08.06.2012
ART CAPITAL: GAS PICKS - GAINS FROM STALLED GAS TALKS

The gas price in Ukraine is a key factor determining the value of private gas-extracting companies. The gas price formula is defined by a 10-year contract signed by Ukraine (NJSC Naftogaz) and Russia (OJSC Gazprom) in 2009. Ukraine imports gas from Russia at USD 425/Mcm, but has been trying to revise the contract price for over a year. Such a high price allows Ukrainian gas extracting companies to operate with a minimum gross margin of 60%, making Ukraine's gas market quite attractive to investors.

The high gas price undermines the competitiveness of Ukraine's industry, so the government has been trying for over a year to talk Russia into revising the contract and lowering the gas price. We expect Ukraine to get Russia to cut 10% off the gas price for 2H2012 and factor into our valuation a USD400/Mcm average contract gas price for 2012 and its decline to USD380/Mcm in 2013, while assuming Brent price to remain little changed around USD110/bbl in the next five years.

JKX: The Russian connection. JKX can increase extracting volume by 50% from 9.1 Mboepd in 2011 to 13.5 Mboepd in 2013 due to a new well in Ukraine and the start of gas extraction in Russia at the Koshekhablskoye field. The latter alone can provide 3500 boepd in 2013. The Ukraine's high domestic gas prices and prospects of extraction volume growth are not yet fully incorporated in the stock price, implying an upside in the next 12 months.

Regal: The Smart story. Regal Petroleum came close to shutting down in November 2010 after stopping extraction at Ukrainian fields when Ukraine's Environmental Protection Ministry suspended the company's Ukrainian licenses. However, Vadym Novynsky's Smart Holding bought a controlling stake in Regal in March 2011 and managed to restore the license using his political power. As a result, extraction was renewed in mid-2011, and this year we expect production to grow 2.8 times year-over-year to 720 Mboe.

Risks. (1) a decline in domestic gas prices if Ukraine and Russia revise the gas contract; the revision is possible if Ukraine accepts all or some of Gazprom's conditions; (2) an increase in oil and gas extraction royalty; (3) world oil price fluctuation.

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