Political Risks Remain

Kirill KravchenkoInterview with Kirill Kravchenko, CEO of «Naftna Industrija Srbije» (NIS)
March 2011. Kommersant

Head of NIS Kirill Kravchenko about partners, assets and Serbs.

Mid-March is the deadline for the offer made by Gazprom Neft to the Serbian NIS minority shareholders, which number some 4.7 million citizens of the country. The Russian Company has acquired one of the first foreign assets in 2008 and it is through NIS that it plans to explore actively the Balkan market. What is Serbia's attitude towards the Russian investor, who will be the company's partner in the region, and is it profitable to sell its shares now, are questions Kirill Kravchenko, NIS CEO answers in an interview with Kommersant.

— The emergence of Gazprom Neft in Serbia was perceived ambiguously. Some politicians opposed the Russian investments; it was also believed that the sum of $ 400 million for which a 51% stake was acquired in NIS, is too small. Has the attitude changed now?

— Yes, at the very beginning views were polarized. Some said that the diamond of the Serbian economy had been sold, others - that the company was on the verge of bankruptcy. NIS is Serbia's largest energy company and, in fact, its largest infrastructure company, providing 11% of budget revenues, so of course, the deal was subject to debate. Also important was that the deal was part of an interstate packaged agreement which, over and above the share purchase itself, envisages some € 500 million of investment in upgrading refinery construction in the Serbian section of the South Stream pipeline and reconstruction of gas storage facilities. Also, Gazprom Neft assumed certain obligations under a five-year shareholder agreement.

The first year can be called a year of crisis management. Now that the company has demonstrated real results in profits, production growth (for the first time in 20 years) and increased market share, the attitude is, of course, has changed. There is, however, no let up in the level of scrutiny. This is because the NIS, in which all Serbian citizens are minority shareholders, remains the largest and the first blue chip company on the Belgrade Stock Exchange; everything it does is scrutinized by the press and the government and it is widely discussed in society. If we are to talk about the political component, we should emphasize that there is a certain degree of improvement: Dmitry Medvedev and Serbia's leader Boris Tadic expressed satisfaction with the pace of project development. Certainly, some political risks remain, but we assess them as very low.

— Is it true that the situation at NIS, discovered by Gazprom Neft after the transaction, did not coincide with the original notions of the Serbian company that were formed based on the audit?

— We participated in due diligence; it is a key process, and it is hardly likely that any investor would simply rely on someone else's figures. Most of the data we received were later confirmed, but I would like to point out two things that were somewhat unexpected for us. The first is that financial statements was not prepared under IFRS standards, so some of the obligations that were reasonably submitted by counterparts later, were not reflected. Second - the fact that the auditors in previous years had never issued an unqualified audit opinion on the financial statements of NIS. The first IFRS audit we made showed significant differences, and also proved that the company is not in the black, as was shown in several reports from previous years but has been showing a loss for the past four years. This had a significant impact on the work with the banks and the ongoing activities of the company in the beginning, but I think we have corrected the situation now.

— So the Serbian partners were not completely honest with Gazprom Neft?

— I don't think so. I'd rather say the case is the attitude towards the principles of accountability in NIS, namely the absence of a requirement that company reporting should be prepared according to IFRS, which must be fully confirmed by an independent auditor. Coming with new rules, counting with a different approach, and relying on the opinion of our auditors over the past several years, we realized that the situation is worse than it looks on paper. I don't see any bad will here; I'd rather call it a difference in approaches.

— Did you consider revising the terms of the deal?

— The NIS Board of Directors, which includes the representatives of both Gazprom Neft and Serbia, considered all the options, and I believe they have chosen the best one – cooperation. Neither shareholders, nor management regret it now. We managed to find a way that catered for the interests of all parties, and without a conflict.

— What is the company's current loan burden?

— Accounts receivable decreased by approximately 30%; accounts payable was halved, and now they are both at a normal level. We have also reduced bank debt by 50% in two years, so now it is a little more than $ 600 million, under a significant growth rate of EBITDA, which was negative in 2008, rose to € 100 million in 2009, and amounts to about € 300 million for 2010. This allows us to assert that the current loan burden level is close to what we consider optimal. As EBITDA grows, which our strategy suggests, new borrowing may be raised for company development.

— What are the main parameters of the NIS development strategy?

— We have developed a ten-year strategy, but we are also working on a twenty-year strategy, because we believe that the ten-year horizon is insufficient for business development. First of all, the strategy involves development of NIS as a leading player in the Balkans and the first phase will be to achieve leadership in the dynamics of performance growth. The second thing we are working on is to balance all the components of a vertically integrated oil company. The region is fiercely competitive, and therefore we understand that our performance must consist of all business segments. We assume a threefold increase in oil production and a doubling of processing growth. In this case, two-thirds of the produced volume will be sold in Serbia, and the other third - in other Balkan countries.

It is assumed that 30-50% of oil production will within Serbia, and 50% - abroad. We have already entered Bosnia and Herzegovina and the next priority area is Romania. We continue to operate in Angola and Turkmenistan, and we are exploring other opportunities to expand both the resource base and production. The strategic objective is to provide 100% of crude oil for refining from our own sources.

— How do you assess the resource potential of the Balkans?

— Depends on what we compare it with. Compared to the resource potential of Russia, the Balkans, of course, is a very small region. But if we compare it to Europe, it is very promising. Therefore, we look at absolutely every opportunity here.

— NIS and Neftegazinkor, a subsidiary of Zarubezhneft, have created a joint venture to develop two sites in Bosnia. Are there any details on stocks yet?

— There is to be 3-D seismic survey held this year. Next year we will be drilling the first exploration wells, and by 2014 we plan to start production proper. According to preliminary estimations, the recoverable reserves total about 10 million tons.

— Do you consider possibly partnering with other Russian companies in the region?

— We are already cooperating with LUKOIL, and have applied to participate in the tender on the Montenegro shelf, where cooperation with other companies is a possibility.

— Does NIS have technology for offshore projects in the Black Sea, that you are expected to implement in Romania?

— We have experience of joint participation in the management of offshore projects in Angola, but NIS is not the operator there. We have gained good offshore drilling experience in Turkmenistan, where we consider different opportunities for business development. In Romania, the priority projects are still land based, because they are more interesting to us from a logistics point of view.

— What is the level of production and processing in 2010? What is the cost of production in Serbia?

— Production amounts to approximately 1.2 million tons in oil equivalent, and this is an increase of 30% compared to 2009, but we intend to maintain the dynamics and plan 1.5 million tons of production for 2011. The processing level amounted to about 3 million tons in 2010. The level of production cost we have now is quite comparable to Russia - $ 5.3 per barrel, while in terms of the EBITDA margin we are on the level of around 15%.

— From January 1, liberalization of the Serbian oil market began and other players appeared. How are you going to overcome the negative consequences of this for NIS business?

— This step, of course, was invigorating. But it should be noted that the liberalization of the market in Serbia was made in stages, and the largest and most important stages were completed before Gazprom Neft got here: European players here have their own network and have long imported diesel, kerosene, LPG (and we are talking, of course, of European standards for fuel), and diesel, unlike Russia, occupies about 60% of the market here. So tough competitive conditions here have already been established and, since the beginning of the year, they have also touched gasoline, which occupies about 30% of the market. The challenge facing NIS is that the refinery is not yet technologically ready to release 100% of Euro-5 standard production (currently it is about 45% of volume) and the full transition will only occur after the upgrade is complete. The second difficulty is an outdated network of filling stations. Therefore, we are trying to perceive the opening of the market as a stimulus for accelerated development and to respond to the challenge with major reconstruction of gas stations, a new level of service and programs for customers and increased production of diesel and Euro-5 gasoline, lack of which we will compensate with import deliveries.

— What is the percentage of imported oil products in NIS?

— This year, we have significant import plans – primarily for Eurodiesel. We need to buy about 40-50% of the total diesel production to meet demand. The situation will remain like this for another two years before the reconstruction of refineries is finished. We buy petroleum products from our partners in Romania and Bulgaria, Bosnia and Herzegovina.

— How much has already been invested in the refinery?

— The main construction is a hydrocracking and hydrotreating complex. Over € 200 million in Gazprom Neft loans has already been invested and around € 300 million has been contracted. There is still a number of projects at the refinery, such as hydrogen plants and environmental infrastructure; these are necessary for the factory to comply with EU requirements. NIS invests its own funds in the production and retail outlets. At the same time we are considering the possibility of additional investment into the motor oil business, which now has its own brand of motor oil and has just launched refined oil production. We will complete the market analysis within six months, and then take decisions on whether to start the investment cycle on our own or together with partners. We see Japanese and Swedish companies among our possible partners; they have experience in processing heavy oil. In any case, we will rely on Gazprom Neft's own technologies.

— How will the sales network outside Serbia develop? And who will take care of it - NIS or Gazprom Neft?

— Apart from Serbia, our target priority markets are Bulgaria and Romania, where we will expand the distribution network together with Gazprom Neft. Opportunities are being studied together, but we have not yet determined which company will become a major investor. Most of the oil will be supplied from our refineries. Second priority markets are Bosnia and Montenegro; we also consider Croatia and Hungary.

— Many Russian companies have sold their service divisions lately, and Gazprom Neft is doing this too. Are you planning to get rid of your service assets?

— Over the past two years, the oil services unit load of the company has almost doubled. And NIS's own projects form about half of the service business; the rest are third-party orders, primarily Turkmenistan. We will assess development options for the types of services that greatly affect the cost of the core business, from the standpoint of NIS efficiency. In the future, both partnership and sale are possible. At the moment, however, we intend to do all we can within the existing structure to optimize our business, and only then implement other options. We are in no hurry.

— NIS is a minority shareholder in petrochemical company Petrochemistry [Petrokhimiya], which the authorities intend to privatize. Are there no plans to purchase?

— The government is considering such a possibility, but it is very important for us to understand the future of Petrochemistry. Everything depends on the state of the European petrochemical market, which is now covered by mass production in the Middle East. We will carefully analyze the situation and make a decision by September.

— Will the financial situation of NIS allow it to develop in accordance with its stated plans?

— One always wants more, of course. What we have now is a yearly two-fold increase in investments from our own cash flow. For example, we plan to invest about € 100 million in production and retail development within the country in 2011. And this does not include potential investments in mergers and acquisitions, as we are also looking at various opportunities of acquisition within our core business in the Balkans.

— Gazprom Neft made an offer to minority shareholders in accordance with obligations under the SPA. Will the company increase its stake in NIS?

—The system of corporate governance at Gazprom Neft, established in these last two years, enables the effective control of the business with 51%. Last year we transformed the company into a JSC, took it to the exchange, and today NIS is the only company in the world that has 4.7 million shareholders, virtually all the citizens of the country. We fulfill all our obligations to them, particularly the obligations within the offer.

— If Gazprom Neft will buy the shares, how does the company intend to use them?

— Of course there will be certain variation in what to do with them. This will be decided by the board of directors of Gazprom Neft. One possible option is an exchange for some assets, selling on the stock exchange and other options, but this is the next step.

— It was said in the NIS purchase agreement that dividends from the company should constitute 15%, but they were never paid once in these two years. Why?

— In 2009, the company had no dividends: there were losses, and significant ones, because despite the operational successes, the final report reflected all the problems of previous years. As a result of this year there will be profits, and the shareholders will decide their fate. Funds which go on dividends may also be used to cover losses of previous years or may be directed to business development.

—But does the management not have its own vision of the situation?

— A vision of the management is to turn NIS from a national oil company into a leading regional player in the Balkans. Therefore, the maximum amount of all funds, in my opinion, should be dedicated to company development. This is the foundation for the growth of its value, and the shareholders, minority and majority shareholders alike, will receive more dividends in future than they would now, when payments may lead to a slowdown in business development. But the shareholders will make this decision.

— You are streamlining the business and have already fired 2,500 people. How was this perceived in the country?

— When Gazprom Neft gained control of NIS, it employed around 16,000 people. The company now employs about 10,000. This was a necessary optimization and a task of no small importance. And discharge is only possible with the voluntary consent of the employee. Society was generally understanding of our actions, as they realized we complied with all the terms and conditions, and had explained the need to improve the company's efficiency.

— What is currently the ratio of Russian and Serbian workers in the company?

—The company employed a maximum of 106 foreign managers, most of whom were Russian. Their number has now fallen to 80 and, by the end of the year, it will be 60. We have Germans, Lithuanians, Romanians and French; a varied team from a total of about ten nations. Initially it was assumed that such a large team would be involved only temporarily, so now we are training and gradually transferring responsibilities to local managers. We invest heavily into educational programs. Plus, we attract Serbs who left to study and work in Russia or Europe. As we are an international team, the company has introduced the compulsory study of each other's culture and languages. There are three working languages in the company: Serbian, Russian and English.

— Last year, Gazprom Neft practically saved the popular Serbian football club Red Star from bankruptcy. Has this move improved the attitude towards the brand?

— Both NIS and Gazprom Neft have a considerable corporate social responsibility and perhaps that is why today's accelerated restructuring is perceived relatively positively. NIS is sponsoring several clubs, including the basketball club Partizan which has enjoyed great success on the international arena. Red Star football club is also extremely popular, and not only in Serbia, but throughout the region. For Gazprom Neft it was not only an image project, but part of the marketing policy. We already have fans who know that by buying NIS oil products, they are supporting their favorite club.

— After the Yugoslav wars, part of NIS's assets was expropriated by other countries. Have you managed to get them back or to at least withdraw them from the balance sheet?

— We have commercial-grade oil remaining in the Croatian part of the Yanaf pipeline, which runs from the Adriatic to our refineries. It was nationalized, and there was about € 16 million reserved for it in the company's statements. There is also a network of gas stations within Croatia, which previously belonged to NIS, and there is a network of tank farms and holiday homes. Such negotiations, however, are really complicated, and it is more likely to resolve the issue on an interstate level. This question is now the mending of differences between Serbia and Croatia on their way to joining the EU within the Commission on succession. Although we, as a company, have also petitioned the court on the matter of gas stations.

— Europe, unlike Russia, has a very developed trade union. Is there such union in NIS? And what is the nature of its relations with the company's management?

— NIS has a syndicate consisting of unions for mining and refining sectors of the company. It has a very high impact on the team, and almost 90% of all employees are members. In Serbia, the trade union movement is very well developed, as well as in the rest of Europe. When negotiations were held on including Gazprom Neft in NIS, representatives of the syndicate were involved in the talks. Previously, union representatives were even present within the company's management. It is not like that now, but negotiations on various issues are held weekly, and I think both sides are satisfied with the constructive cooperation.