Research Notes

We resumed coverage of Lukoil. The oil industry is going through far from the smoothest period in its history. In recent years, a strict tax regime and sector consolidation in the form of escalating influence of state-run concerns have prevailed as negative aspects of the external environment. Against this backdrop, Lukoil's financial and operating performance underscores its successful expansion.

• The oil major has been expanding in line with its intensive development strategy that calls for doubling hydrocarbons output by 2016 by accelerating the rollout of its gas production segment, impressive growth in oil refining, geographical diversification, more harmonious development of all links of the chain to turn out higher value-added products (from exploration activities to retail sales operations). The facts have shown that Lukoil has focused on the right area, but its ambitions could be disrupted by external factors: higher costs, the lack of adequate investment targets and restrictions imposed by some governments.
• The oil major's H107 results turned out to be softer than expected and gave rise to concerns among investors. The reason for concerns is unexpectedly heavy opex and a spike in capital outlays. At the same time, some factors show that management has been making efforts to keep the cost side under control.
• Lukoil is marked by strong corporate governance standards and remains one of the most transparent companies in Russia. The oil producer's chief executive increases his equity stake on a regular basis which, on the one hand, underscores his confidence in the company's prospects and, on the other hand, his aspiration to consolidate a blocking stake.
• The company reacts quite promptly to changes in the market environment and continuously takes steps to optimize supplies and its product mix, thereby deriving additional revenue.
• In our view, the most tangible growth driver for the company's market cap (apart from a rally in crude prices and some lightening in the tax burden) could be its involvement in the development of the country's largest fields from the undistributed subsoil reserve in cooperation with state-run concerns. At present, Lukoil has a number of such arrangements with Gazprom and Rosneft.

Following our valuation of the oil producer's fair share value, we assign a Buy recommendation with a year-end 2008 target price of $100.32.

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Konstantin Reily

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