OREANDA-NEWS. March 20, 2012. With this report we initiate coverage of the three largest E&P companies in the Former Soviet Union: KazMunaiGas Exploration and Production (KMG EP), Dragon Oil (DGO) and Zhaikmunai (ZKM). We rate DGO and KMG a BUY with target prices of GBp817/share (upside potential of 32%) and USD 23.2/GDR (upside potential of 25%), respectively. We believe that the market underestimates DGO’s growth opportunities, and overlooks KMG’s impressive cash pile. We rate ZKM a HOLD with a target price of USD 13.0/GDR, implying 9% upside potential. Once full capacity production is reached in 1Q12, we do not believe the company will show any further growth for the next several years.

Benefiting from oil price growth and more liberal tax regimes. As a rule, Central Asian concessions and PSAs offer much better tax regimes than Russia’s and those applied to KMG, DGO and ZKM are no exception. Not only do they facilitate better returns on investment, they frequently imply that the respective companies have greater sensitivity to the oil price. We estimate that our companies receive 33-60% from a marginal dollar, vs just 12% for Russian upstream, and 24% for Russian integrated. Structurally, 17-70% of marginal tax in Central Asia is income-based vs 3.2-14% in Russia.

… while at the same time surviving the oil price decline. Our top picks DGO and KMG would be able to survive an extreme drop in the oil price (for DGO down to USD 12/bbl, and KMG EP down to USD 37/bbl) thanks to the maturity of their asset portfolios and their rich cash piles. Given its relative youth and financial leverage, ZKM requires a higher oil price (USD 40/bbl) to remain profitable.

Growth or dividends or both. Longer term, all three companies’ appeal depends on their growth and potential dividends, in our view. KMG EP has always been a reasonable dividend payer with yields of some 3-4% in 2006-10. A potential special dividend of USD 2.6/GDR (USD 2.1/GDR discounted) yielding 20% (16% discounted) payable in June 2013 to settle NC KMG’s bond adds to KMG‘s draw, in our opinion. We believe even DGO’s modest dividends, yielding about 2% annualised look good for a company that plans to grow 10-15% in the next four years.

…but relative performance is quite weak Since their low point on 4 Oct 2011, KMG EP and DGO’s shares have gained 32% and 36%, respectively. This performance is better than Brent (20%) but insignificant compared to MSCI Russia’s approximately 40% growth in the same period. We believe this reflects investor’s political concerns as well as fears that the companies’ tremendous cash piles will be judiciously invested. ZKM was a clear outperformer with its share price gaining 66% following the long-awaited launch of its Gas Treatment Facility (GTF).