Arrest and detention of Khodorkovsky cools the anticipation of merger.

As of the end of October the press speculation concerning a possible deal involving Yukos and a western oil company has cooled off considerably. The issue in our view is how serious are the long-term implications of the arrest of two key shareholders of Yukos and the freezing of their shares by the government? We think the greatest danger for investors at the moment is over reaction.

Is it likely that the Russian government has simply lost all sense and sensibility? Is it likely that this is the beginning of a re-nationalization of the Russian oil and gas production sector?

We believe that the answer to both those questions is "no." But, the best answer is "wait and see." Our rationale is as follows. We recognize that this is election season, and that some actions by the government are driven by the desire to mold desired election results. This happens in any democratic country, more in some, less in others. Our impression of President Putin is that he is not given to rash, visceral decisions. There is a logic to what is happening. That logic may, or may not, be threatening to the future for private investors in Russia, be they domestic or foreign. That leads us to the second question.

Is this the beginning of re-nationalization of the oil sector in Russia? We suspect not. Any logical examination of the development priorities and capital constraints facing the Russian government would indicate that re-nationalization would be self-destructive. Are these logical times? Yes, except for the elections. Therefore, we conclude it is best to wait until after the elections to see how this plays out. Although there may not be an optimistic future for Mr. Khodorkovsky, and we don't know that, we do believe that Russia is on an irreversible (but winding) path that will continue to require active private investor support. Perhaps the government (like all governments) needs to be reminded of that from time to time, and the markets will take care of that. But, the end-game is clear. A return to totalitarian, state control is simply not in the cards.

Previous comments on the Yukos merger possibilities are maintained below because we believe they will return to relevance in the near future, although perhaps in a different form and with different parties.

Yukos: Rumors persist of some kind of merger with a western major oil company

As of October 3, the rumors have accelerated and focused more around ExxonMobil than around ChevronTexaco. An article in the Financial Times suggests that ExxonMobil has raised the stakes by offering a higher price for a larger stake: 40% for $25 billion. This clearly raises the stakes in the game, but is still less, in terms of price, than the rumored $18.6 billion offered for 25% plus one share reported offered by ChevronTexaco in the Moscow Times recently. Our earlier analysis regarding those earlier rumors and reports are below. We caution that these are still only press rumors. But, where there is smoke, is there also fire?

There has been press speculation around September 15th (Wall Street Journal and Russian press) that both ExxonMobil and ChevronTexaco were seeking to one-up the TNK-BP deal by taking a 25% plus one share stake in Yukos-Sibneft for around $12 billion (rumors on September 18 are flying that the price is now $18.6 billion). Although everyone has since denied such reports, we take the denials for what they are worth - nothing. It would seem that a new "Resources Boom" is in the making and the mega-majors don't want to get left behind. We would also expect that Shell is looking around as well.

While everyone is looking at the implications of a foreign mega-major taking over the largest Russian major, we are also intrigued by the other side of the coin. What does this mean for the mega-major that "takes over?" The press speculation also hinted that Yukos might accept some kind of stock deal, at least for partial payment. The suggestion has been that 50% of the $12 billion price tag could be paid in stock. What would a $6 billion or more shareholding mean?

In the case of ExxonMobil, whose market capitalization is $250 billion, it would be about 2.5%. While this could be important in any contentious matter before the shareholders for a vote, it is nowhere near effective influence.

But, in the case of ChevronTexaco it is far more significant. ChevronTexaco's market capitalization is about $80 billion, so a $6 billion slice of shares comes to 7.5%. If the deal were done entirely with stock, the influence becomes palpable at 15%. Somewhere in between the Yukos block would start to exercise some real power over the management. Clearly, a deal with ChevronTexaco includes a board seat. ChevronTexaco's "poison pill" provisions kick in at 10%, so we would expect this to be an item of negotiation in any merger discussions.

What would a YukosSibneft (plus ˝ Slavneft) linkup with ChevronTexaco look like? The resulting entity would be huge by any measure. According to its own press release announcing the YukosSibneft hookup, the reserves would be around 19 billion barrels of oil and gas (Bboe)(SPEš methodology, not SEC). According to other sources, using SEC criteria YukosSibneft will have about 12.7 billion barrels of oil (including condensates and natural gas liquids, but not including natural gas). This is more than is stated for either Shell or ExxonMobil (10.1 and 11.8 billion barrels respectively). Add in whatever portion of YukosSibneft would get of Slavneft's 1,600 million barrels (SPE basis) and you have a truly large firm to start with. Then, add in ChevronTexaco's 8.7 billion barrels of oil (also including condensate and natural gas liquids), and you have what could certainly be classified as a truly large oil company. Combined production, using 2002 numbers, would be in the range of 3.7 million barrels per day, or more than any of the privately held companies in the world. Add in Slavneft and the combination comes close to 4 million barrels of oil per day or about 200 million tonnes per year.

If either ExxonMobile or ChevronTexaco paid $12 billion for a 25% stake, looking very simplisticly at it, the buyer would be getting proven reserves for around $4 per barrel. Compared to finding costs for other oil companies in other parts of the world of $10, that is not a bad deal, even considering "Russian risk" (see below). And, the 2,500 or so retail petrol stations YukosSibneft has in Russia come along "for free." It is no wonder that rumors are flying. Such a merger would have world-wide implications for the oil industry and the world's economy and balance of "petro-power."

But the question remains, in the case of Chevrontexaco, who would control whom?

What about second tier international firms?

Does this mean that the days of opportunity for second tier oil companies to enter the Russian market are over? So far, the second tier companies (such as Devon, Apache, Anadarko, etc) seemed to have eschewed Russia. Their risk aversity for the Russian political and economic scene seems to have kept them away. But, with the mega-majors seeming to put up an umbrella of increasing size and integrity, the time will come when they will want in. Will it be possible?

Pan EurAsian believes it will be possible, but will take some clever work. The longer one waits, the smaller the "Russian discount" will become bringing acquisition cost per barrel up to parity with other less risky places in the world. In short, the price per barrel has been slow to catch up with what we believe to be a more realistic perception of Russian risk. But, a mega-merger or two more, and Russian reserves will be at a premium, not a discount.

We would be happy to work with a client who wishes to pursue that question as we have some ideas how this can be done. We welcome your inquiry, which will be received in confidence. Please contact us by email, or by fax at +1 401 633 6246 or by telephone at +1 401 284 0785.

Note 1: SPE = Society of Petroleum Engineers

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revised September 18, 2003