Pavel Kushnir and Olga Danilenko of Deutsche UFG -

In an article today, Nefte Compass reported that Russia is considering setting up a new state oil colossus to rival gas giant Gazprom. The company would apparently be established in the next six months on the basis of Rosneftegaz, which owns shares in Rosneft and Gazprom. Some assets of Surgutneftegaz and Zarubezhneft may also be included. We note that, technically, it is possible to set up such an oil company, which would have a combined 2008 production of 3.75m barrels per day (b/d).

Based on current market prices, we assume that the stakes which Rosneftegaz holds in Rosneft (75.16%) and Gazprom (10.74%) may be sufficient for the state to materially increase its control over the country's energy sector. The government could reduce its ownership in Rosneft to 50.1% and use 25% ($21.3bn at current prices) to buy 50.1% of the voting shares in Surgutneftegaz ($21.0bn at current market prices). The shares in Gazprom are worth $25.8bn at current market prices, and could be used to buy state-owned Zarubezhneft and stakes in Bashkir energy companies for Rosneftegaz.

Future of Rosneft and Surgutneftegaz minority shareholders

We believe that a potential consolidation of oil assets under the Rosneftegaz umbrella would not, at least initially, affect the minority shareholders of Rosneft and Surgutneftegaz. However, if the state were to decide to further the integration of the two Russian oil majors into Rosneftegaz, we would not rule out a transfer of all minority holdings to a single Rosneftegaz share. Without knowing the terms of such a share swap, we are unable to assess its impact on the minority shareholders. We note a risk that the interests of minority shareholders may not be at the top of the government's priority list when considering such transactions.

Oil vs gas - another round of the behind-the-scenes political struggle

The existing structure of state control over Russian energy may look entirely logical: Rosneft has been viewed as a national oil champion while Gazprom has a similar status in the gas segment. However, Rosneft has always underperformed Gazprom in terms of reserves, production, cash flows and, therefore, political power. With the incorporation of new assets, Rosneftegaz could replace Rosneft as the national oil champion, still far from Gazprom in terms of size but looking well positioned for further consolidation.

However, with parliamentary and presidential election season ahead and the accompanying widespread speculation, the vitally important energy sector is likely to be right at the centre of this debate. While we again highlight the possibility of changes in Russian energy, we do not rule out the possibility that the conjecture is totally ungrounded, and that therefore no major changes would take place either ahead of or immediately after the elections.

If the plan does indeed exist, we believe it may be backed by a political group standing behind Rosneft-Surgutneftegaz-Zarubezhneft. While Rosneft has the status of Russian oil champion, it continues to lag behind Gazprom in terms of reserves, production, cash flows and, therefore, political power. While it is not possible to catch up with Gazprom, the new larger oil structure would benefit from expanded powers.

Key assumptions

Nefte Compass has based its analysis on the fact that Rosneftegaz, which was established as a technical Special Purpose Vehicle to enable the Russian government to establish direct control at Gazprom, still exists and owns 75.2% of Rosneft's shares and 10.7% of Gazprom's shares. We note that Rosneftegaz is 100% owned by the Russian Federal Property Fund and as a separate entity does not have any powers. Nefte Compass argues that it may become more independent and exercise the functions of a corporation, rather than as an account for the government's energy holdings.

We believe that, technically, the possibility of the transactions described by Nefte Compass exists. The Gazprom shares are currently Rosneftegaz's most valuable asset, worth nearly $26bn at the current market price. We note that the government currently controls these shares through 100%-owned Rosneftegaz and, including these shares, has a controlling stake in Gazprom. Therefore, the shares cannot be used to buy assets from third parties. However, they may well be used to buy assets from the government (examples of such assets include Zarubezhneft and the Bashkir energy assets).

The second important asset is a 75.2% stake in Rosneft, of which the government may be willing to sell 25%, as this would mean that it still retained control. At the current market price, 25% of Rosneft shares would be worth $21.3bn. These shares may be used to buy assets from third parties. The most valuable asset that may be acquired is Surgutneftegaz. A controlling stake in Surgutneftegaz is worth $21.0bn at current market prices.

As a result of the scenario outlined above, blocking minorities in Rosneft and Surgutneftegaz would fall into the hands of non-commercial partnerships associated with the Surgutneftegaz management.

Further integration

We believe that at the initial stage, when the shares of Rosneft are sold to finance the acquisition of control at Surgutneftegaz, the interests of minority shareholders of both companies may be unaffected. The shares of both entities may continue to trade under the current arrangements. We do not rule out, however, a scenario in which, at some stage, Rosneftegaz turns from being a parent-company for these entities into a centre of consolidation. The final aim may be to transfer all the minority stakes (in Rosneft, Surgutneftegaz, Bashkir energy assets) to a single Rosneftegaz share.

In our view, there are two potential scenarios for this consolidation:

1. Only the shares held by non-commercial partnerships controlled by Surgutneftegaz management are swapped into a single share of Rosneftegaz, giving Surgut management and related power groups direct exposure to one of the largest energy companies in the world. We estimate that in order to consolidate the shares held by the non-commercial partnerships, Rosneftegaz would have to issue new equity worth about $35bn. This would dilute the government's holding to below a super majority stake of 75%.

2. Both the shares of non-commercial partnerships and all the minority shareholders are swapped into a single share of Rosneftegaz, giving all groups of shareholders equal exposure. We would view this latter scenario as a fairer way of consolidating interests at Rosneftegaz. We estimate that in order to consolidate all the minority shares, Rosneftegaz would have to issue new shares worth about $73bn. This would mean that the government was still able to retain control (50%-plus).

What might Rosneftegaz become?

By acquiring Surgutneftegaz, Zarubezhneft and the Bashkir energy assets, Rosneftegaz would become one of the largest oil companies globally. On the basis of our forecasts for these companies, we estimate that in 2008 Rosneft would produce 3.75m b/d of crude oil. For the purpose of this analysis, we ignore the minority stake in Gazprom which may remain the property of Rosneftegaz after the acquisition of certain state controlled assets.

We also attempt to assess the potential market value of Rosneftegaz on the basis of the assumption that both the non-commercial partnerships controlled by the management of Surgutneftegaz and the minority shareholders of Rosneft and Surgut are transferred to a single share of Rosneftegaz. We estimate the market value of the new, enlarged company at $160bn, which compares with Gazprom's current market capitalisation of $230bn.

We note that our analysis has many limitations and does not take into account the potential synergies which may be established once several major energy assets are consolidated under the Rosneftegaz umbrella. One possible example is using cash from Surgutneftegaz to help Rosneft to repay its debts. That said, in the current operating environment, with the oil sector burdened by high taxes and transportation expenses, such synergies may be less pronounced than it may seem.

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