Should you invest in Russian gas?

Plans to list Russian gas and oil giant Rosneft on the London Stock Exchange have proved highly controversial. But have the Rosneft IPO risks been over-exaggerated?

Russia has plenty of what Europe lacks gas, and this is generating plenty of heat at the moment. The planned IPO of Rosneft (Russia's third largest oil & gas producer) is attracting even more controversy than other recent, large listings such as PartyGaming and Kazakhmys. As with all these "new" companies corporate governance and their recent history are not an ideal starting point for an IPO.

An issue for the UK is its over-dependence on gas as a source of energy and it needs to find new supplies (not helped by the UK government imposing additional taxes on national oil companies) as well as developing alternative energy sources.

One outcome is that the UK may have to deal with Gazprom (Russia's giant gas company). This is creating more anxiety and controversy but history suggests that the future holds more opportunities than bear traps for investors.

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Russian gas: Russian IPOs in London

The first Russian IPO, VimpelCom, listed on the New York Stock Exchange in 1996, but the introduction of the Sarbanes-Oxley legislation means that more recent US listings have become more difficult and expensive. At the same time, the London Stock Exchange has been proactive in developing its own relationships with Russian Stock Exchanges, so that London now appears to be the preferred destination for IPOs.

The result is that Russian IPOs in London raised almost $5bn in 2005, which was more than the last five years. Prominent fund raisings included $1.3bn by Sistema (telecoms provider), $0.6bn by Pyaterochka Holding (one of Russia's largest supermarket groups) and $0.4bn by Evraz Group (Russia's largest steel maker).

There remains a large pipeline of companies seeking to increase liquidity and raise extra capital in the London market, with some reports suggesting there could be between 20 to 100 Russian companies seeking a listing. The sum raised in 2006 could therefore rise considerably. Comstar has already raised $1bn this year, but this would be dwarfed by the impending IPO of Rosneft which could raise $10bn (downsized from an expected $20bn).

Russian gas: Rosneft and Gazprom cause a stir

The size of the Rosneft IPO and its involvement with natural resources brings more attention to some common problems with emerging market IPOs i.e. corporate governance and legal issues.

Although complaints about Rosneft's recent history may be valid, they should not be exaggerated. Primarily, equity investors should be focused on the fundamentals of the business and its valuation.

Also, recent comments about Gazprom's actions with regard to restricting European gas supplies look over-blown. Following the listing of Gazprom's ADRs, the market value of the Group has increased to $190bn and it is rated on a 12x PER. In order to grow earnings, Gazprom needs to succeed in international markets which means selling some of its huge gas supplies to Europe and Asia.

Within this context, Gazprom is targeting the UK market. In late April, Centrica's share price rose after the Labour Government said "we welcome companies who play by the rules and want to operate in our competitive, liberalised market". If Gazprom desires to accelerate its penetration of the UK gas market, this policy clarification is welcome.

Russian gas: do the opportunities outweigh the threats?

Following the collapse of communism some Russian companies have moved fast to catch up with western rivals and clearly this raises governance and legal issues. Nevertheless, the listing of Rosneft should be a positive factor, leading to more accountability not less.

For Rosneft, possibly the largest potential risk remains the threat of decline in the oil price but with Iran heading towards a showdown with the United Nations, geopolitical events are likely to keep the oil price high. Rosneft will have a superior production growth profile to most western oil companies with plans to double its production by 2015. Also, it has enviable reserves on its doorstep providing lower development costs than western oil companies.

The downsizing of the IPO is due more to the company's own needs (i.e. it has strong cash generation) rather than outside pressure. The Offer will come at an interesting juncture because of the wave of Russian IPOs to follow.

As far as Gazprom is concerned, it has been supplying gas to European countries for many years and it has every incentive to secure further supply contracts in order to monetise its large reserves of over 100bn barrels of oil equivalent.

By Jeremy Batstone, Director of Private Client Research at Charles Stanley