Group Members:

1
Group Members Violetta Abramova Dennis
Hwang Luba Jacobson Valerie Kritsberg George Oka
2
Our Agenda Today

• Introducing
• Political Conditions
• Economic Climate
• Valuing the Firm
• Conclusion and Recommendations

3
Decisions, Decisions, Decisions
4
Why LUKOIL?
Because

• ? Given the current economic political
  conditions in the world, the future of oil
  industry affects us all
• ? Large multinational the fifth largest oil
  supplier in the world after Exxon Mobile
• ? Improvement of corporate governance control
  relative financial strength of its equity shares
  on NYSE LSE place the company in a strong
  position

5
Introduction to LUKOIL

• The World Over!!!
• Global player and Russias 1 oil producer
• One of the worlds top 5 publicly traded oil
  companies
• Most internationally diversified with projects in
  the Republics of the former Soviet Union, Eastern
  Europe and the Middle East
• Holds up to 2 of worlds output of oil
• Emerged on Nov. 25th, 1991 from a consolidated
  venture of 3 production associations
  Langepasneftegas, Uraneftegas and Kogalumneftegas
  (LUK OIL)
• Organized into an Open Joint Stock company on
  Apr. 5th, 1993

6

Acquisitions

• Making History
• In 1999 Lukoil acquired KomiTEK oil company
• First post privatization corporate merger in
  Russian oil and gas industry
• This strengthened Lukoils position in the oil
  sector even further
• That same year it acquired Saratov petrochemical
  plant
• In 1999 it acquired oil refineries in Odessa and
  Bulgaria
• In 2000 moved its operations beyond the Atlantic
  Ocean
• Acquired Getty Petroleum Marketing Inc.
• American corporation controlling petroleum
• stations in 13 NE States, covering NY NJ
• In 2001 attained 60 voting right of the
• NORSI OIL Nizhniy Novgorod Refinery

7
LUKOIL Production

• GrowingGrowingGrown
• Producing higher volumes of jet and diesel fuel,
  and are expanding in the petrochemical section
• Increasing its refining capacity in both Russia
  and Internationally
• Constantly implementing refinery upgrade to meet
  American and European Standards
• Believe Eastern European Markets provide for low
  cost and retail sales growth opportunities
• Natural gas production went up
• by 11 oil refining volume
• increased by 18 in the last year

8
Caspian Exploration

• Why, When and Where
• Over the past year Lukoil has been penetrating
  the North Caspian Region
• Sign of companys upstream development strategy
• Shift the pressure from worn out fields in
  Siberia to underdeveloped fields
• As per World Bank Caspian will be a key region
  for most of the futures oil production
• In 1997 Lukoil Atlantic Ritchfield Company
• (ARCO, sub of BP) LUCARCO
• Agreement
• Working together on the exploration and
• the development of the North Caspian
• Region
• Political Union BPs down payment for
• Russias compliance on the war against Iraq

9
Gazprom and LUKOIL

• The Venture
• In Nov. 2002 two biggest Russias gas and oil
  producers signed a strategic partnership
  agreement
• Together will sponsor the exploration and
  development in the North Caspian Region
• There are large deposits of gas in the North
  Caspian Region
• Lukoil is intending to use Gazproms pipelines
  because the tariffs
• on those are too high
• Lukoil benefits because it is looking to expand
  its gas sector

Keep you friends close, and your enemies even
closer
10
West Qurna Project

• Entering Dangerous Waters
• In 1997 Lukoil and the Baghdad Oil Ministry
  signed a production sharing agreement (PSA) to
  develop the West Qurna Field
• Would have brought Lukoil 70 billion worth of
  oil
• Lukoil would own one of the biggest oil fields
  Baghdad has ever offered
• In December of 2002 Iraqs ministry terminated
  the contract
• As per Baghdad Oil Ministry Lukoil failed to meet
  its obligations
• Main point was to develop the field, Lukoil
  harmed
• the Iraqi economy
• The true reason behind the termination was hidden

11
Russian Federation Political

• Initial Agenda
• Restore Russias international image as a great
  world power
• Pro-Western stand
• Support following September 11th, 2001
• May 2002 Signed bilateral strategic arms
  reduction agreement with the U.S., and agreed on
  creation of Russian NATO Council

12
Russian Federation Political

• Implications of Impending War in Iraq
• Positioning Side with U.S.?

Side With U.S. Not Side With U.S.
Maintain built-up positive relations with U.S. Economic gains from lucrative oil contracts with Iraq
Improve chances with entrance of NATO Implications with EU leaders France and Germany
Greater involvement in distribution of Iraqi oil in the case of a U.S. victory Husseins tactics from Gulf War could imply rise in Russian oil prices
Might not receive just proportion of Iraqi oil from the U.S.

• Result Not side with the U.S. Side
  with French-German Entente

13
Russian Federation Political

• Political Implications During the War
• U.S. and the coalition forces likely to defeat
  Saddam Husseins Regime
• U.S. to take lead role of developing post-war
  Iraqi government
• Most outside nations, including Russia, believe
  the United Nations should assume the lead role
• If U.S. takes lead role, current Russian
  contracts with Iraq might not be enforced

14
Russian Federation Political

• Political Implications During the War
• April 6, 2003 U.S. House of Representatives
  passed an amendment that bars Russia, France,
  Germany, and Syria from participating in
  contracts for Iraqs postwar restoration
• Elevated importance of U.N. Security Council
  meeting concerning Iraqs oil revenues
• Oil-for-Food Program

15
Russian Federation Political

• Strained Relations
• U.S. accused Russia of providing Iraq with
  military equipment
• Russia claimed that U.S. troops shot at a Russian
  convoy, which was carrying Russian diplomats
• If U.S. pursues other
• Axis of Evil countries,
• Russian-U.S. long-term
• partnership could collapse

16
Russian Federation Political

• Russian Governments Future Decisions
• Recognize strong Anti-American and Anti-War
  sentiment in Russian people
• Upcoming election might force Kremlin party to
  play to a receptive home
• Oil industrys reliance on political
  relationships with foreign countries
• Future Western retaliations to Russian opposition

?
?
17
Russian Federation - Economy

• Russian Trading System
• Created in 1994 Energy Index
• Largest Russian Electronic site uniting
  investment companies and banks
• Two large movements in history
• Rise by 1000 in 1996-1997
• Drop by 1000 in 1997-1998
• Based upon results of 1998, 2nd largest fastest
  rising index in world

18
Russian Federation - Economy

• Russian Trading System (RTS)

19
Russian Federation - Economy

• Ruble Crisis of 1997
• Initially triggered by Asian Financial Crisis
• Government defaulted on debt and lacked hard
  currency to pay out to citizens
• Plan to stabilize economy via currency
  devaluation failed
• As a result, amount of tangible goods in stores
  disappeared rapidly
• Despite problems, LUKOIL pre-tax profit higher
  then forecasted profits and production increased

20
Russian Federation - Economy

• Banking System
• Initial stabilization deprived banks of easy
  profits
• Central banks forced to keep other banks afloat
• Major banks had much capital but could not lend
• Government eager to deal with foreign banks, but
  they are wary
• Problems include lack of transparency and legal
  framework

21
Russian Federation - Economy

• Corporate Governance
• Rapid privatization led to series of scandals
• Early government attempts to fix issues have not
  met with success
• Managers beginning to realize
• benefits of Corporate
• Governance
• Government attempting new
• measures to curb issues

Vladimir Putin meets LUKOIL's President V.
Alekperov.
22
Russian Federation - Economy

• Inflation
• Post-Cold War, inflation stabilized at 11 in
  1997 (compared to 2500 in 1992)
• Financial collapse led to large increase in
  inflation, 6.4 to 84.5 in 1998
• March 2003 Inflation has begin to return to
  normal, forecasts expect to be no higher then 12
  for 2003

23
Russian Federation - Economy

• Tax System
• Burdensome and Complicated
• Tax evasion high in the 1990s
• Tax improvements have begun, but total reform
  still needed
• Recent changes include
• Flat Personal Income Tax 13
• Maximum Corporate Profit Tax down to 24 from 35

But in this world nothing can be said to be
certain, except death and taxes, even in Russia
24
Russian Federation - Oil

• Russia, Thee Oil Producer
• 10 of Worlds proven reserves
• 10 of World oil production
• 2001 348m tons, up from 1999 (305m) 2000
  (323m)
• LUKOIL 78.3 million tons 22.5 of Russian
  production
• 5 major Russian companies LUKOIL, Surgut
  Holdings, Yukos, Tatneft, Sidanco
• Lack of funds caused collapse in early 90s
• Development of new fields has increased

25
Russian Federation - Oil

• Russia, Thee Oil Supplier
• Strong growth has made economy highly dependent
• 2nd largest exporter of oil in 2001 (Saudi
  Arabia)
• Importance as supplier has put in conflict with
  OPEC
• Volatile domestic prices caused domestic
  companies to slow down
• Recent developments have led to new growth

26
Russian Federation - Oil

• Foreign Direct Investment in the Oil Sector
• Foreign investment has been slow to despite
  potential
• Deterrents Political instability, legal
  framework, governance, etc.
• Recent steps by government to liberalize foreign
  entry have improved relations
• BP Amoco Investment
• 2002 Purchase of 15 more of Sidanko USD 375m
• 2003 Expected purchase of 50 of Tyumen for USD
  6.75 billion

27
Valuation
Valuation

• Any oil company with as large of a production
  capacity and world presence as LUKOIL considers
  two eminent factors
• Production
• Capacity and recognition of probable oil
  production from development projects (Caspian)
• World Oil Prices
• OPEC production and reserves
• Russias current and future presence in the oil
  market
• Effects of the war with Iraq

28
LUKOILs strategic plans for the next 10 years

• Lower production costs
• Improve efficiencies in existing operations
• Production expansion in lower cost regions
  (Caspian, Middle East)
• Strengthen Netbacks
• Lower transportation costs
• Increase proportion of sales in international
  markets
• Improve quality of crude oil
• Increase Capital Expenditures to facilitate
  expansion

Capital Expenditures, exploration and investment programs Capital Expenditures, exploration and investment programs Capital Expenditures, exploration and investment programs
Project Completion Date Investment Amount (m)
Neftochim burgas AD 2005 84
Petrotel SA 2008 86
Russian Federation 2006 471
Iraq 2004 495
Caspian Region 2030 1,008
Total Expenditures   2,144
Good Things Come to Those Who Wait
29
Sales Projections Sensitivity Analysis

• Production
• Development of the Caspian Region expected to
  have largest effect on production
• Expected closing of 5000 unproductive oil wells
• Level of ownership of the license
• by Kazakhstan

30
Best Case Production Projections

• Closing of promised 5000 unproductive oil wells
• Optimal cost savings
• Will increase production
• level by 3 for 2002-2008
• Caspian Production
• Highest growth rate for
• 2002-2005 of 5 and
• 10 for 2005-2008
• Based on successful extraction
• and quick extraction of
• 3.3 billion barrels of extractable reserves

Overall Production Growth Rate 2002-2005
8 2005-2008 13
31
Intermediate Case Production Projections

• Closing of approximately 3,000 unproductive oil
  wells
• Moderate cost savings
• Will increase production level by 1.5 for
  2002-2008.
• Caspian Production
• Moderate growth rate
• for 2002-2005 of 4 and 7 for 2005-2008

Overall Production Growth Rate 2002-2005
5.5 2005-2008 8.5
32
Worst Case Production Projections

• Closing of unproductive
• wells is either too costly
• or unsuccessful
• No cost savings.
• No contribution to production level growth
• Caspian Production
• Lower end of projection growth rate for
• 2002-2005 of 3 and 4 for 2005-2008
• Based on slow and low level of extraction and
  higher level of
• ownership of the license
• by Kazakhstan

Overall Production Growth Rate 2002-2005
3 2005-2008 4
33
Sales Projections Sensitivity Analysis

• Oil Prices
• World Bank estimates
• Prolonged war and insufficient oil supplies
• Comparison to the results of the Gulf War
• Note Best Case Prices refer to optimal prices
  for world markets, assuming reduction and later
  stabilization. Under these assumptions prices are
  the lowest of the three scenarios, which in turn
  are least beneficial for LUKOIL.
• It Aint Over Till Its Over

34
Best Case World Prices (Worst Case Scenario for
LUKOIL)

• Based on World Bank Estimates assuming
• Short war with Iraq
• Few subsequent attacks on
• coalition forces
• Quick integration of new
• representative government
• in Iraq
• Increased OPEC production
• Increased growth in non-
• OPEC suppliers, with
• Russian being second largest
• world supplier.
• Emergence of North
• Caspian oil

35
Intermediate Case World Prices

• Comparison to the results
• of post Gulf War Oil Prices
• OPEC led by Saudis, increased production to calm
  oil markets but lacking reserves to offset post
  war non production in Iraq
• Large Iraqi oil fields will remain unproductive
• New supplies from West Africa, Caspian Sea, and
  Venezuela are not significant enough to affect
  oil prices
• New technologies fail to increase rate of
  production as estimated

36
Worst Case World Prices (Best Case for LUKOIL)

• Prolonged War and
• insufficient oil supplies
• Oil stocks remain tight into 2004
• Iraqi opposition will remain strong attacks from
  Iraqi forces from Syria
• Scud missiles with chemical war heads are
  launched at coalition forces
• Acts of sabotage and terrorism reduce oil exports
  from the Middle East

37
Sensitivity Analysis Overview

• Arrived at most likely scenario for LUKOIL
• Correlated production scenarios to oil price
  scenarios

38
Scenario Analysis Conclusion

• Most Likely Outcome Intermediate Production and
  Best Case World Oil Prices
• Why Intermediate Production
• The Caspian project will not be as successful as
  earlier predicted.
• Closing of 5000 unproductive oil wells will not
  be successful high operational and environmental
  costs
• Number of unproductive oil fields to be closed
  will equal breakeven volume
• Decreasing expenses and idle capacity
• Why Best Case World Oil Prices
• Lower demand for oil due to recession and slow
  economic growth
• Higher non-OPEC oil production (West Africa and
  Caspian)
• Release of reserves by OPEC to keep prices within
  target
• Past 20 years shown decline in oil prices at the
  end of war
• History repeats itself

39
Most Likely Scenario Graphical View of Projected
Revenues
40
Cost of Equity CSFB Model

• International Cost of Capital (CSFB) Inputs

International Cost of Capital (CSFB) Inputs International Cost of Capital (CSFB) Inputs
A (CV or RTS/ CV of SP) -0.439
CV of RTS 0.974
CV of SP -2.219
SY (Sovereign Yield) 0.034
Beta of RTSI 0.825
K (Adjustment Factor) 0.6
Russian Fed. Rf rate 0.17
Er-Rf 0.307
Brady Bond Yield-Semi-Annual 0.128
Brady Bond Yield-Annual Adj. 0.271
CV of Local Market Standard Deviation of RTSI/ Mean of RTSI  
CV of US Market Standard Deviation of SP/ Mean of SP  
International Cost of Capital
Er SYBEr-Rf)A K
Er .271.825(.307)(-.439) .6
20.43
41
Cost of Debt

• Cost of Debt
• Credit Spread Rating BB-
• BB- rating of 4.13 is average of B and BB
  ratings (4.75 and 3.5)
• Risk Free Rate 10.47
• Risk Free Rate for US 10 year T-bonds 3.95
• Risk Free Rate of the Russian GKO Ten Year Bond
  17.0
• Average of US Risk Free and Russian Risk Free
  Rate 10.47
• Cost of Debt Average Rf Credit risk spread
  14.61

42
Weighted Average Cost of Capital
WACC WACC
Cost of Equity 20.43
Cost of Debt 14.61
Market Value of Equity 10,412,500,000
Market Value of Debt 71,284,399,127
Market Value of Firm 81,696,899,127
Equity/Total Firm Value 12.75
Debt/Total Firm Value 87.25
Corp tax rate 24.00
WACC(E/V)re((D/V)(rd)(1-T)) WACC(E/V)re((D/V)(rd)(1-T))
WACC 12.29 WACC 12.29
43
Cash Flow Analysis (Free Cash Flows to the Firm)

• Net Income
• Revenue Based on production minus reserves (9
  of annual production) in Scenario 4
• Operating Expenses 1.5 yearly reduction
• SGA 15 annual increase due to increased
  exports
• Depreciation, depletion and amortization 5
  historical annual increase
• Excise and Export Tariffs 30 annual increase
  due to increase in exports
• Interest Expense 15 historical annual increase
• Corporate Taxes Reduced from 35 to 24 in 2002
  per government tax reform.
• Capital Expenditures
• 30 annual increase based on projects in progress
• Changes in Networking Capital
• Growth in current assets and liabilities
• Annual growth in current assets based on Yukos
  financial statements
• Growth in current liabilities of 21.2 based on
  historical data
• Reduction in networking capital as projects
  approach completion dates

44
Free Cash Flows to Firm Analysis Major Highlights

• Free cash flows decrease from 2003 due to
  increase in Capex in short-term projects
• Revenue from short-term projects will not be
  realized till 2010
• Revenue from long-term projects (Caspian) will
  not be realized till 2032
• By discounting annual FCFF by Cost of Capital
  (11.41), firm value equals
• 52,627 million USD.

FCFF Analysis FCFF Analysis FCFF Analysis FCFF Analysis FCFF Analysis FCFF Analysis FCFF Analysis FCFF Analysis
  2002 2003 2004 2005 2006 2007 2008
Net Income 17,701 18,168 14,289 13,785 10,835 11,020 10,917
Depreciation, depletion and amortization 930 977 1,026 1,077 1,131 1,187 1,247
Capital Expenditures -1,059 -1,482 -1,927 -2,505 -3,256 -4,233 -5,503
Changes in Networking Capital -73 -149 -249 -379 -547 -761 -1,034
Free Cash Flows to Firm 15,785 15,858 11,585 10,582 6,994 6,361 5,201
Growth Rates   0.47 -26.94 -8.66 -33.91 -9.06 -18.24
Discounted Cash Flows at Cost of Capital (12.29) 14,152 12,768 8,429 6,939 4,223 3,489 2,628
Value of Firm   52,627 (in million of USD) (in million of USD) (in million of USD)    
45
Free Cash Flows to Equity Analysis

• Proceeds from New Debt Issues
• Based on maturing debt and current debt ratio
• Preferred Dividends
• As per Russian Federal Law, 10 of net income

• New Items
• Principal Repayments
• As projected by LUKOIL, maintaining current debt
  ratio (87)

FCFE 2002 2003 2004 2005 2006 2007 2008
Net Income 17,701 18,168 14,289 13,785 10,835 11,020 10,917
Depreciation, depletion and Amortization 930 977 1,026 1,077 1,131 1,187 1,247
Operating Cash Flows from Operations to Equity 18,631 19,145 15,315 14,862 11,966 12,208 12,163
- Capital Expenditures -1,059 -1,482 -1,927 -2,505 -3,256 -4,233 -5,503
- Principal Repayments 478 799 208 424 374 143 143
Proceeds from New Debt issues 750 1,254 327 666 587 224 224
- Changes in Networking Capital -73 -149 -249 -379 -547 -761 -1,034
-Preferred Dividends 211 1,770 1,817 1,429 1,379 1,083 1,102
FCFE per year 19,824 19,462 15,792 16,559 14,603 16,200 17,680
Discounted FCFE (Cost of Equity 20.43) 16,461 13,419 9,041 7,872 5,765 5,310 4,812
Value per Share (estimated) 73.69
Current Price (LUKOY.PK As of Friday close) 62.50
Percent Undervalued 18
46
Conclusion and Recommendation

• The Country
• Russia will experience a Renaissance, given
  successful policy implementation and monitoring
• Russian oil industry expected to become a
  dominating force in the world markets
• The Company
• LUKOIL is a lucrative long-term investment
• Maintaining of its market share and strategic
  alliances, probable future reserves will equal
  proven current profits
• --------------------------------------------------
  -----------------------
• What Professor Mei will realize in capital gains
  if he invests 1,000,000 is 179,040
  Dividends!!!

Early Bird Gets the Worm
47
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