The submission of preliminary applications from private individuals to buy shares in the Rosneft IPO has started. Anybody can buy these shares: a potential investor only needs to have 15,000 rubles or more. How good a deal is the oil company offering?

Rosneft is the only Russian oil company that is totally state owned. On June 23 its board of directors approved the price range within which it plans to place its shares: from $5.85 to $7.85. This corresponds to a capitalization after the placement of $60 billion - $80 billion. According to Rosneft representatives, the company has appraised itself higher – up to $90 billion. But the company’s appetite was kept in check by a recent correction on the financial markets.

Over the past year and a half Rosneft has been appraised many times and each new appraisal was higher than the last. The first was the investment bank Morgan Stanley, According to it, in spring 2005 Rosneft was worth $26 billion. At this price it was submitted by the government to the charter capital of Rosneftegaz. Then Rosneft was appraised by Deloitte. The result was $48 before the merging of 12 subsidiaries, and $58 billion afterwards. At the end of 2005 Rosneft President Sergei Bogdanchikov said that his company would be worth $70 billion - $80 billion. But only by 2010. But according to preliminary estimates by company analysts – the organizers of the IPO, a fair price for Rosneft in June was within the range of $63 billion - $120 billion. The lowest appraisal was provided by Morgan Stanley, and the highest – by UralSib. So, how much should Rosneft cost?

Lobby for rapid growth

Finance polled independent experts not involved in the Rosneft IPO. Most analysts believe a fair price to be the lower limit of the declared price range. However, they believe that this will not have any potential for growth on the secondary market. “A fair price for Rosneft is $40.5 billion,” Antanta Capital analyst Denis Matafonov said. “But it has non-material assets like state support and the lobbying capabilities of management. The premium for these should amount to at least 50%,” he said. The analyst forecasts that the placement will take place close to the lower limit of the price range, and the resulting capitalization will amount to $70 billion ($6.85 per share). The enormous lobbying potential of Rosneft gives it direct access to Vladimir Putin. Its Chairman of the Board Igor Sechin is also deputy head of the residential administration. It is thanks to his support that Rosneft avoided a merger with Gazprom, planned in 2004. At that time officials wanted to hand over the oil company for 10.74% of the gas monopoly, to consolidate a controlling stake. But Rosneft was able to avoid the embrace of the all-powerful Gazprom. On the contrary, after its struggle with Gazprom it increased almost three-fold, acquiring Yuganskneftegaz for $9.5 billion, which had been taken from Yukos as payment of debts. However, political risk is the main thing for Rosneft. The state support that the company has may rise and fall. The next critical year will be 2008, when the next presidential elections will be held. Also, state support is a double-edged sword. Having helped Rosneft today, the state may politely ask it to reciprocate tomorrow. Then the company will be forced to act not in the interest of minority shareholders, which will have a negative impact on its quotes.

Finam analyst Timur Khairullin believes that the placement will take place close to the upper limit of the declared price corridor. “Buying Rosneft shares will give investors the opportunity to take part in the capital of the second largest Russian oil company,” he said. “It has significant potential to improve its operating and financial indicators, due to its food asset portfolio and dynamic development,” he said.

It is true, Rosneft production is increasing faster than many other vertically integrated oil companies. Its growth, not including Yuganskneftegaz, in 2005 amounted to 7.3%. For comparison, Lukoil production increased only 4.3%. Sergei Bogdanchikov plans that in 2010 his company will produce 100 million tonnes of oil, and in 2015 – 140 million tonnes. Rosneft proposes to diversify into gas – 40 billion cubic meters by 2012. This is a little less than the entire production of independent gas producers in 2005. Rosneft plans to actively expand production of oil and gas due to acquisitions and also its own significant reserves. They amount to 18.9 billion barrels of oil equivalent. Based on this indicator Rosneft is in third place in the world. However, significant reserves are characteristic of all Russian oil companies, which have actively collected licenses for fields, but have not started to develop them.

Payment for lobbyism. The closest equivalent to state-owned Rosneft in terms of reserves and production among Russian oil companies is the privately-owned Lukoil. The competitors have comparable reserves – 2.6 billion tonnes and 2.8 billion tonnes respectively. Lukoil leads in terms of production (90.2 million tonnes), 15.6 million tonnes ahead of Rosneft. At the lower limit of the price range the state company’s capitalization will amount to $60 billion. In this case investors evaluate its reserves at $3.17 per barrel. But with a placement at $7.85 per share Rosneft’s reserves will increase to $4.23 per barrel. Meanwhile, for Lukoil this indicator is $3, and for TNK-BP - $4. At a first glance Rosneft’s requests seem fair. At any rate in terms of reserves. But the company has debt of $11.6 billion. Correspondingly, the EV ratio amounts to at least $71.6 billion. Then the value of one barrel of oil in the ground at a price of $5.75 per share increases to $3.8, and at the upper limit of the share price range – to $4.8. A little more expensive, but the lobbyist qualities of management can be paid for. It is no accident that on the first day of the road show Sergei Bogdanchikov quoted Vladimir Putin as saying: “We will help Rosneft increase its resources.”

Based on current financial ratios Rosneft values itself significantly higher than its Russian colleagues. Even at the lower limit of the price range the P/E and EV/EBITDA ratios were 14.4 and 10.1 respectively. For Lukoil these indicators are a lot lower – 9.7 and 6. In other words, the underwriters value Rosneft at least 50% more than the leader in Russian oil production and foreign counterparts. A bonus for personal contact with the president? That is what it is, according to the analysts polled. They tend to think that Rosneft capitalization after the placement will amount to $70 billion. The state company has other plusses also. “To buy up 1.5% of Lukoil shares on the market, a lot of time and money will have to be spent,” Veles Capital senior analyst Mikhail Zak said. “But you can pay a premium to Lukoil and quickly buy the same stake in its closest equivalent,” he said.

According to Timur Khairullin from Finam, it looks preferable to buy Rosneft shares compared with Lukoil. He considers it fair to pay $6.5 per share. “This price for Rosneft shares will mean that Lukoil, Surgutneftegas and other oil companies are significantly undervalued,” Rye, Man & Gor Securities expert Anton Rubtsov said. “With a placement within the range of $70 billion - $80 billion, Rosneft will not have growth potential,” he said. Olma analyst Igor Dodonov agreed, and noted a situation where Rosneft shares might momentarily soar: “If the state company is given the remaining assets of Yukos, its capitalization will increase to $100 billion - $110 billion,” he said. But in current conditions the value of the Rosneft shares will fall after the IPO. Its fair price amounts to $65 billion - $70 billion,” he said.

Brave investment

Rosneft is subject to the same risks as other Russian oil and gas companies. An increase in the natural resource extraction tax and the export duty has led to a drop in operating profitability in the first quarter 2006 to 25.5% from 29.4% in 2005. True, both results are among the best in the sector. Rosneft, like other Russian vertically integrated oil companies, is significantly dependent on exports of crude, and correspondingly, on world oil prices. The state company could deal with this shortcoming by increasing the added value in the end product. At the moment Sergei Bogdanchikov has only two refineries at his disposal – in Tuapse and Komsomolsk-on-Amur. These refineries, the largest in Russia, processed only 14% of Rosneft’s production last year. And due to the depreciation of equipment yield from crude amounts to only 55%-60%. For comparison: at the refineries of international oil companies this indicator amounts to 95%.

A serious threat to Rosneft’s prosperity is its large net debt, which amounted to $11.6 billion at the end of the first quarter 2006. The company has always stood out due to its enviable credit appetite. But the company’s debt increased particularly significantly at the end of 2004, when Rosneft took a credit to buy Yuganskneftegaz. By the middle of 2005 its debt reached a record $22 billion. The only companies with higher debt were Gazprom and Yukos. The state company was able to halve the debt, largely by challenging a tax claim against Yuganskneftegaz. The remaining amount is in bank credits and bonds. There is the danger of possible claims from minority shareholders in Rosneft subsidiaries. The state company is consolidating 12 companies, which will be completed after the IPO. Some shareholders in the subsidiaries are unhappy with the conversion coefficient proposed. Minority shareholders in Komsomolsk oil refinery have already promised to sue. “Possibly it will be necessary to put up a fight. But not for long,” Khalil Shekhmametiev from Otkritye said. “Rosneft top management has shown its mettle in the struggle with corporate blackmailers from Krasnodarneft,” he said. The risk of claims from Yukos and Group Menatep being upheld is slight: so far Rosneft has won suits in Russia, and foreign courts have refused to accept suits from the former owners of Yuganskneftegaz. Incidentally, during the consolidation process Yukos could receive 9.7% of Rosneft in exchange for 23.2% of Yuganskneftegaz preferred shares. True, it is more likely that the beleaguered company will prefer money, needed to pay debts to the budget.

Unclear advantage

Rosneft owns licenses for difficult fields in Sakhalin and Eastern Siberia. But this could become an advantage if the state reduces the mineral resource extraction tax for fields in difficult regions. Rosneft will be the first contender to receive benefits: it alone is going into projects previously considered to be unprofitable by private companies. Given the lobbyist capabilities of Rosneft management, the likelihood of this turn of events is quite high.

State company priorities

The most attractive market for Rosneft is the Asian market – particularly China. It is expected that by 2015 supplies of Russian oil to the Asia-Pacific region will increase eight-fold. Rosneft accounts for 77% of all Russian oil supplies to that region and hopes to retain its position. For example, at the end of June it bought 97.5% of Nakhodka Commercial Oil Port, which previously belonged to the Alyans group. Rosneft plans to become one of the main users of the East Siberian – Pacific Ocean pipeline, through which oil will be supplied to China and Japan. And at the moment Chinese companies are preparing to take part in the Rosneft placement.