Ling Chen, Bhuvan Jain, M&A IN EURASIAN OIL AND Sunil Kurien, Daim Shah, GAS SECTOR: A FRAMEWORK Jie Shen and Ke Wei

December 2011

EXECUTIVE SUMMARY

High oil prices, ongoing economic liberalization and significant increases in global capital flows have opened up a host of new investment and development opportunities, especially for resource-rich countries like , , Turkmenistan and Kazakhstan. Given their heavy economic dependence on revenues from energy exports, both privately owned and national oil and gas companies (NOCs) of these countries are looking to expand by actively seeking mergers & acquisitions (M&A) opportunities globally.

This paper analyzes the scope for outbound M&A transactions by energy companies in the Eurasian region, in particular investments aimed at establishing a market presence in North America and Europe. This analysis is performed through the development of an M&A framework that gauges the likelihood of future outbound activities, focusing on large oil and gas companies in Russia, Kazakhstan and Azerbaijan.

The framework identifies 6 key factors that play a vital role in any M&A decision and execution. To account for their differing level of importance in the deal-making process, each criterion is allocated a different weight. The first necessary condition is the availability of financial resources, which is assigned a 20% weight. Possible synergies (20%), which underline the rationale for pursuing some opportunities over others, provide clues as to the areas in which hydrocarbon companies from the CIS will invest. Outbound M&A transactions are also affected by political risk (10%) and a company’s prior experience, captured in terms of past acquisitions (5%). The strategy and vision of a firm’s management (20%) also plays an important, albeit less quantifiable role. The most crucial factor affecting the deal-making environment is the set of legal and regulatory requirements (25%) that need to be met by CIS oil and gas companies in target geographies. Each of these criteria is discussed in detail in the context of real world examples. The weights to each factor are assigned in consultation with leading energy experts and scholars on the Eurasia region.

This framework is then applied to two companies—, Russia’s largest privately owned oil company, and KazMunaiGaz, Kazakhstan’s state-owned oil and gas company— through a comparative case study that scores each criterion on a scale of low, medium and high. The paper concludes that a company with the characteristics of Lukoil is more willing and more likely to succeed in acquiring targets in North America or Europe relative to a company with a profile more similar to KazMuaniGaz. However, recent trends among less experienced NOCs such as KazMunaiGaz show that the ambition to become regional and internationally competitive oil and gas players may encourage these companies to actively develop such capabilities in the near future.

Government relations ...... 15 Contents PAST ACQUISITIONS (5%) ...... 15 MANAGEMENT (20%) ...... 16 INTRODUCTION ...... 1 LEGAL AND REGULATORY FRAMEWORK FINANCIAL RESOURCES (20%) ...... 5 (25%) ...... 17 Market value ...... 5 United States ...... 18 Cash and debt ...... 5 Lesson from past acquisitions ...... 18 Reserves ...... 6 Europe ...... 18

POSSIBLE SYNERGIES (20%) ...... 7 EU Third Energy Package ...... 19 Upstream ...... 8 Security concerns ...... 19 Resource needs? ...... 8 Socially responsible behavior ...... 20 Efficiency-improving investments: field Governance and transparency ...... 20 recovery and frontier exploration ...... 9 Unfair competition ...... 21 Mid- and downstream ...... 10 CFIUS qualification criteria and Infrastructure ...... 11 considerations ...... 21 Market access supplemented by APPLICATION OF THE FRAMEWORK ...... 22 efficiency-seeking investments ...... 12 CONCLUSION ...... 24 POLITICAL RISK (10%) ...... 13 APPENDIX ...... 27 Macroeconomic risk ...... 13 Ownership structure ...... 14

This report presents the results of a study by a student team from Columbia University’s School of International and Public Affairs (SIPA), consisting of: Ling Chen, Bhuvan Jain, Sunil Kurien, Daim Shah, Jie Shen and Ke Wei. The Faculty Advisor for the project was Professor Adam L. Shrier. The work was sponsored by the Legal Department of Huron Consulting Group LLP. INTRODUCTION

The dissolution of the USSR in 1991 extending their influence across other marked a momentous turning point in the industries as well as the political process. history of global politics. Not only did it By the early 2000s, however, a confluence represent the West’s apparent victory over of factors would help CIS countries embark communism and the formal end of the cold on a more stable economic and political war, it introduced to the world 15 new states development track, the success of which has that would begin a long journey toward led to a rise in regional and global ambitions establishing economic, political and social among CIS oil and gas companies in recent identities independent of the former Soviet times. The emergence of these countries Union. from the initial years of chaos after the fall of the coincided with The first decade, however, was an structural shifts in international oil and gas exceptionally turbulent one for most markets. In essence, enhanced political and countries belonging to the Commonwealth economic stability was in turn reinforced by of Independent States (CIS). The CIS is a a steady flow of oil and gas revenues to the loose regional organization composed of all state as the energy sector became the critical former Soviet republics except for the Baltic engine of economic recovery and growth for countries and , which withdrew in resource-rich CIS states. Not only did oil 2008. Lacking any experience with full- and gas wealth help states fund budgets, in fledged sovereignty, states such as an era of tight global oil and gas markets, Azerbaijan, Kazakhstan and Georgia had to these countries also assumed a new degree establish new political and economic of global importance, drawing interest from institutions against the backdrop of decades countries such as the U.S., European Union of decay. They also confronted violent (EU) states and an array of international oil secessionist movements, the growth of companies (IOCs). In the words of an Azeri criminal networks to fill power vacuums, national security advisor, “oil is our strategy, and attempts by external forces, including it is our defense, it is our independence.” Western countries and Russia, to exert influence over state policies. Within these countries, macroeconomic conditions stabilized as leaders consolidated Russia, itself, was caught in a whirlwind of political control. The rise of Vladimir Putin economic reform attempts that resulted in in Russia in 2000 lead to a re-centralization the exhaustion of state coffers and a fire sale of state power over the oligarchs and other of key state resources, giving rise to the era powerful stakeholders, as well as a of the oligarchs by the mid to late-1990s. reassertion of state control over the strategic These “entrepreneurs” capitalized on the sectors of the economy, including oil and state’s fiscal weakness to capture control of gas. Notably, Putin saw the strength of natural resource companies, including the Russia’s resource endowment as a key arm hydrocarbon and minerals sectors, before of its economic and foreign policy.

1 In Azerbaijan, “the crossroads of the allowed CIS energy companies to amass Caspian,” the success of Heydar Aliyev’s significant cash reserves while enhancing delicate geopolitical balancing act opened their access to debt and equity-financing. the way to the initial development of its oil reserves, notably the Azeri-Chirag-Guneshli Due to these drivers, by the early to mid- (ACG) field, by a consortium of IOCs led by 2000s, CIS oil and gas companies began BP, resulting in desperately needed looking for new investment opportunities government revenues as early as 1997. abroad. While for NOCs, these efforts are directed at new growth prospects, Meanwhile, Kazakhstan’s growth domestic diversifying and securing markets and product (GDP) has grown at approximately gaining international experience, private 8% per year in the last decade, the strongest companies in the region were also driven among all CIS countries. Nursultan toward outbound diversification to reduce Nazarbayev, its president throughout its 20- the political risk of operating in semi- year history of independence, was among authoritarian states. the first leaders in the region to embrace free markets, moving more aggressively than his While the initial focus of acquisitions began CIS counterparts to establish the necessary in neighboring regions, CIS companies are investment, legal and foreign exchange looking further away from their home base frameworks to manage capital inflows. to new geographies, including Western What followed was significant IOC Europe and North America. The rise of exploration and production (E&P) activity, unconventional assets and technologies in including the discovery in 2000 of the the U.S., ongoing efforts by the European Kashagan field, the largest oil find in the Union (EU) and its member states to past 30 years. liberalize the energy sector, and changing upstream and downstream market dynamics Concurrently, international oil and gas (e.g., harder-to-develop fields and the markets were also experiencing significant impact of high oil prices on downstream structural changes by the late 1990s and margins) presents a host of new early 2000s. Surging oil prices, coupled with opportunities and risks for CIS companies. changing perceptions regarding the importance of state sovereignty over natural While the financial ability to acquire assets resources created an investment is relatively straightforward, CIS firms face environment where states and their a new set of challenges as they look toward respective national oil companies (NOCs) acquiring assets abroad. The need to comply held control over the vast majority of with Western legal and regulatory undeveloped reserves, with IOCs positioned requirements—in addition to their ability to on the outside looking in as they sought new successfully integrate the existing investments. A decade of sustained high oil operations, business culture, technological prices in the 2000s, combined with ongoing assets, and management styles of target companies with their own—will be key. liberalization of global capital flows, has

2 As oil markets remain tight, so do price of how this framework could be utilized in projections are high for the near term, addition to the conclusions that can be hovering at around $100 per barrel. Factors drawn from this analysis. such as limited global spare capacity, significant industry capital investment In brief, financial resources, the first needs, and constrained production in Iraq, criterion of the framework, covers various Libya and potentially due to ongoing indicators of a company’s financial health. political conflict in the Middle East have all Sufficient financial resources are the weighed on expectations. These price levels necessary condition for the fruition of any may exert pressure on CIS companies to M&A deal, and have been assigned a 20% expand output. Oil and gas export revenues weight. make up some 50-80% of government revenues in CIS states such as Russia, The second criterion of this framework Kazakhstan and Azerbaijan (and 20%-45% captures the synergistic needs a company of total GDP). The convergence of politico- hopes to capture from an acquisition, and is economic goals and market trends will assigned a 20% weight. This details a range increase the likelihood of M&A activity in of “push” and “pull” factors that may shape the energy sector, with CIS firms as acquisition ambitions of Eurasian energy important regional and global players. As a companies. Pull factors drive a company to result, this white paper presents a timely acquire assets and skills found in foreign framework that captures the various drivers markets, attracted by value accretive needs. of outbound M&A transactions among Push factors are those where M&A strategy Eurasian oil and gas companies. is used to address the relative disadvantages of operating from one’s home country. A company’s ability to acquire assets is a function of factors identified in this M&A appetite is also affected by the framework. These include the company’s political risk a company is exposed to (10% financial resources, synergistic needs, weight) and the past experience it has in management ability, political risk, legal and making such deals internationally (5% regulatory challenges and past experience in weight). Energy companies may acquire M&A. Developed in consultation with assets to diversify the political risk of leading Eurasian energy experts and operating in the confines of one region, and scholars, this framework also assigns a strong trajectory of past acquisitions may weights to each M&A driver identified. This place it in a strong position in terms of is to account for the fact that some identified negotiation, familiarity with the M&A factors may be more important M&A drivers process and access to information. than others. As it is especially tailored to Eurasian energy companies, this framework The management factor covers a can be applied to different firms and acts as company’s organizational aspects in the a useful comparative tool. Furthermore, the context of M&A, including the profile of top case study at the end provides an illustration executives, the quality of middle

3 management, and management structure. shaping a company’s ability to acquire Quality can also be inferred from corporate assets abroad, and thus given a 25% weight. governance characteristics, the degree of A company’s financial resources and information transparency and corporate synergistic needs are, to a large extent, social responsibility (CSR) activities, within its control. The set of legal and although these factors are inherently regulatory hurdles it faces while acquiring regulatory challenges as well. Compared to assets abroad, on the other hand, are other attributes, a company’s management generally exogenous. Given the strategic quality is less tangible, but no less important nature of the energy industry in particular, in shaping its M&A strategy. The legal and regulatory issues in target framework assigns it a 20% weight. countries can often be particularly sensitive and require sophisticated understanding and Legal and regulatory challenges facing a experience on the part of management. company are the most crucial factor in

4 FINANCIAL RESOURCES (20%)

This criterion captures indicators of above 5. This divergence exists despite financial resources that a company either and Lukoil having greater access to holds or has access to. If a company has more oil reserves, although another rationale large financial resources at its disposal, for lower P/E ratios is the market perception economic literature indicates that it is of political risk and the quality of state unlikely that the company will invest these ownership. in non-core areas or choose to hold large Regardless of the context, EV/EBITDA and amounts of cash for extended periods of P/E ratios matter for potential energy time. acquisitions as higher ratios and valuations M&A is one area where financial resources translate to more favorable deal terms for can potentially be productively deployed to the acquirer. In the case of a stock purchase, meet a company’s core business needs. a potential acquirer would have to offer a M&A deals involve either transfers of cash, larger number of stocks if the stock were undertaking of debt, share swaps, or cheaply priced. different combinations of the three. To Cash and debt incorporate different aspects of a company’s financial resources, we look at the following Most oil and gas companies in the region sub-categories. have been associated with a financial partner Market value that serves primarily as a “cash management” entity rather than an entity

The market valuation of a company is that assists in strategically accessing long important because it serves as a fairly term financing for the sector. For example, accurate indication of its performance and Petrocommerce is still linked to Lukoil its long-term ability to carve out value. despite Lukoil selling about 80% of its However, liquidity in the market also has an stake, while Gazprombank is a full member effect on valuation. Since Russian and of the group. The inability of the Central Asian markets are less liquid, the regional financial system to respond to price to earnings (P/E) ratio of oil and gas rising investment needs has led to increased company stocks could trade at a discount foreign currency funding from foreign compared to its Western counterparts entities. This is further reinforced by lower despite similar fundamentals. This is interest rate environments abroad and demonstrated by the fact that Rosneft appreciating local currencies as seen in the (Russian NOC) and Lukoil (Russian private) case of the Russian ruble. trade at P/E ratios in the range of 3.5 – 5 as However, the financial crisis in Europe and opposed to ExxonMobil (IOC)—which North America has resulted in a decrease of trades at P/E ratios closer to 10—and Statoil funds available for lending. Given the (Norwegian NOC), which trades at levels exposure of these banks, there is bound to be

5 a cascading effect on their ability to fund receives $18 billion dollars of long-term transactional activities. As a result, the debt funding (implying lower interest rates), amount of cash that a company has becomes while Lukoil, being privately owned, more significant. receives 9 billion dollars. All other things being equal, it would be fair to say that Though cash is implicitly present in the Rosneft would be in a better position to calculation of the enterprise value of a firm, make acquisitions if cash were the only the presence of cash and current liabilities in consideration. Moreover, with European the balance sheet suggests that, accounting debt markets likely to remain increasingly for everyday operational expenditures, the unfavorable, it would appear that cash-rich company is in a relatively good position to companies are best placed to strike deals and make acquisitions. While KazMunaiGaz take advantage of falling valuations. (KMG-Kazakhstan’s NOC), Rosneft and Lukoil have less than $10 billion dollars of Reserves 1 cash , Surgutzneftegaz (Surgut) has almost $13.5 billion in cash on its balance sheet, As of 2010, the Eurasia region holds some which significantly boosts its ability to 10% and 30% of proven oil and gas acquire. The company’s balance sheet reserves, respectively. In turn, the known strength is reflected in its annual report, amount of reserves that an oil company which states that “Surgutzneftegaz finances has—i.e. the amount of proven reserves— its operations from its own funds, which can be used as collateral for issuing minimizes the risks related to higher interest corporate debt or reserve-based loans2 (see rates and lower credit availability.” Appendix for national and company-specific reserve levels). A higher level of reserves However, since the cash on the balance intuitively implies larger monetary benefits sheet might be borrowed, it is important to in the future, provided that the company has look at debt ratios. While Lukoil does better the technology to exploit these resources. than Rosneft on the debt front with a long- However, technology (as will be described term debt / equity ratio of 11.8 compared to below) is an area that Russian and other 26.4 for Rosneft, both of them have current Eurasian companies seemingly lack. Lukoil ratios close to 2. More importantly, Rosneft had proven hydrocarbon reserves3 of 17.3 has about $9.6 billion dollars in cash while Lukoil has around $4.5 billion dollars in 2 cash. The net debt for both companies is Reserve-based loans are credit extensions that are collateralized by oil, gas, and/or other hydrocarbons around $22 billion dollars, suggesting that 3 “proven reserves are known reserves which, on the the only real difference between the available evidence, are virtually certain to be companies is in the structuring of the debt. technically and economically producible, i.e., having a better than 90% chance of being produced. Rosneft—being a state owned company— Probable reserves are known reserves which are not yet proven but which are estimated to have a better than 50% chance of being technically and 1 Cash and Cash equivalents economically producible. Possible reserves are those 2Reserve-based loans are credit extensions that are reserves which, at present, cannot be regarded as collateralized by oil, gas, and/or other hydrocarbons probable’, but are estimated to have a significant , but

6 billion barrels of oil equivalent (boe), If oil prices (both Brent and WTI4) continue consisting of 13.3 billion barrels of oil and to push current support levels, even during a 23.6 trillion cubic feet of gas. On the other time of relative financial recession, the value hand Rosneft has proven reserves of around of the vast reserves that these Central Asian 13.97 billion boe. Russian companies, in companies possess would substantially particular, are also dependent on acquired increase. It is also important to remember proven reserves that exist outside Russia. that the valuation is dependent on the costs For example, Surgutzneftegaz’ increase in that are incurred to produce the oil. This is proven reserves was largely due to where existing technology and economies of additional volumes of extra heavy oil from scale play a key role. the Orinoco Oil belt in Venezuela.

Reserve-based lending is still not a widespread phenomenon in Russia. POSSIBLE SYNERGIES (20%) Moreover, the Russian definition of reserves is different from the classical Western A company may choose to pursue M&A as definitions established by the Society of part of its corporate strategy for a variety of Engineers (SPE) and the reasons. Drawing upon common Securities and Exchange Commission frameworks used to analyze outbound M&A (SEC). Due to the sporadic nature of and investment strategies, it is possible to transactions in this particular industry in the arrive at a variety of business drivers that Eurasian region, there are constraints to impact emerging-market-based companies. valuing reserves. Therefore, in the absence According to Sergey Filippov and others, of comparables, the only valuation method broadly speaking, these drivers can be is to find the present value of reserves, divided into two categories: “pull” factors, discounted at an appropriate rate. However, where M&A is used to acquire assets and this methodology has its drawbacks. It is skills found in foreign markets; and “push” difficult to calculate the expected quantity of motives, or the need to address the relative extraction at the start of the year since oil disadvantages of operating from one’s home production is subject to fluctuations that are country. determined by global and domestic demand. The primary drivers that pull CIS-based For example, crude oil production at Rosneft energy companies into M&A activity abroad increased from 796.4 million barrels in 2009 can be divided into three types of incentives: to 847.4 million barrels in 2010. Similarly, access to additional resources, access to the expected future revenue per unit is markets, and access to efficiency-seeking dependent to a large extent on volatile oil investments, including advanced prices. technologies, managerial and marketing experience. Likewise, the key drivers that less than 50%, chance of being technically and 4 Russian oil is considered to be more of the Brent economically producible” variety

7 push CIS companies toward while Kazakhstan is poised to become one internationalization include the need to of the top five oil producers in the world in diversify political and macroeconomic risk the next decade. Azerbaijan, meanwhile, and access to international capital markets produces ~1 million barrels per day (b/d) of due to underdeveloped domestic financial oil and is looking to become a key natural sectors. gas exporter to Europe.

To understand whether it makes sense for a The broad goals of countries such as Russia, company to pursue M&A as part of its Azerbaijan and Kazakhstan, and their overarching business strategy, it is necessary respective NOCs, are to develop their to have a clear understanding of the hydrocarbon resources in line with the company’s existing core strengths and overarching state objectives of economic weaknesses, its short and long-term business development and political control. Privately objectives, and how these qualities interact owned companies in this region seek a more with the incentives and opportunities that conventional business goal of profit exist through foreign acquisitions and maximization, although risk management investment. While inherently each analysis frameworks in this region often place a will differ by company, some broad trends higher emphasis on diversification of with respect to the above-mentioned drivers political and macroeconomic risk (to be can be identified for CIS-based energy discussed in the “Political Risk” section). companies in the upstream, mid- and downstream sectors. It is necessary to note, Therefore, from an upstream perspective, however, that the corporate strategies of smaller NOCs such as SOCAR (Azerbaijan) these companies have been and are subject and KMG will have limited interest in to revision, especially as both energy and pursuing additional upstream acquisitions financial markets confront a period of given the development needs of their uncertainty and volatility. domestic fields. Larger NOCs such as Gazprom and Rosneft will require Upstream replacement reserves given the declining output of mature fields, although initial Resource needs? priorities for E&P will focus on domestic For the most part, the energy companies in undeveloped assets.5 For example, Gazprom the hydrocarbon-rich Caspian region are Neft (Gazprom’s oil subsidiary from its endowed with significant conventional oil domestic takeover of Sibneft) will not be and gas resources. The core strength of these able to meet its production goals for 2020 CIS-based companies is their control of without significant new assets, but according domestic hydrocarbon reserves. Russia to a statement by its deputy CEO, Vadim alone holds the world’s largest Yakolev, growth prospects in Russia remain reserves and the 8th largest oil reserves

(although its annual oil production has 5 The year-on-year decline rates for mature fields surpassed Saudi Arabia in recent years), owned by the largest four oil companies in Russia ranges from 2.5%-2.8%.

8 stronger than those abroad. This analysis . With respect to Europe, KMG has may differ somewhat for privately owned acquired a recent minority stake in an Russian companies such as Lukoil and BP- upstream project in the North Sea, while TNK, which has (or had) an express Lukoil is looking to expand operations there objective of diversifying political risk due to as well. its heavy portfolio of Russian domestic assets, and moreover, confront more Finally, in an environment of high oil prices, competition within Russia. For example, accessible upstream assets will be priced at a Lukoil in 2011—due to its strong balance premium. Having begun as upstream sheet and recent declines in its production companies, CIS-based oil and gas firms are output—plans to invest some $48 billion in looking to expand downstream and retail the next 3 years alone, primarily to stall capabilities. The advantage of vertical production declines in its mature fields in integration allows these firms to minimize Western Siberia, expand its project in Iraq financial and operational volatility with and initiate new projects in the respect to crude prices and refinery margins, and Uzbekistan, according to Vagit while capturing the additional profits from Alekperov, its CEO. Lukoil has also the sale of refined products and expressed interest in upstream assets in . Libya and the Gulf of Guinea (West Africa), Efficiency-improving investments: field and recently increased its projected total recovery and frontier exploration capital expenditures to $100 million over the In addition to resource-seeking motivations, next 10 years. efficiency-improving investments, in The limited availability of conventional particular a company’s technology, project upstream acreage in North America and and risk management skills are also Europe combined with the strong presence significant factors that can drive outbound of international oil companies (IOCs) may M&A in the CIS region. constrain the number of attractive deals for While there may be limited demand for CIS companies in “Western” geographies, upstream reserve acquisitions, NOCs and however, the North American private firms will continue to require unconventional sector, in particular shale technology and project management gas and oil, has experienced much foreign expertise, especially in areas such as interest. While some CIS firms, such as secondary or (EOH) Gazprom, have expressed limited interest in as fields begin to mature, deep , developing such resources, Lukoil’s CEO unconventional extraction and liquefied noted in March 2011 that it is examining natural gas (LNG). The question, however, potential U.S. shale investments, stating that is whether they will be able to acquire these “if we are lucky in identifying a good skills and inputs through ongoing inbound partner, we are ready to be actively involved investments from IOCs, contracts with oil in the U.S.” Meanwhile, TNK-BP has service companies (OSCs), or via agreed to explore for shale resources in

9 acquisitions. In general, the comparative consideration of other factors. However, advantage of IOCs and OSCs is their ability past IOC experiences dealing with Russia’s to efficiently conduct and manage weak legal framework have arguably left a technically complex operations, so it is not “bad taste” in the mouths of some, as the clear whether outright M&A is the most PSA structure is rarely applied and contracts effective approach to access these skills. are prone to revision in favor of the state or state-owned entity. Likewise, the legal In SOCAR’s case, due to Azerbaijan’s open requirement that the state control strategic inbound investment environment, it will resources can make it hard for IOCs to likely be able to continue relying on financially book the reserves that are knowledge transfer through IOCs (e.g., discovered (e.g., Statoil and Total in the contractually mandated through a Barents Sea). production-sharing agreement-PSA) or more directly through joint ventures if SOCAR is Mid- and downstream willing to take on some financial risk. Due to its limited capital, SOCAR has generally While there may be less clear-cut relied upon IOCs to finance, operate and opportunities in the upstream sector, the manage its major oil and gas fields (e.g., goal of vertical integration for the major CIS ACG, Shah Deniz, etc.), with SOCAR oil and gas companies has generated earning a share ranging from 20% to 50% as significant outbound investments in the part of the Azerbaijan International downstream sector, particularly across Operating Company (AIOC). SOCAR, Europe. As producers of oil and gas, a however, is beginning to take on more primary objective of these companies is to exploration risk as it engages in independent ensure sufficient and stable demand for their drilling activities in proven blocks. products (whether it is to support government budgets or corporate balance A similar challenge confronts Russian sheets). Since all these companies produce companies looking to develop fields in more than what can be consumed difficult-to-reach places such as on and domestically, securing market access in offshore Western and Northern Siberia and other regions can be achieved through the Arctic. Frontier exploration activities investments that establish a physical present high risks, given the uncertainty presence (e.g. ownership of transport hubs regarding geological formations and the lack or pipelines, refineries, gasoline stations). of experience operating in these new Efficiency-seeking investments are also environments. In most cases, NOCs will turn needed to reduce overall costs and to to IOCs and OSCs through a variety of upgrade existing equipment and contractual arrangements to take on the E&P infrastructure so that end products are cost- risk, potentially through strategic alliances competitive and meet the regulatory such as the recent Rosneft-Exxon Mobil requirements of their target destination (e.g., deal, but whether it will lead to outright EU standards). Likewise, a high-oil M&A is less clear and would require price environment can decrease refinery and

10 petroleum end-product margins, which Both consuming states in Europe and its key could result in attractive prices for energy suppliers from Eurasia ultimately downstream assets as CIS companies look to have goals that converge. EU states would expand in this sector. like to enhance its energy security by diversifying suppliers and import routes, Infrastructure preferably breaking the current Russian An important component of market access monopoly over east-west pipelines, or at for physical commodities producers is the least bypassing “troublesome” transit quality and breadth of the infrastructure that countries such as Ukraine and Belarus. is needed to transport these goods. Much of Russian companies are also not eager to the Eurasian region suffers from inefficient depend on gas transit through Ukraine and refinery and pipeline infrastructure dating Belarus, as evidenced by the 2008spat back to the Soviet era. between Ukraine and Russia over transit fees and gas prices. Meanwhile, countries While it is no secret that a plethora of such as Azerbaijan and Kazakhstan would pipeline proposals for the Caspian and also like to reduce dependence on Russian- Eurasian region have been under discussion controlled routes. for several years, the inherent complexity of interstate pipeline investments makes it In the case of Azerbaijan, SOCAR has difficult to evaluate exactly what M&A signed a variety of oil and gas export opportunities will exist in the near-term. The contracts with countries in Europe, Middle number of stakeholders combined with the East and Asia, but according to experts, its sheer size of the investments needed (e.g., export capacity will ultimately depend on some estimates for the cumulative costs of infrastructure availability. SOCAR has been the proposed Nabucco or heavily involved in the various Caspian- pipelines exceed 24 billion euros) have region pipeline proposals, and has presented numerous issues for finalizing previously used its State Oil Fund (SOFAZ) such deals. to finance a 25% equity stake in the BTC pipeline, which was completed in 2005 and Regardless, based upon market needs, it is the primary export route for Azeri oil seems inevitable that new pipelines and westward. Similar investments, whether by storage facilities will be built, and demand SOCAR, SOFAZ, or its IOC partners, will for these assets will drive deal activity. In be required to fully take advantage of the particular, offshore and sub-sea pipeline gas assets from the second phase of routes will require a higher degree of development of the giant Shah Deniz field, technical and engineering skill, as evidenced which is expected to come online in 2017. by the extensive surveys and assessments With the ongoing controversy over conducted for the Nord Stream pipeline Nabucco, in May, SOCAR, through a joint project linking Russia directly with venture with ’s Botas Pipeline Germany via the Baltic Sea. Corporation, announced plans to construct a trans-Turkish pipeline that will move gas

11 from Shah Deniz II to markets across Asian markets). Rosneft has also expressed Turkey. plans to expand its retail and marketing divisions, and may be interested in owning CIS companies have focused on upgrading outright or acquiring a significant equity domestic refineries in order to improve share of energy marketing companies to efficiency and decrease costs, as well as to capture additional profits. meet EU fuel standards and other regulatory requirements in consuming countries. While Similarly, SOCAR’s regional investment some of these efforts, especially for Russian strategy has emphasized using acquisitions companies, have been underway for several to gain market share and improve the years, additional investments are still needed efficiency and profitability of its in the near and medium term. downstream operations. Building upon its initial $2 billion acquisition of , a Market access supplemented by efficiency- Turkish company in 2008, it seeking investments recently announced plans to build a $5 The sizeable share of outbound M&A billion on the complex, which activity from CIS energy companies has would allow Petkim to expand its market been directed at expanding downstream and share in Turkey from 25% to 40% over the retail operations, especially in the next 10 years. On the retail end, SOCAR has neighboring Caspian region and in Europe. gradually established a network of over 80 In addition to capturing additional profits gas stations in Georgia, either through from the downstream sector, ownership of acquisitions of privately owned companies physical assets in foreign markets helps or direct investment, and manages Georgia’s secure market access and expand market gas distribution network (excluding Tbilisi). share, enhances international management SOCAR has plans to expand its retail and operations experience, provides access operations in Ukraine, , to better technologies, and increases brand , Georgia and Turkey, with recognition. aspirations to sell its end products throughout Europe. In 2011, it purchased The synergy behind both these motivations Exxon Mobil’s Swiss fuel supply business, can be seen in, for example, in Rosneft’s Schweiz. 2010 acquisition of German refiner Ruhr Oel, which gave Rosneft immediate access SOCAR’s investments to access markets in to 10% of the German market through stakes Eurasia and Europe are complemented by in 4 refineries. Moreover, this acquisition internal efforts to upgrade and expand its provides Rosneft access to the latest refinery and petrochemical production technologies in refinery operations and capabilities. SOCAR is working to upgrade management, an important step as it looks to its existing Sangachal refinery complex into increase refinery capacity nine times from an integrated oil and gas processing plant 2007 levels by 2015 (it should be noted that and petrochemical facility, which would much of this capacity appears to be aimed at allow it to produce higher quality feedstocks

12 to support its petrochemicals industry, a The link between political risk and oil and stated government objective. This facility gas resources has been strong throughout the would effectively replace its two Soviet-era history of the energy industry, beginning refineries, which can only produce fuel at with the ‘concessions’ era in the Persian Euro-2 Standards. The EU market has Gulf in the early 20th century. required that all imported fuel meet Euro-5 standards, while Russia recently adopted a According to this framework, the level of minimum of Euro-4 standards, thus political risk in the context of outbound currently limiting Azeri finished fuel M&A depends on three main factors: products to less stringent markets such as macroeconomic risk; ownership structure Romania and Georgia. These ambitions and the government regime faced by the potentially create space for acquisitions that buyer company; and the relations between can supplement SOCAR’s knowledge in the the acquirer’s home country with other countries. construction and operation of refining and processing facilities. Macroeconomic risk From a market perspective, European Macroeconomic risk is the systematic risk refiners continue to suffer from low margins inherent in the political or economic system and declining demand due to slow economic of a country that cannot be reduced through growth and long-term policies geared diversification within national boundaries. toward reducing oil consumption, and thus Conventionally, it can be gauged from the are looking to sell assets. In 2011, at least 12 spread between long-term U.S. treasury refineries in Europe are looking or were bonds and buyer country debt of comparable sold, most of them formerly owned by IOCs. maturities. However, many CIS countries Recent acquisitions appear to indicate that are not well integrated with world markets European refinery valuations have suffered and their debt is not always denominated in sharp declines, especially in comparison to comparable terms. In absence of comparable what Russian firms such as Rosneft and sovereign debt spreads, we use a country’s Lukoil paid just one or two years prior. This credit default spreads as an indicator of the “discount” should continue to capture macroeconomic risk component. significant interest from foreign companies. A credit default spread (CDS) is similar to a POLITICAL RISK (10%) traditional insurance policy in that it obliges This framework defines political risk as the the seller of the CDS to compensate the likelihood that politically motivated actions buyer in the event of loan default. will hurt the business interests of energy Intuitively, the higher the CDS spread, the companies in the CIS region. The political more risky it is to hold the country’s debt. risks of doing business in Russia and other Russia’s CDS spreads are higher than those CIS countries are an important driver for of other BRIC nations: Brazil (191 basis outbound M&A activity from the region. points), India (203 basis points) and China

13 (178 basis points). As expected, it is also resources are already government owned, much lower than those of OECD countries and its top-level management is appointed at such as the U.S. (56 basis points) and the government’s behest.

Country S&P Rating LC CDS Spread () Russia BBB+/A-2 299.6 Kazakhstan BBB+/A-2 327.7

Azerbaijan BB+/B NA

Ukraine B+ 871.2

Germany (114 basis points). It can be argued Acquiring assets abroad is a general strategy energy companies in the CIS region may for privately owned firms in the CIS region. want to lower the macroeconomic risks they Lukoil acquired Getty (U.S. oil marketing face by diversifying assets beyond national company) in 2000 and Nelson Resources boundaries. (Canadian oil company) in 2005. In June 2011, VimpelCom, Russia’s biggest mobile Ownership structure phone company, bought South Korea’s New

Ownership structure and government regime Telephone Company for $420 million. also play an important role in determining TeleSystems (MTS)— the likelihood a company will acquire assets VimpelCom’s biggest rival—acquired abroad. This white paper argues that Sistema Shyam TeleServices, an Indian privately owned energy companies operating mobile services provider. Another case in in countries with weak democratic point is leading search engine Yandex, the credentials face a higher degree of political “Russian Google.” In Yandex’s IPO risk. This is consistent with real-world prospectus, it notes: “High-profile events as well as political science literature, businesses in Russia, such as ours, can be which point to a relationship between a particularly vulnerable to politically country’s political structure and the motivated actions…. Other parties [may composition of its main sources of wealth. perceive our news service] … as reflecting a political viewpoint or agenda, which could If the source of income is immobile, such as subject us to politically motivated actions.” oil or gas, privately owned oil companies Private oil entrepreneurs in Russia have may attempt to transfer wealth abroad to experienced a high degree of political risk. lower the risk of facing expropriation, The most famous example is the effective higher taxes or regulatory problems. One nationalization of oil company Yukos and way to transfer wealth is through outbound the incarceration of its main shareholder, M&A. If the energy company is state- Mikhail Khodorkovsky. A similar example owned, it faces fewer political risks—its is Mikhail Gutseriev, the owner of smaller

14 oil company Russneft, who fled to London another component that must be considered in 2007 claiming to be the victim of when examining future activity. Past “unprecedented bullying from the state.” As experience generally suggests some level of was the case with Yukos, the Russian familiarity with the legal and regulatory government conducted a tax investigation requirements of such transactions. In the into the company after Gutseriev allegedly energy sector, this can range from specific interfered in presidential elections in the industry, environmental and health autonomous republic of in regulations in addition to foreign tax codes southern Russia. and corporate disclosure laws. While there is inherent variation of these rules by Government relations destination country, an awareness of the overall process, as well as familiarity with Relations between the government of the the political and business climate of target buyer country with foreign governments countries, is useful for companies when also affect a company’s ability to acquire identifying future opportunities. assets abroad. It also matters whether governments of the buyer company support Past acquisition experiences also provide and encourage outbound FDI proposals, and companies with know-how regarding how to whether explicit national policies exist integrate new foreign assets with existing concerning where and how investments operations, including how best to handle the should be undertaken. For example, Russian challenges of combining potentially two President Dmitry Medvedev has gone on different business cultures in a way that record to say that the Kremlin would maximizes return to the acquirer. This encourage Russian companies to invest experience gives would-be acquirers more heavily in foreign assets. "The acquisition of confidence in evaluating the potential foreign companies directly or by buying up synergies between two companies, resulting stakes in their authorized capital is a very in more realistic expectations for the important task," Medvedev told an assembly outcome of M&A activity. However, having of Russian businessmen in February 2008. past acquisition experience does not "Business should always be confident that it necessarily mean a company will have a has state support [when it moves onto] higher propensity toward M&A in the world markets." The main reason for future; rather it is the learning-by-doing Russian investors to buy foreign firms, he effect that gives firms more confidence and argues, is to "help retool and modernize a better understanding of how to undertake Russian companies, boost their production M&A. effectiveness and enter new markets." The attempt by Russian oil giant Surgut to PAST ACQUISITIONS (5%) purchase a 21% stake in MOL Group, an integrated Hungarian oil and gas firm, is an Whether a company has undertaken important example of how past acquisitions outbound M&A transactions in the past is may actually deter future outbound activity.

15 In 2009, Surgut—the most opaque of the big investments in 2011, strengthening its Russian energy companies rumored to be foothold in the Turkish petrochemical closely linked to Prime Minister (now market. Similarly, beginning in 2006, President) Vladimir Putin—purchased SOCAR’s Georgian subsidiary has 21.2% of MOL from Austria’s OMV Group expanded its network of gas stations in for $1.4 billion euros. OMV had Georgia from 1 to over 80 in five years, with unsuccessfully attempted a hostile takeover additional plans to establish a network of of MOL before selling its stake to Surgut. stations in Ukraine and Romania. Both MOL and the Hungarian government viewed Surgut’s purchase as unwelcome, claiming that OMV had acted as a front for Russian interests. Hungary’s regulatory MANAGEMENT (20%) body ultimately blocked the acquisition, In the western business context, the preventing Surgut from claiming any seats composition of the management team, the on MOL’s board. After a prolonged legal quality of mid-level personnel and the battle, the Hungarian government ultimately overall strength of its human resources all bought back Surgut’s share in 2011, albeit at play important roles when it comes to a cost of 1.9 billion euros. Since then, successfully identifying and completing despite sitting on a rumored cash pile of $26 M&A activities. Management, in particular, billion (or $13.5 billion, according to its is responsible for M&A decisions associated non-standardized financial statements), with the broad strategic direction of the Surgut has chosen to direct its focus back to company. acquiring assets in Russia. According to a UBS analyst, Surgut has “never had a profile During the Soviet era, the majority of the of aggressive acquisitions abroad. MOL was management teams of state-owned a bit of an outlier in that respect.” enterprises (SOEs) in the region were composed of technocrats who rose through On the other hand, a history of successful the political ranks, and were thus intimately acquisitions can encourage companies to linked to the political leadership. This trend expand their investments abroad. SOCAR’s has continued since the collapse of the regional expansion since 2005 has shown Soviet Union, especially for the major growing confidence in integrating their NOCs in Russia, Kazakhstan and external acquisitions with their domestic Azerbaijan. However, as these companies assets. Beginning with neighboring states attempt to transition from domestic to such as Georgia and Turkey, SOCAR has regional and international players, there has gradually increased its assets in both been an emergence of U.S. and Western countries through acquisitions and foreign university educated figures in management direct investment (FDI). For example, after and board positions. SOCAR purchased its initial stake in Petkim in 2008, it moved to acquire another 24% Placing western-trained or foreign share while committing some 100 million in individuals in these positions may help these

16 companies pursue M&A activities in our ventures with foreign partners. The desire target geographies for a variety of reasons, for better management and operational including a better understanding of Western expertise could potentially be a motivation corporate culture and practices, international for M&A, especially if they seek to operational and risk management specialize in a certain aspect of the value experience, and a network of contacts in the chain. Overall, these factors play a target country, among other more intangible significant role in management evaluation qualities. Concepts geared toward profit but can be ambiguous to evaluate maximization, corporate governance, and quantitatively. accountability to shareholders and potentially other stakeholders may not be as Finally, the management’s propensity to familiar to those who emerged from Soviet address non-core business functions could legacies. Moreover, the presence of foreign have an indirect effect on the company’s nationals on a company’s board may also ability to facilitate transactions. A reassure would-be targets that its business considerable amount of resources and interests will be more protected from activities of NOCs in the CIS region political influence. inevitably end up being devoted to extraneous concerns such as public works, While CIS firms have looked to upgrade domestic employment and the provision of their top management, the quality of middle social services, as well as corruption and management remains an issue, especially rent-seeking. Therefore, it is not necessarily with respect to integrating companies after far-fetched to compare some NOCs to a the financial aspects of an M&A deal are quasi-fiscal agency of their home countries. complete. While this human resource issue This distortion of incentives suggests that stems in part from the weak education maximizing profit and fulfilling business systems in CIS states, it may potentially be objectives are not the only concerns of the resolved by applying more stringent management. Western training standards and norms toward employees. However, the effectiveness of such practices is a product of a company’s culture as well, which LEGAL AND REGULATORY begins ultimately with the standards and FRAMEWORK (25%) norms set by its top leadership. While there has always been political The managerial structure of a company is opposition to inward FDI in developed increasingly relevant to its success in an countries, particularly when it takes the form international environment. For NOCs in the of large acquisitions of host country firms in region, organizational hierarchy is often a “strategic” sectors such as energy, legal legacy of the Soviet era structure, although barriers to inward FDI have been they have been introduced to alternative substantially weakened in both developed arrangements through cooperation and joint and emerging economies. Relative to

17 emerging market economies, the U.S. and Based on the experience of Japanese Europe are more welcoming of FDI even companies attempting acquisitions in the though occasional protectionist tendencies U.S. in the 1980s and Chinese companies have risen over specific deals. In fact, given more recently, the most important factor for the federal structure of the U.S., there is an acquirer firms is to be able to distinguish additional incentive for its states and between Federal, state and city level municipalities to actively seek FDI. regulatory requirements. Given the history of the cold war and at times, lingering Firms who are new to market need to adhere tension in U.S.-Russia relations, a Russian to the specific aspects of the host countries’ SOE may not be able to avoid the political regulatory framework. They also need to be and media backlash at a Federal level, accepted as “insiders” that contribute to their especially if there is significant publicity host country’s economy and society, which resulting from the deal. However, states in implies a certain degree of stakeholder the U.S. and regional authorities in other engagement across a variety of affected countries that are hard hit from the ongoing groups. financial recession will be more receptive to United States any investment as they seek to fill holes in their budgets. Still, in order to succeed, US policy toward FDI remains based on the acquirer firms will need to integrate fully general principle of neutrality, colored by into the community by forming strong considerations of national security. All networks of interaction with local suppliers, incoming investment where a foreign entity businesspeople and politicians, while acquires control of a US company is complying with environmental, health and potentially subject to review by the labor laws, as well as other social norms. Committee on Foreign Investment in the Europe United States (CFIUS). CFIUS is charged with investigating any transaction that Although the EU governance structure threatens national security. Following a 30- delegates some sovereign decision-making day preliminary review period, if there is credible evidence that the transaction to EU authorities, policies regarding long- threatens national security, CFIUS may term oil and gas purchases, the development initiate further review or propose a and improvement of energy-related mitigation plan, and may ultimately infrastructure, and the use of particular continue to be made at the national level by recommend that the President block the individual member states. This structure transaction. Although filing for CFIUS results in a hugely diverse environment for review is voluntary, CFIUS can initiate a inward FDI in Europe. A study carried out review unilaterally, even after a transaction is completed. by the World Bank’s Investment Climate Advisory Service Group concluded that Lesson from past acquisitions Eastern Europe and Central Asia have the

18 least restrictions on foreign ownership of directly affects Gazprom’s ambitions to companies. continue to acquire mid and downstream energy assets across Europe. It already acts as the producer and transporter for several markets, including the Baltic States, and may be already forced to sell off certain assets in Lithuania. Gazprom has retorted that in no way should it be subject to EU competition and liberalization laws, and Putin has pushed EU authorities hard for a special exemption for Gazprom with an

Source: Investing Across Borders, World Bank 2010 implicit threat to raise . However, with the potential emergence of

an integrated global gas market, higher Specifically, Russia has a significant role in Russian prices could prompt European firms the European energy sector as the largest to search for other import sources, such as exporter of oil and natural gas to the EU. LNG from Qatar. Increased competition has Gazprom has a strong footprint in Europe led some European utilities to buy LNG on through its hundreds of directly and spot markets at prices as low as one-half indirectly controlled subsidiaries, and those established under long-term Russian controls approximately 25% of the gas contracts. market in Europe. However, the EU’s Third Security concerns Energy Package may complicate Russia’s existing position and its future ambitions for The fear of Gazprom ownership of energy expanding its operations in Europe. assets in Europe derives not only from the threat of monopolization, but also national EU Third Energy Package security. From a national security perspective, the most important concern for The main provision of the new EU energy host countries is that a foreign-owned entity liberalization package is the mandated will have less political loyalty to the host separation of the production, transmission country when compared to a domestically and distribution operations (“unbundling”) owned and managed company, and in turn, of vertically integrated energy companies. may be more difficult to control via its This new provision would be also applicable domestic laws. By the same logic, a U.S.- to foreign companies bidding to acquire a based company controlled by a foreign NOC significant control or interest in assets might be less willing to sacrifice their located within the EU. organizational objectives for the sake of the Since the provision is designed to promote national interests of the host country. Of competition and prevent the monopolization particular interest to host countries, of the energy industry in EU countries, it especially in Europe, would be the track record of the acquirer’s commitment in

19 honoring previous bilateral agreements and feature a vast array of stakeholders that can contracts, especially during times of political influence the policy and decision-making tension. Moreover, some European states, process, so foreign firms must be prepared especially those who have had negative to engage on a variety of issues associated historical experiences with Russian, may be with their operations. These can range from particularly wary of Russian companies understanding Western supplier and owning key energy assets. procurement processes to environmental regulations, safety, and labor laws that prohibit nondiscrimination of minorities and Troubled Past women. Eurasian companies must be prepared to proactively discuss these issues Many European observers have characterized the and display a willingness to work Russia-Ukraine and Russia-Belarus gas and oil constructively with local governments and crises as “wake up” calls exposing Europe’s energy security vulnerability even to unintended supply regulators in such matters. disruptions. More importantly, however, the crises raised the dual questions of Russia’s reliability as Governance and transparency an energy partner and Moscow’s willingness to use Another factor that host country regulators its energy power as a political weapon. In response, will consider when approving deals is the European leaders have advocated coordinating decisions on so as to present a degree of organizational transparency and unified front to producer nations like Russia, and good governance associated with the would- have promoted energy efficiency and more efficient be acquirer. Foreign firms operating in the energy use. Despite these calls, some European U.S. are required to reveal elaborate countries and energy companies have continued to information about their operations to the pursue long-term energy deals bilaterally. In the past year, companies from Italy, Austria, Bulgaria, Bureau of Economic Analysis, the Internal and Serbia have signed contracts with Russian Revenue Service (IRS) and the SEC if the energy companies, which some observers contend firms want to participate in local capital

could pose a threat to collective European energy markets. The argument here is that firms security. acquired by NOCs may experience financial Source: CRS Report for Congress, The EU’s difficulties due to a politically appointed and Energy Security Challenges, January 2008 motivated management pursuing non-profit motives. To the extent that financial losses

and other adverse consequences of Socially responsible behavior inefficient management are borne solely by the parent company, no broader externality A lesser but still important concern that costs are presumably imposed upon the host acquirer companies will face when pursuing economy. However, if a lack of transparency acquisitions in developed markets is their makes it relatively difficult for input ability to engage in corporate social suppliers, employees and lenders to responsibility activities in host countries, an accurately assess the ability and likelihood area with which Eurasian companies have of foreign-owned affiliates to carry out their limited experience. Democratic societies contractual and non-contractual agreements,

20 unanticipated financial losses may be developed markets is concern over unfair suffered by host country entities doing competition, or specifically, that these firms, business with foreign-owned affiliates. due to their tight linkages with their home governments, may have access to cheap Unfair competition financing and subsidies, providing them Finally, another concern that CIS energy with an “unfair” capital cost advantage firms may face when acquiring assets in relative to domestic firms in the host country.

CFIUS qualification criteria and considerations

Foreign Acquirer U.S. Company History of compliance with laws and regulations, focus Whether its assets part of critical U.S. infrastructure or on export control compliance and/or prior commitments otherwise could be used as a threat against the U.S. to CFIUS (e.g. for terrorist purposes) Status of home country’s history of cooperation with the Whether it serves government customers, in particular U.S. on important U.S. national security policy the defense or intelligence sectors objectives, including non-proliferation and terrorism Profile of its management including whether its officers Extent of access to government systems and directors have had any past or current connections to the home country’s military or intelligence agencies Reputation of home country for commercial or state Extent of access to U.S. government classified espionage information; possession of U.S. government approved facility security clearance Whether it does business in countries subject to U.S. Importance of U.S. assets to U.S. law enforcement embargoes (e.g. Iran, North Korea, Cuba, Sudan) interests Whether the transaction could aid the military or Importance of U.S. assets or technology to the defense intelligence capabilities of a foreign country with supply chain interests adverse to the U.S. Whether the acquirer is likely to move critical Types of other assets or businesses that are located near technology or key products offshore the U.S. company. Whether a foreign government exercises control or Existing security procedures it has in place. influence over the acquirer Financing structure of transaction and whether it gives Whether existing management will remain in place any other party such as a foreign government control over the acquirer or the transaction Whether U.S. citizens will occupy important security- related positions after the transaction. Existence of sensitive technology, including export- controlled technologies Record on compliance issues, in particular export control compliance Level of competition in the applicable market(s), and whether it occupies a dominant position in a strategic products, services or technologies market.

21

APPLICATION OF THE FRAMEWORK

The table below applies the framework Lukoil and KMG provide strong contrasts, discussed to two companies based in two allowing a rigorous test of various elements different countries in the region. of the framework.

Metric KMG Lukoil Analysis

In line with similar values for other oil and gas companies in the region, KMG has an EV/EBITDA value of 2.1 and P/E ratio of 5.4. KMG has about $3.4 bn in cash and cash equivalents. Lukoil, on the other hand, has a P/E ratio of 3.9 and an EV/EBITDA of 2.8. Lukoil also has around $4.6bn in Financial cash and cash equivalents. While both companies are similar in terms of Resources Medium High (20%) valuation metrics and cash, the larger amount of proven reserves that Lukoil possesses gives it a definite advantage. Moreover, Lukoil's better leverage profile and historically robust financial performance is a better contrast to KMG's aggressive investment policy, which needs additional borrowing to sustain itself.

KMG has limited needs for outbound upstream investments but has strong incentives to pursue efficiency and market-access investments. KMG is looking for enhanced oil recovery and refinery technologies, in addition to improving overall management and operational efficiency. M&A transactions aimed at market access will also be a strong driver as it attempts to diversify export markets away from Russia. While Lukoil Core Needs continues to pursue outbound upstream asset acquisitions, there is limited and Synergies Medium High (20%) likelihood these activities will occur in our target geographies. While Lukoil has a wider breadth of technological experience in more unconventional operations relative to other CIS companies, it is looking to apply advanced technologies and equipment to maximize field recovery. Lukoil’s ongoing refinery modernization and expansion efforts, combined with its attempt to geographically diversify its marketing and retail segment, will also drive M&A activity.

Although Lukoil is privately owned, it is viewed as a stealth NOC, acting in close coordination with the Russian government and often on its behalf. Given its good relations the Kremlin, it is unlikely that its assets will be expropriated. Further, any moves it makes to acquire assets abroad will be Political Risk (10%) Low Medium assessed for political undertones. Both these factors make the probability of Lukoil acquiring assets abroad to diversify political risk lower than a normal privately owned Russian company. As KMG is state-owned, it faces even lower political risk than Lukoil, reducing the possibility it will acquire assets abroad to mitigate political risk.

22 Unlike Lukoil's big appetite for acquiring foreign assets, KMG's experiences were mainly directed at earning its share of domestic upstream development through long term PSAs, however, its 2007 acquisition of Past Rompetrol has provided it with initial M&A experience in Europe. As one Acquisitions Medium High (5%) of the more active players in the region, Lukoil has a richer and more diversified experience, especially in strengthening its foreign refining portfolio. Such experiences, together with its global expansion strategy, enhance the likelihood of Lukoil's future M&A activities.

Lukoil has set up a strategy and investment committee on its Board, which is comprised of a professor of international relations, a chief engineer for E&P, a MIT-educated economic and political science expert, and the ConocoPhillips Asia-Pacific head. KMG has a more local management Management (20%) Low Medium team, most of whom are Kazakh citizens with a domestic education background. KMG has recently put on its Board two foreigners, including one with a Harvard MBA to oversee business development, and another from the Netherlands to manage customer relations in Central Europe and Africa.

Lukoil is the largest private oil company in Russia. It operates in over 40 countries around the world, including the U.S. and 22 European countries. Its securities are traded on stock markets in Germany, the UK and the U.S. Legal and This places Lukoil in a better position to navigate the regulatory challenges while making any new acquisitions in U.S. or Europe. KMG, being a NOC, Regulatory Low High Framework may encounter stronger perceptions that it is the arm of the state, while its (25%) very limited history of acquisitions (with no assets in North America) may make complying with financial, environmental and regulatory standards more difficult. Therefore, any acquisition by KMG will face harder scrutiny by the target country government.

23 CONCLUSION assets, as evidenced by the recent spate of refinery deals in 2011.

The framework gives us a fairly realistic From a core needs and synergies idea of which companies not only have the perspective, three clear trends emerge. ability—but also the necessary incentives— Firstly, all CIS companies in the region will to acquire oil and gas assets in Western have limited interest in acquiring upstream geographies. In the comparative case study acreage in North America or Europe, with of Lukoil and KMG, Lukoil’s higher ratings the potential exception of Lukoil’s interest on most of the elements of the framework in shale assets, although the motivation here convey the greater likelihood of a company would be technology access rather than such as Lukoil to engage in outbound reserve replacement. The resource-seeking transactions than KMG, although the main motivation is even weaker for smaller NOCs differences in this evaluation stem from such as KMG and SOCAR. KMG’s weaknesses with respect to management and legal and regulatory Second, upstream efficiency improvements requirements, and to a lesser degree, focused on technology acquisition and different types of core needs and incentives operational experience associated with high- regarding political risk. While this white risk E&P activities such as deep offshore, paper does not attempt to “match” would-be polar and unconventional development will acquirers with would-be targets, the remain a strong driver for both private and examination of each criterion, further tested state-owned companies, although these through the application of the framework, skills may be sought through strategic leads to some clear trends for outbound alliances and joint ventures rather than M&A activities among CIS companies. outright M&A. Finally, there exists an array of market As European governments and banks access and technology drivers that will continue to deal with the ongoing effects of increase the likelihood of downstream M&A a financial recession and a sovereign debt in particular as CIS companies work toward crisis, the cash reserves of CIS companies the goal of vertical integration across the oil will play a larger-than-usual role for and gas value chain. From a market access outbound acquisitions, given the credit perspective, building up downstream shortages in respective domestic and global capacities, as evidenced in the case of capital markets. At the same time, European Lukoil’s acquisition of U.S. retailer Getty economic problems, the EU push for energy and Italian refiner ISAB, and KMG’s sector liberalization and long-term policies acquisition of Rompetrol, among others, aimed at reducing carbon emissions should helps firms automatically gain market share result in discounted downstream oil and gas in these geographies while reducing operational volatility and capturing

24 additional profits from the sale of petroleum focus on markets in Georgia, Turkey, end-products. Romania and Ukraine, with initial attempts to enter countries such as Serbia, Hungary On the technology side, CIS firms have and Austria before moving further into critical weaknesses in areas such as LNG Western and Northern Europe. and refinery management and technology. Refineries in Kazakhstan and Azerbaijan, In addition to business drivers, another key for example, are struggling to overcome motivation for foreign M&A is the their legacy of outdated technology from the diversification of political risk. One clear Soviet era. In particular, they have limited distinction throughout the white paper has capacities for converting bottom-of-the- been the divergence in M&A incentives and barrel into lighter products as the share of opportunities between state-owned versus heavy fuel oil products makes up on average privately owned companies especially in 35-40% of current output. In particular, a terms of political risk and regulatory shift from catalytic reforming and hydro- obstacles. One element to be on the look out treating to catalytic cracking and hydro- for is whether or not the Russian cracking processes is needed. Similarly, to government chooses to define an explicit meet international fuel standards, hydro- outbound investment strategy for its NOCs, desulfurization technologies and the ability akin to what has occurred for Chinese to isomerize gasoline to produce high-octane NOCs. In addition, domestic policy components and cleaner fuels more cost- developments in terms of energy policy and effectively are in particular demand. Finally, changing tax codes may prompt Russian the deployment of real-time equipment NOCs to expand output abroad since those monitoring systems would also help increase exports could be sold at international market efficiency with respect to refinery prices. maintenance, operations and safety. From a management, legal and regulatory Since Russian companies such as Lukoil and perspective, as indicated by the framework, Rosneft purchased the bulk of their foreign Lukoil’s dynamic management, its status as refinery assets from 2007-2010, marketing a private company, and its prior history of and retail networks will now emerge as key acquisitions gives it a stronger propensity to acquisition targets. Meanwhile, KMG and be on the lookout for opportunities abroad SOCAR will continue to upgrade their relative to other CIS firms. This trend is existing foreign investments while looking likely to continue, especially if political for new opportunities in a gradual push uncertainty remains high in Russia. While in westward. New target markets for general, Russian firms have a step-up downstream products in Europe and the U.S. relative to Kazakh and Azeri NOCs with will be contingent upon technology respect to management skills and regulatory improvements in its refinery and processing familiarity (primarily due to a longer history operations. Therefore, it is likely that of acquisitions), these smaller NOCs are continued M&A activity for these firms will clearly looking to gain knowledge in these

25 fields. While their relative weaknesses in The ongoing integration of Central Asia and these criteria may make successful M&A Russia with global energy and financial integration more difficult, they have shown markets will continue to alter M&A trends a willingness to learn about Western as CIS companies become buyers and business and governance practices, a trend partners abroad rather than simply attractive that should only increase as they aspire to targets for more aggressive IOCs, and other become more integrated with Western Western and Chinese firms. The complex capital and equity markets. Already, geopolitical nature of the oil and gas SOCAR and KMG’s history of past industry requires a framework that is downstream acquisitions shows a clear sufficiently extensive, but also nuanced tendency to consolidate these foreign enough to take into account the business, purchases through additional investments political and macroeconomic drivers for and upgrades in the same country, these transactions. While this framework suggesting greater confidence with each serves as an initial stepping stone for the acquisition. One clear area of improvement evaluation of M&A opportunities in the for all CIS firms, however, will be the Eurasian oil and gas sector, as uncertainty quality of mid-level personnel. continues to loom large for global energy policy and markets in the next decade, it Finally, from a political or protectionist may be helpful to consider the incorporation standpoint, European countries may rather of other factors or a re-weighting of the see their assets bought up by NOCs such as existing criteria depending on significant SOCAR and KMG, as their political industry and political developments. ambitions may be seen as less threatening than those of Russian NOCs.

26 APPENDIX

Key Corporate Financial Metrics

Exxon METRIC KMG Gazprom Rosneft Lukoil TNK-BP Surgut Mobil Chesapeake P/E 5.4 2.8 5.5 3.9 5.1 8.8 9.8 12.6 EV/EBITDA 2.1 3.1 4.0 2.8 3.6 - 5.2 6.7 EBITDA/Interest Expense 52.9 53.8 47.7 26.6 336.0 - 94.2 8.2 Cash ($ bn) 3.4 15.0 9.6 4.6 1.2 13.1 11.3 0.1 LTD ($ bn) 0.2 33.3 16.6 7.8 1.9 0.0 9.3 11.8 Current Ratio 4.2 2.1 1.8 2.0 - - 0.9 0.6 Source: Thomson

CAPITAL EXPENDITURES 2010 Billions % for DS Cost / barrel Gazprom 29 - Rosneft 7.3 20% $7.35 Surgutneftegaz 3.8 - Lukoil* 6.8 19% $4.11 TNK-BP** 4.05 13.5% KMG E&P 0.6 - SOCAR 2.1 - *Planned $3 billion per year in refinery investments from 2012- 2014 ** Planned $3 billion in total refinery investments from 2011-2015 Source: Corporate Annual Reports, investor presentations

National Reserves and Production

OIL AND GAS ENDOWMENTS

Total proven reserves, bln; bcm Oil Gas 2010 R/P ratio* 2010 R/P ratio Russia 77.4 20.6 45,000 76 Ukraine 0.4 n/a 900 50.4 Kazahkstan 40 62.1 1,800 54.9 Azerbaijan 7 18.5 1,300 84.2

*Reserves at end of year divided by 2010 production rates. Source: U.S. Energy Information Administration, BP Statistical Review of World Energy 2011

27 OIL AND GAS PRODUCTION mb/d; bcm Oil Gas 2010 2015 2010 2015 Russia 10.2 10.9 590 728 Ukraine* 0.09 0.05 18.6 19 Kazahkstan 1.76 2.3 33.6 2.8

Azerbaijan 1.04 1.4 15.1 19.7*

*Net importer of oil and gas as of 2010 **Could grow to 34.7 bcm by 2020 Source: U.S. Energy Information Administration, BP Statistical Review of World Energy 2011

REFINING CAPACITY 000 b/d

2010 2015 Russia 5555 5670 Ukraine 850 650

Kazakhstan 390 - Azerbaijan 440 - Source: Industry reports

Past Acquisitions

Source; CapitalIQ

28 Source: CapitalIQ

29 Azerbaijan and Kazakhstan Outbound Oil & Gas M&A into Europe and North AmericaValue Date Target/Issuer ($USDmm) Buyers/Investors Target Country Spencer House Capital Management LLP; 9/22/2010 Lucent Petroleum LLP 11 Compass Asset Management; Tau Capital Cyprus 11/28/2009 The Rompetrol Group N.V. 1000 KazMunayGas National Company Netherlands 11/6/2009 Zhaikmunai LP 200 KazStroyService Ltd United Kingdom 6/26/2009 The Rompetrol Group N.V. - KazMunayGas National Company Netherlands 10/3/2007 CITIC Canada Petroleum Limited 875.5 KazMunaiGas Exploration and Production Canada 8/24/2007 The Rompetrol Group N.V. 2590.79 KazMunayGas National Company Netherlands 3/13/2006 Chaparral Resources Inc. 88.65 Caspian Investments Resources Ltd. USA 5/17/2004 Chaparral Resources Inc. 64.99 Caspian Investments Resources Ltd. USA 8/18/2003 BMB Holding, Inc. 57.14 BMB Munai Inc. USA Source: CapitalIQ

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