PKN Orlen: Mazeikiu Nafta and what’s next?

Maciej Janiec

ReAKKT Newsletter 2006-05-29

Acquisition of Mazeikiu Nafta by Orlen may be the first step to consolidation in the region. The deal should also increase energy security in Poland and Lithuania.

On Friday, May 26, PKN Orlen inked a conditional agreement with Yukos International UK BV to acquire a 53.7% stake in AB Mazeikiu Nafta for  $1.492 billion.  Orlen is also obliged to acquire a further 30.7% stake in the company from the Lithuanian government for $851.1 million.  This deal values the Lithuanian oil company at $2.778 billion, which is 22.7% above its market capitalization. The agreement is the last step in the 10-month long wrangling, during which Orlen competed against TNK-BP, a British Russian joint-venture, and KazMunayGaz (Kazakhstan), to acquire Mazeikiu Nafta. Also Rosneft from Russia was interested in taking over Mazeikiu Nafta.

By acquiring the Lithuanian company, the Orlen Group will become the largest oil company in the Central Europe, in terms of output capacity (31.7 million tons annually vs. 23 million tons at OMV and 21 million tons at MOL), number of service stations (2,732 vs. 2,451 and 834, respectively) and revenues ($17.251 billion vs. $15.580 and $12.321 billion, respectively). But in terms of capitalization (about EUR 8.5 billion – assuming 63% share in Unipetrol and 84.4% share in MN), the Polish company will still lag behind its regional competitors – OMV from Austria (EUR 14.1 billion) and MOL from Hungary (EUR 9.2 billion):

Figure 1 Comparison of market capitalization of selected Central European companies in the oil and energy industry

Source: custom analysis based on stock exchange data

Orlen intends to spend approx. $2.8 billion in total to acquire the Lithuanian company. The deal should be financed by company’s cash reserves ($200 million), existing credit lines ($800 million), as well as new credit lines and the issue of debt securities ($1.8 billion in total). This expense could put some strain on the financial situation of the Polish company.

When the agreement was announced, Fitch, the rating agency preparing evaluations of Orlen’s debt, informed that it would put Orlen on its watch list. The current Orlen’s debt rating is BBB with negative prospects. Should the rating be lowered, its securities would fall into the “junk bonds” category, which would affect the cost of debt management and the ability to acquire further capital.

Orlen should not rather count on Mazeikiu Nafta’s profits ($336.1 million in 2005, $261.1 million in 2004) to achieve quick return on its investment, as the majority of future profits will have to be used to finance the investment program, estimated at $720 to $950 million over the next five years.

As a result, acquisition of Mazeikiu Nafta will lead to at least temporary worsening of Orlen’s financial situation. In a presentation discussing the transaction it is mentioned that  the net debt to EBITDA ratio for the capital group could temporarily increase to over 2.5. Assuming operational turmoil during the group consolidation (frequent case during acquisitions) and possible further weakening of the market environment (oil prices, refinery margins, Brent-Ural differential), the period of Orlen’s weaker financial standing may last longer than the management expects. So is it worthwhile to take such risks? It seems that Orlen had no choice.

The majority of analysts, commenting on the acquisition of the Lithuanian company by Orlen, noted that this deal has been of strategic importance for the company from Plock. The Lithuanian refinery with its processing capacity of 12 million tons is located just 180 km from the Polish border. Currently it processes almost 10 million tons annually, while Lithuania utilizes close to 3 million tons of fuels. The remaining output is exported – to Latvia, Estonia and Poland.  By acquiring Mazeikiu Nafta, any of Orlen’s competitors, having its own sources of crude oil (i.e. a company from Russia or Kazakhstan), would achieve a very favorable position to sell its fuels in the Orlen’s home market. The competition would probably happen at the price level, which would adversely affect Orlen’s margins.

Orlen has been implementing the strategy of defending its market by acquiring the neighboring refinery assets.  It had similar goals – to stop the import of cheaper oil to the southern Poland – when it acquired the Czech Unipetrol in June, 2004.

And it is rumored that in December, 2005, Orlen was interested[1] in acquiring a 32.9% stake in the Ukrainian refinery Drohobych, located close to the Polish border. This refinery has processing capacity of 3.22 million tons annually (with utilization rate of 67.9% in 2004 and 50% in 2005H1) and its market valuation is $297.7 million[2].

Acquisition of Mazeikiu Nafta, which enables Orlen to “cover its north-eastern flank”, fits this operational scheme, aiming at protecting Orlen’s position in the Polish market. Orlen could either outbid its competitors (according to some press reports it offered the highest price), even at the cost of temporary deterioration of its financial parameters, or it could risk the exhausting price war, with no prospects of winning it without access to its own sources of oil.

Apart from the above-mentioned Ukrainian refinery, the only remaining assets in close proximity that could be of interest to Orlen in the future, are the Belarusian companies – Mozyr and Naftan refineries. Both of them are under control of government institutions: the first one is controlled jointly by Byelorussia and Russia, while the latter only by Byelorussia, but Russian LUKoil is interested in acquiring it. By the end of April, it has established a joint-venture with Naftan, which could be the first step to taking over control over the refinery[3]. The future of both Belarusian refineries depends on political relations between the governments of Byelorussia and Russia. But the acquisition of any of them by Orlen seems highly unlikely in the near future.

Figure 2 Close geographical environment of PKN Orlen

Source: based on „PKN Orlen Strategy Update 2006-2009”, PKN Orlen S.A., 2006-01-10, slide no. 15

But there is yet another company close to Orlen, with interesting refinery assets – the Lotos Group. After acquiring Mazeikiu Nafta, Orlen will strengthen both its position in the northern Poland, where Lotos’ operations are focused, and its export capacity in directions that would put it in direct competition with the Gdansk company. Under such circumstances, it will be much easier for the Orlen board to convince the Polish government, which holds both a 27.5% stake in Orlen and a 58.8% stake in the Lotos Group, that this domestic competition makes no sense and that it would be wiser to establish a “national champion”, which could truly reach a significant position in the region. Such arguments could be viewed favorably by currently ruling politicians, who are interested in strengthening national companies.

Merger of Orlen and Lotos makes sense for one more reason. Lotos, via Petrobaltic, has experience in extracting crude oil in the offshore projects, which could prove useful for Orlen, which is lacking extraction operations.

Any Orlen’s plans connected with the extraction of crude oil have been rather vague so far. According to the company’s strategy for years 2006-2009, updated in January, Orlen plans to gradually accumulate reserves and acquire minority stakes in extraction projects. During a teleconference for analysts on company’s Q1/2006 results, Igor Chalupiec, CEO of Orlen, said that “he considered several projects, a few of them very seriously”. They were supposed to be located in Kazakhstan, Russia, Africa and Iraq. First decisions in this regard could be made on the turn of 2006 and 2007. It is not clear how these plans would be affected by the acquisition of Mazeikiu Nafta and the resulting financial burden for the company from Plock. But the cooperation of Orlen and Lotos on crude oil extraction could still be helpful in winning interesting projects.

The combined groups of Orlen (including Mazeikiu Nafta and Unipetrol) and Lotos would have market capitalization of almost EUR 10 billion, which would be equal to the valuation of MOL from Hungary. In theory, it would facilitate merger of the Polish and Hungarian companies on equal terms, which has been considered for a long time. Should such a merger come true, a regional giant would be established, with valuation close to EUR 20 billion and operations in Poland, Hungary, Lithuania, the Czech Republic, Slovakia and Germany. The plans of creating a regional fuel company would eventually be fulfilled. Without acquisition of Mazeikiu Nafta by Orlen and the resulting increase of the Orlen Group’s market capitalization, it would be much more difficult to merge the Polish and Hungarian companies.

Establishing such entity may be justified by the need to improve energy security of the region by counterbalancing the demand side against the increasing power of the Russian companies, which are major suppliers of crude oil for Central European companies.  Concentration of companies purchasing oil and the resulting ability to coordinate their provisioning activates would increase the interdependence between both parties of the trade. It would also block Russians from following the divide and rule policy, which aims at playing customers against each other, by offering them varying terms for oil supplies.

Another company that used to be considered as a partner in regional consolidation is OMV from Austria. The Austrian government holds a 31.5% stake in the company, while IPIC – the investment vehicle controlled by UAE’s government, holds further 17.6%. The company, with its market capitalization of EUR 14 billion, is significantly larger than its Polish and Hungarian counterparts – see Figure 1 Comparison of market capitalization of selected Central European companies in the oil and energy industry

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Additionally, on May 10, 2006, an agreement was reached to merge OMV with Verbund, the largest electric energy generation company in Austria. Combined value of OMV Verbund AG would exceed EUR 25 billion. The Austrian government and IPIC would hold a 45% stake in the new company. According to analyst and media speculation, the primary reason for this deal was to create a company, which would be a much more difficult target for a hostile takeover by a foreign company.

Even though the merger has not yet been carried out due to objections of regional authorities, negotiations in this regard could be resumed after parliamentary elections in Austria, due in October/November this year. Neither Orlen or Mol alone, nor the two companies combined could become a partner on equal terms for OMV Verbund AG. Furthermore, the integrated Austrian company, operating both in the fuel and energy markets, would differ significantly from its counterparts in Poland and Hungary.

Oil supplies for the Lithuanian refinery could be an important risk factor in the acquisition of AB Mazeikiu Nafta. The refinery in Mazeikiu is supplied in oil by a branch of the Russian „Friendship” oil pipeline. It belongs to Transneft, a company under the Kremlin control.

It is supplies problems that forced the American company Williams International Co., which acquired a stake in the Lithuanian company in 1999, to sell it three years later to Yukos from Russia. Guarantee of oil supplies was one of the more important issues for the Lithuanian government during negotiations on selling the company. As Orlen has finally managed to get the deal approval, it must be assumed that it present strong arguments to support its claims that it would be capable of delivering, even in case that Russians are upset about selling the Lithuanian company to Poles.

In theory, talking business-wise, Russians should not cut off supplies to a customer, which alone is utilizing 26 million tons of crude oil annually (utilization of Orlen, Unipetrol and Mazeikiu; additional export via the Butinge terminal amounts to 6.12 tons – data as of 2005) and is affiliated with other companies, utilizing further 45 million tons of oil (Lotos Group, PERN). To put it in perspective, total exports of the Russian crude oil amounted to 251.5 million tons in 2005. By consolidating companies using Russian oil, Orlen is effectively increasing the interdependence between itself and the Russian fuel complex, which should ensure security of supplies. But the Russian oil companies, controlled by the Kremlin, do not necessarily have to follow solely business criteria.

But judging from comments by Sergei Grigoriev, vice president of Transneft, and by dealers trading the Russian oil, it seems that there is a significant probability of suspending supplies to Mazeikiu Nafta. Apparently, Orlen has not yet discussed the issue of supplying the Lithuanian refinery with either Transneft or the major Russian oil producers. But one should also take into account that Orlen is purchasing oil for its refineries primarily my middle-man companies, such J&S Group and Petraco.

Under provisions of a contract signed on September 29, 2005 and effective as of this year’s beginning, Orlen has become the sole supplier of REBCO oil for refineries belonging to Unipetrol. One could expect that a similar agreement will be signed with Mazeikiu Nafta, after the acquisition transaction has been finished. It means that Orlen will have to purchase larger quantities of oil to meet the needs of its enlarged group and will probably ask its current partners for support. They have experience both in provisioning the Russian oil and in booking bandwidth in the Transneft’s transmission system.  Another incentive for traders could be the opportunity to increase exports of the Russian oil to the Western Europe and the United States via the Butinge terminal. So, as paradoxically as it may seem, given some opinions about these middle-man companies, they may play a key role in ensuring security of supplies to Lithuania.  It is hard to imagine that Orlen would not discuss with them the option of supplying oil to Mazeikiu and that it would not include elements of cooperation with J&S Group and/or Petraco or other middle-man companies in the supplies variants presented to the Lithuanian government.

But the Russian government will have the last word. Transneft, controlled by the Kremlin, may refuse to send oil to Lithuania or make it much more difficult for every other company, middle-men included. The question arises whether staging a war against the EU company, which Orlen undeniably has become, and the related scars on the image of a credible supplier of fuels, oil in this case, is the price that the Russians would be willing to pay in order to attempt to forcefully block the sale of the Lithuanian company, given that they have little chance of success under current conditions.  There is no doubt that Orlen would be capable of unwinding a powerful negative media campaign in the Western Europe, while launching emergency supplies via Butenge (Mazeikiu Nafta could even still receive the Russian oil, but via a roundabout route through Naftoport in Gdansk), which could at least partially maintain the Lithuanian refinery operational (86% of utilization from 2005; 67% of nominal processing capacity). Further calls for diversification of supplies of energy fuels to the EU could also adversely affect other Russian projects conducted in Europe and long-term sales of Russian raw materials to the EU.

As much as blocking oil supplies to Lithuania could be awkward for the Russian oil companies, it is much easier for Gazprom, the Russian gas monopolist, to justify price increases of its fuel supplied to Lithuania. Already in the early May this year Gazprom has announced an increase from $105 to $135[4] for 1000 m3 of gas, effective as of July 1, 2006. It is still much less than $250-$280 that companies from the Western Europe are charged. After „losing” Mazeikiu Nafta, Russians will have less incentives to maintain lower gas prices in the Baltic countries. And it would be significantly easier to justify subsequent price increases as a way of adjusting them to free market conditions than to block oil supplies to the Lithuanian refinery. Scale and pace of further gas prices increases may depend on how interested the Russians are in maintaining favorable terms of oil transit through Lithuania and exporting it to the Western market via the Butinge terminal.

When discussing the security issues related to the deal, one provision of the proposed agreement between the Lithuanian government and Orlen is worth mentioning. It states that the Lithuanian government has the right to buy back a stake in Mazeikiu Nafta from the Polish company, should over 50% stake in Orlen become under control of any entity that might be considered as endangering the national security of Lithuania. It means effectively that the national interests of Poland and Lithuania in regard to energy security are tied together. In case of any attempts of hostile take over of the extended Orlen Group, the potential bidder will have to take into account that the group might be decomposed. It may be expected that any future consolidation deals (i.e. acquisition of Lotos or merger with MOL) would be covered by similar security mechanism, which gives politicians the right to decide on the company’s structure, regardless of the stake that the Treasure holds in its equity.

Even though acquisition of AB Mazeikiu Nafta by Orlen will temporarily weaken Orlen’s financial standing, this transaction is still of strategic importance for the company. First of all, it will protect its domestic market against competition. Secondly, it should facilitate negotiations to acquire the domestic competitor – the Lotos Group. Thirdly, it may be an introduction to a further consolidation, i.e. merger of Orlen with MOL from Hungary, which has been planned for years. And lastly, combining Orlen and Mazeikiu Nafta forces will contribute to improved energy security of Poland, Lithuania and the entire Central Europe. The greatest concern is still whether the new company will have direct access to oil resources.