Research Notes

Most regional gas distribution concerns obtained listings on exchanges not long ago and have not yet become the focus of investor attention. However, we are of the opinion that entities from this segment of the gas distribution industry hold substantial upside potential and are alluring investment vehicles. We would like to highlight the following among the primary upside drivers for gas distribution companies:

• Growth in domestic gas prices. A tendency has been seen in recent years in the proportional hike in gas transportation tariffs against domestic gas prices. Given scheduled measures to narrow the gap between regulated and export gas prices (in accordance with EDTM forecasts, the price of domestic gas could reach $110 per 1,000 cu m by 2011, while the average 2006 price was not in excess of $37.00), such trend should produce a positive impact on earnings generated by gas distribution firms which, provided that the current capex level remains unchanged, coupled with inflation in the gas industry should push up cash flows for shareholders.

• Strategic interest of Gazprom. Over the past several years the country's gas transportation system has run at 90% of its capacity (including impressive volumes of gas transit) and the gas transportation system's potential runs the risk of decreasing to critical levels in the next few years. For this reason, sizeable investments will be needed in gas infrastructure and in the amounts provided for by Gazprom's relevant program. However, for the successful execution of such a broad-based investment project it is necessary to have the entire gas distribution network concentrated in the hands of Gazprom. According to our forecasts, the gas monopoly's stable interest in the assets of regional gas distribution concerns could become an additional upside driver for the latter's stocks.

• Diversification and growing efficiency. An important trend for the overwhelming majority of regional gas distribution enterprises is steady reduction in the weight of revenue from regulated business in their total revenue mixes. Business diversification via expansion and development of support units allows the companies to become less reliant on the tariff policy pursued by state authorities and seasonal fluctuations in gas demand.

Among regional gas distribution entities we give preference to the regional gas transportation operators of the Bryansk, Orenburg, Saratov and Tver regions.

According to our estimates, these four entities have the most efficient business structures and are capable of becoming the major beneficiaries of future industry reforms.

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