CEE oil and gas - better up than down

By bne IntelliNews April 27, 2009

Nicholas Watson in Prague -

With signs of the oil price and emerging European economies stabilising, it might be tempting to plough back into the region's oil and gas stocks. Analysts say that would be jumping the gun a bit, but if you do, better to invest upstream than downstream.

Certainly, Central and Eastern European energy stocks - principally Mol, PKN Orlen, OMV, Lotos Group and PGNiG - took a beating as the oil price plummeted from its high of $147 per barrel hit last summer and the global crisis forced economies into recession, cutting demand for the black stuff. Mol fell 65% from its high, PKN by 56% and PGNiG by 40%.

Beginning in March, however, the sector staged something of a recovery as the oil price recovered to stabilise in the range of $40-50 per barrel. Even so, the various stocks are still trading below their European peers on a price/earnings basis as well as the sector's long-term P/E average of 10 times. "Investors perceive CEE stocks as having high levels of risk and the stock prices were additionally under pressure thanks to the overall sell-off on financial markets," explains Jakub Zidon, an analyst with Erste Group.

While the sector is still experiencing significant headwinds and the beginnings of an economic recovery are far from assured, the cheaply valued stocks and a newfound commitment by the Organization of the Petroleum Exporting Countries (Opec) to continue making production cuts to lift the oil price back toward the $75 mark is being used by some analysts as the basis to recommend a selective return to the sector.

That said, few doubt that the oil price could, in the short run at least, face continued weakness. But a shift from the demand side - the oil consumer lobby the International Energy Association expects oil consumption to fall 1.6m barrels per day (b/d) in 2009 - to the supply side as production becomes increasingly cost-intensive, the massive amounts of capital expenditures required only come through at a fraction of the amount actually needed, and numerous oilfields pass their peak production, inevitably means higher prices in the longer run. "Given the more effective approach by Opec this time, there is a realistic prospect the current average of $43/barrel could be realised for the year and Brent will end the year at between $50 and $60," says Chris Weafer, head of research at Russian investment bank Uralsib.

Longer term, a price toward $80/barrel is plausible. "The longer the oil price remains at $40 and below, the more rapid and extreme the future shortage will be, because investment and exploration programmes will have been postponed or cancelled at this level," reckons Erste's Zidon.

Up, up and away

Assuming a higher oil price, some of the pressure on the financial performance of the upstream part of the business should diminish. In this regard, the top picks in the sector are Hungary's Mol and Austria's OMV, both of which have significant upstream businesses. "We like Mol because, unlike its Polish peers, it trades at a significant valuation discount to [emerging market] peers, is projected to have a resilient financial performance, has upside risk in consensus, its balance sheet risk is overestimated and has a growth driver from the INA buy," Gergely Varkonyi, an analyst with Deutsche Bank, wrote in a recent report. "We expect Mol to have the most resilient financial performance, thanks among other things to its diversified, high-quality asset base."

Ironically, the risk for Mol comes from its very attractiveness: after OMV tried and failed to take over the firm, it then shockingly decided at the end of March to offload the 21% stake it had built in the Hungarian firm to the murky Russian oil company Surgutneftegas for a hefty €1.4bn. Surgutneftegas is run by Vladimir Bogdanov, who is believed to enjoy a good relationship with Russian Prime Minister Vladimir Putin, but its ownership structure is opaque, with shareholders thought to include senior Russian officials.

Mol management were understandably apoplectic when they learnt of this deal, and have since drawn up a list of proposals to strengthen the company's defences against a hostile takeover, which include requiring shareholders to reveal who their ultimate beneficial owners are, with failure to do so leading to the suspension of voting rights.

Where the troubles are expected to continue for CEE energy firms is in the downstream part of the business - in refining and petrochemicals. "Despite the revised figures on new capacities to be delivered to the market in the coming two to three years and lower cost inputs, the significant drop in demand for both refining and petrochemical products is the main factor behind the expected drop in downstream profitability," says Zidon. "We are, therefore, slightly negative on the CEE downstream segment, but positive on upstream players like OMV and Petrom."

This will particularly affect the Polish refiners, which are already considered to be pretty inefficient. PKN, for example, generated 84% of its cash flow in 2008 from the refining and petrochemical segments.

Concerns are also growing about many refiners' indebtedness. Fitch Ratings recently downgraded PKN, which actually breached its bank covenants at the end of 2008, to junk status and left them on review for a further downgrade. Lotos is financing a huge modernization plan, which seems very ambitious in the current market environment. "Lotos' indebtedness is high by any standards, while Mol's leverage is also high, although to us it seems the most manageable of the three," argues DB's Varkonyi.

"Overall, the high leverage of Polish refiners could cause problems for them, while both OMV and Mol reacted to the financial crisis by lowering their capital expenditure. Neither Unipetrol nor Petrom should have problems financing capex, as they have very strong balance sheets," says Zidon.

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