Research Notes

The spike in petroleum prices and increased crude output still allow Surgutneftegaz to post fairly strong results. For example, the oil major's 9M05 net profit topped $3 bln, or more than 50% against the same period a year ago.

But the oil producer's focus on the development of highly depleted and small fields in West Siberia, high inflation and ruble appreciation against the US dollar have produced a negative impact on its cost side. Meanwhile, limited export opportunities and shortage of refining facilities limit the oil firm's resources to optimize its sales network depending on the market environment.

The company's poorly thought-out investment policy and passive development strategy show that Surgut's management is not interested in boosting the company's market cap. This is followed by the accumulation on its balance sheet of huge amounts of cash (around $9 bln as of September 30, 2005) which are either dead weight or generate minimal returns.

Surgutneftegaz stands out among other Russian oil producers due to its lax corporate governance standards, opacity and hostile attitude towards minority shareholders.

At the same time, it's noteworthy that the oil major is well positioned to solve all these problems and convert its good relations with the state and cash reserves into new acquisitions which could substantially raise its equity value. For the time being, there are no grounds for expecting any progress in this area (except for a forced increase in preferred dividend payouts).

Based on our discounted cash flow valuation model, the fair value of Surgutneftegaz common shares is $1.30, which implies a Sell recommendation. We rate the oil producer's preferred stocks as a Hold with a $1.11 target price.

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Timur Hayrullin

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