NIS – From Sluggish Monopolist to Modern Player in the Balkan Market

Kirill KravchenkoInterview of Kirill Kravchenko, Director General of Oil Industry of Serbia

Moscow, May 18, 2010. Interfax.

At the beginning of 2009, Gazprom Neft purchased a majority shareholding of the Serbian NIS. In an interview with the Oil Information Agency, Director General of NIS Kirill Kravchenko talks about NIS achievements under the new shareholding structure and about the company’s strategic plans.

INTERFAX: What is your estimation of the company’s work in 2009 – what was the major achievement and what were the major difficulties?

K. KRAVCHENKO: To my mind, on the whole, 2009 was successful for the company. We managed to improve the company’s operational results considerably. A lot was done in terms of restructuring the credit portfolio and decreasing NIS's bank debt. And, what is especially important, we managed to achieve a stable positive operational cash flow of 17.4 billion RSD, which enabled us to carry out 90% of our investment program. Whereas in 2008 the operational cash flow was negative – around 15 billion RSD. At the same time, the expenses decreased considerably.

We have carried out a number of production improvements – we have begun a program of modernization of the oil refining complex in Pancevo, we have increased output of lead-free gasoline and launched stable production of Euro diesel at the facilities of our OR at a rate of 25 thousand tons a month.

For the first time over the last 17 years, we have managed to increase the oil production rate. As of the end of 2009, NIS's oil production rate totaled 990 thousand tons, average daily production rate increased by 40%. In the upstream division, we especially focused on developing our own oil field services. Today, we are not only capable of covering our own needs, we can also render services to third-party companies. For example, our specialists are participating in the reconstruction of Banatski Dvor and are also involved in projects of the British-Arabian company Dragon Oil in Turkmenistan.

The most difficult part, in my opinion, was the process of setting up an effective management system which means not just forming a management team, but also implies creating new tools. This was the first thing we began with. At that stage, we did not have full information on the state of the company. The scale of the problems at the audit stage appeared to be much less.

We have begun the process of transforming the corporate culture. Historically, NIS employees are used to frequent turnover of management teams who were more politically minded instead of focusing on efficiency. At present, the whole motivation system in the company is focused on evaluating the result, not the process.

It seems to me that a good foundation has been laid for further transformations of NIS from a sluggish state monopolist to a company that in the near future will be able to compete with the major players in the oil market of the Balkans.

I would say that another achievement of 2009 was setting up a development strategy for NIS development in the near term – 5 years.

INTERFAX: What were NIS’s financial results in 2009? What is your estimation of it?

K. KRAVCHENKO: As of the end of 2009, we managed to reduce losses incurred in January and February prior to the arrival of the new team by 11 billion RSD – the company’s annual negative result in terms of business activity totaled 4.4 billion RSD. In the last three quarters of past year, despite the difficult macroeconomic situation, we managed to make a profit. Nevertheless, we had a lot of extra expenses on which we spent the profit. First of all, this was a voluntary termination program for employees as part of our obligations under the social program - 2.9 billion RSD.

Throughout the year, we worked with independent auditors with a view to finally revealing those "skeletons in the closet" that had piled up over the years of NIS’s activities. In April we submitted the company’s annual financial report and the official auditor’s (PwC) conclusion to the Serbian Business Registers Agency. In the financial report as of the end of 2009, the company’s loss was recorded as 33.6 billion RSD more than the business result - at the level of 37.6 billion RSD.

The reason is that the final accounting report contains corrective amendments called for by IFRS. The major corrective amendments of the business result are associated with the requirements of IFRS for creation of reserves for “bad” debts, reassessment of the property base and litigation provisions. We had to create “bad” credit debt reserves of around 12 billion RSD for state companies such as Petrochemia, JAT and Serbiagaz.

I believe that in the future, the size of the “accounting” loss may be reduced due to settlement of legal disputes and reversal of a number of other obligatory financial provisions successful for the company.

INTERFAX: What is your estimate of the process of plant modernization that started in 2009? What are the main tasks of the modernization program for 2010?

K. KRAVCHENKO: Within the framework of implementing the modernization program, we have complied with all the obligations set by the purchase and sale contract. But, theoretically speaking, we could do a lot more. This is also because, in particular, we faced certain problems at the initial stage. For example, the quality of preparation of the design documentation proved to be far worse than it appeared at the audit stage.

Besides construction of a hydrocracking complex stipulated by the purchase and sale contract, we made a decision to build a hydrogen unit. To date, site preparation has already been completed and in the near future we will start construction.

INTERFAX: What are the planned performance figures of the business plan for 2010?

K. KRAVCHENKO: In 2009, our major task was the stabilization program. The year 2010 should become a year of major qualitative breakthrough in development – our investment program has tripled as compared with the last year - up to $373 million USD; the bulk of this amount will be spent on reconstruction of the plant in Pancevo and the rest (around 118 million USD) on production and development of the retail chain.

We have coordinated the business plan with the five-year strategy. In 2010, we are planning to increase all production indicators - oil production will be increased by 12%, reserves by 8%, and output of Euro diesel will be increased by over one-third. In addition, considering the overall state of the Balkan market for oil products (for example, according to our estimate, the Serbian fuel market in 2009 shrank by 20%), increasing the sales volume will become one of the main and most ambitious tasks of this year.

For the first time in history, this year we will have stable growth of production and a qualitative change of the output oil products – we will considerably increase the output share of high margin products that comply with European quality standards.

For qualitative and effective development of the company, we need investments, of course. Therefore, one of the major challenges of 2010 is how effectively we will be able to control our own expenses and operational activity. Hence, the major objectives on which we are focusing – cost saving, increasing the efficiency of our production processes due to a continued increase in production and optimization of the production program, as well as sales system development.

Our retail network today includes 474 gasoline filling stations in Serbia. In order to comply with modern quality standards in terms of services, we began to implement a program of reconstruction and construction of new gasoline filling stations in 2009. Over the last two months, the company has opened three new and reconstructed gasoline filling stations in different regions of the country.

All-in-all, in 2010, around 60 gasoline filling stations located on important thoroughfares are planned to be fully or partially reconstructed. Besides sales of Euro diesel and lead-free gasoline, we will develop auto gas sales – we are planning to launch up to 150 outlets to sell this fuel.

The main task of the business plan for 2010 is maximum preparation of NIS for hard times after liberalization of the oil product market, which will take place in Serbia next year.

On the whole, I would call the business plan for 2010 difficult but realistic, and, what is important, it corresponds to our strategic goals.

INTERFAX: What are NIS’s plans for business geography expansion? What assets and forms of cooperation in the region is NIS interested in at the moment?

K. KRAVCHENKO: As one of the tools for expanding the scale of our business, our strategy envisages the possibility of establishing joint ventures or strategic alliances with partner companies not only in Siberia but also beyond it. At present, we are studying partnership options in the region for organizing sales of our oil products, of which we will have a surplus, especially after modernization.

Within the framework of developing upstream projects, in the middle of April we signed a memorandum of understanding with a subsidiary of Zarubezhneft in neighboring Bosnia; the memorandum envisages joint work on a study of the sites located in this country. A working group has been set up for the project; it includes representatives of both NIS and Zarubezhneft. In future, according to the results of geological exploration operations, we will make a decision on the possibility of cooperation in the upstream.

INTERFAX: What financial performance figures are expected in 2010? Are any loans planed or are shareholder investments enough for the company?

K. KRAVCHENKO: The year 2010 should become the first profitable year for NIS over the last few years. According to our forecast estimates, net profit as of the end of 2010 will be around 1.9 billion RSD. The company’s own production growth, reduction of expenses in all business areas, as well as an increase in the share of high margin products in the sales product mix and development of sales channels, should play a key role in increasing its current profitability.

We are not planning new loans in 2010. First of all, the company will focus on increasing its own efficiency and reducing current bank debt.

INTERFAX: One of the main tasks of NIS for the next year is preparation for liberalization of the oil product market in Serbia in 2011. What is being planned in this line?

K. KRAVCHENKO: The algorithm of actions in this case is both simple and complicated. We must optimize expenses as much as possible and ensure stable output of the maximum possible quantity of products complying with European standards.

Of course, we have to actively develop the most profitable business segments. First of all we will develop our production, which will enable us to gain additional funds for investments.

We are facing important work on standardizing the quality of oil products in the local market. Neither consumers nor the government nor NIS are interested in an influx of “gray” imports to the Serbian market, because they damage cars and are environmentally hazardous. It is also a serious economic hazard for such major market players as NIS, OMV and LUKOIL.

INTERFAX: What are the main performance parameters of NIS’s strategy to 2014?

K. KRAVCHENKO: In compliance with the strategy that we elaborated, the key objective of NIS to 2014 is transformation into an international company capable of competing in the South European market. We must become the fastest growing regional player in the Balkans in basic performance factors, i.e., volume of production, refining and retail sales, while at the same time remaining the leader of the Serbian market.

In view of all this, I would say that balance is the key feature of the future NIS. NIS is a vertically integrated company and this means that we have to pay attention to developing all the business segments –from production to sales.

If we go into greater detail about business segments, by 2014 we are planning to increase the production volume by 40% and hydrocarbon reserve volume by 20%. Due to completion of reconstruction of the Pancevo OR, we will increase the refining volume by a factor if 1.5 and the bulk of the output products will comply with European quality standards.

We are planning to considerably improve the sales organization system, increasing not only market share, for example, in the wholesale segment from 60% to 75% and in the retail sector from the current 25% up to one third of the market, but also the effectiveness of each individual sales unit. For example, if we increase the pumping rate through one gasoline filling station from 3.6 tons to 6.3 tons of oil products per day, this will correspond to the level of a good European gasoline filling station.

Of course, one of the focuses of our strategy for 5 years will be internal efficiency. We have given this issue special consideration by setting up reference points for each business segment. This concerns both production where we must reduce unit costs for lifting liquid by over 40%, as well as refining and sales, where we are planning to reduce unit costs by 50%.

All this will help us to achieve the set goal – to become the most efficient oil company in the Balkans.

INTERFAX: What investments will the company have to make in implementing the strategy and what are the sources of financing for it?

K. KRAVCHENKO: In terms of the scale of investments, without considering M&A deals or new production projects, implementation of the strategy will cost us around 100 billion RSD.

Almost half of the amount will be spent on modernization of the refining facilities and environmental projects, financing of which at the expense of Gazprom Neft is stipulated by the NIS purchase and sale contract. The remainder is our own capital investments, which we hope to gain due to improving the efficiency of our own activity – increasing production and improving the sales system.

As we are planning to reduce the amount of the bank debt, I can say that we must control our expenses, increase efficiency, creating added value and earning money for the investment program.

INTERFAX: The Serbian government carried out free distribution of 19.34% of NIS’s shares among the population. It is expected that open sale of NIS’s shares on the Belgrade stock exchange will start this year in June. What advantages will NIS gain as a result of changing the form of ownership?

K. KRAVCHENKO: First of all, I would like to emphasize that 2010 has been an unprecedented beginning for us – on January 6, we became a company with almost 5 million of shareholders, which naturally imposes additional responsibility on NIS.

In the short run, institutional investors will start to show an interest in our company. I am sure that we will be able to provide our minority shareholders and the investment banking community with convincing proof that the company is stable and NIS has potential for increasing in value.

Additional requirements arise to the system of control and decision making as well as to the quality of information control and transparency of business. We began to prepare ourselves for new reality last year in summer. I believe that we will manage to enter the Belgrade exchange without damage to the company’s core business.

Gazprom Neft is a strategic, that is to say, long-term investor and we are considering the cost of shares in the long-term outlook. We can expect that, in the short-term outlook, the cost of NIS’s shares may decrease as it happens when a company shows a loss. However, NIS has already created a strategy providing for active development of the company in the near future, increasing efficiency, production expansion and extension of the refining and sales network, which will undoubtedly lead to an increase in the cost of the shares in the medium-term outlook.

The shares will acquire real cost after modernization of the production complex and expansion of the company’s market position– that is to say - in medium-term and short-term outlook.

Yes, I must admit that the task has proved to be more difficult than we thought at the start. But it can be solved through cooperation of the management and efforts of major shareholders – Gazprom Neft and the government of Serbia.

INTERFAX: With the purchase and sale contract for 51% of NIS shares, Gazprom Neft has secured the obligations of the Serbian government in terms of registration of NIS’s property, as well as settlement of major legal disputes. What progress has already been made in solving these problems?

K. KRAVCHENKO: We are cooperating with the Serbian government to solve these problems. For example, we have already got off the ground with the process of property registration. And although the share of registered property is only 3%, we expect that in the short run this figure will increase, due to re-registration of facilities located within the perimeter of our ORP in Pancevo and Novi Sad to NIS among other things.

This year, we have managed to work out a joint approach to solving property issues. The problem of a large number of unsettled legal disputes of earlier years where NIS was involved is also one of the most serious problems for us. To provide an integrated solution, a special legal committee was set up with the participation of representatives of both the government and NIS experts.

INTERFAX: How do you rate cooperation of two of NIS's major shareholders on the whole?

K. KRAVCHENKO: Issues of cooperation of NIS’s shareholders are being discussed at the state level. We regularly hold consultations with the president and prime minister of Serbia. The last meeting of the board of directors showed that both parties are satisfied with the way cooperation is developing.

I hope that in a short time we will manage to solve the remaining historical problems and devote ourselves entirely to transforming NIS into the Balkan leader.

NIS is one of the largest oil companies in the central Europe, a monopolist of the Serbian market. The production volume is around 1 million tons of oil per year; production is carried out in Serbia and Angola. The company owns OR in the towns of Pancevo and Novi Sad with a total capacity of 7.3 million tons. The company owns a network of 475 gasoline filling stations and is a leading supplier in the Serbian oil product market.