Polish Oil & Gas Report
Diesel to the rescue; PKN
remains our top pick
Gergely Varkonyi, CFA
Research Analyst
(+36) 1 301-3748
gergely.varkonyi@db.com
PKN (Buy) should outperform its peers; Sell retained on PGNiG & Lotos
PKN remains our top pick in the Polish oil & gas sector with a Buy rating and a
33% upside to our revised PT of PLN48. We cite attractive valuation and a decent
growth outlook driven by an improving downstream environment, the Mazeikiu
recovery and less extensive maintenance in 2008. We retain our Sell rating on
PGNiG as the stock tends to perform poorly at times of rising gas import prices.
The downside to our revised PT of PLN3.25 is 8%. Lotos, too, remains a Sell
based on an 11% downside to our revised PT of PLN25.
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DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1
Target Price Revision
Top picks
PKN Orlen (PKNA.WA),PLN36.00 Buy
Companies featured
PKN Orlen (PKNA.WA),PLN36.00 Buy
2007A 2008E 2009E
DB EPS (PLN) 6.46 6.91 4.33
P/E (x) 8.0 5.2 8.3
EV/EBITDA (x) 6.2 4.9 5.4
Grupa Lotos (LTOS.WA),PLN28.00 Sell
2007A 2008E 2009E
DB EPS (PLN) 7.02 6.63 4.29
P/E (x) 6.6 4.2 6.5
EV/EBITDA (x) 5.5 5.4 7.8
PGNiG (PGNI.WA),PLN3.52 Sell
2007A 2008E 2009E
DB EPS (PLN) 0.34 0.30 0.23
P/E (x) 14.2 11.7 15.3
EV/EBITDA (x) 7.9 5.6 7.0
3M performance (US$)
10%
3%
1%
-3%
-9%
-12%
-17%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
MSCI EMEA PKN MSCI PL TUPRS LTS NESTE PGN
Key changes
Rating Revised Prior
PKN Orlen Buy Buy
PGNiG Sell Sell
Lotos Sell Sell
Price target (PLN)
PKN Orlen 48 47
PGNiG 3.25 4.10
Lotos 25 31.5
Global Markets Research Company
Further shift along the oil & gas value chain towards upstream
Record crude prices shifted the value realisation along the oil & gas chain further
upstream. However, the downstream environment is not all that bleak thanks to
record high diesel cracks, which more than offset significant weakness elsewhere
in the slate, and the rising Brent-Urals differential. High crude prices should also
lead to record inventory gains at refiners. On the downside, we highlight the
strong PLN and weak petchem margins. PGNiG should be hit by the yawning gap
between import and domestic prices, a result of political influence on gas pricing.
PKN’s outlook is not all that rosy but still tops that of PGNiG and Lotos
Notwithstanding that PKN is the only company without an exposure to upstream,
it remains our top pick as record high import losses should more than offset the
upstream benefit at PGNiG while Lotos is unlikely to benefit from the crack spread
improvement thanks to its hedging but we also note the risk from what looks like
fx trading rather than hedging. Also, PKN’s balance sheet constraints mean that it
is unlikely to deliver disappointments similar to Lotos (recently doubled its capex
plans) or PGNiG (expanded into the fertiliser sector). We are concerned about the
balance sheet risk at Lotos and PGNiG’s failure to monetise its large reserves.
2Q08 preview and changes in estimates
Operating performance at all three names should be strong in 2Q08. Refiners
should benefit from inventory gains, diesel cracks and the Brent-Urals differential,
PGNiG’s and Lotos’ crude units from high prices and rising volumes, and PGNiG
from the April gas price hike. However, this is just the calm before the storm for
PGNiG as performance from 4Q08 should deteriorate significantly while hedging
losses may take some of the shine away from Lotos. Excluding this from our
estimates, we raised our EBITDA forecast for Lotos by 24% and 15% for ’08 and
’09, and by 28% and 8% for PKN but we cut 6% and 34% off PGNiG numbers.
Valuation & risks
We value the Polish oil & gas sector with the APV method, an absolute cash flow
based valuation (p6, 7). We raise our PKN valuation by 2% to PLN48 but trimmed
our PGNiG and Lotos PT by 21% each to PLN3.25 and PLN25, respectively. While
only used as a sanity check, relative valuation supports our investment view as
PKN has a cheaper valuation than its Polish or most EMEA and GEMs peers (see
p7). For a detailed risk assessment on each company, please turn to p9.

Investment theme
We have reviewed our forecasts, valuation and rating of the Polish oil & gas sector in this
report. PKN Orlen remains our top pick in the sector and we have raised our PT from PLN47
to PLN48, 33% above the current price, and therefore maintain our Buy rating. We have
reduced our PGNiG valuation by 21% from PLN4.10 to PLN3.25 and in the light of the 8%
downside, we maintain our Sell rating. We have also trimmed our PT on Lotos by 21% from
PLN31.5 to PLN25 and since this suggests an additional 11% downside, we retain a Sell
rating on the stock. Therefore, we retain our negative stance on the Polish oil & gas sector
with our only recommended exposure being through PKN stock.

We turned bearish on the Polish oil & gas sector in our previous report of 10 April. The sector
has underperformed the MSCI EMEA index on both a 3M and 12M view (Figure 1 & 2). On a
3M basis PKN and on a 12M basis PGNiG slightly outperformed the local MSCI Poland index.
Lotos stock underperformed most of its peers as well as both indices on a 3M and 12M
view. We believe that sector- as well as company-specific factors contributed to the weak
absolute and relative performance of these downstream names, such as the high oil price
environment, adverse fx trends, margin pressure, adverse regulation in case of PGNiG and
the negative effect of redemptions at Polish mutual funds. While even PKN may remain an
underperformer to the broader market, we expect it to continue to outperform most of its
peers, thanks to an attractive valuation and a decent growth outlook relative to peers.
PKN remains our top pick; we stay negative on PGNiG and Lotos
PKN remains our top pick in Polish oil & gas sector based on attractive valuation, both
absolute (33% upside to our revised PT) and relative, improving downstream oil environment
(e.g. the strong diesel cracks, higher Brent-Urals differential), as well as the Mazeikiu recovery
and less extensive maintenance shutdowns in 2008 contributing to an improving financial
performance. The long-awaited monetisation of the value in its Polkomtel stake could also be
a catalyst over the next 12 months. On the downside, we note weakening petchem margins,
lack of upstream exposure and adverse fx rates.
Despite its weak recent stock performance, we retain our negative investment view and Sell
rating on PGNiG. In brief, the stock is likely to exhibit a weak performance at times of rising
gas import prices, just like in 2006, as the regulator typically does not allow high import costs
to be reflected in domestic gas prices, leading to widening import losses. This should
particularly be the case from 4Q08. We also see PGNiG’s valuation as unattractive, both in an

absolute (8% downside to our revised PT) and relative basis. Further, we are disappointed
about the company’s latest strategic direction of expanding into Poland’s fertiliser sector and
we are concerned that more investments may follow the recent purchase of a 10% in
Tarnow. On the upside, we note our expectations for a solid 5-6% dividend yield, which
could increase further should the government decide so (PGNiG has ample net cash).
We also retain our Sell rating and negative investment view on Lotos. While we continue to
appreciate the company’s significant transformation, we see no reason why to hold an
exposure to the stock before 2012, the first year of tangible results from the heavy
investment programme. Further, financing the investment programme remains a risk as
Lotos plans to spend almost four times its current market cap on capex over the next five
years, entirely financed from debt and cash flow. This entails the risk, in our view, of either a
delay in the execution of investments or an equity refinancing, leading to a potential dilution.
Finally, we disagree with the company’s decision to hedge its refining margin exposure to a
significant degree which should prevent Lotos from benefiting from the current strong
refining environment, e.g. high diesel cracks, while fx hedging increasingly looks like fx
trading which in 1Q08 generated more profits than the core operations but if markets turn
against Lotos’ positions, these huge fx positions may even backfire.
Valuation
We value the Polish oil & gas sector with the adjusted present value (APV) method, an
absolute, cash flow based method, whereby we discount our projected US$ FCF streams
with a variable set of opportunity cost of capital. The cost of capital is derived from the spot
US$ zero coupon yield curve, an equity risk premium of 4.9% (based on a time series of 102
years for 13 countries), a CDS rate (credit default swap) reflecting the company’s
geographical asset mix and a beta reflecting the company’s/stock’s non-systematic risks, e.g.
stock liquidity, management track record & incentives, transparency, corporate governance,
earnings visibility, etc. We believe that this absolute valuation is more suitable in deriving
absolute price targets and ratings, reflecting the company’s attributes on an absolute level
rather than relative to a sector, especially given the challenges in finding comparable stocks.
In terms of changes since our previous review, the US$ yield curve has shifted upwards
considerably, by an average 85bp. This had a negative effect on our valuation of course and
the steepening of the curve adversely impacted our terminal value estimates which typically
account for a large part of our target EV. As CDS rates decreased, this had a positive effect
on our valuation, e.g. Poland’s CDS fell from 55bp to 42bp. We raised PGNiG’s beta from
1.225 to 1.55 to reflect the increased regulatory risk and negative changes in strategy, i.e. an
expansion into the fertiliser sector. Overall, our opportunity cost of capital estimates have
increased by an average 232bp for PGNiG in a range of 10.5-11.8%, by 72bp for Lotos in a
range of 8.8-10.1% and by 71bp for PKN in a range of 8.4-9.7%. For fx, we use the average
spot rate of the preceding month, hence our revised PLN/$ and PLN/