Russian Oil Futures

Richard G. Gordon Executive Vice President John S. Herold, Inc.

John S. Herold, Inc. Study Focus

• Forward-looking evaluation of the domestic and potential emerging international strategies of leading Russian oil companies • Companies included in the analysis: – Yukos –Sibneft – –Tatneft – –TNK

John S. Herold, Inc. Results Generated in the Analysis and Methods Used

• Forecasts of likely future oil production by company and future export potential • Evaluation of future financial performance under alternative international and domestic price scenarios • Incorporate the likely role of financial and operational constraints on the companies’ decision-making and performance • Quantitative results are generated using Herold’s newly released Capital Strategies model – This is a dynamic capital allocation simulation and forecast model – Integrates operational and financial decision-making to evaluate the full spectrum of capital allocation strategies and their implications for performance

John S. Herold, Inc. The Strategic Imperative for Exports • Transport barriers create $40.00 artificially low oil domestic sales $35.00 prices and a uniform strategy $30.00 among the Russian companies

$25.00 of: – Production growth focused on the rrel a $20.00

b export market and / $ $15.00 – Diversion of domestic sales to the export market $10.00 • The current subsidy to the non- $5.00 energy sector of the Russian

$0.00 economy is clear 2000 2001 2002 2003 1st half 2004 • Oil price convergence in the

WTI Cushing Brent Russian economy will have Urals Blend CIF Exports excl. CIS, Lukoil profound effects on company Exports to CIS, Lukoil Russian Sales, Lukoil John S. Herold,performance Inc. Assumptions and Implications Base Oil Price Case $40.00

• The projection assumes that $35.00 WTI Base Case – One or more additional outlets to sea such as the Murmansk pipeline $30.00 proposal are realized and Ural Blend $/bbl – Pipeline bypass of the Bosporus is $25.00

achieved l b

b $20.00

$/ Russian Oil • Three world price scenarios are Sales Price $/bbl, used with different assumptions $15.00 Sustained about Russian domestic prices Discount Russian Oil $10.00 Sales Price $/bbl Convergence $5.00 Case

$0.00 2000 2002 2004 2006 2008 2010 John S. Herold, Inc. Summary of Key Results Oil Volumes • Output rises substantially by Exports 2010 relative to 2003 7000 Sakhalin II, Phase 2 – Exports up by as much as 2 6000 Sakhalin II, Phase 1 mmb/d by 2008 5000 Sakhalin I, Phase 1 d 4000 – Further 400 mb/d potential TNK Mb/ 3000 Surgut diversion from domestic sales 2000 Tatneft • Rate of growth is diminishing 1000 Lukoil and likely to stall out by 2008 0 Sibneft Yukos • Results are not uniform – look 2004 2006 2008 2010 for Tatneft and Surgut to fall 2000 2002 behind Domestic Sales • Volume additions are 1600 Sakhalin II, Phase 2 significant for individual 1400 Sakhalin II, Phase 1 1200 Sakhalin I, Phase 1

Russian companies. d 1000 TNK 800 • However, the indicated Mb/ Surgut 600 Tatneft volumes are unlikely to be 400 sufficient to undercut current 200 Lukoil high oil prices globally 0 Sibneft Yukos 2000 2002 2004 2006 2008 2010 John S. Herold, Inc. Summary of Key Results Capital Spending and Funding

• Production growth will require Capital Spending much higher levels of capital $14,000 spending • Despite the projected rapid $12,000

escalation in capital spending $10,000 requirements, TNK

s Yukos

n $8,000 – High oil prices enable funding Tatneft illio Surgut from Russian company capital m inflows for 3 companies $ $6,000 Sibneft Lukoil – Three others face additional $4,000 funding needs • Prices have risen above our $2,000

scenarios – multiple changes are $0 likely but they only reinforce 1999 2001 2003 2005 2007 2009 our conclusions John S. Herold, Inc. Summary of Key Results Capital Reinvestment Requirements Capital Spending: % of Capital Inflows • Considerable variance emerges Base Oil Price Case

in company capacities to fund 200% their capital investment programs internally • Yukos and Surgut display 150% substantial shortage of Lukoil Sibneft investment outlets relative to Surgut capital inflows 100% Tatneft TNK • TNK, Sibneft and Lukoil Yukos

– Confronted with sharp increases in 50% capital requirements relative to inflows in near to medium-term – Rapidly emerging capital surpluses 0% in the longer-term 2000 2002 2004 2006 2008 2010 John S. Herold, Inc. Summary of Key Results Returns on Capital Employed Return on Upstream Capital Employed • Russian oil companies face an Base Oil Price Case emerging investment 100% challenge 90% • At current oil prices, the 80% Russian companies will 70% Lukoil – Yield more profitable results and 60% Sibneft Surgut much higher capital inflows in 50% the near to medium-term Tatneft 40% TNK – However, long-term profitability Yukos will erode if the companies do 30% not find sufficient new capital 20% outlets or divest themselves of 10% the excess capital 0% 2001 2003 2005 2007 2009 John S. Herold, Inc. One Expanded Example: Lukoil

$14,000 70% $12,000 60% $10,000 50% $8,000 40% $6,000 30% $4,000 20% ow Net of Opex and Cost ow Net of Opex $2,000 10% Generated Funds of Funds ($ Millions) $0 0% Capital Infl 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2003 2004 2005 2006 2007 2008 2009 2010

Historical Low Low w/ Converge Capital Requirements as % of Internally Base Base w/ Converge High Low Low w/ Converge Base High w/ Converge Base w/ Converge High High w/ Converge

25.0% 45.0% 40.0% Capital 20.0% 35.0% tal o 15.0% 30.0% 25.0% of T 10.0% 20.0% % 15.0% 5.0%

as a 10.0% Capital Employed bt 0.0% 5.0% e

D 0.0% 000 001 002 003 004 005 006 007 008 009 010 Percentage Return on Upstream 2 2 2 2 2 2 2 2 2 2 2

Historical Low Low w/ Converge 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Base Base w/ Converge High Historical Low Low w/ Converge High w/ Converge Base Base w/ Converge High John S. Herold, Inc.High w/ Converge Responding to the Challenge

• The investment challenge will likely manifest itself in any or all of 3 related forms of behavior – Growing pressure to increase re-investment rates in Russia • Likely adverse effects on costs due to demand-pull inflationary pressure in the oil-related industries and shifts in capital spending to more costly forms of production enhancement • Also, will only further stress the Russian institutional structure – Capital distributions to shareholders – More substantive moves towards building international E&P operations • The pressure to expand internationally is likely to be reinforced by – A public policy and internal corporate perceived need for international operations to secure one or more Russian companies’ standing as true peers of the leading world oil companies – Institutional rigidities within Russia are likely to become binding constraints on Russian production growth

John S. Herold, Inc. Institutional Rigidities within Russia

• A key deficiency in Russia is the institutionally mandated decoupling of the strategic and economic roles of infrastructure and upstream investments – ’s role is a legacy of the past – The logic of Transneft’s status is contradicted by industry history and current experience in most world class plays elsewhere in the world – In provinces where this decoupling is not present, investor strategic priorities with respect to infrastructure are directly linked to the upstream values that are commercially viable only because of the infrastructure • The newly emerging national oil company is an institutional need – not an economic need • The Russian fiscal system is inadequate to the task

John S. Herold, Inc. Investment Opportunities by Non-Russian Companies in Russia will Likely Deteriorate

• Capital inflows of Russian companies will increase substantially over time – probably more than indicated in our base case • The need for non-Russian capital will rapidly decline – in fact such capital will be perceived by both the Russian companies and the Russian government as unwanted and unnecessary competition • Current Russian company strategic agendas for growth and diversion of output to export markets are already placing substantial stress on the Russian institutional framework and the transport grid • How to succeed within Russia under these circumstances?

John S. Herold, Inc. A New Model for Russian Entry Strategy? Or a New Model for Russian Diversification?

• The results of this study suggest a diminishing perceived need for non-Russian oil companies. • This, coupled with a growing perceived value of international diversification among the Russian companies – may suggest trans-national alliances as an effective tool for new entrants to Russia – the ConocoPhillips/Lukoil arrangement is somewhat suggestive of this approach • But … Turn this solution on its head – Russian companies as acquirers of non-Russian companies with significant international assets – The Chinese/Indian models of international expansion through acquisition expanded

John S. Herold, Inc. One Final Prediction • Under the scenarios of this paper, the Russian fiscal system is unlikely to be stable in the current price environment or in the emerging financial status of the Russian companies • Elements of an emerging shift in power back to governments and to higher taxes is already becoming evident elsewhere in the world: Venezuela, Bolivia, Trinidad are three recent examples • Government take under the Russian system lacks the mechanisms that are likely to satisfy the government’s demands for revenues and its sense of fairness of its share • The result is a volatile business environment. • Look for government take on oil and gas operations in Russia to rise substantially in the not too distant future.

John S. Herold, Inc.