Annual Report 2007 Varyag Resources AB (publ)

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Annual Report 2007

Varyag Resources AB (publ)

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Contents

1 Shareholder information 3 2007 in brief

5 Words from the Chairman 7 Message from the CEO

8 Words from the Investment Manager 9 Aims and strategy

10 Organisation and legal structure 10 Taiga Capital Ltd

11 Investment Advisory Committee 12 Development in Russia

15 Operational development 21 The portfolio companies 29 Share capital and ownership 30 Board of Directors, Management

and Management Company

32 Directors’ Report 35 Income statements 36 Balance sheets

37 Changes in shareholders’ equity 38 Cash flow statement

39 Accounting principles

41 Notes

45 Audit report

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1

AnnuAl RepoRt 2007 | VARyAg ResouRCes AB (puBl)

shareholder information

Annual general Meeting 12 June 2008

The Annual General Meeting of shareholders in Varyag Resources AB (publ) will be held at 3 p.m. on Thursday 12 June 2007, at Forum, the premises of Salén Konferens & Matsalar, Norrlandsgatan 15, Stockholm.

participation

To be entitled to participate in the business of the Annual General Meeting, shareholders shall be registered in the share register maintained by VPC AB (Swedish Securities Register Centre) no later than 5 June 2008 and notify their intention to attend the Annual General Meeting by 4 p.m. on 5 June 2008.

notification

Notification of participation may be made:

By post to Varyag Resources AB (publ), Biblioteksgatan 6, SE-111 46 Stockholm By e-mail to info@varyag.se

By telephone to +46-8 771 85 00

Notification should include name, personal identification number (corporate registration number), address, daytime telephone number.

trustee-registered shares

Shareholders whose shares are held in the name of a trustee must temporarily re-register the shares in their own name to be entitled to participate in and exercise their voting rights at the Meeting. Such registration must be completed not later than 5 June 2008. This means that the shareholder must request such registration in ample time prior to this date.

Dividend

The Board of Directors proposes that no dividend be paid for the 2007 financial year.

Financial information

Interim report Q1, 22 May 2008 Interim report Q2, 28 August 2008 Interim report Q3, 20 November 2008

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Executed four transactions during the year and increased exposure to one existing investment during the year, bringing total exposure up to USD 40.4 million at the year end (SEK 283 million).

Completion of rights issue in December 2007, SEK 199.5 millions before issue expenses.

Made material progress towards consolidating the forestry assets in to one entity, RusForest.

Achieved a degree of scale in the forestry sector, with more than 1.4 million m

³

of annual allowable cut (AAC) on a gross basis, of which 600 thousand m

³

is net to Varyag.

Acquisition of minority interests in Tuba-Les and Tublesprom, resulting in an increase in

RusForest’s forest holdings of 94.4 thousand m

³

of AAC, of which 45.7 thousand m

³

is net to Varyag.

Legal challenge to the Unal coal project bankruptcy process.

significant events after the close of the period

Investment in PIK-89, SEK 11.8 millions, to increase capacity in sawmill with additional 50,000 m

³

up to 150,000 m

³

annually.

Investment of approximately SEK 16 million in order to explore and delineate the Kartagonski coal field.

Increased investment in forestry company OOO Nebelsky LPH with approximately SEK 10 million.

•

• 2007 in brief

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5 the strong economic development continues

The Russian economy remains strong. GDP growth for 2007 amounted to 8.1 per cent and real income grew by double digits. For 2008 it is expected that GDP will continue to show a growth rate exceeding 7 per cent. Growth is particularly high in the retail and construction sectors. Inflation is, on the other hand, a growing problem. For 2007, inflation amounted to 11.9 per cent, which by far exceeds the projection of 8–9 per cent in the state budget. Especially the prices for foodstuff have increased dramatically in Russia the past six months.

The Russian financial position is very strong. As a result of the large revenues from the oil and gas export, the Russian gold and foreign currency reserves, including the capital reserves funds from the export of energy products, exceeded 500 billion dollars in April 2008, which makes them the third largest in the world after China and Japan. On account of that, Russia stands a better chance than most other countries to handle the credit crisis that stems from the US property market and is currently working its way through the global financial system.

During the coming years it is likely that the financial surpluses will slowly decrease in pace with rising state spending to accommodate the populations material and social needs as well as funding for a very ambitious infrastructure program.

A prerequisite for the long term Russian budget is that the oil price remains above 50 dollars per barrel, which seems like a reasonable assessment.

Since 1999 Russia has had an average yearly growth rate above 7 per cent, which means that GDP has doubled in ten years. With a GDP of 1,300 billion dollars Russia is currently the eight largest economy in the world. Under the supervision of President Putin the Government is working on a new long- term program covering the period 2008–2020, with the aim of making Russia the fifth largest global economy at the end of the period. Other noticeable ambitions are that 60 per cent of the population at that time shall belong to the middle class and that the average duration of life shall increase from 67 years today to 75 years. The investment plans for infrastructure during the period amounts to billions of dollars. A prerequisite for fulfilling this ambitious long-term program is that the annual growth rate continues to exceed 7 per cent. This in turn requires that market economy and globalization continues to prevail t in Russia, which will have positive effects on the country’s democratisation process as well as modernization.

stability in domestic politics

The most important event in domestic politics is that Presi- dent Putin, under constitutional forms, will hand over the presidency to his chosen successor Dmitrij Medvedev. The inauguration took place on May 7. The fact that Vladimir Putin keeps a leading position and stays on as prime minister means that we will see a continuity in real politics, especially when it comes to economic and social policies as well as foreign affairs.

President elect Medvedev has in some respect a different profile than Putin. He belongs to a younger generation with fewer roots in the Soviet past and has, in contrast to Putin, a civilian background. Being a professional lawyer, Medvedev has in a number of statements emphasized the importance for Russia to become a society governed by law; at the same time he has criticized the legal “nihilism” that according to him still exists in Russia. There are reasons to believe that Russia under Medvedev’s presidency will move in a more liberal direction.

Energy issues are an important part of Russia’s foreign policy. Russia has, with great success, negotiated with the countries in southeastern Europe about a second gas pipeline under the Black Sea to Bulgaria, Serbia, Hungary, Austria and Italy. Despite at times harsh negotiations Russia has been able to come to agreement about gas deliveries to neighbouring countries Ukraine and Belarus, and also reached transport agreements with Kazakhstan and Turkmenistan.

A number of security issues are being discussed between Russia and the US. Recently there have been signs that a new agreement with regards to strategic armaments is close. The future relationship between Russia and the US will also be affected by the outcome of the American presidential election.

The negotiations concerning a new strategic partnership accord with the EU, which has been blocked for some time, still remains to be settled but looks to gain new speed. It is important for Russia that the US and EU assist Russia in finally becoming a member of the WTO.

good performance in the portfolio sectors

When it comes to our own company, Varyag, the sectors where the company is active, namely forestry and sawnwood, coal and gravel and cross products for road production, all develop well with strong demand and good prices. The strategy of the company has thus proven correct. The problems that we encounter in the portfolio companies are of the general Rus- sian kind, e.g. of bureaucratic nature and the lack of following an accepted business code in commercial life. To solve these matters we have our competent Management Company in Moscow under the supervision of Aleksandr Williams. With the current growth rate in the Russian economy, especially in our selected sectors and also with the large infrastructure investments that are being made in Russia, we have good reasons to believe that Varyag will be a profitable investment for our shareholders.

Sven Hirdman Chairman

Words from the Chairman

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7 Message from the Ceo

Dear shareholders

2007 was Varyag’s first full year of operations. It was characterized by stability in regards to the political and economic development in Russia but with turbulence in the financial markets.

During the year the Stockholm Stock exchange OMXSPI index declined by approximately 6 per cent at the same time the RTS index on the Moscow exchange advanced 27.4 per cent. Dur- ing 2007 the number of companies listed on the Stockholm Stock exchange with a business focus on Russia increased and amounts to around fifteen.

positive development for investment strategy

The strategy of Varyag is to preferentially invest in the area of natural resources. The reason being the enormous assets of natural resources that are available in Russia that combined with a good access to reasonably priced energy gives way to a long-term competitive advantage. Varyag invests in areas that has a fragmented structure and is additionally characterized by increasing domestic and global demand. Other criteria are neglected needs for investment and the demand for capital to carry out expansion plans. The target for Varyag is to execute an exit of the portfolio companies within 3–4 years from the initial investment. The timing will be determined by the market conditions of what will give the best return. Our target sectors are forestry, aggregates for the construction sector and coal.

The positive development in the target sectors confirms the selected investment strategy.

Varyag has executed nine portfolio investments, of which four took place in 2007. Six investments have been made in the forestry sector, one in the construction sector and two in the coal sector.

Consolidation of forestry investments

The investments in the forestry sector will gradually be consol- idated in to a new holding company, RusForest. Together the companies in RusForest will have an annual allowable cut of over 1.4 million cubic metres on an area covering some 723,000 hectares. After the acquisition of a minority interest the net exposure for Varyag increased to approximately 600,000 cubic metres annual allowable cut, corresponding to around 305 000 hectares of forestland. The companies in RusForest has an existing sawmilling capacity of approximately 140,000 cubic metres of sawnwood which is planned to increase to approximately 390,000 cubic metres by the end of 2008 through investments in existing and new saw mills. The strategy from the outset to change the product mix in the forestry companies by investing in sawmill capacity has offset the increased export tariffs on round wood and has had a positive impact on Varyags investments. Russia has almost one quarter of the global forest reserves. All international forestry companies will in the long run, for strategic reasons, need to have a presence in this market. Russia is also well positioned in respect to the large and growing markets in the Far East.

Investment in gravel and coal still in early stage

Varyag has gained exposure to the fast growing Russian construction sector through the investment in Russian Gravel Co and the up coming deliveries of aggregates to the construction and civil engineering market. The investment includes the building of a mill with an annual production capacity of 1.7 million tonnes and finalizing infrastructure projects such as a railway connection. The project has thus far been delayed by negotiations concerning cost of leasing equipment and management problems but production is expected to commence during the course of the year.

During 2007 the first investment was made in the coal sector by investing in the coal project Unal, an investment with a high degree of risk but also with a considerable reward potential. The Coal price reached new highs during the past year.

The scarcity of coal in Asia at the beginning of 2008 is a good illustration of how coal is a part of the total energy equation.

The upward harmonization of domestic Russian gas prices is expected to have a positive impact on coal prices. Environment- friendly technology such as clean coal processing is under development and is expected be of significant importance in the long run.

good foundation to reach critical mass

During the fall of 2007 Varyag had invested or committed capital corresponding to approximately 75 per cent of its share capital. To create the foundation to make add on investments in order to reach critical mass within the target sectors forestry, aggregates and coal a rights issue that raised SEK 195 million was executed at the end of the year.

Doing corporate deals in Russia is not uncomplicated.

A prerequisite for making investments is to have management competence at your disposal. Through the management agreement with Taiga Capital Ltd, which is run by Aleksandr Williams, Varyag can benefit from the knowledge, competence and experience the management team possesses of the Russian business environment.

Investments in private equity are long term by nature. After the acquisition phase a comprehensive effort is needed before the exit phase is reached. This effort comprise of carrying out business and investment plans and legal restructuring. Varyag’s Management Company must take care of both bureaucratic problems as well as changing or appointing new management to the portfolio companies. One of the most important goals for 2008 is to create financial transparency that will be achieved when the portfolio companies transform their accounting in to IFRS.

I would like to thank our shareholders for the confidence they have shown by investing in Varyag. I would also like to thank our management team in Russia. 2008 will be an exciting year as a number of our investments will start production and at the same time we aim to make a number of add on investments.

Torbjörn Gunnarsson Chief Executive Officer

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8 Words from the Investment Manager

In general, the Management Company is very happy with the investments made in 2007. During the course of the year the Management Company assisted Varyag in increasing its exposure in all three of its target sectors. We executed four transactions and increased exposure to one existing investment during the year, bringing total exposure up to USD 40.4 million, corresponding to SEK 283 million, at the year-end. Varyag has now achieved a reasonable degree of scale in the forestry sector.

Market outlook remains positive

At the outset, the Management Company was excited about the outlook for all of the sectors that we were investing into, as time goes on it is still clear that this optimism was well placed.

Whilst the market outlook for gravel and coal remains strong, the market for sawnwood is likely to deteriorate in 2008 as a result of the global slowdown in construction. Specifically sawnwood prices started to decline towards the end of 2007 and this process is expected to continue into 2008. The Rus- sian Government’s decision to increase export duties on sawlogs up to not less than EUR 50 per m³ from 1 January 2009 will be of critical importance. This step is likely to remove a significant volume of sawlogs from the global market and this should have a knock-on effect on sawnwood prices. In this environment domestic sawnwood producers inside Russia will benefit from continued access to low cost logs.

operational issues and transparency

In addition to strong fundamentals, it is critical to get operational aspects right. A key challenge in Russia continues to be project implementation, identifying reliable co-investors and managers. During the year Varyag has increased visibility into all portfolio companies, whilst most management teams are working well, the company still faces difficulties in identifying suitably qualified management who are prepared to work at

the portfolio companies. A number of important changes have been made during the year and management at Tuba-Les has now settled in, more recently we have had to replace most of the management of Russian Gravel Co. following continued delays to the start-up of this project. Russian Gravel Co. has now employed an expatriate manager who is overseeing the work needed to get this asset into production.

Built a strong position

We have been able to cement our position in the regions where we are active, this is important as the Russian business environment requires that investors have good relations with Regional and Federal authorities. Most regional governments are sup- portive of our investment initiatives and work actively to facili- tate the investment environment. Competition is still strong but we still have a significant deal flow in our chosen sectors.

In addition to executing transactions, there is a significant amount of restructuring related work at each of the portfolio companies. Key organisational tasks relate to; legal structuring, introduction of budgeting and management accounting processes, transition in to IFRS and strengthening local management teams.

Progress has been made in these areas in 2007, legal agreements are in place which regulate the contribution of Varyag’s assets into a new holding company, RusForest (Cyprus) Lim- ited. The formal re-registration of holdings inside Russia will take place once Vostok Nafta obtains the relevant regulatory approvals. In addition, the transition to IFRS is underway.

Going into 2008, Varyag has a good asset base in three exciting sectors with positive market outlook and price appreciation potential.

Aleksandr Williams Investment Manager

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9 Aims and strategy

Business concept

Varyag shall invest, actively manage and exit investments mainly in unlisted natural resources companies in Russia and the rest of the CIS.

overall objective

Varyags’ overall objective is to provide its shareholders with an attractive total return.

Financial and operational targets

The majority of capital raised from the share issue in December 2007 shall be invested within 12 to 18 months in accordance with the investment strategy.

Primarily to finance investments with equity although leverage may be used from time to time.

Exit investments within three to four years from the initial investment.

Dividend policy

Over time, Varyag will distribute capital gains achieved after Performance Fees, taxes and other costs, however considering Varyags’ investment prospects, liquidity and financial position in general. Dividends may be made in the form of distribution, redemption or repurchase of shares.

Investment strategy in brief

Investments are primarily made within the natural resources sector in Russia and the CIS in companies with a defined resource endowment, existing operations, strong management and ready access to infrastructure. However, it will be possible in the future to invest in other sectors if deemed attractive for the shareholders.

Investments are not made unless Varyag believes that they will generate an IRR of 30 per cent per year.

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Investments are mainly financed with equity, although leverage may be used when appropriate.

Varyag may not have an exposure exceeding 20 per cent of the value of its gross assets in one single investment. There are however no limitations on ownership share or size in other respects.

Varyag seeks risk diversification in its investments in terms of sectors and regions.

Investments will primarily be made in unlisted companies, but Varyag will be able to invest up to 30 per cent of the value of its gross assets in the securities of listed, but illiquid shares when it is deemed possible to achieve an IRR of at least 30 per cent.

Varyag does not seek to assume full ownership control over its investments, but will rather seek to co-operate with existing owners and management in order to achieve mutu- ally agreed targets in terms of expanding the business through capital expenditure and/or acquisitions.

The primary aim is to exit investments through stock market listings, while alternative exit routes, including selling investments to industrial or financial investors also will be considered.

Varyag has an agreement with the Management Company, which maintains a small and highly skilled team based in Russia and the CIS, thus being close to the market and understanding and responding to opportunities in a timely manner.

The Investment Manager works closely with professional legal, tax, accounting and technical experts to review all pertinent aspects of each potential investment in a prudent manner.

Varyags’ cash shall be managed with limited risk and generate a satisfactory return, secure short and long term capital sourcing and maintain flexibility and secure the manoeuvra- bility to make investments.

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10 organisation and legal structure

Varyag Resources AB is the Group’s Parent Company, with its registered office in Stockholm. In addition to the Parent Company, the Group consists of the subsidiary Varyag Capital (Cyprus) Ltd with its registered office in Nicosia, Cyprus, and Varyag Finance GmbH with its registered office in Zug, Switzerland. Operations began on 1 August 2006 and the company has been listed on the First North list of the Stockholm Stock Exchange since 7 August 2006. Investments in Russia are owned via the wholly owned subsidiary Varyag Capital (Cyprus) Ltd. Varyag Capital (Cyprus) Ltd has concluded a management agreement with Taiga Capital Ltd, which manages the company’s investments. The management agreement extends for a period of seven years from 31 July 2006.

Investment decisions are made by Varyag Capital (Cyprus) Ltd on the basis of proposals made by the Management Company and advice from the Investment Advisory Committee; see next page.

legal structure, 31 December 2007

taiga Capital ltd

The Management Company, Taiga Capital Ltd, operates from Moscow and is owned by Aleksandr Williams. The Manage- ment Company intends to manage and develop the Group’s investments to the best of its ability and to provide the Group with advice and recommendations regarding investments and exits. Taiga Capital provides management and advisory services to Varyag in accordance with the management agreement with Varyag Capital (Cyprus) Ltd. The services provided by the Man- agement Company pursuant to the Management Agreement include the following:

Analysing the market, economic and political conditions and trends in Russia and other CIS countries;

Identifying and evaluating investment opportunities;

Presenting investment opportunities to Varyag for approval;

Negotiating and structuring investments;

Appointment of other professional advisors;

Assuming board positions in Investee Companies;

Managing of and developing the Investments;

Seek exit opportunities;

Coordinating collection of financial returns due to the Company such as dividends or any proceeds received from Investments;

Coordinating the preparation of accounts and the calcula- tion of the net assets value of the Investments for approval by the Board and auditors according to the Company’s accounting principles.

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The Management Agreement is valid for a period of seven years. The Agreement may be extended following this period based on agreement between the Management Company and Varyag.

AleksAnDR WIllIAMs

Aleksandr Williams, born in 1968, manages the Management Company’s operations. Williams has more than thirteen years experience of asset management, corporate finance and advisory activities in Russia and the rest of the CIS. Aleksandr has been a full-time resident in Moscow since 1993 and was previ- ously responsible for Vostok Nafta’s operations in Russia.

Williams’ responsibilities included handling trade sales, corporate actions, buy-side research, tax planning and daily management of Vostok’s Russian entities. Aleksandr has handled trade sales and offmarket transactions with every major Rus- sian oil company including, LUKoil, YUKOS, KazMunaiGaz, the government of Bashkiria, the government of Yakutia and CNPC. During six years at PricewaterhouseCoopers, Williams worked closely with Russian management teams as a management consultant to introduce financial forecasting and cash- flow-based project evaluation to Russian corporations, particularly with LUKoil. Aleksandr has a degree in theoretical phys- ics from the University of St. Andrews and a Master of Business Administration from the City University Business School (London). He was employed by Hagströmer & Qviberg AB between the period November 1997 to October 1999, stationed in Moscow, mainly in the field of corporate finance.

Varyag Capital (Cyprus) Ltd Cyprus Varyag Resources AB (publ)

Sweden

Advisory Investment Committee Varyag Finance Gmbh

Switzerland

Taiga Capital Ltd

Portfolio companies

Portfolio companies For a thorough description of the portfolio companies, please refer to The port

folio companies.

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11 Investment Advisory Committee

Investment Advisory Committee

The Group has an Investment Advisory Committee consisting of three members. All investment and divestment proposals from the Management Company are reviewed by the Invest- ment Advisory Committee, with the aim of receiving advice and recommendations. Accordingly, the Investment Advisory Committee is a key resource in connection with Varyag’s con- siderations ahead of investments and exits. The following is a brief presentation of the members of the Investment Advisory Committee during 2007.

MIkHAIl M. ZADoRnoV Moscow, born 1963 Member since 2007

Education: Graduate of the Plekhanov Russian Academy of Economics and post-graduate studies at the Institute of the Academy of Science of the USSR.

Holding in Varyag Resources AB: None

Mikhail M. Zadornov is currently President of VTB24 (ZAO), a subsidiary of Vneshtorgbank focused on serving retail banking customers and small businesses. Zadornov held a number of important positions in Government of the Russian Federation, including: from November 1997 to May 1999 – Minister of Finance of the Russian Federation, in May 1999 he was appointed the First Deputy Prime Minister of the Russian Fed- eration, June–October 1999 Zadornov was Special Representa- tive of the President of the Russian Federation on International Finance Institutions Relations being in position of the First Deputy Prime Minister, he was also appointed Special Adviser of the President of the Sberbank of the RF in October 1999. In 1997 Zadornov was a Member of the Board of the Sberbank of the RF and acted as Deputy Chairman of the Sberbank’s Supervisory Board.

He was first elected to the State Duma on 12 December 1993 and was a deputy of the State Duma of the Federal Assembly of Russia of the first and second convocations in 1994–1997 as well as Head of the Committee on Budget, Taxes, Banks and Finance. In December 1999 Mr. Zadornov was elected to the State Duma of the Federal Assembly of Russia of the third convocation and appointed Deputy Head of Committee of the State Duma on Budget and Taxes, in Decem- ber 2003 he was elected to the State Duma of the Federal Assembly of Russia of the fourth convocation and appointed the Chairman of Subcommittee on Monetary Policy, Exchange and Capital Control, Activities of the Central Bank of the Russia Federation.

seRgeI VAsIlIeV Moscow, born 1957 Member since 2006

Education: Doctor of economics and graduate of the Leningrad finance economics institute N.A. Voznesen- skovo (1979).

Sergei Vasiliev is senator and represents the St.Petersberg Region in the Federation Council, He is Chairman of the Feder- ation Council’s committee on the Securities Market. Prior to being appointed a senator, Vasiliev held a number of important posts in the Russian Government, in particular he was Deputy Minister of the Economy between 1994 and 1997.

Vasiliev was a key architect of reforms in today’s Russia and formed part of the core team that designed and implemented Russia’s transformation to a market economy.

AleXAnDeR JAMes steWARt London, born 1950

Member since 2006

Education: Stewart is a graduate of Oriel College Oxford and speaks four foreign languages.

Alexander James Stewart has over 20 years of capital markets experience with an emphasis on emerging markets. Stewart has been involved in both equity sales and research. He has held a number of positions in leading investment banks working out of the City of London. Stewart’s previous responsibilities included Head of Equities at RZB, Head of Equities at Banco do Brasil and Head of Emerging Market Equity Sales at Deutsche Morgan Grenfell. He is currently Head of Institu- tional Research at Eden Financial, a specialist firm providing independent research to institutional investors.

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12 Development in Russia

external environment and overview

The global environment is particularly relevant to Russia as the country’s net exports account for 12.6 per cent of GDP, accordingly high commodity prices will tend to stimulate production, improve the trade balance and boost government revenues and generate real Rouble appreciation. This has generally been the story of the last eight years, the Federal Govern- ment now has a significant 5.4 per cent of GDP fiscal surplus, the Central Bank has USD 490.7 billion in reserves, acquired largely to dampen real and nominal Rouble appreciation. The fiscal surpluses have allowed the Federal Government not only to accumulate USD 157.4 billion in the stabilisation fund, but also to dramatically repay the Federal Government’s external debt which had fallen to USD 38.1 billion at the end of Q3-2007, which is less than one third of the level of 1999.

Although many commodity prices underwent a downward correction towards the end of Q1-2008, prices still remain high by historical standards. As an example, the value of hydrocar- bon exports rose even though volume increases were insignifi- cant. In addition to enjoying a relatively strong external environment, Russia is relatively insulated from the credit crisis, which is effecting developed countries. The Federal Govern- ment has been repaying foreign debt for some years, whilst the private sector has only recently returned to the debt markets.

The limited effect of the credit crisis is born out by the continued growth in investment and construction, whose rates of growth have held steady despite the gyrations in international debt markets.

GDP growth has moved from an export driven recovery to a more domestically focused process, although oil and gas remains important, the three sectors which are now contribut- ing the most to growth are Construction (16.4 per cent growth in 2007), Hotels and restaraunts (12.0 per cent) and financial services (11.4 per cent) this compares to growth of only 0.3 per cent in mineral resource extraction over the same period.

The investment element of GDP has traditionally been somewhat low in Russia at around 18 per cent due to concerns over property rights and general political instability. The global average investment share in GDP is 23 per cent, this also includes developed markets whose investment requirements (by definition) are lower than those for emerging markets. The investment element of GDP in Russia is currently growing very rapidly with the growth in the index value of corporate capital formation (investment in fixed assets) and the index of construction activities growing strongly by 19.0 per cent and 30.1 per cent respectively in the year to January 2008. This process could potentially run for a very long time, investment rates well in excess of the global average of 23 per cent could be entirely possible due to the depleted nature of Russia’s capital stock following some 20 years of under-investment. In the event that some measure of political stability is maintained, it is possible to imagine a Russian investment “super-cycle”

benefiting the producers of materials used in construction and machinery manufactures.

government spending and fiscal policy

The Russian government has run a tight fiscal policy over the recent past and has sought to keep much of the terms-of-trade benefit out of the economy by taxing the oil sector. In the recent past, the Federal budget has been set to balance at oil price levels which have (ex post) turned out to be low. The Government recorded a surplus of 5.4 per cent of GDP (pre- liminary) during 2007. Much of this surplus is saved outside the economy, the Central Bank had foreign currency reserves of USD 490.7 billion as at February 2008 and the Government had saved a further USD 157.4 billion in the Stabalisation Fund as at January 2008¹⁾. In addition to saving fiscal surpluses, the Government has rapidly repaid both domestic and foreign debt. The Russian Federation’s total stock of external debt stood at only USD 38.1 billion at the end of Q3-2007.

% change in real GDP (by expenditure)

-8 -6 -4 -2 0 2 4 6 8 10 12

Q3 2007 Q2 2007 Q1 2007 Q4 2006 Q3 2006 Q2 2006 Q1 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997

%

Quarterly data 6.4%

10.0%

4.7%

6.4% 6.8% 7.8% 7.9% 7.8%

1.4%

–5.3%

5.1%

7.3% 7.2%

5.0%

7.0% 7.6%

Source: Rosstat and BOFIT Russia Review

Year on year % change in real GDP

% growth in investment over previous year

-10 -5 0 5 10 15 20 25 30 35

Jan 2008 Oct Jul Apr Jan 2007 Oct Jul Apr Jan 2006 Oct Jul Apr Jan 2005 Oct Jul Apr Jan 2004

%

Investments in fixed assets Construction activity Source: Rosstat – social economic conditions in Russia

Year on year growth in investment in fixed assets and construction activity to January 2008

1) Bank of Finland Russia Statistics.

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1 Inflation

Inflation remains a perennial problem and with commodity (and particularly wheat) prices growing on the back of a steady increase in money supply, it is not surprising that inflation has started to turn up towards the end of 2007. Consumer price inflation was 12.7 per cent for the year to February 2008, significantly exceeding the official government target of 8 per cent for 2007, and is likely to remain elevated as a result of the relatively high monthly rates recorded over the last six months.

Medium term outlook

The Russian economy is clearly in a strong position going into 2008, GDP growth has been consistently high since 1999.

Russia now has a strong fiscal and external position, making the possibility of a major downside shock from economic causes faily low. Going forward, it appears that domestic investors are comfortable with the country’s political direction even though the West in general is sceptical. Russia has the potential to enter into a investment “super-cycle” in order to renew its capital stock after an extended period of under- investments. The signs are that such a cycle is well under-way and the Management Company believes that repatriation of flight capital that left the country in the 1990s is a key indicator of this trend.

In the event that Russia is able to maintain domestic stability and at least workable relations with the West it is likely that strong rates of GDP growth will be maintained for the foreseeable future. The Management Company believes that such an environment will generate exciting investment opportunities for Varyag going forward. This is particularly true in view of the fact that the availability of long term funding is still limited in Russia as the domestic banking system is not yet in a position to make long term loans and few players are providing capital to the medium sized companies that Varyag is dealing with. It is felt that the combination of rapid growth plus relatively limited competition for the provision of long term equity capital will create investment opportunities for Varyag that are assessed to more than compensate them for taking on political and property right risks inherent in Russia.

% increase year to date

0 5 10 15 20 25 30 35

Jan 2008 Sep Jul Apr Jan 2007 Oct Jul Apr Jan 2006 Oct Jul Apr Jan 2005 Oct Jul Apr Jan 2004 Oct Jul Apr Jan 2003

%

PPI inflation CPI inflation Source: Rosstat

Comparison of year to date inflation – CPI versus PPI, January 2003 – January 2008

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15 operational development

sector Developments

FoRestRy

The Russian forestry sector underwent a period of rapid decline during the transition to a market economy and is now beginning its rapid renaissance. This pattern has been repeated in many sectors that have now fully recovered to production levels recorded pre-1990. Russia holds the world’s largest timber reserves by a significant margin, and although there are issues related to the accessibility of those reserves due to a lack of road and rail infrastructure, the fact remains that Russian forestry enterprises have essentially unlimited access to raw material in the foreseeable future.

Further, Russia borders the world’s largest importer of wood and wood products, China. The Chinese market has grown rapidly, the market for imported round wood grew by a cumu- lative average growth rate (“CAGR”) of 15.6 per cent (by volume) for the ten years ending 2004 and the value of this market is now USD 2.95 billion¹⁾. In addition, the market for imported sawnwood has grown at a CAGR of 9.6 per cent over the same period and now has a value of USD 1.8 billion.

Russian forestry companies can access Chinese buyers by land, which enables Russian companies to avoid ever-escalat- ing shipping costs. This provides a significant comparative advantage relative to alternative sources of supply (Brazil, New Zealand and North America).

Asian prices, as monitored by Jakko Pöyry Consulting, remained fairly stable until early 2007, despite the rapid increase in import demand from China, which has primarily been supplied from the recovery in Russian production. Prices did, however, experience a significant boost in 2007, and although there was a subsequent slight slump stemming from the American sub-prime collapse, prices still remain high, and have stabilised at around USD 230/m³ dried sawnwood, with prices delivered to Asia generally higher than prices delivered to Europe, which is suffering from some partial oversupply.

The Management Company believes that there is a chance that Asian prices may increase as Russian exports begin to face capacity constraints throughout the production chain and transport system. In addition, there is no structural reason as to why Japanese prices should be consistently higher than Chinese prices and there is a possibility that Chinese prices will converge towards Japanese levels.

Thousand hectares

0 100,000 200,000 300,000 400,000 500,000 600,000 700,000 800,000 900,000

Indonesia Australia China United States Canada Brazil Russian Federation

Source: UN Food and Agriculture Organisation

Forest area – 2000

1) UN Food and Agriculture Organisation – Statistical Database.

USD/m3

0 50 100 150 200 250 300

Dec Nov Oct Sep Aug Jul Jun May Apr Mar Feb Jan 2007 Dec Nov Oct Sep Aug Jul 2006

Sawnwood prices: Ust-Ilimsk works export price (less railroad charge), 2006–2007

Million cubic meters

0 10 20 30 40 50 60

2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992

Domestic sawnwood production Roundwood exports Value added processing carried out abroad (China and Finland)

Comparison of growth in roundwood exports versus sawnwood production 1992–2005

m3

Russian Non Russian 0

2,000,000 4,000,000 6,000,000 8,000,000 10,000,000 12,000,000 14,000,000 16,000,000 18,000,000 20,000,000

2005 2004 2003 2002 2001 2000 1999 1998

China – Roundwood imports (coniferous)

Source: PIK-2005 company

Source: FAO Stat

Source: FAO Statistics Division – faostat.fao.org

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In addition to this it is worthy of mention that there is also a market in forest land, particularly in the Americas. Transaction prices per hectare vary quite considerably, reflecting factors such as the quality of the forest and the distance from processing facilities. A direct comparison between the price of forest land in Canada, the United States and Chile, with forest land in Russia is not possible since forest land in Russia can only be leased, whereas outright ownership is possible in the Ameri- cas. Furthermore, infrastructure in Russian forest areas is often quite poor, with some forest areas possessing no infrastructure at all; accordingly Russian forest areas should in principle be valued at a discount to forest areas available in the Americas.

The graph below shows a comparison of the value of forest land in Canada, Chile and the United States of America, and the acquisitions made by RusForest Limited.

The data for Canada, Chile and the United States were provided by Pöyry Forest Industry Consulting and are weighted average values for transactions that they monitored during 2006 and 2007. Even given the limitations associated with a direct price comparison, the discount between the value of the assets already acquired by RusForest Limited (excluding OOO Bogouchanski LPK which has no forest land) and forest areas in the Americas is striking. Even more significant is the fact that RusForest acquired equity interests in operating forestry companies with associated forest land, that is to say operating companies with revenues, profits and material sawmilling capacity and not just forest areas.

The structure of Russian exports is being forced to undergo a radical change from basic industrial roundwood to more value-added products, whereby output will have to be upgraded to at least producing sawnwood in the first instance. At the time of Varyag’s first forestry acquisitions in 2006, industrial roundwood exports attracted an export duty of 6.3 per cent, whilst virtually all value-added products could be exported free of duty. On 1st July 2007 the export duty for industrial roundwood was increased to 20 per cent (and no less than EUR 10 per m³) under changes introduced to the Russian Federal Gov- ernment’s resolution on export tariffs on unprocessed forest products. Under this amendment duty on industrial roundwood exports are to be significantly increased over time, reaching 80 per cent (and no less than EUR 50 per m³) on 1st Janu- ary 2009.

The net effect of this radical raising of export tariffs will ultimately be to create a prohibitive duty on roundwood exports, thus forcing investment in the development of roundwood processing facilities within the Russian Federation. At present approximately 54 million m³ of roundwood are exported annually from Russia. 40 per cent of the world’s exports of softwood logs are from Russia, and Russia accounts for 80 per cent of the logs imported into Finland and China. Following the introduction of the 80 per cent export tariff on roundwood exports in January 2009 it will effectively no longer be possible to export unprocessed wood from Russia for the manufacture of value-added wood products abroad.¹⁾

USD per hectare

0 1,000 2,000 3,000 4,000 5,000 6,000 7,000

RusForest¹⁾ Canada

USA Chile

6,429

3,010

938

71

Source: Jakko Poyry and Taiga Asset Management calculations

1) RusForest acqusition cost cover the acqusition of forest land plus sawmilling capacity – the costs include acquisition of 139,667 m³ of sawmill capacity plus the capital required to build a further 100,000 m³ (post cash cost). Outright ownership of forest land is not possible under Russian law, however all portfolio companies have long term leases over their land – the shortest existing lease is due to expire in 2044.

Comparison of price of Americas forest area (2006–2007) versus forest and sawmilling acqusition costs for RusForest

Minimum Export Tariff (EUR/m3) Export Tariff (%)

0 10 20 30 40 50 60

Jan 2011 Oct Jul Apr Jan 2010 Oct Jul Apr Jan 2009 Oct Jul Apr Jan 2008 Oct Jul 2007

Minimum Export Tariff (EUR/m³) Export Tariff (%) 0 10 20 30 40 50 60 70 80 90

Source: Government of Russian Federation

Russian Export Duties on Industrial Roundwood

1) The introduction of prohibitive export tariffs on roundwood export is being challenged by Finland as being non-compliant with WTO regulations. Whatever the outcome of this challenge however, the Management Company is of the opinion that the Russian government’s aim to radically curb roundwood exports and thereby encourage investment in value-added wood processing facilities will ultimately still be carried out.

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AnnuAl RepoRt 2007 | VARyAg ResouRCes AB (puBl) seCtoR pRoFIle — AggRegAtes

The construction, retail and banking sectors are the main driv- ers of the Russian economy, in addition to the oil and gas industries. The aggregate sector provides direct exposure to the construction sector, which in Russia is booming, both in terms of large-scale federal investment in the areas of transport infrastructure and housing, and of private investment into residential and commercial construction projects.

Russia produced a total of some 100 million m³ of various grades of aggregates in 2003, a tiny fraction of the approximately 1.3 billion m³ of aggregates consumed by the US. Of this amount only 15 million m³ is classified as high-grade con- struction quality (magmatichiski). Russia consumes approxi- mately 18 million m³ of high quality aggregates per year, with the balance of 3 million m³ per year being imported from Ukraine. The road construction sector accounts for approximately two thirds of Russia’s total consumption of construction quality aggregates, with the balance being used by the construction sector. The OAO Russian Railways is also a significant user of lower grade aggregates for track foundations (25–60 millimetres fraction size) and for track construction (5–25 millimetres fraction size). OAO Russian Railways consumes an estimated 20 million m³ of aggregates per year.

The market for high-quality construction aggregates is expected to grow rapidly in the coming years on the back of;

Significant road building planned under the “National program of modernization and development of the Russian Federation road system up to 2025” (the Road Building Program); and

Continued strong growth in residential and other construction activities.

The Russian road network is in a poor condition. Road density is limited (44 kilometres per 1,000 km²) and the condition of the existing road network is poor. More than half of Russia’s roads have “poor” surfacing. The country clearly requires a major upgrade of its road infrastructure in order to allow the continued development of GDP growth. The Road Building Program envisages building 6,000 to 10,000 kilometres of new road per year up to 2010 and 40,000 kilometres per year up to 2025. In addition, it is envisaged that a total of 1.774 million kilometres of road will be repaired up to 2025.

A Russian consultancy company (ZAO “Itkor”) has trans- lated the planned Road Building Program into an aggregate requirement. Their forecasts estimate that the requirement for aggregates for road building will quadruple between now and 2010.

•

In addition to growth in road construction, the construction sector more generally is expected to continue its rapid growth, which continues to exceed 20 per cent per year, provided that the investment climate remains stable. The construction sector is the primary beneficiary of any growth in domestic investment, and although the level of investment remains somewhat low in Russia, there has recently been some growth in the rate of investment. In physical terms, 70.1 million m² of buildings were completed in 2005¹⁾, and the Management Company expects the rate of construction growth to be maintained in the event that there is no material deterioration in the investment environment.

Prices for gabbro-diabase aggregates have risen significantly on the back of continuing strong construction growth (aggregates constitute an 80 per cent input into the manufacture of concrete for construction purposes) – nearly a dollar per m³ for the market-indicative 25–60mm fraction since the end of first half-07, and an impressive $3.66 since year-end 2006, from $10.96 to $14.62/m³.

Aggregate requirement – million m3 Year-on-year growth rate

0 20 40 60 80 100 120 140

2010 2009

2008 2007

2006 0

5 10 15 20 25 30 35 40 45 50

Source: InfoTehconsult-R

Forecast of high quality aggregate consumption for road building 2006–2010

USD per cubic meter USD per cubic meter

20.0 20.5 21.0 21.5 22.0 22.5 23.0 23.5 24.0 24.5

Oct Sep Aug Jul Jun May Apr Mar Feb Jan 2007 Dec Nov Oct Sep 2006

5–20 mm fraction 25–60 mm fraction

8 9 10 11 12 13 14 15 16

Source: OOO Belomorskiy Karier average bid prices

Indicative gravel prices – ex mine north west Russia

1) Source: Rosstat.

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AnnuAl RepoRt 2007 | VARyAg ResouRCes AB (puBl) CoAl

Coal is set to become a steadily more important source of primary energy, according to “Official energy statistics” from the US government. During the period from 2004 to 2030 world coal consumption will increase by 74 per cent from 4,710 million tonnes to some 8,192 million tonnes. India and China together account for 72 per cent of the projected increase in world coal consumption from 2004 to 2030. Strong economic growth is projected for both countries, and much of the increase in their demand for energy, particularly in the industrial and electricity sectors, is expected to be met by coal.

Given such demand, world coal production is projected to grow significantly. Production in the US, China, and India is projected to increase by 457 million tonnes, 2,074 million tonnes, and 235 million tonnes, respectively. These three countries will account for 71 per cent increase in production for OECD countries and nearly 79 per cent for non-OECD countries. Increased demand for international trade is expected to support production increases in Australia and New Zealand, Russia, and other emerging economies. Having said that, in OECD Europe, natural gas is expected to capture an increasing share of the region’s total energy mix, primarily displacing coal and liquids and, to a lesser extent, nuclear energy. Slow economic growth in Japan is projected to result in limited growth in overall energy demand, and as a result, the projection for Japan’s coal consumption in 2030 is only slightly lower than the level seen in 2004 total.

Coal prices have also been strong recently as the realisation that China is likely to become a net importer of coal in the near future begins to take hold. Figures for the first nine months of 2007 show that Chinese coal exports fell to 38.01 million tonnes, whilst imports increased by 47.6 per cent to 38.61 million tonnes making China a marginal net importer over the first nine months of 2007. According to recent studies of “Offi- cial energy statistics” from the US government, coal exports from China by 2030 will be only around 40 million tonnes, while imports will grow up to around 131 million tonnes.

As China moves towards being a steady net importer, the seaborne thermal coal market is likely to get increasingly tight.

JP Morgan expects that the thermal coal prices paid by Japa- nese utilities to Australian miners during 2008 will increase by 60 per cent on back of increased demand from India and global infrastructure problems. JP Morgan updated its contract price forecast to $90 a tonne, a 28.5 per cent increase from its earlier forecast of $70.

To date, the Russian coal industry has attracted little interest from portfolio investors as most of the country’s production is owned by large privately held companies (SUEK and Kuzbass- razrezugol) or forms part of integrated steel businesses (Yuzhni Kuzbass). Russian domestic coal prices are depressed by the heavily subsidized gas prices of around USD 45 per thousand m³ (mcm). In this environment it makes sense to export coal, even though transport costs to an export port can be as high as USD 30 per tonne, inclusive of all related handling costs. This means that net-back coal prices are as low as USD 25 per tonne (USD 55 per tonne FoB less USD 30 rail

Metric tonnes – million

OECD North America, Europe, Asia Non-OECD Europe

Non-OECD Asia (without China) China

Other Non-OECD countries 0

500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000

30 29 28 27 26 25 24 23 22 21 20 19 18 17 16 15 14 13 12 11 10 09 08 07 06 05 2004

Source: Derived from EIA International Energy Outlook 2005 (targets for 2010, 2015, 2020, 2025 and 2030)

World coal consumption by region (2004–2030)

USD per tonne

40 50 60 70 80 90 100 110 120 130 140

Feb 2008Jan Dec Nov Oct Sep Aug Jul Jun 2007May

Source: NEWC – thermal coal index for Newcastle Australia, fob trade weighted index – www.globalcoal.com

NEWC – thermal coal index

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transport). Going forward Russian gas prices should reach net back parity of at least USD 100 per mcm (assuming a market price of USD 140 per mcm and USD 40 per mcm transport costs) by 2010. At these gas prices it would be profitable for local power utilities to switch to coal at prices of USD 51 per tonne, assuming that the thermal efficiency of a coal plant is 38 per cent and a gas plant is 49 per cent. Accordingly the local market for coal in Russia is likely to increase as gas prices increase.

Coal – USD per tonne

Assumes 38% thermal efficiency for coal and 49% for gas excluding impact of carbon credits Domestic gas prices – USD per thousand cubic meters 0

10 20 30 40 50 60

100 95 90 85 80 75 70 65 60 55 50 45 40

Approximate – net back parity

Approximate equivalence of coal and gas prices

Source: The Management Company’s estimates

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21 the portfolio companies

general

VARyAg InVestMent poRtFolIo suMMARy

Company Sector Funding provided Equity ownership

Net exposure ¹⁾ % of shareholders’ equity SEK million²) USD million

RusForest Limited³⁾ Foresty Equity 50% 83.5 11.1

Tuba-Les Foresty Loan – 6.1 0.9

Tublesprom Foresty Loan – 0.6 0.1

Bogouchanski Foresty Equity 50% 49.9 7.1

Lesprom Foresty Equity 50% 10.5 1.5

Nebelsky Foresty Equity 25% 33.5 4.8

PIK Filial No.2⁴⁾ Foresty Equity 25% 3.1 0.4

Total foresty sector 187.2 26.7 31.5%

Russian Gravel Company Aggregates Equity plus convertible loan 81% (post conversion) 75.7 10.8

Total for aggregate sector 75.7 10.8 12.7%

Unal /AGK⁵⁾– Step 1 Coal Equity plus loan 50% 20.2 2.9

Total coal sector 20.2 2.9 3.4%

Total investments plus binding commitments per 31 December 2007 283.1 40.4 47.6%

Varyags’ shareholders’ equity per 31 December 2007, mSEK 595.1

Notes:

1) Net exposure is defined as capital commitment, net of any funding which will be received from co-investors (Vostok Nafta in the forestry sector and Trans-Nafta in the coal sector) and repayment of bridge loans provided to the portfolio companies.

2) All USD amounts quoted for illustrative purposes only, at a fixed rate of SEK/USD of 7.0.

3) Through RusForest, Varyag owns shares in PIK-89, PIK-2005, Ul ZSl, Tuba-Les and Tublesprom.

4) PIK Filial No.2 is a rail terminal and forms a part of PIK-Group.

5) Unal is indirectly owned by Varyag through Abakanskaya Gornaya Kompanaya (AGK).

The table above provides a summary of investments and commitments made as of 31 December 2007. The summary takes into account payments which the company expects to receive from its co-investment partners in the forestry and coal sectors. In addition, the table shows the legally binding capital commitments that the company has made. In some cases not all of these capital commitments have been fully disbursed

and for these reasons the figures above will not exactly match cash invested as shown in the company’s balance sheet. The table does however provide an accurate view of Varyags’ exposure to the various projects. Based on the data above, the company had invested and committed 47,6 per cent of its equity funding as of 31 December 2007, including amounts reserved to cover unpaid costs.

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All of Varyags’ current forestry portfolio companies are located in eastern Siberia, an area dense in high-quality Angarsk pine and Siberian larch, and also well-situated for reaching the rapidly growing Asian markets, and especially China.

OOO Abakanskaya Gornaya Kompanaya (AGK), a coal company 50 per cent owned by Varyag, with its coal mine Unal, is also located in eastern Siberia, near the town of Abakan.

This area of Russia is now undergoing development as a new centre of coal exploitation, as the traditional coal region of the neighbouring Kuznetsk Basin, or Kuzbass, is now fully exploited, with little to no scope for finding assets at attractive valuations.

Karelia in north-western Russia, where Varyags’ gravel company, OOO Belomorsky Karyer is located, is the region in Russia with the largest aggregates reserves totalling upwards of 1,700 billion m³. The region also has a well-developed transport infrastructure, linking it to end-users of aggregates in the construction and road-building sectors.

Forestry

RusFoRest ltD

Having made a number of acquisitions in the forestry sector, the focus is now on consolidating the portfolio companies and creating legal and financial transparency. The table below sum- marises the physical forest holdings of the portfolio companies on a gross and net basis.

location of the portfolio companies

= Forestry = Aggregates = Coal

suMMARy oF FoRest HolDIngs

Company

Annual allowable cut (AAC) (gross), m³

Forest area (gross) hectares

Varyag net equity entitlement, %

Annual allowable cut – net to Varyag m³

Forest area – net to Varyag

hectares

PIK-89 629,000 345,150 40% 251,600 138,060

Tuba-Les 318,000 187,722 40% 159,000 93,861

Tublesprom 139,000 70,038 40% 69,500 35,019

Lesprom 117,000 30,988 50% 58,500 15,494

Nebelsky 246,000 89,766 25% 61,500 22,442

Bogouchanski – – 50% – –

Total 1,449,000 723,664 600,100 304,876

Annual Report 2007 Varyag Resources AB (publ)