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THIS REPORT WAS PREPARED BY “STUDENT’S NAME”, A MASTERS IN FINANCE STUDENT OF THE NOVA SCHOOL OF BUSINESS AND ECONOMICS, EXCLUSIVELY FOR ACADEMIC PURPOSES. THIS REPORT WAS SUPERVISED BY ROSÁRIO ANDRÉ WHO REVIEWED THE

VALUATION METHODOLOGY AND THE FINANCIAL MODEL. (SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT)

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MASTERS IN FINANCE

EQUITY RESEARCH

Maximizing opportunities in the upstream We recommend buying Galp Energia given our target price

of €14,82 per share, corresponding to an overall return of 25%

given current price levels.

The expected increase from 87,4 mb/d in 2012 to 101,4

mb/d in 2035 in world demand of oil and natural gas, strengthens

Galp Energia’s growing opportunities. We identified great potential

value in upstream activities where the main projects in Brazil,

particularly Lula´s field, to have a crucial role in this segment

development. Also Angola fields and the NG reserve in

Mozambique contribute for an optimistic situation.

The European and national crisis suggest a slowdown in

demand, lower refining margins and expected negative conditions

for the following years implies a lower value in this segment. The

current refining margins are 2 $/bbl and it´s expected a growth

reaching the 3,5 - 4,0 $/bbl. We expect that the full operation of the

hydrocracker and consequently improved refining margins will

reverse the undesirable situation in the long term.

Despite suffering slightly due to the lower growth

expectations in the Iberian market, the G&P segment remains fairly

stable with forecasted net profits increasing between 1% and 2%

per year until 2020. The window of opportunities for exploitation of

arbitrage in the Asian market, especially Japan, leads to an

expectation of good results in the Gas & Power sector.

Company description

Galp Energia is a Portugal based company engaged in the oil and gas industry and it was established in 1999. In the year of 2006, the company was floated on Euronext Lisbon (NYSEEuronext), and it is a constituent of the PSI 20 index. Company´s activities are divided into three different segments with a diversified portfolio of assets divided across 10 different countries, with the development and production of oil and gas mainly in Brazil, Angola and Mozambique. Galp has a market capitalization of € 9,752 million and in 2012 was rewarded with the insertion in Dow Jones sustainability indexes.

GALP ENERGIA COMPANY REPORT

OIL&GAS 6 JANEIRO 2013

STUDENT: AFONSO FREITAS [email protected]

Growing up in Brazil leads to…

Recommendation: BUY

Vs Previous Recommendation BUY

Price Target FY14: 14,82 €

Vs Previous Price Target 14,82 €

Price (as of 6-Jan-14) 11,89 €

Reuters: GALP .LS

52-week range (€) 10.76-13.40

Market Cap (€m) 9.752

Outstanding Shares (m) 829.251

Source: Bloomberg

Source: CMVM and Galp Energia

(Values in € millions) 2012 2013E 2014F

Revenues 18.644 20.077 20.791

EBITDA 1.038 1.278 1.460

EBIT 542 731 906

Net Profit 343 410 686

Net Debt 1.696 2.256 2.801

Net Debt / Equity 25,3% 40,1% 38,7%

ROE 5,12% 5,98% 9,48%

ROIC 4,30% 4,25% 7,25%

Debt/Assets 52% 61% 65%

Current ratio 99% 70% 75%

Source: Galp Energia, Analyst Estimates

http://www.novasbe.pt/speraltaRectangle


PAGE 2/37

Table of Contents

EXECUTIVE SUMMARY .......................................................................... 3

COMPANY OVERVIEW ........................................................................... 4

COMPANY DESCRIPTION ........................................................................................ 4 SHAREHOLDER STRUCTURE ................................................................................... 5

EXPLORATION & PRODUCTION (E&P) ................................................. 5

MARKET ENVIRONMENT ........................................................................................ 5 BRAZIL .................................................................................................................. 7 ANGOLA ................................................................................................................ 9 MOZAMBIQUE ...................................................................................................... 10 VALUATION E&P ................................................................................................ 11 SENSITIVE ANALYSIS ........................................................................................... 13

REFINING & MARKETING (R&M) ..........................................................14

MARKET ENVIRONMENT ...................................................................................... 14 REFINING ............................................................................................................. 17 MARKETING ........................................................................................................ 18 VALUATION R&M ............................................................................................... 19 SENSITIVE ANALYSIS ........................................................................................... 20

GAS & POWER (G&P) ............................................................................20

MARKET ENVIRONMENT ...................................................................................... 20 GAS ..................................................................................................................... 23 POWER ................................................................................................................. 25 VALUATION G&P ................................................................................................ 26 SENSITIVE ANALYSIS ........................................................................................... 26

SOTP .......................................................................................................27

SENSITIVE ANALYSIS ........................................................................................... 29

FINANCIALS ...........................................................................................30

MULTIPLES.............................................................................................32

FINANCIAL STATEMENTS .....................................................................33

APPENDIX ..............................................................................................35

DISCLOSURES AND DISCLAIMER .......................................................37


PAGE 3/37

Executive summary

This Report has the main objectives of developing a comprehensive analysis of

the Company Galp Energia and providing an investment recommendation based

on the actual price and the possible return in the period of 12 month. Our

valuation implies an upside potential of 25%. We followed the sum of the parts

approach, using DCF for the sectors in which Galp operates: E&P, R&M and

G&P. We have followed the company´s strategy as well as the industry dynamics

in which Galp is inserted. In addition, we strongly believe that there is

considerable growth potential.

Through our analysis we have identified the E&P segment as the main source of

value, even tough is not representing yet the major source of income. This belief

is consolidated mainly with the projects in Brazil. However, Angola and

Mozambique also transmit respectable prospects. Taking into account all the

political, commercial and regulatory challenges we expect that high returns will

be achieved in the next years, coming from this segment.

Regarding the R&M segment, which has been historically the main source of

income, we expect a slowdown on its operations mainly due to the economic

crisis and a change in the pattern of oil &gas supply and demand. We foresee

that the adverse European R&M market will remain in the following years where

non-developed countries seem to gain competitive advantages. The upgrade

project concluded in 2012 helped the company to be aligned with international

demand and we trust that this will be crucial for this segment recovery in the

long-term.

Thirdly, the G&P segment looks to be more stable and it is intensely conditioned

by remuneration rates and tariffs imposed by the regulator ERSE. In this

business, we predict the Company to take advantage from trading in the Asian

market, which its importance has been increasing over the last years.

Finally and to conclude we have set a price for Galp Energia for FY2014 of

€14,82/share.

Overall return of 25%

Upstream activities as

the main source of value

Some risks to be faced

Hostile conditions in the R&M industry

G&P trading to be

exploited


PAGE 4/37

Company overview

Company description

Galp Energia is a Portugal based company engaged in the oil and gas industry

and it was established in 1999 to incorporate the operations of Petrogal (Oil&Gas

Company) and Gas de Portugal (Utility Company). In the year of 2006, the

company was floated on Euronext Lisbon (NYSEEuronext), and it is a constituent

of the PSI 20 index, the main index in Portugal.

Galp’s activities are divided into three different segments: Refining and Marketing

(R&M), Gas and Power (G&P) and Exploration and Production (E&P).

Historically, Galp Energia generated the majority of its EBIT from its downstream

segments (R&M and G&P). The first segment (R&M) has the majority of sales on

the Iberian Peninsula, where the company is one of the most important players

and it is expanding its sales to clients in Africa. In the Gas and Power business

sector, the company is not only a supplier of natural gas and energy in the

Iberian Peninsula but has been also concentrating on its trading of liquefied

natural gas (LNG) among international markets. However, Galp Energia has

turned now its strategy to the upstream business (E&P) with a diversified portfolio

of assets and activities divided across 10 different countries, with the

development and production of oil and gas mainly in Brazil, Angola and most

recently in Mozambique.

The company has a market capitalization of € 9,752 million and is expected to

increase in the coming years since the main concern of its shareholders is to

strength the E&P sector which if the expected unique growth is achieved it will

lead to a likely increase in the company value. The company has been also

aware of the sustainability issues and in 2012 it was rewarded with the insertion

in the Dow Jones sustainability indexes (DJSI), JDSI World and DJSI Europe.

Source: Galp, Analyst Estimates

Figure 1 – Segment waight in the EV

Source: City Group, Analyst Estimates

Figure 2 –EBITDA evolution per segment

Source:Bloomberg, Analyst Estimates

Figure 3 –Peers Market Capitalization

Figure 4 – Peers Estimed Net Income 2013



PAGE 5/37

Shareholder structure

The company has three main different shareholders Amorim Energia1 38,34%,

Eni with 16,34% and Parpública 7%, controlled by the Portuguese State. The

remaining stake of 38,32% is free-float and traded in the Euronext index. Amorim

Energia is owned 55% by Galp´s Energia Chairman Américo Amorim and the

remaining 45% stake is held by Esperaza Holding BV. Parpública is a vehicle for

the Portuguese state equity holdings in a different number of companies

During the last year, Galp Energia has suffered from changes on its shareholder

structure. In May 2013 it was announced the successful of the placement by Eni

of 55 452 341 shares, corresponding to approximately 6,7% of Galp Energia,

after the settlement of the sale, Eni holds 16.34% of Galp's outstanding share

capital of which 8%2 are convertible bonds and therefore it is expected Eni to

reduce its participation to 8,34% in 2015. Another important aspect, was an

adjustment in Galp Energia’s dividend distribution policy which was revised in

2012, estimating a rising dividend and an expected smooth increase in the

following years until 2016.

Additionally, Galp Energia's shareholder structure has a growing representation

of international shareholders, close to 80% of total institutional investors, which

shows the geographic variety of the Company's investors.

Exploration & Production (E&P)

Market Environment

This sector has become one of the most valuable sectors among the different

continents and this role is expected to remain in the next years. In 2013, the

consumption of oil in the world had an increase of 1.1% when compared to the

previous year. The reasons behind this issue are consequence of an increase of

demand for this product by the countries outside the Organisation for Economic

Cooperation and Development (OECD). Oppositely, countries from OECD have

shown a slowdown on its economic growth during the last 4 years. This was a

consequence of the economic crisis in the USA and in Europe but also due to

1 Amorim Energia shareholders are Power, Oil & Gas Investments BV (35%), Amorim Investimentos Energéticos SGPS

S.A. (20%) and Esperaza Holding BV (45%). Esperaza Holding is owned by Sonangol, E.P., Angola’s state owned oil company and Isabel dos Santos 2 Bonds issued on 30 November 2012 and due on 30 November 2015, and the remaining 8.34% subject to certain rights

exercisable by Amorim Energia. If Amorim Energia don’t buy or don´t not indicate a third party, ENI is free to sell

8.34% in the market, meaning that there is risk of overhang on Galp’s shares

ENI participation expected to be reduced

Figure 5 – Share Structure


Figure 6 –Brent price evolution



PAGE 6/37

more efficient markets in developing countries. Conversely, China and India have

been contributing to a rise in oil and gas demand during the years of sovereign

crisis with an increase in consumption of 7%. According to OPEC estimates, the

OPEC member countries3 will continue to expand its upstream businesses and

around 132 projects are expected to come on-stream. The development of the

awaited projects is translated in a net increase of 7 mb/d4 when compared with

2010.

We predict that in a near future some importers will become exporters (the U.S.

is changing its role in the Natural Gas market), large exporters are becoming

large consumers (Middle East countries regarding oil consumption) and earlier

small consumers are becoming the main font of global demand (India and

China). Once again, these changes emerge as the energy sector is reacting to

global trends, alterations in both demography and economic growth and the

faster advance of energy sector followed by an unusual unlocking oil and gas

supplies.

The dated Brent price is also an important driver for the E&P market

environment. This indicator has shown a huge volatility, directly related with Geo-

political events, supply, demand and so on and the last years the data Brent price

ranged between $90/bbl5 and $111.5/bbl. The price instability was mainly driven

by the hostile environment in Syria, southern Sudan and Yemen, but also due to

the USA and European Union (EU) restraint on crude oil from Iran.

Another important issue that can strongly affect the market for natural gas is the

development of shale gas which is a natural gas that is found trapped within

shale formations and has becoming an increasingly important source of natural

gas in the United States since the start of this century. The theory that the USA

might change from importer to exporter of natural gas is increasing the risks for

the players in energy markets since the threat of this new product will have

repercussions on the profitability of different projects for the development of

natural gas. In fact, the huge impact of production of shale resources, especially

in North America, would strongly affect crude oil and gas production and

consequently the economies of countries which heavily depend on crude oil as

their main source of revenue. Also, according to International Association of Oil &

Gas Producers (OGP) the development of shale gas in Europe could add 1

million jobs and consequently make the industry more competitive and less

3 Organization of the Petroleum Exporting Countries 4 Millions of barrels per day 5 Barrels – Oil barrel = 42 US Gallon – 158,9 liters

Changes in the energy

sector

Progress of shale gas as a challenge

Galp E&P projects

among 10 countries

Figure 7 – Growth in world oil demand

Source: IEA, Outlook 2013

Figure 8 –Oil demand evolution by region

Source: IEA, Outlook 2013 – Analyst Estimates

Figure 9 – Unconventional gas evolution

Source: IEA, Outlook 2013 – Analyst Estimates

Figure 10 – Regions where Galp is production

Source: Galp Energia


PAGE 7/37

dependent on energy imports. On the other hand, there are several risks

associated with this unconventional gas with the environmental ones being in the

top of them.

Galp Energia is directing its upstream operations among 10 different countries

with 50 projects but with particularly emphasis on the discoveries in the pre-salt

area of the Santos basin in Brazil, in the Rovuma basin in Mozambique and in

blocks in Angola. The other projects are only in the initial phases of exploration or

appraisal which are recognized as technical reserves and are placed on the

following countries: Venezuela, Uruguay, Portugal, Equatorial Guinea, East

Timor, Namibia and Morocco. The company is preparing to increase its

production. Its goal is to produce 300 kboe/d6 (actual galp’s refineries

consumption) in 2020 which represents more than 10 times of the actual

production. Therefore, our analysis will be focused on the countries where there

is already a development plan or where the company is already producing

Brazil

The discoveries in Brazil and its adjacent participation of Galp Energia have

increased the company´s value, being the projects in Santos basin the main

source of value and leading to perspectives of future development in oil and gas

production. In all these projects, Galp Energia controls its operations through

Petrogal Brazil where Galp has a 70% holding.

In fact, Galp Energia is involved in two great oil & gas discoveries during this

century: Lula in Brazil and Mamba in Mozambique. Over the last ten years, more

oil fields have been discovered in Brazil than in any other country in the world.

Secondly, we believe that there are several technical and commercial challenges

associated with the pre-salt projects where Petrobras is the operator in most

fields and where this company is dedicating significant efforts to research and

advance of proper technologies. The targets for levels of production are a

stimulating opportunity for Galp Energia and it is critical to evaluate properly the

significant level of risk. That is why each project has to experience the four

different phases: exploration, appraisal, development and production. In each

field, EWT7 and Pilot tests are made, in the initial phase where the goal is to

gather the most reservoir and production data possible. The phase of full

development (here is important Petrobras desire to fast-track the pre-salt

6 Thousands of barrels of oil equivalents per day 7 Extended Well tests

Figure 12: Petrogal Brazil Project

Figure 11: Production Curve (Carcará field)


Great increase in production is expected for 2020


Figure 13: Brazil Reserves and Start-up date



PAGE 8/37

developments), is when the tested technologies, FPSOs8 and subsea wells are

used (with the contraction of more units in the production phase if needed).

Together, these investments represent the major part of the capital expenditures

on this kind of projects.

Galp´s exploration calendar in Brazil for the next years includes several high

impact wells with very high risk but also the de-risking operations if successful

could be vital for the company´s future growth. The risks that arise with well

constructions are mainly related with the uncertainty about the existence or not of

hydrocarbons which can lead to abandonment of the field and waste of capital

expenditures. Also, high environmental hazards are associated, where the

process of wells drilling may produce a concentration of surface disturbance and

trash generation. The de-risking operations are the tasks that have to be

performed in order to convert the uncertain reserves into proved and recoverable

reserves. Plus, the development and production stages carry a high level of risks

respecting their critical variables (infrastructure costs, production schedule, and

quality of resources extracted, operational costs and geological reservoir

characteristics). Again, since many of the projects are in the exploratory or

appraisal phase we will only focus our valuation on the projects where there is

already a development plan or which are already in the production phase. These

fields are commonly named commercial reserves.

Regarding the projects that we have evaluated: BM –S 8 Carcará; BM-S 11 Iara

field; BM- S 24 Júpiter and the BM-S 11 Lula and Cernambi fields (we have

modelled the two fields together due to the ANP9 consideration of both fields to

be a single accumulation,) in each one Galp has different participations. Several

issues addressed (date for start-ups, capital expenditures, operating costs and

expected peak of production) appear to be determinant on its value for the

company. Moreover, all these projects are regulated under concession contracts

where there is a special tax applicable depending on the level of production per

year.

Carcará pre-salt oil and gas field lies within the BM-S-8 exploration where

Petrogal Brazil holds a 14% stake and includes other discoveries such as Bem-

Te-Vi and Bigua. The company operator is currently planning to start the Carcará

field production in 2018. In block BM-S-24, also located in Santos basin, Petrogal

Brazil has a 20% holding. Here, the second well, Jupiter was drilled and it was

8 Floating Production Storage and Off-loading facilities 9 Agência Nacional do Petróleo


Figure 15: Global discoveries Oil fields

Wells construction represents high risks

Valuation focused only in upstream projects in

the last phases

Brazil projects controlled under concession contracts

Figure 14: Average E&P Projects duration


Brazil assets transmitting virtuous prospects


PAGE 9/37

evidenced the existence of continuous reservoir and the confirmation of the

presence of commercial oil, and that is why we have considered this field as a

commercial reserve. In the consortium in charge of the BM-S11, Petrogal Brazil

has a stake of 10%. In this area, Iara was one of the largest deep-water

discoveries ever made. Despite being an extended well test planned for 2014,

there is also a full-scale plan of development to follow. The Lula project is already

producing since 2010 while the Cernambi field will start in 2014, therefore we

believe that Lula and Cernambi together will reach its peak of production in 2025.

We have made our investment plan for each project based on Petrobras BMP

2012-201610, since the company is the operator in each block, but also in past

experiences for the Lula field.

Finally, it is important to refer that in the beginning of 2012, Galp has sold to

Sinopec an equivalent stake of 30% in Petrogal Brazil. In this deal, Sinopec has

subscribed the $4,8 billion capital increase in Petrogal Brazil plus a shareholder

loan to the company in the amount of $390million which was used to reimburse

30% of the loans to Galp Energia of $1,3 billion. In fact, when compared to

similar deals in this industry, such as the purchase of Sinopec in Repsol, we

observe a difference in Galp´s deal between 1,7$/bbl and 1,9$/bbl below.

However, we believe that the deal also decreased operations risk, allowed for

liquidity for upstream activities and improved confidence for other shareholders

and possible future investors or partners.

Angola

Galp Energia has currently its main source of production activities in this country,

even though in the medium and long term this will rapidly be replaced by projects

in Brazil. In fact, while Galp has some development prospects in blocks 14/14k

and block 32, we believe that these opportunities are on a much smaller scale

than those in Brazil and Mozambique.

In block 14 Galp holds a participation of 9% and the operator is Chevron, where

the fields of Kuito, Tombua-Landana and BBLT11 are allocated. Here, the

company is already producing and has even reached its peak production in the

year of 2010 with 71 905 kboe. In this block an FPSO facility has been leased

and installed in the late 2000. It was designed to operate for about 10 years and

has to be recertified for continue the production on this block; thus we assume

10 “Petrobrás Business and Management Plan” 11 Benguela / Belize / Lobito e Tomboco

Operation benefit for Galp Energia

Sinopec deal in 2012 appear to be undervalued

Lula field as a reference for the other field’s valuation

No more investments expected in block 14

Figure 16: Angola Projects



PAGE 10/37

that there will not occur more investments in FPSOs in these three fields. The

Tombua- Landana filed is crucial for the company performance on the block 14

since it’s the only field where production is not in a declining phase and has not

reached its peak and therefore we expect that its production phase will offset

block 14 declining production rather than increase production. Galp is also

involved in block 14 in the development of Malange & Lucapa field which was the

first discovered in the Cretaceous Pinda Formation. This field is relatively small

and recoverable reserves are unlikely to be sufficient to support a standalone

development. The two other projects that Galp is operating are Block 14K-Lianzi

and Block 32, in which the company has a participation of 4,5% and 5%

respectively. The block 32 is situated in water depths ranging from 1 400 to 2000

metres and the fields are spread over a large area, which contributes to a larger

amount of capital expenditures on FPSOs facilities and wells. All these questions

show the numerous hazards that projects like these in Angola are associated to,

being the uncertainty about the field geology the main risk. In addition, less

transparent practices, delays in suppliers ‘schedules and the fact that oil

companies operating in Angola must use local banks to make all payments,

constitute a threat for the operations in this country.

The company is also taking part in the first integrated natural gas project in the

country, Angola LNG II but it is still in the initial phase of exploration. In block 33,

the activities in 2012 were dedicated on drilling of Sumatê-1, and in the year of

2013 a new exploration plan was submitted and so we do not consider as a

commercial reserve yet, not taking into account for the valuation purpose.

Mozambique

In Mozambique, Galp Energia has a 10% participation in the consortium for the

exploration of area 4 in the Rovuma basin. The consortium is operated by Eni but

has also ENH12 and Kogas as participants. Here, and particularly in the year of

2012 there were numerous natural gas findings through the execution of six wells

drilled in the area. After the appraisal phase there was an estimate of 27 Tcf13

equivalents to 4.656.284 Kboe exclusively for area 4. Galp Energia and the other

partners should also continue the exploration and appraisal of Area 4. We share

the same opinion of Galp Energia that there is extra value in Rovuma gas prone

structures where the company intends to test liquids prospects in the end of

2013.

12 The National Oil and Gas Company of Mozambique 13 Trillion cubic feet

Area 4 exploration

should continue

Galp investing in the first NG project in Angola

Projects in Angola with

some threats associated

Malange & Lucapa size inadequate for a long-term development


PAGE 11/37

The discoveries in Mozambique are likely to provide exceptional returns in the

medium and long term for the companies involved, and offer access to high LNG

volumes for export essentially to international markets and more precisely to

Asian Markets. The presence of Eni who has LNG experience constitutes a

competitive advantage. On the other hand, the dependence on sales agreements

with LNG buyers might be a threat for the profitability of the development plan.

In December 2012, Eni together with Anadarko (operator of the Area 1 of

Rovuma Basin) awarded a number of FEED (Front End Engineering and Design)

contracts and announced a HD (Heads of Agreement) to track a co-ordinated

development and a common LNG facility. The partners have scheduled a

delivering of the first LNG train in 2018, although we had a more conservative

approach and have forecasted the first LNG train to be implemented in 2019

which will be built near the town of Palma in the north of Mozambique.

Furthermore, we think that the initial capital expenditures might be too high for

some of the participants of the consortium, such as ENH, and therefore there

might be a change in the partnership before the final investment decision, with

the possibility of the major players in the Asian market to acquire the available

stakes and thus improving operations due to their advanced experience. It is also

of the upper importance to refer that we have assumed that if eventual future

domestic sales occur it will be done at market values and hence not affecting

future cash flows14.

Valuation E&P

The method that we have used in the valuation of the E&P segment was the

Adjusted Present Value (APV) which allows us to value each project separately

not taking into account the capital structure. With this method we are able to

evaluate each project and its operations as if the company were all-equity

financed and the value of tax shields that arise from debt financing. First of all it is

important to reiterate that we have only valued the projects that are already

nominated commercial reserves and where that is already a plan of development

or production phase. For each field/project we have discounted the Free Cash

Flow to the firm (FCF) at an unlevered cost of equity (calculating different values

for each country) and then we have added the value of tax shields. In the end,

after computing the total value for each project we had to attribute the percentage

of participation that Petrogal Brazil keeps in each field and then also apply the

14 Appendixes 2 and 3 provide E&P projects information, however it is only related to the first 10 years.

Different participations of Petrogal Brazil have to be addressed

Future domestic sales at

market values

Findings in Mozambique predictable to provide extraordinary returns

Valuation of projects using the APV approach

Figure 17: Area 4, Mozambique partners and financial capacity



PAGE 12/37

stake that Galp Energia has in Petrogal Brazil (70%). Moreover, we have done

our analysis based on the perspective of the operator (Petrobrás, Chevron, etc)

as we thought that it would facilitate our valuation instead of trying to estimate

costs, risks and revenues exclusively for Galp´s Company. The assumptions that

Galp will be prepared to follow the project investments and that each project will

complete its estimated duration are essential for our approach. We have taken

into account the different types of contracts in each country: Concession

contracts (Brazil and Mozambique) and Product Sharing Agreement (Angola). In

the first group the participants have to share a percentage of production with the

State plus the taxable income, while in the PSA there is the possibility of

recovering part of the project costs and the remaining production is shared

between the contractor and the concessionaire.

For each field we have forecasted the expected peak of production based on the

operators and Galp´s reports. Lifting costs, other operational costs and royalties

(10%) were forecasted depending on each year production. Also Brent prices

affect strongly the profitability of the project. In our estimates we have used a

$108 price for 2013 decreasing until $98 in 2022 and after that showing a rising

trend since is expected a recovery of this commodity prices. We have also used

a discount over brent of 4% in Brazil and 3% in Angola mainly due to variances in

API gravity15.

Regarding capital expenditures, for the three countries we estimated the number

of wells required, and having in mind that its number is a big uncertainty and a

critical factor in determining the whole cost of the project, we used an average of

22 wells per FPSO (12 producers and 10 injectors) in Brazil. In Angola we used a

number of 14 wells per FPSO (10 producers and 4 injectors) attributing the

discrepancy between both countries to different levels of production, FPSOs

capacity, distance of each field and percentage of recoverable reserves.

In what respects the Rovuma project, the capital expenditures have a different

nature since it is a Natural Gas Project. Here, we estimated an installation of a

Pipeline with a cost of $500M in the year of 2017 (production starting only in

2019) and 4 LNG trains to be acquired during the project. Also in this project, we

have used a NG/Oil parity to calculate revenues as the reserves of this project

were translated in boe. Although we expect a slighter relation between gas and

oil prices in the future, we made our assumptions based on recent studies16 that

15 American Petroleum Institute´s scale for denoting the “heaviness” or “lightness” of crude oils 16 “ The weak tie between natural gas and oil prices”, David J. Ramberg & John E. Parsons

Variance in discount over brent in Brazil and Angola

Brent prices disturb the

success of the projects

Different types of contracts in the 3

countries

Different levels of production and capacity

in the 3 companies

In Mozambique capital costs and infrastructures vary from Brazil and Angola


PAGE 13/37

establish that crude oil and natural gas prices are co-integrated. We adopt a

constant natural gas – oil parity (boe/mmbtu)17 of 17% and a conversion factor of

a boe to mmbtu of 5,55 approximately.

Therefore, we reached Galp´s E&P operations at a €13,10/share.

Sensitive analysis

In each section we have anticipated the impact in the actual outcome, the equity

value of Galp Energia, by a variation from the base case of the key value drivers.

This analysis is particularly useful since the estimates have always an inherent

uncertainty and therefore it can attenuate the risk of an unfair valuation.

Regarding the E&P segment, we have predicted the impact of a variation in the

data Brent price and in the exchange rate (€/USD). In fact, Galp Energia activities

and its value creation are extremely dependent on these two indicators. This

dependence will increase in the future, as a result of a stronger importance of the

E&P segment. Besides, as the products extracted from the reserves of the main

projects, in this sector, have the data Brent price as a reference, price

movements in the next years will affect Galp price per share. Also, since the

production extracted from the fields and the major parts of cash flow in this

segment are traded in dollars, a depreciation/appreciation of the dollar will also

impact in the E&P performance in the next years. As we can observe, a

depreciation of the dollar has a negative impact in the Company´s value due to

the importance of upstream businesses.

It is important to refer that these two variables also affect the R&M segment but

have a deeper impact in upstream activities, where they yield higher variations.

Also, it is crucial to have in mind that variations in both drivers have opposite

effects on E&P and R&M sectors. In fact, an increase in Brent price has positive

effects in upstream operations while the same variation would impact negatively

in refining margins, since it represents a huge part of the operating expenses. In

what concerns the exchange rate (€/USD) while an appreciation of the dollar may

increase E&P margins, the refining cash costs would also increase.

Concluding, even though these two key value drivers have contraries effects on

different segments, the large importance of the E&P segment points that the data

Brent price is positively correlated with Galp´s value, while a depreciation of the

USD will have an undesirable effect on Galp´s price per share.

17 Ratio between barrels of oil equivalents to millions of British Thermal unit

Brent price and exchange rate affect both R&M and E&P segments

Brent prices moves

affect Galp value

Both variables have a higher impact in

upstream activities


PAGE 14/37

Refining & Marketing (R&M)

Market Environment

The global refining and marketing has been facing a deep transformation over

the last years as a result of several changes in regional demand trends for oil

products but also due to variations in regional energy costs. In this industry,

crude oil and natural gas liquids are mainly used as inputs to provide fuel for the

transformation process. Thus, the importance of low energy prices has increased

and the cost of energy inputs affects strongly the price of fuel. The profitability of

refining margins is affected by the inability of the refiners to reflect the higher

input costs in the final prices. Therefore, the main problem is related with rivalry

between refining companies and with elasticity demand/price (when price

increases, the demand falls) strongly influencing competition for installed

capacity. Commonly the costs are lower for refining companies that are located

close to the market than for companies who have to ship refined products over

long distances. Energy costs are the main cause for the shrinkage of refining

margins in some regions, especially Europe, where several refineries have

already closed and further exits are likely. Since the beginning of the century,

stricter oil-product standards and an upward shift in the demand for middle

distillates (such as diesel) are imposing refining companies to increase

conversion processes. We have predicted an important pattern in company’s

investments in energy-saving equipment. Also, the fall in gas prices in the United

States has given to its companies a competitive advantage with negative

consequences in European refiners with high imported gas costs.

Competition between refineries as the main problem

Conversion processes

are gaining importance

Figure 18: Deviations in price target due to changes in Crude Brent price and €/$ exchange rate

Source: Analyst Estimates


PAGE 15/37

Europe and USA have always been the main refining centres in the world,

together accounting for 46% of total global refining capacity in 2012. Moreover,

while demand in both of these regions tracks a downward trend, Asia and

emerging countries are expected to increase demand and its refinery capacity.

Over the 4 mb/d of refining capacity that has been permanently shut down

worldwide over the last 5 years, half was in Europe mainly due to the sovereign

crisis. The extremely problematic access to crude oil and the difficult to export its

products is a pattern that will persist over the next years. The difficult to access to

crude oil is explained by the inequalities in allocation of crude around the planet

and also by the improvement and construction of refining centres in the countries

producers (as they benefit from cheaper feedstock and lower energy costs, they

can easily compete against Europe's refiners). Besides, the challenges in

exportations are related with the fact that many Europe refineries were

constructed after the Second World War and were heavily geared towards

gasoline production which is being reflected on a surplus of gasoline due to a

change in products demand (with diesel being favoured). At the same time,

massive refineries in the United States, Asia and the Middle East are sending

ever-growing volumes of diesel to Europe which deteriorates even more the

situation. Since the end of the 1990s, European gasoline consumption has

decreased by 1,2 mb/d with diesel consumption playing a significant role and

turning this continent into the biggest importer of diesel, due to government

policies and fuel taxation. The process of “dieselization” started in the beginning

of the 80s where a more favourable tax policy and the creation of a “diesel motor”

were the main causes. In the 90s, the technology improvement in these type of

motors that were perceived to be more environmental friendly, faster and quitter

than “gasoline motors” accentuated the growth importance of diesel. Also, we

believe that this trend is to continue as diesel represents by far the largest

increase in volume terms, rising by more than 5 mb/d to 31 mb/d between 2012

and 2035. All of the net increase in diesel demand comes from the road-transport

sector in non-OECD countries. In Europe, we have two different markets for

trading of oil products: MED18 market and NWE19 market, while in the distribution

sector we have local markets mainly due to logistic and fiscal issues.

Consequently we do not have a European single market in this sector.

We predict that total European oil product demand will decline by 2,4 mb/d to

2035 while distillates increase their share of total product demand. Another trend

18 Mediterranean – Genoa, Lavera 19 Northwest – Amsterdam, Rotterdam and Antwerp

Diesel has been enhancing its position

over the last years

Difficult in access to

crude oil and exports

More European refineries will bankrupt in the near future

Europe´s dependence on imports of middle distillates

Figure 19: Refining Capacity evolution by region

Figure 20: Gasoline and Diesel Quotations evolution

Source: PIRA Energy Group- World Refining Data Portal, Analysts Estimates

Source: Galp Analysts Estimates

Source: Wood Mackenzie- JEC Fleet & Fuels Model, Analysts Estimates

Figure 21: Gasoline and Diesel demand evolution


PAGE 16/37

that we could observe is the intensification of Europe´s dependence on imports of

diesel and jet fuel. In addition, we strongly believe that the capacity for European

refining companies’ exports excess gasoline to USA and to West Africa will be

limited in the future. Both the slowdown of USA demand for gasoline and

increasing production from US Gulf Coast refineries should be a warning for

European refining and marketing managers. Also the fact that US Gulf Coast

R&M companies are already selling to West Africa may be a denunciation for

some European refining companies whose margins cannot persist at this low

levels and which make us believe that more companies will close in the near

future. According to a Bloomberg survey of six European refinery executives, 10

will shut permanently by 2020 from France to Italy to the Czech Republic.

Another reason for apprehension in European refining companies is the

increasing dependence on imported crude which we trust that will raise even

more in the coming years. In an intensive and competitive environment and

where refining margins are constantly under pressure, the fact that Russia has

been reducing exports of crude oil and turning its trade path to China20,

deteriorates the situation.

In conclusion, the European refining and marketing market has been facing an

adverse atmosphere in the last years and is expected to remain the declining

pattern. The combination of lower amounts of product outputs, more competition,

low share in gasoline exports and the expectation of more refining companies to

close take us to a prediction of European refinery runs will decline in 2035 by 2,6

mb/d more than the 2,4 mb/d fall in European demand.

Before Galp´s refinery investments and upgrades21, refining activities were not in

accordance with its retail and marketing sales. The company have been with

extra production mainly in fuel oil and gasoline, and with the necessity of

acquiring middle distillates for resale on its marketing business, aligned with the

competition. One of the goals of the upgrades in the refineries were to increase

the yield rates of the middle distillates from 43% to 49% and at the same time

decrease the output of the excess oil products in order to equilibrate the overall

balance. After the upgrade project we believe that Galp will be more aligned with

European trends in the medium and long term.

20 After a 25 year agreement, through the direct ESPO pipeline link 21 More detailed in the next section

Refining margins persistently under

pressure

Decreasing trend to

persist

Excess of oil products in

refining centres


PAGE 17/37

Refining

Regarding the refining sector, Galp Energia owns two refineries in Portugal. The

first is located in Sines, a deep conversion refinery, and is one of the largest in

Western Europe with a capacity of 220 kboe/d, and the second in Matosinhos, a

hydro skimming refinery with a full capacity of 110 kboe/d.

The main event was the restructuring and upgrading project of the two refineries

which started in the beginning of 2012 and was associated to an investment of

€1,4 bn. This process was crucial for the productivity and profitability of the

company since it was the only way for the company to compete in the current

and future strong environment and to adapt to market dynamics. In fact, the

refineries are now more able to process heavier crudes as well as larger

quantities of diesel (middle distillates) making the operations and output more

adjusted to European and international demand. Therefore we believe that

Galp´s refining margins could increase in the long-term and recover from the

narrow margins we have observed last years. Among the upgrade project, the

first phase was the contracting of new units at Sines refinery which affected the

utilization rate to an average of only 68% during this period. The company also

implemented advanced engineering methods and RCM22, aiming to decrease the

number of stoppages during the refining process and consequently increase

utilization rate. Better integration between the two refineries and a greater

flexibility in its choice of end-product were two important objectives of the project.

When the new units started its operations the process of transforming heavier

crudes (the cost is lower than lighter crudes, even though nowadays the

difference is minimum) was facilitated and from Galp´s accounts report we can

predict that the company wants to continue to take advantage from it in the next

years. In 2013, diesel and gasoline sustained to be the main products processed

in the refining structures.

Galp Energia imports crude oil from 15 different countries and the company aims

to guarantee a great diversification of its suppliers given the impact on the

company profits, as was proven in Europe when the EU embargo on crude from

Iran occurred in the year of 2012. The company represents 100% and 20% of the

Portuguese and Iberian refining capacity respectively.

The third quarter profits for 2013 found even worse expectations especially due

to narrower refining margins and a huge increase in amortization costs which

22 Reliability centered maintenance

Diesel and gasoline as the main products

treated

Upgrade project crucial

to compete

Figure 22: European Refineries

Source: EIA, Repsol, Cepsa and Galp, Analysts Estimates


PAGE 18/37

increased 47% and amounted to 145 €M. It is important to refer that although

amortization costs affect company´s margins, it has no influence on Cash Flows.

However, as we have already mentioned we believe that in the long-term it will

improve to the targets set by the company.

Knowing that historically downstream businesses have been the main source of

company´s earnings, slowdown in refining led top managers to introduce new

methods and systems in order to optimize this downstream segment. Moreover,

together with the investment project in the refineries, the company constructed

cogeneration facilities at the Sines and Matosinhos infrastructures with the start

of fully operations in 2012 and 2013 respectively.

Marketing

The activities of Galp Energia in this segment have its core development in the

Iberian Peninsula and with the other procedures positioned in Africa. The

company owns a total storage capacity of near to 7mm3 in Portugal and Spain

and also holds participations in logistics companies and pipelines of around 4000

Km in both countries which allow the company to have a wider marketing

network. In this segment, Galp Energia aims to market its products under Galp

Energia brand where the vast chain of service stations and its efficiency play an

important role. During the last years there have been a slump in Iberian demand

for oil products mainly due to the crisis and we had taken this into account in our

assumptions for valuation of this segment. To fight this issue, Galp has increased

its actions on a number of new events related to costumer care but also has been

simplifying the organizational structure. In Africa, more precisely in Mozambique

where the company is one of the main operators, the firm controls its operations

through Petrogal Mozambique (100% owned) where distributes lubricants and

liquid fuels but also the supply and marketing of LPG23 in the wholesale and

direct client channels. Over the last 5 years, volumes sold in the retail segment

remained with its fallen trend which reflected a drop of 11% in sales in Portugal.

However, Galp remains as the retail market leader in Portugal with 30% and only

6% in Spain. The company aimed to reduce its service stations networks and in

2012 there were closed 27 stations accordingly to Galp´s Investor Presentation.

In the late 2008 Galp acquired Agip´s and ExxonMobil´s operations in the Iberian

market for oil products as which was a key factor for the company to place is

products originated from refineries. Knowing the adverse margins and the current

23 Liquefied Petroleum gas

Galp remains as the

market leader in Portugal

Top managers

introduced new methods

Galp´s third quarter refining results worse

than expected

Drop in demand for oil products in the Iberian

Market


PAGE 19/37

economic condition, Galp is not planning to follow investments like these in the

next years.

Valuation R&M

In the R&M segment of Galp Energia we have preferred an approach of valuing

both sectors Refining and Marketing independently. We have used this criterion

as each sector has different perspectives of growing and their key value drivers

are not the same. After all, we have used a DCF method using the same wacc for

discounting the FCF of each activity. The wacc24 was computed based on R&M

comparable companies, mainly used to compute Average Beta unlevered (0,73)

and after levered it, we used a terminal growth of 2% and an equity premium of

6%. In the refining sector the EBITDA was a function of Galp´s refining margins

which we expect to stay at slight values until 2018 (ranging from 2 to 3,5 $/bbl)

such as it was confirmed in the disclosure of Galp´s third quarter results where

adverse refining margins were observed. Also the data Brent price and refining

cash costs affected negatively the results for this segment and finally the crude

which is not expected to have great variations in the next years since the

refineries are almost reaching its full capacity of utilization and achieving the

operational levels target for the upgrade.

In the Marketing sector the forecasted EBITDAs were mainly driven by sales

which depend greatly on data Brent price but also on perspectives of growth in

the Iberian Peninsula. Regarding the Brent price we have predicted a growth

pattern starting in 2023 which will have implications in price of refined products

and consequently decreasing marketing sales due to the elasticity demand/price

of refined products. Here we forecasted for the next years an almost flat growth

in sales and consequently in Marketing´s net profit. This was mainly driven due to

an increase in competition, consumer preferences and the uncertainty about

when both Portugal and Spain will recover from the harmful economic trend.

In both sub segments large capital expenditures are not anticipated since an

unprecedented investment was made in R&M in the last years and therefore the

investments will be mainly due to maintenance and to cover amortization and

depreciation of facilities.

Hence, we computed a Galp´s R&M processes at a €2,26/share.

24 WACC= (D/D+E) x Rd x (1-tc) + (E/D+E) x Re

Refineries almost achieving its full capacity of utilization

Galp´s refining margins will remain at short values

Refining and Marketing segments valued independently

Uncertainty about Iberian Market situation


PAGE 20/37

Sensitive analysis

Concerning the Refining and Marketing segment, we have analysed the impact of

the refining margin as well as the utilization rate. In what regards the refining

margin, the main driver of the Refining segment, it is strongly affected by

seasonality, international conflicts, oil prices, turnarounds and several other

factors. Firstly, we have decided to perform a variation depending 50% on Brent

price variations and adding a variation of 5%,10%, 20% and 30% to refining

margins base case, having in mind that is much volatile than the utilization rate

as have been perceived in the last years.

Secondly, for the utilization rate we have only varied 1 %, 2%, 4% and 6% since,

as we have already explained, the refineries are both reaching its full operational

capacity and the utilization rate it is an indicator that is easier to predict in the

future.

These two variables only affect the Refining sector, and we have decided not to

perform a sensitive analysis for the Marketing sector as this segment is mostly

affected by customer’s preferences and economic cycles on the countries where

the Company is placed. Finally, we can observe that R&M value driver’s

variations produce lower deviations in the Company´s value, which can be

explained by a lower weight of this sector in Galp´s equity value.

Gas & Power (G&P)

Market Environment

This industry plays a central role in the world´s energy evolution in the decades

to come. In fact, the importance of natural gas has been growing during the last

R&M value drivers with lower impact than other sectors in Company´s value

Refining margins more volatile than utilization

rates

Figure 23: Deviations in price target due to changes in Refining utilization rate and Galp’s Refining margin

Source: Analysts Estimates


PAGE 21/37

years not only due to various discoveries made in this field but also due to its

safe and flexible use which is environment-friendly. This makes this resource the

perfect partner for renewable sources of energy which we believe that companies

will attribute even more meaning in the long term. Also the reserve life of natural

gas has longer time frames than other resources which make projects on this

industry very attractive and profitable for expanding companies.

In this business sector, we strongly believe that the general prospects for natural

gas are very optimistic. The values for consumption in 2035 are expected to

reached almost 5 tcm25 with an average year growth of 1,6%. We estimate that

82% of this increase will be in non-OECD countries where demand for this

resource will growth by around 1,3 tcm.

The main reasons for this increase in demand will be supported by Middle East,

North America and China motivated by the introduction of energy policies to

diversify the energy uses and with environment issues associated. Regarding the

European Union, we do not forecast a so favourable scenario since it will be

affected by an increase in the prices of natural gas. In the supply side, we expect

that Iraq, East Africa Brazil and the eastern Mediterranean will be the main

players in the coming years. New sources of gas are expected to appear which

brings variety to global supply. Also LNG supplier’s changes can create new

connections between regional gas markets more precisely between those of

North America and Asia contributing to shrinkage of the regional gas prices that

exist nowadays. In fact, regional gas prices are a subject that has been debated

over the last years, more precisely in the World Gas Conference where gas

prices formation models and its mechanisms have been studied. In wholly

liberalised traded markets, the price would be a reference price, as what happens

in the USA, where in many other countries, where gas is imported, it could be

normally a border price. The more difficult cases are when the gas consumed is

provided through local production with no international trade and therefore the

concept of wholesale price is not recognised. Here the price variation depends on

the nature of the market (monopoly, etc.) and on competition. The main types of

gas price formation mechanisms are the following: oil price escalation (where the

gas price is set based on competition of fuels); gas-on-gas competition; bilateral

monopoly (the price is formed based on agreements between large sellers and

buyers) and regulation (where the price is approved by a regulatory authority).

25 Trillion cubic meters

Significance of natural gas has been growing over the last years

Introduction of energy policies in some countries

Natural gas prices is a subject that generates

discussion

Figure 24: Sources of Gas supply by region



PAGE 22/37

Since the turn of the century, the world natural gas consumption has expanded

on average by 2, 7% per year, which showed a quicker growth than oil and power

but slower than coal and renewables and the tendency is to continue. However,

and as we have already referred, this pattern varies among different regions and

with Europe reaching a more difficult future. The main drivers for this disparity in

different areas are the following: the dynamics of inter-fuel competition (mainly

due to co-integration between natural gas and oil prices), economic growth and

policy strategies (e.g. the revision in China´s policy in 2013 where they expanded

the policy´s attention to include new types of gas and coal and with the aim on

price rationalization and inclusive support for gas consumption. Accordingly to

International Energy Agency, in 2035 the share of natural gas in the global

energy industry will correspond to 24% against the 21% observed in 2011 but

with the averages of 1,6% per year declining progressively until 2035. Also, in

OECD view, the production in North America and Australia will increase rapidly

with both regions becoming major gas exporters and production declines in

Europe.

Another trend that we have identified is the existence of new sources of gas

production: for example, NGLs26 which are liquids produced within a natural gas

stream. Even though this is not a new phenomenon (since NGLs production has

been already occurred in Qatar in the last years) we anticipate that Russia will

soon enter in this market attracted by a favourable tax environment and the

possibility to export. This will eventually force natural gas prices to persist lower

until the countries rich in liquids start to reduce its output. This also takes us to a

prediction that NGLs will be in the front of the future upstream investments. After

analysing the movements in the global gas market, we can also assure that this

will not indicate a single world gas price contrary to what happens for example in

the oil market. The main reasons for this are the huge cost of carrying and storing

gas, when compared with a much inferior energy density as happens with oil.

The LNG might be a solution for this density issue but have other threats

associated as an example of the construction of LNG facilities and liquefaction

infrastructures. Consequently we believe that in the coming years there will

remain substantial differences prices between the US Henry Hub27 and the

respective import prices in Europe and Japan. In our valuation we have used the

NG/oil parity to evaluate NG resources.

26 Natural Gas liquids 27 The Henry Hub is the price point for natural gas futures on the New York Mercantile Exchange and the prices set in

Henry Hub are used as benchmarks in the US natural gas market

Huge costs of carrying

and storing gas

Inexistence of a single world gas price

Different types of natural gas price formation

Europe faces a more pessimistic scenario in this sector

NGLs in the top

upstream investments


PAGE 23/37

Regarding the power segment, the demand for electricity is growing more than

other final form of energy. Accordingly to the International Energy Agency it is

estimated that global electricity demand will climb by more than 2/3s over the

period between 2011 and 2035 and growing at an average of 2,2% a year. This

pattern is mainly driven by an increase of population with access to electricity

supply and by an evolution in efficient energy equipment’s. Also global installed

generating capacity is expected to grow by over 70% reaching values of 9760

GW in 2035 when compared with a 5649 GW in 2012. It was also estimate that

considerable investments in the power sector will be required to satisfy the rising

in electricity demand and the global investment in the power sector is expected to

be of $740 billion per year between 2013 and 2035. Finally, electricity prices will

rise in most regions and in 2035 US industrial electricity prices will be half of

those in European Union and 40% lower than those in China, when we think that

markets will be less competitive.

The G&P business segment of Galp Energia includes the supply and marketing

of natural gas mainly in the Iberian Peninsula; LNG trading on international

markets more precisely to Asian Markets and also power generation and supply

of electricity in the domestic market.

Gas

The Galp Energia segment of Natural Gas is divided into liberalized and

regulated activities. The first group is segmented in liberalized procurement and

liberalized distribution to consumers, while the second is divided in regulated

operation of infrastructure and regulated supply. Galp Energia regulated supply is

made over 6 distributions companies and operates under concessions contracts

of 40 years but also through local companies (partially owned by Galp). In 2012

companies distributed an amount of 1,5 bcm28 of natural gas. The regulated

infrastructure profitability is highly dependent on ERSE29 as well as all regulated

activities in the energy sector in Portugal. Here, the returns are based on ERSE´s

revenues formula and are mainly affected by the remuneration rate (9%30), which

we do not expect to change in the next years and would only change if the

regulator perceived a change in the cost of capital, and by operating and

amortization costs which are a percentage of the Regulated Asset Base.

Regarding the remuneration rate, the concession contract with the natural gas

28 Billion of cubic meters 29 Entidade Reguladora dos Serviços Energéticos, Portugal 30 Source: “Tarifas e Preços de Gás Natural para o ano Gas 2013/2014”- ERSE

NG/oil parity to evaluate

NG resources

Electricity demand is increasing more than

other form of energy

Considerable capital expenditures are expected in this sector

Electricity prices will rise

Galp Energia regulated supply of gas is operated under concession

contracts


PAGE 24/37

suppliers ensures the concession financial stability. The regulator establishes the

remuneration rate (based on information provided by Galp Energia and sets the

profits allowed31) and it should be at least equal to the cost of capital for these

activities, otherwise the companies would start to disinvest. Also the regulated

storage of NG in Portugal is operated by Galp Energia and has a current storage

capacity of 40 mm3 with the development of a cavern equivalent to 752 000m3

and with high importance for Portugal energy security, the reason why it is

operated under a public service concession.

In this sector, the company´s strategy is the creation of long term supply

contracts with an average of 20 years for natural gas in Algeria and for LNG with

Nigeria, accounting for 6 bcm per year. This strategy was implemented to reduce

risks and volatility of costs and we expect that the contracts will be renewed on

its maturity date. In the year of 2012, the company acquired a total of 6,3 bcm of

natural gas which represented an increase of 12% from the previous year, of

which 2 bcm came from Algeria (through three different pipelines) and 3,5 bcm of

LNG were bought from Nigeria. The company is also acting in the spot market

where in the same year were acquired 0,8 bcm of natural gas. Although the

incidents in Egypt could lead to some apprehension on the contracts fulfilment,

we do not expect a similar situation in Algeria since it political situation seems to

be stable.

Regarding the liberalized distribution market, the activities are mainly divided in

residential, industrial, electrical and trading segment, Galp Energia is a key

operator with an estimated number of 1,3millions clients in 2012 and the second

place in the Iberian Peninsula market sales transmits the significance of the

operations of the company in this industry. However, there was observed a

contraction in electricity generation via natural gas mainly due to a more

competitive price of coal translated in a higher importance of coal in electricity

production in Portugal. Also the enlarged imports of electricity produced in Spain

influenced this decline in consumption in the electrical segment. Oppositely, in

the industrial sector, the amounts of gas sold increased from 161mm3 in 2011 to

2 113mm3 in 2012, a great variation explained by the upgrade project in both

refineries in Portugal. In fact, refineries play an important role in natural gas

consumption since some unit refineries such as steam reformer32 and

cogeneration plants need natural gas on its industrial processes. In the

residential sector which is much volatile, there was a decrease in 2013 in

31 Document in Appendix section: profits allowed by ERSE and remuneration rate 32 These units use natural gas as input to produce hydrogen necessary for the catalytic units

Contraction in electricity generation via natural gas

Remuneration rate is not

expected to change

Remuneration rate should be at least equal to the cost of capital for

these operations

Galp´s creation of long-term supply contracts


PAGE 25/37

consumption mostly due to higher temperatures in the beginning of the year and

also explained by a loss of clients in Spain. The extension of deregulation in the

Portuguese natural gas industry forced Galp Energia to launch a combined

natural gas and electricity pack, Galp On (around 170000 clients in November

2013).

Finally, in the natural Gas sector the company is increasing its efforts in the

trading segment where the Asian market, more precisely Japan has gained great

meaning in the last years. Sales in this segment reached 2 242mm3 in 2012

which was a significant increase from 2011 and what we expect to gain even

more status in the subsequent years due to Asian Market energy strategies,

government policies and natural gas importance for countries in. Besides, long

term contracts have been signed, in order to stand LNG trading sector, and in

2012 the company signed three contracts for the sale of LNG and 1,4 bcm of

LNG were directed to East market.

Power

Galp Energia´s Power sector consists on power generation and the distribution of

electricity. The first activities are done mainly through its infrastructures of

cogeneration plants in Portugal. In 2013 the company had an installed capacity of

245 MW and there are no investments expected on this field in the next years,

which we had taken into account in our valuation for this sector. In power

generation the natural gas is an important source, but also is crucial for the

processes occurred in the refineries. The two cogeneration plants of Sines and

Matosinhos represented together a consumption of about 500 mm3 in 2012. The

second group of activities are extremely conditioned by a defined tariff set by

ERSE. The cogeneration tariffs set by the regulator are much higher than those

verified in the Iberian market with the differential ranging values around 50

€/MW33. This differential is explained by a subsidy by the Government mainly

related with environmental issues.34

Regarding the electricity market, Galp acquires energy in the MIBEL (Iberian

Electricity Market) and then retails it to customers. Also, the company strategy is

to sell electricity to clients that are already customers for natural gas. In 2012

there was an increase in the residential customer’s network with more than 50

33 According to OMIP - Operador do Mercado Ibérico de Energia (Pólo Português) S.A 34 The electricity produced together with vapor in the cogenerations plants has benefits not only in energetic efficiency,

but also to avoid that electricity would be produced from other pollutants raw materials, such as coal or fuel.

ERSE condition Galp´s

power sector

Refineries play an important role in natural

gas consumption

Trading segment is gaining importance in Galp´s strategy

Long term contracts

have been signed

Differential between cogeneration tariffs and

tariffs for electricity


PAGE 26/37

000 in this business. Moreover, in the same year 614 Gwh35 were sold which

represented an increase of 218% from 2011. Although the Cash flows are stable

in this business and large investments are not expected to occur, the company’s

strategy is to improve its weight in the energy sector of Portugal

Valuation G&P

We have valued the G&P segment using the same approach as in the R&M, the

DCF method. Here we have also divided the Gas Regulated, Gas Liberalized and

Power activities for the valuation determination. However, we have used two

different waccs, hence using different comparable companies for Gas and Power.

Regarding Gas Regulated processes, they are mostly affected by the Regulated

Asset base which corresponds to €1,2bn. Here investments of maintenance will

be the only allowed and therefore we used a capex of €30Mn per year as it was

reported in the investors presentation of the company; and for the rate of return

set by the regulator which accordingly to ERSE reports are not likely to vary in

the medium term. The liberalized activities are more subject to economic trends

and we expect its growth to start in the year of 2014 with LNG trading sales

having significant influence and naming this as the main source of value in G&P

activities. Finally and regarding Power sector, we have used the installed

capacity (245 MW) and the utilization rate and we predict these indicators will

remain constant since the cogeneration infrastructures will not reach higher

levels; but also the tariff set by the regulator ERSE which is currently at a 100

€/MW36 and is addressed to brent price variations and inflation in Portugal,

remaining in values between 98 €/MW and 100 €/MW in the medium term.

Therefore, the Power activities will be positively affected in 2013 and 2014 due to

the improvement in cogenerations but after that we expect stable cash flows in

this sector.

Finally we price the G&P segment at €4,85/share.

Sensitive analysis

In what respects the Gas and Power sector, we have studied the impact of

variations of two key value drivers: remuneration rate, for the Gas regulated

segment, and tariff for the Power segment, both imposed by ERSE and

representing a regulation risk which influence Galp´s value per share. Once

35 Gigawatt per hour 36 According to “Portaria n.º 140/2012” from May 14th

Only investments of maintenance are

predictable

Tariff set by ERSE and installed capacity has

the main drivers

Regulation risk is adressed


PAGE 27/37

more, we do not expect great variations in these two variables as it was

confirmed in regulator´s reports. However, as it represents a risk for the company

we decided to incur in this analysis and the results were the anticipated: slight

changes arises to the value of Galp Energia.

SOTP

The approach that we have used for the evaluation of Galp Energia, relative to

the period of December 2014, was the Sum-Of-The-Parts (STOP). We decided to

incur in this “break-up” analysis since it allows us to identify the main sources of

value for the company in the medium and long term. It also permits us to attribute

different risks, challenges and value drivers for the several segment businesses

which are inserted in different market environments. After reaching the enterprise

value, the equity value of Galp was then calculated by deducting net debt and

non-operating/financial adjustments, in our case, minority interests and pension

liabilities (Retirement benefits).

In the G&P and R&M sectors we have used the DCF approach and therefore

discount its FCF to the firm by each corresponding wacc. In the E&P sector, the

method chosen was the APV in order to value the operations and debt separately

as if each field was an investment project. Whereas in the downstream segments

(R&M and G&P) we have used an explicit period of 7 years (from 2014 to 2020),

in the E&P segment we have used different averages for the maturities of the

projects in each country depending on the nature of the projects and also on the

reserves estimated. Again, oppositely to what we did in downstream operations,

in the E&P we did not use a terminal value which is explained by the fact that oil

and natural gas reserves are not infinite. Therefore each FCF was discounted at

the unlevered cost of equity for each country and the interest tax shields were

discounted at the estimated cost of debt.

“Break-up” analysis

Explicit period for

downstream segments

Figure 25: Deviations in price target due to changes in Tariff set by ERSE

Figure 26: Deviations in price target due to changes in Remuneration rate set by ERSE




PAGE 28/37

Regarding the discount rates, we have used nominal values, we started by

computing each cost of equity by applying the capital asset pricing model CAPM

formula37. Concerning the unlevered betas we have reached it by an average of

unlevered betas of used comparable companies for each sector, and the criterion

was researching companies that faced a similar level of risk and that its core

business was the same of Galp´s segments. Next, we relevered each beta using

an average of each industry of the debt-to- equity ratio target. The risk free rates

that we used were the 10 year German bond for downstream segments since is

the best proxy for risk free assets and the 10 year US Treasury Bond for the

upstream operations as they are translated and traded in US $. The market risk

premium used was 6% which was what was read among financial literature

review. We have also added a country Beta, instead of the common Market Beta,

to each cost of equity for all the segments which we thought that would attribute

better the risks associated to the operations depending on the country that each

sector is most related. For the country Beta of the downstream segments we

have used a correlation between PSI 20 index and Euro Stoxx 50, while in Brazil

we reached it by using a regression between the main stock index in Brazil

Bovespa38 and the MSCI World Index39 as we believe the fields are correlated

with the Brazilian market. For Angola and Mozambique we have not associated a

country Beta risk since we did not find these activities to be correlated with the

country Economy40 and we did not include the unsystematic risks in the Cash

Flows as we believe it probability and occurrence has no significant impact on the

Cash Flows of this business. Finally, the cost of debt that we used was achieved

through an average of the yields for comparable companies with credit rankings

near to Baa1; then estimated the probability of default of 2,5%41, and a recovery

rate of 90% according to Moody´s Rating Agency assessment.

It is important to state that all Cash Flows were estimated at current prices.

In the end, after calculating the Entreprise value of Galp Energia in December

2014 by summing up the value of each segment, we subtracted the value of net

debt, pension liabilities and minority interests of December 2013 and we valued

Galp at €14,82/share.

37 Capital Asset Pricing Model – Re=Rf + (β x Mrk Premium x Country β) 38 IBOVESPA BRAZIL STOCK EXCHANGE INDEZX 39 Captures large and mid-cap representation across 23 developed market 40 According to the OECD document “http://www.oecd.org/dev/emea/35350793.pdf” the oil sector was not affected by

the war period, in fact it even had duplicated its production during this period between 1990 and 2003 41 According to “Moody´s Investor Service” - Corporate Default and Recovery Rates,

1920-2010

Country Beta used in Dowstream activies and

for Brazil

Comparable companies

for each sector

Angola and Mozambique operations are not correlated with the Economy


PAGE 29/37

Sensitive analysis

In this section we have predicted the impact of discount rates and terminal

growth rates which play a crucial role in determining Company´s value and where

misleading estimations may occur. This analysis is particularly important since

equity holders may change its perception of risk in the coming years, which will

make the cost of equity and waccs to change and having implied variations in our

Company´s valuation. The terminal growth rates only affect downstream


Equity holders may change its perception of

risk

Figure 28: SOTP valuation summary

Figure 27: Valuation assumptions



PAGE 30/37

businesses and therefore company´s value is not so sensitive to this variable as

a result of a slighter magnitude of R&M and G&P sectors in Galp´s future

operations. Regarding discount rates, we can observe that a small deviation from

the base case produces a significant alteration in Galp´s price per share that we

have reached. We concluded that if both variables follow opposite patterns it

would lead to extreme Galp´s values per share.

Financials

After Galp Energia faced a contraction on its EBITDAs in the periods of 2011 and

2012 of 3, 5% and 1, 2% respectively, due to the sovereign crisis epicentre, we

expect the company to recover from this declining trend in 2014. This will be

mainly generated by more mature stages of the upstream operations in Brazil,

more precisely in Lula´s field, and by a more optimistic scenario in the other

sectors of the company. Even after 2014, Galp´s EBITDA are expected to grow

at unprecedented rates, reaching an average growth per year of 22%. However,

2015 is an isolated year in the pattern that we have identified. We expect an

EBITDA cont

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