34. 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 assets and 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 by currencies they are denominated are as follows:

As of December 31, 2014

Russian Rouble USD EURO Serbian dinar Other currencies
Financial assets
Current
Cash and cash equivalents 17,543 21,780 4,661 2,058 7,125
Bank deposits 630 66,558 1,146 8,324
Loans issued 2,162 22
Trade and other financial receivables 39,287 33,673 1,988 26,789 1,277
Non-current
Trade and other financial receivables 265
Loans issued 25,680 2,544 5
Held to maturity financial assets 109
Available for sale financial assets 9,276 14
Financial liabilities
Current
Short-term debt (25,918) (30,211) (4,980) (12)
Trade and other financial payables (46,170) (17,195) (1,442) (7,198) (1,891)
Forward exchange contracts (9,921)
Payables and accruals to employees (11,179) (224) (12) (1,969) (336)
Non-current
Long-term debt (69,858) (365,559) (66,613) (1) (275)
Forward exchange contracts (48,391)
Other non-current financial liabilities (57,553)
Payables and accruals to employees (7)
Net exposure (115,842) (346,815) (65,247) 19,693 14,212

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

The following exchange rates applied during the period:

Average rate Reporting date spot rate
Year ended December 31, 2014 Year ended December 31, 2013 December 31, 2014 December 31, 2013
USD 1 38.42 31.85 56.26 32.73
EUR 1 50.82 42.31 68.34 44.97
RSD 1 0.43 0.37 0.57 0.39

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 change in closing exchange rates and no changes in the portfolio of investments and other variables at the reporting dates.

Weakening of RUB
Equity Profit or loss
December 31, 2014
USD/RUB (70% increase) (24,159) (225,022)
EUR/RUB (70% increase) 149 (46,606)
RSD/RUB (70% increase) 61,837
December 31, 2013
USD/RUB (10% increase) (3,834) (12,680)
EUR/RUB (10% increase) 21 (4,434)
RSD/RUB (10% increase) 8,030

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 favourable over the expected period until maturity.

The interest rate profiles of the Group are presented below:

Carrying amount
December 31, 2014 December 31, 2013
Fixed rate instruments
Financial assets 160,238 162,272
Financial liabilities (319,395) (214,800)
(159,157) (52,528)
Variable rate instruments
Financial liabilities (244,032) (99,068)
(244,032) (99,068)

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:

Profit or loss
December 31, 2014
Increase by 100 bp (2,440)
December 31, 2013
Increase by 100 bp (991)

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, 2014 and 2013, the analysis of financial receivables is as follows:

Gross December 31, 2014 Impairment December 31, 2014 Gross December 31, 2013 Impairment December 31, 2013
Not past due 87,434 (88) 76,049 (15)
Past due 0–180 days 9,291 (93) 6,047 (56)
Past due 180 –365 days 799 (623) 1,822 (502)
Past due 1–3 year 11,075 (5,101) 7,588 (3,621)
Past due more than three years 7,656 (7,071) 4,939 (4,797)
116,255 (12,976) 96,445 (8,991)

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

2014 2013
Balance at beginning of the year 8,991 8,189
Increase during the year 662 403
Amounts written off against receivables 104 48
Decrease due to reversal (284) (378)
Other movements (239) (149)
Translation differences 3,742 878
Balance at end of the year 12,976 8,991

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, 2014 and 2013.

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:

A BBB Less than BBB Without rating Total
As of December 31, 2014
Cash and cash equivalents 8,993 26,499 6,051 8,491 50,034
Deposits with original maturity more than 3 months less than 1 year 65,758 5,739 1,719 3,442 76,658
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

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 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:

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, 2014
Bank loans 262,962 293,629 15,797 23,460 78,335 169,132 6,905
Bonds 61,609 70,129 12,452 2,031 23,212 32,434
Loan Participation Notes 221,107 295,615 5,880 2,532 6,566 80,530 200,107
Other borrowings 17,749 18,118 14,362 311 220 1,219 2,006
Other non-current financial liabilities 57,553 85,171 1,031 67,951 16,189
Trade and other payables 73,896 73,896 71,188 2,708
Payables and accruals to employees 13,727 13,727 13,720 7
708,603 850,285 133,399 31,042 109,371 351,266 225,207
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

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:

Year ended December 31, 2014 Year ended December 31, 2013
Long-term debt 502,306 261,455
Short-term debt and current portion of long-term debt 61,121 52,413
Less: cash, cash equivalents and deposits (129,825) (127,946)
Net debt 433,602 185,922
Total EBITDA 300,761 316,463
Net debt to EBITDA ratio at the end of the reporting period 1.44 0.59
Operating profit 212,645 222,117
Operating profit adjusted for income tax expenses 185,796 181,506
Share of (loss) / profit of associates and joint ventures (6,306) 11,251
Average capital employed 1,373,665 1,105,397
ROACE 13.07% 17.44%

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

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 period ended December 31, 2014 and 2013. There are no significant assets or liabilities measured at fair value categorised within Level 1 or Level 3 of the fair value hierarchy. The fair value of the foreign exchange contracts is determined by using forward exchange rates at the reporting date with the resulting value discounted back to present value.

As of December 31, 2014 the fair value of bonds and loan participation notes is RUB 232,210 million (as of December 31, 2013 — RUB 189,693 million). The fair value is derived from quatations in active market and related to Level 1 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, which refer to Level 2 of the fair value hierarchy.

Level 2
As of December 31, 2014
Forward exchange contracts (58,312)
Other financial liabilities (2,228)
Total liabilities (60,540)
As of December 31, 2013
Forward exchange contracts 293
Total assets 293
Forward exchange contracts (3,177)
Other financial liabilities (1,631)
Total liabilities (4,808)

During 2010 the Board of Directors 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 shareh older value over a specified period. Shareholder value is measured by reference to the Group’s market capitalisation. 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 three years 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 recognised 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 recognised in the period the change occurs subject to the vesting period.

The following assumptions are used in the Black-Scholes-Merton model as of 2013:

December 31, 2013
Volatility 3.7%
Risk-free interest rate 6.12%
Dividend yield 4.69%

As of December 31, 2014 no assumption 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, 2014 and 2013 the Group recognised compensation expense of RUB 594 million and RUB 519 million respectively. This expense is included within selling, general and administrative expenses. A three years provision of RUB 2,228 million has been recorded in respect of the Group’s estimated obligations under the plan as of December 31, 2014. As of December 31, 2013 the amount of the two years provision was equal to RUB 1,631 million.