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EQUITY RESEARCH MASTERS IN FINANCE

• Despite we maintain our buy recommendation, after reviewing

Galp Energia’s strategy and after consider the recent

developments in the Iberian economy, we decreased our price

target from €14.48 to €14.00.

• E&P is benefiting from both the USD appreciation against the

euro and the recovery in world oil demand.

• For refining activities we expect the recovery of margins

already in 2010. Galp Energia’s refining margins will also benefit

from the conversion project. However, refineries’ utilization

capacity will remain below the previous levels, following the global

trend.

• Regarding marketing activities, Galp Energia will maintain its

leadership position in the Portuguese market, but growth is not

expected. In Spain, revenues growth is expected as the national

economy activity is re-established.

• In G&P, company will profit from the complete liberalization of

Portuguese retail market, since it will be allowed to charge higher

margins for NG. The recent acquisition will also increase segment

revenues, but overall the operation will not be beneficial to the

company.

Conclusion: Galp Energia current strategy will sustain an

attractive growth, despite the uncertainties and challenges faced

by the company.

Company description

Galp Energia is an integrated Oil & Gas company, whose major businesses are in Portugal, and with a growing presence in Spain. Its activities include refining and marketing of crude oil products, and the supply and distribution of natural gas and power. The group also operates in the Exploration and Production segment, with activities mainly in Angola and Brazil.

07 JUNE 2010

GALP ENERGIA COMPANY REPORT

OIL & GAS

ANALYST: JOANA SEARA DA COSTA [email protected]

Huge challenges

... for a promising future

Recommendation: BUY

Vs Previous Recommendation BUY

Price Target FY10: 14.00 €

Vs Previous Price Target 14.48 €

Price (as of 4-Jun-10) 12.00 €

Upside potential 16.65%

Reuters: GALP.LS, Bloomberg: GALP.PL 52-week range (€) 8.86-13.68

Market Cap (€m) 9,951.01

Outstanding Shares (m) 829.251

Source: Bloomberg

Source: Bloomberg

(Values in € millions) 2009 2010E 2011E

Revenues 12,138 15,003 16,311

EBITDA 819 2,887 1,851

EBITDA margin 7% 19% 11%

Operating profit 459 2,304 1,200

Operating profit margin 4% 15% 7%

Net income 347 1,682 865

EPS 0.42 2.03 1.04

P/E 28.85 6.90 13.42

EV / EBITDA 15.5 4.70 7.33

Source: Galp Energia; Analyst estimates

sstory

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GALP ENERGIA COMPANY REPORT EQUITY RESEARCH 07 JUNE 2010

PAGE 2/30

Table of contents Executive summary ........................................................................................... 3

Macroeconomic outlook ................................................................................... 4

Portugal ...................................................................................................... 4

Spain ........................................................................................................... 5

The Sector .......................................................................................................... 5

Company overview ............................................................................................ 6

Business risks ........................................................................................... 8

Market risks ................................................................................... 8

Operational risks ........................................................................... 9

Financial risks ............................................................................. 10

Shareholder structure ............................................................................. 10

Exploration and Production ........................................................................... 11

Angola ....................................................................................................... 12

Brazil ......................................................................................................... 13

Refining and Marketing ................................................................................... 15

Refining .................................................................................................... 15

World refining industry .............................................................. 15

Dieselization ................................................................................ 16

Galp Energia ................................................................................ 17

Marketing of oil products ........................................................................ 18

Gas and Power ................................................................................................. 19

The business ............................................................................................ 21

European Market ...................................................................................... 22

Deregulation of the Portuguese market ................................................ 23

Regulatory framework ................................................................ 23

Natural gas supply drivers ......................................................... 25

Valuation .......................................................................................................... 25

Discounted Cash Flow ............................................................................ 26

Real Options Valuation ........................................................................... 26

Financials ......................................................................................................... 28

Disclosures and Disclaimer ............................................................................ 30


PAGE 3/30

Executive summary

The present report goal is to present Galp Energia operations and to identify its

strengths, weaknesses, opportunities and threats. We are confident that the

current strategy will sustain an attractive growth, despite the challenges the

company (and the industry) will have to face.

The next few years will be crucial to the success of the company, especially in

the upstream business. In fact, this segment will be company’s main value

driver, since it presents the main growth opportunities. The company is already

profiting from one of the most important oil discoveries ever (Tupi field), and as

other projects are developed, additional benefits are expected. Moreover,

managerial flexibilities associated to this segment also have a positive value.

In downstream activities we expect a better performance than in the recent past,

as world refining margins increase. Moreover, the current conversion projects of

Galp refineries will enable a better performance since the company will be able

to benefit from the Iberian market dieselization and the increasing differential of

diesel prices when comparing to gasoline. However, we expect refineries’

utilization capacity to remain well below the previous levels, following the world

industry trend. In what concerns to marketing, Galp should maintain its

leadership position since it has a natural competitive advantage in the

Portuguese market: it has priority access to resources, since it detains the total

national refining capacity. However, growth is only expected in the Spanish

market.

Finally, G&P1 should remain a source of stable cash flows, as segment’s

activities are partially subject to regulation. The complete liberalization of the

retail market will lead to an increase in the margins charged to final consumers.

Additionally, the recent acquisition in the NG2 Spanish market, which allowed

Galp to reach the second largest market share in Iberia, will allow an important

increase in NG volumes sold.

After taking into consideration all the previous points, we consider that Galp

Energia EV3 is €13.6 billion, or €14.00 per share. In this sense, we believe that

the company has an upside potential of 16.65% in relation to company quotation

at June 4th, 2010.

1 Gas and Power 2 Natural Gas 3 Enterprise Value

Sustainable strategy E&P is company’s main value driver Refining margins recovery… Leader in the Portuguese retail market… … but growth is only expected in Spain G&P will remain a source of stable CF


PAGE 4/30

Macroeconomic outlook Economic conditions have been improving in the last few months but, despite the

positive signs, the deepest recession since the Great Depression is not over.

The stabilization is uneven and the recovery of global economy remains fragile

and is likely to be sluggish. For the near future, growth is expected to remain

below pre-crisis levels, while unemployment rate should continue to rise until

early-2011. One main reason for this slow pace of recovery is the fact that

several countries experienced a serious deterioration of budget deficits during

the crisis: fiscal receipts declined as a result of the overall decrease on income,

while public expenses and investments increased, an attempt made to contradict

the contraction of the economic activity (and in some countries to support the

financial system).

Portugal

This global crisis has severely affected the Portuguese economy: the national

output contracted significantly (2.68% in 2009), and unemployment rose

substantially. Although the decline in GDP4 had been lower than the euro area

average, future growth prospects are modest (0.29% in 2010 and 0.65% in 2011,

according to the IMF5), reflecting the necessary fiscal consolidation and

deleveraging. The difficult economic recovery also results from the structural

weaknesses of the country: Portugal suffers from low productivity and weak

competitiveness.

During 2009 government finances deteriorated strongly, due to the discretionary

support given to economic activity, and the significant shortfall in tax revenues.

The public deficit ratio increased from 2.8% in 2008 to 9.3% in 2009, and the

public debt evolved from 66.3% to 76.8% of national GDP, which led to a

downgrade in the Portuguese sovereign rating. As a result of this sluggish

growth, unemployment is expected to rise further in 2010 (to 11%).

In order to bring public deficit again to less than 3% of GDP by 2013, the Stability

and Growth Program for 2011-2013 was adopted. However, country’s risk

premium has been increasing, and higher bond yields should make economic

consolidation substantially more difficult. In order to increase the confidence of

international investors and to offset higher interest costs, the Portuguese

government recently announced a new package of measures, where the

increase of taxes on income and consumption were included.

4 Gross Domestic Product 5 International Monetary Fund

Economic data indicates the 1 st signs of recovery... ... but it will be gradual

Table 1: Portuguese economic outlook

Source: IMF, World Economic Outlook, April 2010




Source: IMF, World Economic Outlook, April 2010 Source: IMF, World Economic Outlook, April 2010





PAGE 5/30

Spain

Spain was also highly affected by the world economic contraction and, like

Portugal, it should come out of the recession at a lower pace than the European

average. According to the IMF, Spanish GDP should stabilize in 2010 and to

edge up by 0.9% in 2011, while unemployment rate is expected to decline.

However, economic growth is constrained by the large fiscal and current account

imbalances, conditions that should be reversed with the ambitious fiscal

consolidation adopted by the Spanish government. Regarding domestic demand,

its recovery has been sluggish, with the negative pressures of the continued

uncertainty, the need to reduce indebtedness (and consequent increase in value

added taxes) and high unemployment, which rose significantly as house prices

bust (the share of employment in the construction sector was particularly high).

The described reality should affect Galp Energia results in several ways. First of

all, the company will see its tax expenses increase. Moreover, the raise in taxes

(both in Portugal and Spain) will, on one hand, decrease disposable income and,

on the other hand, make products to final consumers more expensive. This,

combined with the high unemployment rate, will translate into a deceleration of

private consumption growth (from 1.5% in 2010 to only 0.1% in 2011). Oil

products will not be an exception, especially when taking into consideration the

high correlation between Oil & Gas sector’s revenues with economic

environment. In this sense, revenues from Iberian activities should increase at a

lower rate in the next couple of years. However, if we consider the global

scenario, an expansion in oil demand is expected as the world economy

recovers. This, combined with the increase in oil prices, which are expected to

be in the range of $72 to $176 per barrel until 2030, and with the USD (US

dollar) appreciation, will benefit upstream activities.

The Sector Oil & Gas includes the global process of exploration, extraction, refining,

transporting and marketing of petroleum products. This industry is traditionally

divided into three major segments: upstream, midstream and downstream.

Upstream refers to the exploration and extraction of crude oil and NG, including

the searching for potential oil and gas fields, drilling and operating of exploratory

wells. Midstream operations, usually included in the downstream category,

consist on the process, storage and distribution of oil products. Finally,

downstream refers to the refining of crude oil, along with the sale and

distribution of NG and products derived from crude oil, such as LNG6, gasoline,

6 Liquefied Natural Gas

Table 2: Spanish economic outlook Table 2: Spanish economic outlook

Source: IMF, World Economic Outlook, April 2010 Source: IMF, World Economic Outlook, April 2010

Table 2: Spanish economic outlook


Increase in tax expenses… … and deceleration of demand


PAGE 6/30

Elevated operating leverage... ... and competition

jet fuel and diesel. The major players of this industry at a global level are BP,

Chevron, ExxonMobil, ConocoPhillips, Shell, ENI and Total.

This is an extremely volatile industry, with revenues highly exposed to

macroeconomic variables: companies’ value is sometimes more dependent on

business cycles or commodity prices than on firms’ characteristics. The value of

an oil company is inextricably linked to the price of oil, especially when

considering a mature one and, as so, one can easily get to the conclusion that

large uncertainties about the future demand levels for energy and oil represent

the greatest challenge to the industry. The graphs presented below reflect the

high correlation between the market value of oil companies and price of oil.

Moreover, and in order to ensure their long-term viability, companies must face

the challenges of a carbon-constrained world with finite resources.

In 2008 world oil demand contracted for the first time since the 1980’s as a result

of the recession in OECD countries and the economic slowdown in developing

countries, a trend that remained through 2009. As a consequence of this drop,

and also due to the tougher financing environment, energy investment worldwide

is plugging and refineries have had high levels of unused capacity. Moreover,

the recovery in the price of dated brent in 2009 was based on favourable

economic data, which led to the positive sentiment about a pickup in the world

economy. Rising demand for oil, namely from US and China also supported this

recovery.

Additionally, due to oil companies’ elevated fixed costs, revenues volatility will be

magnified at the operating level; even during low points in price cycles,

companies usually choose to keep their reserves producing because the costs of

shutting down and reopening operations can be prohibitive. Moreover, this is a

highly competitive industry, which means most of its players are price takers:

even the largest oil companies have to sell their output at the market price.

Company overview Founded in April 1999 as a result of the restructuring of the Portuguese energy

sector and consequent merger between Petróleos de Portugal (Petrogal) and

High exposition to economic variables... ... and to the price of oil


PAGE 7/30

Source: Galp Energia

Exhibit 1: Galp’s organizational chart


GDP – Gás de Portugal, Galp Energia is the country’s leading integrated oil and

gas group. The company is present across the whole oil and gas value chain,

and increasingly in renewable energy. Its operations cover three business

segments - Exploration and Production (E&P), Refining and Marketing (R&M),

and Gas and Power (G&P) - and are deployed over four continents, with South

America and Africa playing a prominent role, namely in E&P.

In the first business segment, Galp Energia explores and produces oil and

Natural Gas (NG) in offshore and onshore fields. The company has a portfolio of

fifty worldwide projects mainly focused in Brazil and Angola, and 3.1 billion

barrels of oil and equivalents (boe) of contingent resources.

Regarding R&M, Galp refines petroleum and other raw materials in Sines and

Matosinhos refineries, which have a combined capacity of 310 thousand barrels

per day. Both refineries are presently under a conversion project which will allow

the company to produce a higher fraction of light and medium distillates. This

project will enable the company to better respond to the rising demand for diesel

in the Iberian Peninsula. Refined products are marked mainly in Portugal and

Spain through a network of around 1,500 service stations. The acquisition of

Agip’s and ExxonMobil’s Iberian subsidiaries enhanced Galp’s presence in Spain

and raised the coverage ratio of refining activities by marketing operations.

Last, but not least, G&P comprises the sourcing and storage of NG, the supply to

large industrial customers, and regulated distribution through its subsidiaries. In

Power, Galp Energia has four cogeneration plants with a total installed electrical

capacity of 180 megawatts. This segment, especially regulated activities, is a

source of cash flow’s stability.

Galp Energia is becoming more and more integrated, especially as it develops

the upstream activities. Part of E&P production is used by company both to

produce refined products and to supply NG in the Iberian network. This

increasing integration allows the company to reduce its dependence on external

supply of raw materials and its exposition to volatile market variables.

Exhibit 2: Galp Energia value chain




PAGE 8/30

Business risks

Since it operates worldwide, and due to the specificities of its industry, Galp

Energia is exposed to several risks. Next, we will briefly explain the most

relevant ones.

Market risks

The energy sector is highly competitive, a characteristic that imposes to the

players in this market the condition of price takers. Prices of oil, natural gas and

refined products are established in the world market, and companies’ operations

are subject to their volatility. In fact, changes in the price of crude oil affect all

business segments of Galp Energia, being upstream activities particularly

exposed to those fluctuations. A decline in the price of crude oil or natural gas

might reduce the economic recoverability of discovered reserves and the prices

realised from production. The economic viability of projects for the production of

oil that are planned or in development may also be jeopardized. On the other

hand, downstream activities benefit from such decline in prices, as it would

decrease the significant portion of expenses related to the purchase of crude oil

and natural gas. Table 3 demonstrates the sensitivity of each segment of Galp

Energia to changes in oil prices. In fact, and as expected, an increase of 1% of

crude prices will translate into an appreciation of E&P business segment, but

R&M and G&P values would decrease by 37.69% and 6.68%, respectively.

Table 3: Galp Energia value sensitivity to changes in oil prices

€ / share E&P R&M G&P

Actual value (million €) 14.00 9,177 2,189 2,194

1% increase in oil prices (million €) 13.26 9,540 1,364 2,047

% change -5.24% 3.95% -37.69% -6.68%

Source: Analyst estimates

The huge sensitivity of refining and marketing activities to oil price fluctuations

should actually decrease company’s EV, which is contrary to market beliefs

(Graphs 2 and 3). In reality, and despite E&P be the larger contributor to Galp

EV, R&M has by far the largest portion of company’s COGS7, which consist

mainly in the purchase of crude to be processed in the refineries. In this sense,

an increase in oil prices has a tremendous impact on operational expenditures,

fact that has not been considered by investors.

Other important risk the company faces is related to movements in currency

exchange rates, specially the USD against the Euro. This is due to the fact that a

significant portion of Galp Energia costs and revenues is denominated or tied to

the USD, namely trading prices of crude oil, NG, and most refined petroleum

products. Again, effects of USD fluctuations are contradictory. If the currency

7 Cost of Goods Sold



Market players are price takers


PAGE 9/30

depreciates by 1% against the Euro, the overall EV will increase by 8.38%,

despite of the E&P value decrease: segment results, denominated in USD,

would word less. Regarding the other two business segments, an appreciation is

expected, as their costs, mainly denominated in USD, would be lower. R&M

revenues would suffer a slightly decrease, as part of refined products are

exported to the North American market, but this would be more than

compensated by the cost reduction.

Table 4: Galp Energia value sensitivity to 1% USD depreciation

€ / share E&P R&M G&P

Actual value (million €) 14.00 9,177 2,189 2,194

USD depreciates by 1% (million €) 15.17 9,114 3,014 2,405

% change 8.38% -0.69% 37.70% 9.61%


Operational risks

Companies dependent on the extraction, processing and/or delivery of fuel face

sustainability risks. Galp Energia’s future oil and gas production depends on the

success of finding, acquiring and developing new reserves. The company also

faces the threat of growing scarcity of oil.

The company needs to replace its reserves on a consistent and cost effective

basis, since the rate of production from NG and oil reservoirs typically declines

as reserves are depleted. However, some obstacles may appear in this

replacement process: possible barriers to gaining new exploration acreage;

inaccurate interpretation of geological and engineering data; unexpected drilling

conditions or equipment failure; inadequate resources and disturbances in the

successful implementation of the drilling programme. Moreover, there is no

guarantee that the company will succeed in its exploration and development

activities or in purchasing proved reserves. Even if it succeeds, the resulting

discoveries or purchases may not be sufficient to replenish the current reserves

or cover exploration costs.

Other important type of risk faced by Oil & Gas companies relates to

environmental issues. E&P is particularly exposed to this, as the recent accident

in Gulf of Mexico proved. Oil spills cause huge damages to the environment, are

very costly and it can take several years to be solved. Additional environmental

risks arise from the common practice of using burial of wastes in drilling and

exploration sites: pollutant migration pathways can damage soils and usable

water resources if seepage is not contained.

Regarding the refining segment, emissions in greenhouse gases and associated

climate changes are also important issues to consider. If Galp Energia is unable

Oil & Gas companies face sustainability risks… …and environmental risks


PAGE 10/30

to find environmental solutions, future government regulation may lead to project

delays and additional costs.

The possibility of an accident is also relevant to consider. In fact, the fire at Sines

facility in January 2009 forced the refinery to stop during six weeks. This led to

important costs, since the company became temporarily more dependent from

its suppliers. Refinery workers, as well as local population and environment were

also put at risk.

Financial risks

Galp Energia also faces some financial risks, like changes in market interest

rates, liquidity shortfalls and credit risk (risk of default of the company and/or its

clients and suppliers).

The recent downgrade of the Portuguese government debt is raising some fears,

since national companies (especially banks) are facing increasing difficulties to

have access to capital and, like the government, they have had to pay an

additional premium to raise funds (Graph 1 ). However, any significant impact is

expected to Galp: although the company has a Debt-to-Equity ratio higher than

its peers (81% in 2009), its assets did not change. Additionally, despite the funds

required to company’s projects, we expect that in the medium term, the company

will generate enough CF to decrease its debt level. In fact, the decrease of

company’s yield over the last two years reflects this reality.

Shareholder structure

Amorim Energia and ENI are the two main shareholders of Galp Energia, with a

participation of 33.34% each. Portuguese state controls 8% of the company

through Parpública (7%) and CGD8. 80% of the freely traded shares belong to

institutional investors, 91% of those being international. In total, 26 countries are

present in company’s shareholder base.

Amorim Energia, CGD and ENI are parties of a shareholder agreement that

regulates the terms on which their participations may be sold during a lock-up

period ending on 31 December 2010. After this date has expired, any party may

sell its holding in full.

In the past, ENI showed its intents to either control or leave the company. Since

the first outcome would be unlikely to achieve, as the other main shareholders

have not revealed intentions to sell their stake, ENI has been showing its will to

leave the company, despite of its presence in Galp Energia creating synergies

and value added, mainly in what concerns to the consolidation of its downstream

activities in the Spanish market. The most likely outcome is the acquisition of

ENI’s stake by Petrobras and Sonangol when the lock-up period ends. In fact,

8 Caixa Geral de Depósitos

Source: Galp Energia Source: Galp Energia


PAGE 11/30

negotiations between the two companies with the Portuguese State and Américo

Amorim to acquire and divide this 33.34% stake are in an advanced stage.

Petrobras’ aim is to detain only 25% of Galp Energia: in this way, the company

does not have to pay the extra premium that a higher participation would imply.

Regarding Sonangol, such deal, besides of being part of its internationalization

strategy, would allow its direct participation, along with Isabel dos Santos, in the

company, which currently is made through Amorim Energia. Since both

companies are major partners of Galp Energia in upstream projects, their direct

participation would add value to the firm, as it would give it access to new E&P

projects both in Brazil and Angola. However, it is possible that the process suffer

some drawbacks, since the Brazilian Petrobras is facing liquidity constraints: its

huge debt level (about €44.2 million) is threatening the current rating, and

without a capital increase, company’s ambitious investment plan may be

jeopardized.

Parpública should also leave the company. In fact, the Portuguese Minister of

Finance declared recently that Galp’s privatization should be made through the

issuance of convertible bonds; in this way, the government would be able to

maintain its voting rights.

Exploration and Production E&P depends not only on the volumes extracted, but also on oil prices. In fact,

higher prices allow a quicker recovery of the costs incurred in the exploration

and production of oil, allowing also a mitigation of the time effect on cash flows.

For this reason, low oil prices would not be sustainable, since the industry would

become unattractive, and consequently future demand would not be ensured. In

fact, the relatively recent drop in oil prices led to the intensification of deferrals

and delays in upstream projects.

This segment is the principal bet of Galp Energia, as its expansion is one of the

company’s main value drivers. Currently, the company has around fifty projects

under way in several parts of the globe, with reserves and contingent resources

being estimated in 3.1 billion barrels of oil. Rather than driven by reserves

acquisition, company’s strategy for this segment is to grow organically or though

farm-in opportunities in projects with relevant exploration potential.

In what concerns the upstream business, Galp’s main projects are located in two

areas: Angola and Brazil. Oil extraction is centred in Angola’s coast, where

growth expectations go beyond the 13.9 thousand barrels per day that Galp is

currently producing. Important developments have been made here and in

Brazil, but in 2009 the company expanded its exploration portfolio with the

addition of new projects to explore and liquefy NG in Equatorial Guinea and in

The company has around 50 projects Strategy: organic growth instead of acquisitions Main areas: Angola and Brazil


PAGE 12/30

Uruguay. Additionally, the company has also a 10% stake in the concession for

the development and production in five blocks in East Timor and one in

Mozambique. Moreover, in 2007, through a partnership with Petrobras and

Partex, the company signed two contracts with the Portuguese state to explore

and produce oil in four blocks located in the Portuguese coast (Peniche and

Alentejo basins).

Angola

Angola is a country highly dependent on oil. In fact, in 2009 this sector

accounted for 85% of the Angolan GDP, 95% of exports, and 85% of

government revenues. This last point explains why policies in Angola are among

the most favoured to operators, and the fact that the country be one of the few

that awards leases on the trend of discovered fields. The country is sub-Saharan

Africa’s second largest oil producer behind Nigeria, and the first in deepwater

discoveries and development. Given its high level of oil dependence, upstream

operations in Angola have low risk, even when considering country’s political and

economical environment. In fact, even during the period of the country’s civil war,

oil production was not jeopardized. However, as a member of OPEC9, Angola is

subject to organization’s impositions. Country’s production potential is markedly

high, but OPEC quota constraints, combined with the relatively higher

development costs for its ultra-deep water offshore projects, have led

International Oil Companies to postpone investment decisions given the

uncertain demand outlook. Indeed, this proved to be a risk factor to Galp Energia

in 2009: company’s production in Angola has been hampered by OPEC

cutbacks10, which was trying to make an upward pressure in world oil prices.

Galp Energia started operations in Angola in 1982, and currently is part of the

partnerships that are exploring and/or developing three offshore blocks: 14, 14K-

A-IMI and 32.

Block 14 is located in offshore Angola and currently produces a total of 155

thousand barrels per day. Until 2009, this was Galp Energia’s sole production

asset in a portfolio of around fifty concessions across four continents. Operated

by Chevron, this block contains the first deepwater field put in production in

Angola (Kuito, in 1999). The fields currently in production are Kuito, BBLT11 and

Tômbua-Lândana. The later is considered to be one of the largest developments

in Angola, and has recoverable volumes estimated at 350 million barrels. Its

production, which started in 2009, is expected to reach its peak by 2011 with a

daily extraction of 100 thousand barrels. Future projects in this block are

Malange-1, which is expected to produce a total of 7,669 barrels per day, and

9 Organization of the Petroleum Exporting Countries 10 These cuts on crude supply also pressured world refining margins, as we explain later. 11 Benguela, Belize, Lobito, and Tomboco

Upstream operations in Angola have a low risk High production potential Tômbua-Lândana has gross reserves estimated at 350 million boe


PAGE 13/30

Negage, with an expected daily production of more than 8,630 barrels of 30º

API12 oil.

The ultra-deep water offshore Block 32 covers an area of 5,090 square

kilometers, and is located about 150km of the coast. With estimated recoverable

volumes of 1.4 billion boe13, field’s estimated production capacity is 200

thousand barrels per day after 2015. There have been 14 oil discoveries so far,

and conceptual development studies are under way in to establish the feasibility

of a first development area.

In Block 14K-A-IMI , Galp Energia has a participation of 4.5%. This field is

located in the deep water area between the Republics of Angola and Congo, and

is in the same stratigraphic trend of Tômbua-Lândana field.

Table 5: Angolan’s fields data

Block 14 Block 32 Block 14K-A-IMI

Gross reserves (billion boe) 1 1.4 0.1

Expected start-up - 2015 2014

Galp’s stake 9% 5% 4.5%

Operator ChevronTexaco Total SA ChevronTexaco


Brazil

Besides Angola, Galp Energia is also present in Brazil. The country already

accounts for around 50% of crude oil and NG production in non-OPEC Latin

America, and it has the potential to be one of the most important long-term

growth areas for world oil resources and production: crude production is

expected to grow by 670 thousand barrels per day to a level of 2.48 million

barrels of oil per day.

The majority of Brazil’s current production comes from the post-salt Campos

basin, an area which is expected to see significant future growth. Important

discoveries have also been done in pre-salt areas, including the Tupi field, the

biggest world discovery over the last ten years. The pre-salt region is located

170 miles of the Brazilian coast, and the accumulation of hydrocarbons can only

be found in deep and ultra-deep waters, beneath a layer of salt which is

approximately two kilometres thick.

In 1999, the company took part in the second bidding round for exploration

rights, and currently the country is the focus of its exploration activities. In fact,

Galp Energia participates in five of ten discoveries in the pre-salt on Santos

basin, an area of high exploration success: Tupi, Iara, Caramba, Bem-Te-Vi and 12 American Petroleum Institute gravity: measures how heavy or light oil is compared to water. API gravity greater than 10º: it is lighter and floats on water. Light crude oil is defined has having an API gravity greater than 31.1º; it is highly priced than heavy crude oil because it produces a higher percentage of refined products. 13 Barrels of Oil and Equivalents

Tupi is the biggest oil discovery over the last 10 years Galp participates in 5 discoveries in the pre-salt on Santos basin


PAGE 14/30

Jupiter. The later is similar to Tupi field, but since it will be developed later, it has

a lower value.

The Tupi field, with an estimated recoverable volume between five and eight

billion barrels of light oil, is the world’s biggest oil find since the discovery of

Kazakh in 2000 and is the first contribution of the Brazilian portfolio to Galp’s

exploration activities. Production started in 2009 and, according to our estimates,

daily extraction should exceed 1 million barrels by 2016, and operations should

continue until 2030 . The current production infrastructure has a capacity to

process 30 thousand barrels of oil per day but, as a result of the limits imposed

by the Brazilian energy regulator, production did not exceed 20 thousand barrels

per day. Tupi should be developed in 10 phases: every 2 years, a new module

should begin, with an individual estimated capital expenditure of $3.7 billion14

($3.7 million net to Galp). Additional Finding & Development expenditures are

needed for the eleven platforms planned for the field until 2016, when Tupi’s

peak production is expected, and to the drilling of the remaining 85 wells

required to develop the field (15 wells were drilled so far).

Despite of its promising size, it should be noticed that there is high uncertainty

regarding the required investment to develop the field, as nobody ever produced

oil at these depths. Tupi poses significant engineering hurdles that may drive

increased costs: to reach the oil, it will be necessary to run lines through more

than 7 km of water and then drill up 17 km through sand, rock and a massive

layer of salt. According to our estimates, the present value of the total investment

required to develop the field is $45.5 billion (excluding the cost of the first 15

wells, as it had already occurred); however, unexpected challenges may appear,

which would increase the amounts required to develop the field.

The five projects mentioned are operated by Petrobras, the Brazilian state-run

energy group, which is considered one of the most efficient companies operating

in deepwater. In this sense, its partnership is valuable to Galp Energia, as it

benefits from Petrobras expertise. However, company’s current liquidity issues

are a risk factor to Galp Energia: if Petrobras does not increase capital, it will be

unable to make the required investments to develop the fields. Selling part or the

totality of is participation seems an unlikely scenario, even though fields’

potential may be appealing to investors: government’s goal is to control the main

oil findings in Brazil. In fact, after the announcement of Tupi’s discovery, the

Brazilian government removed from a bidding round oil blocks potentially linked

to a massive oil reserve discovery, in order to preserve “country’s sovereignty”.

14 Amount already discounted to the present

Tupi:recoverable volume of 5-8 billion boe Development will be made in 10 phases High uncertainty regarding the required CAPEX Galp benefits from Petrobras expertise in deepwater operations


PAGE 15/30

Table 6: Brazilian´s fields data

Tupi Iara Caramba Bem-Te-Vi Jupiter

Gross reserves (billion boe) 6.5 3.5 0.9 1.4 3.4

Expected start-up 2009 2013 2014 2014 2014

Galp’s stake 10% 10% 20% 14% 20%


Refining and Marketing R&M activities consist in the refining of petroleum products and other raw

materials in two refineries, with a combined throughput capacity of 310 thousand

barrels per day. Refined products are then marketed mainly in Portugal and

Spain. The strategy for refining is to streamline operations in order to attain high

levels of profitability, efficiency and safety. To achieve such goal, it is currently in

progress the conversion of the refining base, which will enable a better response

to the rising demand for diesel in the Iberian Peninsula and will allow an increase

in company’s refining margin. The increase in refining margins combined with

Galp’s large client base will lead to a strong cash flow generation.

Regarding marketing activities, Galp Energia’s main goal is to market oil

products under its own brand and maximize returns by means of efficiency gains

and operational synergies.

Refining

Typically, refineries consist of a number of parallel and serial processes used to

transform crude oil into a range of final products. This is a highly volatile

business, as refineries’ annual revenues fluctuate substantially due to shifts in

the price of crude oil. In fact, such exposure to crude oil prices, combined with

the lower demand of refined products, led to a huge drop of refining margins and

a decline in utilization rates since the summer of 2008. Additionally, the reduction

in throughputs has created an overhang of excess refining capacity that should

persist through the next five years and will likely be reflected on refining margins.

World refining industry

Between 2004 and mid-2008, refining margins achieved its highest level.

However, in the past few years, oil industry costs have been significantly inflated.

Moreover, as a result of the massive global financial crisis, global oil demand

dropped, leading to a collapse of the refining margins. World refining industry

experienced its largest ever demand drop, and future prospects do not point to a

return to previously expected capacity requirements, due to a lower demand

growth and rising supply of alternatives to petroleum products.


PAGE 16/30

Currently, and despite the world economy stabilization, refining margins are not

expected to return to the past levels. In fact, and until 2015, a continued supply

growth projected for biofuels and other non-crude streams is predictable, at the

cost of a decrease in demand for the refinery processing of crude oil. Refinery

utilization rates will remain well below 90%, and worldwide crude net throughput

is expected to be only 72.4 million barrels per day in 2015, which is equivalent to

a global average utilization rate of only 76.6% . However, it should be pointed

that despite the stagnant demand in developed economies, a rise in fuel

consumption is expected in Asia and other parts of the world: for instance,

gasoline demand in US is expected to decline, while worldwide consumption of

gasoline and other fuel products will rise more than 25% by 2030. The

conclusion that all growth is in the developing world is supported by the relatively

recent trend in what concerns oil product demand: the so-called developed

countries were consuming 58% in 2006, compared with the current 52%.

What had been a profitable industry running at respectable operating rates, will

see higher costs, steady declining demand and excess capacity – refinery

utilization rate is expected to drop to a world average of only 77% in 2020 –

which, in turn, will be the main barrier for refining margins to return to past levels.

Moreover, lower quality crude oil, crude oil price volatility (supported by the

presence of high economic uncertainty), and environmental regulations, which

require a cleaner manufacturing process and higher performance products,

present new challenges to the refining industry. As an answer to this reality, Galp

Energia completed in 2009 the construction of a cogeneration plant in Sines to

cover refinery’s steam needs, and will install a similar cogeneration plant in

Matosinhos by 2011. Each cogeneration plant will avoid domestic emissions of

close to 500 thousand tonnes of CO2 and will reduce the primary energy

consumption by 23%.

In the next years, demand trends will be driven by economic growth and

efficiency improvements: new cars will be more efficient, travelling larger

distances with the same quantity of fuel. In fact, it is this demand for efficiency

that is leading to concentration of consumption in premium-end use sectors,

which, in turn, has greatly diminished the demand price elasticity of refined

products.

Dieselization

Europe’s shift toward diesel began more than one decade ago, since the

European Commission encouraged lower taxes on diesel: several government

policies were adopted to tax this fuel at a lower rate than gasoline. This trend,

where gasoline engines have been replaced by diesel engines, is denominated

dieselization. This process is one of the European Union’s main strategies for

World average capacity utilization rate well below 90% Futures increase in costs… … lower demand… … and excess capacity


PAGE 17/30

meeting the greenhouse gas targets under the Kyoto protocol: diesel engines are

more fuel efficient (plus 30 to 40% when compared to gasoline engines), and

therefore more economical, burning less CO2.

The lighter tax burden kept diesel prices below gasoline ones for a number of

years, making diesel cars more economical, with cheaper running costs proving

to be popular amongst consumers. The sale of diesel cars increased, leading to

a decline in gasoline demand and, as a consequence, approximately 50% of

today’s passenger cars and light truck in Europe are powered by diesel engines.

The growing popularity of diesel (at the expense of gasoline vehicles), is putting

Europe in a situation of chronic shortage of diesel and oversupply of gasoline.

Nevertheless, overall transportation fuels demand should remain unchanged in

Europe, since the steep fall in gasoline demand should be offset by the rising

middle distillate consumption (diesel and jet fuel).

Galp Energia

Galp Energia owns the total Portuguese refining capacity. This activity is

developed in two refineries, Matosinhos and Sines, which have a combined

production capacity of 310 thousand barrels per day. The production structure is

dominated by diesel, gasoline and fuel oil, which account for about 75% of total

production.

Matosinhos is a hydroskimming refinery15 with a Nelson complexity index16 of

9.4, and it has the capacity to produce 90 thousand barrels per day and storage

1,986 cubic meters. Sines, on the other hand, is a cracking refinery17 with a

lower level of complexity (6.3), and is considered one of the most modern

refineries in Europe. With a refining capacity of 220 thousand barrels per day

and storage capacity of 3.031 thousand cubic meters, it produces reformulated

gasoline, which exports for the North American market.

Since 2008, a project for the conversion of both refineries has been taking place

in order to create a modern and efficient refining infrastructure that will improve

Portugal’s current account balance: by raising the production of diesel, a large

share of country’s current import needs of this product will decrease. With a total

cost of €1.3 billion, this is the Portuguese largest ongoing industrial project, and

represents the last key investment for the future of company’s refining activity.

After this (second semester of 2011), only general maintenance investments are

expected, once every four years. The maintenance of equipment requires

refineries’ general stops, a sacrifice needed to maintain high levels of efficiency

15 Hydroskimming refinery: produces mainly gasoline; it also produces a surplus of fuel with unattractive price and demand. 16 Nelson complexity index: measure of secondary conversion capacity in comparison to the primary distillation capacity of a refinery. The higher the index number, the greater is the cost of the refinery, but also the higher is the value of its products. 17 Cracking refinery: adds one more level of complexity to the hydroskimmimg refinery by reducing fuel oil.


Source: Analyst estimates Source: Analyst estimates


PAGE 18/30

and reliability of production. In Matosinhos, the next general maintenance will

occur during this year, while in Sines it is schedule for 2013.

The main purpose of this project is to align production with the relative increase

in the demand for diesel. In fact, like the rest of the European market, Portugal

and Spain have been moving towards a majority diesel fleet since the European

Commission encouraged lower taxes on this product due to environmental

questions. As the converted Sines and Matosinhos refineries start operating in

2011, crude needs are expected to rise in amount and change in composition,

with an increase in medium and heavy sweet oil. Given the price difference

between heavy and light oil, this change in consumption profile will bring cost

benefits. Additionally, we expect a better performance of Galp’s refining margins,

as diesel is highly priced than gasoline, due to the pressures from the demand

side, as we explained previously. Graph 12 shows our expectations regarding

the evolution of company’s margins. However, we predict lower utilization

capacity rates for the future: Galp Energia should follow world trend, having

production levels of only 77% of its capacity by 2020.

Marketing of oil products

Marketing of refined products is made in three main markets: retail, wholesale,

and LPG18. In the LPG segment sales are driven by the development and

marketing of innovative kitchen, heating and lighting products, as well as higher

customer satisfaction levels. In this market, Galp has currently around half a

million clients, mostly bottled LPG, which accounts for 69% of total sales. The

wholesale segment dominates company’s sales in the Iberian market with sales

in marine, aviation and industrial sub-segments accounting for more than 75% of

total sales.

Regarding the retail market, Galp Energia has currently around 1,500 service

stations, mainly in Iberia, and company’s current goal is to consolidate its

marketing network, which was enlarged in 2008 with the acquisition of Agip and

ExxonMobil operations in the Iberian Peninsula. The aim of those acquisitions

was not only to increase company’s presence in the Spanish market, but also to

raise the coverage ratio of refining by own-brand marketing. These acquisitions

also allowed the company to achieve important economies of scale, translated

into lower unit costs of logistics and procurement, and capture synergies in terms

of external supplies, services and staffing.

However, the anaemic state of Spanish economy in 2009 affected the retail

business, since the demand for refined products shrank: the demand for

gasoline and diesel declined by 5% and 6%, respectively, while the markets of

18 Liquefied Petroleum Gas



PAGE 19/30

jet and fuel decreased 9% and 12%. Nevertheless, and in spite of its economic

state, after these acquisitions the Spanish market became particularly relevant

for company’s results: in 2009, sales in Spain increased from 27% in 2008 to

41% of Galp sales in the Iberian retail market. Additionally, Spain represents the

only growth opportunity to company’s marketing activities: this market will follow

the global trend, and quantity sold should increase by an annual average of

0.99%. Presently, the company has a broadening presence in Iberia, with a

market share of 15% in the retail segment.

In Portugal, Galp Energia is the fuel retail market leader, with a share of 35%.

One key issue supporting this position is the fact that Galp is the only company

offering a full range of premium products, which accounted for 10% of

company’s total sales in 2009, representing one of the highest penetration rates

in Europe. Additionally, sales by station in company’s Portuguese network have

been above the market average, fact supported by company’s strong brand

awareness.

As in the rest of the world, the Portuguese fuel market contracted as the global

economy entered into a recession. Several steps were taken to mitigate the

effects of weak demand, including the broadened and diversified offering of

various services, such as repair and washing facilities, as well as restaurant and

hotel services. As the economy started to recover and fuel prices became more

stable after their steep rise in 2008, Portuguese sales expanded. This growth

was also supported by the increasing penetration by unbranded and

independent products. In the future, Galp Energia should maintain its leadership

position in the Portuguese market, since it has competitive advantage as the

owner of total national refining capacity. However, given the Portuguese

competition reality, growth in quantity sold is not expected.

Galp Energia is also present in the African market in the three marketing

segments. Here, company’s strategy is to seize new marketing opportunities in

countries that are in a critical stage of development. This will boost Portuguese

exports to these markets and allow Galp to build good business relationships

with several African countries in E&P activities. Despite their small size in Galp

Energia’s current activity portfolio, sales in Africa have been increasing,

Mozambique, Angola and Swaziland presenting the highest growth rates.

Gas and Power G&P is a key segment of Galp Energia: it is a source of stable CF, partially due

to its regulated nature, and also because the company has a strong position in

the Portuguese market, one of the fastest growing in Europe. Currently, with

around 1,300 thousand clients, Galp Energia detains the second largest market

Sales in Spain increased from 27% to 41%in 2009 Portuguese leadership in retail market Growth is not expected in the Portuguese market


PAGE 20/30

share in Iberia and controls about 72% of the NG distribution market in Portugal:

five of the six national distributors are Galp subsidiaries. Its activity consists in

the sourcing, distribution and marketing of NG, and also in power generation. In

the case of NG, Galp’s activities are partially subject to regulation.

NG, the main source of sector’s revenues (about 95% in 2009), is nowadays the

primary energy source with the highest potential worldwide. This is the fuel with

the most diverse range of uses, from electricity generation (representing the

largest portion of global gas use) to industry (in petrochemicals), and finally in

residential, commercial and agricultural sectors. In 2009, the major portion of

Galp Energia NG sales was in the electrical segment, followed by the residential

and industrial ones. Trading represented only a residual part of the NG business,

and this tendency is expected to be maintained.

According to Energy Information Administration (EIA), world consumption is

expected to increase 33.33% between 2010 and 2030, to a level of 158

quadrillion Btu19. In Iberia, where the company operates, expectations are

aligned with the remaining European OECD countries, whose consumption will

increase 18.1% between 2010 and 2030: between 2010 and 2015 demand

should increase at an annual rate of 1.03% ; in the period 2015-2020, annual

increase is expected to be 1.06% ; and from 2020 onwards , the pace of

European NG consumption will decelerate to an annual rate of 0.76% . The

electrical segment will remain the principal consumer of NG, but final consumers

will gain importance, a trend already observed in 2009. The following graph

illustrates our expectations regarding the future sales of NG by the company, as

well as the evolution of the different segments:

19 British thermal units

Source: Galp Energia; analyst estimates


Graph 14: NG Sales by segment - 2009

Table 7: OECD Europe NG consumption

Source: EIA International Energy Outlook 2009


Source: EIA International Energy Outlook 2009




PAGE 21/30

The business

G&P is a business with some particular features, since it is a mix of regulated

and unregulated activities in the Portuguese market: sourcing is not regulated,

the operation of distribution is exclusively regulated, and finally the marketing of

this product is only partially liberalized. In 2009, regulated activities represented

a total of 69% of NG revenues, despite of the increasing volumes transferred

from the regulated to the liberalized market. The weight of regulation in Portugal

is explained by the fact that this is still considered an emergent market. Such

categorization is explained not only by its size, but also by its immaturity: national

consumption was only initiated by the end of 1997. Since then, power generation

has been the major NG consumer.

The company has long-term contracts for the supply of six billion cubic meters of

NG from Algeria (Sonatrach is currently Galp’s most important supplier), by

pipeline, and from Nigeria, by LNG methane tankers. These two countries, along

with Egypt, produce more than 85% of African’s NG, and together account for

81% of Africa’s proved NG reserves. NG is also bought in the spot market, which

represented 49% of Galp’s purchases in 2009, a portion that it is expected to

increase in the future. By 2015, the company expects to increase its supply base

to twelve billion cubic meters, including new projects in midstream business,

namely in Angola and Venezuela. This diversification of supply sources is part of

company’s strategy against its dependency from Algeria and Nigeria: although

Galp Energia has not experienced any significant feedstock sourcing shortages,

there is no assurance that it will not face future interruptions and that it would be

able to compensate any deviations or short delivery that might occur. Moreover,

if the company is forced to source NG through the spot market, it may have

some difficulties given the tight supply of NG on the market, and the purchase is

likely to be more costly than it would be with contracted prices.

The pipeline which transports Algerian NG starts in Magreb and ends in Campo

Maior, where it makes the connection with the Portuguese network. Then, this

product is either distributed in Iberia throughout a network of close to eleven

thousand kilometres to more than one million clients, or stored in Portugal. The

average cost of those contracts is linked to international oil prices, a traditional

practice in Europe to ensure the competitiveness of gas price.

In marketing of NG, Spain is a priority, given that its industrial segment is ten

times larger than its Portuguese counterpart. One important step to enter in such

market was taken in 2009: through a partnership with Morgan Stanley

Infrastructure, Galp Energia started negotiations to acquire from Spanish

operator Gas Natural regulated and unregulated marketing activities, as well as

regulated distribution assets in the Madrid region, for a total amount of €800


Galp will increase its supply base to 12 cubic meters Spain is a priority…


PAGE 22/30

million. This operation, closed in April 2010, turned the company into the second

largest operator in the Iberian market, since the additional 412 thousand final

clients increased its market share to 15%. However, and according to our

estimates, the Net Present Value of this operation has a negative value of €18

million . Despite the dimension of the Spanish market, and even when

considering the difficulties to enter a national European market (we will develop

this later), Galp Energia paid too much, considering the expected cash flows this

acquisition will generate. Indeed, we expect those assets will generate a total

amount €782 million (value already discounted to the present), which is below

the amount paid.

Regarding the power sector, Galp Energia owns and operates cogeneration

plants with an installed capacity of 160 megawatts. The company is also

developing a portfolio of new Combined Cycle Gas Turbine (CCGT) plants, and

the exploitation of renewable energy, namely wind power. These investments

have been made in order to the company achieve its goal of detaining an

integrated portfolio of projects of NG, and generation of electrical and thermal

power. It is important to notice that Galp is well positioned to develop its power

business, benefiting from the strong growth in electricity demand in Iberia.

European Market

The European Commission is currently reforming the regional markets in order to

integrate them into a single gas market. Such aggregation should make

investment targeting this market more attractive, since productivity gains

between 10 and 20% are expected when fragmented networks become

integrated. Moreover, making the energy sector more competitive and efficient is

part of the response to growing concerns on the competitiveness of European

industries in globalising markets. Note that Portugal, along with Finland and

Greece, started this reforming process later, due to its immaturity stage.

However, this has been a slow process because some important barriers persist

despite the efforts taken by the European Commission. Even though it is

becoming more dynamic, European gas industry structure remains too

concentrated. This concentration, as well as the vertical integration of key market

players, may be viewed as a strategy to offset the growing uncertainties and

risks in the European (and in the global) energy scene. In fact, and despite of the

rising demand and tightening supply, there is current substantial lack of

investments in the European NG market: concerns about storage nationalism,

local opposition to new energy installations, and complex planning and approval

procedures have been important barriers to further investments.

Additionally, competition between suppliers may be difficult to achieve on a

national basis, where one import source dominates the market, and customer

… but the recent acquisition hás a negative NPV


PAGE 23/30

switching has not been sufficient. Other important obstacle is the absence of

increased interconnection: new suppliers are not able to enter the markets, and

gas cannot freely circulate from one point to another. In fact, many European

countries do not have interconnected networks to their neighbors, and without

long-term guarantees, companies are reluctant to invest in new pipelines or

storage capacity. Moreover, insufficient regulatory harmonization or lack of

regulatory responsibility for international projects threats cross-border

investment.

This absence of an European market means that storage, flexibility and

consumer protection is handled either at national or company level: each country

has its own criteria and requirements and, as so, the market remains fragmented

and the majority of investment takes place within national borders. Little attention

is given to the idea of minimum essential infrastructure requirements before a

market can physically operate. At the European level, a much greater

interconnection capacity is required before a single European internal market

can be a reality.

Deregulation of the Portuguese market

The liberalization of the Portuguese market started in 2007, first with respect to

power plants, then to clients with an annual consumption of over one million

cubic meters (2008) and, finally, to customers of over 10 thousand cubic meters

per year (2009). Currently, those consumers can freely choose their supplier,

and, by the time the market becomes fully open (in 2010), all NG customers will

be able to make this choice, without incurring in any additional costs. However,

this deregulation process only applies to marketing of NG (commercialization of

last resort is also an exception). All intermediate activities (transport, storage,

distribution and regaseification of LNG), will remain regulated.

Next, we will briefly explain of the regulatory framework in Portugal: how the

industry is structured and how prices are fixed. Galp Energia carries out the

storage, distribution and NG commercialization of last resort activities subject to

national regulation. Allowed rates of return are fixed at 8% for NG storage and

9% for the distribution activities, applicable on a Regulatory Asset Base of €19

million and €1,184 million, respectively.

Regulatory framework

ERSE20 is the authority responsible for regulating the NG sector. It establishes

prices to final customers and sets the rules for remuneration of all regulated

activities: transport, storage, distribution and regaseification of LNG. The tariffs

charged to final clients include the tariff for energy, for accessing the transport

20 Entidade Reguladora dos Serviços Energéticos



Exhibit 3: The NG sector in Portugal


PAGE 24/30


Calculation of allowed revenues for regulated activities

network and the overall distribution system, as well as for commercialization, as

presented below:

Exhibit 4: Tariffs to final clients

Source : ERSE

The commercialization of NG is free, but licences attributed by the competent

entity are required. Galp Energia has concession contracts attributed by the

Portuguese State, which were initially set for a period ending in 2028 (2034 for

Beiragás). Traders can freely purchase and sell NG, and have the right to

access LNG storage and terminal installations, as well as to transport and

distribution, in exchange for a regulated tariff. Under the current legislation, Galp

Energia had to sign contracts related to the transfer of regulated assets, a step

to implement the separation of the NG distribution and supply activities.

Moreover, given its condition of supplier of the national system, Galp Energia

must promote annual auctions of 300 million cubic meters.

For distribution activities, allowed revenues are equal to the sum of the cost of

capital, operating expenses and the tariff gap. Cost of capital is calculated as the

product of the RAB by the rate of return set by regulator (9% in this case), plus

depreciation charges. The tariff gap, in turn, is defined as the difference between

estimated allowed revenues and actual revenues for year n-2. The regulation

model also provides for a mechanism of flat tariffs throughout the concession

period, which started in 2008 and runs for 40 years.

The underground storage of NG is also a regulated activity whose concession

was granted to Galp Energia for a period of 40 years. Here, the regulatory model

follows the same method as the one applicable to the regulation of NG

distribution, except for the tariff-smoothening mechanism and the rate of return

established by ERSE, which is 8% in this case.


PAGE 25/30

If we compare the remuneration rates established by ERSE with segment’s

WACC21 (7.11%), we conclude that regulated activities are profitable to the

company: the allowed return is higher than what Galp pays to finance its

activities, both to shareholders and debtholders.

Natural gas supply drivers

Although the deregulation had already started, Portugal remains a protected and

monopolistic market. Important measures have been taken by national

authorities, and currently almost all consumers have the right to choose their NG

supplier: each client has the right to change its supplier up to four times in each

period of twelve consecutive months, without incurring in any additional expense.

This open market was already a reality for industrial clients, and since the loss in

competitiveness of the regulated price vis-à-vis the free price there has been a

significant transfer of volumes of NG sold in the regulated to the liberalised

market. The liberalization process, along with the growing generation capacity in

the power sector, made Galp Energia able to present to the Portuguese

industrial market a dual offer of NG and electric power, which should be

extended to final consumers as deregulation is complete. Actually, the growing

generation capacity will absorb an important share of the NG purchased, and

thus optimise the business segment’s margin through this dual offer.

This deregulation process increases the potential of G&P business segment:

Galp will be able to increase its margins and, given the monopolistic nature of

the national market, it is not expected a significant change in company’s market

share. Moreover, Portugal follows the worldwide trend of raising demand of NG,

with an expected increase in national consumption of 10.55% between 2010 and

2015. This, combined with the penetration in the Spanish market, will allow the

company to increase volumes sold. Finally, upstream and midstream options are

being studied; if Angola LNGII and Santos basin projects succeed, Galp Energia

will be able to reduce its dependence on external supply.

Valuation We value Galp Energia according to the Sum Of The Parts (SOTP)

methodology. The Discounted Cash Flow analysis was used for the business

segments R&M and G&P, and also to value the current production fields (Block

14 and Tupi). Our explicit forecast period comprises 7 years in the case of R&M

and G&P, since we expect that current projects will be fully implemented by

2017. In what concerns the referred fields, we estimated cash flows until the

exhaustion of reserves (2019 for Block 14 and 2030 for Tupi). Regarding the

21 Weighted Average Cost of Capital

NG national consumption should increase by 10.55% in the next 5 years


PAGE 26/30

other company’s concessions, we applied the Real Options Valuation (ROV), in

order to consider the option to defer an investment.

Since E&P CFs were estimated in USD, the value of each field was firstly

computed in this currency, and only in the end we made the conversion to Euros.

We applied the EUR USD spot exchange rate as of June 4th, 2010.

Discounted Cash Flow

Cash flows for each segment were estimated according to the expected

evolution of the market, which we explained before. In what concerns oil and NG,

prices for the forecast period were derived from futures prices for Brent Crude Oil

and Henry Hub Natural Gas, respectively. Cash flows were then discounted at

the WACC, assuming the company target Debt-to-Equity ratio (100%).

To estimate company’s cost of equity, we applied the Capital Asset Pricing

Model. The risk-free used both in R&M and G&P was the yield on the 10-year

German Government Bund; for the current producing fields, we used the yield on

the 10-year AmericanTreasury Bond, since oil fields’ CF were estimated in USD.

We assumed a market premium of 5.4%, which is the sum of the historical

market premium (4.5%) with the country specific risk for Portugal. Finally, we

estimated Galp Energia beta based on industry average: first, we unleved the

beta of a set of comparables, and then we adjusted the avregare to Galp Energia

target Debt-to Equity ratio. We assumed the opportunity cost of debt (after taxes)

to be 5.05%, taking into consideration Galp Energia implicit rating (AA-). The

following tabe summarizes our assumptions to compute the WACC.

Table 8: Discount rate assumptions

R&M / G&P E&P

Risk-free rate 2.58% 3.19%

Market premium 5.40%

Beta 1.22

Cost of equity 9.16% 9.77%

Cost of debt 6.72%

Effective tax rate 24.79%

After-tax cost of debt 5.05%

Target D/E ratio 100%

WACC 7.11% 7.41%


Real Options Valuation

To value non-producing oil fields we applied the Black-Scholes model, since the

decision to invest (or not) can be viewed as a call option. Since Galp Energia is

subject to block’s operator decisions, we value each field in the perspective of


PAGE 27/30

the operator, and only then we compute Galp’s share on it. Additional, please

note that we do not consider those fields which are in the pre-exploration phase.

The value of each block will depend on five parameters:

• The present value of future CF, if the field will be explored (S0): it depends

on estimated reserves, oil prices and production costs;

• The expected capital expenditure to develop the field (k);

• The historical volatility of oil prices (36.45%), which reflects the volatility of

the underlying asset;

• The development period (T);

• And finally, the risk free rate (rf), which we assumed to be the yield on the

10-year American Treasury Bond

We estimated production costs similar to Block 14 and Tupi field, depending on

the location of the field (Angola or Brazil), after incorporate estimated inflation.

Regarding capital expenditures, they were assumed to be a multiple of the

development costs for Block 14 and Tupi field, again depending on the location.

Galp Energia valuation summary is presented below. Based on our expectations,

we value the company at €14 per share.

Table 9: Valuation Summary

EV (million €) % EV

Angola

Block 14 2,260 16.66%

Block 32 470 3.47%

Block 14K-A-IMI 18 0.13%

Brazil

Tupi 1,987 14.65%

Iara 1,305 9.63%

Caramba 446 3.29%

Jupiter 2,223 16.39%

Bem-Te-Vi 469 3.46%

Exploration and Production 9,177 67.68%

Refining and Marketing 2,189 16.14%

Gas and Power 2,194 16.18%

Total EV 13,560

Total Debt 1,953 Total Equity 11,607 Number of shares 829 Share price €14.00



PAGE 28/30

Financials

Income Statement (million €) 2008 2009 2010E 2011E 2012E 2013E 2014E 2015E

Revenues 15,188 12,138 15,002 16,309 16,661 17,475 19,497 21,664

COGS (14,447) (10,980) (11,764) (14,098) (14,608) (15,395) (17,066) (18,935)

Employee costs (292) (339) (352) (360) (366) (379) (409) (442)

EBITDA 449 819 2,887 1,851 1,687 1,701 2,022 2,287

Depreciation & Amortization (240) (297) (511) (562) (644) (729) (938) (775)

Provisions (42) (64) (72) (89) (92) (116) (191) (273)

Operating profit 167 459 2,304 1,200 951 856 892 1,239

Share of profit of associates 48 69 70 71 72 73 74 75

Net interest expenses (61) (76) (131) (114) (113) (112) (117) (81)

EBT 155 451 2,243 1,156 909 817 850 1,233

Income tax expense (33) (99) (556) (287) (225) (203) (211) (306)

Profit before minorities 122 353 1,687 870 684 615 639 928

Profit attributable to minorities (5) (6) (5) (5) (5) (5) (5) (5)

Net income 117 347 1,682 865 679 610 635 923


Balance Sheet (million €) 2008 2009 2010E 2011E 2012E 2013E 2014E 2015E

Non-current assets

Tangible fixed assets 2,760 3,190 3,654 3,967 4,360 4,763 5,382 5,782

Goodwill 172 189 189 189 189 189 189 189

Other intangible fixed assets 409 498 549 597 657 719 815 876

Investments in associates 297 227 202 213 232 271 320 320

Other non-current assets 290 312 317 322 327 332 338 343

3,928 4,416 4,911 5,288 5,765 6,275 7,044 7,511

Current assets

Inventories 1,076 1,229 1,234 1,466 1,517 1,559 1,603 1,646

Other current operating assets 1,488 1,352 1,593 1,732 1,769 1,856 2,071 2,301

Other investments 3 2 16 17 18 18 18 17

Cash and cash equivalents 127 244 327 356 356 354 400 448

2,695 2,826 3,170 3,571 3,662 3,788 4,091 4,412

Total assets 6,623 7,242 8,081 8,859 9,427 10,063 11,135 11,923

Shareholders equity 2,219 2,389 3,905 4,605 5,118 5,563 5,990 6,664

Financial debt 2,351 2,604 1,953 1,704 1,689 1,669 1,737 1,200

Non-current liabilities 1,056 1,128 1,393 1,554 1,587 1,741 2,191 2,701

Current liabilities 997 1,122 831 996 1,032 1,090 1,216 1,358

Total equity and liabilities 6,623 7,242 8,081 8,859 9,427 10,063 11,135 11,923



PAGE 29/30

Cash Flow Statement (million €) 2008 2009 2010E 2011E 2012E 2013E 2014E 2015E

Net income 117 347 1,682 865 679 610 635 923

Depreciation and amortization 240 297 511 562 644 729 938 775

Change in operating assets 265 (16) (246) (372) (88) (129) (258) (274)

Change in operating liabilities 42 124 (291) 166 36 58 126 141

CF from operating activities 663 752 1,657 1,221 1,271 1,268 1,441 1,566

Capital expenditures (1,146) (833) (1,026) (922) (1,097) (1,194) (1,653) (1,237)

Other financial investments (212) 50 6 (17) (25) (45) (53) (5)

Other CF from financing activities (134) 71 265 162 33 154 450 509

CF from investing activities (1,492) (712) (755) (778) (1,090) (1,085) (1,256) (732)

Increase in equity (324) (177) (166) (166) (166) (166) (207) (249)

Incease in debt 1,173 254 (652) (249) (15) (20) 68 (538)

CF from financing activities 849 76 (818) (415) (181) (186) (139) (786)

∆ change in cash 20 117 84 28 1 (2) 46 48

Initial cash 107 127 244 327 356 356 354 400

Ending cash 127 244 327 356 356 354 400 448



PAGE 30/30

Disclosures and Disclaimer

Research Recommendations

Buy Expected total return (including dividends) of more than 15% over a 12-month period.

Hold Expected total return (including dividends) between 0% and 15% over a 12-month period.

Sell Expected negative total return (including dividends) over a 12-month period.

This report has been prepared by a Masters of Finance student following the Equity Research – Field Lab Work Project for exclusively academic purposes. Thus, the author is the sole responsible for the information and estimates contained herein and for the opinions expressed, which exclusively reflect his/her own personal judgement. All opinions and estimates are subject to change without notice. NOVA or its faculty accepts no responsibility whatsoever for the content of this report nor for any consequences of its use. The information contained herein has been compiled by students from public sources believed to be reliable, but NOVA or the students make no representation that it is accurate or complete and accept no liability whatsoever for any direct or indirect loss resulting from the use of this report or its content. The author hereby certifies that the views expressed in this report accurately reflect his/her personal opinion about the subject company and its securities. He/she has not received or been promised any direct or indirect compensation for expressing the opinions or recommendation included in this report. The author of this report may have a position, or otherwise be interested, in transactions in securities which are directly or indirectly the subject of this report. NOVA may have received compensation from the subject company during the last 12 months related to its fund raising program. Nevertheless, no compensation eventually received by NOVA is in any way related to or dependent on the opinions expressed in this report. The School of Economics and Management at NOVA is a public university thus not dealing for, advising or otherwise offering any investment or intermediate services to market counterparties, private or intermediate customers. This report may not be reproduced, distributed or published without the explicit previous consent of its author, unless when used by NOVA for academic purposes only. At any time, NOVA may decide to suspend this report reproduction or distribution without further notice.

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