Vostok

Summary of Proposed Investment

This Summary of Proposed Investment is prepared and distributed to the public in advance of the IFC Board of Directors’ consideration of the proposed transaction. Its purpose is to enhance the transparency of IFC’s activities, and this document should not be construed as presuming the outcome of the Board decision. Board dates are estimates only.

Project number	26442
Company name	Vostok Energy Ltd
Country	Russian Federation
Sector	Oil, Gas and Mining
Environmental category	B
Department	Oil, Gas, Mining And Chemicals
Status	Active

Date SPI disclosed	October 31, 2007
Projected board date	November 30, 2007
Previous Events	Invested: December 19, 2007 Signed: December 14, 2007 Approved: December 7, 2007

View Environmental & Social Review Summary (ESRS), click here

Overview

Sponsor/Cost/Location

Development Impact

Contacts

Attachments

Project description

Vostok Energy Limited (Vostok or the company) is a small independent oil and gas company operating in one of Russia’s frontier regions - Saratov oblast, close to the border with Kazakhstan. Its strategy is to grow into a sizeable upstream operator, focusing primarily on the development of natural gas properties. Currently, Vostok’s primary asset is the 3,215 km2 Bortovoe license block which is estimated to hold proved and probable reserves of approximately 370 billion cubic feet (bcf) of gas and 19 million barrels (mmbbls) of liquids, as certified by the independent international engineering firm Miller & Lents. The block is located in an industrialized region which is facing a gas supply deficit due to limited local output and insufficient deliveries by Gazprom, the dominant Russian gas producer and domestic supplier.

Vostok is currently seeking financial support for its 2007-1Q2009 capital expenditure, which includes:

- drilling of new wells;
- selective re-entry of existing wells;
- acquisition and processing of seismic information; and
- construction and commissioning of a gas processing plant and other field infrastructure.

The project is forecast to help increase Vostok’s daily gas production from minimal volumes in 2006 to 46 million cubic feet in 2009.

Anticipated development impact of the project

The proposed investment will support the establishment and growth of an independent private company in Russia’s oil and gas sector, operating in one of the country’s frontier regions. Specific development benefits from the project are expected to include:

- Enhancing Availability of Cleaner Fuel:

The investment will support the exploration for and development of natural gas reserves in Russia, in line with World Bank Group commitments following the Extractive Industries Review. The increased availability of natural gas will promote the increased use of a cleaner fuel (given that natural gas has much lower carbon emissions than coal which is frequently the alternative fuel for power generation in Russia).

- Promoting Competition and Private Sector Participation in the Gas Sector:

The Russian upstream gas industry is dominated by state-controlled Gazprom. The participation of smaller privately-owned companies is important to the industry, as they often focus on reserves deemed too small to be of interest to larger players. More importantly, these smaller private companies deliver production and recovery rates that tend to be higher than industry averages.

- Sustaining and Increasing Local Employment:

The project will have a sustaining impact on existing employment levels and will potentially contribute to new job creation in one of Russia’s frontier regions. The company currently employs 55 people in Russia, all locals in Saratov oblast. It is expected that the number of permanent jobs may potentially double as Vostok expands its operations, with even more employment created during the construction phase. In addition, there is expected to be a considerable benefit through employment of local contractors and subcontractors (e.g. providing oilfield services).

- Contributions to Central and Local Government Revenue:

The project will generate fiscal receipts from hydrocarbon production taxes, rent and corporate taxes. A material portion of these receipts (100% of Property Tax payments and over 70% of Corporate Income Tax payments) will be remitted to the oblast government and thus contribute to the development of one of Russia’s frontier regions.

- Enhanced Support for Local Communities:

With the implementation of the project, Vostok is expected to step-up its activities in the Bortovoe license block. The communities surrounding these new operations will benefit with Vostok’s tailored support programs. With the rollout of structured Community Development Plans, Vostok will be able to enhance the sustainability and efficacy of its social interventions.

IFC plans to monitor the following development impacts:

- employment,
- production of natural gas, and
- payments to government.

Governance risks assessment

A significant part of the project's expected benefits are in the form of employment, both direct and indirect, in a lower income region of Russia, as well as payments to Government in the form of royalties and taxes. In coming to a view of whether to support this project, IFC has considered the value of the project’s benefits and the governance and other risks to these benefits. In doing so, a number of governance assessments on Russia, including the World Bank Institute's Governance Indicators, as well as Transparency International's Corruption Perceptions Index, have been reviewed. While the Russian Government's influence in the hydrocarbons sector has increased along with an apparent policy of promoting strong state-controlled champions in the sector, the country's overall fiscal and economic management has been relatively strong in recent years. The World Bank Group has an active program in the country, of which governance is one key component. Therefore, IFC believes that this is a project which it should support.

IFC's expected development contribution

The World Bank Group’s 2007-2009 joint Country Partnership Strategy (CPS) for Russia prioritizes:

- sustaining and diversifying economic growth,
- improving public sector management and governance,
- improving the delivery of social and communal services, and
- enhancing Russia’s global role.

The CPS also anticipates deeper regional engagement as the Bank directs its efforts towards sub-national developmental challenges and away from financial support at the federal level.

IFC’s strategy in Russia is to facilitate the growth and diversification of the private sector through its advisory services and financing operations. IFC intends to finance:

- projects with large spill-over potential, such as those in financial markets and infrastructure,
- projects in sectors where Russia has a comparative advantage, and
- projects which increase consumer choice in products and services, such as in retail trade, manufacturing and agribusiness.

To a greater extent, IFC will seek opportunities to participate in equity financing, to invest in poorer or underserved regions and to invest in medium-sized companies with limited access to long-term funding.

In line with the goals of the CPS and IFC’s strategy in Russia, the proposed investment would promote broadbased economic activity in one of Russia’s less developed regions in several ways. By financing the expansion of a privately-held mid-sized producer, the project would help to fill a gas supply deficit caused by Gazprom's lagging production growth, promote competition in a heavily state-dominated sector, introduce more efficient industry practices and boost production of a cleaner energy source. The project would also increase fiscal receipts and sustain and create employment and economic activity in Saratov Oblast, a region with only 60% of average Russian GDP/capita (2002). Further supporting IFC’s strategic goals in Russia’s real sector, the investment also involves an equity component aimed at helping the company transition to large-scale production and access capital markets.

Specifically, IFC’s expected development contributions are as follows:

- Provision of Critical Long-Term Capital:

Vostok requires considerable long-term capital in order to implement its growth plans. Yet, currently the company’s ability to raise funds from the equity and debt capital markets is limited. Equity markets’ appetite for financing small upstream oil and gas ventures has waned significantly in the last year, and a sizeable commercial debt financing is unlikely to be feasible before the company has established a certain minimum track record, especially in the current credit market environment which is heavily influenced by the fallout from the US subprime mortgage market. Accordingly, Vostok sees considerable value in IFC’s investment which will help the company both fund the critical next stage of its growth plan, and secure a minimum capital contingency to mitigate the impact of any operational delays, cost overruns or adverse market conditions. This is especially the case in view of IFC’s readiness to provide Vostok with a package of equity, quasi-equity and senior debt – a combination which is not available to the company from any commercial source.

- Long-term Shareholder:

Apart from the management and board member shareholders, Vostok’s other present equity investors are seed capital providers, private equity houses, and hedge funds, all of which share a relatively short-term investment horizon. In requesting IFC’s equity investment, the company is seeking to rebalance its shareholder register towards an increased participation by longer-term investors.

- Stamp of Approval/IPO Preparation:

The company believes that the proposed investment will enhance Vostok’s credibility and provide comfort to other investors, given IFC’s long-term investment horizon, robust due diligence requirements and strict adherence to high standards of corporate governance and environmental/social sustainability. Vostok’s management and board are especially focused on this value-addition in view of the plan to seek a public listing within the next 18 months.

- Environmental Policies and Systems:

Historically, the company’s Health, Safety and Environment policies have been geared towards compliance with Russian legislation and regulatory requirements. IFC’s guidance and support on the development and implementation of an integrated Health, Safety, Environment and Social Management System, facilitating the consistent application of IFC's Performance Standards, will provide the company with a valuable tool to manage adequately the risks inherent in its operations, in line with international best practice in the oil and gas industry. In conjunction with this work, Vostok has undertaken to implement - with guidance from IFC - a structured Community Development Plan, which will be designed to further enhance the process of selecting, planning, implementing and evaluating the company’s community development projects, as well as to build cooperation with the local partners and maximizing participation of local communities.

Environmental and social issues - Category B

This is a category B project according to IFC’s Procedure for Environmental and Social Review of Projects because a limited number of specific environmental and social impacts may result which can be avoided or mitigated by adhering to generally recognized performance standards, guidelines or design criteria. IFC’s environmental and social appraisal for the project consisted of document review, company interviews, visits to the proposed project sites, and meetings with members of the local communities, local elected officials, and the regional branch of Rostekhnadzor (the state environmental, health and safety oversight agency) in Saratov.

Environmental and social issues associated with this project include:

- environmental and social management systems;
- occupational health and safety management, including job hazard analyses and housekeeping;
- emergency response and community safety, including oil spills and well blowout;
- labor and working conditions;
- land acquisition, compensation and previous land uses;
- air emissions from production processes;
- use, treatment and discharge of process wastewater;
- sustainable management of process solid waste;
- management of hazardous materials and wastes;
- noise from drilling operations;
- contamination from past or present operations;
- greenhouse gas emissions;
- biodiversity preservation;
- cultural and historical heritage preservation;
- community development; and
- public consultation and disclosure.

The company has presented plans to address these issues to ensure that the proposed project will comply with all relevant environmental and social requirements of Russian law and of World Bank/IFC policies, performance standards and guidelines.

Specific information about how potential environmental and social impacts will be addressed by Vostok (including a detailed action plan) is set out in the Environmental and Social Review Summary (ESRS) on IFC’s website as well as locally in Saratov.

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