Once the global economy gets back on its feet, we expect a strong
recovery in natural gas consumption, in particular in Europe.
Gazprom looks set to keep and enhance its role as a major gas
exporter to European markets. Europe has been and should remain
for the next few years Gazprom’s most important market from the
point of view of the cash flow generation.
Gazprom is looking particularly compelling both on our DCF
valuation and in relative terms. Our target price implies a 66%
potential return and the stock represents our preferred play among
the Russian oil and gas names.

Europe’s dependence on Russia for gas supplies looks set to continue for the
foreseeable future
Although the European authorities are acutely concerned about the region’s growing dependence on
imported gas supplies and are actively making efforts to diversify, we believe Russia has a strong position
among potential suppliers of gas to Europe. It already enjoys a 35% share in the European market which
it is striving to maintain going forward. Russia’s investment in huge new gas export projects (Nord
Stream, Yamal-Europe expansion) emphasises its commitment to the European market, as well as its
growing dependence on it.
From its side, the European parliament has worked out a list of priority projects aimed at securing
coverage of its future gas demand: the two Russian projects – Nord Stream and Yamal-Europe – top the
list of 10 Priority Projects of European Interest. Our view is that, unlike LNG supplies, pipeline projects
bring the two parties closer together, spurring their interest in mutual success. Although we acknowledge
the risk that Russia’s share in European gas supplies might decline over time, we do not foresee a
significant reduction in Russia’s role as a key gas supplier.
Gazprom is our preferred play among the Russian energy stocks
Europe remains Gazprom’s most important gas market from a cash flow generation standpoint. Although
the Russian government is committed to raising domestic gas prices to converge with European netback
levels by 2011, we do not expect this convergence to occur before 2015. This means that domestic gas
sales would remain sub-profitable relative to its European sales for several years longer.

Although smaller in absolute terms (Europe accounts for 29% of Gazprom’s gas sales compared with 53% of
gas volumes sold within Russia), Europe’s impact on Gazprom’s earnings is significantly larger – it generates
68% of Gazprom’s gas-related revenues. Therefore, any material consistent decrease in volumes exported to
Europe would particularly hurt Gazprom’s profitability. This is the key factor that prompted us to conduct this
analysis of the European gas market. Our conclusion is that Europe will continue to depend on Russia’s gas
(and more specifically, on its rising volumes) for the foreseeable future.
Our investment case for Gazprom is supported by its valuations. Our DCF-based target price of USD37/ADR
(up from USD30/ADR as a result of the move in the DCF period from 2008-2013e to 2009-2015e) implies
66% potential return from current levels and confirms our Overweight (V) rating on the stock.
Gazprom shares look undervalued on a number of relative metrics. The stock is trading at 6.9x 2010e P/E,
or at 27% and 13% discounts to its emerging market and international major peers, respectively. Peer
comparisons also show that the stock remains dislocated on the basis of its price performance and
earnings revisions relative to MSCI EMF. It is also looking cheap relative to its own five-year average
12-month trailing P/E – it is trading at a 47% discount to this benchmark.
For investors covering various asset classes, Gazprom’s equity looks more attractively valued than its
traded debt following the healthy run-up in its bond prices. In its valuation of Gazprom, the market is
currently factoring in either an overly conservative oil price, or negative production volume growth each
year in 2009-2015e, or an overly conservative risk-free rate or equity risk premium in perpetuity, or a
negative terminal growth rate. We do not concur with the market’s assumptions, since our own DCF
analysis is already based on conservative assumptions.

Europe’s dependence on
Russian gas: from strength to
strength 5
Russia looks set to keep its position as Europe’s largest
foreign gas supplier for the foreseeable future 5
Global gas reserves 7
Global gas production 10
Gas consumption 14
Europe’s key gas suppliers 36
Pipeline gas versus LNG 53
Gas storage capacity 54
Europe’s efforts at securing energy supplies 56
Gazprom valuation 62
Key value drivers 62
Gazprom DCF model assumptions: conservative costs and
volumes 64
Gazprom MSCI effect 67
Market too cautious towards Gazprom 67
Gazprom leverage and cash flow generation 67
Gazprom currency exposure 68
Gazprom dividends 69
Valuation looks particularly compelling 69
Disclosure appendix 81
Disclaimer 84