Russian oils consolidation: Start of round three

Implications for the sector. It remains to be seen whether a new model of cooperation between NOCs and IOCs promoted by Russia will be successful. To avoid the mistakes of countries such as Venezuela or Mexico, the Russian state needs to create incentives for state companies to learn from their global partners, which will happen naturally if the former's strategy is based on shareholder value rather than scale and power. In that case, investors can also remain confident that their interests are well protected. Following a multi-year de-rating of Russian oil companies, the Russian oil sector is now back at valuation levels which were last seen at the start of the 2000s when the previous M&A wave started. Therefore we see a good opportunity to recapture almost $500bn of lost value through a new M&A wave, but the ability of minority investors to share this upside may be less in Russia than in western markets as the protection of minority rights and the general level of corporate governance in Russia are lower.

Our preferred exposure to the new trend would be through what we see as undervalued private companies with strong balance sheets such as Lukoil (BUY, TP: $88/GDR) and Surgutneftegas preferred shares (BUY, TP: $1.3/preferred share). While we see upside potential for Rosneft in a future deal with TNK-BP (from up to $15bn value of potential synergies and simple 20-30% earnings accretion in 2013), first we think that the 17% jump in the share price over the past two months largely reflects potential gains and second we are not fully convinced how much value Rosneft can eventually extract from this deal and more importantly how much of this value will be shared with minorities. The recent expansion of its presence in Venezuela, its commitment to at least four new refineries in Russia and China, and the fact that its core assets are peaking and may face various operational issues in the near term, indicate to us that the company may prioritise scale over anything else which is a typical factor determining strategies of state-owned companies. We also maintain our cautious view on TNK-BP Holding (HOLD, TP $2.3/share) as we see risks that future capital allocations will have to prioritise servicing debt over dividends. We also think that the change in ownership and possibly corporate structure at TNK-BP may lead to operational issues at the company due to a possible lack of focus of the new management team.