Transcript Presentation title to go here

Oil, Oligarchs and Putin Thoughts on Russia and Emerging Europe
Grant Felgenhauer
Hermitage Capital Management
Background
After many months of lackluster performance due to the Yukos affair, the Russian
equity market has finally started to break out
950
RTS Index
900
850
Yukos Affair
800
RTS Index 750
700
650
600
YTD +47%
550
500
Jan-04
May-04
Source: Bloomberg, Hermitage Estimates, September 2005
Sep-04
Jan-05
May-05
Sep-05
Why has the Russian market finally started to rally?
After scaring everybody with Yukos, Putin has made a major effort to alleviate fears
and to improve the investment climate
Putin's Words...
...Putin's Actions
Privatization amnesty, restricting the unwinding of
disputed privatizations older than 3 years (signed by
Putin on July 22, 2005)
Tax reforms that rein in the power of the tax collectors
(to be considered by Duma in 3Q2005)
"We need to focus... on dramatically improving
the environment for free enterprise and capital
investment in Russia."
Annual Address to the Federal Assembly
(April 25, 2005)
Amnesty for repatriation of offshore income (submitted
to Duma, expected to take force January 2006)
Major privatization program for 2006: Svyazinvest, SG
Trans (monopoly LNG transporter), +1,500 other
enterprises (approved by Government on August 4,
2005)
Liberalization of Gazprom shares (full liberalization
expected by year-end 2005)
Source: Russian Government, Prime-Tass, Reuters, August 2005
Why has the Russian market finally started to rally?
Despite people's worst Yukos-inspired fears, no other Russian companies have been
destroyed by tax fines...
Back-Tax Charges as % of Net Income (%)
250%
208%
Back-Tax 200%
Charges
as %
150%
of Net
Income
100%
50%
23%
22%
9%
8%
5%
5%
0%
Yukos
(2000-2003)
Vimpelcom
(2001-2002)
TNK
(2001)
Source: UBS, CSFB, Bloomberg, Reuters, Hermitage Estimates, August 2005
UES
(2001)
Megafon
(2001)
MTS
(2002)
Baltika
(2002-2003)
0.4%
Lukoil
(2002-2003)
Why has the Russian market finally started to rally?
...and Yukos had such a powerful demonstration effect that all other Russian
oligarchs are now paying their taxes and behaving themselves
Effective Tax Rate (GAAP-Based) Paid by Major Russian Companies (%)
35%
2002
30%
30%
25%
Effective Tax
Rate (%)
2004
29% 29%
25%
23%
24%
20%
15%
12%
9%
10%
4%
5%
4%
0%
Sibneft
TNK-BP Ltd
Evraz Group
Mechel
Source: Companies' financial disclosure, Hermitage Estimates. Mechel 2004 data is adjusted for one-time off-shore non-taxable gain of $800 million
Lukoil
Why has the Russian market finally started to rally?
...and finally, the international press is beginning to focus on the positive
economic trends
Number of articles about Yukos*
350
300
304
155
150
Economy
& Oil
129
105
101
100
78
86
54
50
0
Dec-04
Jan-05
Feb-05
Mar-05
Apr-05
May-05
Jun-05
Jul-05
Number of articles about Russia's economy*
126
130
106
110
95
105
90
90
82
74
70
70
50
Dec-04
Jan-05
Feb-05
Mar-05
*NYT, WSJ, Washington Post, FT, Guardian, The Independent, The Times, Daily Telegraph, International Herald Tribune. Source: Factiva
Apr-05
May-05
Jun-05
Jul-05
Is the Russian market still cheap?
In spite of the recent rise, the Russian equity market is still one of the cheapest
stock markets in the world on a P/E basis...
Price/Earnings Ratios, 2005E
40
36.0
Price/Earnings Ratios
35
30
34.9
33.0
30.0
Developed Markets Average (23.5)
25
20
16.2
15
16.0
15.6
14.8
14.4
14.0
14.0
13.8
13.7
13.7
Emerging Markets Average (14.5)
13.1
10
12.8
12.7
12.6
11.8
11.0
10.7
9.9
9.7
8.4
6.6
5
0
Nikkei 225 Nasdaq Comp
Malaysia
Qatar
Israel
India
Mexico
United Arab
Saudi Arabia
S&P 500
Taiwan
Hungary
Germany
Turkey
Emirates
Source: HSBC, Deutsche Bank, UBS, Hermitage Estimates, September 2005
UK
Poland
Kuwait
South Korea
Thailand
Russia
South Africa Indonesia
Argentina
China
Brazil
Is the Russian market still cheap?
...and those cheap valuations are accompanied by higher earnings growth
Price/Earnings Ratio (2005E) vs. Earnings Growth (2005E)
60%
Nasdaq Comp
Brazil
50%
40%
+36%
30%
Earnings
Growth
2005
South Africa
Kuwait
Qatar
Russia
China
20%
10%
Mexico
United Arab Emirates
India
S&P 500
Israel
Hungary
Turkey
Indonesia Germany
Thailand
Saudi Arabia
Nikkei 225
Poland
0%
Malaysia
-10%
South Korea
-20%
-30%
Price/Earnings Ratio
Taiwan
5
10
15
Source: UBS, Deutsche Bank, Bloomberg, Hermitage Estimates, September 2005
20
25
30
35
40
Is the Russian market still cheap?
Russia is also cheap relative to its own history
Russia's Price/Earnings Ratio*
12
10.7
11
10
10.6
9.6
Price/Earnings Ratio
+27.3%
9
8.4
8
7
6
5
4
Jan-02
May-02
Sep-02
Jan-03
May-03
Sep-03
Jan-04
* 12 month forward. Source: HSBC, Deutsche Bank, CSFB, UBS, Hermitage Estimates, September 2005
May-04
Sep-04
Jan-05
May-05
Sep-05
Is the Russian market still cheap?
As a result, the earnings yield is still significantly higher than the bond yield...
Earnings Yield - Sovereign Yield (%)
Russian Earnings Yield and Sovereign Yield (%)
17%
Earnings Yield
15%
13%
11.9%
11%
Current Risk
Premium
9%
7%
(6.65%)
Sovereign Yield
5.25%
5%
Jan-02
Apr-02
Jul-02
Oct-02
Jan-03
Apr-03
Source: Bloomberg, HSBC, UBS, Hermitage Estimates, September 2005
Jul-03
Oct-03
Jan-04
Apr-04
Jul-04
Oct-04
Jan-05
Apr-05
Jul-05
Is the Russian market still cheap?
...and the Russian equity risk premium (the earnings yield minus bond yield) is still
very high in historical terms
Russian Equity Risk Premium (%)
12%
"Yukos Crisis"
"Normal Time"
10.57%
10%
Equity 8%
Risk
Premium
(%) 6%
Average
(before Yukos crisis) = 3.2%
6.65%
Back to
normal ?
4%
2%
0%
Jan-02
Apr-02
Jul-02
Oct-02
Jan-03
Apr-03
Source: Bloomberg, HSBC, UBS, Hermitage Estimates, September 2005
Jul-03
Oct-03
Jan-04
Apr-04
Jul-04
Oct-04
Jan-05
Apr-05
Jul-05
Is the Russian market still cheap?
This makes the Russian equity risk premium higher than most other
international markets
8%
Equity Risk Premium (%)
7.5%
Risk Premium (%)
6.7%
6%
5.5% 5.4%
4.1% 3.9%
3.7%
4%
3.3%
2.9% 2.7%
2%
2.3%
2.0% 1.9% 1.9% 1.8%
Emerging Markets Average (2.3%)
1.5% 1.3% 1.3%
Developed Markets Average (1.9%)
1.0%
0.5%
0%
-0.3%
-0.7%
-2%
-4%
-1.0%
-2.0%
Brazil
Thailand
Russia
China
South
Hungary
Kuwait
Poland
Taiwan
Korea
Germany
UK
South
Israel
S&P
Africa
500
Source: Bloomberg, HSBC, UBS, Hermitage Estimates, September 2005
India
Indonesia
Nikkei 225
Qatar
Mexico
Argentina
Malaysia
-2.2%
Nasdaq
United Arab
Comp
Emirates
Turkey
Saudi
Arabia
What are the main drivers for a continued rise in the
Russian equity market?
Major Drivers of the
Russian Equity Market
Surge in Domestic
Liquidity
Shift in Allocations of
Global Fund Managers
Toward Russia
Earnings Upgrades and
Reserve Growth at
Russian Oil Companies
Surge in domestic liquidity
The most important driver of the Russian stock market in the last three years has
been the surge in domestic money supply
Russian Equity Market vs. Money Supply
Correlation between Russian Equity Market and
Money Supply
Money Supply (RUB bln.)
RTS Index
900
3100
RTS Index
RTS Index
900
+110%
800
2600
800
700
700
600
+160%
2100
600
500
1600
500
400
300
Money Supply
1100
200
600
May-02 Sep-02 Jan-03 May-03 Sep-03 Feb-04 Jun-04 Oct-04 Feb-05 Jun-05
R 2 = 0.85
400
300
700
900
1100
1300
1500
Money Supply (RUB bln.)
Source: Bloomberg, Hermitage Estimates, August 2005
1700
1900
Surge in domestic liquidity
Russian money supply has been driven by high commodity prices
US$ per $80
barrel $70
Price of Oil, Brent
(US$ per barrel)
US$ bln.
$24
$25
Russias Current Balance
(US$bn)
$20
$60
$50
$15
$13 $14
$11
$40
$10
$30
$6
$20
+225%
$8 $7 $8
$8
$7
$22
$18
$15
$9
$5
$10
$0
$0
$160
$150
$139
$125
Russia's Central Bank Reserves
(US$bn)
US$ bln. $140
$120
$100
$78
$80
$60
$40
$37
$44 $45 $48
$55
$84 $88
$94
$64 $63
2000
RUB bln. 1800
1600
1400
1200
1000
$20
800
$0
600
Source: Bloomberg, Aton, Hermitage Estimates, August 2005
Russian Money Supply
(RUB bn)*
+160%
Surge in domestic liquidity
The same relationship between money supply and equity markets exists in other
oil-producing countries
4000
4000
Saudi Arabia
3500
3000
Saudi SE
Index
United Arab Emirates
3500
UAE
Index
2500
2000
3000
2500
2000
1500
1500
1000
500
1000
R 2 = 0.78
0
16
18
35000
20
22
24
26
Money Supply
(US$bn)
R 2 = 0.65
500
3.0
4.0
3500
Kuwait
5.0
Money Supply
(US$bn)
Qatar
3000
30000
2500
25000
Kuwait Exchange
20000
Index
DSM
Index
2000
15000
1500
10000
1000
5000
500
R 2 = 0.77
0
1.5
1.7
1.9
2.1
2.3
Money Supply
(US$bn)
R 2 = 0.86
0
0.0
Source: Bloomberg, Deutsche Bank, HSBC, SAMA, SAMBA, Central Bank of Kuwait, Hermitage Estimates, August 2005
0.2
0.4
0.6
0.8
Money Supply
(US$bn)
Surge in domestic liquidity
However, the Russian equity market has seriously underperformed these other
oil-producing countries
Performance of the Russian Stock Market vs. Gulf Countries, 2-year Performance (%)
350%
306%
300%
250%
Return (%)
221%
229%
Qatar
Saudi Arabia
200%
150%
100%
66%
80%
50%
0%
RTS Index
Source: Bloomberg, Hermitage Estimates, September 2005
Kuwait
United Arab
Emirates
Surge in domestic liquidity
This is because the Russian stock market is much less sensitive to changes in money
supply than the Middle Eastern stock markets
Stock market growth vs. increase in money supply (M0)
500%
Saudi Arabia
Kuwait
(+10% in MS = +97% in Equities)
(+10% in MS = +96% in Equities)
400%
300%
Stock Market
Growth
UAE
(+10% in MS = +49% in Equities)
200%
Qatar
100%
(+10% in MS = +13% in Equities)
Russia
(+10% in MS = +6% in Equities)
0%
0%
10%
20%
30%
40%
Increase in Money Supply
Source: Bloomberg, Hermitage Estimates, August 2005
50%
Surge in domestic liquidity
Why? Because there is a much less developed banking system in Russia, which depresses
the money multiplier and restricts the effect of new money on asset prices
Different Layers of Money Supply as Percentage
of GDP in the Gulf Countries and Russia
77%
80%
Money multiplier (M2/M0)
25
70%
20.0
20
60%
44%
46%
Term deposits
Average = 13.7
15
13.4
13.9
40%
10
25%
20%
Demand deposits
Currency issued (M0)
0%
Russia
Saudi
Arabia
Qatar
UAE
Kuwait
5
7.2
3.0
0
Russia
Saudi Arabia
Source: Bloomberg, Deutsche Bank, HSBC, UBS, CSFB, SAMA, SAMBA, Central Bank of Kuwait, Hermitage Estimates, August 2005
Qatar
UAE
Kuwait
Surge in domestic liquidity
However, there are signs that the Russian banking system is now starting to change
as a result of the banking reform
Russian Banking Reform:
New deposit insurance
(effective January 2005)
US$ bn
110
100
New law on credit bureau
(enacted in June 2005)
90
New mortgage law
(adopted in December 2004)
70
Mortgage-backed securities market
(developing now)
Source: Central Bank of Russia, UBS, Hermitage Estimates, August 2005
Bank deposits in Russia
(2003-2005, US$ bn)
80
60
50
40
CAGR = 44%
Surge in domestic liquidity
If Russia develops its banking system to the level of the Gulf states, that would likely
expand the money multiplier which would increase the sensitivity of its stock market to
the change in the money supply...
Stock market growth vs. increase in money supply (M0)
500%
Saudi Arabia
Kuwait
400%
300%
Stock Market
Growth
UAE
200%
Russia (potential)
(+10% in MS = +26% in Equities)
100%
Qatar
Russia (current)
(+10% in MS = +6% in Equities)
0%
0%
10%
20%
30%
40%
50%
Increase in Money Supply
Source: Bloomberg, Deutsche Bank, HSBC, UBS, CSFB, SAMA, SAMBA, Central Bank of Kuwait, Hermitage Estimates, August 2005
Surge in domestic liquidity
...which could lead to a further re-rating of Russian assets
Russian Stock Market: Impact of Banking System
2000
Perfect Fit
(with a more developed
banking system)
1800
1600
+78% based on a money
supply growth and
change in money
multiplier
1400
RTS Index
1200
1000
+18% based on a money
supply growth*
800
600
Perfect Fit
(at
current level of sensitivity)
400
Actual Market (RTS Index)
200
May-02
Sep-02
Jan-03
May-03
Sep-03
Jan-04
May-04
Sep-04
Jan-05
May-05
+1 year
* Assuming 30% annual growth. Source: Aton, Troika Dialog, Bloomberg, Deutsche Bank, HSBC, UBS, CSFB, SAMA, SAMBA, Central Bank of Kuwait, Hermitage Estimates, August 2005
External liquidity
In addition to domestic liquidity, external liquidity also plays an important role in the
Russian equity markets
Composition of the Russian Market Cap and Free Float (%)
100%
90%
80%
International
Investors
11.8%
23.2%
70%
33.7%
International
Investors
66.3%
Domestic
Investors
Domestic
Investors
60%
50%
40%
30%
65.0%
Strategic
Holders
20%
10%
0%
Total Market Cap
Source: Bloomberg, Hermitage Estimates, August 2005
Free Float
External liquidity
Despite the recent strong performance of the Russian equity market, the average
emerging market fund is significantly underweight Russia
40%
Weighting of GEM Funds in Russia vs. MSCI Emerging Markets Index (%)
30%
Overweight
20%
10%
0%
-10%
Underweight
-20%
-30%
Source: CSFB, Hermitage Estimates, August 2005
Current
Underweight
-26%
External liquidity: Gazprom inclusion in MSCI
There is also going to be an important change in the Russia's weight in the MSCI
Emerging Market index with the removal of the ring fence at Gazprom
$110 billion
(at ADS price)
$120
$100
$80
US$ bn
$60
$40
$20
$-
Current ADS free float
in MSCI Russia, 3% of
GAzprom
$100 billion
(6.8%of MSCI)
Gazprom
$65 billion
(4.4% of MSCI)
Gazprom
Other
Russian
Stocks
Current
MSCI Russia
Future free in MSCI
Russia, 35% of
Gazprom
Other
Russian
Stocks
Gazprom Market
Capitalization
Source: Aton, UBS, Citigroup, CSFB, Renaissance Capital, Hermitage Estimates, August 2005
New
MSCI Russia
+54%
External liquidity
The increase of Russia's weight in the MSCI Emerging Market Index will exacerbate
global fund managers' "underweight" levels of Russian stocks
Weighting of GEM Funds in Russia vs. MSCI Emerging Markets Index (%)
70%
Neutral Weight after Gazprom Inclusion in MSCI
50%
Overweight
Shift in Neutral Weight
30%
-53%
10%
-10%
Underweight
-30%
Future
Underweight
Current Neutral Weight
-50%
Source: CSFB, Hermitage Estimates, August 2005
Earnings upgrades & reserves
The third catalyst for the Russian equity market is positive earnings surprises
$15
+138%
UBS estimates of 2005 Earnings, Current and 6 Months Earlier
(US$ billions)
$14.2
$14
February 2, 2005
+75%
$7
$6
US$bn
August 5, 2005
$6.0
$6.0
$5
+28%
$4
$3.4
$3.4
$3
$2.6
+30%
$3.0
$2.3
$2
$1
+42%
$0.6
$0.8
$0
Gazprom
Source: Brunswick UBS, Hermitage Estimates, August 2005
Lukoil
SurgutNG
Sibneft
Tatneft
Earnings upgrades & reserves
So far analysts have been hesitant to upgrade their long-term oil price estimates
Price of Oil, (US$ per barrel) vs. Consensus Estimates
$75
$65
Futures contract, 2011
Oil Price, Spot
$55
US$
per
barrel
Futures, 2011
-52%
$45
$35
18 Month Delay
$25
Long-Term Estimate,
U$30 per barrel
Oil Price Consensus Estimate, 1 Year Earlier
$15
Jun-01
Jun-02
Jun-03
Source: Bloomberg, Goldman Sachs, Hermitage Estimates, August 2005
Jun-04
Jun-05
Jun-06
Earnings upgrades & reserves
If oil prices remain high in the long term, Russian oil companies have significant further
upside
Share Prices under Various Long-Term Oil Price Scenarios (US$ per share)
Long-Term
Brent Oil Price
$20
$25
$30
$50
$70
$90
LUKOIL [$48]
7.96
26.32
42.69
101.60
163.67
226.06
Gazprom [$4.2]
1.21
2.17
3.08
5.41
8.75
12.10
SurgutNG [$0.95]
0.63
0.82
0.96
1.89
2.98
4.07
Current trading ranges
Excluding treasury shares. Source: Renaissance Capital, Hermitage Estimates, June 2005
Earnings upgrades & reserves
Russian oil companies are even more undervalued on an asset-based valuation
(relative to both public and private valuations)
Market Cap or Acquisition Value per Barrel of Proved Oil Reserves (US$ per BOE)
$20
$17.9
$17.1
$16.8
$16.8
$16.2
$16.0
$15
$14.3
$13.4
$13.3
$12.7
$10.9
$10.9
US$ $10
per BOE
$10.7
$10.6
$9.0
Russia
$8.8
$8.4
$6.1
$5
$4.2
$2.6
$2.1
$2.0
$0.9
$0
ExxonMobil
Pogo/
UnoCal*
RD Shell
BP
Moller-Maersk/
Kerr-McGee*
Cimarex/
MagnumHunter*
Total
Apache/
Anadarko*
Noble/Patina*
Sinopec
Various/
Devon*
*Indicates M&A deals. Source: Bloomberg, HSBC, CSFB, Hermitage Estimates, September 2005
CNOOC/
Unocal*
Chevron
Texaco
Occidental/
ExxonMoble*
Pionner/
Evergreen*
CNPC/
Petrochina
PetroKazakhstan*
TNK-BP
Petrobras
Surgutneftegas
Sibneft
Gazprom
LUKOIL
Earnings upgrades & reserves
...yet Russian companies still have huge potential in the Possible/Probable reserve
categories, whereas their western counterparts are close to being "fully proven"
Proven Oil Reserves as % of 3P Oil Reserves (Proven+Probable+Possible)
100%
Probable
&Possible
Probable
&Possible
80%
60%
40%
Proven
64%
Proven
60%
20%
0%
Sibneft
Source: CSFB, Hermitage Estimates, April 2005
Lukoil
46%
Surgut
85%
31%
TNK-BP
Western
Companies
Earnings upgrades & reserves
There may be even more reserve growth because Russia is just beginning to develop its
vast East Siberia territory, and is yet to explore most of the off-shore potential
Off-shore
Potential
Arctic Ocean
Timan Pechora
Volga Ural
Mature Fields
Source: Brunswick UBS
West Siberia
East Siberia
Risks - Political risks
The main market risk revolves around the upcoming transition of power in 2008.
The Russian Constitution limits the President to two consecutive terms
1. Oversee normal
elections
Putin's Choices:
Putin elected to 1st
term
2. Appoint a
successor
Putin re-elected 2nd
term
?
2000
2004
2008
3. Change the
Constitution, remain
in power
4. Become "Super"
Prime Minister
5. Unexpected catastrophic political
upheaval
?
Risks - Political risks
Whatever happens, the one thing we know for certain is that the future president
of Russian may not even be on the radar screen
%

Putin Approval Ratings (1998 - 2005)
Yeltsin Resigns, Putin
Elected
(Jan., March 2000)


Putin
 Putin Appointed Prime

Minister
(August 1999)



Zhirinovsky


Zyuganov

Luzhkov






































Putin Unknown on
National Stage
Source: Levada Center (www.levada.ru) Council on Foreign Relations, The December 1999 Duma Elections, (http://www.cfr.org/pub3575/cfr/the _december
_1999_duma_elections_russian_nationalism_on_the_rise.php) some monthly figures interpolated from quarterly data.
Risks - Correlation with risky assets
The other significant risk is a deterioration in the general risk appetite given the current
high correlation between the Russian equity market and other risky assets
Correlation of the Russian Equity Markets with MSCI Global Emerging Markets Index and High Yield Index
1.0
92%
High Yield Price
Index
0.8
63%
0.6
0.4
0.2
Correlation*
MSCI Emerging Markets
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
Jan-05
Jan-05
Feb-05
Mar-05
Mar-05
Apr-05
*8 week rolling correlation. Source: Bloomberg, Hermitage Estimates, September 2005
May-05
Jun-05
Jun-05
Jul-05
Aug-05
Sep-05
Other major risks
Oil price falls to less than US$20 per barrel
Equity risk premiums rise all over the world
Catastrophic political change within Russia
Hermitage investment approach
We focus on stocks with low valuations
Price/Earnings Ratios of Russian Stocks vs. Hermitage Portfolio (2005E)
45
40.5
40
34.6
35
30
27.9
- Major positions in the Hermitage portfolio
25.9
24.2
25
P/E
22.9
19.1 18.6
20
18.3 18.2
Russia Average
17.1 16.9 16.5
16.1 15.8 15.7
14.2
15
10
13.4 13.2 12.8
12.5 12.2 11.9 11.8
11.3 10.8
10.5
8.4 8.0
5
0
Hermitage Fund
7.3 7.0 6.9 6.8 6.8 6.7
6.4 6.0 5.8
5.4 5.3 5.1
4.4
Apteka Seventh RBC
Volga
Irkut
MGTS Siberia Lebed- Vimpel- Kalina Aeroflot Fesco
Ros- UES Russian TNK- Novoship Hermitage Sever- Sibneft NLMK
Surgut36.6 Continent
Telecom
Telecom yansky
Com
telecom
Market
BP
Fund
stal
NG
Eastern
EFES PyaterOpen Wimm- Baltika Novatek Oriflame AFK
Golden
MTS VSMPOSeverstal- Norilsk Gazprom Tatneft
Lukoil Mechel Bashneft Transneft
Property
ochka
InvestBillSistema Telecom
Avisma
Auto
Nickel
Holding
ments
Dann
Source: Aton, UBS, CSFB, ING, Alfa Bank, Hermitage estimates, September 2005
Background - Why do we care about Gazprom?
Gazprom is the cheapest hydrocarbon company in the world, trading at 95% discount to
international energy companies. One of the principal reasons for that is inefficiency and
graft
Market Cap or Acquisition Value per Barrel of Proved Oil Reserves (US$ per BOE)
$20
$17.9
$17.1
$16.8
$16.8
$16.2
$14.3
$15
US$
per
BOE
$16.0
$13.4
$13.3
International Average =$12.7
$12.7
$10.9
$10.9
$10.7
$10.6
$10
$9.0
$8.8
$8.4
$6.1
-93%
$4.2
$5
$2.6
$2.1
$2.0
$0.9
$0
ExxonMobil
RD- Pogo/ MollerShell UnoCal* Maersk/
KerrMcGee*
BP
Total Cimarex/
MagnumHunter*
Noble/
Patina*
Apache/
Anadarko*
Various/
Devon*
Sinopec
ChevronTexaco
CNOOC/
Unocal*
*Indicates M&A Deals. Source: Bloomberg, HSBC, CSFB, Hermitage Estimates, September 2005
Occidental/
ExxonMoble*
CNPC/
PetroKazakhstan*
Pionner/
Evergreen*
Petrochina
TNK-BP Sibneft Surgut- LUKOIL Gazprom
neftegas
Petrobras
1. Asset stripping -10% of reserves found stolen
In October 2000, Hermitage study revealed that Gazprom had lost control over
subsidiaries and JVs accounting for nearly 10% of its gas reserves and worth about
$5 billion through a series of dilutive issues and questionable transactions
Gazprom
Market
Value,
mln USD
% lost
Price paid,
mln USD
Value of
stake,
mln USD
Lost value
to Gazprom ,
mln USD
% of total
Gazprom
reserves
2,535*
81%
275
2,053
1,778
1.25%
1997-2001
954
51%
26
487
461
1.62%
Tarkosaleneftegas
1997-2001
780
38%
16
298
282
1.33%
Sibneftegas
1999
530
35%
0.3
186
185
1.04%
Achimneftegas
2000
596
49%
292
292
1.16%
Vostokgas
1999
503
49%
247
247
0.98%
Severneftegasprom
2000-2001
2,523*
89%
2,245
2,235
2.26%
Total
1997-2001
5,480
9.65%
Company
Date
Purgas
1998-1999
Rospan
10
325
Source: FCSM official website, PWC Audit of Gazprom-Itera Relationships, Audit Chamber Report on Gazprom-Itera Relationships, Hermitage Estimates
1. Asset stripping - Official reaction to the public campaign
Following the highly publicized Hermitage board campaign, the CEO of Gazprom,
Rem Viakhirev was fired and Putin's candidate, Alexey Miller became the new CEO with
a clear mandate of recovering the lost assets
"Company assets are being transferred ... for the benefit
of the management"
"Gazprom has quietly shuffled two trillion cubic meters
of gas reserves"
"Gazprom has transferred hundreds of millions of dollars
in assets"
"Questions are mounting about officials' selfserving deals"
FIRED
APPOINTED
1. Asset stripping - Progress in asset recovery
Since that time, Gazprom has regained control over 63% of previously lost reserves
Reserves lost by Gazprom (bboe, Russian standards, ABC1)
25
20.5 bboe
20
Sibneftegas, 2.0 bboe
Tarkosaleneftegas, 2.5 bboe
15
Rospan, 3.1 bboe
10
Nortgas, 2.1 bboe
Achimneftegas, 2.2 bboe
Vostogas, 1.9 bboe
5
Purgas, 2.4 bboe
Recovered
assets
Severneftegazprom, 4.3 bboe
0
Reserves
Source: FCSM official website, PWC Audit of Gazprom-Itera Relationships, Audit Chamber Report on Gazprom-Itera Relationships, Hermitage Estimates
2. Missing export revenues - Export through intermediaries
Another study by Hermitage (2002) identified unexplained discounts that Gazprom
granted to certain intermediaries who then re-sold Russian gas at higher market prices
Country
Germany
Germany
Germany
Romania
Romania
Romania
Poland
Poland
Poland
Poland
Austria
Austria
Bulgaria
Bulgaria
Bulgaria
Importer
Ruhrgas
Wingas
Wien
Transgas
Wien
Konef
PGNiG
Bartimpex
EuRoPol GAZS.A.
Clair air industriin
air
OMV
GWH
Zarubezhgasm-nt
Overgas
Bulgargas
Average
price
$/1000m3
Discount to
the best
country
importer
Volume of
gas purchased
mln m3
Percent not
owned by
Gazprom
110.5
96.2
94.3
100.6
98.0
76.0
96.4
95.6
63.4
51.7
110.0
102.9
96.1
95.7
83.0
0.0%
13.0%
14.7%
0.0%
2.6%
24.5%
0.0%
0.8%
34.2%
46.3%
0.0%
6.5%
0.0%
0.3%
13.6%
16,342
2,575
12,096
535
2,522
455
5,767
1,284
61
136
3,519
1,695
480
826
1,520
100%
65%
50%
100%
50%
100%
100%
100%
52%
100%
100%
50%
100%
100%
100%
Total Gazprom profit foregone due to intracountry price disparities:
Source: Russian Customs Committee, Hermitage Estimates
Gazprom
foregone
profit
mln USD
0.0
24.0
98.0
0.0
3.3
11.2
0.0
1.0
1.0
6.1
0.0
6.0
0.0
0.3
19.9
$ 170.8mln
2. Missing export revenues
Campaign effect: CEO of Gazexport fired
At the end of 2002, Alexey Miller fired the CEO of Gazexport, Oleg Siyenko
Alexey Miller,
CEO of Gazprom
FIRED
APPOINTED
Oleg Siyenko,
ex-chief of Gazexport
Alexander Medvedev,
new chief of Gazexport
Export underpricing practices stopped
3. Exuberant expenditures
Example: North Tyumen - Torzhok pipeline
In 2005, Hermitage started to focus on Gazprom's capital expenditures, and discovered
that Gazprom planned to spend over $9 billion to build a pipeline from the Urengoi field
to European Russia
North Tyumen - Torzhok Pipeline
Estimated Cost - $9,041m
Urengoi
Length - 2,700 km
Torzhok
Torzhok
Source: Gazprom Structured Notes Preliminary Offering Circular, July 12, 2004 (p.124)
Urengoi
Cost per 1 km,
over $3.3 mln
3. Exuberant expenditures
Abnormally expensive construction
The cost per kilometer was 3.4 times the cost of building a similar pipeline in
the rest of the world, including the U.S.
Cost of gas pipeline construction (US$ m per 1 km)
$4
$3.35
$2.95
$3
Estimated $2.3 million is overspent on each 1 km
$2
$1.40
$1.39
$1.35
$0.99
$1
Average excl. Gazprom
$0.90
$0.63
$0.63
$0.50
Source: Gazprom Structured Notes Preliminary Offering Circular, July 12, 2004 Pipeline and gas industry construction report, Hermitage Estimates
(Peru)
Camisela-Ilo
US average
(Latin America)
Cuidad Pemex
(Latin America)
Colonia
Punta Lara -
Baku-Erzerum
(Caucasus)
(Turkish part)
Blue Stream
(TurkmenistaPakistan)
Centgas
(China)
Tarim-Xinjang
(Gazprom)
Blue Stream
(Gazprom)
Torzhok
SRTO -
$0
3. Exuberant expenditures
Effect of public campaign: $3 billlion saved
After Hermitage released the information to the press, Gazprom slashed
the budget for the project by $3.1 billion
Initially budgeted and revised cost of N. Tyumen-Torzhok pipeline (US$ m)
10,000
$9,041 m
8,000
$3.1 bn
saved
$5,937 m
6,000
4,000
2,000
2004 (initial budget)
2005 (revised)
Hermitage will push Gazprom to save more on this and other projects
Source: Gazprom Structured Notes Preliminary Offering Circular, July 12, 2004 Pipeline and gas industry construction report, Gazprom Briefing June 2005, Hermitage Estimates
Summary - Less waste, less stealing
Shareholder activism has helped
reduce the scale of stealing and
waste at Gazprom...
...and has helped the stock appreciate
6 times in 4 years
Estimated theft and inefficiencis detected
by Hermitage audit (2004 vs. 2000, US$ m)
US$ m
Gazprom share price
(2001-2005, US$ per share)
10000
$9,439 m
9000
Capex write-offs
926
FSU revenues
1064
$4.0
Special deals
1799
$3.0
8000
7000
6000
$4.5
170
$3.5
$2.5
80% less
5000
4000
3000
2000
Asset stealing
5480
$1.5
$1,879 m
320
740
1000
767
0
2000
Source: Bloomberg, Hermitage Estimates, September 2005
+820%
$2.0
2004E
Excess materials
Excess staff costs
Eural Trans Gas
$1.0
$0.5
$0.0
Jul-01
Feb-02
Sep-02
Apr-03
Nov-03
Jun-04
Jan-05
Aug-05
Hermitage performance
Performance of the Hermitage Fund vs. the Russian Market*
1500%
1400%
1300%
1200%
1100%
1000%
900%
800%
700%
600%
500%
400%
300%
200%
100%
0%
*As of September 9, 2005
+1470%
Hermitage Fund
+758 %
CSFB ROS Index
Disclaimer
This material is for information purposes only and is not an invitation to subscribe for units or shares in the Hermitage Fund.
Subscriptions will only be received and units or shares issued on the basis of the current prospectus for the Fund, and
prospective investors should carefully consider the risk warnings and disclosures for the Fund set out therein. Investors
should also consider any other factors that may be relevant to their circumstances, including tax considerations, before
making an investment.
The information is based on data obtained from publicly available sources, which have not been verified by Hermitage Capital
Management Limited, or any of its respective associates or affiliates. As a result of the difficulty in obtaining reliable data in
Russia, we do not represent this information to be accurate and complete and we do not accept any responsibility for the
reasonableness of any conclusions based upon such information.
Past performance is not necessarily indicative of the likely future performance of an investment. The price of units or shares
can go down as well as up and may be affected by changes in rates of exchange.
The Hermitage Fund has been authorised by the Guernsey Financial Services Commission as a Class B Collective Investment
Scheme under the Protection of Investors (Bailiwick of Guernsey) Law 1987 and the Collective Investment Schemes (Class B)
Rules 1990. It must be understood that in giving this authorisation the Commission does not vouch for the financial
soundness or correctness of any of the statements made or opinions expressed with regard to The Hermitage Fund. Investors
in The Hermitage Fund are not eligible for the payment of any compensation under the Collective Investment Schemes
(Compensation of Investors) Rules 1998 made under the Law.