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Uralsib - Russia Equity Research - Alliance Oil Company - Unveiling the Inner Beauty; Maintaining value through efficient management of existing assets - Feb 2, 2010.

UNVEILING THE INNER BEAUTY

MAINTAINING VALUE THROUGH EFFICIENT MANAGEMENT

Haute couture oil company. Alliance is a small-sized oil company that is comprised of a number of small-size upstream assets spread out across Russia, a refinery, and a network of petrol stations in Russia's Far East. From first glance these assets would not appear to provide substantial growth opportunities. What makes the value is the quality and care with which these assets are managed - management is now utilizing all of the internal opportunities that they offer. The relatively small size of the company's business and the ability of its management to dedicate specific attention to individual assets (making fast and flexible business decisions) enable the extraction of maximum worth from these assets.

(To view the full report please click here:

http://russianreports.aiidatapro.com/UralSibEN/100202_Alliance_Initiation_of_coverage.pdf)

Limited operational opportunities compensated for by efficiency. We initiate coverage of Alliance with a Hold recommendation and a target price of $17.3/share (SEK122/SDR), which implies 9% upside to the current share price. We believe that limited operational opportunities are compensated for by efficient management of existing assets, resulting in better cost efficiency and profitability.

VALUE THROUGH INTERNAL OPTIMIZATION

Efficient management gives competitive edge a[bar] Alliance has limited revenue growth opportunities, with 2010-15 revenue CAGR of only 5.7%. Instead, value is generated by minimizing costs and expenses; hence, it's five-year 2010-15E EBITDA CAGR of 7.6%, and average 2012-15E EBITDA margin of 21.5%, which is the same as strong integrated peers. Utilization of internal competitive advantages include:

(1) an optimal managerial structure with strong control over SG&A;

(2) marketing flexibility, which minimizes transportation expenses;

(3) tax exemptions, which minimize mineral extraction tax (MET) payments;

(4) a strong retail network, which maximizes downstream netbacks; and

(5) high standards of investor communications and corporate governance, which allow low-cost access to capital markets.

a[bar] against four SSSR risks. Four risks that face the company are: 1) Small size - the company's oilfields are small and quite depleted, and Alliance's sole refinery, located in Russia's Far East, is also small with capacity of just 4.5 mtpa; 2) Scattered - the upstream assets are scattered across Russia; 3) Synergistically unrelated - the fields have no direct link with the refinery and it is only via crude swaps that the company can supply its own crude to its refinery; 4) Rosneft is the main competitor - in both upstream and downstream, in most of the regions that Alliance operates in.

VALUATION VIRTUES

SOTP for DCF and analogous comparison for multiples. We apply sumof- the-parts DCF valuations to Alliance and use analogous company - Hungarian oil company MOL for comparative analysis. The company's downstream business accounts for approximately 70% of total value.

Close to peers on multiples. The stock is trading at a 2010E P/E of 8.3 and 2010E EV/EBITDA of 5.0 - an average premium of 12% to integrated Russian oil and gas companies, though with an average discount of 10% to analogous company MOL.

INVESTMENT SUMMARY

Back to history: the right price for the only available assets. Alliance comprises the upstream assets of former West Siberian Resources (WSR) and the upstream and downstream assets of Alliance (the aolda Alliance), formerly a private company. The aolda Alliance controlled the small Khabarovsk refinery and a network of 256 petrol stations in Russia's Far East, as well as two oilfields in Tatarstan, in the European Russia. In April 2008, core shareholders of former WSR sold their controlling stakes to aolda Alliance. In May 2009, aolda Alliance completed a reverse split of shares in WSR and changed the name to Alliance Oil Company - the anewa publicly traded Alliance, inheriting all of WSR's liabilities and obligations. The top managerial positions are currently occupied by former aolda Alliance management.

- We believe the main reason that WSR shareholders sold their stakes was to cash out at the right time, when oil prices were high. The two companies did not appear to have significant synergies, in our view.

- The only reason that Alliance bought the assets was that WSR's upstream assets were the only ones for sale at that time. Alliance had planned to expand its upstream segment via M&As and license auctions, but the small E&P companies (M&A targets) were either too expensive or unwilling to sell their assets, while the best licences that were tendered in 2007 to early 2008 were also expensive and mostly acquired by more powerful competitors Rosneft, Surgutneftegas, and TNK-BP.

Alliance today - more of a domestic downstream company. aOlda Alliance's R&M business - the Khabarovsk refinery and petrol stations in Russia's Far East - currently dominate the former WSR's upstream business. Alliance became a unique example of a company converting from a pure upstream play into primarily a downstream play. The downstream currently comprises up to 75% of the company's revenues, and accounts for 65% of current and planned capex. Management targets further integration of WSR's upstream and Alliance's downstream into a single integrated company. We believe, however, that this goal is very challenging, if not impossible: Alliance can optimize crude flows only via oil swap operations, while organic synergies, apart from those between Tomsk upstream assets and the refinery, are very small. Nonetheless, the synergies between its refinery and product-marketing divisions are strong.

Competitive advantages outweigh risks. Although Alliance positions itself as a newly-emerged integrated company, it is hard to find advantages from the integration of the upstream and downstream assets. Alliance does not have large Vankor-sized assets apart from the Kolvinskoye field, where geological difficulties present risks. Our analysis indicates that the company's overall upside lies in the veiled upsides of each of its individual assets and effective management of these assets. We ascertain that each asset has potential through specific competitive advantages. Cumulatively, the opportunities outweigh Alliance's core risks - we call these risks the aSSSRa risks of the assets: the letters stand for Small, Scattered, Synergistically unrelated, and competing with state-controlled Rosneft assets. We believe that these risks could be offset by internal competitive advantages such as: efficient management, upstream tax reliefs, expansion via upstream M&A, improvement of downstream efficiency through increasing the scale of secondary refining, and optimization of retail operations. Alliance, with its boutique-like structure (which is different from more the bureaucratic structures of large oil companies) is keen to extract maximum value from its existing assets via efficient management and marketing flexibility.

Back in uSSSR. In addition to the core SSSR risks, the fact that the upstream assets are small implies (among other things) low production levels, lack of proprietary crude with which to load their own refinery (a low refinery cover ratio), and the necessity of buying crude for refining on the open market. This adds to the risk of higher processing costs if we assume that domestic crude prices will grow to netback parity levels.

- Small upstream assets. All of the oilfields developed by Alliance are very small, with no field having annual production above 0.5 mtpa. Some are depleted or have limited growth potential due to their small size. Although the Kolvinskoye field in Timano-Pechora has certain production potential, its production will not be sufficient - even if 100% of the crude is swapped for deliveries to the refinery - to provide a 100% of refining coverage (the share of the company's own refining capacity which is covered by proprietary production).

- Scattered across Russia. The company's oilfields are located in the Tomsk region, Timano-Pechora, Tatarstan, and the Samara region. The regions do not have common logistical infrastructure, are far from one-another, and have different geology. Thus, no synergy effect (in logistics or SG&A) can be reached between these upstream assets.

- Synergy between upstream and downstream is minor. As the upstream assets are scattered (oil fields in Timano-Pechora, Tatarstan and in the Samara region are in European part of Russia) and are far from the refinery (located in Russia's Far East) there is practically no synergy between the company's upstream and downstream. There is currently no direct pipeline between any of the upstream assets (including fields in the Tomsk region) and the Khabarovsk refinery. We do not see any full-scale value chains on the same scale of integration that exist for Rosneft and LUKOIL.

- Rosneft - main competitor. Rosneft is Alliance's main competitor in three of the four upstream regions, and is the sole competitor in Russia's Far East (the downstream business). Rosneft extracts oil in Timano-Pechora, Samara region, and Tomsk region, and may have prioritized access to the pipeline or to the refineries in the region. Rosneft operates the Komsomolsk refinery in Russia's Far East, which it plans to upgrade, and also contemplating the construction of an export-oriented Primorsk refinery at the end of the Eastern Siberia - Pacific Ocean (ESPO) pipeline. In addition, Rosneft controls the Angarsk refinery, from where oil products are also delivered to Russia's Far East, increasing the competitive pressure on Alliance.

Doing its best to prop up value. We believe that the unrealized value of Alliance lies in the efficient utilization of very specific internal competitive advantages: management efficiency, crude swaps and marketing flexibility, tax relief, and retail optimization. Effectively, this value comes from internal improvements, optimizations, and flexibilities. It is true that Alliance does not have powerful abreakthrougha external value drivers (it does not have any Vankor-sized assets), but we would argue that Alliance is successful enough to achieve efficiency and support valuation through utilization of existing assets' hidden opportunities.

- Management efficiency. Fast managerial decisions and a low level of bureaucracy in the decision making process maximize the efficiency of operating such scattered assets.

- Management and core shareholders separated. Unlike in many small independent Russian companies, at Alliance, the core shareholders and the management are to a large extent unrelated, allowing mismanagement to be avoided. Shareholders are interested in high returns and good dividends, but do not interfere in the day-today course of business.

- Crude swaps. Although the upstream assets are not logistically linked to the refinery, the company uses crude-oil swap operations. In addition, the company transfers export quotas from one subsidiary to another depending upon the profitability of the logistics. For example, Tomsk passes its export quotas to the Timano-Pechora business unit. All of the crude from Tomsk is delivered to the Khabarovsk refinery, first via the Transneft pipeline and then by rail. The Tatarstan upstream arm partially swaps its crude for deliveries to the Khabarovsk refinery as well.

- Flexible marketing. Due to efficient decision making, Alliance has a very flexible marketing policy. It can swiftly switch from Transneft's pipeline to proprietary or rented rail cars to transport oil, or decrease crude exports while increasing deliveries to the refinery, maximizing the utilization of its own crude at its Khabarovsk refinery.

- Tax relief for the upstream. Fields in Timano-Pechora are liable for MET holidays, and one field in Tatarstan is liable for zero MET due to the high viscosity of its crude. The company is in the process of negotiating MET tax relief on depleted fields in Samara.

- Expanding via M&A. We believe that the company will try to increase its upstream portfolio via M&A. According to the management, Alliance has two strategies in its near term M&A plans:

- 1. Buy exploration assets in Eastern Siberia: The most probable M&A target is Urals Energy with its Dulisma and Sredne-Botuobinskoye fields in Eastern Siberia.

- 2. Buy upstream assets in regions that will provide synergy effects with existing upstream assets, preferably with existing production that can generate cash now. We think that the most attractive regions are the Tomsk region (with several attractive targets, including certain upstream Russneft assets) and Western Siberia, to which Alliance is not yet exposed. According to management, the company will consider all available assets on the market.

- Increasing refining conversion. Although we do not support the company's plan to expand the Khabarovsk refinery's prime capacity, we strongly support the company's plans to upgrade secondary refining capacity to increase the conversion ration and increase the output of high-quality oil products.

- Retail optimization. Although the company faces strong competition from Rosneft in the downstream in the Far East, we think that the niche captured by the company in retail thus far will enable it to sustain the potential pressure from Rosneft. Optimization of petrol stations, i.e. spinning off less-profitable ones and modernization of more-profitable ones will, in our opinion, enable it to increase retail sales volumes without increasing the number of stations. We also welcome the expansion into new retail-sales segments, namely ship and aircraft fuelling.

Intact corporate governance and transparency. After the consolidation of former WSR and the aolda Alliance's assets under one brand of anewa Alliance, the management, most of which comes from aolda Alliance, did its best to preserve good communications between the company and former WSR international investors, who became anewa Alliance shareholders via a reversal share swap. aOlda Alliance, which never dealt with equity investors, approached the investors of former WSR with zealousness and care, providing perfect disclosure, regular management meetings and conference calls on financial results. We specifically emphasize this, as poor corporate governance or an arrogant attitude to minority investors is a notorious problem affecting the Russian stock market.

Undervalued relative to emerging markets companies. We apply two approaches to reach final valuation for Alliance. Due to the specifics of the business structure, we believe that sum-of-the-parts (SOTP) DCF valuation is the most appropriate. Our comparative analysis is based on a comparison of average multiples for Russian oils and with analogous company - Hungarian oil company, MOL, is the best business-structure proxy for Alliance. Alliance is overvalued relative to Russian oil and gas companies trading at 5.0 and 8.3 on 2010E EV/EBITDA and P/E, although it is undervalued to MOL on the same multiplies trading with, respectively, 4% and 16% discounts.

VALUATION: OIL PRICE OUTLOOK

Long term mid-cycle Brent at $70/bbl. We assume long-term mid-cycle Brent at $70/bbl, with Urals having a long-term 3% discount to Brent. We do not adjust our long-term Brent price for US inflation. We presented our view on oil-price drivers and provided a fundamental outlook on long-term prices in our April oil report aOil Sector. Cost Cutting in Action. Survival, not revival a[bar] yet!a and in our June strategy report for 2H09 aStrategy. Russia by Numbers - DCF Points to Fair Valuea. In our December 2009 Strategy Report aRussia Remonta we use Bloomberg consensus oil price forecast for 2010 and further years to come: we expect oil price to grow to $87/bbl in 2012, before gradually sliding to $70/bbl in 2016. The outlines of our core assumptions and driving factors for oil-price performance are below.

Weakening dollar supports oil a[bar] We believe a weakening dollar and anticipation of global inflation to be the core factors that drive oil prices up. The dollar weakened from $1.2/EUR in October 2008 to $1.5/EUR in October 2009. Brent prices followed the dollar/euro very closely though 2009, with Brent reaching $80/bbl in October 2009. Meanwhile, oil-industry related indicators point to crude being overpriced; global supply-demand expectations, data on OPEC and Russia's production, and data on crude and product inventories in the US all indicate that crude prices are at unsustainable levels if the dollar-euro rate is not taken into account. Every time the dollar strengthened, sector-specific indicators started to dominate, pushing oil prices down. In July, it took oil eight days (from 2 to 13 July) to drop from above $70/bbl to below $60/bbl when the dollar strengthened from $1.411/EUR to $1.388/EUR and the low demand factor started to prevail. In October, the dollar had weakened to $1.5/EUR and oil broke the $80/bbl threshold.

a[bar] while other oil-related factors do not. If the US dollar starts to strengthen the oil-related factors should dominate and the market might see significant drop in oil prices.

- 2009 global oil demand not yet restored. In September, the International Energy Agency (IEA) updated its 2009 global oil demand forecast to 84.4 mbpd from 83.9 mbpd in August on improved Asian economic activity. The IAE expects 2010 demand to reach 85.7 mbpd, thus reaching the 2008 demand level of 85.8 mbpd.

- Oil prices follow stock market on recovery expectations. Oilprice growth also reflected expectations of economic recovery in the US and EU, moving in tandem with US and European stock markets. As the US and European economies are oil-importing, the rise in oil prices could hinder economic recovery or even reverse it into another wave of economic slowdown.

- OPEC and Russia ramp up production. Although OPEC agreed to maintain its 2009 production quotas at 24.85 mbpd (4.2 mbpd lower than end-2008 quotas) at its meeting on 10 October, many OPEC members continue to break the quotas constantly. According to Reuters, 11 OPEC members produced 26.40 mbpd in September 2009. Although the market expected Russia's production to fall by 1- 2% last year, 2009 daily production showed 2% growth YoY, reaching nearly 10 mbpd, and is likely to increase further thanks to increasing production at Rosneft's Vankor field, TNK-BP's Verkhnechonskoye, and Surgutneftegas's Talakanskoe.

- US oil inventories still high. US oil inventory statistics indicate that demand remains very weak. In 1Q09, oil inventories reached a high of 377 mln bbl, their highest level since 1993. Although inventories had dropped to approximately 340 mln bbl in October due to a drop in oil imports, we still regard this level as high, as demand for petroleum products remains low in US.

- Restocking of oil products continues. Although oil inventories have declined, this is partially due to restocking: with the slide in oil inventories, inventories of gasoiline, diesel, and jet fuel are up. People drive less, transport less cargo by roads, and fly less.

- No extraordinary growth in seasonal gasoline demand. We did not see US gasoline demand in 2009 exceeding 2008 levels during the traditional summer driving season. As gasoline prices in the US rose by 39% from December 2008 to May 2009, people threatened by the higher risk of unemployment, drove and travelled less.

- Heating oil reserves historically high. Prior to the winter period, heating oil reserves in US exceed their historic average.

- No lack of oil reserves due to new discoveries. Recent discoveries in the Gulf of Mexico and on the shelf of Gabon and Ghana in Africa indicate that the world is compensating extraction with new resources, and that there will be no lack of long-term supply due to an absence of new oil reserves. New reserves in Eastern Siberia in Russia also add to the new sources of oil.

Supply from Russia to close China demand gap. Although we expect China to contribute substantially to long-term demand growth, we do not expect such growth to create a supply-demand gap. This gap is to be closed by Russian deliveries via the ESPO. Russia is to start pumping 30 mtpa (7.3% of 2008 oil consumption in China) of oil through the ESPO to Asia, particularly China, at the end of 2009, which we believe will be sufficient to close the potential demand gap in China.

Upside on premium to domestic product prices. The underlying principle of Alliance's valuation is the 10-20% premium for domestic oil product prices in the Russian Far East market. This premium provides for 32.1% of the value-added, relative to the average Russian oil product prices. In our opinion, the main reason for this phenomenon is the longer transportation shoulder from Western Siberian oilfields. The cost of transportation to the Khabarovsk refinery consists of pipeline transportation tariffs that vary from approximately $10/ton to $20/ton, depending upon where oil is shipped from and a railroad tariff from Krasnoyarsk to Khabarovsk of approximately RUB2500/ton ($84/ton). We attribute this fact partially to the monopolistic positions of Alliance's Khabarovsk refinery and Rosneft's Komsomolsk refinery in the region. At the same time, we addressed this issue to different marketing specialists at different oil companies, who argued that it is namely due to the specifics of local demand that the prices of oil products have such a high premium to the average prices in other Russian regions.

Domestic crude price uncertainty is a risk. A lack of crude necessitates Alliance to buy substantial volumes on the domestic market for refining. Our oil price model assumes that domestic oil prices will reach netback parity with the export price at in the future. There is no specific period for domestic prices to reach the netback parity officially set (unlike with domestic gas prices), and it is usually through market mechanisms that domestic prices reach parity when the gap appears. Due to this, every consecutive period our domestic prices - i.e. purchase prices for crude oil to load up the refinery - have a tendency to grow until they reach net back parity.

Efficient marketing is a hedge for domestic purchases. The company managed to overcome depressed domestic product prices in 1H09 (a negative impact on revenues) and higher domestic crude prices (a negative impact on costs) via an efficient marketing policy. It significantly increased its oil inventories in 1Q09, stocking up at the lowest oil prices. It increased its refining throughput in 2Q09, but restrained product sales on the stilldepressed domestic market, increasing its product inventory. Domestic product prices had begun to recover by the end of 2Q09, and the company expected demand to increase in 3Q09. Indeed, products sales accelerated in 3Q09 due to utilization of the accumulated product inventory.

VALUATION: MACRO OUTLOOK

RUB/$ and inflation rate updates. Although we have increased our Brent forecast from $62.6/bbl to $62.2/bbl for 2009, $62.5/bbl to $72.3/bbl for 2010, $68.5/bbl to $82/bbl for 2011 and $70/bbl to $87/bbl for 2012, our long-term Brent forecast remains $70/bbl. Our macro forecast implies gradual ruble depreciation, with 5% long-term inflation. For more details on our oil price forecast please see our strategy aRussia Remonta, published on 2 December 2009. Our current Brent forecast is based on the Bloomberg consensus.

VALUATION: SOTP - FOR DCF

Sum-of-the-parts or integrated business valuation. Our belief that Alliance's upstream assets provide a low synergy with its downstream ones has lead to us applying a sum-of-the-parts valuation for the company:

- Upstream. We value the company's upstream business on a per-field basis. Our approach for Alliance is different from the one we apply when modelling the production profiles of integrated companies' upstream businesses, for which we apply a 10-year DCF and a perpetuity growth formula to calculate the terminal value:

- Forecast period: The period of time we use for calculating the DCF valuation of upstream is until 2030, which we believe is the year when most of the 3P reserves will be depleted and pass into the fourth stage of production;

- Terminal value: The residual value of 3P reserves is estimated using a target EV/reserves multiple of 3x (current EV/2P reserves ratio of Russian integrated peers is 3.4).

- Downstream. We apply a DCF and perpetuity growth formula to ascertain the value of the company's downstream segment:

- Forecasted period: We use a ten-year DCF model based on mostly flat throughput, as we remain conservative about the necessity to increase the capacity of the Khabarovsk refinery. Meanwhile, we take into account the upgrade of secondary refining units, and respectively increase the proportion of lightproduct output;

- Terminal value: We apply a perpetuity growth formula to estimate the terminal value of the downstream segment, and a 2% conservative terminal growth rate for the downstream business. We believe that the company will be successful, not only in retaining its current retail sales share (disregarding Rosneft's plans of expansion), but also in increasing it through efficient utilization of its existing network of filling stations. In addition, we believe that Alliance will be able to increase export sales of products to China - according to the company, the regions of China that border Russia have unique potential in terms of product sales.

Valuation upside. The valuation upside for Alliance comes from greenfield sites, tax relief in the upstream segment and from optimization of existing downstream assets:

- Upstream:

1. Kolvinskoye: the main upside will come from the introduction of the Kolvinskoye field located in Timano-Pechora; although currently not producing, when it is put on stream it will cover up to 50% of Alliance's production. In addition, this field will be eligible for MET tax holidays once it comes on stream.

2. MET - zero tax regime: for Timano-Pechora greenfields (including Kolvinskoye), for viscous oil in Tatarstan (Stepnoozerskoye field) and potentially for depleted fields in Samara region.

Downstream. We believe that the upside potential from the downstream should come not from expansion of the prime refining capacity, but from more efficient utilization of existing capacity. We believe that plans to increase the secondary refining coverage by constructing hydro-treating and hydro-cracking units are worth implementing. This will improve the quality of products, increase the share of high grade diesel, and thus improve the company's cash flow. We consider it a risk for the downstream to be exposed only to the Far East market, especially given Rosneft's plans to upgrade the Komsomolsk refinery in the Far East and the Angarsk refinery in the southern part of Eastern Siberia, as well as the plans to construct a refinery in Primorsk at the end of the ESPO. There is a risk of overproduction and, thus, the disappearance of the price premiums for oil products sold at the Far East relative to average prices for oil products in Russia.

Virtues of comparative analysis. Alliance can hardly be called a full-scale vertically integrated company. From an integrated perspective, its larger exposure to downstream business cannot be ignored nor can the low synergy between individual assets, which causes a dilemma as to how to compare Alliance as a single company with Russian peers - if indeed there is any comparable peer group. We tested the value by applying several approaches: comparisons with the average multiples of Russian oil and gas companies, comparisons with analogous company MOL. We rely on DCF to derive our target price, while using multiples to test relative performance.

- Comparison with domestic peer average. We compare Alliance with the average multiples for Russian oil companies. We believe that the Russian market is more beta (systematic risk factor) driven, than alpha (non-systematic risk factor) driven. Although in many respects Alliance's business structure cannot be compared with that of its peer group (LUKOIL or Rosneft), the assumption that beta drivers prevail in the market valuation of these companies justifies the comparison with the average multiples of Russian oil peers, disregarding the differences in business structures.

- Comparison with MOL. We believe that Hungarian oil company MOL could be the best proxy for a comparative valuation of Alliance. Although the scale of MOL's downstream segment (refining capacity and number of petrol stations) is much larger than Alliance's, the proportion of downstream and upstream in each company's revenue is similar. MOL is mostly an R&M company with a small upstream segment: MOL has 23.5 mtpa of refining capacity with more than 1,500 filing stations (including Slovenian INA), while its 2P SPE oil reserves are only 295 mln bbl. Downstream, accounts for approximately 75% of Alliance versus 82% for MOL.

UPSTREAM VALUE THROUGH KOLVINSKOYE AND TAX HOLIDAYS

Fields are small and scattered. Alliance's oil fields are small and scattered across four different regions of Russia - Timano-Pechora, Tomsk (in Western Siberia), Tatarstan and Samara. In Tatarstan and Samara, the fields are quite depleted and some have difficult geological characteristics and poor oil properties.

Looking for upstream added-value. We believe there are several core issues that Alliance can concentrate on to achieve value in its upstream business:

- Wide use of swap operations. While the company already utilizes swap operations extensively, their size and value for the business is still limited. Swaps are used for 100% of oil produced in Tomsk, which passes its crude export quotas in favour of Timano-Pechora. Partial swaps are used for oil production in Tatarstan. According to the company there are no problems in doing swaps with oil extracted in Samara and Timano-Pechora if necessary.

- Flexibility in marketing crude. For oilfields developed in the Tatarstan and Samara regions, Alliance applies a flexible and efficient marketing policy, using its proprietary rail cars to deliver export crude directly to its final destinations to avoid blending in the pipe, as well as to swap crude for deliveries to the Khabarovsk refinery.

- Tax relief upside for value. Currently, Alliance uses mineral extraction tax (MET) tax holidays for one field in Timano-Pechora and tax relief on MET for one field in Tatarstan. In addition, Alliance is in talks to obtain tax relief for several depleted fields in Samara. The overall affect of Alliance's existing tax breaks provides 4.3% of an additional value-added. If zero MET is applied to the Samara fields starting from 2010, this would imply a 1.2 ppt increase in 2010E EBITDA margin to 26.3%, and would raise our target price 4.6% to $18.3/share.

- Green fields in Timano-Pechora. According to a government decision of July 2008, starting from January 2009, zero MET tax holidays have been introduced for greenfields in Timano- Pechora either until cumulative production reaches 15 mln tons or for a period of seven years for fields in the development stage, or for 12 years for the combined exploration and production license. Alliance's Severo-Khariyaginskoye field qualifies for these tax holidays until 2016. We project that in 2017 the field will reach the plateau and will produce 552 ktpa, which will account for 14% of Alliance's total production (22% of the company's production in Timano-Pechora in 2017). In addition, the Kolvinskoye field, which has not yet come on stream, will be granted MET tax holidays as soon as production starts.

- High viscous oil in Tatarstan. If crude viscosity exceeds 250 MPa/second, the crude is classified as highly viscous and is liable for zero MET. Of the two fields being developed by the company in Tatarstan, only the Stepnoozerskoye field qualifies for zero MET. The field produced 329 ktpa in 2008, or 13% of Alliance's production (approximately 64% of the company's production in Tatarstan). The company has built separate collector facilities for the field, which register the specific volumes of viscous oil extracted for accounting purposes. Later, this oil is mixed with lighter oil to meet Transneft's oil quality specifications.

- Possible MET relief for depleted fields in Samara. Currently, the company is in talks with the federal tax authorities to get a zero MET for several of its depleted fields in the Samara region. According to the management, the Kochevnenskoye field could be classified as more than 85% depleted, as its cumulative production relative to Initial Geological Oil Reserves in Place (IOIP) is 86.9%. Alliance is exploring the possibility of having two other fields classified as past the depletion threshold (Solnechnoye and Kovalevskoye), but believes that the state geological authorities will take recent exploration into account, and include corresponding reserve additions made on these two fields in the IOIP calculations, thus preventing these fields from being considered depleted.

- Kolvinskoye has a two-fold upside in production. The Kolvinskoye field, located in Timano-Pechora, might become be the core production driver for the company in the future. Currently, the oil field is still in the exploration stage and the company plans to begin production by 2011. The quality of oil here is low: high gravity of above 900 kg cub m and high paraffin content above 16%. But production at Kolvinskoye is crucial for the company as, according to our estimates, the field will account for 27.5% of the company's cumulative production in 2015 and nearly 46% in 2020.

- Targeting new upstream assets. We believe that it is in the interests of Alliance to add new upstream assets over time. Falling production from its depleted fields, the risk of the Kolvinskoye field not coming on stream in time, and the fact that the Khabarovsk refinery is located in a region where crude flows will have other priorities (such as ESPO and the Komsomolsk and Primorsk refineries of state-controlled Rosneft) mean that it will be increasingly difficult for Alliance to find spare crude on the open market for its downstream. While we do not model the company's potential purchases, we believe that it is inevitable that it will look for new acquisitions. The company has underlined two strategies that it will adhere to: 1) look for exploration assets in Eastern Siberia (possibly the assets of Urals Energy), and 2) look for production assets in the regions where it currently has a presence preferably the Tomsk region) and new regions that afford the greatest synergy with its refinery, i.e. producing assets in both Eastern and Western Siberia.

Modelling production profiles. We have modelled the cumulative production profile for Alliance based on the individual production profiles of each of its fields, including Kolvinskoye. The company provided sufficient data to model the fields on a field-by-field basis, assuming a certain number of wells drilled and their daily flows, as well as the rate of flow decline from old wells. Our individual field models utilize so called aGosplan formsa and aRD formsa, which are widely used by Russian oil and gas companies to show production profiles.

Tomsk region. Alliance is developing four fields in the region, which account for approximately 11% of company's 1P and 14% of 2P reserves and 25% of 2008 total production. All of them have similar geological characteristics. The collectors of stretched uplifted pools are made of Jurassic sandstones, which lie at depths of 2,700-2,900 meters and are 3-7 meters thick with 1-70 miliDarsi permeability. Daily well flows are 15-250 tons per day. Wells are easy to drill (approximately 20 days per well) and the company does not have any problems servicing them (the maintenance period is quite long). The fields have an identical system of water injection to support the stratum pressure.

- Sredne Nurolskoye, Klyuchevskoye, Puglalymskoye. Each of these three fields is associated with homogenous Jurassic sandstone layers, 2,600-2,700 meters deep, with good porosity and permeability and no tectonic disruptions. Effective thickness varies from 4-10 meters. These three fields are linked to the Transneft pipeline system, through which 100% of the oil is shipped to the Khabarovsk refinery.

- Khvoynoye. Khvoynoye has a similar sandstone structure, with the pay zone at a depth of 2,580 meters with a thickness of approximately three meters. The field differs in terms of its logistics, as the pipeline connects the field to the local Alexandrov mini-refinery (2008 throughput was 0.05 mtpa), which was previously owned by WSR. Alliance sold off this mini-refinery in March 2009 after it took over WSR's business, but crude processing arrangements are still in effect.

Timano-Pechora. All four of the company's fields in Timano-Pechora have different geological and development characteristics. Timano-Pechora reserves account for 48% of 1P reserves, 56% of 2P reserves and 30% of the company's 2008 overall production. The Kolvinskoye field, which is also located in Timano-Pechora, is not yet producing, but is expected to be the core production driver in the future. If the Kolvinskoye field comes on stream by 2011, as the company plans, production in Timano-Pechora will account for 27.5% of overall production in 2015 and 46% in 2020.

- Sredne Kharyaginskoye field. This field has deep carboniferous deposits at depths of 3,900-4,000 meters, with a thickness of 20-125 meters. Deposits are associated with the reef structures of the Upper Devonian period, highly porous and cracked, which makes drilling and development difficult. To drill a well on this field will takes up to three months using heavy weight (350 tons of capacity) drilling rigs.

- Lekh Kharyaginskoye and Severo Kharyaginskoye fields. Both fields are associated with shallow (1,900-2,200 meters) carboniferous deposits of the Lower Permian period. Such shallow depths allow for the construction of cluster wells, which cannot be used in the development of the Sredne Kharyaginskoye field. This implies lower capex and opex for the wells. Productive layers vary in thickness from 6 to 25 meters. In both fields, oil has a gravity of approximately 830 kg m cub (30-34 API), which is typical for Urals blend. The oil also has a high sulphur and high paraffin content. Due to lower daily well flows from the Severo Kharyaginskoye field (on average 25 tons per well), compared to the high flows at Lekh Kharyaginskoye (above 150 tons per well), paraffin residue accumulates on the inner walls of the pipes in the wells, and in the flow lines. Cleaning the paraffin requires higher opex for the Severo Kharyaginskoye field. At the same time, the fact that Severo Kharyaginskoye came on stream only in 2006, it qualifies for the MET tax holidays introduced in 2009 for greenfields in Timano- Pechora (seven years of zero MET tax, or until cumulative production reaches 15 mln tons). The zero MET tax regime will be in effect for the field till 2015.

- Kolvinskoye field. The Kolvinskoye field will become the core production driver for Alliance. According to our model, if it comes on stream as planned in 2011, the field will produce 27.5% of Alliance's cumulative production in 2015 and nearly 46% of production in 2020. Development of the Kolvinskoye field encounters multiple geological risks. The deposits are associated with the Lower Devonian period at depths of more than 4,000 meters. The effective pay zone is not very thick - only 5-7 meters (a maximum of 15 meters). The oil has a very high gravity of 900 kg m cub (25-27 API) and very high paraffin content (above 16%). Paraffin crystallizes and accumulates on the inner walls of the pipes and in flow lines at temperatures below plus 40 degrees Centigrade. The extreme depths of the deposits, difficult geological conditions and oil properties not only imply high capex and opex, but emphasize the technical difficulties facing the company in extracting and transporting oil from the Kolvinskoye field. While we included the development of the Kolvinskoye in our DCF, we also ran a sensitivity analysis on the possibility that the field may not come on stream at all or that its production may not be as robust as the company expects. In our cash flow model and financial forecast Kolvinskoye results in EBITDA margins improvement from 20% in 2012 to 25% in 2015.

Samara region. Alliance is developing seven small oil fields in the Samara region. All but one (the Novo Kievskoye field, the largest of the seven), are located in the southern part of the region, compared to Rosneft (a core competitor in the region), whose fields are located in the northern, central and eastern parts of the region and account for 85% of production there. According to our conversations with Rosneft, the northern and central fields have better geological and oil quality characteristics, while fields located in the southern part of the region have more complicated geology and have a lower crude quality. Altogether, 1P reserves in the Samara fields make up 8% of Alliance's total reserves, while 2P accounts for 6%. Production from these seven fields in Samara makes up 24% of Alliance's overall production. In terms of transportation, the oil is transported from the fields first by tank cars and then by rail cars, making transportation expenses higher than those of Rosneft, which uses Transneft's pipeline network.

- Novo Kievskoye (located in the centre of the region) is the largest company's field in the region and accounted for 35% of company's production in the Samara region in 2008. Its deposits are at a shallow depth (1,650 meters) and are associated with the terrigenous domeshaped formations of the Carbonic period. The oil has a higher gravity (875 kg m cub), but unlike the southern fields, it does not contain sulphur mercaptans.

- The six fields in the southern part of the region are all associated with carboniferous limestone formations, which are highly cracked and porous, with deposits at depths of 2,500-2,700 meters, with very thin pay zones of 2-6 meters. The oil here is lighter than in Novo Kievskoye (825 kg m cub), but contains merkaptan sulphur. Thus sweet crude purchased from the other producers in the region must be added to meet Transneft standards, which slightly increases the opex on these fields. Each of these fields is small and two of them (Kochevnenskoye and Zapadno Kochevnenskoye) are quite depleted and have high production decline rates. While there is still the possibility of drilling approximately 13 wells in these six fields (five of them in the Kovalevskoye field), their production potential is limited by high decline rates of 10% (compared to 5-7% in other regions where the company operates). In addition, Alliance has three exploration licenses (Cheremushkinskiy, Ivanikhinskiy, Pushkarikhinskiy) in the south of Samara region and all three expire in 2013. This could provide certain opportunities as, according to the company, pay structures have been discovered in all of them and they are ready for exploration drilling. Neither capex nor potential production from these fields is included in our DCF model.

Tatarstan. Alliance is developing the Elginskoye and Stepnoozerskoye fields in Tatarstan. The field's 1P reserves account for 34% of the total 1P reserves of the company, while 2P make up 24% of the total 2P reserves. 2008 production of 472 ktpa accounted for 21% of the overall production that year. Both fields are located west of the core group of fields being developed by Tatneft in Tatarstan (Tatneft covers approximately 80% of crude production in Tatarstan). These are the assets that were incorporated into a merged anewa Alliance, not from WSR side as were all the other upstream assets, but namely from aolda non-public Alliance. Both fields have heavy, viscous oil, while the geological formations have high permeability and porosity. As a result of this, Alliance is obliged to keep well flows at a low level of five tons per well. Because the oil has high viscosity (and thus moves through the pores more slowly then water) and the formation has a high permeability, it is easier for water to penetrate the formation faster than oil and to form oil traps, destroying the oil flows and increasing the water cut.

- Elginskoye. The field contains heavy and highly viscous oil in shallow (1,500-1,720 meters deep) carboniferous deposits of the lower Carbonic and Upper Devonian periods. The field is highly depleted, and the company believes a maximum of 10 wells can be drilled on the field in the future. The oil from the Carbonic layers is quite heavy, with a low daily flow of five tons per well, while the oil from the Devonian layers is less heavy (about 100 MPa/second) with well flows of 20-25 tons per day. As a result, the viscosity of mixed blend is still below 250 MPa/second, which means it does not qualify for the zero MET.

- Stepnoozerskoye. This field's deposits are even shallower (1,000- 1,480 meters) than those of Elginskoye, with structures from the Middle and Upper Carbonic period. The three layers from Middle Carbonic deposits have oil with a viscosity of more than 250 MPa/second, which qualifies for the zero MET. To properly account for this oil, the company has constructed a separate metering and gathering system, which measures the volume of viscous oil to which the special MET tax regime can be applied. This oil is later mixed with lighter oil to meet Transneft's oil-quality specifications. Alliance believes that it can drill more than 150 new wells before 2020, adding up to 15 wells annually.

Kazakhstan. Alliance is developing the Eastern wing of the Zhanatalap oil field in Kazakhstan through its subsidiary, Potential Oil, under a PSA agreement. This field is part of the Begaidar block in the north Caspian region of Kazakhstan. Typical of this region, the oil deposits here are either shallow (less than 1,000 meters), above the salt layer, or very deep (at almost 4,000 meters) and associated with sub-salt formations and salt intrusions. Currently, Alliance is developing carboniferous tectonically isolated formations at a depth of 650-750 meters, with a thick pay zone of about 12 meters.

- Terms of PSA in Kazakhstan. Alliance is working in Kazakhstan under a 50/50 PSA agreement with the Kazakh government. Of the 50% Russian stake in the project, Alliance controls 80%. It is also the project operator and thus bears a proportionate share of capex.

SECONDARY REFINING TO UPGRADE; NO NEED FOR ADDITIONAL PRIME CAPACITY

Lack of opportunities. The Khabarovsk refinery can be described as small and cramped, as the refinery is actually located in the middle of the city. Any plans for expansion will always have to deal with a lack of available space, as the refinery is surrounded by housing blocks. At the same time, these limitations have engendered an understanding within the company that potential upgrades must be implemented as efficiently as possible. Khabarovsk is one of the smallest refineries in Russia. It is one of five refineries located east of the Ural mountains: three (Angarsk, Achinsk and Komsomolsk) are owned by Rosneft, one (Omsk refinery) by Gazprom Neft and the last (and the smallest terms of capacity) is Alliance's Khabarovsk refinery.

Additional prime capacity is not necessary ... Alliance has alternative plans to increase current capacity from 4.35 mtpa to 6 mtpa by building additional primary refining units. In our opinion, any additional primary refining capacities will be excessive. At present, the company can maintain or even increase its market share by improving the structure of products produced through increasing the share of light products and by further improving the efficiency of marketing of such products, i.e. increase the share of retail and small bulk wholesale volumes sold through its proprietary retail stations and terminals. Demand for oil products in the Far East is growing very slowly and besides, Rosneft, the company's chief competitor, has extensive plans to upgrade its Komsomolsk and Angarsk refineries, as well as construct a new refinery for exports at the end of ESPO.

a[bar] but upgrades to increase conversion are. We believe that if the company concentrates on upgrading secondary refining units to increase the conversion ratio and light-product yield, this would have a more positive impact on efficiency than any expansion of prime capacity. We would welcome the construction of additional secondary refining units, if they can fit on the refinery's small property and pose no harm to the environment and safety of the town.

Risks may outweigh opportunities - a catch 22. We believe that with regard to refining in the Far East, Alliance faces a tentative balance between a desire to expand its downstream business and the risk of being confronted with overproduction or an inability to find crude oil for such an expansion. On the one hand, if total throughput grows above current capacity, the company will be faced with marketing problems and pricing pressures on the domestic market from the effect of overproduction. On the other hand, the company might have difficulty finding spare oil to purchase on the domestic market to supply an expanded Khabarovsk refinery.

Rosneft has a monopoly on regional refining. The Russian Far East is completely dominated by Rosneft refineries. Rosneft's Komsomolsk refinery is located near Khabarovsk (approximately 400 km). It also operates its Angarsk refinery (near the town of Irkutsk, on the southwest side of Lake Baikal), which ships volumes of oil to the Far East. Rosneft is also considering the possibility of building an additional 10-20 mtpa exportdedicated refinery at the end of the ESPO.

- Upgrading Komsomolsk refinery. Production from Rosneft's Komsomolsk refinery reached 7.3 mtpa in 2008, and Rosneft plans to increase throughput to 8 mtpa by 2013 by upgrading existing prime refining units. Currently, Rosneft plans to rebuild a catalytic reforming unit to start producing Euro-4 grade gasoline as well as to build isomerisation and hydro cracking units. The installation of these units will enable the refinery to increase its conversion ratio from the current 59.4% to 95% as well as to double the production of automotive gasoline and diesel and triple the production of jet fuel.

- Pressure from Angarsk refinery from the west. Although Rosneft's Angarsk refinery is located to the west of Lake Baikal in the southern part of East Siberia, certain products from this refinery are shipped by rail to the Far East, particularly to the Amur region. The Angarsk refinery refined 9.5 mtpa of oil in 2008, and Rosneft does not have any plans to increase throughput in the long term. The refinery's depth is 78.1% and it is oriented to the domestic market, as approximately 75% of its production is sold on the domestic market. Additionally, Rosneft plans to build an isomerisation unit, hydro treatment facilities for diesel fuel and catalytic cracking units (after 2013) at the refinery. These upgrades will increase the share of light, value-added products. Currently yield on light products is just above 50%.

- Export oriented refinery at the end of ESPO. Rosneft is exploring the possibility of constructing 10-20 mtpa capacity export-oriented refinery at the far end of the ESPO. It is estimated that such a project could not be realized until 2020, after the second string of ESPO is in place, which will be not earlier than 2015. The refinery will have a refining depth of 95%, with up to 85% of products going to export, and the remainder going to the domestic market.

ESPO becomes higher priority for oil deliveries to east. The ESPO will be particularly important to Russian companies' oil exports once it is complete. The reason is an obligation to China, stated in loan agreements with Transneft and Rosneft. However, increasing the volume of exports eastward could mean a lack of crude for export to the west. If so, assuming domestic demand for oil products does not increase significantly, the Russian government will urge oil companies to direct spare volumes to the west. Thus, it will be quite difficult for Alliance to buy spare oil on the open market to ship it eastwards. This crude will also be quite expensive. Regarding fields located in the southern part of Eastern Siberia (SPES), which will feed into ESPO, it is important to note that if demand in China collapses, the only way to meet the demand fall would be to shut down the wells in these fields. It is not possible to redirect crude extracted in the SPES to the west via Transneft pipelines, as the ESPO will operate one way only. Meanwhile, Alliance has indicated that it has made long-term agreements with Transneft to allocate sufficient crude volumes to the Khabarovsk refinery to secure its utilization rate.

Refining margins undermined by assumption of crude netback parity. If we assume that domestic oil prices recover to the net-back parity level, our valuations and margins for Alliance will be undermined for each consecutive period of our DCF model due to the rising price of domestic crude, which Alliance has to purchase to send to its refinery. Our model assumes that domestic prices will reach net back parity with international oil prices by 2012, while Brent is kept at $70/bbl for the long term. This implies that until 2012, domestic prices will rise, while international prices remain the same. This assumption duly implies that, if the company is buying crude for refining on the domestic market and then selling the refined oil products, its costs are growing faster than its revenues.

SECURED NICHE IN OIL PRODUCT RETAIL

Strong retail positions. We believe that Alliance's biggest added value is not the Khabarovsk refinery, but the network of retail outlets that it has developed over the years, the significant local market share of retail sales, and its ambitions to develop new segments of retail business, such as aviation and ship fuelling (bunker fuelling business). According to the company, its share in the Far East retail market in 2008 was 35% and 31% of the wholesale market, respectively. Alliance sells more than 80% of the automotive gasoline and 20% of the diesel fuel produced on domestic market through its 256 retail outlets in the Far East. This network is supported by 24 terminals for oil products with a combined storage capacity of 448,800 cubic meters, through which the company delivers products for its retail network and conducts its small bulk wholesale business. Alliance acquired 10 more filling stations and five modern oil-product terminals in the Amur region in September 2009. The filling stations acquired are advantageously located and have high oil-product sales rates, averaging 5.5 tons per day per station. The acquisition should increase the company's retail sales in the region by about 30% to 90,000 tons per year.

Optimization of network continues. According to management, Alliance plans to optimize the number of petrol stations and tank farms to make them more efficient operationally. As part of this program, the company plans to close less profitable stations and increase the efficiency of the rest. In addition, Alliance plans to expand into neighbouring regions, including the Kamchatka and Magadan regions and Sakhalin Island. Alliance plans to increase the share of small bulk wholesale volumes by reducing sales of products at the refinery gate, gaining from the better margins of small bulk wholesale operations.

Development of bunker and aviation fuel segments. Alliance plans to utilise its close proximity to the sea and relations with its core shareholder to develop new retail businesses in aviation and bunker fuel.

- Bunker fuel. As the Khabarovsk refinery is located near the Far East sea ports of Vitino, Vladivostok and Nakhodka, Alliance has always been keen on selling marine fuel directly to the sea vessels.

- Producer of bunker marine fuel. The Khabarovsk refinery produces approximately 0.5 mtpa of marine fuel annually, which makes up about 15% of total oil-product production. Alliance also purchases additional volumes of fuel, which means that bunker fuel accounts for 17% of the total amount of products sold by the company.

- Tanker fuelling business. Alliance operates a rail and water loading terminal in Vladivostok, with a shipment capacity of 2.5 mtpa. In addition, the company has loading facilities in Nakhodka, the home port of Rosneft.

- Core Alliance shareholders control local airport. Alliance delivers jet fuel to Khabarovsk airport via a pipeline that links it to the Khabarovsk refinery. Currently, jet fuel makes up approximately 6% of production, but we expect the company to increase this to 7% after the construction of the reforming unit. The airport is 100% controlled by Alliance's core shareholders. Alliance clearly benefits from this relationship, as it has guaranteed access to the lucrative aviation fuel business.

Established presence in the Far East domestic market. Although Rosneft is able to elbow Alliance in refining capacity and throughput, the companies have different marketing strategies in the region, with Rosneft being export oriented and Alliance domestic oriented. Alliance has developed a wide and strong network of wholesale and retail outlets, which will enable it to preserve its niche in the domestic market, regardless of Rosneft's ambitions for expansion.

- Rosneft and Alliance have different marketing strategies. In general Rosneft has a more export-oriented marketing strategy in the region. Rosneft exports approximately 65% of production from the Komsomolsk refinery, including more than 50% of diesel and nearly 80% of fuel oil. At the Primorsk refinery, 85% of production is to be exported. Alliance, on the other hand, historically has a strong presence in the domestic market, and exports only 12% of gasoline and 65% of diesel produced. The core limitation for Alliance stems from surplus volumes at Rosneft refineries. The region's limited industrial growth, competition from increasing sales of Rosneft products, and the limited export capacities of existing sea ports hamper Alliance's plans to increase capacity from 4.35 mtpa to 6 mtpa.

- Marketing niche is preserved by quality sales, not quantity. We believe that Alliance will benefit more if it continues with its current capacity and improves the quality of products produced via the modernization of secondary refining units and also increases sales per station.

- Retail positions are stronger. Alliance has a wider network of petrol stations than Rosneft in the Far East region, which will enable it to compete successfully if it works within the existing limits of product volumes produced.

Could China help in expanding retail and wholesale marketing? From the demand side, we believe that one option for Alliance is to develop the sale of petroleum products to China across the border. According to the company, Chinese towns bordering Russia are developing at a faster pace than the Russian towns near the border. Selling oil products to China may be a way to increase sales and contribute to a need for increased refining capacity.

SOLID FINANCIALS SUPPORTED BY DOWNSTREAM

Downstream dominates financials. Revenue from downstream accounted for approximately 83% of the company's total revenue in 2008, with revenues from domestic sales of oil products being 77% of downstream revenues, or 64% of total revenues. Downstream capex in 2008 accounted for nearly 68% of the total capex. In our base case scenario, which does not envisage any upstream acquisitions, downstream will continue to dominate: by 2015 downstream will account for 58% of revenue and 67% of capex.

Efficient marketing - solid margins. Alliance's valuation paradigm is based on the idea that its value stems not from its revenue line, but from the efficient management of costs. Among the most manageable are lifting costs, refining costs, transportation costs and SG&A. Cost of crude oil purchased is an item which, in the future, will undermine the financials of Alliance most. We expect domestic oil prices to grow at a rate close to the rate of inflation of 6% per annum to USD399/ton ($54/bbl) by 2018, which implies a net back parity. We foresee EBITDA and net margins to be 24.7% and 13% by 2015, respectively, while ROACE is projected to be 31.4% by 2015.

- 2009 proved that the company can efficiently apply its marketing levers to compensate for a negative price environment. The company managed to overcome depressed domestic product prices (a negative impact for revenue) and higher domestic crude prices (a negative impact on costs) in 2Q09 through an efficient marketing policy. It significantly increased its oil inventories in 1Q09, stocking up at the lowest oil prices. It increased its refining throughput in 2Q09, but restrained product sales on the still-depressed domestic market, increasing its product inventory. Domestic product prices had begun to recover at the end of 2Q09 and continued throughout 3Q09. Products sales accelerated in 3Q09 due to utilization of the accumulated product inventory.

- In addition, Alliance optimized its product purchasing, switching the purchase point from Transneft's Meget station to the Uyar station, which the company says provided savings from cheaper rail transportation from Uyar to the Khabarovsk refinery.

We do not like assets being pledged, but debt level is comfortable. As of 30 September 2009, company's debt position was $706 mln, of which 46% was short-term and current portion of long-term debt, while it had a cash position of $326 mln. This implies debt to aggregated debt and equity capital of 43%. As of end-2008, 100% of all of the upstream assets were pledged under different loan agreements, while in March 2009 Alliance borrowed RUB5 bln ($167 mln) from VTB Bank and used a 95.76% stake in the Khabarovsk refinery and controlling stakes in oil product wholesale subsidiaries as collateral.

On 21 September 2009, Alliance announced that it had redeemed RUB2.7 bln ($90 mln) of its RUB3 bln ($99 mln) bond issue due in 2011. The company redeemed the bonds at 100% of their face value, using its own cash. The remaining RUB267 mln ($9 mln) of the bond issue will remain outstanding until September 2011. At the same time, the company increased the coupon rate for the remaining part of the issue to 14% per annum from 8.92% per annum. The company's 2009E EBITDA is expected at $706 mln, implying a 2009E net debt/EBITDA ratio of 0.5, which we regard as very low and comfortable. We believe that in the long run, Alliance will be able to finance its working capital and capex requirements, mostly from cash flow, without any additional borrowings on the capital market.

Kolvinskoye and refining upgrades to have core impact on financials. Introduction of Kolvinskoye field and capex for upgrading secondary refining units are to have the strongest effect on companies' long-term financials.

- Kolvinskoye: bringing Kolvinskoye on stream in 2011 will improve Alliance's financials starting from 2012. The EBITDA margin should decline from 25% in 2010 to 20% in 2012 due to mild production growth not compensating for the increasing domestic crude price, which is the core component of downstream costs. Starting from 2012, additions from Kolvinskoye are set to outweigh the negative effect of high prices of crude purchased, improving the EBITDA margin to 25% in 2015 and ROE from 14% in 2012 to nearly 20% in 2015.

- Secondary refining units: in our DCF model, we account for construction of hydrotreating and hydrocracking units, with peak capex of $200 mln planned for 2015 (52% of total upstream and downstream capex for that year), as well as a visbreaking unit, with a capex peak of $75 mln in 2016 (30% of total 2016 capex). The overall effect will be investment cash outflow more than doubling, from $316 mln in 2011 to $780 mln in 2015.

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Publication:Russian Banks and Brokers Reports
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Date:Feb 2, 2010
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