Aton Capital -

Aton

April 25, 2007

Shares of Imperial Energy, a leading Russian independent oil producer, went on a roller coaster ride last week, following reports that its reserves and operations were being investigated by Rosprirodnadzor (the Russian environmental watchdog).

This was the second incident of a major Russia-related, AIM-listed company experiencing abnormal volatility following media campaigning by Rosprirodnadzor; the first was a similar incident involving Peter Hambro in December 2006. As such – as well as due to its potential spillover to other AIM-listed Russian independent natural resource producers – the latest incident merits a more detailed analysis. We conclude that given the questionable nature of charges and the history of past investigations by Rosprirodnadzor (very few of which have resulted in any material action by the relevant authorities), we believe that the agency’s latest activities will have little practical impact on Imperial Energy or other independent producers. It is regrettable, however, that government officials are still allowed to engage in practices that so adversely affect the investment image of the country and the market values of successful Russian businesses.

THE CLAIMS OF OVERSTATEMENT OF RESERVES APPEAR GROUNDLESS AND ILLOGICAL, EVEN BY RUSSIAN STANDARDS.

The reserves and resources of independent natural resource companies operating in Russia are evaluated by the leading Western reserve engineers and consultants; for instance, DeGolyer & MacNaughton, which audits Imperial Energy, Urals Energy, and other independents, also signs off on the reserves of Gazprom, Rosneft, and Gazpromneft.

While a discrepancy certainly exists between the Russian classification (GKZ) and Western classification (SPE or SEC) – and is likely to be especially visible for up-and-coming companies – to demand homogenous reserve reporting across the standards is akin to demanding that companies’ consolidated US GAAP results match their unconsolidated RAS accounts. Nearly all the companies mentioned by Rosprirodnadzor Deputy Head Oleg Mitvol have operated in Russia for many years, and on numerous occasions were found to be in full compliance with all relevant laws and regulations by both federal, regional, and industry supervisory authorities.

SPEAKING SPECIFICALLY OF IMPERIAL ENERGY, WE NOTE THAT IT STARTED OUT AS A GREENFIELD PLAY BY ACQUIRING EXPLORATION PROPERTIES WITH A MINIMAL AMOUNT OF WORK PERFORMED AND DATA AVAILABLE ON THEM.

Hence, the amount of proven or probable reserves attributable to them under any classification, GKZ or Western, was insignificant, if any.

Consequently, subsequent successful development efforts, which saw Imperial Energy spend close to $100mn, drill numerous new wells, and build new pipeline infrastructure to reach current production of about 3mbpd had a major positive impact on the commercial assessment of the reserves. Also, testifying to Imperial’s compliance with the relevant Russian regulations, it only recently received a formal written Act of Confirmation from the Ministry of Natural Resources, stating that the company has met or exceeded all of its license obligations and commitments, as well as successfully converted one of its exploration licenses to full production status. In our view, Imperial Energy represents one of the more successful examples of Western investment in Russia, consistently delivering on production targets, rapidly developing new fields, investing money, and creating new jobs.

IF THERE IS SO LITTLE APPARENT MERIT TO THE CHARGES, THE QUESTION BECOMES "QUI BONO?" OR "WHO IS TO BENEFIT?"

The easy conspiracy theory explaining the Imperial case is that this is the latest round of Russian resource nationalism, in which the authorities – or entities connected to them – attempt to further strengthen their control over the nation’s resources under questionable pretexts.

HOWEVER, WE WOULD PREFER TO STICK TO THE RULE THAT HAS SERVED US WELL IN OUR RESEARCH EFFORTS IN THE PAST: IN RUSSIA, WHEN CHOOSING BETWEEN CONSPIRACY AND PETTY SELFISH INTERESTS, ALWAYS PICK THE LATTER.

Recent Russian history has seen a number of such examples, with the numerous tax cases launched in the wake of the Yukos affair in 2003- 2004 being perhaps the best illustration. Sometimes believed to be a Kremlin-inspired plot to take over the entire Russian business world, these investigations – likely brought around by overzealous mid-level bureaucrats eager to please the powers that be, to earn extra money, or both – fizzled out, resulting in minimal actual judgments against the companies involved. Yet they also resulted in massive share price volatility as the news of the avalanche of new tax cases hit the media. We also tend to think that few serious players – state or corporate – would employ the services of someone with the track record of Oleg Mitvol, the deputy head of Rosprirodnadzor, who constantly makes headlines with his investigations.

OF HIS NUMEROUS CASES, MITVOL APPEARS TO HAVE SUCCEEDED ONLY WHEN HE SUPPORTED GOVERNMENT CAMPAIGNS THAT WERE ALREADY IN MOTION

(Sakhalin 2, Kovykta, former prime minister Mikhail Kasyanov’s dacha). In all other cases, from Alla Pugacheva’s summer house to LG’s new plant in the Moscow Region to TNK-BP’s gas subsidiaries to Peter Hambro’s licenses and Lukoil, his challenges have generated numerous headlines but had little practical impact on the businesses he pursued, as higher authorities almost invariably ultimately decided in favor of his targets (for a full list, see the table in the end of this note).

Finally, just to make matters clear, we note that Mitvol's agency lacks any authority to issue or revoke licenses; it can only initiate investigations and make recommendations to other federal agencies. In this, it is fairly similar to the parliamentary requests to the Audit Chamber and the Prosecutor General, used previously by some unscrupulous Duma deputies, often for personal business purposes.

IF IT IS NOT PART OF A BIGGER PLOT, THEN WHY ARE MITVOL AND ROSPRIRODNADZOR DOING IT?

Here, we are completely at a loss. Why would a government agency and a particular official pursue such an aggressive campaign against what seems to be a collection of random targets (mostly Western corporates working in Russia), typically accompanied by relentless PR efforts and often including a virtual indictment ahead of any conclusive investigation results (a practice we see as completely unacceptable for any government office or individual official)? Overzealous fulfillment of one’s professional duties and love of Russian nature could possibly play a role. However, considering the apparent leak of the information ahead of the official press release by the Ministry of Natural Resources, as well as the frenetic trading in Imperial Energy’s shares the day before the announcement and in the morning of April 18, we believe other motives and participants could have been involved. We believe both London Stock Exchange officials and Russian regulators would do investors and themselves a big favor by investigating this incident.

ALTERNATIVELY, WE COULD PARAPHRASE THE QUESTION AS "WHY ARE MITVOL AND ROSPRIRODNADZOR ALLOWED TO DO IT?"

After all, poorly supported but well publicized attacks on foreign investors operating in the country appear to adversely affect Russia’s investment image, and possibly foreign direct investment in the country. Moreover, in the case of independent junior oil and gas producers, attacks on companies that are investing hundreds of millions of dollars and increasing their output several-fold, against the backdrop of overall Russian oil production increasing by just a few percent, may ultimately pose a threat to the country’s energy security. In this context, it is interesting what Mr.

Mitvol’s boss, Sergey Sai; his boss, Minister of Natural Resources Yury Trutnev; and in turn his boss, Prime Minister Mikhail Fradkov, think about these campaigns?

WHAT SHOULD INVESTORS DO WITH SHARES OF IMPERIAL ENERGY AND OTHER INDEPENDENT ENERGY AND METALS PRODUCERS THAT HAVE FALLEN IN THE WAKE OF MITVOL’S LATEST CAMPAIGN? BUY.

We believe the whole situation is binary. Either such investigations succeed, or they result in no material actual action by the relevant authorities. If investors believe in the first scenario, they probably should dispose of their Russian holdings altogether or have a permanently underweight position in Russia. In such a scenario, any mid-level official in a Russian government agency could launch questionable investigations that would ultimately succeed in inflicting material damage on Western investors – a situation that would bring new, unquantifiable risks to the market. In our view, however underdeveloped Russian institutions are, this will not be the case. If one believes in the second scenario, as we do, the current share prices of leading Russian independent oil and gas and metals and mining companies, such as Imperial Energy, Sibir Energy, Urals Energy and others appear attractive. Even if their shares recover, however, it is regrettable that government officials are still allowed to engage in poorly thought-out actions that adversely affect Russia’s investment image and the market values of successful local businesses.