Like many of its state-controlled peers, Poland’s largest oil company, Polski Koncern Naftowy Orlen, has seen changes in the boardroom since the change of government in November. Warsaw then said in mid-January that it is mulling a plan to merge the company with the state’s other oil and gas companies. However, neither plan alters the fact that PKN Orlen must adapt.

After years of struggling to transform high-cost crude into a profit, PKN – like other refiners across Europe – is in a sweet spot thanks to a rare confluence of situations. While low oil prices are not uncommon, they rarely accompany economic growth and elevated demand for fuels.

That has allowed the blue chip, which the Polish state controls via a 27.5% stake, to report a 48% rise in net profit in the third quarter of 2015 to PLN795mn (€178mn), despite a drop of around PLN5.7bn in revenue to PLN23.5bn.

The momentum has not gone unnoticed by the market. The political controversy accompanying the new Law and Justice (PiS) government in early 2016 has pushed the share price down from its August peak of over PLN85, but at around PLN65 it’s still well up on the PLN49 at which it traded a year previously. That gives PKN – the only Polish company listed in the Fortune Global 500 at 353rd last year – a market capitalisation of close to PLN28bn.

However, the good times won’t last forever, and the various pressures on the industry mean not all European refiners will survive. Those are issues PKN managers will be keenly pointing out to the company’s new CEO.

PKN must change, insists the company’s senior economist Adam Czyzewski to bne IntelliNews. “We are moving – or want to move into – different segments. Meanwhile, we see less and less activity in the core business. That’s why we’re moving into power production, general retail, technology and R&D. Everyone has to change in today’s climate.”

It’s a stance appreciated by Fitch Ratings. The agency affirmed PKN at ‘BBB-’ in December, noting “PKN’s business diversification… and moderate leverage”. The analysts also warn of the risks of “the cyclicality of the refining and petrochemical operations”.

The replacement of Jacek Krawiec as CEO by former treasury minister and PiS MP Wojciech Jasinski in December won’t alter the global and European conditions impacting Poland’s largest refiner. Nor will it change the Treasury Ministry’s propensity to push politically led demands onto the large listed companies that it controls.

Like Poland’s state-controlled power and gas utilities, PKN has long been forced to toe the line in efforts to improve Poland’s energy security, and the new nationalist PiS government is highly unlikely to relax such demands. In recent years, the company has been roped into prospecting for the country’s elusive shale gas reserves and operating loss-making refineries in neighbouring Czech Republic and Lithuania. It may yet be forced to help bail out the struggling coal industry.

Life is sweet

Those foreign facilities are – for the moment at least – sending cash the other way, thanks to the heady refining margins. PKN Orlen made around $8.20 on each barrel of oil it processed in 2015.

Downstream Ebitda rose a stunning 90% in annual terms in the first nine months of 2015, notes Fitch, “on the back of favourable refining and petrochemical margins and a 11% increase in downstream sales volume”.

Oil is the ultimate cyclical market, however, and if there’s one thing guaranteed, it’s that the likes of PKN won’t be able to live so high on the hog for long. Czyzewski says it’s almost impossible to predict how long the good times will last. “No one really knows where the oil price is due to oversupply,” he grimaces. “By the end of 2016 we expect it to start rising after an erratic year. It’s not possible for margins to remain at $8-10 per barrel. We think they’ll be shrinking up to 2020, but they won’t descend to the lows of 2013 when they were at $0.5-1.0.”

Tamas Pletser, an analyst at Erste Bank, concurs. “The refining margin is likely to see a 20% drop in 2016,” he predicts.

The real issue pushing PKN to diversify, however, is that Europe hosts too many ageing and expensive refining plants, while competition from cheaper and more modern facilities in the developing world is set to rise.

“The longer-term outlook for the refining sector is… uncertain,” points out Fitch. “Excess refining capacity, structural decline in fuel consumption because of growing engine efficiency and environmental policies, and stronger competition from new refineries in emerging markets are likely to put pressure on the European refining sector in the medium to long term.”

Pletser argues the mooted competition from the Middle East, Asia and Russia is being overstated. In addition, “most problems in European refining are further west,” he claims. “Consumption in Central and Eastern Europe is still expanding, and Poland is short of fuels.”

Czyzewski sits somewhere in the middle, but clearly sees Europe’s downstream industry on a one-way street. “To 2040 we see European demand climbing by as much as 50%, therefore there is demand for additional refining capacity,” he concedes. “However, you need refining margins of $8-10 to build new capacity. High energy and labour costs in the EU make it very hard to compete with the new capacity that will be coming online.”

“We are prepared for the fact that poorer European refiners will go under,” he sums up. “PKN’s strategy is to be very cost effective and energy efficient, and invest in technology to give us a competitive advantage.”

Foreign (mis)adventures

The shorter-term tactic, however, is to hedge against the inevitable rise in crude prices by buying production assets. Flush with cash, PKN, its smaller Polish rival Lotos Group and other refiners around the globe have been busy in recent months hunting for bargains upstream.

PKN acquired exploration assets both at home and in Canada in late 2015, to the value of around PLN1.5bn. The acquisitions added oil and gas production of 4,200 barrels of oil equivalent per day (boe/d) to the 7,000 boe/d it held at the start of the year. The company held virtually no production assets in 2013. “Due to the oil price, upstream companies are cheap at the moment and it’s a good time to buy,” Czyzewski states. “However, sellers aren’t keen of course if they can survive.”

The moves have been welcomed by many. One Polish equities trader on Twitter pronounced: “this year was a great moment for PKN Orlen to invest in upstream. Low oil prices + lots of generated cash...”

However, while Pletser admits that most refiners in the EU are owned by integrated companies – “they help balance one another” – he’s unsure of the strategy to go far afield. “I’m not sure of the rational – the added value – for the upstream acquisitions,” the analysts says. “Perhaps it makes sense in Poland where PKN has strong relationships and knowledge, but Canada? I think it may have been pushed politically.”

Certainly, it wouldn’t be the first time PKN has been nudged by Warsaw into make efforts to turn itself into an international giant. That saw it buying refining capacity in its home region in the mid-2000s. However, it was a misguided strategy that has caused the company no little pain. The Polish company has suffered huge losses through the crisis at both Ceske Rafinerska, operator of the Czech Republic’s two major refineries, and the Mazeikiai refinery in Lithuania. It wouldn’t be a surprise to see PKN look to take advantage of the current sweet spot to offload them, if it can.

Prague, as well as several local oligarchs, have been sniffing around Ceske Rafinerska for years. “PKN is looking at two solutions in the Czech Republic,” says Pletser. “Sell the refining business or develop the retail operation as it is doing in Poland. I think it would be open to sell if it got a strong offer and a good supply agreement for its retail.”

There are few options in Lithuania, however. Mazeikiai was one of the top refineries in the former Soviet Union and a prime hard currency earner. And Moscow’s nose was put out of joint when PKN bought it from defunct oil company Yukos in 2006. The Russian pipeline supplying crude to the plant was closed for “repairs” the same year, meaning the refinery has had to buy an expensive train ticket for the oil it takes in and the fuels and other products it sends back out. Vilnius has hardly helped, as it has juggled development of its transport infrastructure, and particularly the Klaipeda Port without allowing PKN to become involved.

The Lithuanian refinery is such a drain that the Polish owner mulled a shut down in 2014. “When margins are low Mazeikiai simply can’t compete,” admits Czyzewski. For the meantime, it’s working at 90% capacity, thanks to the margins boost, he points out.

“Mazeikiai is a great example of how not to do M&A,” laughs Pletser. “It would be best to sell, but that’s politically impossible. The only potential buyer would be Russian.”

Top retail dog

The problems in the traditional core business have pushed PKN to hunt for new opportunities. It’s found a lucrative new role as a grocer, turning its network of over 2,000 Polish fuel stations into convenience stores and launching its own brands of hot dogs and coffee.

“PKN has done very well with retail,” Pletser notes. “That business is bringing in PLN1.5bn per year right now. Practically everyone in Poland has had one of its hot dogs I should think – it made PLN50mn or so last year just on hot dogs! It is also now the biggest coffee chain in Poland, and PKN has by far the biggest retail profit in CEE.”

“We’ve worked very hard at expanding the retail offer at our fuel stations,” says Czyzeewski. “People buy petrol once a week, but if you offer other products, they may come daily – and the margins are far higher than on fuel.”

It already holds what it claims is the largest network of fuel stations in Central Europe, but is keen to expand its role as a shopkeeper. The company confirmed in January that it is eyeing Lukoil’s retail network in Latvia and Lithuania. It is also working to expand its roadside presence in Germany and the Czech Republic, although faces stiff competition in those markets from the likes of Hungarian peer Mol.

Efforts to leverage more value out of its Czech refining assets – held via subsidiary Unipetrol – include plans to build a large polyethylene unit at the Litvinov plant, which will be “among the most advanced units of this type in Europe”, PKN’s press office claims. The project is the Polish company’s largest investment in the Czech market and the biggest in the history of the country’s petrochemical sector, it adds.

Back at home, the urgent need for new, cleaner power generation capacity has not gone unnoticed at PKN’s Plock headquarters. In late 2014 the company approved a PLN1.65bn project to build a 600-megawatt (MW) gas cogeneration facility at its refinery in the town in central Poland. That will join a similar 463MW project in Wloclawek, which will feed power to chemicals unit Anwil as well as the refinery there. Around half the output from each should head out to the national grid.

But despite the chronic problems caused to Poland’s major industrial companies by the breakdown of the power system during heat waves in the summer of 2015, Pletser says he struggles to see the rationale for PKN to get involved. “I think the move into power is at least partially politically motivated,” the analyst remarks. “There are large risks in Polish power, while other EU gas-fired plants remain loss-making for the moment.”

That may explain why Czyzewski is clearly most excited by new projects that PKN is establishing to try to push innovation across all segments, including power. The company has set up an open source platform for a project that seeks to capture low temperature heat released during refining. Other technological challenges will use the same tool. “Our profit depends on global market conditions that we can’t control,” he says. “Therefore we need technological improvements to compete.”

While the open source project – as well as other innovative schemes that “cannot be talked about currently” – is in its infancy, Czyzewski insists PKN must continue to move onwards and upwards. “Dinosaurs were big with a small head, but it was still the most important part,” he laughs.

Of course, while PKN clearly knows it must change, the route it takes could yet suffer significant diversions – or even find the way barred. The change of CEO is one issue, points out Pletser. “The former team had been there for several years and was doing well,” he states. “Disturbing that management setup is a key risk for the company.”

However, that may be the least of it. The new government said in early January that it is studying a potential merger of PKN with Lotos and gas utility PGNiG. While that wouldn’t necessarily alter the strategy, it would likely extend PKN’s exposure to political decision-making.

Of the large state companies, PKN has traditionally been one of the most distant from Warsaw. However, gas is a far more vital issue for the country’s energy security than fuel.