What exactly are investors paying for in the upcoming Rosneft IPO: oil reserves and production, or a political fashion show? How did a company which had an estimated value of just $8 billion in mid-2005 – just before it acquired Yukos’ Yugansneftegas for $11 billion and the big debt that came with the acquisition – come to make a $14 billion partial public offering that presumes a company valuation of some $60 billion?

In 2005, Rosneft’s revenue was $24 billion. If Rosneft were a publicly traded oil company in the U.S. its market capitalization would be approximately equal to its annual revenues. However, if analysts are correct, Rosneft’s market capitalization after the IPO may be up to $110 billion, or about four times the price of a comparable U.S. company. Given Russia’s punitive taxation regime and Rosneft’s debt load, this valuation borders on the absurd. The most important part of the debt load comes from Rosneft’s purchase of nearly 11 percent of Gazprom – a deal which required the company to pledge half of its future profits to service the debt.

The IPO is supposed to privatize some very attractive fields and resources. Those fields are less attractive now that they’re controlled by the state, but they are still alluring.

Over two-thirds of Rosneft’s current oil production comes from Yukos’ main asset, Yuganskneftegas. That asset was forcibly ripped from the embattled Yukos to settle part of a crushing $33-billion back tax bill. The business unit was bought by a totally new outfit called the Baikal Finans Group, in a shady sole-source auction for $9.3 billion as part of the campaign against Yukos’ CEO, Mikhail Khodorkovsky. This asset has been well advertised to international investors by Yukos and no additional explanations about hidden resources in Rosneft are necessary.

But there are legitimate concerns about Rosneft’s real value, given the company’s financials and legal exposure. What exactly has Rosneft done to bring about such a huge increase in market capitalization? Rosneft was valued at $8 billion before the Baikal Finans $9.3-billion Yuganskneftegas rip-off. So simple math would put Rosneft’s value around $17 billion. Reserves-based valuation – assuming that Rosneft’s proven reserves are 12 billion barrels of oil equivalent – makes the company’s actual value a bit over $34 billion. Compare this to Lukoil, for instance, which booked 20.6 billion barrels and reached market capitalization of $55 billion.

Two loans (total: $13.5 billion) and legal risks of Rosneft being sued in American and Dutch courts by Group Menatep – which was Yukos’ holding company – could drastically reduce Rosneft’s valuation. Litigation may take ages to settle. Despite its 10 percent share in Gazprom (which has been showing healthy profits), Rosneft is unlikely to have as good a balance sheet. Rosneft’s primary profits are derived from oil sales, while Gazprom’s come from gas transportation. Rosneft’s only source of profit increase is in oil production enhancement and cost-cutting. But this approach requires efficiency, which has been lacking throughout its entire history. Over the years, Rosneft’s organic growth has been flat to lacluster. And the sharp increase in 2005 was primarily due to the unseemly acquisition of Yukos’ main asset, Yuganskneftegas, with 390 million barrels a year.

Rosneft’s History

1993: Rosneft created by USSR Ministry of Oil and Gas.
2000: Rosneft increases production, begins revitalization of Chechen oil fields.
2001: Rosneft becomes the Russian government’s representative in the Sakhalin PSA projects.
2002: Rosneft buys license blocks in Algeria, Colombia, and Khazakhstan.
2003: Rosneft buys Severnaya Neft production unit with 10 million barrels of oil production per year.
Dec. 2004: Rosneft acquires Yuganskneftegas
Jul. 2006: Rosneft IPO

Rosneft’s Indebtedness

Jan. 2005: $6 billion debt under the short-term loan agreement with CNPC to buy BaikalFinans.
Sep. 2005: Rosneft’s parent, Rosneftegaz, takes on a $7.5 billion loan to purchase 10.74 percent of Gazprom, by pledging profits derived from 49 percent of the income from Rosneft shares.