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Investment summary
Recently proposed sector tax cuts have helped improve investor
sentiment towards Russian oil & gas names – but we do not share
market optimism about additional large tax cuts in near term
Lukoil and Gazprom appear to be key beneficiaries from the
proposed production tax cuts in their respective sectors and, give
their attractive valuation, remain our top picks among Russian oil
and gas integrateds
We downgrade Rosneft to Neutral (from Overweight) as we
expect investor profit taking after the steep share price rise over
the past three months. Novatek remains rated Neutral.
Warming market sentiment
Impressive recent share price
performance…
A lack of strong catalysts has resulted in the
stagnation of Russian oil and gas stocks
throughout most of 2007, despite generally
unchallenging valuations.
The situation finally improved markedly this
spring, with the sector exhibiting a stellar
performance over the past three months – Rosneft
is up 42%, Lukoil 34%, Gazprom 18%, and
Novatek 14%.
… thanks to the government’s
promise of tax cuts
This strong share price performance was initially
driven by the improving market sentiment on the
back of attractive valuations and rising
expectations of new tax cuts, and was then
propelled further on the actual announcement by
Finance Minister Alexey Kudrin of his agreement
to a c5% cut in the oil production tax (mineral
extraction tax, or MET) on 24 March. Since the
last round of oil industry tax cuts in January 2007,
Kudrin had been the strongest opponent of any
further tax cuts, as he feared a spike in already
high inflation levels. His change of heart was an
important event, as it signified the deep concern
within the government about the stagnating
domestic oil sector.
We do not share market optimism
about further sizeable tax cuts in the
near future
Although various government officials continue to
discuss potential further reductions in taxes for the
sector, we do not think additional material cuts are
likely in the near future. The signs of an
overheating economy (fuelled by high commodity
prices, fiscal incentives and relatively cheap
credit), which are manifesting themselves in
rapidly rising inflation, are beginning to threaten
seriously the government’s macroeconomic
targets, in our view.
Any additional substantial tax cuts would result in
two outcomes, we believe: (1) pressures on the
government to trim federal budget expenditures
(which is unlikely, given the rising social needs,
among other things); and (2) greater domestic
money supply and hence the threat of accelerating
inflation (which would be politically unacceptable
to the government).
In other words, we do not expect any strong
sector-wide catalysts (such as additional tax cuts)
in the near future and therefore focus our attention
on the most attractively valued stocks – which
appear to be Gazprom and Lukoil.
Gazprom and Lukoil continue to offer
attractive upside potential…
We see the recent boost in valuations as the
beginning of a rally for Gazprom and Lukoil.
Both remain inexpensive on multiples
(see Figure 20), trading at 2008e PERs of
10.1x and 6.2x, respectively.
Both are fundamentally strong, in our view.
Gazprom is driven by rising domestic gas prices
and expected cheap access to new large reserves,
and also would benefit from any strategic
alliances with international majors in both
upstream and downstream. Lukoil is supported by
market expectations that its growth will remain
above the industry average, despite our downward
revisions to its production growth estimates.
Lukoil’s has the most balanced downstream
exposure among its domestic peers, as well as
rising gas production which means it would
benefit most from rising oil and European gas
prices (for which we have made conservative
forecast assumptions).
A number of investors we have spoken to have
said they see the lack of catalysts serving as a
brake on Gazprom’s rapid share price
appreciation. However, what’s important, in our
view, is Gazprom’s improving fundamentals. In
addition to strong European gas realisations and
rising domestic gas prices, Gazprom has also
demonstrated strengthening production growth
(natural gas production for January-May was up
3.1% year-on-year, exceeding its full-year 2008
target of 2.5% growth).
… but Rosneft appears somewhat
overheated after its recent share
price rally
We continue to see Rosneft as a fundamentally
solid operator, with strong production growth
prospects, improving margins through increased
integration of the refining assets acquired during
the course of Yukos’s bankruptcy in the spring of
2007, as well as future preferential access to
trophy reserves due to its state-ownership status.
We note the impressive increase in the company’s
share price over the past few months – mainly
driven by the government’s discussions of further
tax cuts for the oil industry and by the company’s
strong lobbying power with the government.
However, the stock now looks somewhat overheated
to us, and while we believe in the company’s longterm
strong investment case, we downgrade it to a
Neutral rating (from Overweight). The valuation gap
between Rosneft and Lukoil has widened further to
74% on 2008e PER and 45% on 2008e
EV/production, which makes the investment case for
Lukoil stronger, we believe.
The key catalysts for Rosneft would be the
announcement of the introduction of tax holidays
(possibly in August) for offshore, in particular for
the Russian Far East, where Rosneft is the most
active operator, as well as the long-promised
publication of its long-term strategy (now moved
to end-2008, at the earliest).
Novatek remains the most efficient oil
and gas producer in Russia – but its
valuation already reflects this
We continue to highlight Novatek’s superior
operating and financial performance – its
production CAGR for 2008-10e of 10% compares
with the industry average of 2% and its 2008e
EBITDA margin of 51% substantially exceeds the
industry average of 30%.
However, we believe the company’s valuation,
particularly after the 14% share price appreciation
over the past three months, already reflects its
strong fundamentals and we therefore retain our
Neutral rating.
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