Jaroslaw Adamowski in Warsaw -

Four years after PKN Orlen bought the only Baltic refinery Mazeikiu Nafta, Poland's leading oil and gas company is still struggling to turn the €1.9bn purchase into a profitable investment, leading to widespread speculation about a possible resale of the Lithuanian plant to a Russian company.

In the first quarter of this year, the refinery's loss widened to €23m from €14.5m in the same period of 2009. But PKN Orlen's troubles with the refinery go back to 2006 soon after it was purchased from the Lithuanian government and now bankrupt Russian oil company Yukos when Russian oil stopped flowing to the refinery by pipeline and a fire broke out. Russia blamed the halt of crude supplies on a rupture to the spur from the Druzhba oil pipeline that feeds the refinery; Russian state-owned pipeline monopoly Transneft has denied blocking deliveries on purpose even though it hasn't resumed supplies in four years. However, given the Kremlin was frustrated it couldn't expropriate the refinery from the previous owner Yukos like it had that oil company's other assets and expressed anger when the Lithuanian government didn't choose a Russian company in the subsequent tender, the general impression in Lithuania and Poland is quite different.

"Orlen overpaid for Mazeikiu, which was originally designed as an export-oriented refinery for the Soviet crude," says Andrzej Sikora, president of the Energy Studies Institute, a consultancy in Warsaw. "Ever since Russian oil stopped flowing via the Druzhba pipeline four years ago, the plant has been entirely dependent on supply by sea. Given that Mazeikiu is an inland, not seaside, refinery, adapted for crude delivery through pipeline, the shift in supply source simply had to skyrocket the costs of refining."

Further weighing on Mazeikiu's performance have been the deep recessions that all three Baltic states have suffered during the global economic crisis. Approximately 50% of the refinery's 10.3m tonne annual output is sold in the three countries, but in 2009 demand for petroleum products in the Baltic states dropped by over 22%. Consequently, in 2009 Mazeikiu refined only 8.4m tonnes of crude compared with 9.6m in 2008. PKN Orlen decided to cut Mazeikiu's production capacity to just 68% in the first quarter of 2010; in the same quarter last year this rate was at 86%. "Cut off from pipeline deliveries, Mazeikiu has lost a large part of what previously established its competitiveness," says Andrzej Szczesniak, former CEO of Lotos Partner, another Polish fuel retailer. "A combination of costly transport, expensive crude and very low refining margins could be lethal for Mazeikiu."

Sikora also notes that the way the refinery is managed is confused, which is leading to problems. "There are two management models for refineries: the German one, in which the state remains a key shareholder, but also controls the level of refining margins; and the entrepreneurial one, in which the state withdraws from the market, but at the same time doesn't interfere in the pricing policy," he says. "Orlen's situation is somewhat hybrid, as Poland's Treasury owns only a 27% stake in the company, but maintains a major political influence over its operation. And such a state of affairs isn't either in Orlen's or in Mazeikiu's best interests."

Pipe dreams

Mazeikiu's sale to a Russian company would probably solve the problem of pipleine supplies to the refinery. However, such an outcome would boost competition on the region's petrochemical market and for PKN Orlen, which owns another three refineries in Poland and two in the Czech Republic, would therefore see its profits hurt in the long run. "Sold to a Russian company and reconnected to the pipeline, Mazeikiu could become a groundwork for its new owner's expansion in Central-Eastern Europe," says Szymon Araszkiewicz, chief analyst for the E-Petrol consultancy.

Three Russian oil giants are said to be interested in Mazeikiu: TNK-BP, Lukoil and Surgutneftegas. However, given that selling a majority stake in Mazeikiu is not PKN Orlen's preferred option, TNK-BP, which so far has shown the greatest flexibility on this matter, would appear to be the most probable buyer. "If Orlen will be interested in gaining a strategic partner for the [Mazeikiu] refinery, we will be open to talks," German Khan, TNK-BP's executive director, told journalists in May.

Acquiring a major stake in the refinery would advance TNK-BP's wider strategy of further emphasizing its downstream business. TNK-BP already boosted its presence in the Ukrainian downstream sector with the increase of its stake in 2009 in the Lysychansk refinery, which has a capacity of 8m t/y. As PKN Orlen hopes that a Russian partner could help relaunch crude delivery to Mazeikiu via the Druzhba pipeline, it is not without importance that Prime Minister Vladimir Putin is said to endorse TNK-BP's move into Mazeikiu.

The chances of the other two firms taking an interest in Mazeikiu are slimmer. Lukoil CEO Vagit Alekperov said a few months ago that his company was not interested in venturing into Mazeikiu, while another discussed option is an exchange between PKN Orlen and Surgutneftegas involving a 25% stake in Orlen Lietuva, the sole owner of Mazeikiu, in return for Surgutneftegas' 21% stake in Hungary's Mol Group, which the Hungarian firm and its government are trying to wrestle back from the Russian firm. But so far, the TNK-BP scenario remains the most likely for Mazeikiu.

However, as Araszkiewicz of E-Petrol notes, "The eventual resale depends on the outcome of Orlen's negotiations with the Lithuanian government." Given the latter didn't want to have a Russian firm involved in Mazeikiu four years ago, the outcome of PKN's talks with the government remain a big question.