31. 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 increase effectiveness of Management decisions through detailed analysis of related risks.

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 these transactions 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:

RUB millions

As of December 31, 2013

Russian Rouble

USD

EURO

Serbian dinar

Other currencies

FINANCIAL ASSETS

CURRENT

Cash and cash equivalents

46,635

38,365

3,195

1,216

1,666

Bank deposits

10,804

25,031

794

240

Loans issued

18,434

556

1

Forward exchange contracts

10

Trade and other financial receivables

32,897

32,939

580

20,232

700

NON-CURRENT

Trade and other financial receivables

106

Loans issued

15,287

48

Forward exchange contracts

283

Available for sale financial assets

6,009

779

FINANCIAL LIABILITIES

CURRENT

Short-term debt

(19,002)

(29,871)

(3,305)

(228)

(7)

Trade and other financial payables

(36,555)

(23,889)

(546)

(5,649)

(1,350)

Forward exchange contracts

(46)

Payables and accruals to employees

(7,294)

(213)

(4)

(964)

(198)

NON-CURRENT

Long-term debt

(61,034)

(155,452)

(44,799)

(1)

(169)

Forward exchange contracts

(3,131)

Other non-current financial liabilities

(3,897)

Payables and accruals to employees

(1,982)

(42)

NET EXPOSURE

408

(115 370)

(44 085)

15 386

840

RUB millions

As of December 31, 2012

Russian Rouble

USD

EURO

Serbian dinar

Other currencies

FINANCIAL ASSETS

CURRENT

Cash and cash equivalents

58,860

15,856

1,425

2,214

844

Bank deposits

5,078

1,443

476

522

Loans issued

6,044

133

640

15

Forward exchange contracts

632

Held to maturity financial assets

906

Trade and other financial receivables

21,175

30,774

307

13,580

778

NON-CURRENT

Trade and other financial receivables

160

Loans issued

15,441

66

Forward exchange contracts

342

Available for sale financial assets

6,332

424

333

63

255

FINANCIAL LIABILITIES

CURRENT

Short-term debt

(38,224)

(37,574)

(146)

(1,235)

(14)

Trade and other financial payables

(31,294)

(13,353)

(963)

(3,560)

(819)

Forward exchange contracts

(18)

Payables and accruals to employees

(6,061)

(40)

(129)

(1,450)

(100)

NON-CURRENT

Long-term debt

(60,724)

(101,098)

(3,133)

(804)

(688)

Forward exchange contracts

(995)

Other non-current financial liabilities

(4,237)

Payables and accruals to employees

(1,112)

NET EXPOSURE

(27,656)

(103,408)

(1,190)

8,823

778

RUB millions

As of January 1, 2012

Russian Rouble

USD

EURO

Serbian dinar

Other currencies

FINANCIAL ASSETS

CURRENT

Cash and cash equivalents

17,307

8,688

2,922

173

716

Bank deposits

246

Loans issued

10,777

102

205

Forward exchange contracts

1,858

Held to maturity financial assets

713

1,610

Trade and other financial receivables

18,822

43,783

467

7,701

208

NON-CURRENT

Trade and other financial receivables

221

Loans issued

2,759

27

14

Held to maturity financial assets

7

Available for sale financial assets

5,685

745

165

90

5

FINANCIAL LIABILITIES

CURRENT

Short-term debt

(28,395)

(25,047)

(412)

(3)

(92)

Trade and other financial payables

(22,705)

(11,763)

(538)

(3,365)

(282)

Forward exchange contracts

(1,782)

Payables and accruals to employees

(8,401)

(3)

(109)

(1,181)

(97)

NON-CURRENT

Long-term debt

(63,262)

(109,833)

(3,257)

(509)

(129)

Forward exchange contracts

(6,822)

NET EXPOSURE

(66,472)

(98,437)

(762)

3,111

589

The following exchange rates applied during the year:

Average rate

Reporting date spot rate

Year ended December 31, 2013

Year ended December 31, 2012

December 31, 2013

December 31, 2012

January 1, 2012

USD 1

31.85

31.09

32.73

30.37

32.20

EUR 1

42.31

39.95

44.97

40.23

41.67

RSD 1

0.37

0.35

0.39

0.35

0.40

Sensitivity analysis

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.

RUB millions

Weakening of RUB

Equity

Profit or loss

DECEMBER 31, 2013

USD/RUB (10% increase)

(3,834)

(12,680)

EUR/RUB (10% increase)

21

(4,434)

RSD/RUB (10% increase)

8,030

DECEMBER 31, 2012

USD/RUB (10% increase)

1,907

(12,094)

EUR/RUB (10% increase)

27

(297)

RSD/RUB (10% increase)

882

JANUARY 1, 2012

USD/RUB (10% increase)

(179)

(11,769)

EUR/RUB (10% increase)

23

(98)

RSD/RUB (10% increase)

311

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 significant part of the Group’s borrowings is at variable interest rates (linked to the LIBOR or EURIBOR rate). To mitigate the risk of unfavourable changes in the LIBOR or EURIBOR rates, the Group’s treasury function monitors interest rate in debt markets and based on it decides whether it is necessary to hedge interest rate or to obtain financing on a fixed-rate or variable-rate basis.

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:

RUB millions

Carrying amount

December 31, 2013

December 31, 2012

January 1, 2012

FIXED RATE INSTRUMENTS

Financial assets

162,272

109,963

46,266

Financial liabilities

(214,800)

(149,559)

(94,030)

(52,528)

(39,596)

(47,764)

VARIABLE RATE INSTRUMENTS

Financial liabilities

(99,068)

(94,081)

(136,909)

(99,068)

(94,081)

(136,909)

Cash flow sensitivity analysis for variable rate instruments

The Group’s financial results and equity are sensitive to changes in interest rates. If the interest rates applicable to floating debt increase 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:

RUB millions

Profit or loss

DECEMBER 31, 2013

Increase by 100 bp

(991)

DECEMBER 31, 2012

Increase by 100 bp

(941)

JANUARY 1, 2012

Increase by 100 bp

(1,369)

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 and payment conditions 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. Any excess of receivables over approved credit limit is secured by either letter of credit from bank with external credit rating not less than A or advance payment. Management believes that not impaired trade receivables are fully recoverable.

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 December 31, 2013, December 31, 2012 and January 1, 2012, the analysis of financial receivables is as follows:

RUB millions

Gross

Impairment

Gross

Impairment

Gross

Impairment

December 31, 2013

December 31, 2013

December 31, 2012

December 31, 2012

January 1, 2012

January 1, 2012

Not past due

76,049

(15)

60,284

(315)

70,336

(366)

Past due 0–180 days

6,047

(56)

5,447

(18)

864

(187)

Past due 180–365 days

1,822

(502)

3,900

(2,715)

723

(230)

Past due 1­–3 year

7,588

(3,621)

1,049

(950)

1,254

(1,221)

Past due more than three years

4,939

(4,797)

4,283

(4,191)

4,287

(4,258)

96,445

(8,991)

74,963

(8,189)

77,464

(6,262)

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

RUB millions

2013

2012

Balance at beginning of the year

8,189

6,262

Increase during the year

403

3,837

Amounts written off against receivables

48

388

Decrease due to reversal

(378)

(1,064)

Other movements

(149)

(567)

Translation differences

878

(667)

BALANCE AT END OF THE YEAR

8,991

8,189

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 and January 1, 2012.

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:

RUB millions

A

BBB

Less than BBB

Without rating

Total

AS OF DECEMBER 31, 2013

Cash and cash equivalents

4,157

71,719

8,027

3,594

87,497

Derivative financial assets

151

4

61

77

293

Deposits with original maturity more than 3 months less than 1 year

33,211

1,399

2,259

36,869

AS OF DECEMBER 31, 2012

Cash and cash equivalents

5,789

58,037

6,526

5,635

75,987

Derivative financial assets

101

804

69

974

Held to maturity investments

516

390

906

Deposits with original maturity more than 3 months less than 1 year

24

7,495

7,519

AS OF JANUARY 1, 2012

Cash and cash equivalents

2,579

13,923

541

11,495

28,538

Derivative financial assets

1,362

496

1,858

Held to maturity investments

1,710

613

7

2,330

Deposits with original maturity more than 3 months less than 1 year

246

246

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:

RUB millions

Carrying amount

Contractual cash flows

Less than 6 months

6–12 months

1–2 years

2–5 years

Over 5 years

AS OF DECEMBER 31, 2013

Bank loans

98,516

104,339

9,014

23,556

27,158

38,833

5,778

Bonds

61,583

73,526

921

2,476

14,483

55,646

Loan Participation Notes

132,534

177,739

848

1,067

4,921

49,557

121,346

Other borrowings

21,235

22,638

17,706

2,114

1,098

444

1,276

Other non-current financial liabilities

3,897

4,123

1,031

3,092

Trade and other payables

67,989

67,989

66,381

1,608

Payables and accruals to employees

10,697

10,697

8,673

2,024

396,451

461,051

103,543

30,821

50,715

147,572

128,400

AS OF DECEMBER 31, 2012

Bank loans

95,324

101,284

31,260

9,045

28,826

31,204

949

Bonds

82,025

97,976

23,466

2,637

4,682

47,191

20,000

Loan Participation Notes

46,118

53,534

997

997

1,994

3,987

45,559

Other borrowings

20,173

20,615

17,012

89

644

929

1,941

Other non-current financial liabilities

4,237

4,369

874

2,621

874

Trade and other payables

49,989

49,989

44,953

5,036

Payables and accruals to employees

8,892

8,892

7,780

1,112

306,758

336,659

125,468

17,804

38,132

85,932

69,323

AS OF JANUARY 1, 2012

Bank loans

136,572

148,002

11,091

18,411

53,264

64,125

1,111

Bonds

71,999

90,975

5,272

11,249

24,415

30,039

20,000

Other borrowings

17,904

17,904

15,913

101

271

1,619

Finance lease liabilities

4,464

5,178

983

599

599

1,798

1,199

Trade and other payables

38,653

38,653

37,941

712

Payables and accruals to employees

9,791

9,791

9,791

279,383

310,503

80,991

30,971

78,379

96,233

23,929

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 ratio 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:

RUB millions

Year ended December 31, 2013

Year ended December 31, 2012

Long-term debt

261,455

166,447

Short-term debt and current portion of long-term debt

52,413

77,193

Less: cash, cash equivalents and deposits

(127,946)

(86,718)

NET DEBT

185,922

156,922

Total EBITDA

316,463

305,124

NET DEBT TO EBITDA RATIO AT THE END OF THE REPORTING PERIOD

0.59

0.51

Operating profit

222,117

217,926

Operating profit adjusted for income tax expenses

181,506

176,882

Share of profit of associates and joint ventures

11,251

12,767

Average capital employed

1,105,397

978,416

ROACE

17.44%

19.38%

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

FAIR VALUE MEASUREMENT

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an ordinary transaction between market participants at the measurement date.

The different levels of fair value hierarchy 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).

The following assets and liabilities are measured at fair value in the Group’s Consolidates Financial Statements:

  • Derivative financial instruments (forward exchange contracts used as hedging instruments),
  • Stock Appreciation Rights plan (SARs)
  • Financial investments classified as available for sale except for unquoted equity instruments whose fair value cannot be measured reliably that are carried at cost less any impairment losses.

Derivative financial instruments and SARs refer to Level 2 of the fair value measurement hierarchy, i.e. their fair value is determined on the basis of inputs that are observable for the asset or liability either directly (as prices) or indirectly (derived from prices). There were no transfers between the levels of the fair value hierarchy during the year.

There are no significant assets or liabilities measured at fair value categorised within Level 1 or Level 3 of the fair value hierarchy.

Carrying value of other financial assets and liabilities approximate their fair value.

The table below analyses financial instruments carried at fair value, wich refer to Level 2 of the fair value hierarchy.

RUB millions

Level 2

AS OF DECEMBER 31, 2013

Forward exchange contracts

293

Total assets

293

Forward exchange contracts

(3,177)

Other financial liabilities

(1,798)

Total liabilities

(4,975)

AS OF DECEMBER 31, 2012

Forward exchange contracts

974

TOTAL ASSETS

974

Forward exchange contracts

(1,013)

Other financial liabilities

(1,112)

Total liabilities

(2,125)

AS OF JANUARY 1, 2012

Forward exchange contracts

1,858

TOTAL ASSETS

1,858

Forward exchange contracts

(8,604)

Other financial liabilities

(1,896)

TOTAL LIABILITIES

(10,500)

During 2010 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, 2013 and Deccember 31, 2012:

RUB millions

December 31, 2013

December 31, 2012

Volatility

3.7%

7.50%

Risk-free interest rate

6.12%

6.27%

Dividend yield

4.69%

3.90%

As of January 1, 2012 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, 2013 and 2012 the Group recognized compensation expense of RUB 547 million and RUB 1,112 million correspondingly. This expense is included within selling, general and administrative expenses. A provision of RUB 1,798 million has been recorded within other non-current liabilities in respect of the Group’s estimated obligations under the plan at December 31, 2013. As at December 31, 2012 the amount of the provision was equal to RUB 1,112  million. As at January 1, 2012 the amount of the provision was equal to RUB 1,896 million.

Notes in Consolidated Statements:

Consolidated Statement of Cash Flows