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Uralsib - Russia Equity Research - Bashneft - Entering the Integrated Oil Universe; Value Through Business Consolidation - Feb 18, 2010.

Entering the Integrated Oil Universe Value Through Business Consolidation

Center of oil-business consolidation. After acquiring Bashkirian oil assets in early 2009 (cumulatively referred to as BashTEK), AFK Sistema is now streamlining the cashflows under Bashneft. Formerly just an upstream company, Bashneft is being transformed into a fully integrated oil company. Value will be created through the whole value chain: from oil extraction to wholesale and retail sales of valueadded refined products.

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Yet to be fully priced in. Full integration of Bashneft in our DCF implies a target price of $44/share, offering 63% upside. The market reacted positively to AFK Sistema's decision to leave Bashneft as a consolidation center and not to squeeze out minorities; Bashneft's share price rose 100% in September 2009 alone, from $12/share. However, we see still see upside in the name. We value the prefs at a 25% discount to the comms and a target price of $33/share, providing 44% upside. We reinstate coverage of both the common and and preferred shares with Buy recommendations.


Bashneft - a newly integrated oil company. Bashneft is fully integrated, controlling four refineries and consolidating all cashflows.


Upstream: unveiling hidden opportunities. Most brownfields are depleted, wells have low productivity, and oil has high gravity and a high sulfur content. 80% of production comes from 34 (of 163) fields. Production covers only 50% of refining.

Downstream: full-scale value added. Bashneft controls 100% of its product sales, utilizing the benefits of product price margins.


Benefiting from high dividends. Sistema will monetize from Bashneft via high dividends, and thus Bashneft minorities should benefit. We recommend investing in both Bashneft and AFK Sistema.


DCF and multiples give substantial upside. DCF implies 63% upside, which stems from business consolidation. 2010E P/E and EV/EBITDA imply nearly 50-60% upside to Russian peers.

Purchased crude threatens margins. EBITDA margins could come under pressure from crude volumes purchased to cover refining needs and from rising domestic crude prices.

FROM UNRELATED ASSETS TO VERTICAL INTEGRATION Bashneft - a newly integrated oil company

Bashneft to become consolidation center. After acquiring controlling stakes in Bashkirian oil assets (collectively known as BashTEK), AFK Sistema made a crucial decision to consolidate them all under Bashneft. Formerly a pure E&P company, Bashneft is now a vertically integrated oil company. Consolidation implies that Bashneft now controls both the upstream and downstream businesses, centralizing crude exports and selling oil products to end customers, using the refineries only as processing centers. The new value stems from the difference in value that Bashneft should receive from selling oil products versus selling crude at domestic prices.

Minorities to benefit. This decision also implies that Bashneft minorities are not going to be squeezed out. In addition to potential share-price appreciation, which should be driven by business consolidation, Bashneft minorities will benefit from strong dividends: Sistema will use Bashneft as a source of cash for itself; the cash will be transferred to Sistema in the form of dividends. We expect Bashneft to pay at least 50% of its net income in dividends, which would imply a dividend yield of 12-19% on average net income of $1.2-1.9 bln in 2010-15.

Chronology of consolidation. Sistema currently controls approximately 75% of the total share capital of each of Bashneft, Ufa Refinery, Novo-Ufa Refinery (NOVOIL), Ufaorgsintez, Ufaneftekhim, and Bashnefteproduct.

1. 2005: Sistema-Invest, then fully owned by Sistema, acquired minority stakes in Bashneft (20.77% of total capital), Ufa Refinery (22.5%), NOVOIL (25.6%), Ufaorgsintez (21.5%), Ufaneftekhim (18.19%), and Bashnefteproduct (17.21%).

2. 2006: Sistema Invest buys shares in these companies from the market, bringing its ownership to between 25% and 30%.

3. 2006: Sistema sells 35% of Sistema Invest to an undisclosed third party.

4. 2008: Sistema signs a management agreement to manage controlling stakes of BashTEK companies that are owned by four funds rumored to be associated with the Bashkirian government: Agidel Invest, Ural Invest, Inzer Invest, and Yuryuzan Invest.

5. March 2009: Sistema increases its stake to approximately 75% in each of the BashTEK companies by buying out the four above-mentioned Bashkirian funds: it thus increased its stake in Bashneft by 55.04% of capital, in Ufa Refinery by 53.68%, in NOVOIL by 60.24%, in Ufaorgsintez 50.24%, in Ufaneftekhim by 42.24%, and in Bashnefteproduct by 47.88%. Sistema's stake in Bashneft, also includes shares bought from the market by Sistema Invest in 2006, is now 55.68% (65.61% of voting shares).

6. October 2009: Sistema decreases its stake in Sistema Invest from 65% to 19.99%, selling 45.01% to a third party. Sistema still reports 65% ownership in Sistema Invest under US GAAP, as the third party is within the GAAP consolidation perimeter, and Sistema has the right to restore this 65% stake under the share option agreement. In addition, Sistema reduced its stake in Bashneft from 55.68% to 50.90%

7. December 2009-January 2010: Sistema sells controlling stakes in the Ufa refinery (55.58% of total capital), NOVOIL (61.57%), Ufaorgsintez (51.50%), Ufaneftekhim (47.18%), and Bashnefteproduct (56.11%) to Bashneft (50.90% owned by Sistema and 20.8% still owned by Sistema Invest). These stakes include stakes acquired from Agidel Invest, Ural Invest, Inzer Invest, and Yuryuzan Invest in March 2009, and also small stakes purchased by Sistema from the market in 2006. Former Sistema Invest stakes, acquired in 2005, are retained within Sistema.

8. February 2010: Bashneft makes buyout offers to minorities of Bashkirian refineries and Bashnefteproduct. In addition, each of these companies owns a stake in Bashkirenergo, which, combined, comes to approximately 50%. However, Bashkirnergo will be carved out and will be directly controlled by Sistema, and will not be included in Bashneft's oil business.

Consolidation - change in cash-generation principle. Consolidation implies Bashneft becoming the parent company of the business and the center of operating flows and cashflows. Full consolidation will be reflected in Bashneft's first-ever consolidated GAAP statements for 1Q10; previously the company, as well as each of the Bashkirian refineries and Bashnefteproduct, reported only RAS accounts.

How it was before: Bashneft was purely an E&P company that extracted oil (approximately 12 mtpa), of which it sold some 28% on export markets, with the rest being sold on the domestic market to refineries, including Bashkirian refineries, which operated as independent legal and business entities. They owned neither crude nor oil products. Refineries were profit centers, generating cashflow from the refining fee, which included the relevant profit margins and capex requirements.

How it is now: Bashneft became the holding center: all operating flows (crude exports and oil-product sales) and cashflows (bank accounts) are consolidated at Bashneft. In production, the new entity, Bashneft Dobycha, operates oilfields, while Bashneft remains the license owner. A similar organizational and management principle has been developed in Rosneft's upstream segment, where former upstream subsidiaries such as Yuganskneftegas or Purneftegas are field operators, which receive fixed operators' fees, while licenses are fully transferred to holding-company Rosneft, which controls all cashflows. Bashneft retains the right to all crude extracted, and also buys the crude on the open market from third parties that is necessary to load up the Bashkirian refineries, which it now controls. Refineries operate on a processing basis, and the refining fee nearly equals the cost of refining. Capex for refineries is planned at the holding-company level, i.e. Bashneft, and will probably not be included in the processing fee. Bashneft retains the right to the oil products which it markets itself via its newly set up trading divisions.

Valuation of consolidated Bashneft. Our valuation is based on a DCF model of the fully consolidated Bashneft (see the explanation above) and implies a target price of $44/share, which provides 76% upside from the current market price. Nearly 75% of the value comes from Bashneft's downstream business. We do not include the value of Bashkirenergo in our DCF, as it is going to be carved out of BashTEK and integrated directly with Sistema. Our DCF forecast is based on certain assumptions, set out below. Our macro forecast is outlined in our Strategy report aRussia Remonta published in December 2009. The macro forecast implies ruble appreciation through 2010, from where we expect it to depreciate gradually, reaching RUB32.7/$ in 2012. We expect annual CPI to fall from 9% in 2010 to at approximately 7% in 2015. Our oil-price forecast is based on the Bloomberg consensus forecast and implies Brent at $72.3/bbl in 2010, $82/bbl in 2011, and $87/bbl in 2012. Our long-term Brent assumption remains at $70/bbl, to where it gradually slides after 2012. Our domestic oil and oil product price forecasts are based on the Brent price and the assumption that the domestic crude price will reach netback parity with Brent. Bashneft's WACC is 12.7%. Its terminal growth rate is assumed at 0%, which reflects its depleted oil reserves and our assumption that its product slate will remain unchanged.

Multiples support DCF valuation. Relative valuation based on multiples (P/S, P/E, EV/EBITDA) using target prices and target EV in the numerators imply that, at our target price of $44/share, Bashneft should be valued in line with its peers if its peers' multiples are based on their current market prices or on target prices. This indicates that in our aHolda oil-sector environment, there is no room for share price growth. At current prices and forecasts for 2010-11 financials, a comparative analysis indicates that Bashneft is nearly 60% undervalued on P/S and approximately 20-30% undervalued on EV/EBITDA, EV/capital employed, EV/production, and P/E.

Bashneft is nearly 70% undervalued on EV/refining throughput. Of our aHolda universe, we pinpoint a few alpha driven companies on which we have Buy recommendations despite the systematic risks that influence the Russian market, i.e. even if the market goes down due to some systematic beta-related market risks, stocks of companies such as Bashneft may grow. Bashneft could outperform if the market rises, and be a safe haven in times of market volatility. For more on our other oil-sector recommendations, see our Russia Remont Strategy Report of December 2009.


Upstream - unveiling hidden opportunities

History of production in Bashkiria. The first oil was discovered in Bashkiria in 1901, but large-scale production began only in 1937. The giant Tuymazinskoye field was discovered in 1944, followed by the huge Arlanskoye field in 1955. By 1967, production had peaked at 47.8 mtpa, and was retained at approximately 40 mtpa until 1981. It continuously declined thereafter, first due to an increase in the watercut, and starting from 1919, to massive shutdowns of production wells. The first production minimum of 11.9 mtpa was reached in 2000 and, after a small bounce to 12.1 mtpa in 2004, production slid to a new low of 11.6 mtpa in 2007. A total of 1,600 mt of oil has been recovered since production started in Bashkiria: the fields are currently at the final stage of production, which is characterized by a stable, flat profile, though with low well productivity and a high watercut.

Organic turnaround. During just two months after the acquisition, Bashneft started to increase its daily production, reaching 36.5 ktpd in January 2010, up 14% YoY. This the highest daily production since January 1998, and was achieved by working over some underproduced wells, opening some idle wells, and shutting down wells with high watercuts. Also, the overall watercut was decreased from 91% to 90%.

We believe that Bashneft is quite able to repeat the TNK-BP Samotlor success story - with 94% water, Samotlor has increased annual production by 38% since 2000. We believe that production potential can be quickly monetized by the new management team that joined Sistema from Russneft, headed by Alexander Korsik. Most of the new team members are former Sibneft (now Gazprom Neft) and YUKOS managers who know how to create value for shareholders. We believe that their expertise in enhancing recovery and optimizing water flooding should put Bashneft's output on a steady growth track in 2010-15. Through the application of additional exploration of new deposits in Bashkiria and elsewhere in Russia, Bashneft will be able at least to sustain its current reserve levels and retain its production level.

Reserves: depleted, sour, low productivity . As Bashneft does not provide internationally audited reserves assessments, we use Russian ABC1 classification in our assumptions. Miller & Lents is currently involved in the engineering audit, and by the end of 1Q10, PRMS (former SPE) reserves estimates are to be made public by the company for the first time. 2009 ABC1 reserves were around 300 mt; almost all were 85% depleted. High gravity (an average of 900 kg/cub.m), a high watercut (90%), and the oil's viscosity (10-50 MPa/sec) mean low daily well-flow rates of only 2.2 tons. The company drills approximately 160 new wells per year, and until 2009, new wells had average daily flows only of 4 tons per well. The new management plans to improve well productivity. In addition, Bashkirian crude is sour, with a sulfur content of above 2%, which requires additional desulfurization before being put into Transneft's network.

Bashkirian oil deposits are located in three core sub-regions: the North West, with Arlanskoye, the largest field, where the fields are associated with the Birskaya, Blagoveshenskaya, and Verkhnekamovskaya depressions and the Bashkirskiy arch (the cumulative share of residual ABC1 reserves is approximately 57%); the Western zone, with the Tuymazinskoye field, the second-largest, where the fields are associated with the South Tatarstan arch (the cumulative share of residual ABC1 reserves is approximately 30%); and the Central and Southern part of Bashkiria (Ishimbay, Mrakovskaya, Belskaya depressions), where the first oil was discovered in Bashkiria before Soviet times (approximately 9% of residual ABC1 reserves). The two largest fields - Arlanskoye and Tuymazinskoye - are 94% depleted and cover 17% of overall ABC1 reserves and 30% of overall production. Bashkiria borders oilfields of LUKOIL-Permneft (in the Perm region), Rosneft-Udmurtneft (in Udmurtia), and Tatneft (in Tatarstan) in the North, Northwest, and West. Oil in these areas has common characteristics - it is heavy, viscous, and sour. In the south, Bashkiria borders the Orenburg region, with assets of TNK-BP Orenburgneft located there; the oil is lighter, but still slightly sulfurous, with a higher gas factor.

- Arlanskoye oil field. The largest oilfield in Bashkiria, with ABC1 reserves of 33 mt (nearly 10% of overall ABC1 reserves) and production of 3 mtpa (26% of overall production) was discovered yet in 1955. It is associated with both the Birskaya and Verkhnekamskaya depressions. The pay zone lies between 800 and 1,300 meters down, covering up to eight separate layers, with the most productive layers associated with deep terrigenous collectors of the Lower Carboniferous and Devonian period. The oil is of high viscosity, high gravity (880-900 kg/cub.m), high sulfur content (2.4-3.6%), and high paraffin content.

- Tuymazinskoye oil field. The second-largest field in Bashkiria, it was the first giant field discovered. In 1937, the first oil was discovered in Carboniferous layers and in the 1950s, oil was discovered in the Devonian layers. The Devonian deposits were so productive that the first well drilled produced more oil than all wells that pumped oil from Carboniferous collectors. Productive terrigenous sandstones of the Devonian and Carboniferous periods lay at depths of 1,000-1,700 meters. Crude gravity varies from 850 kg/cub.m for Devonian oil to 890 kg/cm for Carboniferous oil.

Sulfur contents also vary from 1.5-2% for Devonian oil to 2.7-3% for Carboniferous oil. Oil from the Tuymazinskoye field is of slightly better quality than that from the Arlanskoye field. The core characteristics of crude for refining - the share of light hydrocarbons that boil at 200 degrees Centigrade - is 25% in oil from Tuymazinskoye field and only 18% in oil from Arlanskoye field. The Tuymazinskoye field's ABC1 reserves currently cover 7% (22 mt) of overall ABC1 reserves, while production is 4% of overall production (0.5 mtpa).

Hidden potential of depleted assets and new reserves yet to be discovered. We believe the region has the geological potential to at least maintain production at current levels or even see a slight increase, despite the fact that the majority of oil fields in Bashkiria, including the two largest fields (Arlanskoye and Tuymazinskoye), are approximately 85% depleted. Many geologists believe that within the Birskaya depression Devonian layers contain additional oil reserves (Devonian oil) and new fields could be found within the Bashkirskiy arch. In the southern part of Bashkiria, in the Ishimbay depression, we expect new discoveries of smaller fields containing carboniferous oil bearing sediments.

Technology matters. We expect Bashneft's new management to bring in new geologists (possibly former Sibneft geologists) who will start applying secondary recovery technologies, which were previously not utilized or underutilized. The potential is still big. In the early days of development at the Bashkirian oil fields, daily flow from new wells reached 250 tons per well - as high as some of the best fields in Western Siberia. We believe management will be more aggressive in maximizing production. Under the company's previous management, it was not in the interests of the company to show strong operational results. Target production was usually kept to a minimum so that this target could easily be surpassed, as meeting the annual plan resulted in a good annual bonus.

Under the new upstream team, we expect a huge turnaround. Simply by reopening idle wells, Bashneft was able to increase production by approximately 9% YoY to 12.2 mtpa in 2009. Until now, the most widely used secondary recovery technique in Bashkiria was injecting surface-active reagents to wash off oil film from sand particles in the stratum. With a water cut of 85-90%, the only oil left is the film around the sand particles. Now we believe the company will introduce hydro-fracturing, sidetracking and waterflood optimization techniques.

Gas: rather immaterial, but another penny in the value basket. In addition, we expect Bashneft to start producing gas from the gas fields in southern Bashkiria, at the southern tip of the Ishimbay depression, which has similar geological structures to Gazprom's fields in the Orenburg region. Currently, gas production in Bashkiria is immaterial at only 0.35 bcm of gas (associated and natural). We expect gas production to double, with Bashneft technically being able to produce 0.8-1 bcm of gas, which could be sold to the Korobkovskiy or Orenburg gas processing plants. Despite this, the company estimates that its gas business will only account for 1% of future revenues.

Geographical diversification. The new management team has already announced that Bashneft will diversify beyond Bashkiria into other regions, including Western and Eastern Siberia. Currently, Bashneft controls a number of licenses in the Orenburg region and Western Siberia. Although these assets' current input into overall production is immaterial, we believe they may contribute up to 5- 7% to Bashneft's overall production in 2020. Clearly, if the company continues to diversify through license acquisitions or M&As, the share of production in other regions could be much bigger.

Russneft announced as a target. AFK Sistema's core shareholders have publicly announced their interest in the assets of Russneft, a private oil company known to be controlled by Mikhail Gutsiriev. On 15 February, Sistema requested Federal Antimonopoly Service approval to acquire 49%.

- In 2007, Gutsiriev left Russia after being convicted of non-payment of RUB20 bln in tax. Control over the company passed to Oleg Deripaska, head of metals holding Basic Element (BASEL) and one of Russia's wealthiest oligarchs. Gutsiriev returned only in late 2009 and, according to the press, has regained full control of the company. Alexander Korsik and some other top Bashneft's managers helped to run Russneft's business while the company was controlled by Deripaska.

- Russneft's 24 upstream subsidiaries are located across Russia, producing 14.2 mtpa (284 kbpd). According to Miller & Lents, proven oil reserves as of 1 January 2009 were 1,092 mln bbl, while oil and gas reserves were 1,235 mln boe. Russneft controls two refineries, namely the Orsk refinery in Orenburg with 5.0 mtpa throughput, and the Krasnodar refinery in southern Russia, with 2.5 mtpa throughput. Russneft controls approximately 100 petrol stations in Orenburg region, selling some 0.6 mtpa through retail outlets and covering nearly 50% of the retail petrol product market in the Orenburg region. Russneft exports approximately 75% of its crude, the highest export share among Russian oil peers. If Bashneft uses oil swaps for 49% of Russneft's production, it can increase its refining cover from 48% to 75%. While Russneft's upstream assets are located across the country, only those in European Russia provide direct synergies with the Bashkirian refineries (see the map of Russneft's assets at the end of this report). Others, like those in the Tomsk region, can probably be used in swap operations.

- Russneft's debt is the biggest problem for the acquisition. According to its RAS accounts, as of 3Q09, Russneft had RUB149.5 bln ($5.0 bln) in long-term debt and RUB36.2 bln ($1.2 bln) in short-term debt. The long-term debt mainly comprises RUB118.5 bln ($4.0 bln) of Sberbank loans, due in 2012 and 2016. We believe that Sistema plans to acquire only a 49% stake in order to avoid having the $6.2 bln debt burden on its accounts.

- Our rough estimates based on target multiples show that Russneft's equity value should be $2-5 bln. Thus, Sistema would pay approximately $1-2.5 bln for the 49% stake.

Tatneft may provide synergies. We also believe that Bashneft might have an interest in gaining control over Tatneft. Although it is still unclear what the structure of such an amalgamation could be, it would definitely provide synergies: Tatneft's oilfields boarder those of Bashneft. While Tatneft is primarily an upstream company, Bashneft has excess refining capacity.

Downstream: realizing value potential

Control over product sales - core aim of centralizing downstream flows. The principle impact of downstream on Bashneft's valuation stems from the consolidation of crude and product flows. While before the company's refineries were operating on a purely processing basis, now Bashneft will own crude delivered to the refineries - both proprietary and purchases from third parties. But, most importantly, it will own oil products produced from this crude at its refineries. Bashneft will further market these oil products to final customers, both through its wholesale and retail networks. Centralization also implies that Bashkirian refineries will be costs centers, with a refining fee just covering operating costs and maintenance capex. All new capex dedicated to the construction or reconstruction of refining units will be approved and financed through Bashneft.

Gradual modernization refining capacity. Bashkirian refineries (Ufa Refinery, NOVOIL, Ufaneftekhim) are some of the most complex in Russia. Build in the late 1940s, these refineries were once the most modern in the Soviet Union. However, they have since fallen behind, following the construction of more modern refineries in the 1970s and 1980s. In 1990, the level of amortization reached 75%, as most of the refining units were obsolete. Over the past decade, these refineries have undergone substantial upgrades, with costs estimated at nearly $1 bln. Currently, both the Ufa refinery and NOVOIL have isomerization units. Additionally, the Ufa refinery and Ufaneftekhim have catalytic cracking and catalytic reforming units. All three have complexity ratios of around 80%, compared to the Russian average of 65%. The combined capacity of the Bashkirian refineries is nearly 25 mtpa, with the Ufa refinery at 7.9 mtpa, NOVOIL at 7.0 mtpa and Ufaneftekhim at 9.8 mtpa. Overall utilization in 2009 was 77%, with a yield on light oil products of 58.5%.

Bashneft aims for 100% refining cover. Bashneft's refining cover is approximately 48%, while, if excluding export operations, production covers 36% of combined refining capacity. In November 2009 Bashneft terminated all processing agreements with third parties. From now on the company plans to buy crude oil and refine it without the interference of third parties. Historically, crude deliveries were conducted by traders, however, the business of these traders was not consolidated and thus not reflected on the refineries' RAS accounts. Traders, including RM Processing Ltd, Selena-Neftekhim Ltd, Fartek, Ltd, ATEX Ltd, Nafta-Ufa Ltd, Bashresurs Ltd and Bashregion Ltd, each contributed approximately 5% to the refineries' capacity. These traders sold crude to the refineries from LUKOIL, Surgutneftegas, Slavneft and other smaller companies, the largest of which was Sibir Energy (at the Salym oil field), which is currently controlled by Gazprom Neft. The traders also collected the finished oil products, once they had been processed by the refineries.

Historically efficient oil product sales. Bashneft's location in the European part of Russia makes both the export and domestic sale of refined products a very lucrative business. On average, nearly 50% of production is exported, of which approximately 50% is diesel fuel and 25% - automotive gasoline. While it is possible to export fuel oil given the short transportation distance, on average, only 17% of fuel oil produced was exported from Bashneft's refineries. However, this is still a much larger share than from other domestic oriented refineries, such as Gazprom Neft's Omsk refinery. The company exports 67% of its oil products to northern Europe and countries of the former-Soviet Union (shipping directly to the Baltic states, Finland and Belarus as well as through the ports of St Petersburg, Arkhangelsk and Murmansk). Approximately 15% of exported oil products are shipped to Kazakhstan, Kyrgyzstan, Tajikistan, China and Mongolia. Transportation is efficient due the ability to ship oil products by river tanker (25-30% are shipped by river) as well as through the Transnefteproduct pipeline.

More streamlined distribution. Following its consolidation, Bashneft took over the sale of its oil products, as, historically, exported oil products were sold through same traders that supplied oil to the refineries. These operations were outside refineries' RAS accounts, and thus the refineries' shareholders did not benefit from exports or the domestic sale of its oil products. RM Processing Ltd and Selena-Neftekhim Ltd each exported 15% of the refineries' oil products. ATEX Ltd, Sidex Ltd and Fartek Ltd each exported 10%. LUKOIL related distributors exported only 7% of oil products. We believe that following Sistema's consolidation of flows, only Bashneft-affiliated distributors (who will be within the consolidated US GAAP parameters) will be responsible for export operations.

Marketing targets best domestic clients. Bashneft's target domestic markets are Bashkiria, Tatarstan and the Moscow region in the European part of Russia as well as the Chelyabinsk region in the Urals federal district, which borders Bashkiria to the east. The domestic market accounts for approximately 50% of total product sales: 95% of that share is sold as wholesale at the refinery gate, while only 5% goes through the retail network.

Ufa refinery. The Ufa refinery is the largest of the three refineries with an effective capacity of 7.9 mt, a refining depth of 77.3% and a utilization ratio of 80% (which we believe can easily be increased to 85-90%).

Novoufimskiy refinery. NOVOIL has four atmospheric distillation units with 1.75 mt capacity each, which account for 7 mt of overall primary refining capacity. A refining depth of 87.6% is currently the highest among Bashneft's refineries. The refinery has the largest number of secondary reefing units, which enable it to produce a wide range of valueadded products, including petrochemical products. NOVOIL's coking unit makes it one of the few refineries in Russia that can produce needle coke for electro-metallurgical and electrode industries. Of the three Bashkirian refineries, it is the only one that can produce high grade A-98 gasoline.

Ufaneftekhim. While Ufaneftekhim has 9.8 mt of technical capacity, it only has an effective capacity of approximately 7.5 mt, as one of the refining units (1.7 mt of capacity) mostly stands idle and is used only when one of the other refining units is under repair. In 2009 the refinery's coking unit came into operation, and refining depth increased from 75-78% in 2007-08 to 85% in 2009. In 2010 the company plans to increase refining depth to 95.2%. By way of comparison the average Russian refinery has an average depth of 65% and utilization rates of 70-75%. In addition to classic oil products, Ufaneftekhim also produces a wide range of petrochemical products.

Ufaorgsintez. Ufaorgsyntez is a typical petrochemical plant with 0.7 mt of capacity and specializes in the production of polyethylene and polypropylene using raw materials that are supplied by the other three Bashkirian refineries. In 2009 Ufaorgsintez produced 0.5 mtpa of petrochemical products, of which 95% were polyethylene, polypropylene and phenol.

Bashnefteproduct. Bashnefteproduct is the largest fuel distributor in Bashkiria, operating nearly 319 petrol stations and 240 kt of fuel tank capacity. Approximately 0.7 mtpa of both gasoline and diesel fuel were sold in 2009, all sold in Bashkiria. LUKOIL is Bashnefeproduct's core retail competitor on the retail market.


Benefiting from high dividends

Sistema consolidates assets and retains full control. We believe Sistema plans to consolidate all of the BashTEK assets under the name Bashneft and retain full control over it. Sistema will likely use Bashneft as a source of financing for the holding's other projects, however, it will also leave a rather generous amount of cash within Bashneft to secure its growth and development.

Dividends play. Sistema will use dividends to channel cash from Bashneft back to the holding (we expect dividends to account for at least 50% of Bashneft's net income). To do this, Sistema will maximize dividends on preferred shares by setting maximum dividends for prefs first, and then by raising ordinary dividends to the level of pref dividends. This strategy is common in the oil and gas industry, when more than 50% of net income is paid in the form of dividends, such as core shareholders assigning high dividends for Sibneft, TNK-BP and Gazprom Neft approving strong dividends for Slavneft, or when Gazprom Neft pays strong dividends to Gazprom, which controls 95% of the company. Dividends could be an excellent play for minority shareholders.

Sistema or Bashneft - your choice in a winning game. We believe Bashneft and Sistema provide relatively equal opportunities for investors. We have a target price of $31/share for Sistema with a 23% upside. The holding is traded in ADRs, and has a strong history of corporate governance and financial reporting. According to our estimates, oil business makes up approximately 35% of Sistema's current value.

Improvements to corporate governance on track. Bashneft shares have a low liquidity. While Sistema and its affiliated companies control 75% of Bashneft, big blocks of shares are tied to portfolio investors who have no intention of selling. Bashneft will publish its first US GAAP results for 1Q10. Additionally, the company will have its first reserve audit report for that period as well. It should also be stressed that the new Bashneft management team seeks to strengthen the company's relations with shareholders and become more opened to the market.


Consolidation adds value, but purchased crude threatens margins

DCF consolidated base. We base our valuation of Bashneft on the company's consolidated flows of crude oil and oil products, meaning that we have valued Bashneft as a fully integrated oil company:

1. Bashneft exports approximately 15% of its crude oil, while the remainder is delivered to Bashkirian refineries.

2. Bashneft purchases crude from third parties at domestic prices to supply its refineries.

3. Bashneft owns all of the oil products it produces and sells them to end customers, both for export and on the domestic market.

4. Our financial forecast is based on a consolidated and integrated Bashneft. Transactions between production units are not reflected, as they are assumed to have been eliminated.

5. We have not incorporated any upstream acquisitions and did not account for the modernization of Bashneft's refineries or changes to the company's product slate.

6. Our upstream operational model includes an increase in production from existing assets in Bashkiria, which results in a stable long-term production profile with a rate of decline of only 0.2% per annum in Bashkiria. In addition to Bashkiria, we expect to see an increase in production from Bashneft's assets in Western Siberia and the Orenburg region. We assume that by 2020 (the final year of our DCF forecast period) production from non-Bashneft regions will account for 7% of overall production.

7. We have based our downstream operational model on the historical performance of Bashneft's refineries. We have not accounted for any substantial changes in their product line up, but we expect the company's new management will work to improve utilization rates.

Year of transition. It is important to note that 2009-10 is transition period for the company from a purely E&P business to an integrated oil company. We expect a substantial growth in accounts receivable and inventories, which is due to the growth in the sale of the company's own oil products and their storage in the tank farms of its refineries. The growth in accounts payable is due to the necessity to purchase crude oil for supplying the company's refineries. In addition, prior to 2010 Bashneft only reported under unconsolidated RAS accounts. We warn against comparing Bashneft accounts for 2008, 2009 and 2010 and refrain from doing so ourselves.

Crude purchases - core cost and core risk. We believe purchasing crude at market prices to supply the company's refineries constitutes the chief risk to our valuation and the company's financials. Our model assumes that domestic crude prices will grow until they reach net back parity with international prices in 2016. Thus, the domestic oil price will grow faster than the export price. As such, margins will fall to 15% in 2011-13, growing back to 16-18% thereafter. Such a fluctuation is due to the mixed effect of domestic price changes and the effect of the introduction of new oil fields outside of Bashkiria with lower lifting costs. We also believe that Bashneft will be able to maintain an average peer group ROACE ratio of 23-25% throughout the period of our DCF forecast.

URALSIB Capital, 8, Efremova St, Moscow, Russia,119048,


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Publication:Russian Banks and Brokers Reports
Article Type:Company overview
Geographic Code:4EXRU
Date:Feb 18, 2010
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