TNK-BP Holding: Creating Shareholder Value

Company Report Oil & Gas TNK-BP Holding: Creating Shareholder Value Investment Summary TNBP TNBPP BUY $3.5 35% BUY $3.2 38% TNK-BP Holding is one of the most efficient Russian oil companies. A combination of high dividend payments, an increasing efficiency on brownfields and a huge greenfields portfolio suggests a promising outlook for shareholders. We estimate company target prices of $3.5 per common share and $3.2 per preferred share, both justifying BUY recommendations. TNK-BP Holding (TNK-BP) is the third largest oil producer in Russia (output in January-November 2011 was 66.4m tonnes). Increasing well stock optimization and the concept of the SMART field have helped minimize the production decline effect in West Siberia and Orenburg, the main exploration regions for the company. A huge greenfields portfolio will enable production growth in the future. The company is one of the most efficient by capex per bbl of production among large VICs ($5.5/bbl against Rosneft s $7.5/bbl and Lukoil s $7.2/bbl). We count TNK-BP as the main winner in the introduction of the export duties system 60-66 (the gain to the company is about $600m, or 4.3% of EBITDA 12E). Benefits come from a 52% share of crude oil exports in revenue (export duties for crude oil were reduced under 60-66) and small volumes of purchased oil (domestic prices rose). Company R&M strategy is focused on asset modernization and further penetration of domestic and FSU markets. This will contribute to an increasing share of high-margin refining in the structure of sales. EBITDA per bbl in 6M 2011 was $22 vs. leaders, Rosneft with $28/bbl and Lukoil s $27/bbl. TNK-BP shares are currently traded at 3.1x EV/EBITDA 11, which is a 40% discount to long-term pre-crisis levels of some 5x. We see an opportunity of coming closer to historic levels in future. The company demonstrates high FCF (about $6b annually), and it expects to keep positive cash flows despite capex growth. We also do not see any risks in leveraging, if it comes: net debt to EBITDA ratio of 0.2x is one of the lowest among oil VICs. TNK-BP is one of a few Russian oil VICs generous in paying dividends. Dividend yields were 15% per common and 17% per preferred share in 2010. We do not expect any substantial reduction of payout ratio in the future due to the cash needs of majority shareholders (AAR and BP), and forecast $0.40 per share for 2011, implying 13% and 18% current yields for commons and prefs. We see as major risks for the company its very low liquidity (free float 5% for total capital, and only 3% for commons alone) and continuing shareholders conflict. On the other hand TNK-BP Holding is attractive due to its high dividends, the increasing efficiency of brownfields and its large greenfields portfolio, so we recommend the stocks as BUY with a 30-40% upside potential. Current market cap, $m 40 027 EV, $m 41 908 Estimated free-float, % 5% Common shares - ticker (MICEX) TNBP - number, m 14 997 - market price, $ 2.6 - fair price, $ 3.5 - up/down, % 35% - previous fair price, $ 2.4 Preferred shares - ticker (MICEX) TNBPP - number, m 450 - market price, $ 2.3 - fair price, $ 3.2 - up/down, % 38% - previous fair price, $ 2.2 Other stock exchanges LSE N/L NYSE N/L IFRS, $m 09 10 11E 12E Revenues 31 660 41 255 55 453 53 322 EBITDA 8 330 9 944 13 637 12 478 - margin, % 26% 24% 25% 23% Op. income 6 600 8 132 11 391 9 847 Net income 5 480 6 540 8 962 7 653 - margin, % 17% 16% 16% 14% EPS, $ 0.35 0.42 0.58 0.50 09 10 11E 12E EV/S 1.3 1.0 0.8 0.8 EV/EBITDA 5.0 4.2 3.1 3.4 P/E 7.3 6.1 4.5 5.2 RMG Research, December 23, 2011

Brief sector outlook New reality of oil prices Oil (Brent) has been traded at over $100/bbl for the last 3 quarters, backed by political turmoil in oil-pumping countries in North Africa (in particular Libya), the effect of monetary easing in the USA (QE1, QE2), and high costs of oil extraction at new fields (shelf production in the Gulf of Mexico, West Africa and the Arctic shelf in Russia, and heavy oil production in Venezuela), supporting stable demand. We expect oil prices to exceed $100/bbl in the next few years (see our forecast in macroeconomics table below). QE1-2 influence on oil prices and S&P500 Source: Bloomberg, RMG estimates World oil market balance Source: BP, RMG estimates 2

Oil production benefits Efficient brownfields TNK-BP is the third largest oil producer in Russia after Rosneft and Lukoil (oil production from January to November 2011 totalled 64.4m tonnes). The main brownfield assets are located in West Siberia with its depleting stocks, so the company is working under well stock optimization. Efficiency initiatives enabled an increase in output at Orenburgneft (TNK-BP subsidiary, with a 28% share in company s production) by 8% in 2010. Another project of this kind is the launch of SMART field technology, for the first time ever in Russia, in the Samotlor fields (also with a 28% share in production). TNK-BP maintains a rational investment strategy. It has shown one of the lowest levels of capex per barrel of production among largest Russian VICs ($5.5/bbl against $7.5 for Rosneft and $7.2 for Lukoil in 2010). Oil production dynamics Source: companies data, RMG estimates Huge greenfields portfolio The greenfields of TNK-BP are represented by a large portfolio of fields on the Yamal peninsula. The Suzunskoye oilfield with reserves of about 0.2b bbl (peak production of 4.5-5m tonnes per year) and the Russkoye field with reserves of some 2.2b bbl (peak production 7.5m tonnes per year) are scheduled to start output in 2016. The Tagul field (reserves of 1.3b bbl, peak production of 5m tonnes) is to begin production in 2017. Among the largest projects is the development of the Messoyakha field jointly held with Gazprom Neft (50:50). Its peak production is estimated at 20m tonnes per year, which is just a little less than at the Russian major greenfield, Vankor, belonging to Rosneft (25.5m tonnes per year). All these projects require major investment: total capex attributed to TNK-BP is forecasted at $17b, which we reflect in our valuation. The Yamal projects have a privileged MET (mineral extraction tax) rate from 2011: a zero tax rate will be applied till cumulative oil production reaches 25m tonnes. Moreover the Russian government ratified a decision that the Zapolyarie-Purpe pipeline, which will connect the Yamal oilfields with the WSPO pipeline, will be financed solely by Transneft (costs are estimated at $4b). Previously it was suggested that this pipeline would be a JV with TNK-BP, Gazprom Neft and Lukoil. This decision will also contribute to higher profitability of the Yamal projects. 3

Already commissioned greenfields, now compensating for falling production at brownfields, are represented by the Kamennoye, Verkhnevhenskoye and Uvat fields. They are already charged with a zero MET rate and Verkhnevhenskoye also had reduced export duties till last May, which gave an extra gain of $1.2b for TNK-BP in 2011. Aggressive gas production plans TNK-BP is making attempts to become a fully integrated global oil&gas company, in so doing developing gas projects. Increase in gas output is supposed to follow the development of Rospan fields, along with utilization of associated petroleum gas (APG). In 2010 the company produced 13.1bcm of APG (utilization level stood at 85%), which it delivered to its gas refining plants in Nignevartovsk, Belozersk and Krasnoleninsk. Rospan gas production totalled 2.7bcm last year, and we forecast a further rise in output there. The fields have access to the Gazprom gas-transport system (a delivery contract is signed until 2016). 60-66 winner TNK-BP looks the main winner from the introduction of the new 60-66 export duties system. We estimate the positive gain for the company to stand at about $600m, or 4.3% of EBITDA 12E. Benefits come from a 52% share of crude oil exports in revenue, as export duties for crude oil have been reduced under the new system, and from only marginal volumes of purchased oil, as domestic prices have grown. Moreover TNK-BP has a high share of light oil in its production mix, which means the equalization of duties for light and heavy oil products is not critical for the company. Oil refining structure Source: CDD FEC, RMG estimates 4

Refining and marketing Assets modernization Further market penetration The TNK-BP refining segment is represented by four refining plants: the Nizhnevartovsk, Ryazan, Saratov and Krasnoleninsk refineries, with total capacity of 24m tonnes per year (output in 2010 was a full 24m tonnes). Company strategy in the segment is focused on modernization to raise light product yields and processing depth, which we take into account in our forecasts. The TNK-BP retail network comprises TNK and BP petrol stations (110 BP and 664 TNK ones). Company strategy is directed on further penetration of the Russian and FCR markets via purchase of new assets. Management announced that the company will increase capex for the filling stations network. We see this strategy as rational (as margins rise) and take account of growing capex on retail sales expansion in our valuation. Dividends Company is a cashcow for main shareholders via dividends TNK-BP Holding is one of a few Russian oil companies whose dividends impress. The company paid 90% of net profit for 2010 as dividends, offering yields of 15-17% for common/preferred shares. We expect high dividend payments to continue due to the policy of the major shareholders, BP and AAR. For BP the company is one of the largest generators of cash to compensate for its huge losses after the disaster in the Gulf of Mexico (reserves for losses are about $40b). AAR also supports payment of dividends as preferable to cash-out. We estimate dividends for 2011 to be $0.40 for shares of both types, thanks to record financial results this year, and based on the stable payout ratio. Dividend yield dynamics Source: Company data, RMG estimates 5

Macroeconomic forecasts Valuation 2007 2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016E Brent 72 97 62 80 112 100 103 106 108 111 Urals 69 95 61 78 110 98 101 103 106 108 Oil product exports, $/tonne: Gasoline 624 788 531 711 1 017 908 936 959 983 1 008 Fuel oil 652 924 519 672 970 873 907 937 961 985 Heating oil 346 457 344 441 631 563 580 595 610 625 Domestic sales of oil products, $/tonne: Gasoline 612 752 540 627 750 779 872 913 904 946 Fuel oil 498 725 398 469 685 600 625 647 663 680 Heating oil 186 283 208 252 283 189 198 207 215 224 Gas prices, $ per thousand c.m.: domestic 51 66 58 76 91 103 114 127 135 143 Export duties, $/tonne: Crude oil 207 355 179 274 432 348 361 373 384 396 Light products 151 252 133 197 289 230 239 246 254 261 Heavy products 82 136 72 106 202 230 239 246 254 261 Taxes: Oil MET $/bbl 13 19 10 14 21 21 22 23 23 24 Gas MET $/1000m3 5.8 5.9 4.6 4.8 8.1 8.4 8.5 8.8 9.0 9.2 R/$ exchange rate 25.6 24.8 31.9 30.4 29.3 29.9 31.0 32.1 33.2 34.3 CPI, % 12% 13% 9% 9% 7% 8% 7% 6% 6% 6% PPI, % 25% -7% 14% 17% 11% 10% 9% 8% 8% 8% Source: RMG estimates Operational review, m tonnes 2007 2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016E Oil production 72.5 73.7 74.3 72.9 75.4 77.1 75.9 75.0 72.8 70.5 Gas production: 8.9 11.3 12.1 12.9 13.7 14.6 15.2 16.0 16.9 17.8 - APG 7.4 8.8 9.7 10.2 10.5 10.7 10.6 10.4 10.1 9.8 - Rospan 1.5 2.5 2.4 2.7 3.2 3.8 4.6 5.6 6.7 8.0 Refinery throughput 26.9 29.6 28.2 31.9 32.2 32.5 32.8 33.1 33.4 33.4 Purchases of crude oil 10.5 9.8 9.5 9.2 8.9 8.6 8.2 7.9 7.6 7.3 Crude oil exports: 42.4 41.9 33.7 38.3 36.0 37.0 37.7 37.2 36.8 35.9 - Non CIS 34.4 26.6 31.8 30.6 31.6 32.3 31.8 31.4 30.5 29.6 - CIS 7.5 7.1 6.5 5.4 5.4 5.4 5.4 5.4 5.4 5.4 Oil products exports 14.5 16.6 16.9 18.8 19.1 19.2 19.3 19.5 19.7 19.6 Domestic sales of oil products: 12.0 12.3 10.9 12.9 13.1 13.3 13.5 13.6 13.7 13.8 - wholesale 3.0 2.6 1.3 2.6 2.7 2.8 2.9 3.0 3.1 3.2 - retail 9.0 9.7 9.6 10.3 10.4 10.5 10.6 10.6 10.6 10.6 CIS sale of oil products 0.4 0.7 0.4 0.2 0.2 0.2 0.2 0.2 0.2 0.2 Source: Company data, RMG estimates 6

Financial review, $m 2007 2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016E Revenue Crude oil sales: 21 028 23 987 17 754 21 788 28 603 27 756 28 247 28 669 28 709 28 668 - domestic 1 354 2 302 1 759 2 341 2 976 2 941 3 039 3 129 3 222 3 318 - exports 19 674 21 685 15 995 19 447 27 132 24 815 25 207 25 540 25 487 25 350 Oil products sales: 13 180 19 831 12 685 17 827 24 879 23 376 25 149 26 394 27 172 28 060 - exports 6 990 10 847 7 110 10 308 15 194 13 792 14 485 15 153 15 775 16 077 - domestic: 6 190 8 984 5 365 7 378 9 526 9 440 10 514 11 086 11 238 11 820 - wholesale 2 579 2 995 1 788 2 459 3 268 3 171 3 548 3 810 3 973 4 257 - retail 3 611 5 989 3 577 4 919 6 258 6 270 6 966 7 276 7 265 7 563 - CIS - - 210 141 159 143 150 155 160 164 Gas sales 270 365 809 1 107 1 251 1 502 1 733 2 029 2 372 2 787 Other revenue 517 950 412 533 720 688 718 741 752 763 Total revenue 34 995 45 133 31 660 41 255 55 453 53 322 55 847 57 832 59 004 60 279 Costs and expenses Production & operating expenses 3 713 5 034 3 957 4 609 5 189 5 694 5 929 6 160 6 341 6 509 Transport expenses 2 239 2 614 2 669 3 282 3 846 4 265 4 442 4 623 4 746 4 867 SG&A 1 542 1 730 1 198 1 236 1 287 1 413 1 454 1 492 1 507 1 516 DDA 1 341 1 481 1 730 1 812 2 246 2 631 3 042 3 466 3 931 4 384 Purchased oil & oil products 1 874 1 605 1 811 2 417 2 887 2 711 2 663 2 606 2 550 2 496 Taxes 7 560 10 888 5 816 8 006 11 165 11 553 12 940 13 059 12 764 12 401 Export duties 9 256 13 528 7 681 11 438 17 191 14 972 15 387 16 515 16 735 16 839 Exploration expenses 127 57 54 62 90 82 83 84 84 83 Other expenses 88 160 144 119 160 154 161 167 170 174 Total C&E 27 740 37 097 25 060 32 981 44 062 43 475 46 100 48 172 48 827 49 270 Operating income 7 255 8 036 6 600 8 132 11 391 9 847 9 748 9 661 10 177 11 009 EBITDA 8 596 9 517 8 330 9 944 13 637 12 478 12 789 13 127 14 108 15 393 EBITDA, margin 25% 21% 26% 24% 25% 23% 23% 23% 24% 26% Income tax expenses 1 453 1 807 1 258 1 530 1 773 1 514 1 483 1 453 1 517 1 627 Minority interest 202 113 154 260 346 295 289 283 296 317 Net income 5 732 6 367 5 480 6 540 8 962 7 653 7 498 7 343 7 667 8 226 Source: Company data, RMG estimates FCF valuation, $m 2010 2011E 2012E 2013E 2014E 2015E 2016E Revenues 41 255 55 453 53 322 55 847 57 832 59 004 60 279 Growth rate (%) 30% 34% -4% 5% 4% 2% 2% EBITDA 9 944 13 637 12 478 12 789 13 127 14 108 15 393 Margin (%) 24% 25% 23% 23% 23% 24% 26% EBIT 8 132 11 391 9 847 9 748 9 661 10 177 11 009 Margin (%) 20% 21% 18% 17% 17% 17% 18% Income tax expenses 1 530 1 773 1 514 1 483 1 453 1 517 1 627 NOPAT 6 602 9 618 8 333 8 264 8 208 8 661 9 382 DDA 1 812 2 246 2 631 3 042 3 466 3 931 4 384 Capex -3 184-5 400-5 501-5 862-6 063-6 642-6 479 Changes in working capital 716-1 606 395-118 -31 33 23 Free cash flow 5 946 4 858 5 859 5 326 5 580 5 983 7 310 Source: Company data, RMG estimates 7

WACC calculation Risk free rate 7.0% Equity risk premium 5.0% Company's specific risks 3% Beta 1.16 Leveraged beta 1.60 Cost of equity 18% Cost of debt 8.0% After tax cost of debt 6.4% WACC 14.3% Source: RMG estimates Fair value calculation Terminal growth rate, % 2% Discounted cash flows 2012-2016, $m 23 087 Terminal value, $m 60 733 Discounted terminal value, $m 31 163 Enterprise value, $m 54 250 Net debt, $m 2 222 Minority interest, $m 894 Equity value, $m 51 134 Number of common shares, m 14 997 Number of preferred shares, m 450 Target per common share, $ 3.5 Target per preferred share, $ 3.2 Source: RMG estimates Sensitivity analysis (common share fair price, $) WACC 12.8% 13.3% 13.8% 14.3% 14.8% 15.3% 15.8% 3.5% 4.49 4.25 4.04 3.85 3.68 3.52 3.37 3.0% 4.31 4.10 3.90 3.62 3.57 3.42 3.28 2.5% 4.16 3.96 3.78 3.51 3.47 3.33 3.20 2.0% 4.02 3.84 3.67 3.52 3.37 3.24 3.12 1.5% 3.89 3.72 3.56 3.32 3.29 3.17 3.05 1.0% 3.77 3.62 3.47 3.23 3.21 3.09 2.99 0.5% 3.67 3.52 3.38 3.16 3.14 3.03 2.92 Source: RMG estimates Terminal growth rate (%) 8

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