Having doubled production over the past two years, Cub Energy is steadily shedding its status as a junior E&P company and maturing into a real player on Ukraine's natural gas market. Demand prospects in Ukraine and high local gas prices offer the right conditions for the company to continue unlocking reserves.

The 85% slide in the company's share price over 2014 was mainly driven by investor concerns regarding Ukraine risk and the country's stability. Due to Ukraine's heightened military and economic risks we initiate coverage of Cub Energy with a HOLD recommendation, even though out 12-month target price of USD 0.052 per share implies 161% upside to the current price.

• The launch of production at seven new wells in 2013 and 2014 has boosted output to record highs. As of end-2014, the company's exit rate is up 16% yoy at 2,407 boe/d. In 11M14, Cub was the 7th largest independent gas producer in Ukraine with a 4% market share.
• Even though the average netback decreased 18% yoy in 9M14 due to both an increase in operational expenses and a hike in tax rates in Ukraine since August, it is still estimated at an attractive USD 30.4/boe in 2014. The tax rates will remain elevated in 2015 and as a result we see the average netback sliding to USD 15.9/boe in 2015E. Local gas prices are tied closely to import prices, which rose more than 30% over 2014 due to the gas dispute with Russia. However, the decline in global oil prices over the past couple of months implies gas prices will adjust accordingly, with a bit of lag.
• Cub is ramping up operations in Western Ukraine. Its 100%-owned RK field accounted for an estimated 17% of total production in 2014 (vs. 8% in 2013) after the launch of the new RK-22 and RK-21 wells. Additionally, the company launched a new RK-23 well in December 2014 and we see the share of gas produced in the west growing to 28% in 2015 and 2016. The greater focus on the western assets will mitigate the risks related to assets in Ukraine's east (E&P company KUB-Gaz in which Cub owns a 30% working interest).
• Ukraine's parliament approved abnormally high royalties for gas E&P companies for 2015. The tax rate has been set at 55% for gas extracted from wells up to 5,000m, which applies to all of Cub's wells. The rates were initially increased from 28% in August 2014 and the hike was to have been temporary. However, fiscal considerations have outweighed the economic arguments and the rate was not scaled back. Conservatively (for valuation purposes), we assume the 55% rate will remain through end-2016 and slashed to 28% from 2017. At the same time, we believe there is a good chance the tax will be reduced from 2016 because the current rate creates strong disincentives for exploration activities.
• Cub shares are trading at 2.1x EV/1P and 1.4x EV/2P, a 87-92% discount to international peers and a 37-56% discount to local E&Ps after losing 85% over 2014 and 34% since the beginning of 2015. We value Cub Energy using only core NAV and adjust the valuation of the company's assets in Eastern Ukraine by 70% to incorporate the risks and uncertainty caused by ongoing military conflict.

Our valuation yields a target price of USD 0.052/share, which offers 161% upside to the current price. We initiate coverage with a HOLD recommendation.

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