Novatek: From Russia With Love

| About: Novatek Joint (NOVKY)
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OAO Novatek (OTC:NOVKY) is the largest independent producer of natural gas in Russia, producing a total of 57.32 billion cubic meters of natural gas and 4,287 thousand tons of liquids in 2012. The company produced 16.3% of the natural gas consumed inside of the Russian Federation in the same year. Unfortunately, the company has not been able to export gas outside of Russia because of the presence of a state-sanctioned export monopoly held by Gazprom (OTCPK:OGZPY). However, that situation is about to change. This ban on gas exports by companies other than Gazprom is scheduled to be lifted in 2014. The end of this export monopoly could prove to be a game changer for Novatek.

One of the most significant and expensive projects that Novatek has been involved with in recent years is the Yamal LNG plant. This plant is a liquefied natural gas plant that is to be built at Sabetta, located at the northeast corner of Russia's Yamal Peninsula. The project is expected to cost $15-$20 billion and to be completed in 2018. Novatek owns a 60% stake in the project. The Yamal LNG plant has also likely been one of the biggest drags on Novatek's stock price. One reason for this is that the project continues to suffer from delays. According to an article published by Bloomberg on January 29, 2013, Novatek and Total (NYSE:TOT), two of the partners on the project, decided to postpone the start up liquefied natural gas production at Yamal to early 2017 from its previously planned start-up date in the fourth quarter of 2016. Unfortunately, many investors have begun to believe that the construction and start-up this plant will be indefinitely delayed. As this project is very important to the company's ambitions to begin exporting natural gas to Asia, the company's growth prospects would be greatly stunted should the construction of this plant be indefinitely delayed.

Another concern that investors have with the Yamal LNG project are the potential costs of it. The project was originally expected to cost $15 to $20 billion but there were concerns about whether a liquefied natural gas plant can really be constructed in such a harsh area for that price. These concerns were revealed to have some grounding in reality as the project partners increased their estimate of the plant's construction costs to $26.9 billion in December. The Yamal plant is going to be a particularly large one, boasting three trains. The scale of this project further raises concerns about its ability to be completed within that budget. In fact, the complete project including the construction of the required infrastructure will cost considerably more than $26.9 billion - this $26.9 billion is simply the high end of the amount of private money that has been budgeted for the project. The Russian government will be covering half of the total cost of the project by providing debt financing (the Russian government will have no equity stake) from one of the state controlled banks that will be used to construction the necessary infrastructure at the Sabetta port and two LNG carriers, meaning that the project itself will cost an estimated $40 billion. However, there are still some concerns that even this will not be enough.

Admittedly, this could be a significant concern if the project does run over budget as such a large investment could strain the finances of the companies involved. However, there are a few factors to consider here. First, the price of natural gas in Asia, the destination of the LNG leaving this plant, is significantly higher than the prices of the commodity in either Europe or America. This fact raises significantly the amount of revenue that the plant will be able to generate (once it is complete) to repay the investors in the project. Analysts at Citibank, writing in a research report dated March 19, 2013, have previously calculated the Yamal LNG plant to have an estimated after-tax return of just over 15% assuming an oil price of $85/barrel and that the Asian natural gas price maintains a level of 14% of the Brent oil price which is where it stood at the time the calculation was made. The Russian government expects an 8% return on its investment. Since it is investing fully half of the money required to build out the required infrastructure at the Sabetta port and the construction of two LNG carriers via one of the government's state-controlled bank, the non-government investors such as Novatek should receive a return that is substantially above this 15%. This is because if the Russian government will be receiving an 8% return on half of the total investment required to construct the plant and the required infrastructure then, mathematically, private investors must be receiving more than 15% on the remaining half of the project in order to reach the 15% total return that Citibank expects the project to generate. Of course, this is based on the project costing no more than its budgeted amount and Asian natural gas prices maintaining their presently high levels. Should either of these assumptions cease to be true then the calculated after-tax return will be lower. However, there does appear to be sufficient headroom here for the project to remain profitable even if it runs slightly over budget.

Another problem with the project was that Gazprom was, for years, the only company permitted by law to export natural gas out of Russia. However, the construction of the Yamal plant would have made no economic sense unless Novatek and the other investors in the project were permitted to export natural gas to the undersupplied markets of Asia. Novatek's management has long held out hope that the Russian government would eventually remove these export restrictions and liberalize its markets. However, the fear that the government would not lift these restrictions was prevalent among foreign investors and this was likely one factor that was weighing on the company's stock price. Fortunately for Novatek, the Russian government has lifted these restrictions and beginning in 2014, independent gas companies will be permitted to export natural gas outside of Russia. Novatek has already moved to take advantage of this potentially very lucrative growth opportunity. In October, Novatek signed an agreement with China's CNPC (NYSE:PTR) to provide the Chinese energy company with three million tons of LNG per year. The exact amount of natural gas that is in each ton of LNG depends on the temperature and density of it so unfortunately I cannot provide an exact figure of the amount of gas in cubic feet that this is equivalent to in order to determine the amount of revenue that this deal will generate for Novatek. However, I can make some estimates. According to Dan Hofstand of Iowa State University, one million tons of LNG is approximately equivalent to 52 trillion BTU's. Therefore, three million tons of LNG would be approximately equivalent to 156 trillion BTU's or approximately 152.88 billion cubic feet. Thus, assuming a price of $15 per MMBTU (roughly equivalent to the price of natural gas in China), this deal represents approximately $2.4 billion in revenue. However, not all of this revenue will go to Novatek. This is because, as a part of the deal that the company signed with CNPC, CNPC will acquire one fourth of Novatek's stake in the Yamal LNG plant which will be providing all of the LNG that is being sold to LNG. This reduces Novatek's stake in the project to 60% from its former 80%. Thus, Novatek will receive approximately $1.44 billion per year in revenue.

The revenues that Novatek derives from this deal will represent a continuation of the company's historic growth. This growth has come mostly from growth in the company's production. As the chart below shows, Novatek has, on average, grown its natural gas production relatively steadily since 2010, allowing for the usual production fluctuations that are common in this industry:

Source: Novatek

Unfortunately, the company's historic production growth has not always reliably led to revenue growth. For example, the chart below shows Novatek's total quarterly oil and gas sales and total overall revenues over the past few quarters:

Source: Novatek

As the chart shows, revenues and earnings have generally trended upward, but the growth has been erratic. This is not unusual for an energy company and is largely due to fluctuating commodity prices. In the third quarter of 2013, the company received a price of 1,973 Russian rubles per MCM of natural gas. This is much higher than the RUB 1,581/mcm of natural gas that the company brought in during the second quarter. This higher price was one of the major reasons why the company increased its revenues so much on a quarter-over-quarter basis. This price is also significantly higher than in the prior year quarter and so thus contributed to the company's year-over-year revenue growth.

Earlier in this article, I calculated that Novatek's massive new deal will result in revenue of approximately $1.44 billion in revenue for Novatek. This is 51.1 billion Russian rubles annually. If we assume that the revenue boost will be equally distributed between quarters, then this deal will result in a revenue boost of approximately RUB 12.775 billion per quarter or roughly a 16.9% increase over third quarter levels.

Admittedly, Novatek will probably not see a revenue boost quite of this magnitude. This is because at least some of the revenue from the sale of LNG to CNPC will need to be used to pay Russia's large export and Mineral Extraction Taxes. Fortunately though, Novatek will not need to reduce its sales of natural gas inside of Russia to meet this large new demand from CNPC as the Yamal plant will be providing all of the necessary gas to meet the terms of the contract. However, this deal with China is still a potential game changer for Novatek and could pave the way for more gas export deals now that the Gazprom monopoly has been lifted.

Like many energy companies, Novatek pays out a portion of its profits to its investors in the form of a dividend. This dividend varies depending on the company's profits (like many foreign companies) but is always at least 30% of Novatek's total profit.

Source: Novatek

The company's most recent dividend was 3.4 Russian rubles (34.0 Russian rubles for the GDR) but that was for only the first half of 2013. It has not yet declared its dividend for the second half of 2013. However, this dividend payment was higher than the company's dividend that was paid in the first half of 2012. That dividend was 3.0 Russian rubles (30 Russian rubles for the GDR). In total, Novatek paid 6.8 Russian rubles in dividends to its investors in 2012. As the company's GDR, which trades in London, represents ten ordinary shares, this works out to 68 Russian rubles per GDR share. 68 Russian rubles is approximately equivalent to $1.91 at today's exchange rate, so this would give the company a trailing dividend yield of 1.49%. However, as the company has been growing its profits at a considerable rate and because it pays out a percentage of net profit in the form of dividends, the company has a very high dividend growth rate. According to Bloomberg, Novatek has a five-year dividend growth rate of 17.53%. Thus, holding the stock for a few years while the Yamal project is constructed and brought online could provide investors with a very solid yield-on-cost, assuming the company maintains its historical dividend growth.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.