formation

TGCs will be formed throughout 2005. Pilot TGCs formed on a lease basis were launched in 2004. UES management expects to gain formation approval for nearly all TGCs by spring 2005. In line with this pace of reform, the procedure for merging generating companies to TGCs will get off the ground during 2005. Since the merger procedure could last up to 12-18 months, the process will take 2005, continue in 2006 and be complete with conversion of shares in generating companies into shares in this TGC.

WGC formation

In our opinion, the state has taken the right approach to rescheduling decision-making on the WGC privatization procedure. Since industry risks will decrease and the valuation of the companies’ market cap will move towards their fair value as the restructuring process unfolds, it makes sense to lay down the procedures for increasing the share of private investors in WGC and therefore reducing UES’ stake in these wholesale generating companies only after formation of the target structure of the industry is complete, the statutory base is developed and the property structure in the future industry entities is in place.

We would like to point out that the following ways to increase participation of minority shareholders in WGC are possible: holding cash auctions (this idea is seriously backed by EDTM spokespersons), lease of generating capacities or assigning management functions to private companies. The Industry and Energy Ministry has been more cautious in its pronouncements concerning the privatization and backs the option where the state maintains its control over core energy assets.

However, Victor Khristenko, German Gref and Mikhail Fradkov have repeatedly voiced the need to motivate private investors’ interest in the generation segment. Obviously, discussion on this issue will continue in 2005. However, we do not expect to see any radical changes in the timeframe for decision-making on WGC privatization.

When will gencos be privatized?

It’s noteworthy that privatization of generating companies is a crucial issue in the restructuring process and liberalization of the industry. We are of the opinion that by year-end 2005 the decision on privatization of generating companies will not be taken. The state’s position will be finalized only after the target structure of the industry is formed and WGC and TGC going concerns are formed to which assets are assigned as property.

Long term prospects for changes in the industry (more than 12 months)

We can expect qualitative change in infrastructural conditions of operating power utilities in 2006, at the earliest. Beginning early 2006, the procedure for concluding bilateral agreements between electricity producers and consumers will be launched. Although this approach will ease the transition phase of consumers to the market relations, we do not rule out possible delays in the pace of framing the final model for the liberalized electricity market.

In 2006, cross-subsidization in the power industry is to be done away with, while reorganization and spinning off of UES into horizontally integrated segments is to be completed in the same year. The power holding itself is to be liquidated by year-end 2006. By this date, all newly established industry entities (WGC, TGC, IDGC, etc.) will have been spun off from UES with pro rata share distribution among shareholders of the power holding.

We believe that in 2Q 2005 the first power concern established on the lease basis (TGC-9) will become the single going concern to which all assets will be assigned on an ownership basis.

By the time the reform is wrapped up, all assets spun off to each of the newly established industry entities will have been consolidated as a single share.

Companies spun off from UES could be switched to a single share before the reform is complete. However, this issue is to be considered only in early 2005. In 1Q 2005, the decision could be adopted to switch shares of the companies which are part of the single hydro-WGC and already established thermal WGCs to shares in these WGCs.

Companies

Mosenergo

Mosenergo shares topped the list of gainers in 2004. However, the company’s performance was totally erratic last year. As a result of strategic buying in these shares by Gazprom’s structures, the Moscow utility’s stocks rapidly headed north in late September. Starting September 25, stock quotes shot up 200% in 10 days. They managed to stabilize only in late October. As of December 24, the price of common share stood at $.15, which was equal to over a 100% rise in annualized terms.

At present, we assign a Sell recommendation to Mosenergo shares with a target price of $0.07.

To date, the Gazprom group has accumulated a 25.01% stake in UES. FAS is reviewing Gazprom’s status as the owner of a blocking stake in the Moscow utility. Given the current uncertainty over Gazprom’s status as Mosenergo’s minority shareholder, it will be more reasonable to consider the restructuring of the Moscow power company after anti-monopoly authorities have delivered their verdict. Thus, we do not rule out futher procrastination in restructuring the largest regional energo.

In addition, 2005 is forecast to be extremely important for Mosenergo. The company’s assets will be merged into the largest TGC, with aggregate installed capacity of 10.5 MW. Previously it was announced that shareholders meetings of 14 companies, which are to be spun off from Mosenergo, were to be held on March 13, 2005. Mosenergo BoD at its December 25 meeting approved the charters of the new companies which are to be established in the process of Mosenergo’s restructuring. Thus, there remains a distinct possibility that the Moscow utility will be restructured by the end of 1Q 2005, which is the official deadline for the completion of regional energo restructuring.

UES

UES share performance in 2004 vindicated debates over whether the company’s shares are highly speculative stocks. Financial information had a meager impact on investor interest in the company’s shares while heightened volatility arose over discussions surrounding utility sector reform.

Last year witnessed lively debates over the procedure for distributing shares in companies spun off from UES among the electricity monopoly’s shareholders. News about pro rata distribution of shares and holding WGC privatization auctions drove up share demand, whereas comments by state officials about possible cancellation of genco privatization acted as a negative driver.

We believe that at present moment UES shares are adequately valued by the market and that uncertainty risks due to several restructuring issues have already been priced in. We assign a Hold recommendation to UES stocks with a fair value of $0.30.

Top picks

In the absence of clear-cut decisions on crucial reform issues, we do not view significant changes in market cap of the industry entities as highly probable. The decision on procedure for privatization of generating assets, formation of the final structure in the industry and formation of market conditions for operating the electricity market head the list of such crucial issues.

In our opinion, hydro power plants, which are parts of the single hydrogenerating company of the wholesale electricity market, offer the highest investment appeal. In particular, we would like to name the Zeiskaya, Volzhskaya, Zhigulevskaya and Sayano-Shushenskaya GESs.

	UES stake	Valuation price per share in UES stake, USD	RTS share price, USD	Premium of valuation price to market price, %	MarketCap$ / kWt vapacity	RTS ticker	Number of RTS transactions in 2004
Volzhskaya GES	83.31%	0.28	0.11	159%	128	VOLG	112
Zhigulevskaya GES	84.11%	0.18	0.067	166%	113	VLGS	44
Sayano-Shushenskaya GES	78.91%	0.74	0.37	99%	112	sshg	88
Zeiskaya GES	56.39%	0.21	0.11	88%	67	ZYGS	197

The valuation report released in mid-December by the independent appraiser of hydro power plants, which are part of the single hydro-WGC, underscored that the valuation price significantly exceeds the RTS price. Therefore, the estimate of HPP value is in excess of market value. However, during the conversion of HPP stocks, which are part of the single hydro generating company of the wholesale electricity market, other conversion ratios in other proportions could also be applied.

Since the state will retain control over the single hydro-WGC, the utility’s profit margins will be reasonable but we do not expect to see sky high profits. We expect that in the process of spinning off the single hydro-WGC from UES, taxation of the single WGC will be cut in such a way that the company could implement its investment program to complete the construction of the Bureiskaya and Boguchanskaya GES. We believe that these plants will be built using financial resources of the single hydro-WGC.

We are of the opinion that by the time the hydro-WGC is spun off from UES in 2006, the company’s market cap will increase due to reduced restructuring risks and the synergetic effect among hydro-generating assets merged as part of Russia’s largest generating company. The single hydro-WGC could be the flagship for generating companies in the utilities industry and investors could be assured of the efficiency of the reform process in this case.

Summary – utilities

We assume that in 2005 high volatility of utilities assets will be retained due to increased interest of arbitrage players in the utilities assets.

The state as the leader of utility sector reform should be interested in maintaining the interest of not only speculative investors but also strategic and long-term portfolio investors. This interest will be largely determined by meeting announced pace of reform, the degree of liberalization of the utilities market and the state’s aspiration to assign control over gencos in the industry to minority shareholders.

However, we believe that the decision on the privatization of the generating segment will only be taken after a transparent property structure in the utilities sector has been set in place and all controversial issues have been coordinated with the Federal Antimonopoly Service and various groups of minority shareholders in newly established industry entities.

Therefore, we do not expect to see any qualitative growth in demand for utilities assets before the decision is adopted on the precise procedure for distributing shares in new industry entities spun off from UES and ways to increase the shares of minority shareholders in utilities assets.

Metals

The year 2004 was extremely successful for metal makers. We have reason to believe that 2005 will yield more modest results due to a slowdown in demand.

By and large, we maintain favorable forecasts for 2005 and do not anticipate any precipitous decline in the industry (as has been the case in recent ferrous metallurgy cycles when sharp declines followed growth periods.) However, there are risks which could squeeze the industry, such as overrunning the peak and price correction, phasing in import limitations, rising prices for raw materials coinciding with falling steel prices, as well as lower-than-estimated economic growth rates in China.

According to estimates, steel demand growth rates in 2004-2008 are forecast to slow down by an average of 3% per annum against a 6% average annual increase in 2001-2004, with Asian demand expected play a key part due to downgraded economic growth rates.

By and large, the outlook in 2005 for non-ferrous metals is positive. In 2004, copper, aluminum and nickel prices jumped significantly, by 56%, 20% and 43%, respectively (average annual values). In 2005, we will most likely see similar trends. Copper is forecast to rise on the back of a shortage (estimated at 81,000 tons in 2005) due to rising Chinese demand and at the same time lack of processing facilities.

What’s more, 2005 should see an aluminum shortage. According to estimates, aluminum demand is to rise by 5.3% to 30.8 mln tons in 2005, outstripping the supply side by 371,000 tons.

According to producers’ estimates, nickel prices could slide to $11,000-11,500 per ton, which is not negative and is viewed as an adequate price. Otherwise, in order to bring down nickel shortage on the global market, stainless steel makers (which account for 75% of aggregate nickel demand) could switch from nickel to alternative metals. Meanwhile, new nickel production facilities located in New Caledonia and Canada should also contribute to liquidating nickel shortage on the market and reducing nickel prices.

As of now, we see no signs indicative of a downturn in gold demand, and we could see gold prices rise in view of the declining dollar.

$ per ton	average value
	2003	2004	Chng, %
Aluminum	1,428.37	1,716.04	20.14%
Copper	1,788.49	2,784.15	55.67%
Nickel	9,612.79	13,747.80	43.02%

$ per troy ounce	average value
	2003	2004	Chng, %
Palladium	200.61	231.91	15.6%
Platinum	690.15	845.66	22.5%
Gold	362.94	408.46	12.5%

Companies

Severstal

We assign a Buy recommendation to Severstal shares with a fair price of $9.40.

From the standpoint of the stock market, Severstal is the most transparent company among ferrous metals makers which have shown an interest in capital markets.

High steel prices and the fact that this company is well stocked with raw materials ensure robust gains in 2005 and hefty dividend payouts to its shareholders. However, Severstal’s ambitious plans to gain a leadership position in the industry due to the acquisition of new assets and boost annual output to 100 mln tons (at present, the company’s annual output amounts to some 12.5 mln tons) could depress the company’s profit margins in the long term. For the record, in 2004 Severstal acquired American Rouge, has targeted Canadian Stelco, and is eyeing Italian Lucchini and Czech Vitkovice Steel.

Norilsk Nickel

We assign a Buy recommendation to NorNickel stocks with a fair price of $70.38.

NorNickel is also forecast to post strong profit thanks to favorable forecast for many metals produced by the company.

The company has been successful in expanding its business. In 2005, it will most likely continue to develop its gold assets. Norilsk Nickel still intends to participate in the auction to sell off Eurasia’s largest gold deposit Sukhoi Log, which has been constantly rescheduled. This deposit has estimated reserves of over 1,000 tons of gold, and other M&As in Russia are also possible. We do not rule out the possibility that Norilsk Nickel will establish a single gold miner (Polyus), spinning it off from other business segments and then possibly launching an IPO. Another crucial issue is how the Gold Fields issue will pan out.

However, there is one significant point of concern, the so called oligarchic risks. Although at present we view the possibility of any problems with the authorities as immaterial, this factor has a negative impact on the metal maker’s shares.

In addition to the above metal stocks, we would advise investors to focus on Evrazholding’s assets: ZapSib and NTMK, as well as on the Chelyabinsk metal works (a core asset of Mechel Steel Group) owing to the expected consolidation in these companies and the increasing transparency of their business. Another interesting instrument is VSMPO-Avisma due to anticipated upside in the titanium industry.

Recap table of recommendations

Company	Market price, $	Market cap, $ mln	Fair price	Upside	Recommendation
NorNickel	51	10909.2	70.38	38%	Buy
Severstal	161	3553.9	238.6	48%	Buy
ÌÌÊ	0.6	4783.6	0.5	-17%	Hold
NLÌÊ	0.9	5388.5	1	11%	Hold
NÒÌÊ	0.95	1244.5	1.01	5%	Hold
ZapSib	93	1188.8	101	9%	Hold

Summary – metals

To summarize, 2005 will likely be positive for both ferrous and non-ferrous metals. Nearly all metals are pointing to upside (albeit not as steeply as in 2004). Obviously, metal makers will likely allocate their high profit earnings to expand their own businesses: building vertically integrated holdings (to contain their costs and provide themselves with raw material) and upgrade production facilities to maintain their competitiveness in the future. We also expect to see increased activity in the way of consolidation processes and an enlargement of the metals market participants. For the time being, active steps on the stocks market (not including bellwethers Severstal and NorNickel) will not be a top priority for metal maker managements. However, we believe that the situation will gradually turn around in the long term.

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