Q2 & H1 2012 Novatek OAO Earnings Conference Call (IFRS)

NVTK.MZ - Novatek PAO
Q2 & H1 2012 Novatek OAO Earnings Conference Call (IFRS)
Aug 14, 2012 / 01:00PM GMT 

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Corporate Participants
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   *  Mark Gyetvay
      OAO NOVATEK - CFO

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Conference Call Participants
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   *  Geydar Mamedov
      Goldman Sachs - Analyst
   *  Karen Kostanian
      Bank of America Merrill Lynch - Analyst
   *  Igor Kurinnyy
      ING - Analyst
   *  Artem Konchin
      JPMorgan - Analyst
   *  Denis Demin
      BFA - Analyst

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Presentation
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Unidentified Company Representative   [1]
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 Hello, everyone, and welcome to NOVATEK's Second Quarter Results Conference Call. My name is Alex (inaudible), and I would like to introduce Mark Gyetvay, the Company's CFO and member of the board.

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 Mark Gyetvay,  OAO NOVATEK - CFO   [2]
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 Ladies and gentlemen, shareholders, and colleagues, good evening, and welcome to our second quarter 2012 earnings conference call. I would like to thank everyone for joining us this evening and again extend our sincere gratitude to Troika Dialog for organizing and hosting our earnings conference call.

 Before we begin with the specific conference call details, I would like to refer you to our disclaimer statement, as is normal practice. During this conference call, we may make reference to forward-looking statements by using such words as plans, objectives, goals, strategies, and other similar words which are other than statements of historical facts. Actual results may differ materially from those implied by such forward-looking statements due to known and unknown risks and uncertainties and reflect our views as of the date of this presentation. We undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events.

 Please, refer to our regulatory filings, including our annual review for the year ended December 31, 2011, as well as any of our earnings press releases and documents throughout the past year, for more descriptions of the risks that may influence our results.

 The second quarter was a very volatile quarter for many non-controllable reasons, but, nonetheless, we continued to demonstrate the resiliency of our business model, as well as our ability to create new market opportunities for our hydrocarbon products.

 During the quarter, the Russian ruble depreciated 11.9% relative to the US dollar, resulting in a substantial swing from a noncash foreign exchange gain in the prior reporting period of RUB1.1 billion to a noncash foreign exchange loss of RUB5.3 billion, or a change of roughly RUB6.4 billion, which negatively impacted our net profit for the current reporting period. If we exclude this noncash foreign exchange gain and loss from the respective reporting periods, we actually achieved a 10.3% increase in our net profit attributable to NOVATEK's shareholders versus the corresponding reporting period.

 There was also a significant weakening in the underlying benchmark crude oil prices using a contracting pricing formulation for our stable gas condensate volumes sold on international markets of roughly 10% year on year and 13.5% quarter on quarter, combined with an increase in both our export duties and transit port expenses for both periods. As a result, our average net-backs were generally weaker for all of our liquid sales lines sold on international markets, which I will return back to a little later in my presentation.

 Against this weak macroeconomic background, the financial results we achieved in the second quarter 2012 were somewhat mixed but relatively stronger than the overall comparative results achieved by our peers in the oil and gas sector.

 More importantly, however, we achieved strong production growth for our natural gas throughout the first half of 2012, trending much higher than our original production guidance for the year. As a result, we anticipate better financial results and cash generation throughout the remainder of the year, sans a complete collapse in the commodity pricing markets, on continued, strong production growth, a good sales mix between end customers and wholesale traders, and the benefits of the recent domestic tariff increase for natural gas effective July 1.

 Before I discuss the financial and operational results, I would like to begin tonight's conference call with my usual update on important news flows to our investors and analysts.

 I can formally confirm this evening that we have executed our first commercial contract to sell natural gas on the European markets with the conclusion of a contract with EnBW in Germany, which will commence in the fourth quarter this year for approximately 2 billion cubic meters of natural gas per annum with a contract duration of ten years. This agreement is purely a commercial trading operations between NOVATEK Gas and Power and the counterparty, and we will begin our initial process to create a consumer market for our natural gas and LNG in Europe when production and sales commences, as well as establishing a market position when legislative changes are eventually made to the export natural gas.

 We will continue to appraise the investment community on our ongoing, international commercial marketing efforts on future conference calls. But, as a normal course of business, we don't disclose specific terms and conditions with counterparties; nor will we speculate on potential future events.

 For our Yamal LNG project, we don't have any new news to report at this particular time regarding partner selection, but I can confirm that we are in discussions with a consortium of Indian companies for a potential stake in the project. One of the potential consortium members has already made this information public, and, according to a press report, a decision may be made within the next two months. We continue to work closely with interested parties, conducting due diligence, but this process is, obviously, time-consuming and will only conclude once the thorough process is completed.

 As for the project itself, we are moving forward as planned, and we are now in the engineering and procurement contract stage, or EPC, and we expect to begin receiving EPC proposals by yearend from potential contractors.

 In addition, the Russian government has agreed with our work program at the port of Sabetta and has recently announced their commitment to finance the cost of the port construction. Accordingly, we commenced work activities at the port. During the period, we continued ongoing work activities on the construction of housing for workers, the field depot, communication infrastructure, and a landing strip for an airport. Project documentation for the airport in Sabetta has been completed, and this information has been handed over to the relevant government agency for review.

 In addition, ROSATOM has recently signed an agreement with Atomflot for the construction of a new, 60-megawatt, dual-draft, nuclear icebreaker that has the capabilities to navigate and operate in the Gulf [of Ob], which is expected to be completed in time for our production launch.

 In addition to ongoing construction activities, the commercial marketing team of Yamal LNG completed their initial marketing road show and is conducting preliminary discussions with potential LNG buyers. We expect the process of executing concrete purchase and sales contracts to gain more traction once we make the final investment decision, which is expected towards the end of 2012 or, possibly, early 2013.

 We continued to solidify our market position in Russia by executing new, long-term contracts with end consumers for the delivery of natural gas covering ten years or longer, a new record for the Company in terms of contractual duration. During the quarter, we executed new supply contracts with MMK (inaudible) via NOVATEK Chelyabinsk, which demonstrates the importance of maintaining a close dialogue with a consumer base, as well as a commercial presence in the regions.

 Another primary area of focus is our strategic commercial plans to expand our regional presence in Russia. We successfully established our marketing presence in the Perm and Chelyabinsk regions to facilitate our commercial trading operations, and we currently consider the Kostroma region as one of the next commercial trading operations. However, as of this date, we are not presently considering acquiring gas distribution networks to accomplish our regional expansion plans, despite some market speculation. We will look at opportunities on a case-by-case basis and determine which geographical regions best facilitate our expansion plans, as well as to what is the best way to accomplish this objective, either organically by building our own trading operations or through potential acquisitions.

 During a recent press interview, Mr. Mikhelson raised our production guidance for natural gas to approximately 7% to 11% based on the actual results achieved to date. As we have done on previous conference calls, I can confirm that we are, in fact, revising upward our production guidance for the remainder of 2012, subject to normal economic conditions and seasonal weather patterns.

 For the first half of 2012, we produced approximately 28.7 billion cubic meters of natural gas, including our equity share of natural gas from joint ventures, which represented a year-on-year increase of 12.3%, or by, roughly, 3.1 billion cubic meters. The rate of increase in our natural gas production over the course of the past year has been much stronger than originally anticipated and reflects stronger consumer demand during a seasonally adjusted trough period, although we continue to fluctuate our sales mix between end customers and wholesale gas traders, as well as utilize an available underground storage capacity to smooth out some of the seasonal cyclicality in our demand.

 For liquids, we have not revised our production guidance of 3% to 5% because most of the incremental growth in liquids production will come from the launch of the next stage of field development at the Yurkharovskoye field in the fourth quarter, as well as increased crude oil production from the East-Tarkosalinskoye and Khancheyskoye fields. Although relatively small in terms of overall volumes, the development of the crude oil layers at these fields has essentially doubled our output of crude oil during the first half of 2012, and we believe we can continue growing these volumes throughout the remainder of the year based on our planned capital program.

 Another major area of concern from an investor perspective centered on the Russian government's discussions regarding the mineral extraction tax, or MET. And, as we discussed thoroughly on the first quarter conference call, we believe the aggressive position postulated in the media and reported by the analytical community will not materialize for the natural gas sector. We believe the overall changes in the MET rate for natural gas will not be punitive, and the recent indications from various governmental agencies support our position.

 Presently, we expect a decision to be made in September regarding MET for 2013 and another decision to be made in early spring of 2014 regarding the question of taxation for the whole gas sector, as well as differentiated tax due to field complexity and geographical location. Recent discussions on this very crucial topic were held with Prime Minister Medvedev, and we believe the final outcome will not be punitive to NOVATEK.

 On similar topics, the Russian government has indicated that future increases in transport tariff will be linked to inflationary adjustments, and this position is the one we adopt for budgetary purposes and fully support. For domestic natural gas pricing, the Russian government has already approved tariff increases of 15% for the next couple of years, and we believe they are committed to this [gas globalization] plan and will maintain these tariff increases as adopted, although the timing of these tariff increases has changed.

 One of the big differences in our year-on-year comparatives is the fact that the domestic natural gas tariff was increased in the prior year on January 1, as compared to July 1 in the current reporting period. Therefore, despite strong increases in our overall natural gas production in the first half of 2012, we have only recently benefited from the change in the domestic gas tariff. And, on a dollar-adjusted basis, we actually report a theoretically lower realized price due to the Russian ruble depreciation during the period.

 During the second quarter and first half of 2012, we invested capital in various exploration, development, and processing activities, consistent with our announced capital expenditure program for the year. Specifically, we invested capital in the Ust-Luga gas fractionation and transshipment complex, which represented about 26% of our total capital expenditures in the first half of 2012, as well as doubling our capital spend at both the East-Tarkosalinskoye and Khancheyskoye fields as part of our plan to exploit the crude oil layers at these particular fields.

 Our decision to increase our capital program for crude oil development was facilitated by the adoption of a zero MET rate for crude oil development in the Yamal-Nenets autonomous region above the 65th degree on a northern latitude, which corresponds to the geographical location of our fields.

 During the first half of 2012, we correspondingly increased our crude oil production at the East-Tarkosalinskoye and Khancheyskoye fields by approximately 100,000 tons, although the overall volumes of 217,000 tons represented less than 1% of our total production on a barrel of oil equivalent basis.

 As for Ust-Luga, we are still on track for project commission in the fourth quarter of this year, and we will announce the formal commission and date at a later time.

 During the first half of 2012, we worked on the construction of the first phase of the processing complex, planned infrastructure, and reservoir tank form. 25 reservoir tanks with a capacity of 640,000 cubic meters were completed, and final testing is being conducted. We expect the capital intensity of this project to remain quite high throughout the remainder of 2012.

 As for exploration activities, we drilled approximately 27,000 meters, or 81,000 feet, of exploration drilling in the first half of 2012, which was mainly distributed to the Olimpiyskiy, Samburgskiy, North-Russkoye, North-Khancheyskoye, and the West-Yurkharovskiy license areas, as well as conducted a series of geological surveys at various license areas. Our exploratory activities continue to yield positive results.

 We had a number of new discoveries in the first half of the year as a result of our exploratory activities. Specifically, new gas condensate deposits were discovered at the South-Tambeyskoye, North-Chaselskiy, Khancheyskoye, and Yurkharovskiy fields, as well as positive indications of another 13 hydrocarbon deposits at the Yurkharovskiy field and the Yarudeyskoye field.

 As we migrate away from our core producing fields and begin developing our full portfolio of assets, we will incur significant costs in geological and geophysical activities at these early stages of exploration and/or development. We have a substantial portfolio of un-booked resources, as well as our recent acquisition of new license areas in the Yamal and Gydan Peninsulas.

 Therefore, after careful consideration and concurrence with our external auditors, we decided to change our accounting policy in respect to capitalize the cost of our three-dimensional, seismic surveys, retroactively, to January 1, 2012. An adjustment to the financial result of approximately RUB597 million was booked in the current reporting period.

 We also commenced initial production of gas and gas condensate at SeverEnergia's Samburgskiy field in April and are currently producing approximately 6 million cubic meters of natural gas and roughly 800 tons of gas condensate per day. Ongoing work activities are underway to launch the second production complex at the field, whereby we plan to launch a second train, thus increasing the field's overall productive capacity by another 6 million cubic meters per day and approximately 800 tons of gas condensate, according to our scheduled work program.

 Over the next several years, we expect to substantially increase the productive capacity at SeverEnergia's other fields through our planned capital expenditure program, which will serve as a significant driver of wet gas and liquid production for the joint venture.

 The expected increase in SeverEnergia's total production corresponds with our expansion plans at the Purovsky processing plant, whereby we will increase the plant's processing capacity by an additional 6 million tons over a two-phase upgrade in 2013 and 2014, as well as expand the existing Yurkharov-to-Purovsky unstable gas condensate pipeline to accommodate the expected increase in liquids production.

 We continued to work on a number of different projects during the first half of 2012 and spent approximately RUB19.8 billion on capital projects, representing an increase of RUB5.8 billion year on year, or by 41.8%, as well as increased our capital spend quarter on quarter by RUB4.8 billion, or by 63%. Our capital spending at the Ust-Luga complex (technical difficulties) rubles, as we move forward with our plans to launch the initial phase of this plant in fourth quarter. We also tripled our capital expenditure at the East-Tarkosalinskoye field, particularly relating to the crude oil development activities, by spending RUB3.3 billion versus RUB866 million over the first half of the year.

 Of particular note, during the second quarter, we increased our capital spend at the Yurkharovskoye field by approximately RUB412 million year on year and by RUB1.2 billion quarter on quarter, as we plan to launch another production line of approximately 4 billion cubic meters at the field by yearend. But equally important is the fact that our capital intensity over the first half of this year has actually declined by 6.4%, reflecting our gradual shift towards maintenance capital at this important, producing field.

 The main capital projects aggregated 68% of our total capital spending during the first half of the year, and we are still forecasting a total capital expenditure program for 2012 at roughly RUB50 billion. As of tonight's conference call, there are no changes to our forecasted capital expenditure program for the full year.

 I would now like to discuss the operational and financial results achieved in the second quarter before opening the session to questions and answers.

 Excluding purchases and inventory movements, our natural gas production increased by 16.5%, whereas our liquids production declined by 0.9% during the second quarter 2012 as compared to the prior year. We have maintained a strong production trend for natural gas throughout the first half of 2012, which necessitated the upward revision in our production forecast for the remainder of the year, as noted earlier.

 The slight decrease in liquid production, however, was essentially an anomaly in the reporting period, as we had a decline in liquid outputs from the Yurkharovskoye field, mainly due to extremely warm temperatures in the region, which affected the wet gas separation process at the field. Essentially, gas injected into the underground storage contained liquid concentrations that normally would have been separated from the dry gas stream prior to injection.

 For natural gas, we had a relatively strong production growth from our three core fields, led by resumption of gas production at both the East-Tarkosalinskoye and Khancheyskoye fields of 51% and 49%, respectively, as well as continued output growth at the Yurkharovskoye field of roughly 5%, representing total growth in gas production of 1.8 billion cubic meters as compared to the prior year. We had a slight decline of 3.4% in our purchase of natural gas from our Sibneftegas joint venture, largely due to a pipeline pressure differential in Gazprom's unified gas supply network, which negated our ability to inject some gas into the UGS from the (inaudible) field, as well as other purchases from third parties totaling 800 million cubic meters as compared to nil volumes purchased in the second quarter 2011.

 We have explained many times in the past that it is difficult to compare quarter-on-quarter sales volumes when you are subject to seasonal fluctuations in demand. So it's not too surprising that we had a 16.2% decline in our sales volumes, or by roughly 2.6 billion cubic meters in the second quarter relative to the first quarter. This situation was also somewhat magnified by a substantial increase quarter on quarter in our natural gas injections into the underground storage facility of approximately 1.1 billion cubic meters. But, nonetheless, we continued to demonstrate our ability to market our natural gas volumes in comparable periods by increasing our volumes of natural gas sold by approximately 1.6 billion cubic meters, or by 13.7% year on year.

 It is also important to note that the compositional mix of our sales volumes sold between end customers and wholesale traders changed between the respective reporting periods. In the second quarter 2012, we significantly increased our percentage of natural gas sold to end customers, from 54.5% in the second quarter 2011 to 62.2% in the current reporting period, which meant that we were able to capture additional retail net-back margins of approximately RUB46 per 1,000 cubic meters, or $1.48 per mcm over the corresponding period. Despite the seasonality effect on total volumes sold, we managed to increase our end customers net-back margins quarter on quarter by RUB21 per mcf, or by 1.4%, reflecting marginally stronger pricing dynamics in the geographical regions where we market our natural gas, even though our proportional mix of end customer sales declined from 76% in the first quarter 2012 to roughly 62% in the current reporting period.

 The change in our natural gas sales mix is important for a number of reasons but, essentially, meant that we achieved a higher average realized price, stronger net-back realizations, and was able to effectively control our production profile by maintaining our customer relationships.

 We significantly increased our volumes sold to the Chelyabinsk region, representing 36% of our total customer volumes sold, which contributed to a higher realized average price and improved net-back realizations.

 During the first half of 2012, 57% of the volumes sold were to the power sector, 33% to large, industrial customers, and the remaining 10% split between regional gas companies 1%, residential customers 2%, and others at 7%.

 Our average realized price for end customers during the second quarter increased by 1.4% year on year and 1.5% quarter on quarter, despite no domestic tariff increase during the period. For ex-field or wholesale gas traders, our average realized price increased year on year by approximately RUB12 per 1,000 cubic meters, or by 0.9%, but slightly decreased relative to the prices received for this category of sales quarter on quarter.

 We continued to achieve a high margin differential between end customers and ex-field net-backs, excluding trading activities and sales to residential customers, as compared to the prior year, which continues the pricing dynamic trends achieved prior to the economic crisis, although we cannot be certain that these trends will remain consistent or continue to fluctuate period on period.

 Our average distance to transport our natural gas to end customers was relatively consistent with that achieved in the prior year, averaging approximately 1,920 kilometers during the second quarter 2012, but was 118 kilometers higher relative to the first quarter 2012. The geographical markets representing at least 10% of our sales volumes were Chelyabinsk, Perm, and Orenburg regions, which was comparable to the prior reporting period, with the exception of an inclusion of the Moscow region.

 The financial results in many oil and gas companies have been negatively impacted from the declines in benchmark prices during the current reporting period. We were no exception. During the second quarter, we realized weaker liquid pricing year on year and quarter on quarter across all three products -- stable gas condensate, LPG, and crude oil.

 Specifically, our contractual price for stable gas condensate sold on international markets was lower by $95 per ton year on year and $138 per ton quarter on quarter, largely due to a decrease in the underlying commodity prices during the respective periods, as well as pricing pressures in the markets where our products were shipped. The underlying weaknesses in commodity prices, combined with increase in both our tanker expenses and export duties during the periods, resulted in lower net-back prices of approximately $112 per ton year on year and $175 per ton quarter on quarter.

 Our total volumes of liquids sold increased by 9.2%, or by 94,000 tons, and was largely comprised of purchases and inventory movements during the respective periods. In terms of liquid production from our core, producing fields, we achieved positive growth in crude oil output from the East-Tarkosalinskoye field sufficient to offset decline in liquid concentration in the fields of wet gas streams. But overall decline in outputs from both the Khancheyskoye field consistent with our recent field experience and the anomaly reported earlier regarding wet gas separation issues experienced this quarter at the Yurkharovskoye field resulted in less than 1% decline in our overall liquids outputs. Nonetheless, the Yurkharovskoye field still represented about 65% of our total liquid output.

 Stable gas condensate continued to represent the largest portion of our liquid sales volumes sold during the period, accounting for approximately 71% of our total sales volumes. We sold 794,000 tons of stable gas condensate versus 755,000 tons in the corresponding period and 624,000 in the first quarter, realizing an average net-back price per ton of $339 in the second quarter as compared to $450 per ton in the corresponding period and $515 per ton in the first quarter. The general weakness in our average realized net-back prices covered a range of price formulations and was not specific to any particular region. Although the price weaknesses tended to occur over the second half of the quarter, we are experiencing general price strengthening in the cargos delivered so far in the third quarter.

 During the period, we dispatched 12 tankers of stable gas condensate from the port of Vitino, of which five tankers were destined to the European markets, two tankers were destined to the United States, and the remaining five tankers destined to the Asian-Pacific region. To date, we have launched and landed two tankers utilized in the Northern Sea route to China and South Korea, and we have another three tankers time chartered later this quarter.

 Our Purovsky plant operated at 78% of its rated capacity, with total output reaching 972,000 tons comprised of 737,000 tons of stable gas condensate, 231,000 tons of LPG, and approximately 4,000 tons of methanol products.

 We increased the volumes of LPG sold in the second quarter by 3.2%, or by 7,000 tons, as compared to the prior reporting period but experienced a decrease of 14,000 tons, or 5.9%, quarter on quarter.

 Correspondingly, our volume of crude oil sold during the reporting period was up by 91% and 20% relative to the second quarter and first quarter of 2012, respectively. But, as I mentioned, overall, these volumes represented less than 1% of our sales volumes for the period.

 Our liquid hydrocarbon volumes in inventory aggregated 402,000 tons at period end versus 371,000 tons year on year and 449,000 tons at the end of the first quarter, of which 295,000 tons represented stable gas condensate in various stages of the inventory supply chain.

 On a barrel of oil equivalent basis, we increased our total second quarter hydrocarbon production to 99 million barrels of oil equivalent versus 87 million barrels of oil equivalent in the prior reporting period, representing an average total hydrocarbon production per day of 1.1 million barrels per day, or an increase of 13.8% year on year.

 We had no major surprises to our operating costs during the second quarter relative to the composition and growth of our revenues. Our total operating expenses increased in absolute terms from RUB22.5 billion to RUB26.8 billion, as well as increasing as a percentage of revenues from 55% to 59%, largely due to the significant increase in transportation expenses and third-party purchases of natural gas.

 It is also important to note that we incurred transport and MET charges for the volumes of natural gas injected into the underground storage facilities without any correspondent increase in our revenues.

 Operational expenses for the first quarter 2012 amounted to RUB31.9 billion but was relatively consistent as a percentage of revenues compared to the current reporting period.

 The most significant change in our operating expenses for the comparative periods was the relative increase in our transportation expenses, which is explainable by the overall year-on-year growth in end customer sales volumes by roughly 30%, combined with a slightly higher per-unit transport cost as compared to the prior year.

 In addition, during the second quarter, we increased the amount of natural gas purchased from a related party, SIBUR Holdings, as well as slightly decreased the volumes purchased from our joint venture, Sibneftegas, to complement our commercial gas marketing efforts. Natural gas accounting for 86% of our total hydrocarbon purchases was relatively consistent with the amount spent on gas purchased in the first quarter 2012 and is consistent with our commercial strategy to further capture market share in the Russian domestic market.

 With our efforts to penetrate new gas trading opportunities in the European markets, as well as expanding our processing capabilities, such as at Ust-Luga complex, we should expect to see our overall costs of purchasing hydrocarbons increase as we expand the future level of our commercial trading activities.

 We manage and control our overall G&A expenses as a normal course of business, although these expenses continue to fluctuate period on period in this controllable expense category due primarily to semiannual and annual employee bonus payments and/or bonus accruals, charitable contributions, consulting services, and business travel expenses, among other line items.

 The increase in our G&A expenses during the reporting period was largely attributable to salary expenses due to the increased employee headcount resulting from the acquisition of the Chelyabinsk regional gas trader in the amount of RUB124 million, as well as our employee salary indexation of 9.6% effective July 1, 2011. We also incurred an additional RUB140 million payment as part of our social insurance contribution due to changes in the taxable base rate and a new 10% rate payable to the state pension fund, which was offset by reductions in our share-based compensation, amongst other minor changes.

 At the end of the second quarter, the Company had a total employee headcount of approximately 4,658 employees, of which 1,324, or 28%, represent employees classified under the general and administration cost classification. Overall, our total headcount increased in the first half of 2012 by approximately 810 employees, representing additional employees acquired from the regional gas trader and an increase in the number of employees hired at Yurkharov Neftegaz due to expanded work requirements.

 As mentioned previously, we began capitalizing our three-dimensional, seismic activities for those seismic surveys that are performed to maintain production levels at our current producing fields, increase the recoverability of our reserves, as well as increasing the effectiveness of our well placements for development drilling and, accordingly, recorded a reversal to our exploration expense in the amount of [RUB597] (sic - See Slide Presentation RUB597 million) during the current reporting period as compared to an exploration charge of RUB273 million in the prior year. We will continue to write off unsuccessful, exploratory wells as incurred as part of our successful efforts accounting policy.

 As a result of the factors enumerated above, our EBITDA margin continued to remain robust in the respective reporting period, achieving a level of approximately 45% for the second quarter 2012, which is consistent with our overall financial guidance.

 Unfortunately, we continue to see high levels of volatility in the currency markets, which can positively and/or negatively influence the Russian ruble and the US dollar exchange rates. And, when applied against our US-dollar-related debt portfolio, we tend to report wide swings in noncash foreign exchange gains and losses during our reporting periods. Therefore, we adjust our net profit numbers and margins in an attempt to smooth out these fluctuations. And, when adjusted in the current period, our net profit margin is consistent with our financial guidance.

 In the absence of making this noncash foreign exchange adjustment, our net profit margin was 21% in the current reporting period.

 Our balance sheet and liquidity position continued to remain strong throughout the reporting period, although we had some movements in our debt and working capital positions during the period. Our net debt position increased from RUB69.4 billion at the end of the first quarter 2012 to RUB77.8 billion, largely on the use of a portion of our spare bank credit facility in the amount of RUB10 billion, which was offset by a reduction in our cash and cash equivalent positions and a corresponding reduction in crude liabilities.

 In the reporting period, we made our final option payments aggregating approximately RUB16.3 billion in respect of acquiring our equity stakes in Yamal LNG.

 All of our liquidity and credit ratios remained strong throughout the reporting period, and we ended the second quarter with a cash and cash equivalent position of approximately RUB15.9 billion, or $483 million.

 We ended the reporting period in a negative free cash flow position for the first time over the past 12 quarters, largely due to a 61% increase in our capital expenditures but, more importantly, to a significant cash payment of income taxes during the period, resulting in a current income tax prepayment on our balance sheet. If we adjust our financial results and exclude this income tax prepayment, we would be free cash flow positive in the amount of approximately RUB1.3 billion.

 We will continue to fund our capital expenditure program through internally generated cash flows and have the ability to meet all of our debt obligations and liabilities when they mature or become due for payment.

 In conclusion, we ended the current reporting period in a reasonably strong position, despite the mixed financial results, and we continue to demonstrate our ability to increase our gas production, develop new market opportunities, and execute long-term, contractual relationships with our end customers.

 We confirmed our commitment to seek new market opportunities in Europe, and we believe this development will open a new chapter in our corporate history and another milestone toward becoming a truly global energy company.

 We also confirm the Russian government's commitment and financial support for our Yamal LNG project and the building of a port facility at Sabetta and recently laid the groundwork to commence work with the ceremonial commissioning of construction activities at the port.

 Despite the period of uncertainty surrounding discussions relating to MET for natural gas, we remain steadfast in the capital investment program and believe the position ultimately adopted by the Russian government in respect to MET for natural gas will not be punitive for NOVATEK.

 I would like to sincerely thank all our valued shareholders for the positive support you have provided to us and your continued belief in our Company, in our growth story, and in our management's ability to deliver industry-leading results.

 We know the journey to success is not always linear, and, periodically, there will be bumps along the path. But the foundation we have established in terms of our portfolio of opportunities; our commitment to cost control and project execution; our commitment to financial transparency and corporate governance; our commitment towards sustainable development, social responsibility, and environmental awareness; and the commitment and dedication of every one of our employees throughout the NOVATEK organization will serve us well in the future as we realize our ambitious strategic objectives and goals.

 I would like to end this portion of the conference call and now open the session to questions and answers. Thank you very much.



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Questions and Answers
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Operator   [1]
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 (Operator Instructions). (Inaudible).

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 Geydar Mamedov,  Goldman Sachs - Analyst   [2]
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 This is Geydar Mamedov from Goldman Sachs. I have a question about the contract with EnBW. If I understood you correctly, this is just a trading agreement between NOVATEK Gas and Power and EnBW for supply of 2 bcm per annum. May I ask where you plan to source gas for the deliveries to EnBW? And what margin do you expect to realize on these trading operations? Thank you.

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 Mark Gyetvay,  OAO NOVATEK - CFO   [3]
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 First of all, you're correct on assuming that it is a trading arrangement between NOVATEK Gas and Power and EnBW. But, as I mentioned in the prepared text, we are not going to talk about specific terms and additions on the contract. You'll see that later on when we start separating out the results from that. But, right now, we're not going to disclose specific terms and additions relating to this particular contract.

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 Geydar Mamedov,  Goldman Sachs - Analyst   [4]
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 Okay. Thank you.

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Operator   [5]
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 Karen Kostanian.

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 Karen Kostanian,  Bank of America Merrill Lynch - Analyst   [6]
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 I appreciate your inability to talk about the EnBW contract, but, in any case, would you be able to confirm that, for now, that contract doesn't involve an agency agreement with Gazprom? Thank you.

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 Mark Gyetvay,  OAO NOVATEK - CFO   [7]
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 Right now, I confirm it does not include an agency agreement with Gazprom.

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 Karen Kostanian,  Bank of America Merrill Lynch - Analyst   [8]
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 Thank you very much.

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Operator   [9]
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 Igor Kurinnyy.

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 Igor Kurinnyy,  ING - Analyst   [10]
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 I might again ask about the same trading contract. I realize you can't provide any details, but can you comment, for example, on [pricing rates]? For example, if spot prices in Europe change, is there risk that you could incur trading loss on that contract or not, dependent on the (inaudible)?

 And I have two more questions also. One is CapEx outlook -- if you could give any indication for CapEx for next year and, if not, maybe, at least, you could tell us how much you would spend on Yurkharov field.

 And, finally, on the Yamal LNG project, if you could, comment whether you're still looking actively for new partners. Thank you.

------------------------------
 Mark Gyetvay,  OAO NOVATEK - CFO   [11]
------------------------------
 I don't want to be redundant on this thing. But, at this particular point in time, we confirm the export contract for the European contract, and that's all we're going to talk about at this particular moment in time. There could be no details, no more discussions on terms and conditions, et cetera.

 As of CapEx for 2013, we have not provided that yet. We'll do that towards the latter part of the year, which will also include an indication of where we expect to be on the Yurkharovskoye field. But, as I mentioned, absent any expected increase in the productive capacity beyond what we've planned to bring on stream by the end of the year, we are headed into maintenance capital program at that field.

 I also in my text said that we are talking to other potential partners in Yamal LNG. And the one that was specifically confirmed as a discussion is with the Indian consortium. And we're doing everything possible to move this process forward. And they have indicated that they will make a decision in the next couple months. So we'll just have to wait to see what their view of the project is. But, at that point, I really don't have any more discussions on those particular discussions.

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 Igor Kurinnyy,  ING - Analyst   [12]
------------------------------
 Okay. Thank you.

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Operator   [13]
------------------------------
 (Operator Instructions). Artem Konchin.

------------------------------
 Artem Konchin,  JPMorgan - Analyst   [14]
------------------------------
 I was curious if you can comment on the upcoming trials of formula-based MET, supposedly, in November -- if there is a chance that NOVATEK will participate or if you know any details about this. Thanks.

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 Mark Gyetvay,  OAO NOVATEK - CFO   [15]
------------------------------
 All I can say at this particular point is that the discussions going on in respect of MET -- we're involved in those governmental discussions. We have people involved on committees. We are providing input to the government when requested, and we'll continue to do so in respect to both the meetings and the decision, hopefully, up until September, as well as the meetings that we plan to attend for the remainder of this year leading up to the discussions going on in the spring. So we are actively involved in it, and we will provide input as requested by the Russian Federation. But that's really about all I can say at this particular point on those discussions.

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 Artem Konchin,  JPMorgan - Analyst   [16]
------------------------------
 Thanks.

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Operator   [17]
------------------------------
 Denis Demin.

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 Denis Demin,  BFA - Analyst   [18]
------------------------------
 Thank you for your presentation. It was brilliant, as always. And I have just two little questions.

 The first is about your forecast of production -- gas production, actually. Maybe I just missed the number. But I would like to hear the absolute number of your forecast of gas production for this year.

 And the second issue is in relation -- is about the dividends, which will be discussed on September 30. Can we be sure that the dividends will be somewhat lower in the first half of 2011, a year ago, because of the dynamics of the (inaudible) income?

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 Mark Gyetvay,  OAO NOVATEK - CFO   [19]
------------------------------
 To answer your first question, it's -- to give you an absolute number is almost impossible to do at this particular time. And that's why we tend to formulate in a particular range. As you can see from the first half of the year, we're up above the initial guidance that we provided. And so Mr. Mikhelson has raised the guidance, so far, from between 7% and 11%. And that's why we want to keep it as subject to weather conditions and continued economic conditions within the country. So, to give you an absolute number is just -- it's impossible. So we're going to just stick to this guidance between 7% and 11%.

 In terms of dividends, it's always been our position to increase dividends subject to cash flow availability, capital expenditure program, and debt service. We have a dividend policy in place that says that we'll pay out at least 30% of our dividends, according to the Russian accounting, and we have done that. And so I suspect that, when the next dividend payment comes up, we'll be consistent with our trend of either growing dividends or maintaining according to this particular policy. But that will come up pretty soon.

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Operator   [20]
------------------------------
 (Inaudible).

------------------------------
Unidentified Participant   [21]
------------------------------
 Just a couple of questions, mate. First is in respect of CapEx. Can you remind me what -- ? Given the state of affairs that we have today in terms of gas production and sales capacity, what would be the maintenance CapEx annually for NOVATEK as it stands today, assuming a non-growth scenario? That's the first question.

 The second question is -- I understand the guidance was increased between 5% to 7% to 7% to 11%, as you mentioned. I really appreciate the fact that you can't pinpoint because you can't pinpoint what will happen to weather the next two, three, four, five, six days, let alone six months. The highlight I want to understand is, given that, by and large, operations CapEx are more fixed than variable, an increase in volume throughput -- does it suggest that production costs would be lower than previously thought or not? Those two questions. Sorry.

------------------------------
 Mark Gyetvay,  OAO NOVATEK - CFO   [22]
------------------------------
 Okay. To answer your first one, again, it's not a straightforward answer to a question because things obviously change. And we can give you a kind of relative range of what we believe maintenance capital will be at our particular fields. But, if you have to put in some -- or do some additional work, they obviously change. But I think it's safe to say that, in terms of maintenance capital for our core, producing assets, we're probably talking an order of magnitude of about $300 million to maintain the current levels of production.

 In terms of production cost, I don't really see -- more or less, inflation adjusted, will be probably the way I would look at it. We're anticipating on production, on transportation, et cetera, and taxes, I think we should be reasonably in line with some kind of inflationary-adjusted number.

------------------------------
Unidentified Participant   [23]
------------------------------
 Okay. Thank you. So, once again, just to confirm, this $300 million maintenance CapEx is based on around 55 bcm of production level. Correct?

------------------------------
 Mark Gyetvay,  OAO NOVATEK - CFO   [24]
------------------------------
 Yes, about that. (multiple speakers)

------------------------------
Unidentified Participant   [25]
------------------------------
 Thank you very much.

------------------------------
Operator   [26]
------------------------------
 (Operator Instructions). Igor Kurinnyy.

------------------------------
 Igor Kurinnyy,  ING - Analyst   [27]
------------------------------
 I forgot to ask the first time around regarding your cooperation with Gazprom for your Gydan Peninsula fields. I know that there was agreement before with Gazprom (inaudible) Gazprom to look into this. Have there been any developments? Are you in discussions with Gazprom as to how to develop these fields?

------------------------------
 Mark Gyetvay,  OAO NOVATEK - CFO   [28]
------------------------------
 As I reported on the first quarter conference call -- I think we said that working groups have been established. They're discussing a range of activities to develop both the Gydan and the Yamal Peninsulas, particularly in respect of the sort of new license areas outside of our current Yamal LNG project and Gazprom's current activities. I have heard of nothing new that has come out of these particular meetings in light of the last couple months (inaudible) any kind of meaningful updates to everybody on this conference call.

 It's still at a very, very early stage. We have continued our ongoing activity, particularly relating to exploration at these particular fields. And I would just wait a little longer for us to make some more progress before we really can come down and give you any sort of concrete type of information.

 I can tell you, in terms of our capital, for example, we have invested almost RUB600 million in terms of capital, both to the -- and this is related to, more or less, geological exploration type activity at the Utrenniy and Geofizicheskiy fields, which is a substantial increase over the, roughly, RUB130 million that we spent in the first quarter.

 So activity is moving forward, but it's kind of premature to really discuss what would be outcomes of these early meetings with Gazprom, et cetera, on this particular joint venture. I would just say be patient. And, when information is available, we'll discuss it on future conference calls.

------------------------------
 Igor Kurinnyy,  ING - Analyst   [29]
------------------------------
 Okay. Thank you, Mark.

------------------------------
Operator   [30]
------------------------------
 There are no further questions, Mr. Gyetvay, if you want to do your closing remarks. Thank you.

------------------------------
 Mark Gyetvay,  OAO NOVATEK - CFO   [31]
------------------------------
 Thank you very much for your time tonight, and we look forward to seeing everybody in the upcoming meetings; I guess, September as far as [update process] meetings.

 But I'd also just like to announce that we have hired a new IR person, Alexander (Inaudible), formerly of Rossnet. Effective starting date was today. So you'll hear somebody else, at least get involved with somebody else within the NOVATEK IR function moving forward. We look forward to getting Alexander ready to go out there and meet with our investors.

 But thank you very much. We appreciate your support. Thank you.

------------------------------
Operator   [32]
------------------------------
 This will conclude today's conference call. Thank you for your participation, ladies and gentlemen. You may now disconnect.




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