18 Jun 2007 17:19
OJSC OC Rosneft18 June 2007 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED 31 MARCH 2007 AND 2006 The following discussion of Rosneft's financial condition and results ofoperations are based on, and should be read in conjunction with, the Company'sfinancial statements and the notes thereto for the periods ended 31 March 2007and 2006 (the "Interim Financial Statements"). Such terms as "Rosneft","Company" and "Group" in its different forms in this report mean OJSC Rosneftand its consolidated subsidiaries and affiliated companies. This report presentsRosneft's financial condition and results of operations on a consolidated basis.This report contains forward-looking statements that involve risks anduncertainties. Rosneft's actual results may differ materially from thosediscussed in such forward-looking statements as a result of various factors. Overview Rosneft is a vertically integrated oil and gas company with upstream anddownstream operations located principally in Russia. Rosneft is one of theworld's largest publicly traded oil companies in terms of proved crude oilreserves and among the top ten in terms of crude oil production. According toDeGolyer and MacNaughton ("D&M"), Rosneft's independent reservoir engineers, asof 31 December 2006, on the basis of the standards set forth by the Society ofPetroleum Engineers ("SPE"), Rosneft had proved reserves of 20.09 billion boe,including proved crude oil reserves of approximately 15.96 billion barrels (2.20billion tonnes) and proved gas reserves of approximately 701.07 bcm. Alsoaccording to D&M, as of 31 December 2006, Rosneft had SPE proved and probablecrude oil reserves of approximately 24.72 billion barrels (3.40 billion tonnes)and SPE proved and probable gas reserves of approximately 1,133.86 bcm.Rosneft's reserves are located in Western Siberia, Timano-Pechora, the RussianFar East, Southern and Central Russia and Eastern Siberia. Rosneft also hassignificant prospective crude oil and gas resources in Western Siberia, theRussian Far East, which includes Sakhalin Island and the Kamchatka Peninsula,Southern Russia and Eastern Siberia. Rosneft has recently purchased additionalreserves in Western and Eastern Siberia and in the Samara region as a result ofauctions for the sale of certain exploration and production assets of OJSC Yukos("Yukos") won by Rosneft's subsidiary (Neft-Aktiv LLC) in May 2007. See"-Significant Acquisitions-2007-Purchase of Assets in Yukos Auctions". During the first quarter of 2007, Rosneft produced 1,643.60 thousand barrels ofcrude oil per day (20.22 million tonnes per quarter). In the first quarter of2007, Rosneft sold approximately 68% of the crude oil it produced or purchasedfrom third parties to customers outside Russia, comprising both sales to CIScountries and exports to international markets other than the CIS. Most of theremainder was refined in Russia at Rosneft's two main refineries, Tuapse andKomsomolsk, and at the Angarsk, Achinsk, Kuibyshev, Novokuibyshev and Syzranrefineries formerly controlled by Yukos and then sold in the form of petroleumproducts in international and domestic markets. Rosneft has an integratedproduction, transportation, refining and marketing strategy and seeks tomaximise netbacks by optimising its product mix, sales destinations andavailable transport routes. In May 2007, Rosneft purchased the Angarsk andAchinsk refineries in Eastern Siberia and the Kuibyshev, Novokuibyshev andSyzran refineries in the Samara region as a result of auctions for the sale ofcertain refining assets formerly controlled by Yukos, which were won by Rosneft(by the Company's subsidiary - Neft-Aktiv LLC). See "-SignificantAcquisitions-2007-Purchase of Assets in Yukos Auctions". Rosneft's total revenues increased from U.S.$ 7,327 million in the first quarterof 2006 to U.S.$ 8,220 million in the first quarter of 2007 primarily as aresult of increased sales volumes. Rosneft's net income was U.S.$ 802 million inthe first quarter of 2006 and U.S.$ 358 million in the first quarter of 2007.The decline was mainly due to the impact of higher export customs duty, accrualof interest related to OJSC Yuganskneftegaz' ("Yuganskneftegaz") tax liabilitiesfor the years 1999-2004, which are in the process of being restructured, higherdepreciation, depletion and amortisation and the appreciation of the rouble. Business Segments and Intersegment Sales The Company operates primarily in the Russian Federation. As geographicalregions of the Russian Federation have similar economic and legalcharacteristics, the Company does not present geographical segments separately.The Company also carries out projects outside Russia, including projects inKazakhstan, Turkmenistan and Algeria. These projects are in the early stages andhave had little to no impact to date on the financial condition or results ofoperations of the Company. Business Segments The activities of Rosneft are divided into two main business segments: • Exploration and production ("upstream"). Geological exploration and development of fields, and crude oil and gas production; and • Refining, marketing and distribution ("downstream"). Refining of crude oil, as well as the purchase, transportation, sale and transshipment of crude oil and petroleum products. Rosneft does not separate its distribution and transportation divisions into a"midstream" segment. These activities are reflected in the "downstream" segment.Other types of activities are incorporated in the "other activities" segment andinclude banking and financial services and drilling and construction servicesprovided to third parties. Intersegment Sales and Segment Presentation Rosneft's two main business segments are interconnected: the majority of therevenues of one main segment is included in the expenses of the other mainsegment. In particular, the holding company, OJSC Oil Company Rosneft, buyscrude oil from its producing subsidiaries, part of which it sells in and outsideRussia and the remainder of which it delivers to its proprietary or third-partyrefineries in Russia for processing. Petroleum products are then either sold bythe holding company through wholesale sales in the international or domesticmarkets or sold to the Company's marketing and transshipment Business Units (asdefined below) and subsidiaries for subsequent wholesale and retail sale inRussia. Following the Share Swap (as defined below), the Company became theproducer and owner of the crude oil previously produced by the subsidiaries thatwere merged into it. It is difficult to determine market prices for crude oil in the Russian domesticmarket, mainly due to the significant intragroup turnover within the verticallyintegrated oil companies that dominate the market. Moreover, to the extent theyexist, crude oil market prices in Russia can be significantly lower than theymight otherwise be due to seasonal oversupply and regional imbalances. Prior tothe Share Swap in 2006, transaction prices for crude oil between Rosneft'scompanies were established taking into consideration market prices andtransportation costs, but were also affected to a considerable degree by thecapital investment requirements of different enterprises within the upstreamsegment. Accordingly, an analysis of individual segments in isolation from theanalysis of other activities may present a distorted view of Rosneft's financialand operating performance. For this reason, the Company's management does notanalyse each main business segment in isolation. The Company does, however,provide financial data by segment in Note 12 to the Interim Financial Statements. On 1 October 2006, twelve subsidiaries, Yuganskneftegaz, OJSC Purneftegaz, OJSCSelkupneftegaz, OJSC Severnaya Neft, OJSC Krasnodarneftegaz, OJSCStavropolneftegaz, OJSC Sakhalinmorneftegaz, OJSC Komsomolsky Refinery, OJSCTuapsinksy Refinery, OJSC Arkhangelsknefteprodukt, OJSC Nakhodkanefteprodukt andOJSC Tuapsenefteprodukt (the "Merged Subsidiaries") were merged into the Companyby means of a share swap (the "Share Swap") (see "-Development ofRosneft-Consolidation via Share Swap" below). Following the merger, the Companybecame the legal successor to the rights and obligations of the MergedSubsidiaries to the extent provided by Russian law. The Company leases thebusiness units, which are the assets previously owned by the Merged Subsidiaries(the "Business Units") to wholly owned subsidiaries of the Company, which arelimited liability operating and service companies each corresponding to a MergedSubsidiary and which operate these assets under service agreements. Revenues andcosts from operations of the seven Merged Subsidiaries previously engaged inexploration and production were and continue to be accounted for under theupstream segment. Revenues and costs from operations of the five MergedSubsidiaries previously involved in refining and marketing were and continue tobe accounted for under the downstream segment. Significant Acquisitions 2007 Purchase of Assets in Yukos Auctions Treasury Stock On 27 March 2007, RN-Razvitie LLC, a wholly owned subsidiary of the Company, wonthe tender for the purchase of 9.44% of the share capital of the Company andpromissory notes of Yuganskneftegaz having a face value of RUB 3,558 million(U.S.$ 136 million at the Central Bank of Russia ("CBR") exchange rate in effectas at the date of the auction), from Yukos for a total consideration ofRUB 197.84 billion (U.S.$ 7.59 billion at the CBR exchange rate in effect as atthe date of the auction). For the purposes of the Company's consolidatedfinancial statements, the total aggregate consideration for the acquired assetswas allocated to fair value on a pro rata basis and amounted to RUB 194.43billion for Rosneft's shares, or RUB 194.43 per share (U.S.$ 7.46 billion, orU.S.$ 7.46 per share, at the CBR exchange rate in effect as at the date of theauction). Title to the shares and promissory notes was transferred toRN-Razvitie LLC on 17 April 2007. Yukos Assets In June 2007, the Company made an irrevocable offer to purchase certain assetsof Yukos that were not purchased by the successful bidder at the auction. Theassets comprise shares in various marketing and energy-generating companieslocated in the South region of Russia. The total consideration will be RUB 4.9billion (U.S.$ 188 million at the CBR rate as of 31 March 2007). In April-May 2007, Neft-Aktiv LLC, a wholly owned subsidiary of the Company, wonauctions for the sale of certain Yukos assets. These assets comprise shares invarious exploration and production, refining, service and marketing companies inWestern and Eastern Siberia and in the Samara region, including OJSCTomskneft-VNK, OJSC Samaraneftegaz and OJSC East Siberian Oil and Gas Company inthe upstream segment and the Angarsk, Achinsk, Kuibyshev, Novokuibyshev andSyzran refineries together with 269 retail outlets in the downstream segment.The total aggregate consideration for the acquired assets was RUB 344.1 billion(U.S.$ 13.3 billion at the CBR exchange rate in effect as at the date of theauctions). The Company is currently analysing the acquired assets andliabilities, including the tax and legal contingencies as of the acquisitiondate. Financing of the Purchases In March 2007, the Company and its wholly owned subsidiary RN-Razvitie LLCentered into loan agreements with a syndicate of international banks. Theagreements provide for a U.S.$ 9.5 billion part of the loan that has a six-monthterm, a U.S.$ 6.0 billion part of the loan that has a 12-month term and a U.S.$6.5 billion part of the loan that has an 18-month term. These loan agreementsbear interest at the London inter-bank offered rate ("LIBOR") plus 0.25-0.50%per annum, depending on the final repayment date. These loans were drawn tofinance the purchase of the treasury stock and other Yukos assets describedabove in the course of auctions for the sale of these assets. The total amountunder these loan agreements was U.S.$ 22.0 billion and was drawn down throughMay 2007. Truboprovodny Consortium Burgas-Alexandroupolis LLC In January 2007, the Company participated in the creation of a joint venture,LLC Truboprovodny Consortium Burgas-Alexandroupolis, with equal equitycontributions from the Company, OJSC AK Transneft ("Transneft") and OJSC Gazprom("Gazprom"). This joint venture was registered with a share capital of RUB9 million (U.S.$ 0.4 million at the CBR exchange rate in effect as at theregistration date). The joint venture is expected to design, construct andoperate oil terminals in Burgas (Bulgaria) and Alexandroupolis (Greece), whichwill be connected by a pipeline crossing the territories of Greece and Bulgaria.The Company has no funding commitments in connection with this joint venture. Ohinskaya TETS In April 2007, the Company purchased 9,876,869 newly issued ordinary shares ofOJSC Ohinskaya TETS for a total consideration of RUB 112 million (U.S.$ 4million at the CBR exchange rate in effect as at the transaction date). As aresult, the Company increased its share in OJSC Ohinskaya TETS to 87.52%. In January 2007, the Company purchased 85.61% of the ordinary shares of OJSCOhinskaya TETS for RUB 629 million (U.S.$ 24 million at the CBR exchange rate ineffect as at the transaction date). OJSC Ohinskaya TETS is a combined heat andpower station mainly servicing the production activities ofRN-Sakhalinmorneftegaz LLC, one of the Company's exploration and productionwholly owned operating and service companies. Verkhnechonskneftegaz In January 2007, the Company purchased 339,582 newly issued ordinary shares ofOJSC Verkhnechonskneftegaz, an exploration and production company, for a totalconsideration of RUB 201 million (U.S.$ 8 million at the CBR exchange rate ineffect as at the transaction date). As a result, the Company maintained its25.94% share in this company. The other shareholders of OJSCVerkhnechonskneftegaz are TNK-BP with a more than 60% share andVostochno-Sibirskaya Gazovaya Kompaniya with a more than 11% share. 2006 Exponeft In December 2006, the Company purchased 100% of LLC Exponeft for a totalconsideration of RUB 335 million (U.S.$ 13 million at the CBR exchange rate ineffect as at the transaction date). LLC Exponeft owns a network of fillingstations in the Murmansk region. Nakhodka Oil Seatrade Port In June 2006, the Company purchased 97.51% of the shares of Nakhodka OilSeatrade Port ("Nefteport") for RUB 528 million (U.S.$ 20 million at the CBRexchange rate in effect as at the settlement date). The acquisition createdU.S.$ 10 million in goodwill, which is attributed to synergies expected toresult from the integration of Nefteport with the operations of the Company'ssubsidiary LLC Nakhodkanefteprodukt. Nefteport is one of the largest commercial trade seaports on Russia's Pacificcoast located in Novitsky Bay on the west side of the Nakhodka Gulf. Nefteporthas now been integrated into Rosneft's technological and infrastructural chainfor the storage and transshipment of oil products, enabling Rosneft to establisha single self-contained industrial complex in the Nakhodka Gulf, which theCompany believes is one of the largest of its kind in Russia. Udmurtneft On 28 April 2006, the Company and China Petrochemical Corporation ("Sinopec")entered into an option agreement granting to the Company an option to purchase acontrolling interest in OJSC Udmurtneft ("Udmurtneft") if Sinopec were to winthe tender for purchasing 96.86% of Udmurtneft's shares from OJSC TNK-BP("TNK-BP"). In June 2006, TNK-BP announced its decision to sell 96.86% shares ofUdmurtneft to Sinopec. Sinopec completed the purchase of Udmurtneft on 10 August2006. In November 2006, the Company and Sinopec created a joint venture, TaihuLimited ("Taihu"), of which the Company owns 51% through its wholly ownedsubsidiary, Rosneft International Ltd., and Sinopec owns 49% through its whollyowned subsidiary, Sinopec Overseas Oil and Gas Ltd. Taihu purchased 96.86% ofUdmurtneft's shares via a wholly owned subsidiary, CJSC Promleasing, in December2006 from Sinopec. The Company accounted for this investment using the equitymethod from December 2006. On 13 November 2006, Bank of China provided a creditfacility to Taihu in the amount of U.S.$ 3.6 billion for financing the purchaseof the 96.86% stake in Udmurtneft and the additional 3.14% shares from minorityshareholders of Udmurtneft. The cash flows of Udmurtneft will be used directly,to repay this financing. Repayment of Carried Interest in Sakhalin-1 Joint Venture In February 2001, the Company entered into a sale and purchase agreement withOil and Natural Gas Corporation Videsh Ltd. ("Videsh") in relation to theCompany's interest in the Sakhalin-1 production sharing agreement ("PSA"), whichreduced the Company's interest in the project to 20%. The Company recorded theinvestment in its retained share under the "carried interest" method. Commercialhydrocarbon production under the Sakhalin-1 PSA commenced in October 2005.Accordingly, the Company's share in Sakhalin-1 hydrocarbon reserves wasreclassified as proved developed reserves. On 31 July 2006, the Company repaid U.S.$ 1,339 million (including accumulatedinterest) to Videsh with respect to the Company's costs carried by Videsh inprevious years. Following this repayment, the Company recovered the right toreceive its pro rata income in the Sakhalin-1 project. Rosneft accounts for thisinvestment using the proportionate consolidation method. Of the total amountrepaid, U.S.$ 1,328 million was recorded as an addition to oil and gas propertyas of 31 December 2006 and effectively treated as capital expenditures. Development of Rosneft Increased Stakes in Subsidiaries 2006 Tuapsenefteprodukt In January 2006, the Company purchased 39.26% of the common shares (30.24% ofthe share capital) in OJSC Rosneft-Tuapsenefteprodukt, a company providingtransshipment services for crude oil and petroleum products, increasing itsstake in the common shares from 50.67% to 89.93% and in the total share capitalfrom 38.00% to 68.24%. The purchase price was RUB 2,835 million (U.S.$ 100million at the CBR exchange rate in effect as at the settlement date). Thepurchase resulted in U.S.$ 34 million of goodwill, attributed to the estimatedbenefits arising from obtaining over 75% of voting shares in this company. Daltransgaz In February 2006, the Company purchased its 25% pro rata share of an additionalissue of shares in OJSC Daltransgaz, a company operating an independent pipelinesystem, for RUB 722 million (U.S.$ 26 million at the CBR exchange rate in effectas at the settlement date), thus maintaining its share at 25% plus one share. In August 2006, the Company purchased its 25% pro rata share of an additionalissue of shares by OJSC Daltransgaz for RUB 525 million (U.S.$ 19 million at theCBR exchange rate in effect as at the settlement date), thus maintaining itsstake at 25% plus one share. VBRR In July 2006, the Company purchased 25.49% of the common shares in OJSCVserossiysky Bank Razvitiya Regionov ("VBRR"), a Russian full service bank,thereby increasing its stake in the common shares of VBRR from 50.98% to 76.47%.The purchase price was RUB 333 million (U.S.$ 12 million at the CBR exchangerate in effect as at the settlement date). In September 2006, the shareholders of VBRR approved an additional share issueof 223,500 shares (RUB 10,000 per share at par value), all of which will bepurchased by the Company. The total par value of the shares to be purchased isRUB 2,238 million (U.S.$ 85 million at the CBR exchange rate in effect as at 31December 2006). As a result, the Company's ownership interest in VBRR will beincreased to 94.00%. This additional share issue is planned to take place laterin 2007. Corporate Restructuring RN-Burenie In March 2006, the Company created LLC RN-Burenie ("RN-Burenie") following theBoard of Directors' decision to optimise the Company's service arrangements.During the second quarter of 2006, drilling and other supporting assets weretransferred from upstream subsidiaries to RN-Burenie. In the third quarter of2006, the drilling divisions of the Company, namely LLC PNG-Burenie, LLCKNG-Burenie and LLC KNG-Sibir, were merged into LLC RN-Burenie. Consolidation via Share Swap Until the autumn of 2006, the Merged Subsidiaries had significant minorityinterests. See "-Results of Operations-Minority Interest in Subsidiaries'Earnings." On 1 October 2006, the Company exchanged 1,220,939,458 newly issuedordinary shares (11.52% of the Company's share capital) for shares of the MergedSubsidiaries held by third parties at specified exchange ratios and as approvedby the respective shareholders. These subsidiaries were then merged into theCompany. The Share Swap has been accounted for as a purchase. The fair value ofthe purchase consideration, which is the Company's ordinary shares issued forpurposes of the Share Swap, was determined based on the market value of theCompany's shares as of the closest date prior to the Share Swap and amounted toU.S.$ 9,218 million. The excess of the fair value of the shares issued over thefair value of minority interests purchased in the amount of U.S.$ 69 million hasbeen reflected as goodwill and relates to the refining and marketing segment.The Company attributes this goodwill to the synergies resulting from the merger.The majority of the purchase price was allocated to oil and gas properties,property, plant and equipment and mineral rights. Where the fair value of thenet assets purchased exceeded the purchase price, negative goodwill existed,which reduced on a pro rata basis the amounts assigned to the long-term assetspurchased. As a result of the merger following the Share Swap, all licences for thedevelopment and production of hydrocarbons previously held by the MergedSubsidiaries operating in the exploration and production segment weretransferred to the Company. Licences Won at Auctions The Company won a number of auctions for licences for exploration, developmentand production. 2007 Samara region In June 2007, a subsidiary of the Company won an auction for licences for theexploration and development of two oil and gas fields in the Samara Region. Thetotal cost of the licenses amounted to RUB 932 million (US$ 36 million at theCBR rate as of 31 March 2007). 2006 Kulindinsky Block In August 2006, the Company won an auction for a licence for the exploration andproduction of crude oil and gas in the Kulindinsky block in the Kransnoyarskterritory (previously the Evenkiysk autonomous district). The total cost of thelicence amounted to RUB 1,561 million (U.S.$ 59 million at the CBR exchange ratein effect as at the settlement date). The Kulindinsky block is located in theTungus-Chusk region in the South-Eastern part of the Kransnoyarsk territory.TheCompany expects to benefit from synergies arising from the development of theKulindinsky and Sanarsky blocks. The licence was granted in November 2006 andexpires in December 2031. North Charsky Block In July 2006, Rosneft won an auction for a licence for the exploration andproduction of crude oil and gas in the North Charsky block located at the borderof Taymir and Yamalo-Nenetsk autonomous districts. The total cost of the licencewas RUB 4,730 million (USD 177 million at the CBR exchange rate in effect as atthe settlement date). This purchase brought Rosneft's total number of licencesat the Vankorskoye field in Eastern Siberia to 14. The licence was granted inAugust 2006 and expires in August 2031. Osoveysky Block In July 2006, the Company won an auction for a licence for the exploration andproduction of crude oil and gas in the Osoveysky block in the Yamalo-Nenetskautonomous district, which is in close proximity to the developed Cherpayuskoye,Khasyreiskoye and Nyadeiyuskoye fields in the Yamalo-Nenetsk autonomousdistrict. The total cost of the licence was RUB 2,250 million (USD 84 million atthe CBR exchange rate in effect as at the settlement date). The licence wasgranted in September 2006 and expires in August 2026. Danilovsky Block In June 2006, the Company won an auction for a licence for the exploration andproduction of crude oil and gas in the Danilovsky block in the Irkutsk region.The total cost of the licence was RUB 1,210 million (U.S.$ 45 million at the CBRexchange rate in effect as at the settlement date). The licence was granted inAugust 2006 and expires in August 2031. Mogdinsky and Sanarsky Blocks In April 2006, the Company won an auction for licences for the exploration andproduction of crude oil and gas in the Mogdinsky and Sanarsky blocks in theIrkutsk region. The total cost of the licences was RUB 2,523 million(USD 94 million at the CBR exchange rate in effect as at the settlement date).These blocks are located in close proximity to the Verkhnechonskoye field,currently under development, allowing for reduced development costs, shouldcommercial volumes of hydrocarbons be discovered, through the share of certaininfrastructure with the Verkhnechonskoye field. The licences were granted inJuly 2006 and expire in June 2031. East Sugdinsky Block In March 2006, the Company obtained a licence for the exploration and productionof crude oil and gas in the East Sugdinsky block as a result of an auction wonin December 2005. The total cost of the licence was RUB 7,470 million, of whichRUB 300 million (U.S.$ 10 million at the CBR exchange rate in effect as at thepayment date) was paid in December 2005 in the form of an auction fee and theremaining consideration of RUB 7,170 million (U.S.$ 258 million at the CBRexchange rate in effect as at the payment date) was paid in 2006. The licencewas granted in March 2006 and expires in February 2031. Tukolandsky, Vadinsky and Pendomayakhsky Blocks In February 2006, the Company won auctions for licences for the exploration andproduction of crude oil and gas in the Tukolandsky, Vadinsky and Pendomayakhskyblocks in the Krasnoyarsk territory. The total cost of the licences amounted toRUB 5,377 million (U.S.$ 199 million at the CBR exchange rate in effect as atthe payment date). These blocks are located in close proximity to theVankorskoye field, which Rosneft started to develop in 2003. Consequently, theywill be able to share certain infrastructure with the Vankorskoye field, therebyreducing development costs should commercial volumes of hydrocarbons bediscovered. The licences were granted in May 2006 and expire in April 2031. Strategic Partnership Agreement with Gazprom On 28 November 2006, the Company and Gazprom entered into a strategicpartnership agreement (the "Strategic Partnership Agreement"). The partiesintend to participate jointly in tenders and auctions for subsoil use rights andimplement joint projects, the terms of which will be defined under separateagreements, involving in particular, the creation of gas-processing andpetrochemical facilities in Eastern Siberia and the Russian Far East. BothRosneft and Gazprom will share equally in joint projects involving geologicalprospecting and development of gas deposits, except projects with third-partyparticipation. Pursuant to the Strategic Partnership Agreement, Gazprom and itsaffiliated companies will purchase from Rosneft and its affiliated companies theexcess of its actual production of natural gas at the Western Siberia fieldsconnected to the Unified Gas Supply system (the "UGSS"), the national gaspipeline network operated by Gazprom, over the levels of Rosneft's production in2006, which was 8.45 bcm. The Strategic Partnership Agreement is effective untilthe end of 2015. Shareholder and Operating Agreement with Sinopec on Sakhalin-3 On 26 March 2007, the Company and Sinopec entered into a shareholder andoperating agreement for the exploration and development of a portion of theVeninsky block on the shelf of the Sakhalin Island (Sakhalin-3 project).According to this agreement, a wholly owned subsidiary of the Company, RosneftInternational Ltd., and a wholly owned subsidiary of Sinopec, Sinopec OverseasOil and Gas Limited, will hold the shares of Venin Holding Ltd., which wasestablished in October 2006. Venin Holding Ltd. will in turn become the soleshareholder of LLC Venineft ("Venineft") and the licence owner and operator ofthe Sakhalin-3 project. The Company will have a 74.9% stake in the project, theremaining 25.1% being held by Sinopec. Shareholder and Operating Agreements with BP Holdings on Sakhalin-4 andSakhalin-5 On 21 November 2006, the Company and BP Holdings International B.V. ("BPHoldings") entered into two shareholder and operating agreements for theexploration and development of the East Shmidtovsky (Sakhalin-5) and WestShmidtovsky (Sakhalin-4) blocks. According to the agreements, the Company willhold 51% and BP Holdings will hold 49% of the shares of each of Vostok-ShmidtNeftegaz Holdings B.V. and Zapad-Shmidt Neftegaz Holdings B.V., holdingcompanies incorporated in the Netherlands. Vostok-Shmidt Neftegaz Holdings B.V.will in turn become the sole shareholder of CJSC Vostok-Shmidt Neftegaz, thelicence owner and operator of the Sakhalin-5 project. Zapad-Shimdt NeftegazHoldings B.V. will in turn become the sole shareholder of CJSC Zapad-ShmidtNeftegaz, the licence owner and operator of the Sakhalin-4 project. Thefinancing of the projects is based on a carry financing agreement, whereas BPHoldings has agreed to carry the totality of the Company's financing costs ofthese projects during the exploration phase. Shareholder and Operating Agreement with KKC on West Kamchatka On 8 December 2006, the Company and K.K. Korea Kamchatka Co. Limited ("KKC")entered into a shareholder and operating agreement for the exploration anddevelopment of a shelf area in West Kamchatka. Korean National Oil Corporationowns 50% of KKC and a Korean consortium of 6 companies owns the other 50% ofKKC. LLC Kamchatneftegaz ("Kamchatneftegaz"), the licence owner and operator ofthe West Kamchatka shelf area, is a wholly owned subsidiary of the holdingcompany of the project, West Kamchatka Holding B.V., incorporated in theNetherlands in 2005. The Company owns 60% of West Kamchatka Holding B.V. and KKCowns 40% of this company. The financing of the project is based on a carryfinancing agreement, whereas KKC will carry the totality of the Company'sfinancing costs for this project during the exploration phase. Pursuant to theshareholder and operating agreement, key business decisions of West KamchatkaHolding B.V. shall be subject to the unanimous approval by both the Company andKKC and neither of the participants has a preferential voting right. As aresult, the Company accounted for this investment using the equity method. Main Factors Affecting Results of Operations The main factors that have affected Rosneft's results of operations during theperiods being analysed, and that can be expected to affect its results ofoperations in the future, are: • Changes in crude oil, petroleum products and gas prices; • RUB/U.S.$ exchange rate movements and inflation; • Changes in mineral production tax and export customs duty; • Changes in transport tariffs; and • Acquisitions of upstream and downstream assets from Yukos as a result of the May 2007 auctions described above under "-Significant Acquisitions-2007 - Purchase of Assets in Yukos Auctions". Changes in prices, export customs duty and transport tariffs can have asignificant impact on the mix of products and export routes the Company selects,as it seeks to maximise netback prices for the crude oil it produces. Rosneft'snet income has been negatively affected by a significant growth in exportcustoms duty in the first quarter of 2007 despite a decrease in world crude oilprices due to the impact of the time lag in setting applicable export customsduty rates and due to the imposition of export customs duty on export sales ofcrude oil and petroleum products to Belarus effective from 1 January 2007. Changes in Crude Oil, Petroleum Products and Gas Prices The prices of crude oil and petroleum products internationally and in Russiahave a significant impact on the Company's results of operations. World pricesfor crude oil are characterised by significant fluctuations that are determinedby the global balance of supply and demand. The crude oil that Rosneft exportsthrough the Transneft pipeline system is blended with oil of other producersthat is of a different quality. The resulting Urals blend is traded at adiscount to Brent. Russian domestic market prices for crude oil are difficult todetermine, mainly due to the significant intragroup turnover of the verticallyintegrated oil companies that dominate the market and unite their own upstreamand downstream activities. Moreover, to the extent they exist, crude oil marketprices in Russia can be significantly lower than they might otherwise be due toseasonal oversupply and regional imbalances. The dynamics of petroleum product prices in the international and Russianmarkets are determined by a number of factors, the most important among thembeing the level of world prices for crude oil, supply and demand for petroleumproducts, competition in the different markets and distances from the refinerieswhere the crude oil is refined into usable end products or intermediateproducts. The table below sets forth the average crude oil and petroleum products pricesworldwide and in Russia for the periods indicated: For the three months ended % change from the three months ended 31 March 31 March 2007 2006 2006 to 2007World market (U.S.$ per barrel)Brent 57.75 61.75 (6.5)%Urals (average Med+NWE) 54.30 58.20 (6.7)%Dubai-Oman (Singapore) 55.52 58.49 (5.1)% (U.S.$ per tonne)Fuel oil 3.5% (average Med) 256.11 283.90 (9.8)%Gas oil 0.2% (average Med) 525.79 551.73 (4.7)%Naphtha (average Med) 533.93 561.67 (4.9)%Russian market (U.S.$ per tonne)(1)Crude oil 195.24 256.41 (23.9)%Fuel oil 130.74 205.92 (36.5)%Diesel fuel 498.48 526.86 (5.4)%High octane gasoline 731.49 651.45 12.3%Low octane gasoline 556.35 541.74 2.7% Sources: Platts (world market), Kortes (Russian market). (1) Including VAT of 18%. Rosneft's gas sales have been limited to date, but the Company's strategyanticipates a significant increase in its gas business. Gazprom controls accessto the UGSS, and is the predominant supplier of gas in Russia and the onlyexporter of gas produced in Russia. Rosneft sells the gas it produces to Gazpromfrom time to time and is currently in the process of negotiating a long-termagreement to secure Rosneft's access to the UGSS for gas sales to third partiesand to sell additional gas to Gazprom, consistent with the Strategic PartnershipAgreement entered into between the Company and Gazprom on 28 November 2006. See"-Strategic Partnership Agreement with Gazprom." The Russian governmentregulates the prices for the gas Gazprom sells in Russia. While the regulatedprice has been rising in Russia, and is expected to continue to rise to a levelcloser to parity with export netbacks, it is currently still significantly belowworld prices levels. The regulated price has affected, and is likely to continueto affect, the pricing of the gas Rosneft sells to Gazprom from time to time orpursuant to the contract it is negotiating. Rosneft's average gas sale price wasRUB 812 (U.S.$ 30.84) per thousand cubic meters and RUB 589 (U.S.$ 20.92) perthousand cubic meters in the first quarters of 2007 and 2006, respectively.These prices were affected by the appreciation of the rouble over the U.S.dollar. For a discussion of the risks associated with crude oil, gas and petroleumproducts prices, see "-Quantitative and Qualitative Disclosures About MarketRisk-Prices for Crude Oil, Gas and Petroleum Products Risk". RUB/U.S.$ Exchange Rate Movements and Inflation The rouble - U.S. dollar exchange rate and inflation trends in the RussianFederation affect Rosneft's results of operations since most of Rosneft'srevenues from sales of crude oil and petroleum products are denominated in U.S.dollars, while a substantial portion of its expenses are denominated in Russianroubles. Accordingly, any real appreciation of the rouble versus the U.S. dollarnegatively affects Rosneft's margins. The rouble has appreciated against theU.S. dollar in real terms throughout the periods being analysed, and in nominalterms on average as well. The Company began to use currency hedging mechanismsin January 2007 in order to partially mitigate the effects of the fluctuation ofthe rouble against the U.S. dollar. See "-Quantitative and QualitativeDisclosures about Market Risk-Foreign Currency Risk". Whether the rouble appreciates or depreciates in real terms is a function of therelationship between movements in the nominal exchange rate and inflation. Thetable below sets forth information on exchange rate movements and inflationduring the periods being analysed. Inflation and Exchange Rates ---------- --------------- For the three For the year ended months ended 31 December 31 March ---------- ------------------ 2007 2006 2006 2005 2004 ----- ------ ----- ------ -----Rouble inflation (CPI) (1) 3.4% 5.0% 9.0% 10.9% 11.7%Rouble/U.S. dollar exchangerate at the beginning of 26.33 28.78 28.78 27.75 29.45the period(1)Rouble/U.S. dollar exchangerate at the end of the 26.01 27.76 26.33 28.78 27.75period(1)Average rouble/U.S. dollarexchange rate during theperiod(1) 26.31 28.16 27.19 28.29 28.81Nominal appreciation/(depreciation) of the 1.2% 3.5% 9.3% (3.6)% 6.1%rouble, as calculated byRosneft (2)Real appreciation/(depreciation) of the 4.7% 8.7% 19.1% 6.9% 18.5%rouble, as calculatedby Rosneft (2)Real appreciation/(depreciation) 2.3% 6.9% 16.7% 3.9% 14.0%of the rouble(1) (1) Source: CBR, State Statistics Committee of Russia. (2) Source: Rosneft. Changes in Mineral Production Tax and Export Customs Duty Mineral production tax and export customs duty accounted for approximately 45%of Rosneft's total revenues during the periods being analysed. The table belowsets out the mineral production tax and export customs duty paid by Rosneftduring these periods. The table below sets forth the rates of mineral production tax and exportcustoms duties during the periods being analysed: For the three months ended % change from the three months 31 March ended 31March 2007 2006 2006 to 2007 Mineral production taxCrude oil (RUB pertonne) 1,903 2,224 (14.4)%Crude oil (U.S.$ perbarrel) 9.89 10.80 (8.4)%Gas (RUB per thousandcubic meters) 147 147 0.0%Export customs dutyCrude oil (U.S.$ pertonne) 180.03 167.10 7.7%Crude oil (U.S.$ perbarrel) 24.61 22.84 7.7%Light and mediumdistilled products 133.60 129.20 3.4%(U.S.$ per tonne)Fuel oil (U.S.$ pertonne) 71.93 69.60 3.3% Mineral Production Tax The rate of mineral production tax for crude oil in the first quarters of 2007and 2006 was calculated by multiplying the base rate per tonne of crude oilproduced by the adjustment ratio equal to (P - 9) * Rt / 261, where "P" is theaverage Urals price per barrel during the previous month, and "Rt" is theaverage rouble/U.S. dollar exchange rate established by the CBR during theprevious month. The base rate was RUB 419 in the first quarter of 2007 and 2006. In the first quarter of 2007, the rate of mineral production tax for crude oildecreased by 14.4%, primarily due to a decrease in crude oil prices by more than5.1% and of the impact of the amended mineral production tax regime, asdescribed below. Excluding the effect of accruing in the first quarter of 2007 interest relatedto OJSC Yuganskneftegaz' tax liabilities for the years 1999-2004 to berestructured, mineral production tax was U.S.$ 9.37 per barrel of crude oilproduced and U.S.$ 8.09 per barrel of oil equivalent produced in the firstquarter of 2007 and U.S.$ 10.52 and U.S.$ 9.13, respectively, in the firstquarter of 2006. The rate of mineral production tax for gas is flat and was RUB 147 per thousandcubic meters of gas produced in the first quarter of 2007, unchanged compared tothe first quarter of 2006. On 27 July 2006, the State Duma adopted the Federal law #No. 151 -FZ and on 30December 2006, the Federal law #No. 268- FZ. These laws amended the mineralproduction tax regime. The key provisions of the laws are: • Certain mineral production tax-free periods for "greenfield" crude oil projects in the Republic of Sakha (Yakutya), the Irkutsk region and the Krasnoyarsk territory for up to 10 years for new production licences and 15 years for new combined exploration and production licences or up to 25 million tonnes of crude oil per licence during the tax-free period without paying mineral production tax. • Certain mineral production tax-free periods for crude oil losses within normative limits, approved for the previous years, if by 25 February of the current year the new norms are not approved. • Inclusion of a depletion ratio in the formula for calculating mineral production tax rates, which enables correction of the tax rate depending on degree of depletion of each field. The lowest mineral production tax rates apply to "brownfield" interests that are 80% or more depleted. • Zero mineral production tax for high density crude oil (more than 200 Megapascal second in layer conditions) where the direct method of accounting for produced oil is used. This legislation is expected to benefit Rosneft as it has extensive "greenfield"interests in Eastern Siberia and has significant "brownfield" interests that are80-99% depleted. Rosneft expects that in 2007 it will receive approximately RUB1.83 billion (U.S.$ 70 million at the CBR exchange rate in effect as at 31 March2007) in benefits as a result of this legislation. Rosneft expects this benefitto increase in the following years beyond the amount expected for 2007. Export Customs Duty As described in the following table, the rate of export customs duty is linkedto the average Urals price in the world oil markets of North-West Europe and theMediterranean in U.S. dollars per barrel of extracted crude oil (expressed inU.S. dollars per tonne). The table below sets forth the calculation of export customs duty in the firstquarters of 2007 and 2006:Urals price Export customs duty------------- ---------------------(U.S.$ per tonne) (U.S.$ per tonne)Below 109.5 (15 U.S.$ per Export customs duty is not leviedbarrel)109.5 to 146 (15 to 20 35% of the difference between the average Urals priceU.S.$ per barrel) in U.S.$ per tonne and U.S.$109.5146 to 182.5 (20 to 25 U.S.$ 12.78 plus 45% of the difference between theU.S.$ per barrel) average Urals price in U.S.$ per tonne and U.S.$146Above 182.5 (25 U.S.$ per U.S.$ 29.2 plus 65% of the difference between thebarrel) average Urals price in U.S.$ per tonne and U.S.$182.5 While the average Urals prices decreased during the periods analysed, the rateof export customs duty for crude oil increased to U.S.$ 180 per tonne (U.S.$ 25per barrel) of crude oil in the first quarter of 2007 from U.S.$ 167 per tonne(U.S.$ 23 per barrel) in the first quarter of 2006. This difference is primarilydue to the Russian government setting the rate of export customs duty every twomonths based on changes in the average world prices for the Urals crude oil.Effective export customs duty with respect to oil and gas sales was U.S.$ 23.3per barrel of crude oil exported in the first quarter of 2007, excluding theeffect of export customs duty on sales to Belarus, which is significantly lowerthan standard export customs duty, and U.S.$ 22.7 per barrel of crude oilexported in the first quarter of 2006. Export duties for petroleum products are established by the Russian governmentdepending on rates of world crude oil prices. Until 1 January 2007, export dutywas not payable on exports of crude oil and petroleum products to CIS countriesthat are members of the Customs Union, which are Belarus, Kazakhstan, Kirgiziyaand Tadzhikistan. Starting from 1 January 2007, export customs duty is levied onexport sales to Belarus as specified. Sales to countries that are exempt frompaying export customs duty were U.S.$ 43 million (1.46 million barrels) in thefirst quarter of 2007 and U.S.$ 395 million (11.52 million barrels) in the firstquarter of 2006. Impact When volumes of hydrocarbon sales remain unchanged, the mineral production taxand export customs duty reduce to a considerable degree the impact of upward ordownward movements in crude oil export prices on the Company's net income fromthe export of crude oil after a time lag of several months from the change inthe hydrocarbon prices. For companies that pay income tax at 24% of marginal revenues, when crude oilprices are in excess of U.S.$ 25 per barrel, the overall marginal rate of taxfor exports of crude oil outside the CIS at the average Urals price was asfollows: For the three months ended 31 March ------------ 2007 2006 ------ ------Mineral production tax 21.95 21.95Export customs duty rate above U.S.$25per barrel 65.00 65.00 ------ ------ 86.95 86.95Profits tax at 24% on U.S.$1 of marginalrevenue after mineral 3.13 3.13production tax and export duty ------ ------Overall marginal rate 90.08 90.08 ====== ====== For any price increase above U.S.$ 25 per barrel, the marginal rate of tax ishigher than the effective rate, as export customs duty is a progressive tax.Based on a U.S.$ 54.00 per barrel Urals crude oil price and the tax rates in thefirst quarter of 2007, the effective combined rate of mineral production tax andexport customs duty would be 60.65% compared with the marginal rate of 86.95%shown in the table above. As a result of these taxes, after a time lag of several months, the net incomeof businesses that export crude oil and petroleum products from Russia has areduced sensitivity to changes in crude oil prices. Moreover, the impact ofexport customs duty on crude oil relative to the impact of excise taxes onpetroleum products affects the choice to be made between exporting crude oil andrefining it for sale both internationally and in Russia. Changes in Transport Tariffs Rosneft transports most of its crude oil through the pipeline network owned andoperated by Transneft, a state-owned oil pipeline monopoly engaged in thetransportation of crude oil in Russia and abroad. The FTS, a governmental bodyregulating the natural monopolies, sets annually Transneft's base tariff for thetransportation of crude oil via trunk pipelines, which includes a dispatchtariff, a pumping tariff and a loading tariff. The dispatch tariff is set withrespect to the entire pipeline network, and the other tariffs are set withrespect to each Transneft "district" and the entry and exit points. From 1January 2007, the FTS set the dispatch tariff at RUB 9.6778 per 100 tonne/kmexclusive of VAT. The overall expense per tonne for the transport of crude oildepends on the length of the transportation route from the producing field tothe ultimate destination and the number of Transneft "districts" through whichthe crude oil is transported. Rosneft's crude oil tariff per tonne of crude oiltransported via Transneft increased by 10.7% on average in the first quarter of2007 compared to the first quarter of 2006. Rosneft seeks to utilise alternative means of transportation to optimisenetbacks, including the Northern route via Rosneft's Belokamenka exporttransshipment facility, the Southern route via the Caspian Pipeline Consortium("CPC") pipeline, the Far Eastern route via Rosneft's pipelineOkha-Komsomolsk-on-Amur located on the Sakhalin Island and the Nakhodka exporttransshipment facility for exports to Asia. In the first quarter of 2007 and 2006, Rosneft exported approximately 12.2% and11.7%, respectively, of its petroleum products through the pipeline system ownedand operated by OJSC AK Transnefteprodukt ("Transnefteprodukt"), a state-ownedpetroleum products pipeline monopoly, soon to become Transneft's subsidiary,engaged in the transportation of petroleum products in Russia and abroad. Theoverall expense per tonne for the transport of petroleum products depends on thelength of the transportation route to the ultimate destination. The petroleumproducts transported through the Transnefteprodukt pipeline system were producedat refineries formerly owned by Yukos located in the Samara region underprocessing contracts. Rosneft's petroleum products tariff per tonne of petroleumproducts transported via Transnefteprodukt increased by 255.0% in the firstquarter of 2007 compared to the first quarter of 2006, due to the use of newlogistical schemes and transportation routes (Ventspils and Bryansk-Ventspils)and due to rouble appreciation. Rosneft also depends on railway transportation, which accounted for 30.6% of itsexport sales of crude oil in the first quarter of 2007, including railway usedin a combination of transportation means, and approximately 62.2% of its exportsales of petroleum products in the first quarter of 2007. In the first quarterof 2006, railway transportation accounted for 29.9% of the Company's exportsales of crude oil and 32.2% of the Company's export sales of petroleumproducts. The Russian railway system ("RZD") is a state-owned monopoly providerof railway transportation services. Rosneft's railway tariff per tonne of crudeoil shipped increased by 13% in the first quarter of 2007, generally due to moredistant deliveries to China. RZD's tariffs are subject to control by FTS and toantimonopoly regulations. Recent Acquisitions of Upstream and Downstream Assets from Yukos Rosneft's acquisitions of upstream and downstream assets from Yukos as a resultof the May 2007 auctions are expected to have a substantial impact on theCompany's results of operations. While it is too early to gauge the full extentof this impact, Rosneft has identified five factors that it currently expectswill influence its results. These include: •increased debt and interest costs related to the financing and refinancing of the acquisitions. This debt and the related interest costs are expected to be gradually reduced over time in relation to earnings as the Company implements its financial strategy, which targets a ratio of financial debt to EBITDA of approximately one to one by the end of 2010; •increased production of crude oil and petroleum products, the latter resulting from the utilisation by the five acquired refineries of increased volumes of Rosneft crude oil; •increased capital expenditures, both upstream and downstream, as improvements are made to increase and optimize crude oil production and refining at the newly acquired assets; •higher production and operating expenses, both upstream and downstream. Higher upstream expenses per barrel are expected to be reduced in relative terms over time as the company works to improve efficiency and purchases and to increase crude oil production at the new upstream assets. The increase in refining operating expenses is expected to be offset in part by significantly lower costs for refining crude oil at third-party refineries as these have now been incorporated into the group; and •higher depreciation, depletion and amortisation due to the increased asset base in the group. Management expects to develop and finalize its plans for the new assets in thecourse of 2007. Production of Crude Oil, Petroleum Products and Gas Rosneft's ability to generate revenues depends on its production of crude oiland petroleum products. In addition, as noted elsewhere, an important part ofRosneft's strategy is to expand its production and sale of gas. Production of Crude Oil Rosneft produces crude oil at seven production Business Units and four fullyconsolidated production and development subsidiaries. The Company also has a 20%share in the Sakhalin-1 project consolidated into Rosneft under theproportionate consolidation method in which Rosneft recovered the right toreceive its pro rata income following the repayment of the carried interest toVidesh starting from 31 July 2006. See "-Significant Acquisitions-2006-Repaymentof Carried Interest in Sakhalin-1 Joint Venture." In addition, Rosneft producesoil at two producing joint ventures, which Rosneft accounts for using the equitymethod. Yuganskneftegaz, Purneftegaz in Western Siberia and Severnaya Neft inTimano-Pechora are Rosneft's most important production and development BusinessUnits, collectively accounting for 88.8% in the first quarter of 2007.Yuganskneftegaz accounted for 70.3%, Purneftegaz for 11.6% and Severnaya Neftfor 6.9% of Rosneft's production in the first quarter of 2007. The following table sets forth Rosneft's crude oil production during the periodsbeing analysed: For the three months % change from the three ended 31 March months ended 31 March ---------- -------- 2007 2006 2006 to 2007 (millions of barrels) (%)Crude oil production byBusiness Units and fullyand proportionately 147.92 136.11 8.7%consolidatedsubsidiaries (1)Crude oil production,as above, plus the sharein production ofjoint ventures(2) 154.38 137.24 12.5% (1) Crude oil production by Business Units and subsidiaries includes Rosneft'snet share of oil produced under the Sakhalin-1 PSA in the first quarter of 2007,net of an 8.00% royalty of 0.32 million barrels and a 2.07% Russian government'sshare of 0.08 million barrels. (2) Crude oil production by Business Units and subsidiaries as set forth above,together with the share in production of joint ventures, including Rosneft's50.0% share in crude oil produced by Polar Lights and Aday Petroleum jointventure in Kazakhstan and 49.4% share in crude oil produced by Udmurtneft. In the first quarter of 2007, Rosneft increased its production of crude oil by8.7%, to 147.92 million barrels compared with 136.11 million barrels in thefirst quarter of 2006. This growth was largely attributable to increasedproduction by Yuganskneftegaz and to the Company's 20% share in the productionof crude oil at Sakhalin-1. Production by Yuganskneftegaz increased from 96.21million barrels in the first quarter of 2006, to 103.99 million barrels in thefirst quarter of 2007, or by 8.1%. The Company's net pro rata share of oilproduced under the Sakhalin-1 PSA was 3.57 million barrels in the first quarterof 2007. Daily crude oil production in the first quarter of 2007 was 1,643.60 thousandbarrels as compared with 1,512.34 thousand barrels in the first quarter of 2006.Among the factors contributing to an increase in daily oil production was a risein average well production rates from 107.24 barrels per day in the firstquarter of 2006 to 109.73 barrels per day in the first quarter of 2007, inparticular, for newly drilled wells from 705.82 to 806.00 barrels per day. Production of Gas The table below sets forth Rosneft's gas production during the periods beinganalysed: For the three months % change from the three ended 31 March months ended 31 March ---------- ---------- 2007 2006 2006 to 2007 (billion cubic meters) (%)Gas productionby BusinessUnits and fully andproportionatelyconsolidatedsubsidiaries(1) 3.98 3.52 13.1%Gas production, asabove, plus the sharein production of jointventures(2) 3.99 3.52 13.4%_______________ (1) Gas production by Business Units and subsidiaries includes in the firstquarter of 2007 Rosneft's net share of gas produced under the Sakhalin-1 PSA,net of an 8.00% royalty of 4.87 million cubic meters and a 2.07% Russiangovernment's share of 1.26 million cubic meters. (2) Gas production by Business Units and consolidated subsidiaries as set forthabove, together with the share in production of joint ventures, includingRosneft's 50.0% share in gas produced by Polar Lights and 49.4% share of Rosneftin gas produced by Udmurtneft. Rosneft's gas production increased by 13.1% in the first quarter of 2007 to 3.98bcm, primarily due to the growth of production in Krasnodarneftegaz,Selkupneftegaz and Purneftegaz. The level of associated gas utilisation was 64.2% in the first quarter of 2007 compared to 61.9% in the first quarter of 2006. Rosneft has started developing a gas programme to increase the level ofassociated gas utilisation. This programme envisages the construction ofassociated gas gathering facilities, booster compression stations andunderground gas storage facilities. In addition, Rosneft plans to improve thegas quality by constructing oil and gas separation equipment and gas treatmentfacilities. Pursuant to the Strategic Partnership Agreement, it is expected that Rosneftwill participate in joint projects with Gazprom involving geological prospectingand development of gas deposits. See "-Strategic Partnership Agreement withGazprom." Production of Petroleum Products Rosneft refines the crude oil it produces at its two major refineries, TuapseRefinery on the Black Sea in the South of Russia and Komsomolsk Refinery in theRussian Far East. Rosneft also arranges for the crude oil it produces to beprocessed at refineries owned by third parties. These operations have increasedconsiderably from the beginning of 2005 as a result of purchasingYuganskneftegaz and routing its oil production for processing at refineriesformerly owned by Yukos. Rosneft purchased in May 2007 refineries formerlycontrolled by Yukos in Eastern Siberia and in the Samara region as a result ofauctions for the sale of certain refining assets of Yukos won by Rosneft'ssubsidiary (Neft-Aktiv LLC). See "-Significant Acquisitions-2007-Purchase ofAssets in Yukos Auctions-Yukos Assets". Rosneft also owns the MZ-Nefteprodukt lubricant plant in Moscow andmini-refineries in Gubkin in the Yamalo-Nenets autonomous district, in Usinsk inthe Komi Republic and in Nalchik in the Kabardino-Balkarsk Republic. The following table sets forth Rosneft's petroleum product production from itscrude oil during the periods being analysed: For the three months % change from the three ended 31 March months ended 31 March ----------- --------- 2007 2006 2006 to 2007 ------ ------ (millions of tonnes) (%)Petroleum productsoutput by TuapseRefinery, KomsomolskRefinery andmini-refineries 3.00 2.70 11.1%Petroleum productsoutput by thirdparty refineries 3.60 3.04 18.4% ------ ------ --------- Total 6.60 5.74 15.0% ====== ====== ========= In the first quarter of 2007, the Tuapse and Komsomolsk refineries processed22.18 million barrels (3.03 million tonnes) of Rosneft-produced crude oil, 12.1%more than in the first quarter of 2006. The depth of refining by the KomsomolskRefinery decreased from 62.2% in the first quarter of 2006 to 59.7% in the firstquarter of 2007, and by the Tuapse Refinery from 56.5% in the first quarter of2006 to 56.3% in the first quarter of 2007, yielding an aggregate of 2.94million tonnes of petroleum products in the first quarter of 2007. The decreasein the depth of refining was due to changes in crude oil quality and in theproduct mix. The total output of petroleum products from Rosneft-produced crudeoil, including output of mini-refineries and refineries controlled by thirdparties, increased by 15.0%, from 5.74 million tonnes in the first quarter of2006 to 6.60 million tonnes in the first quarter of 2007. In the first quarterof 2007, 23.75 million barrels of Rosneft-produced crude oil were refined atthird party refineries, including the Angarsk, Achinsk, Kuibyshev, Novokuibyshevand Syzran refineries formerly controlled by Yukos that Rosneft purchased duringthe May 2007 auctions, yielding approximately 3.60 million tonnes of petroleumproducts. In the first quarter of 2007, the Komsomolsk and Tuapse refineries did notrefine crude oil produced by third parties. In the first quarter of 2006, thethroughput of crude oil produced by third parties represented less than 0.2% ofthe total throughput of the two refineries. Both the Tuapse Refinery and the Komsomolsk Refinery have been operating at nearfull capacity during the periods being analysed. Results of Operations The following table sets forth statement of income information both in absolutevalues and as a percentage of total revenues during the periods being analysed: For the three months ended 31 March -------------------- --------- --------- 2007 2006 ---------- ---------- ------ (U.S.$ % of (U.S.$ % of millions) total millions) total revenue revenueRevenuesOil and gas sales 5,638 68.59% 5,039 68.77%Petroleum productsand processing fees 2,496 30.36% 2,219 30.29%Support servicesand other revenues 86 1.05% 69 0.94% ------ ------ ------ ------Total revenues 8,220 100.00% 7,327 100.00%Cost and expensesProduction and operatingexpenses 542 (6.59)% 443 (6.05)%Cost of purchasedoil,gas, petroleum 480 (5.84)% 288 (3.93)%products and refining costsSelling, general and 186 (2.26)% 142 (1.94)%administrative expensesPipeline tariffs and 939 (11.42)% 735 (10.03)%transportation costsExploration expenses 35 (0.43)% 26 (0.35)%Depreciation, depletion 673 (8.19)% 384 (5.24)%and amortisationAccretion expense 11 (0.13)% 8 (0.11)%Taxes other than income 1,916 (23.31)% 1,609 (21.95)%taxExport customs duty 2,678 (32.57)% 2,164 (29.53)% ------ ------ ------ ------Total cost and expenses 7,460 (90.74)% 5,799 (79.13)% ------ ------ ------ ------Operating income 760 9.26% 1,528 20.87% ====== ====== ====== ======Other income/ (expenses)Interest income 37 0.45% 38 0.52%Interest expense (201) (2.45)% (206) (2.81)%Loss on disposal ofproperty, plant and (12) (0.15)% (4) (0.04)%equipmentGain on disposal of 4 0.05% -investmentsEquity share in affiliates'(loss)/profits (11) (0.13)% 8 0.11%Dividends and income 1 0.01% 1 0.01%from joint venturesOther expenses, net (51) (0.62)% (26) (0.35)%Foreign exchange loss (47) (0.57)% (159) (2.16)% ------ ------ ------ ------Total otherincome/(expenses) (280) (3.41)% (348) (4.72)% ------ ------ ------ ------Income before incometax and minority interest 480 5.85% 1,180 16.15%Income tax expense (121) (1.47)% (335) (4.57)% ------ ------ ------ ------Income before minority 359 4.38% 845 11.58%interestMinority interest in (1) (0.01)% (43) (0.59)%subsidiaries' earnings ------ ------ ------ ------Net income 358 4.37% 802 10.99% ====== ====== ====== ====== Sales Revenues The table below analyses revenues from sales of crude oil, gas, petroleumproducts and processing fees in the first quarters of 2007 and 2006: For the three months % change from the three ended 31 March months ended 31 March -------------- ----------- 2007 2006 2006 to 2007 (U.S.$ % of total (U.S.$ % of total millions) revenue millions) revenue ------ ------ -------- Crude oilExport to non-CIScountries 5,159 62.8% 4,536 61.9% 13.7% Europe and otherdirections 3,930 47.8% 3,573 48.8% 10.0% Asia 1,229 15.0% 963 13.1% 27.6% Export to 362 4.4% 395 5.4% (8.4)% CISDomestic 38 0.5% 58 0.8% (34.5)% Gas 79 1.0% 50 0.7% 58.0% ------- ------ ------ -------- -------- Total oil and gas 5,638 68.7% 5,039 68.8% 11.9% ======= ====== ====== ======= ======= Petroleum productsExport to non-CIScountries 1,315 15.9% 1,266 17.3% 3.9% Europe and otherdirections 800 9.6% 810 11.1% (1.2)% Asia 515 6.3% 456 6.2% 12.9% Export to 24 0.3% 38 0.5% (35.8)% CISDomestic 1,157 14.1% 915 12.5% 26.4% Wholesale 975 11.9% 780 10.7% 25.04% Retail 182 2.2% 135 1.8% 34.8% ------- ------ ------ -------- ------- Total petroleumproducts andprocessing fees 2,496 30.3% 2,219 30.3% 12.5% ======= ====== ====== ======= ======= Support servicesand other revenues 86 1.0% 69 0.9% 24.6% ------- ------ ------ ------- ------ Total sales 8,220 100.0% 7,327 100.0% 12.2% ======= ====== ====== ======= ======= The table below analyses crude oil, gas and petroleum products sales volumes inthe first quarters of 2007 and 2006: For the three months % change from three months ended 31 March 2007 2006 2006 to 2007 % of total sales % of total sales volume volume ------ ------ ------ ------- --------Crude oil (millions of barrels) (%)Export to non-CIScountries 96.56 61.6% 80.67 58.8% 19.7%Europe and other 74.98 47.8% 64.45 47.0% 16.3%directions Asia 21.58 13.8% 16.22 11.8% 33.0%Export to CIS 10.10 6.5% 11.52 8.4% (12.3)%Domestic 1.39 0.9% 2.24 1.7% (37.9)%Crude oil (millions of tonnes)Export to non-CIS 13.20 61.6% 11.03 58.8% 19.7%countriesEurope and otherdirections 10.25 47.8% 8.81 47.0% 16.3%Asia 2.95 13.8% 2.22 11.8% 33.0%Export to CIS 1.38 6.5% 1.58 8.4% (12.3)%Domestic 0.19 0.9% 0.31 1.7% (37.9)% ------ ------- ------ ------- --------Total crude oil sales 14.77 69.0% 12.92 68.9% 14.3% ====== ======= ====== ======= ========Petroleum productsExport to non-CIScountries 3.43 16.0% 3.27 17.5% 4.9%Europe and otherdirections 2.16 10.1% 2.06 11.0% 4.9%Asia 1.27 5.9% 1.21 6.5% 5.0%Export to CIS 0.08 0.4% 0.13 0.7% (38.5)%Domestic 3.11 14.6% 2.43 12.9% 28.0%Wholesale 2.84 13.3% 2.18 11.6% 30.3%Retail 0.27 1.3% 0.25 1.3% 8.0% ------ ------- ------ ------- --------Total petroleum product 6.62 31.0% 5.83 31.1% 13.6%sales ====== ======= ====== ======= ======= Total crude oil andpetroleum product 21.39 100.0% 18.75 100.0% 14.1%sales ====== ======= ====== ======= ======= (billion cubic meters)Gas 2.562 2.390 7.2% Note: The total volume sold is different from the volume of crude oil produceddue to changes in inventory levels, purchases for resale, own use of oil byRosneft and losses during transportation and in refining. Average Crude Oil and Petroleum Products Sales Prices Achieved by Rosneft The unit prices in the following table may differ from unit prices of crude oiland petroleum products provided by information agencies due to the followingfactors: • Seasonal and other production fluctuations; • Different conditions of sales and supplies versus those cited in mass media; • Different conditions in local markets; • Discounts or mark-ups depending on crude oil or petroleum product quality, sales volume and timing of transactions; and • Terms of individual contracts differing from average market prices. The following table sets forth the average export and domestic prices of crudeoil, gas and petroleum products in the first quarters of 2007 and 2006: For the three months ended 31 March ------------------- 2007 2006 (U.S.$/ (U.S.$/ (U.S.$/ (U.S.$/ barrel) tonne) barrel) tonne)Average export pricesCrude oil export to non-CIS countries 53.43 390.83 56.23 411.24Europe and other directions 52.41 383.41 55.44 405.56Asia 56.95 416.61 59.37 433.78Crude oil export to CIS 35.86 262.32 34.29 250.00Petroleum products export to non-CIScountries - 383.38 - 387.16Europe and other directions - 370.37 - 393.20Asia - 405.51 - 376.86Petroleum products export to CIS - 300.00 - 292.31 Average domestic pricesCrude oil 27.34 200.00 25.89 187.10Gas (U.S.$/thousand cubic meter) - 30.84 - 20.92Petroleum products - 372.03 - 376.54Wholesale - 343.31 - 357.31Retail - 672.73 - 546.56 Revenues were U.S.$ 8,220 million in the first quarter of 2007, a 12.2% increaseover the first quarter of 2006 (U.S.$ 7,327 million). Revenues from the sale ofcrude oil and gas grew by 11.9%, and revenues from the sale of petroleumproducts by 12.5%, in the first quarter of 2007 compared with the first quarterof 2006. The growth in revenues was due to increased sales volumes of crude oiland petroleum products, offset in part by a decline in average world prices. Thegrowth in volumes was made possible by an 8.7% increase in crude oil productionand a 15.0% increase in petroleum product production during the period analysed. Crude Oil Export Sales to Non-CIS Countries In the first quarter of 2007, crude oil export revenues from exports to non-CIScountries were U.S.$ 5,159 million compared to U.S.$ 4,536 million in the firstquarter of 2006, an increase of U.S.$ 623 million, or 13.7%. The growth resultedfrom a 19.7% increase in sales volumes, which had a positive impact on revenuesof U.S.$ 892 million. The growth was partially offset by a 5.0% decrease inaverage prices, which decreased revenues by U.S.$ 269 million. The pricedecrease was attributable to the general decline of world prices; in particular,the average price for Urals crude oil Mediterranean fell by 6.7%. Crude Oil Export Sales to CIS In the first quarter of 2007, revenues from sales of crude oil to the CIS wereU.S.$ 362 million compared to U.S.$ 395 million in the first quarter of 2006, adecrease of U.S.$ 33 million, or 8.4%. A 4.9% increase in prices, which wouldhave increased revenues by U.S.$ 17 million, was offset by a 12.3% decrease involumes, which had a negative impact on revenues of U.S.$ 50 million, mainly dueto a shift of volumes from the CIS to other export destinations. Crude Oil Domestic Sales The volume of crude oil sold in Russia decreased significantly in the firstquarter of 2007. Domestic crude oil sales decreased in the period by U.S.$ 20 million to U.S.$ 38 million as compared with the first quarter of 2006. Thisresulted from a 37.9% decrease in sales volume, contributing U.S.$ 22 million ofthe decrease in revenues. This decrease was partially offset by a 6.9% increasein average prices, which had a positive impact on revenues of U.S.$ 2 million.The decline in volumes resulted from the allocation of more crude oil to exportsales and refining to achieve maximum netback prices as domestic sales of crudeoil have a relatively low profitability, in comparison to export sales. Petroleum Products Export Sales to Non-CIS Countries Revenue from the export of petroleum products to non-CIS countries was U.S.$1,315 million in the first quarter of 2007 compared to U.S.$ 1,266 million inthe first quarter of 2006, an increase of U.S.$ 49 million, or 3.9%. The growthin revenue from the export of petroleum products was attributable to a 4.9%growth in sales volume, which had a positive impact on revenues of U.S.$ 62million, partially offset by a 1.0% decrease in average prices, which reducedrevenues by U.S.$ 13 million. The decrease in average prices was due to theoverall decrease in world prices; in particular, the average price for fuel oilMediterranean fell by 9.8%. The growth in volumes was mainly attributable toincreased sales in Europe and other non-CIS countries and Asia. Petroleum Products Export Sales to CIS Countries In the first quarter of 2007, revenue from sales of petroleum products to theCIS were U.S.$ 24 million compared to U.S.$ 38 million in the first quarter of2006, a decrease of U.S.$ 14 million, or 36.8%. This decline resulted primarilyfrom a 38.5% decrease in volumes, which was mainly due to a shift of volumesfrom the CIS to other export directions. The decrease in volumes resulted in aU.S.$ 15 million decrease in revenue and was offset in part by a 2.6% increasein prices, which resulted in a U.S.$ 1 million increase in revenue. Petroleum Products Domestic Sales Revenue from the sale of petroleum products on the domestic market was U.S.$1,157 million in the first quarter of 2007 compared to U.S.$ 915 million in thefirst quarter of 2006, an increase of U.S.$ 242 million, or 26.4%. The growth inrevenue from domestic sales of petroleum products was attributable to a 28.0%increase in sales volume, which had a positive impact on revenues of U.S.$ 256million. The volume growth was mainly attributable to an increase in crude oilproduction and a decrease in domestic crude oil sales. The growth was offset inpart by a 1.2% decrease in average prices, which had a negative impact onrevenues of U.S.$ 14 million. The decrease in sales prices was mainlyattributable to the decline in world prices of petroleum products. Gas Sales Revenue from the sale of gas was U.S.$ 79 million in the first quarter of 2007compared to U.S.$ 50 million in the first quarter of 2006, an increase of U.S.$29 million, or 58.0%. The growth in revenue from gas sales was attributable to a47.4% increase in prices, which increased revenues by U.S.$ 25 million, and a7.2% growth in sales volume, from 2.390 bcm to 2.562 bcm, which had a positiveimpact on revenues of U.S.$ 4 million. Support Services and Other Revenues Support services and other revenues were U.S.$ 86 million in the first quarterof 2007, 24.6% higher than in the first quarter of 2006 (U.S.$ 69 million). Thisgrowth was mainly attributable to an increase in the volume and value ofdrilling and rent services and sales of materials. Costs and Expenses The following table sets forth Rosneft's costs and expenses during the periodsbeing analysed. For the three months % change from the three ended 31 March months ended 31 March ------------ --------- 2007 2006 2006 to 2007 ------ ------ --------- (U.S.$ millions) (%) Production and operatingexpenses 542 443 22.3%Cost of purchased oil,gas, petroleum products andrefinery costs 480 288 66.7%Selling, general andadministrative expenses 186 142 31.0%Pipeline tariffs andtransportation costs 939 735 27.8%Exploration expenses 35 26 34.6%Depreciation, depletion andamortisation 673 384 75.3%Accretion expense(1) 11 8 37.5%Taxes other than incometax 1,916 1,609 19.1%Export customs duty 2,678 2,164 23.8% ------ ------ -------Total costs and expenses 7,460 5,799 28.6% ------ ------ ------- (1) Unwinding of discount related to asset retirement obligations. Costs and expenses were U.S.$ 7,460 million in the first quarter of 2007, or28.6% higher than in the first quarter of 2006 (U.S.$ 5,799 million). The growthin costs and expenses was driven by higher export customs duty, accrual ofinterest related to Yuganskneftegaz' tax liabilities, which are in the processof being restructured, higher depreciation, depletion and amortisation, pipelinetariffs and transportation costs, costs of purchased crude oil, and real roubleappreciation of 11.7% in the first quarter of 2007 as compared to the firstquarter of 2006, according to the CBR. Costs and expenses accounted for 90.74%and 79.13% of Rosneft's total revenues in the first quarters of 2007 and 2006,respectively. Production and Operating Expenses In the first quarter of 2007, production and operating expenses were U.S.$ 542million compared to U.S.$ 443 million in the first quarter of 2006, a 22.3%increase. The main contributors (excluding rouble appreciation of 11.7%) werehigher production volumes, an increase in staff and employees, an increase insalaries, an increase in the cost of materials used in the downstream segmentand an increase in well workovers expenses in the first quarter of 2007, ascompared with the first quarter of 2006, due to abnormally low temperatures inthe beginning of 2006. Upstream production and operating expenses include costs related to rawmaterials and supplies, equipment maintenance and repair, wages and salaries,activities to enhance oil recovery, procurement of fuel and lubricants,electricity and other similar costs of production and exploration Business Unitsand subsidiaries. Upstream production and operating expenses were U.S.$ 478million in the first quarter of 2007, or U.S.$ 3.23 per barrel of crude oilproduced and U.S.$ 2.79 per barrel of oil equivalent produced. These expenseswere U.S.$ 315 million in the first quarter of 2006, or U.S.$ 2.31 per barrel ofcrude oil produced and U.S.$ 2.01 per barrel of oil equivalent produced.Upstream production and operating expenses in the first quarter of 2007, net ofSakhalin-1 costs, were USD 3.00 per barrel of crude oil produced and USD 2.59per barrel of oil equivalent produced. These measures are defined below under"-Key Financial Ratios." Downstream operating expenses include costs of services provided by thirdparties (such as transshipment and storage services), operating expenses of themarketing companies, operating expenses of refineries and other items. Of the total production and operating expenses, the upstream and downstreamsegments accounted for U.S.$ 478 million and U.S.$ 45 million, respectively, inthe first quarter of 2007 and U.S.$ 315 million and U.S.$ 118 million,respectively, in the first quarter of 2006. Other activities' operating expenses accounted for U.S.$ 19 million in the firstquarter of 2007 and U.S.$ 10 million in the first quarter of 2006. The following table sets forth Rosneft's refining costs and volumes at itsproprietary refineries during the periods being analysed (including refineries'operating expenses as well as selling, general and administrative expenses): For the three months % change from the three ended 31 March months ended 31 March ---------- --------- 2007 2006 2006 to 2007 ------ ------ --------- Refining costs for ownedrefineries (Komsomolskand Tuapse Refineries) 26 18 44.4%(U.S.$ millions)Throughput at Rosneft-ownedrefineries (Rosneft'sand other parties'crude oil) 3.03 2.71 11.8%(millions of tonnes) Refining cost per tonne(U.S.$) 8.58 6.64 29.2% ------ ------ --------- The main contributors to the growth of refining cost per tonne, excluding roubleappreciation of 11.7%, were increased rent expense and costs incurred inrelation to new equipment put into use at the end of 2006. Cost of Purchased Oil, Gas, Petroleum Products and Refining Costs The cost of purchased oil, gas, petroleum products and refining costs includescrude oil, gas and petroleum product procurement costs and costs of refiningRosneft's crude oil at third-party refineries. The costs of refining Rosneft'scrude oil at third party refineries and petroleum products procurement costshave been high in absolute terms since they are driven by the imbalance betweenRosneft's crude oil production and its refining capacity, as well as by thegeographical complexity of Rosneft's logistics. These factors explain the highproportion of crude oil refining costs paid to third-party refineries, as wellas the need to purchase petroleum products from third parties, in the firstquarter of 2007. The following table shows Rosneft's third-party refining costs and crude oil,gas and petroleum product procurement costs during the periods being analysed: For the three months % change from the three ended 31 March months ended 31 March ------------ ------------- 2007 2006 2006 to 2007 ------ ------ ------------ Refining fees paid tothird-party refineries(U.S.$ millions) 154 105 46.7%Rosneft crude oilthroughput atthird-party 3.87 3.25 19.1%refineries (millionsof tonnes)Refining fees per tonne 39.79 32.31 23.2%(U.S.$)Cost of procurementof gas (U.S.$ 10 - 100.0%millions)Procurement of 0.30 - 100.0%gas (bcm)Cost of procurementof petroleum productsfrom third partiesby the downstream 58 100 (42.0)%segment(1)(U.S.$ millions)Procurement ofpetroleum productsfrom third parties by thedownstream segment (1) 0.15 0.24 (37.5)%(millions of tonnes)Cost of procurement of crudeoil from third partiesby the downstream segment (2) 258 83 210.8%(U.S.$ millions)Procurement of crude oil fromthird parties by thedownstream segment (2) 11.00 2.80 292.9%(millions of barrels) Total cost of purchased oil,petroleum products and refining costs 480 288 66.7% ------ ------ --------- (1) The upstream segment also purchases petroleum products from third partiesfor use in its own operations. These purchases are reflected in production andoperating expenses and are included in upstream operating expenses to calculatethe relevant key performance indicators mentioned below. (2) The Company purchases crude oil from Udmurtneft. In the first quarter of2006, Rosneft also purchased crude oil from the Sakhalin-1 PSA. Starting from 31July 2006, the Company started to account for Sakhalin-1 under the proportionateconsolidation method. In the first quarter of 2007, cost of purchased crude oil, petroleum productsand refining costs were U.S.$ 480 million, a 66.7% increase from U.S.$ 288million in 2006. The increase was mainly attributable to the growth in domesticpurchase prices of crude oil. In addition, the Company began to purchase gas in2007. These purchases amounted to U.S.$10 million. The cost of refining crude oil at third-party refineries is high relative tothat of refining crude oil at Rosneft's refineries, since the processing feescharged by third parties are fully costed, while the cost of refining crude oilat Rosneft's refineries as reported above does not include depreciation, whichis reported in depreciation, depletion and amortisation, and taxes other thanincome tax. The need to rely on third-party refineries arose following thepurchase of Yuganskneftegaz, when Rosneft's crude oil production increasedsignificantly. At the end of the first quarter of 2005, Rosneft entered intoagreements with refineries controlled at the time by Yukos for the refining ofcrude oil produced by Yuganskneftegaz. Rosneft purchased these refineries in theMay 2007 auctions. In the first quarter of 2007, third-party refining feesincreased by 46.7% compared to the first quarter of 2006, which is explained bya 19.1% increase in the volume of refining, whereas the processing cost pertonne at third party refineries increased by 23.2% compared to the first quarterof 2006 due to a revised agreement with Yukos to cover capital expenditures incertain refineries to meet the new quality standards EURO-2 and EURO-3 and dueto expanding the product mix to include more expensive petroleum products, inparticular, lubricants. In some circumstances, it may be more economical for Rosneft to purchasepetroleum products from third parties to supply, together with its own petroleumproducts, Rosneft's marketing and transshipment Business Units and subsidiaries.The volume of petroleum products purchased from third parties was 0.15 in thefirst quarter of 2007 and 0.24 million tonnes in the first quarter of 2006. In the first quarter of 2006, Rosneft purchased almost all of the crude oil(approximately 2.80 million barrels) produced by the Sakhalin-1 joint venturefor U.S.$ 83 million. Approximately 1.98 million barrels of crude oil weresupplied for refining to the Company's Komsomolsk Refinery and the rest wasexported to Asia. Starting from September 2006, the Company no longer purchasesoil from Sakhalin-1 since the parties to the PSA commenced exports via theConsortium's own terminal in De-Kastri, which started operations in the fourthquarter of 2006. In the fourth quarter of 2006, Rosneft started to purchasecrude oil from Udmurtneft. The volume of crude oil purchased in the firstquarter of 2007 was 11.00 million barrels accounting for U.S.$ 258 million. Selling, General and Administrative Expenses Selling, general and administrative expenses include wages and salaries andsocial benefits, banking commissions, third-party professional service fees foradvisory, legal and audit services, insurance expenses, lease expenses withrespect to non-core property, expenses to establish allowances for doubtfulaccounts and other general expenses. Selling, general and administrative expenses in the first quarter of 2007 wereU.S.$ 186 million, 31.0% higher than in the first quarter of 2006 (U.S.$142 million). This increase was mainly due to increased salaries and bonuses,which were U.S.$ 83 million in the first quarter of 2007 versus U.S.$ 56 millionin the first quarter of 2006 due to increased number of employees. Pipeline Tariffs and Transportation Costs Pipeline tariffs and transportation costs include costs to transport crude oilfor refining at own and third-party refineries and to end customers, and todeliver petroleum products from refineries to end customers. Transportationcosts include the cost of pipeline transportation, sea freight, railway andriver tariffs, handling, port fees and customs costs and demurrage. Pipeline tariffs and transportation costs grew to U.S.$ 939 million in the firstquarter of 2007 from U.S.$ 735 million in the first quarter of 2006, a 27.8%increase due mainly to an increase in the volume of transported oil (e.g., crudeoil export volumes to Asia increased by 33.0%) and in the pipeline and railwaytariffs of natural monopolies. Rosneft's crude oil export pipeline tariffsincreased by 7.73% in the first quarter of 2007 compared to the first quarter of2006. Rosneft's crude oil domestic pipeline tariffs for transportation torefineries increased by 13.7% in the first quarter of 2007 compared to the firstquarter of 2006. Rosneft's tariff per tonne of exported petroleum productstransported via Transnefteprodukt increased by 255.0% in the first quarter of2007 compared to the first quarter of 2006, due to the use of new logisticalschemes and transportation routes (Ventspils and Bryansk-Ventspils) and torouble appreciation. In the first quarter of 2007, Rosneft transported 50.0 million barrels (6.8million tonnes) of crude oil via Transneft to domestic refineries andapproximately 69.5 million barrels (9.5 million tonnes) for export sales viaTransneft and CPC, compared to approximately 43.0 million barrels (5.9 milliontonnes) of deliveries to domestic refineries and 60.2 million barrels (8.2million tonnes) for export sales in the first quarter of 2006. For the first quarter of 2007, the Company transported 2.4 million tonnespetroleum products, including 1.9 million tonnes by railroad, 0.3 million tonnesvia pipelines and 0.2 million tonnes using a combination of transportationmeans. For the first quarter of 2006, the Company transported 1.4 million tonnespetroleum products, including 1.0 million tonnes by railroad, 0.1 million tonnesvia pipelines and 0.3 million tonnes using a combination of transportationmeans. Railway domestic tariffs increased by 17.0% and railway export tariffs increasedby 6.0% in the first quarter of 2007 compared to the first quarter of 2006. Exploration Expenses Exploration expenses mainly represent expenses relating to exploratory drilling,seismic and other geological and geophysical costs. Exploratory drilling costsare generally capitalised if commercial reserves of oil and gas are discovered,or written off as expenses in the current period in the event of unsuccessfulexploration results. In the first quarter of 2007, exploration expenses increased by U.S.$ 9 million,or 34.6%, to U.S.$ 35 million from U.S.$ 26 million in the first quarter of2006. The increase was mainly due to Yuganskneftegaz's and Vankorskoye fieldexploration works expenses. Depreciation, Depletion and Amortisation Depreciation, depletion and amortisation includes depreciation of oil and gasproducing assets, and other production and non-production assets. Depreciation, depletion and amortisation was U.S.$ 673 million in the firstquarter of 2007 compared to U.S.$ 384 million in the first quarter of 2006. The75.3% increase was mainly due to a revaluation of fixed assets as a result ofthe Share Swap and also due to increased capital expenditures, which resulted inan increased balance sheet value of fixed assets in the first quarter of 2007compared to the first quarter of 2006. This increase was partially offset by adecrease in average depletion rates for oil and gas properties to 1.7% in thefirst quarter of 2007 from 1.9% in the first quarter of 2006. Taxes Other than Income Tax Taxes other than income tax include the mineral production tax, the excise tax(mainly with respect to petroleum products), the unified social tax, theproperty tax and other taxes. The basis for the calculation of mineralproduction tax is described under "-Main Factors Affecting Results ofOperations-Changes in Mineral Production Tax and Export Customs Duty" above.Taxes other than income tax have increased throughout the periods beinganalysed, mainly due to the impact of the mineral production tax. The following table sets forth Rosneft's taxes other than income tax during theperiods being analysed: For the three months % change from the three ended 31 March months ended 31 March ----------- ---------- 2007 2006 2006 to 2007 ------ ------ ---------- (million U.S.$) (%) Mineral production tax 1,609 1,432 12.4%Excise tax 142 81 75.3%Social security 48 35 37.1%Property tax 38 23 65.2%Land tax 2 2 0.0%Transportation tax 1 0 100.0%Other taxes and payments 76 36 111.1% ------ ------ ----------Total taxes other thanincome tax 1,916 1,609 19.1% ====== ====== ========== Taxes other than income tax increased by 19.1% in the first quarter of 2007 toU.S.$ 1,916 million, compared to U.S.$ 1,609 million in the first quarter of2006. The growth in taxes resulted mainly from an increase in mineral productiontax. Following the intention of the Company to proceed with the tax restructuringprocess in respect of OJSC Yuganskneftegaz back-taxes, the tax authoritiesretroactively cancelled suspension of certain interest accruals for them to befully included in the tax restructuring plan. These tax liabilities were alreadyfully accrued in the consolidated financial statements in prior periods togetherwith all penalties and a portion of interest before such interest accrual wassuspended following the Company's applications for restructuring. As a result ofthe cancellation, additional interest of approximately U.S.$ 388 million becamedue as of 1 June 2007. The additional amount of interest, not previouslyrecorded, amounted to approximately U.S.$ 332 million as of 31 March 2007. Thetotal amount of interest and penalties payable as of 31 March 2007 amounted toU.S.$ 831 million. The interest will continue to accrue in accordance with theTax Code of the Russian Federation based on CBR refinancing rate until therestructuring plan is approved by the Government of the Russian Federation,which is currently expected before the end of 2007. The total principle amountsubject to tax restructuring provisions is U.S.$1,260 million. Tax restructuring rules generally provide for forgiveness of interest andpenalties subject to overall compliance with the restructuring plan and accelerated payments of principal amounts of tax liabilities. The Company intends tocomply with the tax restructuring plan, including acceleration provision, onceand if it is in force. The management concluded that the criteria of'more-likely than-not' in respect of forgiveness of income tax related interestand penalties is currently not met as well as 'probable' criteria in respect offorgiveness of all other tax interest and penalties. Therefore the full accrualof additional interest in the amount of U.S.$ 332 million was recorded in theInterim Financial Statements for the period ended 31 March 2007 as a change inestimate. Mineral production tax in the first quarter of 2006 included U.S.$ 26 millionfines accrued in relation to Yuganskneftegaz tax contingencies. The reduction inmineral production tax in the first quarter of 2007 compared to the firstquarter of 2006 excluding the effect of the fines accrued in relation to theliabilities of Yuganskneftegaz was primarily attributable to tax benefits inrelation to Rosneft's "brownfield" interests. See "-Main Factors AffectingResults of Operations-Changes in Mineral Production Tax and Export CustomsDuty-Mineral Production Tax." Export Customs Duty The export customs duty payable by Rosneft includes crude oil and petroleumproduct export customs duties. The export customs duty is discussed above under" -Main Factors Affecting Results of Operations-Changes in Mineral ProductionTax and Export Customs Duty." Export customs duty has increased as a percentageof total revenue throughout the periods being analysed. The following table sets forth Rosneft's export duties during the periods beinganalysed: For the three months % change from the three ended 31 March months ended 31 March ----------- -------------- 2007 2006 2006 to 2007 ------ ------ -------------- (U.S.$ millions) (%) Export duty 2,312 1,833 26.1%for crude oilExport duty for 366 331 10.6%petroleum products ------ ------ --------Total export customs 2,678 2,164 23.8%duties ====== ====== ======== The following table sets forth Rosneft's calculations of the export customs dutyas a percentage of crude oil export sales revenues for the period indicated: For the three months ended 31 March 2007 2006 (U.S.$ per barrel, except %)Average Urals price 54.3 58.2Customs duty as defined in customs legislation 23.1 25.6Average price of crude oil sold by Rosneft tonon-CIS 53.43 56.23countriesExport customs duty as % of average Uralsprices as calculated 43% 46% (U.S.$ million, except %)Crude oil customs duties (1) 2,312 1,833Crude oil export sales (2) 5,159 4,536Export customs duty as % of crude oil exportsales (2) 45% 40% (1) Until 1 January 2007, export duty was not payable on exports to the CIScountries that are members of the Customs Union, which are Belarus, Kazakhstan,Kirgiziya and Tadzhikistan. Starting from 1 January 2007 export customs duty islevied on export sales to Belarus. (2) Excluding crude oil export sales where duties are not payable onexports. For a description of calculation of the export customs duty under applicableRussian tax legislation, see "Main Factors Affecting Results ofOperations-Changes in Mineral Production Tax and Export Customs Duty-ExportCustoms Duty." The impact of the export customs duty on Rosneft's margins variesfrom period to period depending not only on the average Urals price per barrelduring each period but also on the timing and direction of price movementswithin each period. This is due to the more rapid impact of price changes onRosneft's revenue determined under U.S. GAAP than on the amount of exportcustoms duty determined under the formula. The effect of this timing factor canbe seen in the relative movements over time of "export customs duty aspercentage of average Urals prices, as calculated" and "export customs duty aspercentage of crude oil export sales" in the preceding table. In the firstquarter of 2007, the export customs duty declined as a percentage of averageUrals prices, compared to the first quarter of 2006, while it increased as apercentage of crude oil export sales. Export customs duties were U.S.$ 2,678 million in the first quarter of 2007compared to U.S.$ 2,164 million in the first quarter of 2006. The increaseresulted from a growth in export volumes to non-CIS countries of 19.7% for crudeoil and 4.9% for petroleum products, and an increase in tariffs of exportcustoms duties in the range of 3.3-7.7%, depending on the type of hydrocarbons.The increase also resulted from the introduction of export duty on crude oilexported from the Russian Federation to Belarus. Operating Income As a result of the factors discussed above, operating income decreased by 50.3%in the first quarter of 2007 compared to the first quarter 2006. As a percentageof total revenues, operating income was 9.26% and 20.87% in the first quartersof 2007 and 2006, respectively. As a percentage of revenues operating income before taxes other than income taxand export customs duty was 65.14% and 72.35% in the first quarter of 2007 and2006, respectively. Other Income/(Expenses) Interest Income Interest income decreased by 2.6% to U.S.$ 37 million in the first quarter of2007 from U.S.$ 38 million in the first quarter of 2006. Interest Expense Interest expense decreased by 2.4% to U.S.$ 201 million in the first quarter of2007 compared to U.S.$ 206 million in the first quarter of 2006. In April 2006,Rosneft entered into a contract improving conditions of existing loanagreements, which decreased interest rates to LIBOR plus 0.7% (previously LIBORplus 3.0%) for loans totalling U.S.$ 4,770 million as of 31 December 2006 anddecreased interest rates to LIBOR plus 0.65% (previously LIBOR plus 1.8-2.2%)for loans totalling U.S.$ 2,643 million as of 31 December 2006. Loss on Disposal of Property, Plant and Equipment Rosneft disposes of property, plant and equipment from time to time. Loss ondisposal of property, plant and equipment was U.S.$ 12 million in the firstquarter of 2007, compared to a loss of U.S.$ 4 million in the first quarter of2006. Other Expenses, Net Other expenses, net, consist principally of social expenditures andcontributions to charity. In the first quarter of 2007, other expenses, net, were U.S.$ 51 million, a96.2% increase from the first quarter of 2006, which amounted to U.S.$ 26million. This increase is primarily due to increased charity contributions. Foreign Exchange Loss Foreign exchange loss was U.S.$ 47 million in the first quarter of 2007 comparedto a foreign exchange loss of U.S.$ 159 million in the first quarter of 2006.The decrease in the foreign exchange loss resulted from the impact of thefurther appreciation of the rouble against the U.S. dollar. Income Tax Expenses The following table sets forth the Company's effective income tax rate underU.S. GAAP: ---------------- For the three months ended 31 March ---------------- 2007 2006 Effective income tax rate for Rosneft under U.S. GAAP 25% 28% The Company does not pay taxes based on consolidated income before taxes underRussian law. Income tax is calculated for each subsidiary based on its profitsin accordance with RAR. The U.S. GAAP effective profit tax rate was 25% in thefirst quarter of 2007, based on the projections for 2007, and 28% in the firstquarter of 2006, based on the projections for 2006, compared to the maximum rateof 24% established by the Russian tax legislation throughout the periodsanalysed. The most significant factors influencing the effective income tax rate in thefirst quarter of 2007 and 2006 was the impact of foreign exchange gaindetermined under U.S. GAAP, which is not taxable and is included in incomebefore tax and minority interest. As discussed above under "-Business Segments and Intersegment Sales," Rosneftsubsidiaries engage in significant intragroup transactions for which Rosneftmanagement determines transfer prices. Russian transfer pricing rules enteredinto force in 1999, giving Russian tax authorities the right to control transferprices between transacting parties, for barter and foreign trade transactionswhere prices deviate more than 20% from the market price for similartransactions in the same period. For deviations of more than 20% from the marketprice, tax authorities may assign additional taxes and penalties, using themarket price as a basis for calculating them. Russian transfer pricing rules arevaguely drafted, leaving wide scope for interpretation by Russian taxauthorities and courts. Moreover, it is difficult to determine domestic marketprices for crude oil. Due to the uncertainties in the interpretation of transferpricing legislation, and the difficulty of determining domestic market pricesfor crude oil, the tax authorities may challenge Rosneft's transfer prices andpropose adjustments. If such price adjustments are upheld by the Russian courtsand implemented, Rosneft's future financial results could be adversely affected.In addition, Rosneft could face significant losses associated with theassessment of prior tax underpaid and related interest and penalties, whichcould have an adverse effect on Rosneft's financial condition and results ofoperations. Rosneft seeks to ensure that its transfer pricing complies with thetransfer pricing rules. Income tax was U.S.$ 121 million in the first quarter of 2007 compared to U.S.$335 million in the first quarter of 2006. Current income tax decreased fromU.S.$ 413 million in the first quarter of 2006 to U.S.$ 236 million in the firstquarter of 2007, while deferred tax benefit increased from U.S.$ 78 million toU.S.$ 115 million, mainly due to the effect of the Share Swap resulting inincreased US GAAP fixed assets value. The current income tax expense decreaseddue to lower taxable profit in 2007 as compared with 2006. Minority Interest in Subsidiaries' Earnings As discussed above under "-Development of Rosneft-Consolidation via Share Swap,"there were significant minority interests in the Company's subsidiaries duringthe periods being analysed prior to the Share Swap in October 2006, which wereeliminated as a result of the Share Swap. Minority interest in subsidiaries' earnings was U.S.$ 1 million in the firstquarter of 2007 compared to U.S.$ 43 million in the first quarter of 2006,mainly as a result of the consolidation via the Share Swap. Net Income As a result of the factors discussed above, net income decreased by 55.4% toU.S.$ 358 million in the first quarter of 2007 from U.S.$ 802 million in thefirst quarter of 2006. As a percentage of total revenues, net income was 4.37% and 10.99% in the firstquarters of 2007 and 2006, respectively. Liquidity and Capital Resources Cash Flows The principal items of the statement of cash flows for the first quarters of2006 and 2007 are as follows: For the three months % change for the three ended 3 March months ended 31 March ------------ ----------- 2007 2006 2006 to 2007 -------- -------- ------------ (U.S.$ millions) (%) ------------ ------------Net cash providedby operating activities 894 1,413 (36.7)%Net cash usedin investing (1,046) (1,506) (30.5)%activitiesNet cash providedby/(used in)financing activities 1,271 (601) 311.5% Net Cash Provided by Operating Activities Net cash provided by operating activities was U.S.$ 894 million in the firstquarter of 2007 and U.S.$ 1,413 million in the first quarter of 2006. Thisdecrease principally reflected a decrease in net income in the first quarter of2007 compared to the first quarter of 2006 and a significant increase inaccounts receivable as of 31 March 2007 compared to 31 December 2006, mainly dueto an increase in trade accounts receivable to U.S.$ 1,675 million as of 31March 2007 from U.S.$ 1,176 million as of 31 December 2006 and an increase inbanking loans to customers to U.S.$ 679 million from U.S.$ 580 million inconnection with loans provided by VBRR and Dalnevostochny Bank, respectively. Net Cash Used in Investing Activities Net cash used in investing activities was U.S.$ 1,046 million in the firstquarter of 2007 compared to U.S.$ 1,506 million in the first quarter of 2006.Net cash used in investing activities in the first quarter of 2006 includedU.S.$ 463 million resulting from the acquisition of Yukos debt from a consortiumof Western banks in the total amount of U.S.$ 483 million. Capital expendituresaccounted for U.S.$ 1,033 million in the first quarter of 2007, as compared withcapital expenditures and licence acquisitions of U.S.$ 848 million in the firstquarter of 2006. The Company did not acquire new licenses in the first quarterof 2007. Net Cash Provided by/(Used in) Financing Activities Net cash provided by financing activities was U.S.$ 1,271 million in the firstquarter of 2007 compared to U.S.$ 601 million used in financing activities inthe first quarter of 2006. The change was primarily due to a RUB 39,100 million(U.S.$ 1,503 million at the CBR exchange rate in effect on 31 March 2007)deposit paid by the Company in March 2007 to participate in the auction for thesale of one billion ordinary shares of the Company (9.44% of the share capital)that were owned by Yukos. On 22 May 2007, Rosneft's Board of Directors recommended to the annualshareholders' meeting to declare annual dividends (based on the 2006 performanceresults) for common stock in the amount of RUB 14,096 million or RUB 1.33 pershare (U.S.$ 541.9 million or U.S.$ 0.05 per share at the CBR rate as at 31March 2007). Capital Expenditures Rosneft's total capital expenditures by types of activities, as well as itslicence acquisition costs, for the periods being analysed are set forth below: For the three months ended 31December % change from the three ----------- months ended 31 March 2007 2006 2006 to 2007 ------ ------ ---------- (U.S.$ millions) (%) OJSC NKRosneft - Yuganskneftegaz 457 317 44.2%(RN-Yuganskneftegaz LLC)Vankorskoye field 276 1 27,500%OJSC NK Rosneft - Purneftegaz 51 36 41.7%(RN-Purneftegaz LLC)Sakhalin-1 PSA 39 - 100%OJSC NK Rosneft - Severnaya Neft 39 30 30.0%(RN-Severnaya Neft LLC)Other 54 82 34.1%Total upstream segment 916 466 96.6%OJSC NK Rosneft 50 14 257.1%OJSC NKRosneft - Tuapse refinery 14 1 1,300%(RN-Tuapse Refinery LLC)OJSC NKRosneft - Komsomolsk refinery 7 0 100%(RN-KomsomolskyRefinery LLC)Marketing Business Units andsubsidiaries 29 16 81.3%Other 8 1 700%Total downstream 108 32 237.5%Other activities 9 92 (90.2)% ------ ------ ----------Total capitalexpenditures 1,033 590 75.1%Licence acquisition costs - 258 (100.0)% ------ ------ ----------Total capitalexpenditures andacquisition of licences 1,033 848 21.8% ====== ====== ========== Rosneft's total capital expenditures increased by 75.1% or by U.S.$ 443 millionto U.S.$ 1,033 million in the first quarter of 2007 compared to U.S.$ 590million in the first quarter of 2006. The increase in capital expenditures inthe first quarter of 2007 was primarily driven by the upstream segment, wherecapital expenditures increased by 96.6%, or by U.S.$ 450 million. Upstreamsegment capital expenditures growth was mainly attributable to investments inYuganskneftegaz, Sakhalin-1 PSA and the Vankorskoye field. There were no licenceacquisition costs in the first quarter of 2007. Downstream capital expenditures increased by 237.5%, to U.S.$ 108 million, inthe first quarter of 2007 from U.S.$ 32 million in the first quarter of 2006 asa result of increased investments in the development of the Company'soperations, as well as in the Komsomolsk and Tuapse refineries and in theCompany's marketing and distribution subsidiaries. Capital expenditures for other activities decreased by 90.2%, or by U.S.$ 83million, in the first quarter of 2007, compared to U.S.$ 92 million in the firstquarter of 2006, primarily as a result of the construction of twin-hull shuttleoil tankers in the first quarter of 2006. In addition to capital expenditures described above, Rosneft made acquisitionsand increased its shareholdings in certain subsidiaries. See "-SignificantAcquisitions" and "-Development of Rosneft-Increased Stakes in Subsidiaries." Debt Obligations Over the past years, Rosneft has raised significant amounts of funds through netadditional short-term debt and long-term loans to supplement the net cashgenerated by Rosneft's operating activities in order to fund the capitalexpenditures required to develop Rosneft's upstream and downstream operationsand to purchase new businesses, assets and licences, in particular in theupstream segment. Most of the additional debt was raised in the first quarter of2007 in connection with the acquisition of Yukos assets. Rosneft's total loans and borrowings increased to U.S.$ 16,617 million as of 31March 2007 from U.S.$ 13,829 million as of 31 December 2006, primarily due tothe drawing of U.S.$ 2,635 million used to participate in the Yukos auctions inwhich Rosneft purchased treasury shares and intended to purchase OJSCGazpromneft shares and certain other assets (the bid was unsuccessful). InApril-May 2007, Rosneft drew additional amounts in the aggregate amount of U.S.$19,365 million to participate in auctions for the sales of other Yukos assets.See "Significant Acquisitions-2007-Purchase of Assets in Yukos Auctions." Theseloans are a mix of short and medium term obligations, a significant part ofwhich Rosneft plans to refinance over time. Additional borrowings contracted byRosneft to fund the Yukos auctions are described below. As of 31 March 2007, the bank loans raised for funding the acquisition of OJSCYuganskneftegaz represent a long-term loan obtained through a government-ownedbank at a rate of LIBOR plus 0.7% per annum repayable in equal monthlyinstallments. It is scheduled for repayment in 2011 and is secured by pledgingthe Company's receivables under a long-term contract for the supply of crudeoil. Rosneft's strategy has been to finance its growth primarily with long-termborrowings, which are predominantly denominated in U.S. dollars. Rosneft'slong-term borrowings (excluding the current portion of long-term debt) increasedto U.S.$ 8,663 million as of 31 March 2007 from U.S.$ 7,402 million as of 31December 2006. The weighted average rate of interest on Rosneft's long-termloans denominated in U.S. dollars was 5.89% and 5.96% per annum (LIBOR plus 0.57% and LIBOR plus 0.64%) as of 31 March 2007 and 31 March 2006, respectively. Long-term loans are generally secured by oil export contracts. Under the termsof such contracts, if the Company fails to repay debt in time, the lender isusually provided with an express right of claim for contractual revenue thatmust be remitted directly to U.S.$ denominated accounts opened with the creditorbanks. As of 31 March 2007 and 31 December 2006, 54.0% and 68.2%, respectively,of Rosneft's borrowings were secured by crude oil export contracts (excludingexport to the CIS). As of 31 March 2007 and 31 December 2006, pledged oilexports as a percentage of total crude oil export sales, constituted 40.0% and31.8%, respectively. As discussed in Note 7 to the Interim Financial Statements, the Company isobliged to comply with a number of restrictive financial and other covenantscontained within its loan agreements. Restrictive covenants include maintainingcertain financial ratios. As a result of the Company's acquisition of OJSCYuganskneftegaz in December 2004 and the resulting debt incurred and assets andliabilities, including consolidated contingent liabilities, the Company was notin compliance with various financial and other covenants of existing loanagreements as of that date. In July 2005, the creditors waived violationsrelated to restrictive financial ratios and agreed to amend the financial ratiocovenants in line with Rosneft's new structure and scope of activities. Thecreditors also waived other events of default arising from the breach of othercovenant provisions. With effect from 1 January 2007, the creditors grantedamendments to the loan agreements which remove these provisions and haveincluded new waivers which state that the Company must: •redeem, secure, discharge in full or restructure (and comply with any restructuring plans once it is agreed upon) all Yuganskneftegaz's tax liabilities by 3 January 2008; and •pay any arbitration award relating to the Moravel litigation or the Yukos Capital S.a.r.l. litigation if any such arbitration award is granted by a court of the Russian Federation, within the time frame provided for such payment under Russian Law. These conditions also apply to certain new borrowings obtained throughout thefirst quarter of 2007. As of 31 March 2007, the Company was in compliance withall restrictive financial and other covenants contained within its loanagreements. Rosneft's short-term borrowings (including the current portion of long-termdebt) increased to U.S.$ 7,954 million as of 31 March 2007 from U.S.$ 3,925million as of 31 March 2006. U.S. dollar-denominated short-term loans representloans received from a consortium of international banks, bearing interest atLIBOR plus 0.25-0.50% annual interest rate depending on the final settlementdate, and inter-bank loans entered into by the Company's subsidiary bank. VBRR,bearing interest at LIBOR plus 0.25%- 3.02% per annum. The loans received fromthe consortium of international banks were drawn to finance the acquisition ofcertain assets during the auctions for sales of these assets. Therouble-denominated loans represent loans received from Russian banks, whichgenerally bear interest ranging from 6.2% to 6.5% per annum depending on thematurity schedule, and inter-bank loans raised by the Company's subsidiary bankVBRR bearing interest ranging from 4% to 7.25% per annum. The following table shows the scheduled maturities of Rosneft's long-term debtoutstanding as of 31 March 2007: (U.S.$ millions) 2007 2,063 2008 2,647 2009 2,900 2010 2,613 2011 7512012 and after 339 ------------Total long-term debt 11,313 ============ In February 2007, the Company entered into a six month bridge loan with aconsortium of international banks in the amount of U.S.$ 2.5 billion at aninterest rate of LIBOR plus 0.25 to 0.30% per annum, depending on the finalrepayment date. These funds were used for the temporary refinancing (untilcorresponding long-term loans are entered into) of short-term loans obtainedfrom Russian banks in the fourth quarter of 2006 with less favourable terms. InMay 2007, the Company entered into a five-year loan agreement with a syndicateof international banks for U.S.$ 2 billion at LIBOR plus 0.5% per annum duringthe first three years and 0.575% per annum during the fourth-fifth years. TheCompany used these funds to refinance a portion of the short term bridge loanobtained from a consortium of international banks in February 2007. In March 2007, RN-Razvitie, a wholly owned subsidiary of the Company, won thetender for the acquisition of 9.44% of the share capital of the Company andpromissory notes of Yuganskneftegaz from Yukos for a total consideration of RUB197.84 billion (U.S.$ 7.59 billion at the CBR exchange rate in effect as at thedate of the auction). For the purposes of the Company's consolidated financialstatements, the total aggregate consideration for the acquired assets wasallocated to fair value on a pro rata basis and amounted to RUB 194.43 billionfor Rosneft's shares, or 194.43 RUB per share (U.S.$ 7.46 billion, or U.S.$ 7.46per share, at the CBR exchange rate in effect as at the date of the auction).In April-May 2007, Neft-Aktiv LLC, a wholly owned subsidiary of the Company, wona number of auctions for the sale of certain Yukos assets. These assets compriseshares in various exploration and production, refining, service and marketingcompanies in Western and Eastern Siberia and in the Samara region. The totalconsideration for acquired assets was RUB 344.1 billion (U.S.$ 13.3 billion atthe CBR exchange rate as at the date of the auction). These purchases werefinanced by syndicated loans in the total aggregate amount of U.S.$ 22 billion.See "Significant Acquisitions-2007-Purchase of Assets in Yukos Auctions." Guarantees In January 2007, the Company entered into a guarantee agreement with respect toall the obligations of Vankorneft under a letter of credit for the amount ofU.S.$ 62 million expiring 730 days after the date of issue of the letters ofcredit. Under the agreement, in case of occurrence of events making solvency ofthe Company doubtful, the bank can require to place money on deposit in amountsufficient for meeting all its current and future obligations till the letter ofcredit maturity. The Company evaluates the default risk of Vankorneft under theletter of credit as low. In January 2007, RN-Yuganskneftegaz LLC entered into a guarantee agreement withrespect to all the obligations of RN Energo LLC under an electricity supplyagreement with OJSC Tyumenskaya Energosbytovaya Companiya through 31 January2010, in the amount of approximately U.S.$ 58 million. Key Financial Ratios Rosneft monitors and evaluates its activities on an ongoing basis. Key financialratios for the periods indicated are set forth below: For the three months ended 31 March 2007 2006EBITDA margin 21.6% 26.2%Adjusted net income margin beforeminority interest 8.4% 11.5%Net debt to capital employed ratio 0.40 0.53Net debt to adjusted EBITDA ratio,annualised 2.11 1.45Current ratio 0.86 0.66 (U.S.$)EBITDA/bbl 12.01 14.11EBITDA/boe 10.37 12.24Upstream capital expenditure/bbl 6.19 3.42Upstream capital expenditure/boe 5,35 2.97Upstream operating expenses/bbl 3.23 2.31Upstream operating expenses/boe 2.79 2.01Adjusted free cash flow beforeinterest/bbl 0.34 7.44Adjusted free cash flow beforeinterest/boe 0.30 6.46 The Company considers EBITDA/bbl, ROACE, ROAE, upstream operating expenses/bbl,upstream operating expenses/boe and the related indicators as important measuresof its operating performance. In addition, these measures are frequently used byfinancial analysts, investors and other interested parties in the evaluation ofoil and gas companies. These measures have limitations as analytical tools andshould not be considered in isolation, or as a substitute for analysis of theCompany's operating results as reported under U.S. GAAP. EBITDA/bbl and EBITDA/boe are calculated for any period by dividing EBITDA forthat period by the barrels of crude oil or barrels of oil equivalent,respectively, produced during that period. No adjustments to these measures aremade to take into account the effect of changes in inventories during theperiod. Upstream capital expenditures/bbl and upstream capital expenditures/boe arecalculated for any period by dividing the capital expenditures in the upstreamsegment during that period by the barrels of crude oil or barrels of oilequivalent, respectively, produced during that period. No adjustments to thesemeasures are made to take into account the effect of changes in inventoriesduring the period. Upstream operating expenses/bbl and upstream operating expenses/boe arecalculated for any period by dividing the production and operating expenses ofthe upstream segment during that period by the barrels of crude oil or barrelsof oil equivalent, respectively, produced during that period. No adjustments tothese measures are made to take into account the effect of changes ininventories during the period. Adjusted free cash flow before interest/bbl and adjusted free cash flow beforeinterest/boe are calculated for any period by dividing adjusted free cash flowbefore interest during that period by the barrels of crude oil or barrels of oilequivalent, respectively, produced during that period. Adjusted free cash flowbefore interest is net cash provided by operating activities minus capitalexpenditures plus cash interest payments. Licence acquisition costs are notincluded in capital expenditures. No adjustments to these measures are made totake into account the effect of changes in inventories during the period. Upstream operating expenses include lifting costs, and the costs of gathering,treating, processing and storing the crude oil and gas in the fields anddelivering the crude oil and gas to a main pipeline (e.g., a Transneft trunkpipeline transshipment point). Upstream operating expenses exclude a portion ofthe costs relating to intersegment transactions, mainly operating leasesrelating to certain oil and gas facilities. Upstream operating expenses includefor 2006 similar operating leases between Yuganskneftegaz and service entitiescontrolled by Yukos. One of these entities, CJSC Yukos-Mamontovo, has beentransferred to Rosneft in April 2007 pursuant to a court decision and amounts inrespect of these operating leases will be excluded as intersegment transactionsgoing forward. Rosneft believes these exclusions are appropriate because if theleased oil and gas facilities had been owned by the upstream segment instead ofbeing leased by it from another segment, depreciation expense would have accruedinstead of lease expense, and that depreciation expense would not have beenincluded in upstream operating expenses. The following tables set forth relevant figures relating to these measures forthe periods indicated: Upstream Measures For the three months ended 31 March 2007 2006Upstream capital expenditures(1) (U.S.$millions) 916 466Upstream operating expenses (U.S.$millions) 478 315Barrels of crude oil produced(millions) 147.92 136.11Barrels of oil equivalent produced(millions) 171.34 156.84 (1) Does not include licence acquisition costs. Calculation of Adjusted Free Cash Flow before Interest For the three months ended 31 March 2007 2006 (U.S.$ millions)Net cash provided by operatingactivities 894 1,413Capital expenditures(1) (1,033) (590)Free cash flow (139) 823Cash interest payments(2) 190 190Adjusted free cash flow before interest 51 1,013 (1) Does not include licence acquisition costs. (2) Cash interest payments, whether capitalised or expensed, as reflected in thestatement of cash flows. Calculation of EBITDA Margin For the three months ended 31 March 2007 2006 (U.S.$ millions, except %)Net income 358 802Minority interest in subsidiaries'earnings 1 43Income tax expense 121 335Total other (income)/expenses 280 348Operating income 760 1,528Interest accrued in relation toYuganskneftegaz tax liabilities for1999-2004 332 -Accretion expense(1) 11 8Depreciation, depletion andamortisation 673 384Adjusted EBITDA 1,776 1,920Total revenues 8,220 7,327Adjusted EBITDA margin 21.6% 26.2% (1) Unwinding of discount related to asset retirement obligations. Calculation of Adjusted Net Income Margin before Minority Interest For the three months ended 31 March 2007 2006 (U.S.$ millions, except %)Net income 358 802Minority interest in subsidiaries'earnings 1 43Interest accrued in relation toYuganskneftegaz tax liabilities for1999-2004 332 -Adjusted net income before minorityinterest in subsidiaries' earnings 691 845Sales revenues 8,220 7,327Adjusted net income margin beforeminority interest in subsidiaries'earnings 8.4% 11.5% Calculation of Capital Employed and Related Indicators For the three months ended 31 March 2007 2006 (U.S.$ millions)Short-term loans and current portion oflong-term debt 7,954 3,925Long-term debt 8,663 7,708Cash and cash equivalents (1,626) (489)Net debt 14,991 11,144Shareholders' equity 22,233 8,235Minority interest in subsidiaries'earnings 226 1,842Equity 22,459 10,077Capital employed 37,450 21,221Average equity, including minorityinterest(1) 22,280 9,685Average capital employed 36,437 20,772 (1) Average equity including minority interest is calculated as a simpleaverage of the equity including minority interest at the start and end of thegiven period. (2) Average capital employed is calculated as a simple average of thecapital employed at the start and the end of the given period. This information is provided by RNS The company news service from the London Stock Exchange
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