Research Notes

Surgutneftegaz: To Hold or to Sell?

Maria Radina
radina@finam.ru
(095) 204-8275

Kseniya Samartsieva
samartsieva@finam.ru
(095) 204-8275

• Despite its strong operating and financial performance, Surgutneftegaz is still a dark horse for investors. It is hard to value the oil company due to its high opacity.

• The oil company’s corporate structure is such that even under Russian Accounting Standards (RAS) the oil firm fully reflects its revenue and expenditure (around 95%). Therefore, the oil company’s RAS financial statements are quite relevant to build a framework for assessing the cash flows that Surgutneftegaz generates.

• In view of the fact that lawsuits filed by the oil entity’s minority shareholders to cancel its treasury stocks have dismal prospects (since natural gas giant Gazprom has a similar ownership structure), we have used the entire amount of Surgutneftegaz’s common shares outstanding (35.7 mln) for our calculations.

• As Surgutneftegaz markets the bulk of its crude oil on the domestic market, a rise in domestic oil prices will produce a positive impact on its results. According to our estimates, the oil major’s FY 2004 revenue and net profit will total roughly $9.7 bln and $2.6 bln, respectively.

Introduction

Despite its strong operating and financial performance, Surgutneftegaz remains a dark horse for investors.

On the one hand, the absolute loyalty of the oil company’s management to the state guarantees that a favorable environment for its activities will be retained. On the other hand, Surgutneftegaz has adopted a rather hostile policy towards minority shareholders. This is driven by the fact that, according to different estimates, Surgutneftegaz management controls up to 65% of the company’s voting shares.

It is hard to value Surgutneftegaz due to its high opacity.

Surgutneftegaz became even murkier after the state held an auction to sell a 76.6% stake in YuganskNG. The fact that Surgutneftegaz representatives participated in the auction on behalf of Baikal Finance Group, which came out on the winning end, and was then taken over by state-owned Rosneft has already been established. We maintain that at present it makes no sense to make assumptions of how the participation in the Yugansk auction will affect the company’s future.

Let us assume that the oil firm’s representatives took part in the December 19 auction solely as intermediaries and its financial resources were used in the primary financing of the deal on the terms of repayment of the advance payment Surgutneftegaz made. Thus, the participation in the auction will have no financial implications for the company and produce no impact on its shareholders’ equity.

In any case, we have again become convinced that Surgutneftegaz is under the wing of the state.

However, bearing in mind the fact that last autumn Deutsche Bank hired by Gazprom to act as its consultant for strategic development of its oil assets recommended the gas monopoly to pick up not only Yuganskneftegaz, but also Sibneft and Surgutneftegaz, we do not rule out the possibility that sooner or later Surgutneftegaz will get involved in the consolidation process carried out by Gazprom or some new state-run oil and gas corporation. One may presume that this will be possible through the scheme involving treasury stocks when they will be gradually removed from the balance sheets of the oil entity’s subsidiaries. Nonetheless, at this point we are not going to review this situation or engage in conjecture by way of figures.

This research report is devoted to updating our assessment of Surgutneftegaz on the basis of a DCF model. Due to the fact that the oil firm has not presented its financial statements drafted to IAS for a number of years, we used the oil entity’s RAS figures for our calculations and made the required adjustments.

Our research report is entitled “Surgutneftegaz: To Hold or to Sell?” not by chance: as we expect the reader to make up his/her mind after deciding which factors, politics or fundamentals, should be awarded higher priority when adopting an investment decision.

Business Overview

As noted above, it is hard to analyze Surgutneftegaz’ activities due to its opacity, namely: the company discontinued the practice of releasing its IAS financial statements and investors have access solely to RAS figures and news about the oil company’s operational achievements.

The oil major’s operating results may please investors. The company has been ramping up crude oil production at a steady pace and accounts for 13% of Russia’s oil production. It currently ranks fourth among domestic oil majors, trailing Lukoil, Yukos and TNK-BP. In recent years, the company’s average incremental production has been around 10% per year.

Figure 1. Crude Oil Production at SurgutNG in 2001-2004

Source: company data

Admittedly, Surgut’s increment production rates are much lower than those exhibited by the leading oil giants: 16.3% and 19.4% in 2003 for Yukos and Sibneft, but this fact should not be viewed as a negative. For the record, in 2004 Sibneft faced the problem of hitting its oil production target after its incremental production rose by 11% instead of 20%. Aggressive extraction techniques could result in high incremental rates in the short term, but cause trouble in the long run. Based on the foregoing, we maintain that the oil company’s oil production policy may be viewed as well-thought-out and squarely in line with the interests of strategic investors.

It should be noted that in 2004 Surgut jacked up oil production by 10% to 59.4 mln tons. Therefore our forecasts are based on the fact that such extraction rates will be retained in 2005 thanks to bringing on stream such oilfields as the Yukyaunskoye, Severo-Labatyuganskoye and Larkinskoye (under pilot development) and also by increasing oil production at the Ulyanovskoye, Tretyakovskoye, Zapadno-Chigorinskoye and Severo-Seliyarovskoye oil fields, commissioned in 2003.

However, beginning 2006 we do not expect the oil company to maintain such high incremental rates as in previous years, since it will have to boost production of hydrocarbons at a slower pace due to the lack of sufficient export and refining capacities. We base our calculations on the fact that Surgut’s incremental growth will be 8% in 2006 and no higher than 5% in the years to come.

It is noteworthy that the oil company’s investments total around $1.3 bln to $1.6 bln per year, but the investment program largely aims to explore reserves, raise oil production, exploit advanced methods to boost reservoir recovery, while devoting little attention to the expansion of refining capacities and marketing channels.

Table 1. Breakdown of Surgut’s capex

As an exemplary subsoil user, Surgutneftegaz has always devoted special attention to the replacement of its mineral reserves base. It is driven by the fact that the oil firm’s crude reserves are way below those of other Russian vertically integrated oil companies and will be depleted in 18 years versus 25-26 years, the oil industry’s average. However, the oil major’s reserve incrementation declined in 2003 and the replacement ratio stood at a mere 0.55 points and this trend, according to the company’s estimates, will persist in the future. This can be to a certain extent explained by falling capex per barrel of crude oil extracted.

Figure 2. E&P capex, $/bbl

Source: Company data, Finam estimates

The bulk of crude oil extracted by the oil company is refined at the Kirishi refinery, with primary hydrocarbon refining capacity of 17.3 mln tons a year. According to our estimates, the refinery runs at over 95% of its capacity.

Surgutneftegaz has been investing funds into the expansion of the Kirishi refinery’s throughput capacity. However, these investments could reap tangible results if steps are taken to boost the oil firm’s oil export potential, since the domestic petroleum products market is quite limited.

Surgutneftegaz’s target to expand its refining business is based on the construction of a deep crude refining complex, which will enable the refinery to increase the refining depth to 96%. This will make it possible for the company to produce light hydrocarbons that meet the highest international standards. Moreover, the flexibility of deep crude refining technology will make it possible to shift the product mix according to demand for petroleum products on the market.

However, in any case the upgrade of the Kirishi refinery will not help eliminate the lack of refining capacity at Surgutneftegaz. Despite this, the oil company has already suspended the implementation of its joint project with Rosneft to erect a refinery in Primorsk.

According to estimates, around $6 bln was accumulated on the oil major’s balance sheet at the end of 2004, not counting the participation of its representatives in the Yugansk auction.

Over the past several years the oil company has taken no action to invest several billion dollars, lying dormant on its accounts. For incomprehensible reasons, Surgut management has not channelled these funds towards the implementation of ambitious projects to boost its refining and sales volumes, e.g. construction of an oil terminal in the Batareinaya Bay in the Leningrad region, which would have enabled the oil firm to raise crude exports or towards the acquisition of oil refining facilities, which Surgutneftegaz clearly lacks.

We maintain that the lack of a clear-cut investment policy designed to expand refining and sales potential is another negative that could seriously affect the shareholders’ equity of Surgutneftegaz.

Shareholder capital

The structure of shareholder capital at Surgutneftegaz is extremely untypical for a private company. The controlling stake is listed on the balance sheet of the company’s subsidiaries. Due to changes made to the company’s corporate structure in autumn of 2003, after the company fended off a hostile takeover attempt in spring of the same year, it is extremely difficult to determine the precise number of shares accumulated on the balance sheet of the company’s subsidiaries.

According to our preliminary estimates, the company’s treasury shares, which are listed on the balance sheet of the company’s affiliated entities, ensure that management controls over 60% of the votes, while it directly owns a mere 1% of shares. By and large, Surgutneftagaz has a similar property structure to that of Gazprom, since the treasury shares of the latter will enable the state to have a controlling interest in the gas holding.

In view of the fact that appeals of minority shareholders to cancel treasury shares of Surgutneftgaz have meager chances (more so due to the existence of similar property structure in Gazprom), we used the total number of the company’s common shares (35.7 mln) for our estimates.

Model for estimating fair value

The company’s corporate structure is such that even in its RAS financials the company records nearly alls revenues and costs (roughly 95%). For this reason, RAS data are quite relevant as a basis for calculating cash flows.

We determined engineering and economic performance of the forecast period based on the company’s 2003 and 9m2004 real accounting records. The forecast period spans nine years, from 2004 to 2012.

Scenario projections in estimating the company’s value in 2005-2007 were based on figures priced into Russia’s 2005 budget, and the forecast for social and economic development in 2005-2007, developed by EDTM in 2004.

However, we are of the opinion that projected crude prices in the budget and EDTM’s forecast, are quite conservative, which is logical. For this reason, our forecast prices are slightly higher than the prices projected in the budget.

The scenario conditions, which we used in forecasting the results of the oil major’s future performance, are given in table 2.

Table 2. Key forecast parameters for 2005-2007

In the process of forecasting scenario conditions for the upcoming period (2008-2012) we were guided by stabilization of inflationary processes in Russia and based on the following data:

• producer price growth rates – 5% in each consecutive year against the previous one;

• rise in the ruble/dollar exchange rate of 2% pa with subsequent stabilization starting 2010;

• rise in prices for Urals oil in the dollar terms stands at 2% pa with subsequent stabilization starting 2011;

• rise in oil products prices corresponds to dollar inflation.

The company’s P&L breakdown is maintained at 2003-2004 level in the absence of an aggressive M&A policy. We also forecast no considerable changes in the product mix of saleable commodities.

Thus, while estimating:

• Revenue – we maintained that 35% of the total crude output minus losses and use for internal needs is shipped to Kirishinefteorgsintez. Export/domestic sales ratio stands at 52% and 48% or 33.8% and 31.2% of the total output.

• Opex – we proceeded from the assumption that as mentioned above, the cost structure will remain the same except for the tax parameter – MET rate is calculated in accordance with amendments to the tax legislation from 2005 and 2007. Cost growth rates correspond to those of producer prices.

• Investment cash flows – we assumed that capex in 2005-2008 will rise in accordance with a rise in crude output. In the future, the major stage of greenfields development and upgrade of Kirishinefteorgsintez will be completed and capex will stabilize at $1.2 bln per year.

• Forecast of depreciation costs was made in view of an increase in fixed assets value due to implementing the company’s investment policy.

Forecast of financial results

Since Surgutneftegaz sells the bulk of its crude on the domestic market, rising oil prices will have a positive impact on the company’s performance, which has surged 4-fold since early 2003. According to our estimates, the company’s FY2004 revenue is forecast at $9.7 bln, and net profit at $2.6 bln.

Òable 3. Forecast of headline financial parameters for 2004-2006, $ mln

As we can see from table 5, despite an increase in crude output, we forecast a slight decline in the company’s 2005 revenue and net profit due to sliding prices on the domestic and global markets (p6) which we incorporated in our model, as well as an increasing tax burden in the industry.

However, further down the road, the oil major’s net profit, operating cash flow and, generally, free cash flow show positive trends, largely due to boosting crude output.

Òable 4. Calculation of cash flows in 2003-2006, $ mln

We determined discount rates based on forecast capital breakdown and valuation of shareholder capital using a capital asset pricing model (ÑAPM). Risk free return margin in the forecast period is equal to the yield on Russian Eurobonds with maturity in 2010. Expected profit margin of the market portfolio for the forecast period is estimated at 18%, after which we allowed for a gradual decrease in annual yields to 15% in the post-forecast period. We also considered those corporate governance risks inherent in the discount rates which are characteristic of Surgutneftegaz.

Òable 5. Estimation of weighted average cost of capital (WACC)

According to our estimates, we have determined the fair value of Surgutneftegaz. Our results are shown in table 6.

Òable 6. Estimate of fair value

In the event that Surgut’s treasury shares are canceled, which is unlikely in the short-term, the fair price of the company’s shares will jump 30% to $0.95 per common share and $0.71 per preferred share.

It’s noteworthy that looking at the oil major’s forecast balance sheet, we see the amount accumulated and listed as “deadweight” on the company’s account, will double in the 9 years of the forecast period, provided that the company’s existing investment policy undergoes no changes.

At the same time, despite strong operating and financial results, Surgutneftegaz failed to create a procedure for distributing earnings among portfolio investors. We do not expect to see any material changes in the company’s dividend policy. Needless to say, amendments to the JSC law, endorsed in spring 2004, will not allow Surgutneftegaz to continue to understate net profit, which serves the basis for dividend payouts using capex. On the other hand, we do not expect to see any turnaround on the issue.

Summary

We would like to reiterate that Surgutneftegaz combines lax corporate governance standards and a hostile attitude towards minority shareholders with strong financial performance and heightened loyalty to the state.

Given the changes in Russia’s political climate, strong ties with Russian authorities is an important prerequisite in the destiny of any domestic company. In the event that the state does not rethink its approach to development of the domestic economy, low political risks could drive up Surgutneftegaz’ marcet cap. If such factors matter to you in picking an investment strategy on the Russian stock market, you should Hold Surgutneftegaz stocks.

However, in tems of fundamentals, the company’s stocks have nearly reached their target price and you might possibly consider turning to market instruments with stronger upside potential like Lukoil and Gazprom’s shares. We have framed our valuation of Sufgutneftegaz on the basis of fundamentals. It’s up to you whether you attach higher importance to fundamentals or politics when making your investment decision concerning the company’s stocks. Only after you have made up your mind, will you be able to decide between the two options given in the headline of our report.

Forecast of Surgutneftegaz’ Balance Sheet, $ mln

Forecast of Surgutneftegaz’ P&L Statement, $ mln

Calculation of Surgutneftegaz’cash flow, $ mln

Maria Radina

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