29. Financial risk management

Risk Management Framework

Gazprom Neft Group has a risk management policy that defines the goals and principles of risk management in order to make the Group’s business more secure in both the short and the long term.

The Group’s goal in risk management is to create additional guarantees of achievement by Gazprom Neft of its strategic goals by identifying and guarding against risks and by instituting effective mechanisms to deal with them.

The Group’s Integrated Risk Management System (IRMS) is a systematic continuous process that identifies, assesses and manages risks. Its key principle is that responsibility to manage different risks is assigned to different management levels depending on the expected financial impact of those risks. The Group is working continuously to improve its approach to basic IRMS processes, with special focus on efforts to assess risks and integrate the risk management process into such key corporate processes as business planning, project management and mergers and acquisitions.

Financial Risk Management

Management of the Group’s financial risks is the responsibility of employees acting within their respective professional spheres. The Group’s Financial Risk Management Panel defines a uniform approach to financial risk management at the Company and its subsidiaries. Activities performed by the Group’s employees and the Financial Risk Management Panel minimise potential financial losses and help to achieve corporate targets.

In the normal course of its operations the Group has exposure to the following financial risks:

• market risk (including currency risk, interest rate risk and commodity price risk);
• credit risk; and
• liquidity risk.

Market risk

Currency Risk

The Group is exposed to currency risk primarily on sales and borrowings that are denominated in currencies other than the respective functional currencies of Group entities, which are primarily the local currencies of the group companies, for instance the Russian Ruble for companies operating in Russia. The currency in which transactions described above are denominated is mainly US Dollar.

The Group’s currency exchange risk is considerably mitigated by its foreign currency liabilities: significant share of the Group’s borrowings is US dollars. The currency structure of revenues and liabilities acts as a hedging mechanism with opposite cash flows offsetting each other. A balanced structure of currency assets and liabilities minimises the impact of currency risk factors on the Group’s financial and business performance.

Furthermore, the Group applies hedge accounting to manage volatility in profit or loss with its cash flows in foreign currency.

The carrying amounts of the Group’s financial instruments denominated in the foreign currencies are as follows:

The following exchange rates applied during the year:

The Group has chosen to provide information about market and potential exposure to hypothetical gain/loss from its use of financial instruments through sensitivity analysis disclosures.

The sensitivity analysis showed in the table below reflects the hypothetical effect on the Group’s financial instruments and the resulting hypothetical gains/losses that would occur assuming a 10 percent change in closing exchange rates and no changes in the portfolio of investments and other variables at the reporting dates.

10% decrease in the exchange rates will have the same in the amount, but the opposite effect on Equity and Profit and loss of the Group.

Interest Rate Risk

The major part of the Group’s borrowings is at variable interest rates (linked to the LIBOR rate). To mitigate the risk of significant changes in the LIBOR rate, the Group’s treasury function performs periodic analysis of the interest rate environment, depending on which Management of the Group decides whether it is more secure to obtain financing on a fixed-rate or variable-rate basis. When changes in the fixed or variable market interest rates are considered significant Management may consider refinancing of certain debt instruments on more favorable terms.

Changes in interest rates primarily affect debt by changing either its fair value (fixed rate debt) or its future cash flows (variable rate debt). However, at the time of any new debts Management uses its judgment and information about current/expected interest rates on the debt markets to decide whether it believes fixed or variable rate would be more favorable over the expected period until maturity.

The interest rate profiles of the Group are presented below:

The Group’s financial results and equity are sensitive to changes in interest rates. If the interest rates applicable to floating debt increase/decrease by 100 basis points (bp) at the reporting dates, assuming all other variables remain constant, it is estimated that the Group’s profit before taxation will change by the amounts shown below:

Decrease by 100 bp in the interest rates will have the same in the amount, but the opposite effect on Profit and loss of the Group.

Commodity Price Risk

The Group’s financial performance relates directly to prices for crude oil and petroleum products. The Group is unable to fully control the prices of its products, which depend on the balance of supply and demand on global and domestic markets for crude oil and petroleum products, and on the actions of supervisory agencies.

The Group’s business planning system calculates different scenarios for key performance factors depending on global oil prices. This approach enables Management to adjust cost by reducing or rescheduling investment programs and other mechanisms.

Such activities help to decrease risks to an acceptable level.

Credit Risk

Credit risk is the risk of financial loss to the Group if a customer or counterparty to a financial instrument fails to meet its contractual obligations, and arises principally from the Group’s receivables from customers and in connection with investment securities.

The Group’s trade and other receivables relate to a large number of customers, spread across diverse industries and geographical areas. Gazprom Neft has taken a number of steps to manage credit risk, including: counterparty solvency evaluation; individual lending limits depending on each counterparty’s financial situation; controlling advance payments; controlling accounts receivable by lines of business, etc.

The carrying amount of financial assets represents the maximum credit exposure.

Trade and other receivables

The Group’s exposure to credit risk is influenced mainly by the individual characteristics of each customer. However, Management also considers the demographics of the Group’s customer base, including the default risk of the industry and country, in which customers operate, as these factors may have an influence on credit risk, particularly in the currently deteriorating economic circumstances.

The Group establishes an allowance for impairment that represents its estimate of incurred losses in respect of trade and other receivables and investments.

Impairment losses

As of 31 December 2012, 31 December 2011 and 1 January 2011, the analysis of financial receivables is as follows:

The movement in the allowance for impairment in respect of trade and other receivables during the year was as follows:

Investments

The Group limits its exposure to credit risk mainly by investing in liquid securities. Management actively monitors credit ratings and does not expect any counterparty to fail to meet its obligations.

The Group does not have any held-to-maturity investments that were past due but not impaired at December 31, 2012, December 31, 2011 and January 1, 2011.

Credit quality of financial assets

The credit quality of financial assets that are neither past due nor impaired can be assessed by reference to external credit ratings (if available) or to historical information about counterparty default rates:

The credit quality of trade and other receivables is assessed regularly by the Management of the Group. For this purposes the customers are individually analysed based on the number of characteristics, such as:

• legal form of the entity;
• duration of relationships with the Group, including ageing profile, maturity and existence of any financial difficulties;
• whether the customer is a final customer or not, related party or not.

One of the major factors that is considered while taking decision is ageing profile. The most significant current customers do not have any breakage of payment history.

Liquidity risk

Liquidity risk is the risk that the Group will encounter difficulty in meeting the obligations associated with its financial liabilities that are settled by delivering cash or another financial asset.

The Group’s approach to managing liquidity is to ensure that it will always have sufficient liquidity to meet its liabilities when due, under both normal and stressed conditions, without incurring unacceptable losses or risking damage to the Group’s reputation. In managing its liquidity risk, the Group maintains adequate cash reserves and actively uses alternative sources of loan financing in addition to bank loans. The Group’s stable financial situation, which is confirmed by international rating agencies, helps it to mobilise funds in Russian and foreign banks with comparative ease.

The following are the contractual maturities of financial liabilities, including estimated interest payments and excluding the impact of netting agreements:

Capital management

The Group’s objectives when managing capital are to safeguard the Group’s ability to continue as a going concern, to provide sufficient return for shareholders and benefits for other stakeholders and to maintain an optimal capital structure to reduce the cost of capital. In order to maintain or adjust the capital structure the Group may revise its investment program, attract new or repay existing loans or sell certain non-core assets.

On the Group level capital is monitored on the basis of the net debt to EBITDA ratio and return on the capital on the basis of return on average capital employed ratio (ROACE). Net debt to EBITDA is calculated as net debt divided by EBITDA. Net debt is calculated as total debt, which include long and short term loans, less cash and cash equivalents and short term deposits. EBITDA is defined as earnings before interest, income tax expense, depreciation, depletion and amortisation, foreign exchange gain (loss), other non-operating expenses and includes the Group’s share of profit of equity accounted investments. ROACE is calculated in general as Operating profit adjusted for income tax expense divided by average for the period figure of Capital Employed. Capital employed is defined as total equity plus net debt.

The Group’s net debt to EBITDA ratios at the end of the reporting periods were as follows:

There were no changes in the Group’s approach to capital management during the year.

Fair value hierarchy

The table below analyses financial instruments carried at fair value, by valuation method. The different levels have been defined as follows:

• Level 1: quoted prices (unadjusted) in active markets for identical assets or liabilities
• Level 2: inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly (i.e., as prices) or indirectly (i.e., derived from prices)
• Level 3: inputs for the asset or liability that are not based on observable market data (unobservable inputs).

Except for forward exchange contracts and SAR all other financial assets and liabilities of the Group are included in Level 3 of the hierarchy.

During 2012 the Board approved the implementation of a cash-settled stock appreciation rights (SAR) compensation plan. The plan forms part of the long term growth strategy of the Group and is designed to reward management for increasing shareholder value over a specified period. Shareholder value is measured by reference to the Group’s market capitalization. The plan is open to selected management provided certain service conditions are met. The awards are fair valued at each reporting date and are settled in cash at the conclusion of the vesting period. The awards are subject to certain market and service conditions that determine the amount that may ultimately be paid to eligible employees. The expense recognized is based on the vesting period.

The fair value of the liability under the plan is estimated using the Black-Scholes-Merton option-pricing model by reference primarily to the Group’s share price, historic volatility in the share price, dividend yield and interest rates for periods comparable to the remaining life of the award. Any changes in the estimated fair value of the liability award will be recognized in the period the change occurs subject to the vesting period.

The following assumptions are used in the Black-Scholes-Merton model as of December 31, 2012 and January 1, 2011:

As of December 31, 2011 no assumptions required to be made by the Group as SAR accrual based on actual calculation is accounted for in these Consolidated Financial Statements.

In the consolidated statement of comprehensive income for the period ended December 31, 2012 and 2011 the Group recognized compensation expense of RUB 1,112 million and RUB 467 million correspondingly. This expense is included within selling, general and administrative expenses. A provision of RUB 1,112 million has been recorded within other non-current liabilities in respect of the Group’s estimated obligations under the plan at December 31, 2012. As at December 31, 2011 the amount of the provision was equal to RUB 1,896 million. As at January 1, 2011 the amount of the provision was equal to RUB 1,429 million.

Notes in Consolidated Statements: