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A desperate swim upstream

Poland's largest oil firm is pressing on with its long-delayed plan to turn itself into an integrated oil company less dependent on Russian crude. However, there are questions over its finances and whether it has the management ability to achieve this end, writes NJ Watson

DAYS AFTER Polski Koncern Naftowy Orlen (PKN) signed up to take over Lithuania's Mazeikiu Nafta, the Baltic region's sole refiner, it appeared ready to take another step in its international expansion by buying a stake in Slovakia's Transpetrol.

Although yet to comment officially, sources close to PKN say the company is closely following the sale of a 49% stake in the Slovakian pipeline operator, after a preliminary $103m deal to sell it to Russia's Russneft expired 90 days after the deal was struck in February. PKN had previously expressed interest in buying the stake when it was put up for sale by Yukos at the start of the year. Russneft was Yukos' preferred buyer until the Slovakian government, which holds the other 51% of Transpetrol, went off the idea in May.

Slovakia has not publicly stated the reasons for its backtracking, but observers claim the sale became tangled up in widely held regional fears about over-dependence on Russian oil and gas. Transpetrol manages the Slovakian section of the Druzhba pipeline, which carries about 10m tonnes a year (t/y) of Russian crude to Central Europe.

PKN's renewed interest in Transpetrol has been spurred by its surprise $1.49bn triumph in the auction for another Yukos asset, its 53.7% stake in Mazeikiu Nafta. PKN has also agreed to buy a 30.7% stake from the Lithuanian government for $0.85bn.

The firm hopes to complete the acquisition of the combined 84.4% stake in the first quarter of 2007, when it will make a public offer to buy out the remaining minority investors in Mazeikiu – which controls the 13m t/y Mazeikiai refinery, the Butinge crude-export terminal and Lithuania's crude and products pipelines. The agreement also gives PKN the right to buy the state's remaining 10% stake for $278m during the next five years.

The acquisition of Mazeikiu is a milestone for PKN. Until now, the firm has been largely unsuccessful in its international strategy compared with its regional peers, completing only one sizeable transaction – the purchase of the Czech Republic's Unipetrol in 2004.

PKN's goal of full integration will culminate in buying stakes in foreign oilfields, Igor Chalupec, PKN's president and chief executive, told the Financial Times (FT) in June. "After the purchase of Mazeikiu, oil extraction will become our priority for expansion," he said.

In this regard, PKN is following its regional competitors, such as Hungary's Mol and Austria's OMV, which have already snapped up rivals to become major vertically integrated regional players.

However, some experts are questioning whether it was wise for PKN, the region's largest downstream company, to spend such a large amount on Mazeikiu. The Lithuanian firm will help beef up PKN's presence in Central and Eastern Europe, but it will also increase its dependence on Russian oil – something the Polish government is trying to reduce. Arkadiusz Wicik, an analyst at Fitch Ratings in Warsaw, reckons Poland will be buying more than 10% of Russia's oil exports after this acquisition.

A defensive move
Analysts say the Mazeikiu deal is mainly a defensive move, because if the refinery had fallen into the hands of a Russian state-backed company, it could have disrupted the oil market in the Baltics and even Poland.

Furthermore, after a sustained period of consolidation there are few significant energy assets left in the region to buy. The next major company up for sale is Serbia's Naftna Industrija Srbije, which is receiving interest from Lukoil among others.

Analysts say PKN's renewed interest in Transpetrol could be a way to try to deal with its growing dependence on Russian crude. "Control of Transpetrol would give PKN additional leverage in any dealings with Russian oil firms, which have been surprised to see the company move in on what is considered Russian oil turf," says Andrew Neff, an energy analyst at Global Insight.

Indeed, that unrequited Russian interest in Mazeikiu, particularly from Lukoil, has given rise to worries about whether Russia may play politics with the acquisition and disrupt supplies to the refinery, forcing a renegotiation in the sale terms. During the initial privatisation of Mazeikiu, in 1999, the government, fearing the sale of a 53.7% stake in Mazeikiu to Lukoil would give Russia too much influence over the oil sector, blocked the deal and sold the stake to the US' Williams.

Russian oil firms retaliated by withholding crude supplies, forcing Mazeikiu to operate below capacity, while debts at the refinery mounted. "It was only in 2002, when Lithuania approved Williams' sale of its stake to Yukos, that Mazeikiu was brought back from the brink and returned to profit," says Neff.

However, PKN has convinced Lithuania's government over the stability of oil supplies and Chalupec says: "There is no doubt about crude supplies to Mazeikiu. We are convinced they will come from our traditional suppliers." Some analysts share his confidence. Wicik says that while it is impossible to rule out a disruption of supply, any such trouble is likely to be temporary. "PKN is a strategic oil buyer for Russia," says Wicik.

Political patronage and meddling
What is less clear to analysts is the ability of PKN to integrate such a major acquisition. Not only has it little experience in these matters – it is just completing the first stages of restructuring and integrating Unipetrol – but it has also been a perennial victim of political patronage and meddling. Successive governments have used the state's stake to appoint political allies to its board, hampering PKN's ability to act independently

Chalupec, a respected banker, was brought in as chief executive in August 2005 to bring some financial discipline to PKN's expansion strategy. Investment decisions made under the previous chief, Zbigniew Wrobel, were regarded by many as overly optimistic, in particular PKN's investment in the German retail market.

PKN has said it would consider selling its German network of more than 500 stations if it is unable to increase its market share to 10%, from 7%. Analysts claim the purchase was conducted mainly to satisfy PKN's desire to become bigger, rather than to meet any strict profitability targets.

Even so, PKN has paid a full price for control of Mazeikiu, leaving some analysts to question whether the Polish government's wish to make PKN an integrated oil firm less dependent on Russia is overriding investment decisions that should be based on sound economics.

With PKN committed to making large investments to upgrade Mazeikiu's facilities, as well as buying large stakes in expensive oilfields, the company's balance sheet is expected to come under increasing strain.

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