TNK-BP Holding: classical definition of a cash cow

Transcription

1 RESEARCH DEPARTMENT OIL & GAS Scott Maxwell - Fotolia.com Alexander Nazarov +7 (495) Alexander.Nazarov@gazprombank.ru

2 EQUITY RESEARCH: OIL AND GAS TNBP OVERWEIGHT Target price, $ 4.06 Closing price, $ (Mar 14, 2012) 3.19 Upside potential 27% TNBPP OVERWEIGHT Target price, $ 3.71 Closing price, $ (Mar 14, 2012) 2.88 Upside potential 29% Stock price performance YTD Jan 11 Mar 11 May 11 Jul 11 Sep 11 Nov 11 Jan 12 Mar 12 TNBP RX Equity TNBPP RX Equity INDEXCF Index Source: Bloomberg, Gazprombank estimates Russian oil majors 2010 Free cash flow, $ per bbl Average Bashneft Gazprom Neft Tatneft* LUKOIL Rosneft TNK-BP % 3.6% % 4.2% % Source: Bloomberg, Gazprombank estimates *- Tatneft FCF estimate includes TANCEO construction Russian oil majors dividend yield 2011E, % Average 6.3% 11.0% 8.6% Bashneft pref Bashneft Gazprom Neft Tatneft pref Tatneft LUKOIL Rosneft TNK-BP pref TNK-BP 8.6% 7.6% We initiate coverage of TNK-BP Holding with OVERWEIGHT rating and DCF-based TP of $4.06 per common share, implying a 27% upside. We also calculate the fair discount of 8.7% for TNK-BP preferred shares over ordinary shares, assuming TP of $3.71 per share, which corresponds to 29% upside. We assign OVERWEIGHT rating to preferred shares of TNK-BP. We point out the high ability to generate free cash flow, which is almost 100% distributable as dividends, providing the largest ROI among Russian oil and gas majors. We highlight the lack of short-term drivers and high dependence of share price performance on dividends. Russia s third largest oil producer with good crude production outlook. TNK-BP is the third largest Russian oil producer with output of 74 mln tonnes of crude oil in Also, it is probably the only Russian oil major with the outlook to increase its crude oil production by at least 1% a year over the next 5 years. Decent free cash flow generation ability. While on EBITDA per bbl TNK-BP is behind Rosneft, Lukoil, Gazprom neft and Bashneft, on FCF per bbl TNK-BP is one of the best Russian oil companies. We estimate its EBITDA per bbl in 6M11 at $24, 15% lower than the industry majors average, while FCF per bbl net of working capital changes was $11 per bbl, or just 3% below the industry average. FCF per bbl for 2010 was 38% higher than the industry average. One of the best dividends plays on the Russian market. The structure of TNK-BP Holding also suggests that the most appropriate way for shareholders to get benefits from the company is to pay out large dividends. We note that over the last 3 years, TNK-BP Holding s dividend yield was higher than 15% for ordinary shares and 17% for preferred shares. Moreover, TNK-BP pays out interim dividends, a pretty rare case for Russian oil and gas industry. Unique shareholders structure positions the company among the most efficient in the Russian oil and gas industry. TNK-BP is co-owned by international oil major BP and Russian shareholders consortium AAR. The combination of technical and financial expertise of international managers and local shareholders lobbying power provide TNK-BP with unique opportunities. The company is one of the most efficient in the Russian oil and gas industry in terms of capex per bbl and operating expenses per bbl, and at the same time, it has a remote risk of major unfriendly actions from Russian authorities. The lack of short-term drivers is compensated with excellent fundamentals. TNK- BP has a small free-float and is listed on a Russian stock exchange only. While back in 2009, TNK-BP shareholders were talking about the possibility of an IPO, we do not think it is an option, at least for the next 12 months. Due to the size of the company we do not expect any acquisitions, which may lead to the company s revaluation by the market. As for Slavneft s assets, which are jointly owned by TNK-BP and Gazprom neft, their division between two shareholders is also unlikely, in our view. As a result, we see lack of strong short-term drivers for the stock. However, large dividend yield and strong fundamentals provide investors a strong defensive play with high ROI. Dividend Discount Model (DDM) assumes TNK-BP share fair value at $4.06, supporting our DCF-based target price. We have also performed DDM valuation for TNK-BP shares, which results in DDM-based fair value of $4.24 per both ordinary and preferred share, assuming 31% and 45% respective upsides for ordinary and preferred shares, supporting our DCF-based target price. 0% 2% 4% 6% 8% 10% 12% Source: companies, Gazprombank estimates Key financial indicators, $ mln E 2012E 2013E 2014E 2015E 2016E Revenue 41,113 50,539 53,323 55,383 58,133 60,162 62,618 EBITDA 9,944 12,235 12,822 12,169 12,294 12,340 13,573 EBITDA margin 24% 24% 24% 22% 21% 21% 22% Net income 6,384 7,493 7,301 6,257 5,798 5,263 5,710 NI margin 16% 15% 14% 11% 10% 9% 9% EV/EBITDA P/E Source: company, Gazprombank estimates Alexander Nazarov +7 (495) AlexanderNazarov@gazprombank.ru Copyright Gazprombank (Open Joint-Stock Company) 2

3 CONTENTS Investment summary Investors F.A.Q. to TNK-BP Gazprombank answers Risks Oil price may fall Oil taxation system may be changed in a adversely affect Russian oil majors Shareholders may go on with conflicts Valuation Company overview Corporate structure Upstream Downstream Preferred shares valuation Dividend Discount Model (DDM) valuation TNK-BP share market Peer group valuation. TNK-BP seems fairly valued compared to Russian peers Financial outlook Income statement Capex and free cash flow Appendices

4 TNBP OVERWEIGHT Target price, $ 4.06 Closing price, $ (Feb 22, 2011) 3.19 Upside potential 27% TNBPP OVERWEIGHT Target price, $ 3.71 Closing price, $ (Jun 22, 2011) 2.88 Upside potential 29% General information Closing price, $ (Mar 14, 2011) 3.19 # of shares outstanding, mln 14,997 Free float 4% Market Cap, $ mln 47,791 Net debt (cash), $ mln 4,422 Minority Interest, $ mln 1,199 EV, $ mln 53, week high week low 1.99 Source: Bloomberg, company, Gazprombank estimates In 2010 TNK-BP was among the best free cash flow generators in the industry we estimate it was $7.6 per bbl net of working capital. Investment summary We initiate coverage of TNK-BP with OVERWEIGHT rating and TP of $4.06 per ordinary share implying 27% upside to the current price level. We also assign OVERWEIGHT rating to TNK-BP preferred shares with TP of $3.71 per share, assuming 29% upside. We calculate the fair discount of 8.7% to ordinary shares, resulting in our target price. An alternative valuation using DDM approach yields TP of $4.24 per both ordinary and preferred share. Russia s No. 3 oil company. TNK-BP Holding is the third largest Russian company in terms of crude oil output. In 2011, TNK-BP Holding produced 74 mln tonnes of crude oil. It is also the fourth largest refiner in Russia, with 23 mln tonnes of refined volumes in In terms of revenues we estimate TNK-BP as also the third largest Russian company - we estimate its 2011 revenues at $53 bln. Good upstream profile could provide growth over the next 5 years. TNK-BP holds an attractive profile of greenfield licenses. We note that TBH production portfolio assumes crude oil production not only in the medium term, but also in the long term. TBH owns or may purchase at least 5 significant prospective fields (some of them are currently owned by the parent company), which may start production in These fields contain total 3P+3C reserves of about 6 bln bbl, and could account for up to 25% of total TNK-BP crude oil production by Decent free cash flow generator,... In 2010, TNK-BP was among the best free cash flow generators in the industry we estimate it at $7.6 per bbl, net of working capital. In our view, only Lukoil had higher FCF per bbl - $8. Moreover, in 1H11 TNK-BP s FCF per bbl was up 45% YoY at $11 per bbl, which was still one of the highest numbers in industry. Russian oil majors FCF net of working capital and acquisitions, $ per bbl of crude oil output TNK-BP Rosneft Lukoil Tatneft Gazprom neft Bashneft In may pay out about $23 bln as dividends, or 50% of its market cap. Source: companies, Gazprombank estimates...and free cash flow is distributed through dividends. Unlike most of other oil majors, TNK-BP distributes almost all of its FCF as dividends. We estimate that in Н11, TNK-BP distributed 91% of its FCF net of working capital as dividends and paid off more than $17 bln, or 37% of its current market capitalization. Moreover, we estimate that in TNK-BP may pay out about $23 bln as dividends, or 50% of its market cap. 4

5 TNK-BP FCF net of working capital and dividends paid H11, $ mln % % 140% % 120% 100% % 91% 80% 80% % 65% 58% 58% 60% % 40% 40% 40% % 0 0% H 2011 Average FCF net of WC Dividends % of FCF Payout ratio TNK-BP shares are likely to be driven by news on dividends payments. Source: companies, Gazprombank estimates Lack of speculative short-term drivers, but strong fundamentals. We do not expect TNK-BP shares to be driven by any major corporate event in We note that listing of TNK-BP shares at foreign stock exchange or changes in the shareholder structure could drive the shares, but we do not expect these events to occur in Moreover we would see such changes in the shareholder structure as illogical and so we do not expect them to change at all. As a result we think that TNK-BP shares are likely to be driven by news on dividends payments and its performance would not largely differ from the average market. We underline that we consider TNK-BP as a defensive play on the back of excellent fundamentals good crude oil productions growth, low capex per bbl and decent gas production prospects. TNK-BP Holding is by approximately 95% owned by TNK-BP International, which is a dividend payer to major shareholders, BP and AAR. TNK-BP International is one of the highest-quality Russian borrowers and cost of debt raised could be probably one of the lowest among Russian corporates. Investors F.A.Q. to TNK-BP Gazprombank answers Investor s Question. Dividends are forever? Gazprombank s Answer. Yes, because it is the way of cash transfer to TNK-BP International and we do not expect major changes in corporate structure. TNK-BP Holding is approximately 95%-owned by TNK-BP International, which is a dividend payer to major shareholders, BP and AAR. Dividends payment is the most appropriate cash transfer way from TNK-BP Holding to major shareholders through TNK-BP International, and minorities enjoy this way, as well. Dividend policy for TNK-BP International envisages distribution of minimum 40% of net income. There is no formal dividend policy for TNK-BP Holding however distribution of dividends from TNK-BP Holding is an important funding source for TNK-BP International. It shall be noted that actual dividend flows normally do not match each other as the dividends from TNK-BP International are paid on a quarterly basis and from TNK-BP Holding are normally declared twice a year. Q. TNK-BP shares are illiquid, do you expect IPO? A. No, we do not see any logical reason behind IPO of TNK-BP and do not expect in the nearest future. We use a straight-forward logic approach to IPO issue for TNK-BP. We argue the main goal of IPO is fund-raising. We see no point in fund-raising for the company which pays out several billion dollars annually. Furthermore, TNK-BP International is one of the highest-quality Russian borrowers and cost of debt raised could be probably one of the lowest among Russian corporates. We admit liquidity issue for TNK-BP shares and unfortunately we are not looking for any substantial improvement in the nearest future for TNK-BP shares liquidity. 5

6 TNK-BP is an extremely important asset both for BP and AAR. The shareholder conflicts between BP and AAR, both in 2009 and 2011, did not change anything in the shareholder structure of TNK-BP and did not materially affect operational and financial performance of the company. Q. If not IPO, maybe one of major shareholders would like to sell its share? A. No, we do not believe in sale of its TNK-BP share neither by BP nor by AAR. BP in its 4Q11 report said that in 2011 its reserve replacement ratio was 103%. Without TNK-BP it would be just 83%. Also, in 2012 BP production excluding TNK- BP is expected to be broadly flat compared with We think share in TNK-BP is one the most important BP assets, currently the only source of growth for BP production and reserves, as well as a good cash source. BP is not in position to sell TNK-BP stake. AAR public position was also pretty clear it was ready to sell its share, assuming the total TNK-BP cost of $70 bln, about 46% premium to the current market price. First, we doubt that anybody would pay such a premium for a non-control stake. And second, we do not see any asset which would be comparable with TNK-BP for AAR in terms of size and return to shareholders. We do not see the logic in AAR sale of its TNK-BP stake, as well. Q. Do you expect any major shareholders conflict in the future A. It does not matter. We see conflicts do not really hurt TNK-BP. When none of shareholders have control conflicts are hard to avoid. We cannot forecast with high level of certainty both absence of conflict between BP and AAR in the future and its presence. At the same time we recap that both conflicts of 2009 and 2011 between BP and AAR did not change anything in the shareholder structure of TNK-BP, did minor changes into corporate structure of the group and did not materially affect operational and financial performance of the company. We are not looking for any further shareholders conflict would be a major driver for TNK-BP shares. Risks Oil price may fall TNK-BP has one of the lowest refining capacities as a 32% of total crude oil output among Russian oil majors, not accounting for YANOS and LINIK Russian oil companies refining capacity, as a % of total crude oil output, 2011E Bashneft Gazprom Neft Rosneft LUKOIL TNK-BP * - TNK-BP refining capacity does not include YANOS and LINIK Source: companies, Gazprombank estimates Surgutneftegas Tatneft Average Russian top-7 Total Russia 6

7 As a result, crude oil export accounted for about 45% of the total revenue of TBH for 1H11, one of the largest shares in Russian oil and gas. In our estimates, each $10 incremental decrease in our oil price forecast would lower our TP for TBH shares by $0.25, or by 6%. Crude oil export, as a % of total revenues, 1H11 80% 70% 60% 50% 40% 30% 20% 10% 0% Tatneft Surgutnefteg as TNK-BP Rosneft Gazprom Neft LUKOIL Bashneft Average Source: companies, Gazprombank estimates Although the share of crude oil exported is flexible and may be a subject for significant change, we still point out TNK-BP revenues is one of the most dependent among Russian oil companies revenues to the oil price changes. We estimate each $10 decrease in our oil price forecast would decrease our TP for TBH shares by $0.25, or by 6%. We have to underline that our current Urals oil price forecast is $104.4 per bbl, thus we currently see rather upside risk to TNK-BP financial projections than downside risk. Any further changes of Russian oil taxation system could potentially adversely influence on Russian oil companies revenues and margins. Oil taxation system may be changed in a adversely affect Russian oil majors Starting 1 January 2012 the base oil MET rate will be increased from current RUB 419 to RUB 446, or by 6.4% YoY, and further to RUB 470, or by 5.4% YoY starting 1 January That would effectively increase our projected 2012 crude oil MET rate from RUB 4,409 per ton ($20 per bbl) to RUB 4,693 per ton ($21 per bbl). Also excise taxes for gasoline and petrol would significantly increase in 2012, we estimate in average by more than 50% YoY. We note the risk that any further changes of Russian oil taxation system could potentially adversely influence on Russian oil companies revenues and margins. At the same time we estimate effect of these changes to TNK-BP EBITDA is positive, we estimate it at least at 1% of additional EBITDA for TNK-BP, mainly as a result of crude oil export duty rate decrease. Shareholders may go on with conflicts The share capital of TNK-BP Limited, which is the top holding company of TNK-BP, is owned 50% by AAR and 50% by BP. After the first shareholders conflict, BP and AAR have entered into a shareholders agreement dated 9 January 2009 which contains a number of provisions regarding the management of TNK-BP. Nevertheless, in 2010 shareholders started a new conflict regarding the possible BP participation in joint venture with Rosneft on Russian Arctic offshore. This conflict still goes on through several court claims, which we do not expect to influence TNK-BP operations. We note that risk that TNK-BP shareholders may go on with conflict which pressure TNK-BP share price in the future. TNK-BP is one of the largest investments both BP and AAR, providing extremely attractive cash returns. At the same time TNK-BP is one of the largest investments both BP and AAR, providing extremely attractive cash returns. We don t see an investment of comparable size and quality which could provide for BP and AAR the same returns. That is the main reason why we do not believe in any significant change in TNK-BP shareholders structure. 7

8 We do not expect TNK-BP to perform an additional shares placement in the nearest future and do not see an IPO as a driver for TNK-BP shares. The DCF valuation approach yields the target price of $4.06 per one ordinary share of TNK-BP Holding, which implies a 27% upside to the current price. In our DCF valuation, we use WACC of 11.0%. Our terminal growth rate assumption is 0.5%. Moreover, for the same reasons we do not expect TNK-BP to perform an additional shares placement in the nearest future and do not see an IPO as a driver for TNK-BP shares. We estimate TNK-BP is able to generate enough cash both to finance its own capex requirements and to pay out large dividends. Valuation We use DCF valuation and arrive at a target price of $4.06 per ordinary TNK-BP Holding share, which implies a 27% upside to the current price. We assign OVERWEIGHT recommendation to TNK-BP ordinary shares. We also set a target price of $3.71 per preferred TNK-BP share, which implies a 29% upside. We assign OVERWEIGHT recommendation to TNK-BP Holding preferred shares, as well. WACC calculation For the purposes of DCF valuation of TNK-BP Holding we use WACC of 11.1%. We calculate TBH cost of equity as a sum of risk-free rate, which we define as a yield of UST 10 of 2.61%, and Russian-equity specific risk premium of 8% as a combined 5% equity beta and Russia country-specific premium of 3%. We estimate after-tax rate for TBH Eurobonds at 4.6%. TNK-BP Holding WACC calculation Risk-free rate: 10-year US Treasury yield, 1M average 2.6% Russian country-specific risk premium 8.0% Company-specific premium 1.5% Cost of equity 12.1% After-tax cost of debt 4.6% Weight of equity 86.5% Weight of debt 13.5% WACC 11.1% Source: Bloomberg, Gazprombank estimates DCF valuation We use the terminal growth rate of 0.5% for TNK-BP, accounting for the short reserve life and large size of the company, which makes us conservative in terms of long-term growth rate forecast. TBH DCF valuation model summary, $ mln E 2012E 2013E 2014E 2015E 2016E 2017E Revenues 41,113 50,539 53,323 55,383 58,133 60,162 62,618 64,943 Operating costs (incl. purchases, excl. DD&A) (31,169) (38,305) (40,501) (43,213) (45,839) (47,822) (49,045) (50,402) EBITDA 9,944 12,235 12,822 12,169 12,294 12,340 13,573 14,541 EBIT 8,132 9,898 9,907 8,594 8,035 7,391 7,947 8,249 - Profit tax (1,530) (1,796) (1,944) (1,666) (1,544) (1,402) (1,521) (1,590) - CAPEX, incl. acquisitions (3,721) (5,344) (5,795) (5,915) (6,065) (6,132) (6,305) (6,470) - Changes in working capital 234 (24) (463) (90) (334) (261) (749) (420) + DD&A 1,812 2,337 2,915 3,576 4,259 4,949 5,625 6,292 - Interest expense - (121) (186) (263) (316) (383) (344) (299) Free cash flows 5,125 4,951 4,434 4,236 4,035 4,163 4,654 5,762 Source: Gazprombank estimates TBH DCF valuation model summary, $ mln NPV 35,008 Perpetual growth rate 0.5% Terminal value 31,448 Net debt 6,833 Target value 59,623 Common shares in circulation, mln 14,997 Target price, $ 4.06 Upside 27% Source: Gazprombank estimates 8

9 TNK-BP Holding is the third-largest oil producer in Russia with the crude oil output of 74 mln tons of crude oil and about 11.5 bcm of gas in Company overview TNK-BP Holding is the third-largest oil producer in Russia with the crude oil output of 74 mln tons of crude oil and about 11.5 bcm of gas in TNK-BP largest crude oil production assets are located in Western Siberia, including one of the largest oil fields in the world Samotlor field, in Orenburg region, with some perspective assets in Yamal region and Eastern Siberia. TNK-BP is historically pretty conservative in terms of reserves appreciation. According to SEC methodology, TNK-BP proved reserves life is just 15 years, the shortest among Russian oil majors. But if we will take into account probable reserves, as well, reserves life may triple, as we estimate TNK-BP probable reserves are close to 25 bboe. TNK-BP International proved reserves under SEC methodology, bln boe Total proved reserves, SEC 8,112 8,586 8,794 9,115 Change 6% 2% 4% Reserves life, years Source: company, Gazprombank estimates Corporate structure In 2010, the revenue of TNK-BP Holding was 85% of the total revenue of TNK-BP, in 1H11 - about 92%. TNK-BP has a pretty confusing corporate structure for the first glance. The company itself, while talking about TNK-BP, usually means TNK-BP International, the holding company, which consolidates all TNK-BP assets both in Russia and abroad, including about 95% of TNK-BP Holding, a listed company, covered in this research. The main differences between the whole TNK-BP and TNK-BP Holding comes from 50% stake in Slavneft, Ukrainian refinery LINIK, several greenfields in Russia and activities abroad, including activities in Venezuela (partially), Vietnam and Brazil. At the same time we note that in 2010 TNK-BP Holding revenues were 85% of TNK-BP total revenues, in 1H 2011 about 92%, in our estimates. TNK-BP corporate structure AAR BP Plc. 50% 50% TNK-BP International About 95% TNK-BP Holding (TNBP RU Equity) Slavneft (50%) LINIK TNK-BP Overseas Upstream crude oil: - West Siberian brownfields; - Orenburg; - Greenfields; - Prospective fields Upstream gas: -Rospan Refining and Marketing: -Ryazan Refinery - Saratov Refinery -Retail Source: company, Gazprombank 9

10 TNK-BP Holding buys about 3 mln tonnes of crude oil per annum from Slavneft, and refines crude oil at YANOS under processing scheme. In 2010, TNK-BP Holding (TNK-BP) produced 74 mln tonnes of crude oil (1.527 mbpd) and about 11.5 bcm of gas (215,000 boepd). TNK-BP crude oil production can be divided by three main categories: West Siberian brownfields); Orenburg brownfields; New production fields. TNK-BP assets, not included into the TNK-BP Holding structure, have significant but not determinative influence to TNK-BP Holding economics, in our view. TNK-BP Holding buys about 3 mln tonnes of crude oil per annum from Slavneft, and refines crude oil at YANOS under processing scheme. As we pointed out above, we do not expect Slavneft assets would be further distributed among its shareholders, TNK-BP and Gazprom Neft. Foreign assets do not create any synergy in our estimates. In this report, we concentrate in this research on TNK-BP Holding operations and results, We have to highlight only one upside opportunity for TNK-BP Holding from other TNK-BP group assets, which is the transfer of some Russia-based assets, namely Suzun, Tagul and Russko-Rechenskoye fields, which may contribute approximately 10% of reserves and production to TNK-BP Holding by At the same time upside is limited, as the company stated that assets would be sold for a cash consideration. Upstream In 2010, TNK-BP Holding (TNK-BP) produced 74 mln tonnes of crude oil (1.527 mbpd) and about 11.5 bcm of gas (215,000 boepd). TNK-BP is the third largest Russian oil company in terms of crude oil production. TNK-BP crude oil production can be divided by three main categories: West Siberian brownfields, together accounting for about a half of the company s crude output (about 39.5 mln tonnes of crude oil in 2010, or 52% of total production); Orenburg brownfields, accounting for another quarter of TNK-BP production (about 20 mln tonnes of crude oil in 2010, or 26% of total output); New production fields Verkhnechonskoye field and Uvat (2010 about 8 mln tonnes of crude oil, or 10% of the total output) and prospective fields; most of them are going to start production in These mainly include Yamal-based oil fields Russkoe, Messoyakha fields, Suzun, Tagul and Russko- Rechenskoye fields (the last three currently owned by parent TNK-BP group company). TNK-BP crude oil production forecast E 2012E 2013E 2014E 2015E 2016E Western Siberia brownfields Orenburg Greenfields Source: company data, Gazprombank estimates 10

11 In 2010, Samotlor produced about 21.6 mln tonnes of crude oil, accounting for about 28% of the total crude oil output by the company. Samotlor is an already perfectly developed field with all infrastructure in place and no large capex requirements. It is the source of technologies in water flood management. Orenburg region is a source of oil production growth for TNK-BP as well as for Gazprom neft, Gazprom and Tatneft. West Siberian brownfields Samotlor is the main production location of TNK-BP. It is one of the largest Russian oil fields. In 2010, it produced about 21.6 mln tonnes of crude oil, accounting for about 28% of the total crude oil output by the company. The field production is declining we estimate 7% YoY decrease in crude oil output at the field in This is the main source of possible downside for TNK-BP s crude output. The company aims to stabilize the decline rate at 2-3% in and, probably, further to 1% since 2016, when crude production at the field would stand at slightly above 15 mln tonnes. On the other hand, Samotlor is also the source of free cash flow and new technologies for the company. It is an already perfectly developed field with all infrastructure in place and no large capex requirements. Samotlor is the source of technologies in water flood management. Just a simple example: in order to produce about 21.6 mln tonnes of oil TNK-BP pumps out more than 350 mln tonnes of liquid; as a result, water flood management technologies are crucial for TNK-BP. Samotlor is also a pilot project for intellectual field technology implementation. From a single dispatch center, operators can plan and manage current maintenance and workover activities, remotely start or stop individual production or injection wells, change the productivity of pumps installed in individual wells, track movements of crews. As far as we know, none of Russian oil companies use systems like this. Orenburg brownfields Orenburg currently is being one of the good surprises for Russian crude oil production as a whole and for TNK-BP in particular. The region has no large major fields, but a plenty of small fields. Together with softer climate and excellent infrastructure, Orenburg region is a source of oil production growth for TNK-BP as well as for Gazprom neft, Gazprom and Tatneft. On more than 100 license fields in Orenburg region, TNK-BP produced approximately 20 mln tonnes of crude oil in In our estimates, the largest of those fields yielded less than 3.5 mln tonnes of crude oil in We estimate TNK- BP may produce in Orenburg about 24 mln tonnes of crude oil by 2017, CAGR of almost 5%. We project production of 24 mln tonnes of crude oil would be a plateau at Orenburg through New production and prospective fields TNK-BP has one of the best greenfield portfolios in the Russian oil and gas industry. TNK-BP has one of the best greenfield portfolios in the Russian oil and gas industry. It has both productive greenfields and prospective fields, which could provide upside for TNK-BP s production starting in 2017, when the current growth drivers are depleted. Verkhnechonskoye field in 2011 produced about 4.6 mln tonnes of crude oil in our estimates. By 2015, it would peak at 7.5 mln tonnes per annum, where we think it could stay for at least 5 years. Uvat field is another major greenfield project with 2011 estimated production of about 5.3 mln tonnes of crude oil, peaking at 9 mln tonnes by 2015, which we estimate as the major source of growth of TNK-BP crude oil production by We also highlight a number of projects, where the company would start production in Yamal fields, including Messoyakha, Suzun and Tagul fields, as well as Russkoye and Russko-Rechenskoye fields. Suzun, Tagul and Russko-Rechenskoye fields are owned by TNK-BP International now. Transfer of these fields ownership to TBH is possible in the future, but is not crucial in our view. We also note that these 3 fields would be sold to TBH by TNK-BP International for cash. On the one hand, these three fields are key new upstream projects for TNK-BP for On the other hand, there is the risk that deal may be treated by the market as a form of dividend to major shareholders. Even if it happens, the price would be at the fair valuation. Crude distribution 11

12 TNK-BP has relatively low refining capacity as compared to its crude output volumes, which makes the company the second-largest crude exporter in Russia in terms of volume. Being the second largest crude oil exporter in Russia, TNK-BP is one of main beneficiaries of decrease in oil export duty, which was a part of changes in taxation of oil and gas industry, known as scheme. As a result of taxation changes, we estimate in 2012 Russian oil companies crude oil export netback (before transportation expenses and lifting costs) may increase by 10%, from 28$ per bbl to 31$ per bbl, as compared to the old taxation scheme. As mentioned above, TNK-BP has relatively low refining capacity compared to its crude output volumes. That makes TNK-BP second largest crude exporter in Russia in terms of crude oil output. According to CDU TEK data, in 2011 TNK-BP Holding exported almost 30 mln tonnes of crude oil, or 41% of its total 2011 crude output. At the same time we note, that the share of export in TNK-BP crude oil distribution matches the average 41% among Russian oil majors. Rosneft, Surgutneftegaz and Tatneft export larger share of its crude oil than TNK-BP does. Russian largest crude oil exporters in 2011, mln tonnes Company Export Output Share Rosneft % TNK-BP Holding % Surgutneftegaz % Lukoil % Tatneft % Gazprom neft % Russneft % Bashneft % Other exporters % Total export % Source: Contek, Gazprombank estimates Further 32% of crude oil are refined at TNK-BP own refineries in Ryazan and Saratov. The rest of the crude oil, 27% of the total TNK-BP Holding output, or slightly less than 19.6 mln tonnes of oil, are mainly refined at other TNK-BP Group s refineries through the tolling scheme, namely, at YANOS and LINIK (deliveries to LINIK suspended from 1 March 2012), sold domestically or to other related partied of the company. We estimate changes in taxation would increase TNK-BP EBITDA by at least 1% in Being the second largest crude oil exporter in Russia, TNK-BP is one of main beneficiaries of decrease in crude oil export duty, which was a part of changes in taxation of oil and gas industry, known as scheme. Crude oil export duty decrease was the major change in taxation for the oil companies in monetary terms, which would bring Russian oil companies more than $ 5 bln in 2012, in our estimates. The base rate of oil MET was calculated as $29.2 per ton plus 65% from the surplus of Urals price under $29.2/bbl. Starting 1 October 2011 the base ratio of the crude oil export duty formula was decreased from 65% to 60%. As a result, we estimate, that average crude oil export for 2012 would decrease by $5 per bbl, or by 9%, compared to the old tax regime. That is partially corrected with MET increase. Starting from 1 January 2012 the base rate in oil MET formula will be increased from current RUB 419 to RUB 446, or by 6.4% YoY, and further to RUB 470, or by 5.4% YoY starting 1 January That would effectively increase our projected 2012 crude oil MET rate from RUB 4,409 per ton ($20 per bbl) to RUB 4,693 per ton ($21 per bbl). As a result of taxation changes, we estimate in 2012 Russian oil companies crude oil export netback (before transportation expenses and lifting costs) may increase by 10%, from 28$ per bbl to 31$ per bbl, compared to the old taxation scheme. 12

13 Crude oil export netback, old scheme vs. new, at Urals price of $104/bbl $120 $100 $80 $60 $40 $20 $28 $31 $20 $21 $56 $52 $0 Old Export duty MET Netback New In 2011, TNK-BP was also the third-largest producer of fuel oil in Russia, making 7.5 mln tonnes of fuel oil. Source: Gazprombank estimates We estimate that TNK-BP may get extra $1 bln of crude oil export EBITDA in At the same time, changes in oil products export duties, as well as higher excise taxes, partially decrease the positive effect of crude oil netbacks growth. In 2011, TNK-BP was also the third-largest producer of fuel oil in Russia, making 7.5 mln tonnes of fuel oil, and the export duty on this product would increase by 58% YoY in 2012 to about $250 per tonne, in our estimates. We assess the additional tax payments by TNK-BP on oil product sales at approximately $0.4 bln. Another $0.4 bln would be paid additionally as MET payments as a result of MET increase in As a result, the net result of changes in taxation would not alter EBITDA of TNK-BP by more than $0.2 bln, or at least 1% of 2012 projected EBITDA. Gas TNK-BP is also the fifth-largest gas producer in Russia. In 2011, the company produced 10.8 bcm of TNK-BP is also the fifth-largest gas producer in Russia. In 2011, the company associated petroleum gas, and 3.3 bcm of natural produced 10.8 bcm of associated petroleum gas, and 3.3 bcm of natural gas at gas at Rospan International. Rospan International. In total, in 2011 TNK-BP has produced about 87 mln boe, which is approximately 13% of total TNK-BP group hydrocarbon production. Associated gas in mainly processed and then sold to industrial consumers. They have consumed almost 10 Bcm of TNK-BP associated gas in 2011 in our estimate. At the same time, according to our estimate, in 2011 gas has brought less than 3% of TNK- BP total EBITDA. TNK-BP plans to increase gas production at Rospan to 8 Bcm by The company notes a possibility for further increase of gas production at Rospan to 16 Bcm by TNK-BP has a 20/20/20 strategy for gas gas should contribute 20% of production and EBITDA of TNK-BP group by We model Rospan will contribute $6bln to TNK-BP revenues, by 2020, or 9% of total 2020 estimated revenues of TNK-BP and note an upside risk to our long-term revenue and margins projections. Downstream TNK-BP Holding is the fourth largest Russian refiner, TNK-BP Holding is the fourth largest Russian refiner, operating two large refineries operating two large refineries in Ryazan and Saratov. In 2011, TNK-BP Holding refined about 22.9 mln in Ryazan and Saratov. In 2011, TNK-BP Holding refined about 22.9 mln tonnes of tonnes of crude oil, or about 9% of the total crude oil, or about 9% of the total Russian refined volume. This accounted for 32% Russian refined volume. of TNK-BP s production. We note that this figure significantly differs from the total TNK-BP group refining cover of 44%, according to the company. The difference attributes mainly to YANOS refinery, which is 50% owned by TNK-BP through Slavneft and Ukrainian refinery LINIK. 13

14 TNK-BP Holding 2011 refining overview, mln tonnes 25,000 16,638 20,000 15,000 10,000 5,000 3,025 4,242 5,759 1,090 0 Oil refined Petrol Diesel Fuel Oil Kerosene Ryazan Sa ratov Source: company, Gazprombank estimates TNK-BP Holding oil products output share in Russia, 2011 Kerosene 12% Fuel Oil 10% Diesel 8% Petrol 11% Oil refined 9% TNK-BP s downstream contributes significantly into the company s total revenues and EBITDA. The company has the largest retail network among Russian oil majors in Moscow, the largest petrol consuming region in Russia, occupying almost 30% retail petrol market share in Moscow region. 0% 2% 4% 6% 8% 10% 12% 14% Source: company, Gazprombank estimates TNK-BP refining capacities are slightly below average Russian figures in terms of quality and refining depth. We estimate in 2011 light product yield at TNK-BP refineries was 53%, while Russian average yield was 61%. At the same time we note TNK-BP downstream contributes significantly into the company s total revenues and EBITDA. According to the 2010 segment information report from TNK-BP, its downstream segment (refining, marketing and distribution) has contributed 35% of the company s EBITDA, or $3.6 bln out of total $10.2 bln. Oil products revenues were about 43% of total 2010 TNK-BP revenues of $41.1 bln. TNK-BP has one of largest retail stations network in Russia (stations in Belarus and the Ukraine are owned by the parent company) operating more than 1,000 retail stations. We note TNK-BP retail is concentrated mainly in the premium regions Moscow, Saint-Petersburg, southern regions of Russia. The company has the largest retail network among Russian oil majors in Moscow, the largest petrol consuming region in Russia, occupying almost 30% retail petrol market share in Moscow region. At the same time we do not see TNK-BP retail network as competitive advantage of the company to other Russian oil majors. Rosneft operates more than 1,700 stations in CIS, Gazprom Neft about 1,600 stations, Lukoil almost 2,800 stations. At the same time we may estimate TNK-BP average petrol station daily traded volume is larger than any other Russian oil major retail network. 14

15 We are not looking for any substantial additional upside from downstream for TNK- BP. We think TNK-BP is unlikely to increase its refining capacity in the nearest future, which makes us believe that share of downstream segment in total TNK-BP revenues and margins would not differ much from current. We estimate 2011 oil products share in revenues would be slightly less 49% of total estimated revenues of $51 bln, by 2016 we see oil products revenues share at 48% out of total $61 bln estimated revenues. Preferred shares valuation Our estimate of the fair discount for the company s preferred stock relative to common shares is 8.7%. TNK-BP has historically paid out dividends on preferred shares equally to ordinary shares. We have calculated a 8.7% fair discount for the company s preferred stock relative to common shares. Based on our estimates, the company s average daily traded volume is $0.5 mln for common shares and $0.3 mln for preferred shares. We note that the free float of common shares is about 5%, as compared to almost 100% for prefs, making the cost of free float of prefs about 40% less, than the free float cost of common shares, which makes the trading volume for prefs seem fair for a free float. Taking these factors into account, we do not apply any discount for liquidity of preferred shares. The par value of both preferred and common shares is RUB 1. Preferred shares generally lack voting rights, although in years when dividends are not paid out, they are automatically vested with voting rights. However, TNK-BP has historically paid out dividends on preferred shares equally to ordinary shares. We also note free float of ordinary shares is just 5%, which makes minorities ability to influence decisions of TNK-BP major shareholders is insignificant. We therefore apply just a 10% discount for voting factor. Finally, to account for the higher dividend yield on preferred shares relative to common stock, we are introducing an offset factor of 1.3%. The overall fair discount for preferred shares is 8.6%, or 10% for voting rights, minus 1.3% for the difference in the dividend yields. The dividend payout ratio is expected to be maintained at approximately 40% of US GAAP-based net profit. We note that in 2009 and 2010 payout ratio was above 90%. Preferred shares valuation Preferred current price per share, $ 2.88 Preferred dividend per share, $ 0.38 Preferred dividend yield 13.4% Common current price, $ 3.19 Common dividends per share, $ 0.38 Common dividend yield 12.1% Difference in yields -1.3% Discount calculation Voting rights discount 10.0% Liquidity discount 0.0% less dividend yield premium -1.3% Total discount 8.7% Common share, target price price, $ 4.06 Preferred share target price, $ 3.71 Source: Gazprombank estimates Dividend Discount Model (DDM) valuation In order to provide an alternative valuation of TNK-BP preferred stock, we use a dividend discount model (DDM). We contend that the DDM is appropriate as amounts of dividends on TNK-BP shares have been significant over the past five years, with the yield above 5%. We believe that the dividend payout ratio will be maintained at approximately 40% of US GAAP-based net profit. We note that in 2009 and 2010 payout ratio was above 90%. We apply two threshold discount rates to determine the present value of dividend flows: the cost of equity at 10.6%, and the 2010 annual preferred dividend yield at 13.4%. We believe that a reasonable discount rate for determining the PV lies 15

16 . We do not expect the company to make an additional share placement or to list its shares on any other major stock exchange. somewhere between these two values. At the same time, however, we think that the discount rate should be closer to the lower end of the spectrum as TNK-BP shares have historically demonstrated high dividend return and outpaced Russian market in last 3 years. In this respect, we apply the WACC (11.1%) used in our discounted free cash flow model for TNK-BP as a proxy to discount the forecasted dividends (see the table below). Ultimately, we obtained the fair value of $4.24 per both ordinary and preferred share (RUB 125,5), 31% above the current price of ordinary share and 45% - of preferred share, which supports our DCF-based target price. We underline that even discounting dividends at the highest assumed rate of 13.4%, we still get an upside potential for the share price, which supports our recommendation. DDM valuation for TNK-BP shares Cost of equity (10.6%) 10.6% NPV 2.78 Terminal value 1.66 Fair value, $ per share 4.44 WACC (10.4%) 11.1% NPV 2.73 Terminal value 1.51 Fair value, $ per share 4.24 Preferred dividend yield (13.4%) 13.4% NPV 2.51 Terminal value 1.02 Fair value, $ per share 3.53 Source: Gazprombank estimates TNK-BP share market The company s shares are listed on the MICEX, tickers are TNBP for ordinary shares and TNBPP for preferred shares. Average daily traded volume in last 12 months was $0.5 mln for common shares and $0.3 mln for preferred shares. TNK-BP is not listed on any other Russian or foreign stock exchange, which reduces company s shares liquidity and restricts access of some international investors to TNK-BP shares. As we mentioned above, we do not expect the company to make an additional share placement or to list its shares on any other major stock exchange. We note TNK-BP historical spread between ordinary and preferred shares is one of the lowest in Russian equity universe and usually fluctuates between 5% and 15%. We note that spread usually tightens before the dividend cut-off date and peaks just after this date. Spread between TNK-BP ordinary and preferred shares 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Jan 11 Feb 11 Mar 11 Apr 11 May 11 Jun 11 Jul 11 Aug 11 Sep 11 Oct 11 Nov 11 Dec 11 Jan 12 Feb 12 Mar 12 Spread Average Source: Bloomberg, Gazprombank estimates 16

17 On all three multiples we used TNK-BP looks fairly valued compared to its Russian peers and on 2012 and 2013 multiples is traded with a premium or discount not exceeding 10%. Peer group valuation. TNK-BP seems fairly valued compared to Russian peers Although DCF valuation is our preferred method, for the sake of integrity we also provide peer groups multiple comparison. We compare TNK-BP Holding with Russian largest integrated oil companies, as well as international oil and gas majors. We employ EV/EBITDA, P/E and EV/Proven Reserves multiples. We use our in-house estimates for covered Russian oil and gas companies multiples and Bloomberg consensus projections for other companies. We note that on all three used multiples TNK-BP looks fairly valued compared to its Russian peers and on 2012 and 2013 multiples is traded with a premium or discount not exceeding 10%. Moreover, it is traded in line with international majors on EV/EBITDA multiple and has a discount on P/E and EV/Reserves to international majors mainly. We consider multiples comparison as an indirect support to our opinion that TNK-BP shares has pretty limited upside. At the same time we note that the major part of TNK-BP earnings is distributed as dividends, which could justify a premium for TNK-BP shares, that is why we believe TNK-BP shares have valuation potential. TNK-BP peer comparison on multiples Mcap EV/EBITDA P/E Reserves, $ mln E 2012E 2013E E 2012E 2013E $/boe Bashneft 12, Gazprom neft* 26, Lukoil 54, Rosneft 80, SurgutNG 42, Tatneft 14, TNK-BP Holding 47, Average Gazprom 158, NOVATEK 43, Average Developed markets majors BP 145, Chevron Corp. 219, ConocoPhillips Inc. 114, ExxonMobil Corp. 416, Repsol YPF 23, Royal Dutch Shell 218, Total SA 131, Average TNK-BP discount (premium) to Russian oils 12% 19% 7% 7% -38% 4% -2% 5% 18% to Russian gas -66% -60% -52% -40% -59% -67% -42% -29% 33% to international majors 18% 12% 8% 20% -30% -27% -24% -6% -70% Source: Bloomberg, Gazprombank estimates 17

18 Oil price will be the main driver for TNK-BP revenues. We do not model any significant acquisitions both in downstream and upstream. For TNK-BP, which together with pretty stable oil price estimates makes our revenue forecast more or less unchanged compared to Financial outlook Income statement We see oil price as the main driver for TNK-BP revenues. As we forecast TNK-BP 2020 oil output in 2020 to be just 1% larger than in 2011, the revenue dynamics is mainly determined by the oil price changes. Our base case forecast assumes the average Urals price of $104.4/bbl in 2012, a 2% YoY decrease. We expect oil price to stay flat YoY in 2013, that we are looking for about 1.5% a year increase in oil price in Macro assumptions used in Tatneft model E 2012E 2013E 2014E 2015E 2016E Urals price, $/bbl End of year exchange rate, RUB/USD Average exchange rate, RUB/USD Source: Gazprombank estimates We do not model any significant acquisitions both in downstream and upstream. For TNK-BP, which together with pretty stable oil price estimates makes our revenue forecast more or less unchanged compared to We estimate after sharp increase in 2011 revenues by 22% YoY on the back of oil price increase a 5% YoY increase in revenues in 2012 to $53.3 bln and further 4% YoY increase in 2013 to $55.3bln, mainly on the back of crude oil output and sales increase. TNK-BP revenues estimates summary, $ mln 70,000 60,000 50,000 40,000 30,000 20,000 10, E 2012E 2013E 2014E 2015E 2016E Export of crude oil Domestic crude oil sales Export of oil products Domestic oil products sales Other revenues Source: company, Gazprombank estimates The main drivers for expenses are taxes, other than profit tax. In 2011, 63% of total TNK-BP s costs would constitute taxes other than income tax, mainly Custom Export Duties (CED) and Mineral Extraction Tax (MET). TNK-BP expenses estimates summary, $ mln 60,000 50,000 40,000 30,000 20,000 10, E 2012E 2013E 2014E 2015E 2016E Export duties Taxes other than income tax Operating expenses Purchasing expenses Transportation DD&A SG &A Other Source: company, Gazprombank estimates 18

19 We estimate the total expenses to increase by 17% YoY in 2011 to $40.6 bln, followed by a 7% YoY increase to $43.4 bln in In TNK-BP does not have any formalized dividend policy, but follows several basic rules, based on the charter or on historical practice. Taxes other than income tax are mainly driven by CED and MET rates for crude oil, whose rates are linked to oil prices. As a result, cost dynamics will be generally in line with the revenue dynamics. We estimate the total expenses to increase by 17% YoY in 2011 to $40.6 bln, followed by a 7% YoY increase to $43.4 bln in In 2013, costs should increase by 8% YoY to $46.8bln, mainly on the back of CED and MET payments. After 20% jump in EBITDA per bbl in 2011, driven mainly by oil price increase, we expect TNK-BP EBITDA per bbl to fluctuate between $20-23 in , while total EBITDA to change between $12-13 bln. TNK-BP EBITDA projections, $ mln (right scale), EBITDA $ per bbl (left scale) 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2, E 2012E 2013E 2014E 2015E 2016E EBITDA, % mln EBITDA per bbl, $ Source: company data, Gazprombank estimates TNK-BP does not have any formalized dividend policy, but follows several basic rules, based on the charter or on historical practice: dividends on preferred share should be equal to dividends for ordinary shares, TNK-BP Holding declares dividends normally twice a year and TNK-BP International, whose largest asset is TNK-BP Holding, pays at least 40% of US GAAP Net Income on a quarterly basis. Based on that, we estimate TNK-BP Holding. Based on that assumptions we forecast dividends to be at least RUB 9.6 per both TNK-BP ordinary and preferred share until 2016 at least in case if the company would not make major changes in its corporate structure, which we do not believe in, as discussed above. TNK-BP dividends estimates, RUB per ordinary and preferred share E 2012E 2013E 2014E 2015E 2016E Dividend per share, RUB Source: company data, Gazprombank estimates 19

20 We do not project sharp capex increase. Capex and free cash flow Unlikely two largest Russian oil companies, TNK-BP does not have any plans to hugely increase its capex for next two years. Company s guidance for 2012 is about $5.5 bln organic capex (not including acquisitions) for TNK-BP International group, but we do not think large part of that would be attributable to non-tbh assets. In the company plans to spend around $6 bln organically each year. We do not see much upside risk potential for TNK-BP capex and we think capex is unlikely reach $6.5 bln by 2015, unless the company would make some major acquisitions on TNK-BP Holding level. 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 TNK-BP Holding capex estimates and FCF yield, $ mln, % E 2012E 2013E 2014E 2015E 2016E 15% 14% 13% 12% 11% 10% 9% 8% 7% 6% 5% Capex FCF yield (RHS) TNK-BP is one of the most stable FCF generators in the industry. We estimate that the company is able to generate around $5 bln of FCF each year. Source: company data, Gazprombank estimates As we noted before, we estimate TNK-BP is one of the most stable FCF generators in industry. We estimate the company is able to generate around $5 bln of FCF each year. FCF yield in this case would be around 10%, one the highest FCF yield in industry in our estimates. 20