CEE energy firms look beyond another terrible start to the year

By bne IntelliNews February 5, 2007

Nicholas Watson in Prague -

If Central and Eastern European energy firms were hoping for a less-tumultuous start to 2007 than last year, then they were sorely disappointed; instead of Moscow cutting off gas supplies to Ukraine, it cut off oil to Belarus. Despite this, analysts say the remainder of the year should be much kinder to the region's oil and gas firms.

Russia's decision to shut off oil supplies destined for Europe via Belarus certainly cast a pall over the entire CEE oil and gas sector.

The dispute, which began January 8 when Russian oil to Europe suddenly stopped flowing in pipelines transiting Belarus in retaliation for Minsk allegedly siphoning off around 900 tonnes of oil, caused consternation among European policymakers and frightened investors because about 40% of Russia's crude is exported via the Druzhba pipeline across Belarus into the EU.

The fear, of course, was that refineries in countries like Poland, which is the CEE region's largest recipient of Russian oil importing some 360,000 b/d, would run dry. Happily, this dire scenario was avoided because the crisis was resolved a week later when Russian President Vladimir Putin and his Belarussian counterpart Alexander Lukashenko saw sense and forced a compromise that would see Belarus cancel its oil transit tax of $45/tonne, while Russia lowered its crude oil export tariff on oil supplies to Belarus to $53/tonne from $180/tonne.

Even had the crisis dragged on, analysts say refineries in Central Europe have a buffer in that they are required under EU law to hold significant inventories of crude – 80 days' worth of fuel consumption in the case of Poland.

Unfortunately, as with much to do with Russia and its energy supplies these days, another spat is usually just around the corner. Within weeks Lukashenko, whose regime is propped up by what are effectively subsidies it receives from Moscow in the form of cheap energy, was moaning to the press about how Belarus would now be paying $2.5bn more for its gas and $1bn more for oil, and so needed to find a way to "not lose this $3.5bn."

He has mooted the idea of getting Russia to buy the land under the oil pipelines that Moscow took possession of as part of the settlement. And towards the end of January he also threatened to impose new duties on Russian oil transit unless Russia sold oil for Belarussian refineries at lower prices, sparking fears of another round of supply disruptions.

However, Russian state-owned oil giant Rosneft announced on January 30 that it had signed a deal with Belarus' state refining and petrochemicals firm, Belneftekhim, on a new oil price formula for Russian oil supplies to Belarussian refineries, calming fears – at least until the end of this year. Russia and Belarus have agreed to process a total of 21.5m tonnes at Belarussian refineries this year, up from 20.9m tonnes of oil supplied to Belarus in 2006.

"These interruptions should not have any material negative impact on 2007 profits of oil refining companies in the region, but interruptions in crude oil supplies to CEE show the need to diversify sources of crude oil away from Russian suppliers," says Arkadiusz Wicik, an analyst at Fitch Ratings.

Indeed, most analysts agree one lasting consequence of the oil dispute between Belarus and Russia is that CEE oil firms will press ahead with moves to try to diversify away from their traditional reliance on Russian oil and instead import, for example, Brent North Sea oil.

Poland's Grupa Lotos is perhaps in the best position to do this, as its refineries are situated near the port of Gdansk so could receive supplies of oil by tanker. Likewise, the other Polish oil group PKN Orlen could transport oil supplies from Gdansk to its refineries elsewhere in the country.

However, this would of course harm their refining margins because transporting oil by sea or by rail is more expensive – an effect that would be magnified by the fact that heavier Russian crude is cheaper than other sources of oil.

"The Belarus-Russia problem might trigger a slight deviation in where these CEE refiners get their supplies, but crude from Russia is almost always the cheapest option," says Gergely Várkonyi, an analyst at Deutsche Bank in Budapest.

A precious difference

A more fundamental worry for the region's oil and gas firms is the oil price, which fell steeply in January toward the $50 mark, a level not seen since May of 2005. Though the price has since clawed its way back toward the high $50s, many analysts don’t predict it will return to its 2006 highs, but remain around $60 a barrel for the rest of the year. Deutsche Bank's forecast for the whole of 2007 stands at $61 per barrel.

This fall in the oil price has had a knock-on effect on the difference in prices between Brent crude and the heavier lower-grade Urals crude from Russia, which is a key source of income for these CEE refiners. For reasons related to the substitution of fuel oil with coal and gas, when the global price of oil falls the so-called Brent-Urals differential tends to narrow, in this case from December’s $4.7 per barrel to around $3.0 per barrel in January.

"The Brent-Urals differential goes straight into the pockets of CEE refiners so the larger the differential, the more they make," says Deutsche Bank's Várkonyi.

Fitch's Wicik expects the Brent-Urals differential to gradually decrease to some $2-3 per barrel by 2008-2009. "This is due to increasing demand for Russian crude oil from China and increasing refining capacity in Russia," says Wicik.

Those setbacks for the region's refiners, however, must be set against a number of positives for the region's oil and gas firms, say analysts.

The warm winter weather and sturdy economic growth in almost all CEE states have meant that the all the downstream parts of these firms' businesses – refining, petrochemicals and retail – have been performing well and are likely to continue to do so throughout 2007, reckon analysts.

Wicik says the economy of Central Europe as a whole is expanding twice as fast as that of Western Europe, which "will have a direct impact on growing demand for power and refined products."

This demand is reflected in the improving refining margins for diesel and gasoline, which have recovered from a weak end to 2006. So-called crack spreads for gasoline increased from $4-5 per barrel to $8-9 per barrel, while diesel crack spreads recovered to around $17 per barrel from $12 per barrel.

Analysts say the petrochemicals business, though highly cyclical, is also seeing marked growth in demand for products, with the estimated integrated polymer margin rising to about €400 per tonne during the second week of January from a 2006 high of €380 per tonne in the fourth quarter of 2006.

The retail business is also expected to continue performing well throughout 2007 as increasing car use and lower prices at the pump boost retail volumes. A sign of how these firms view this part of the business can be seen in Hungarian MOL's announcement in February that it plans to expand its petrol station network in Serbia to 25 by the end of this year from the present 13, with the aim of securing a 15% market share by 2010.

As well as such organic growth, mergers and acquisitions (M&A) are expected to play a big role in CEE oil and gas firms' plans in 2007.

Acquiring a habit

One consequence of the high refining margins, a cyclical upturn that began in 2003 and should continue throughout the year with margins staying considerably above the long-term average, is that all the largest players in the region except for PKN are flush with cash and have low debt levels. Coupled with high economic growth in a low interest rate environment, this creates the ideal conditions for M&A.

For most of the large Central European oil companies, the refining and marketing (R&M) segment is the main contributor to the bottom line. Indeed, for PKN and Romania's Rompetrol Group this segment generated virtually all of the cash flow in the first nine months of last year. With oil prices so high and a decline in refining margins predicted from 2008-09, these firms are looking to shift their profile from being pure R&M businesses into those with a combination of R&M and exploration and production (E&P). For example, PKN, which is to date the only large CEE oil and gas firm without any E&P operations, announced in early 2006 a strategic plan to increase the contribution of this part of the business to the group's cash flow to 21% by 2015.

On 29 January, the Polish daily Dziennik reported PKN had begun negotiations with the official Russian receiver for the now-bankrupt Yukos about being admitted to tenders on crude oil deposits and refineries in Russia in return for withdrawing a $109m lawsuit against Yukos linked to the disruption in oil deliveries in 2005. Outside of such "barter" arrangements, however, analysts say PKN's ability to buy large upstream assets this year is largely constrained by its giant $2.34bn acquisition of the Lithuanian refiner Mazeikiu Nafta, which is proving a bit of headache since a fire at the refinery and an oil spill that has stopped Russian oil supplies by pipeline.

Hungary's MOL, whose R&M operations contributed about 50% of cash flow in the first nine months of last year, looks well placed to buy more upstream assets this year to add to January's acquisition of the Russian oil company Baitex.

Though MOL didn't reveal how much it paid for Baitex, which currently produces 1,800 b/d (versus MOL’s overall 100,000 b/d) and has some 60m barrels in proven reserves, Tamás Pletser, an analyst at Erste Bank, estimates the purchase price in the range of $5-7 per barrels of oil equivalent (boe) proven reserve, meaning the value of the company was in the range of $300m-420m.

"MOL is buying the project at the best stage, just before the production accelerates," reckons Pletser.

However, the Hungarian company needs several more such acquisitions if its upstream business is to reach its 2010 target of 300,000 b/d production. The full consolidation of its Croatian asset INA would add another 60 b/d to that 100,000 b/d total, but the remaining 140,000 b/d must be covered primarily by acquisitions, based on the assumption that the current hydrocarbon production cannot be boosted further, says Pletser.

"This assumption is valid, as the top current operations – the Hungarian oil and gas fields and ZMB in Russia – have already reached the plateau production level and are set to decline in the coming years," he says.

Pletser thinks that MOL is in a good position to win more such tenders for small and medium-sized acreages in Russia, as well as similar deals in Kazakhstan. However, the problem for the region's companies is that many other companies, particularly deep-pocketed state-owned firms from China and India, are also eyeing such assets.

"The oil and gas upstream business is attractive, but there are significant business and financial risks, especially for new players. And in the current environment when oil prices remain high and guarantee a solid margin above upstream costs, the risk of overpaying is high as there are many investors and companies looking to acquire upstream companies," says Wicik.

Deutsche Bank's Várkonyi agrees. "Yes, there is a risk of overpaying for these upstream assets, that's because every company in the world are looking, especially the state companies from India and China, which when they find an asset they want, they are prepared to pay the highest price."

There are alternatives, though. Analysts point out that PKN and other Polish companies like gas monopolist Polskie Gornictwo Naftowe i Gazownictwo (PGNiG) would do better to spend money on developing domestic reserves rather than competing for expensive overseas assets. Much of these reserves are located in the southeast of Poland in the heart of the Carpathians where oil and gas has been produced since the mid-1850s. The Przemysl field, Poland’s largest gas field with reserves of 70bn cubic metres, is located there.

There are also some choice assets in the region to buy.

OMV acquired a 34% stake in the largest Turkish fuel distributor Petrol Ofisi last year. And next door in the Balkans there are a number of energy assets that are expected to be put up for sale, including the Serbian state oil monopoly NIS. The Serbian government began the sale of a 25% stake in NIS in October last year, before later postponing the tender until after a new government is formed following the country's elections, which were held on 21 January. Firms that have already expressed an interest in bidding for NIS are Rompetrol, MOL, OMV, Greece's Hellenic Petroleum, Russia's Lukoil and PKN. OMV won tenders for two offshore exploration licenses in Norway and another two in the UK in January. OVM is operator on all four projects and owns 70% stake in one Norwegian project and 50% stakes in the other three.

Of course, the logical conclusion of the privatisation of the region's oil and gas firms would be consolidation of the large players between themselves, but for political reasons few believe that will happen soon.

"It's not that that it won’t happen, it's just that it probably won't happen this year," Várkonyi says. "The Polish firms are not up for sale."

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