A brief review of the Gazprom/Rosneft merger

Present information (June 19) is that it has been agreed that the government will pay Gazprom $7.15 billion for 10.74% of Gazprom's shares. This transaction will be registered before the annual shareholder's general meeting on June 24. (Note: The transaction was endorsed at the general meeting. Gazprom has announced that the transaction has been completed.)

The plans of the Russian government to create a super-sized, national champion oil and gas company have all but collapsed amid confusing plans, chaotic implementation and opaque actions. The information below tells the story. The status as of the beginning of June 2005 is this. The government has created a new holding company called Rosneftegaz which will hold the government's shares of both Rosneft and Gazprom. The 10.74% stake in Gazprom's shares that the government wants to acquire to raise its holdings to 50% plus one share is valued by the government at $6.5-7 billion. Rosneftegaz will partially privatize Rosneft to pay for the shares in Gazprom. So, from a government control standpoint, the end result is more or less the same as merging Gazprom and Rosneft. From the standpoint of managements, especially the Rosneft management, there is a big difference. Both managements get to keep whatever degree of independence they thought they had before the transaction was done. Maybe.

The Russian Federal Property Management Agency (Rosimuschestvo) on June 1 transferred its shares of Rosneft to the new company: Rosneftegaz. The government has also stated that all the steps necessary for the government to acquire the Gazprom shares (10.74%) it has decided to buy will be done by June 14 and the transaction will be completed by the time of the Gazprom annual shareholders meeting on June 24. Thus, the government seems to have all but accomplished its initial intention to increase its shareholdings of Gazprom to 50% plus one share.

Nonetheless, a number of questions remain. Rosneft has become an effective "poison pill" with the debt burden it incurred to buy Yuganskneftegaz from Yukos at the tax auction described below. That transaction is swimming in law suits. Can Rosneft actually sell shares successfully to the public? Once the two companies come under common holding company ownership, will the holding company management seek to assert control and gradually combine the enterprises? Will Gazprom remember that it is a national gas company with a responsibility to provide gas to the markets and forget its many diversions? With even more government contol than before, and a whole new political bureaucracy (Rosneftegaz) in the making, the temptations to use the combined pot for political purposes can only increase. We can only wait and see.

It also seems to us to be a lot of fuss about very little. In fact, the shares the government is "buying" are being acquired from subsidiaries of Gazprom that hold shares in Gazprom. Since Gazprom controls those subsidiaries to start with, and the government already had the dominant voice in Gazprom's affairs, the whole transaction seems only to clarify an existing reality: the government controls Gazprom. In our opinion very little will improve for Gazprom until the government lets go.

Included for Background

The "end of January" has come and gone as a target to complete the proposed merger of Gazprom and Rosneft. That was the original plan. Now, the target date is the end of June. The Rosneft debt-financed acquisition of Yuganskneftegaz has clearly thrown the process off balance. Internal squabbling in the Kremlin gives this merger an on-again off-again character that is difficult to follow. Recent reports suggest that everything reported below is off the table, that Rosneft may retain Yuganskneftegaz and that Gazprom may get a smaller share of Rosneft, Rosneft would remain a separate entity, still controlled by the government. But, Gazprom might still acquire enough of Rosneft in a stock swap to put government ownership of Gazprom at the 50% + one share level. This latter point seems to be the one agreed-upon objective, to give the government control of Gazprom. Whether or not Rosneft remains and independent entity and controls Yuganskneftegaz, or Rosneft becomes a subsidiary of Gazprom with Yuganskneftegaz becoming a separate government-owned company, seems to be a matter of bitter, bureaucratic debate.

Another possibility has been introduced into the rumor mill in early May. The Russian government is looking at simply buying a 10.7% share of Gazprom stock, leaving Rosneft to sort out its problems by itself. This would seem to be the least likely solution as it abandons the National Champion concept, puts Rosneft (100% owned by the government) at serious risk of insolvency by leaving the entire issue of Yuganskneftegaz acquisition debt unresolved. The Russian government seems to have gotten itself into a terrible "lose-lose" situation over this, and seems now to be looking for an escape route.

The most specifically described version of the deal would have Gazprom issue 10.7% of its shares in return for the government's shares of Rosneft. Since the government owns all the Rosneft shares, this would achieve the government's objective of gaining over 50% ("50% +one share") of Gazprom's shares while giving Gazprom almost complete ownership of Rosneft. The target for completing the merger is set for the end of June. It now seems clear that Yuganskneftegaz will not be a part of the merged enterprises, but will be spun off by Rosneft as a separate, government owned company. We suspect that a big part of the problem with the merger is deciding what to do about the debt that Rosneft took on to buy Yuganskneftegaz from Yukos at the tax auction. For reasons described below, Gazprom may be strongly resisting accepting that debt as part of the deal.

The government appears to be standing by its commitment to liberalize the trading of Gazprom's shares once the merger has been effected.

Older Background

Gazprom had indicated that it wished to acquire Yuganskneftegaz (see below) at an auction in December 2004. Ostensibly, those plans were derailed by an end run by Yukos going to a US court in Houston and getting an injunction against dismantling of Yukos. The story then was that the banks that had agreed to finance Gazprom's acquisition of Yuganskneftegaz had backed out for fear of getting cross-wise with the US court system. However, recent events suggest something a little different.

Rosneft was already heavily in debt. Gazprom faces enormous capital requirements for its own needs, nothing to do with either Rosneft or Yuganskneftegaz, but everything to do with replacing gas production with new reserves and maintenance of an effective gas transportation infrastructure. Is it possible that the banks may have raised the question that raising money to finance those needs based on a post-Rosneft + Yuganskneftegaz balance sheet would be very difficult if not impossible. If so, then Gazprom may have backed away from acquiring Yuganskneftegaz, using the US courts as an excuse, in order to preserve its ability to perform its core business obligations.

At the same time, some members of Rosneft's management were very unhappy about being folded into Gazprom, and seized upon the acquisition of Yuganskneftegaz as a "poison pill" to derail the Gazprom/Rosneft merger. Whether or not that is the case, the result is the same: the merger has problems. It seems that the government would now like to find a way to go ahead with the merger anyway, but leave Yuganskneftegaz out of it. This creates an almost impossible situation: what to do with Yuganskneftegaz?

There are no easy, or good, answers to that question. Here are the problems:

There are others waiting in the wings to take a piece of Yuganskneftegaz in case Rosneft decides to go ahead with buying that piece of Yukos and the Rosneft/Gazprom merger is called off. There are both foreign and Russian suitors. This may be the most practical, but also most embarressing, solution for the Russian government. Rosneft would emerge as a much larger, albeit heavily indebted, state-owned oil company. Gazprom would be free to going back to concentrating on its core business (to which Rosneft brings very little anyway) with a strong balance sheet. However, the driving motivations in this entire scene seem to be political, not commercial. Given the embarressment to the Russian government of adopting this scheme and the intense political nature of the whole thing, we doubt such a solution would emerge. But, economics may force it, so we do not dismiss it.

There seem to be practical issues standing in the way of the government's preferred scenario at the moment, which appears to be merging Gazprom with Rosneft and spinning off Yuganskneftegaz as a separate, state-owned, entity. The main barrier is that Yuganskneftegaz as a free-standing entity has no commercial management structures. Yukos retains the commercial structures to transport, market and refine the Yuganskneftegaz production. While not insurmountable, this is a considerable obstacle to a quick fix.

Pan EurAsian will continue to watch this situation as it develops. Special client briefing services are available to follow this more closely on a proprietary basis. Please contact us for further information.

FURTHER BACKGROUND
The following describes the government original intentions in the planned merger of Rosneft into Gazprom. At present, the Russian government owns about 38% of the shares of Gazprom, the rest are publicly traded. However, it has been the present government's apparent intention to do the following with Gazprom:

The sale at a tax auction of the largest unit of Yukos, Yuganskneftegaz (from which Yukos derived part of its corporate name) was conducted in December. Despite a last-ditch effort by Yukos to use the US bankruptcy laws and a court in Houston, Texas, to forestall the sale, the auction went on as planned. However, the original intent of having Gazprom acquire Yuganskneftegaz through a new, special subsidiary company was evidently derailed by the issuance of a restraining order by the Houston court against any sale of Yukos assets by anyone. Instead of flaunting this overtly, a scheme was developed whereby a presumably new and never-heard-of-before company (Baikal Finance Group) was the sole bidder at the auction, and acquired 76.79% of the Yuganskneftegaz stock for $9.37 billion.

Subsequently, Rosneft absorbed Baikal Finance Group in a transaction that has not been clearly documented to the public. It was also not clear who would pay the $9.37 billion for Yuganskneftegaz, or how this will be done. Press indications are that Rosneft does not have sufficient resources to pay such an amount.

The next step was due to happen before the end of January. Rosneft would transfer all its assets (and liabilities?) into a subsidiary company of Gazprom, and would be paid for that transaction in Gazprom stock. The Russian government is 100% owner of Rosneft. Then Rosneft would be liquidated and the Gazprom shares acquired by Rosneft would be transferred to the Rosneft shareholder in return for the Rosneft shares. In this way, the Russian government could increase its share of Gazprom shares to over 50%, giving it effective control of the company. The government has also said that once all this has been done, that the limits on foreign ownership of Gazprom would be increased, but not eliminated.

In this way, the Russian government would create a new, super-major, National Champion that Russia hopes can stand toe-to-toe with the international oil majors and set the pace in the future development of both the oil and the gas sectors in Russia.

2005 Pan EurAsian Enterprises, Inc.

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As of June 23, 2005