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Description of key risks

Risks associated with geological exploration operations

One of the Company’s key strategic objectives is growth in the raw hydrocarbon resource base in quantitative and qualitative terms in order to ensure the required level of production, which in turn largely depends on the success of geological exploration. The main risk associated with geological exploration operations is the failure to confirm the planned level of hydrocarbon reserves and objective deterioration in the quality of the resource base. Another important factor is geological exploration work in different geographic regions, including regions with adverse climatic conditions and environmental restrictions, which often leads to the risk of increased costs. Estimates depend on a number of variable factors and assumptions, including the following:

  • the correlation of the historical level of productivity in the region of production with the productivity of other regions that are comparable in terms of characteristics;
  • the interpretation of geological exploration data;
  • the effect of the requirements of government structures and legislative acts.

Due to the exclusion of the volume of geological exploration from license obligations, Gazprom Neft manages licensing risks as regards geological exploration by making timely changes to design documents for geological study.

Risk management measures

Gazprom Neft has considerable experience in conducting geological exploration work and employing the latest geophysical methods to prospect and explore hydrocarbons as well as advanced technologies in the drilling and development of fields, which results in the decreased probability of such risks. The Company has hired the auditor DeGolyer & MacNaughton to perform an independent audit of reserves based on the estimates of the Gazprom Neft’s subsidiaries. Gazprom Neft actively cooperates with government structures at the federal and regional levels on matters concerning the sustainable use of subsoil resources.

Licensing risks

The Company performs its subsoil resource operations on the basis of special permit documents and licenses for the right to use subsoil sites, which specify the intended use (type of subsoil use), spatial boundaries, dates and mandatory conditions for the use of the subsoil resources. Existing law envisages administrative sanctions for the unlicensed use of a subsoil site, and there is a risk of criminal liability in a number of cases.

The failure to meet the conditions for the use of subsoil resources may entail an administrative sanction with the imposition of fines, while the repeat (continued) violation of significant conditions for the use of subsoil resources may entail the risk of the long-term termination of a license in accordance with Article 23 of Federal Law No. 2395-1 dated 21 February 1992 “On Subsoil Resources”. If the right to use subsoil resources is terminated prematurely, the Company bears both reputational risks as well as material losses related to the expenses incurred on acquiring the right to use the subsoil resources, investments to develop the subsoil site and decreased capitalization associated with the loss of the resource base.

Risk management measures

The Company views the prohibition on the unlicensed use of subsoil resources as a categorical imperative. The Company provides end-to-end surveying support for all stages of prospecting, exploration and production drilling as an exhaustive measure to prevent the unlicensed use of subsoil resources.

The Company’s Subsoil Use Monitoring System (SUMS) automated complex with its well-developed matrix for the risks involved with fulfilling the main (significant) conditions for the use of subsoil resources is the main risk management tool that is used to assess the current state of risks using matrix indicators and plan for an acceptable level of risk in the future.

Standing Regional Licensing Commissions (RLC) review the status of current and potential license risks and the implementation of targeted measures to mitigate such risks on a quarterly basis.

One of the measures aimed at reducing the level of licensing risks was the transition from risk management to managing licensing obligations. The basic idea of managing license obligations is to adjust the physical volumes of specific types of geological exploration and development indicators that had previously been strictly recorded in the conditions for subsoil resource use in accordance with the requirements of design documents (for example, an associated gas processing facility, raw hydrocarbon production levels). The Company’s goal is to update the entire license portfolio with the exclusion of specific types, volumes and indicators from the conditions for the use of subsoil resources.

The CEOs of the Company’s subsidiaries are responsible for retaining licenses for the right to use subsoil resources with the relevant objectives recorded at their training and production centres.

Project risks

The Company continuously develops and implements investment projects that aim to achieve strategic goals, in particular growth in the extraction of raw commodities and improvements in the quality of the products manufactured. When implementing projects, the Company encounters a variety of risks that could lead to a violation of the deadlines and/or the increased cost of the project. The main factors behind such risks are poor planning, violations of the project terms and safety requirements by contractors as well as new circumstances (increased cost of materials, errors in the assessment of infrastructure conditions and switching equipment suppliers).

Risk management measures

The Company manages these risks, while paying special attention to the development and coordination stages of investment projects. In 2014, a risk management system was introduced to the process of preparing and implementing major projects. This system is based on the generally accepted approach in the global industry to establishing a project’s value using the Stage-Gate process with a risk assessment of the project at each of its stages. Requirements for contractors are based on a risk assessment and also take into account the requirements of the laws of the country in which the project is being implemented. In addition. The Company has established a project monitoring system.

Risks associated with human resources

The Company’s business depends on highly skilled key employees, and a lack of skilled labour, in particular in engineering and technical areas, may lead to risks associated with a shortage of personnel. The Company’s success largely depends on the efforts and abilities of key employees, including skilled technical personnel, as well as the Company’s ability to recruit and retain such personnel. Competition for personnel in Russia and abroad may intensify due to the limited number of skilled specialists on the labour market. The inability to recruit new skilled personnel and/or retain existing skilled personnel could have a negative effect on the Company’s appeal as an employer. Demand for skilled employees and the related expenses are expected to grow, thereby reflecting the considerable interest in such resources from other industries and social projects.

Risk management measures

The Company offers a safe workplace and competitive salaries and provides training for employees in specially designed programmes. In addition, the Company is improving personnel recruiting procedures and implementing measures that aim to reduce personnel turnover and encourage the self-development of personnel.

Risks associated with occupational and industrial safety

The Company is exposed to risks involving the safety of employees, equipment, buildings and structures. Numerous factors may have a negative effect on the Company’s core activities, including the breakdown or failure of equipment, labour disputes, injury to personnel and third parties, natural disasters, political disputes or acts of terrorism. Any of the risk factors may have a significantly adverse impact on the business, financial condition and results of the Company’s activities.

Risk management measures

In order to mitigate these risks, the Company is implementing a large-scale integrated programme that aims to ensure safe working conditions for employees and safe manufacturing processes. This programme complies with the best international practices and is based on enhancing the role of production managers of all levels in ensuring work safety. The Company has successfully applied the experience gained from international oil companies by adapting it to the conditions of its production sites. In particular, the Company has introduced behavioural safety audits and internal incident investigations in order to identify and eliminate the causes, is implementing a transport safety programme, has introduced risk assessment for hazardous work and holds numerous drills, training exercises and seminars for all levels of the organisation. The Company has certified the work safety management system for compliance with the OHSAS 18001 international standard, adheres to the principle of continuous improvement and has selected priority areas of this system for the coming years. The Company has declared 2016 the Year of Occupational Safety.

Environmental risks

The production activities of Gazprom Neft are fraught with the potential risk of an environmental impact that exceeds the permitted standards, which may result in civil liability and the need for work to eliminate such damage. The Company is fully aware of its social responsibility to create safe working conditions and maintain a favourable environment, continuously monitors its activities to ensure compliance with the relevant environmental standards and is implementing an environmental protection programme. In the future, costs associated with observing environmental requirements or obligations may increase.

Risk management measures

The environmental protection policy of Gazprom Neft aims to ensure compliance with the requirements of current environmental legislation by investing substantial funds in environmental measures, including the use of technologies that ensure minimal negative impact on the environment. These activities have resulted in a significant decline in the probability of risks associated with environmental pollution. The Company is also following the changes in environmental legislation in the different countries in which it operates.

The main areas of operation of Gazprom Neft are oil and gas production, oil refining and the sale of oil and petroleum products, thus the Company is exposed to risks that are traditionally inherent to the oil and gas industry, namely:

  • risks associated with a possible change in prices for purchased raw materials and services;
  • risks associated with a possible change in oil and petroleum product prices;
  • risks associated with industry-wide competition;
  • risks caused by economic instability in the industry.

Risks associated a possible change in prices for purchased raw materials and services

In the process of its business operations, Gazprom Neft uses the infrastructure of monopoly service providers for the transportation of oil and petroleum products and the supply of electricity. The Company has no control over the infrastructure of these monopoly service providers and the amount of tariffs charged. It should be noted that tariffs are regulated by the oversight authorities of the Russian Federation, however tariffs are increased each year despite this fact, which leads to increased costs for the Company. At the same time, additional expenses may arise as a result of the following factors:

  • during rail transportation — the incompatibility of Russia’s broad gauge rail system with the rail systems of neighbouring countries;
  • during transportation by trunk pipeline — mixing of the Company’s oil with that of other companies, which diminishes its quality and consequently its value;
  • during transportation by marine vessels — violation of the vessel arrival and departure schedule as well as the loading and unloading deadlines in the event of icing during winter.

Risk management measures

The Company is implementing a number of measures that aim to mitigate the impact of such risks:

  • long-term planning of commodity flows and the timely provisioning of the cumulative flow of oil and petroleum products as well as the necessary rolling stock;
  • the optimal redistribution of commodity flows by transportation type;
  • the use of alternative and internal sources of power generation;
  • long-term contracting with fixed volumes and prices for the entire duration of the contracts;
  • the use of transparent cost revision formulas as part of long-term service contracts that are strictly dependent on market fluctuations.

These measures make it possible to reduce risks associated with the use of services and the acquisition of goods from monopoly providers to an acceptable level and ensure the Company’s continuity of operations.

Risks associated with a possible change in the price of oil, petroleum products, gas and gas products

The Company’s financial indicators are directly related to the price level of crude oil, petroleum products, gas and gas products. The price level depends on a number of factors which the Company cannot fully control. Such factors include:

  • the volume of oil reserves explored as well as global and regional supply of and demand for crude oil and petroleum products;
  • Russian and foreign government requirements and actions;
  • the impact of global production levels and prices from oil exporting countries (OPEC);
  • the military and political situation and/or instability resulting from the escalation of hostilities or acts of terrorism, including in the United States, the Middle East, the CIS and other resource producing regions;
  • prices and the availability of alternative and competing types of fuel;
  • prices and the availability of new technologies;
  • weather and climatic conditions, natural disasters and industrial accidents.

Risk management measures

Comprehensive measures were prepared to reduce the cost of extracting minerals. The Company has a business planning system which at its core has a scenario-based approach for determining the Company’s key performance indicators depending on oil prices on the global market. This approach makes it possible to cut costs, including by reducing them or carrying them over to future periods of investment programmes. These measures enable the Company to reduce risks to an acceptable level and fulfil the obligations it undertook.

Risks associated with industry-wide competition

There is intense competition in the Russian oil and gas industry between the leading Russian oil and gas companies in the main areas of production and economic activities, including:

  • the acquisition of licenses for the right to use subsoil resources to produce hydrocarbons at auctions organised by the government authorities;
  • the acquisition of other companies that own licenses for the right to use subsoil resources to produce hydrocarbons or that own existing assets associated with production raw hydrocarbons;
  • the implementation of foreign projects;
  • the hiring of leading independent service companies;
  • the acquisition of high-tech equipment;
  • the hiring of experienced and the most qualified specialists;
  • access to critical transportation infrastructure;
  • the acquisition of existing retail sales network enterprises and land plots for the construction of new ones;
  • the expansion of sales markets and sales volumes.

In addition, there is competition from the suppliers of alternative energy sources, including eco-friendly sources such as solar energy and wind energy.

Risk management measures

The implementation by management of the portfolio of strategic projects that aim to develop key areas of the activities of OJSC Gazprom Neft ensures the gradual strengthening of the Company’s positions in the oil and gas industry through a reduction in risks associated with competition.

Risks caused by economic instability in the industry

The Russian economy is sensitive to price fluctuations for crude oil, natural gas and other raw commodities on the global market. Negative oil price dynamics on the global market and a slowdown in the Russian economy may have an adverse effect on the Company’s business. Over the past decade, the Russian economy has at different times experienced:

  • a significant decline in GDP;
  • high inflation;
  • high levels of corruption;
  • a price slump on hydrocarbon markets;
  • instability on the currency market;
  • a high level of state debt versus GDP;
  • unstable lending terms and liquidity restrictions given the weakened banking sector;
  • deterioration of the financial position of contractors and the quality of work;
  • fictitious bankruptcies in the industry for the misappropriation of property;
  • tax evasion practices;
  • weak diversification and a high dependency on global raw commodity prices;
  • a significant increase in unemployment and underemployment;
  • ethnic and religious conflicts;
  • a high level of depreciation of the main infrastructural production facilities.

Risk management measures

In order to mitigate the negative effect of these factors on the Company’s performance results, work is being conducted to expand sales markets and increase the volume of products sold in foreign countries.

Gazprom Neft companies also provide support to the country’s economy as major taxpayers and take part in large-scale infrastructure and socially significant projects.

The Company is constantly improving production and working on enhancing performance efficiency, including by implementing investment projects and updating and modernising fixed assets.

Financial risks at Gazprom Neft are managed by employees in accordance with their professional activities.

The Financial Risk Management Committee determines the unified approach to financial risk management at Gazprom Neft and its subsidiaries. This approach is based on mitigating the degree of risk impact and the probability of such risks occurring by implementing the relevant measures and control procedures.

The activities of the employees of the Company and the Financial Risk Management Committee help to reduce potential financial damage and achieve stated goals.

Credit risk of counterparties

Company executives devote extra attention to the credit risk management process, particularly during crisis periods, since some of the Company’s counterparties may experience financial difficulties.

Risk management measures

Gazprom Neft has implemented a number of measures making it possible to manage risks, including: an assessment of the creditworthiness of counterparties, the establishment of individual limits depending on the financial condition of counterparties, control of advance payments and measures for working with receivables by business area, among others.

Risk associated with borrowing

The imposition of sanctions on Gazprom Neft by the U.S. and EU has significantly narrowed the range of financing instruments available to the Company.

Risk management measures

Gazprom Neft effectively manages risk associated with the borrowing of funds.

Despite the levying of sanctions against the Company by the U.S. and EU in 2014, the Company fully implemented a programme to attract funding in 2014-2015 and also signed credit agreements for financing that may be used in 2015.

The Company is also searching for alternative sources of funding.

Currency risk

The bulk of the gross revenue of Gazprom Neft comes from export transactions for the sale of oil and petroleum products. Consequently, fluctuations in currency exchange rates versus the rouble affect the results of the Company’s financial and business activities.

Risk management measures

The currency structure of revenue and liabilities acts as a hedging mechanism, whereby opposing factors compensate one another. A balanced structure of assets and liabilities in foreign currency minimises the impact of currency market factors on the results of the Company’s financial and business activities. As regards the unbalanced proportion of claims and liabilities, the Company hedges such risks and in each specific situation utilises internal tools and provisions that allow for effectively managing the currency risk and guarantee the performance of its obligations.

Interest risk

As a major borrower, the Company is exposed to risks associated with changes on financial markets. Much of the debt portfolio consists of loans denominated in U.S. dollars. The interest rate for servicing the existing credits is based on interbank loan rates (primarily LIBOR). An increase in these interest rates may lead to higher debt servicing costs for the Company. Growth in the cost of credits for the Company may negatively impact creditworthiness and liquidity indicators.

Risk management measures

The Company in each specific situation utilises internal tools and provisions to manage financial risks that guarantee the performance of its obligations.

Gazprom Neft carries out its activities in strict compliance with the standards of Russian legislation as well as the legislation of the jurisdictions in which the Company performs its operations.

Gazprom Neft cannot guarantee the absence of adverse changes in Russian legislation in the long term since most risk factors are out of its control. The negative impact of this risk category is mitigated by monitoring and timely reaction to changes made to various sections of legislation as well as active interaction with the legislative and executive authorities and public organisations on matters involving the interpretation, proper application and improvement of legislative norms

Risks associated with more sanctions from the eu and U.S.

In 2014, the U.S., EU countries and certain other nations imposed sanctions on the Russian energy section that partially apply to the Company. Further sanctions could negatively impact the overall situation in the industry and also have a specific effect on the Company’s long-term projects and the ability of its counterparties to meet their obligations.

Risk management measures

The sanctions have had a negligible effect on the Company’s business and financial condition. In response, the Company is implementing a targeted programme to phase out imported services and equipment. The Company has no grounds to believe that it will be specifically targeted by any new sanctions, but the sanctions may have a specific effect on the Company’s long-term projects. At present, the Company continues to assess the impact of the sanctions, but does not believe that they will have a significant effect on the consolidated financial statement.

Political risks

The political situation in Russia is currently stable, which is characterised by the stability of the federal and regional branches. Gazprom neft PJSC is registered as a taxpayer in St Petersburg, which is the second largest city in the Russian Federation and the administrative centre of the Northwest Federal District with significant natural resource potential, highly developed industry and an extensive transportation network. Gazprom neft PJSC has subsidiaries in the Central, Northwest, Urals, Volga, Siberian and Far Eastern Federal Districts.

Risk management measures

Overall, the Company regards the political situation within the country as stable and believes that there are currently no risks of negative changes.

Risks associated with foreign assets

The Company is implementing a number of foreign projects that aim to expand the geography of production operations. Entering new regions is associated both with the ability to obtain additional competitive advantages as well as the risks of underestimating the economic and political situation in countries where the Company’s assets are located, which subsequently may lead to the failure to achieve planned performance indicators.

Risk management measures

At present, Gazprom Neft assesses the level of risks associated with foreign assets as acceptable, however it cannot guarantee the absence of negative changes since the risks described are beyond the Company’s control.

Corruption risks

As the Company actively enters new international markets, the risk increases of U.S. or UK anti-corruption laws extending to it.

Risk management measures

Gazprom Neft pursues a strategy of corruption risk management on an ongoing basis. The Company has approved an anti-fraud and anti-corruption policy and all Gazprom Neft subsidiaries have been given recommendations to approve similar policies. All Gazprom Neft employees are required to review and comply with the policy requirements.

In order to monitor corruption risks when working with third-party contractors, standard forms of anti-corruption reservations have been prepared and approved by an order of the Gazprom Neft CEO for inclusion in contracts with third parties (both Russian and foreign).

The Company also has a permanent anti-fraud and anti-corruption hotline. An internal inspection is conducted in response to hotline complaints.

Risks associated with changes to tax legislation

Gazprom neft PJSC is one of the biggest taxpayers in the Russian Federation and pays federal, regional and local taxes, in particular VAT, the corporate profit tax, mineral extraction tax, corporate property tax and land tax.

The taxation system of the Russian Federation is continuously evolving and improving. Potential growth in tax rates paid by the Company as part of its business operations may lead to increased costs and a reduction in the amount of cash at the Company disposal to finance its day-to-day operations and capital expenditures and meet its obligations, including on outstanding bonds. Virtually any company in Russia may potentially incur losses as a result of claims by the tax authorities that may arise for previous periods and current operations. However, the Company estimates such risks as average.

The Company believes that the impact of the obligations arising as a result of such potential events on its operations would not be any more significant than the impact of similar obligations on other Russian oil sector companies with government participation.

Risk management measures

In order to mitigate risks related to changes in tax legislation, the Company carries out thorough work to analyse bills and legislative acts that have been adopted in tax legislation.

The most significant recent changes to tax legislation affecting the issuer’s activities include:

  • the introduction of new transfer pricing rules in 2012;
  • the institution of the consolidated group of profit taxpayers in 2012;
  • changes to the base rates of the Mineral Extraction Tax (MET) for oil, gas and gas condensate;
  • the introduction of additional coefficients that describe the degree of difficulty of extracting oil (Ce) and a coefficient that describes the degree of depletion of a particular raw hydrocarbon deposit (Cdp) for deposits containing so-called hard-to-recover oil reserves to the formula used to calculate the MET for oil;
  • the introduction of a formulaic procedure for calculating the MET for gas and gas condensate on 1 July 2014;
  • changes to the excise tax rate for petrol, diesel fuel and jet fuel as a result of ‘tax manoeuvring’.

The Company evaluates and predicts the extent of a possible negative impact from changes to tax legislation and makes every effort to minimise risks related to such changes. In particular, risks caused by ‘tax manoeuvring’ were identified by the Company on time and taken into account when compiling the business plan for 2015.

Risks associated with changes to the rules for customs control and duties

Gazprom neft PJSC is involved in foreign economic relations and therefore exposed to risks associated with changes to legislation in the government regulation of foreign trade activities as well as customs legislation governing relations to establish the procedure for the movement of goods across the customs border of the Russian Federation, establishing and applying customs regimes as well as establishing, introducing and collecting customs payments.

Another risk may be the ability of the Russian Government to change customs duty rates (both import and export) for certain goods for which the Company concludes foreign trade transactions. The primary adverse effect from this risk is an increase in expenses and lower export efficiency.

Risk management measures

The Company meets the requirements of customs legislation, completes all documentation required for both export and import transactions in a timely manner and has sufficient financial and human resources to comply with the standards and rules in matters of customs regulation.