In this article, we look at the implications for Bulgaria from Lukoil’s exit from the country’s and possibly EU’s market. While Bulgaria is definitely not Lukoil’s most important market in Europe, it bears significance, due to Lukoil’s almost complete monopoly in the oil fuels sector there, further exacerbated by this country’s full reliance on Russian energy. While Lukoil’s expected exit may represent an opportunity for Bulgaria to foster competition on its energy market, this analysis suggests that for a number of internal and external reasons, it may fail to make use of it.
By some accounts, Lukoil is considering disposal of its remaining downstream assets in Europe, including its refinery and possibly retail business in Bulgaria. The refineries in Italy, the Netherlands and Romania are also up for sale. Reportedly, Lukoil targets completion of the disposals within the next couple of years. The company stated its desire to concentrate on upstream activities, i.e. oil and gas exploration and production in its main regions, rather than on the downstream. As an alternative to outright sale of its EU assets, it is considering a spinoff in a separate listed company.
The last couple of years have indeed been rough for the oil sector worldwide as the crude oil prices collapsed. From around U.S.$ 110/bbl in the first half of 2014, Brent crude averaged about U.S.$ 42/bbl so far in 2016. The weakness has also spilled onto refining margins, even though their linkage with the crude oil price is not direct. Refining and retail are lower-margin businesses anyway and there may be some logic to Lukoil’s shift towards upstream. At the end of the day, upstream operations rely on a scarce resource whose price may be currently depressed but it is possible and likely that at some point will rebound.
The real reason for the planned disposal may lay elsewhere though, in the realm of regulation and not commerce. On several occasions Lukoil has been accused in wrongdoing. In 2014, the Romanian state prosecution commenced proceedings against the local Lukoil subsidiary for money laundering and fraud, and estimated the damages at EUR1.8 billion. Lukoil has been so far successful in repelling the case, but has not been acquitted and the investigation continues. In Bulgaria, following years of unexplicable price anomalies, the national antitrust regulator discovered market manipulation and anticompetitive behavior by six retail market participants, of which Lukoil has by far the greatest share. In this case, the law caps the possible fine at 10% of annual turnover, i.e. for Lukoil this would translate into a payment to the tune of 300 million Euro. There is a suspicion of more significant breaches however, which if investigated may trigger claims exceeding the ones in Romania, i.e. commensurate or exceeding the value of Lukoil’s entire Bulgarian operation. It is possible that Lukoil considers exiting certain markets, especially in the EU, before such claims may arise. Bigger considerations may also be at play. While the growing tensions between Russia and the EU (and NATO) may not ultimately lead to an all-out war, the environment in Europe may become more difficult for major Russian companies, even beyond the state-owned ones.
Bulgaria, a Province of Lukoil
Even by the standards of the former Soviet empire, Bulgaria stands out in its dependence on Russian energy. Indeed, Bulgaria imports 100% of its crude oil, gas, nuclear fuel, and spare parts for its nuclear power plant from Russian entities. The suppliers are companies that are either state-owned or directed or influenced by the Russian government (below we refer to it as the Kremlin). Looking at the oil sector in particular, we can see a complete vertically integrated monopoly, owned and operated by Lukoil, via its four main domestic subsidiaries. It controls all the domestic facilities for crude oil import, processing, storage, transportation, as well as export of oil products. Lukoil’s main oil port near Burgas is a de facto exterritorial zone with no Bulgarian state officials, not even custom ones, on the ground. Lukoil also has virtual monopoly on the bunkering sea-going and river-going ships, and the fuel facilities at the airports. It is the main (and actually the only one, via intermediaries) supplier of fuel for all critical national institution and services, including the police and the army.
A large part of the state reserve of oil-based fuels aimed to be used in emergency and war is also stored at Lukoil’s premises. As to oil imports, Lukoil conveniently has its hand on the valve. As per Bulgarian law, any excise taxed goods, including oil fuels, that are imported must pass through an excise depot, i.e. a specially licensed storage facility. In 2011 the Bulgarian Ministry of Finance officially announced that Lukoil controls over 80% of the capacity of these depots. Per the same announcement Additional c. 15% are controlled by Naftex Petrol, a financially troubled locally-owned company that is fully dependent on Lukoil for financing and supplies. Even more intriguingly, Lukoil leases some additional excise depot capacity from small nominally independent players, i.e. its control over excise depots approaches 100%. Lukoil’s all-important position was even recognized in a court resolution, documenting the critical monopoly dependency the national institutions and infrastructure from Lukoil’s supplies. Paradoxically, the court arguments its resolution to reinstate Lukoil’s license with exactly this monopoly dependency, regardless of the uncovered tax infringements.
Not surprisingly, Lukoil and its top management team in Bulgaria have immense political clout. A good example is the saga with oil product metering that started in 2011. While all traders and retailers have installed the meters as required by the law, Lukoil has staunchly resisted and quoted “unacceptably high installation costs”. Within the next couple of years, it has demonstrably failed to install meters. The Ministry of Finance retracted its license, only to be speedily reinstated by the court on national security grounds. Soon afterwards the government resigned amid protests. The new government inserted a special carve-out in the law, allowing Lukoil to skip metering on some facilities. These shenanigans prompt the question what is really going on at Lukoil? How much oil does it import, export, sells locally, and pays taxes on? Its sheer resistance suggests that Lukoil has a lot to hide.
A Monopoly is Up for Sale. Who’s Buying?
A monopoly is a very profitable affair. So buyers must be circling around. But Lukoil’s Bulgarian monopoly is about more than mere financial profits. It is of “geopolitical” significance, in the parlance of the Russian policy wonks. In plain English, this means a vehicle conveying not only economic but political dependence on Russia. And it goes beyond monopolizing supplies for Bulgarian citizens, firms and the government. It is also the ability via apparently kosher, business-as-usual, deals to generate substantial funds at friendly firms and to finance various political and even covert activities in Bulgaria and elsewhere. In the current Bulgarian setup, such influence can only be exercised and has significant value only for the Kremlin. Based on the available evidence, we believe that Russian assets in key sectors, first and foremost energy, are sheltered by some implicit “understanding” of Russia’s legacy positions and interests in the former Soviet bloc. This understanding is not only maintained by the ruling elites in Bulgaria but also finds important proponents in the major EU countries. In addition, due to historical reasons, the Bulgarian public appears somewhat more tolerant to what it perceives as the Russian interests, compared these of other countries. A Middle-eastern or Western European oil company for example would likely face much stronger reaction from both the government and the public if it tries to pursue competitive and tax practices akin to those in which Lukoil is currently suspected. Consequently, the value of Bulgarian business is much higher for a player, like Lukoil or other Russian major, which can make use of such practices, than to third-party oil companies. Clearly, via its energy firms, Russia has truly unique levers over Bulgaria. Would it like to part with the biggest and most important of them? Unlikely. This background is key when analyzing who may be the likely buyer of Neftochim and other Lukoil’s assets in Bulgaria, and possibly Romania. For convenience we split the potential buyers in four groups.
Companies under Russian control. These are by far the most likely buyers, since they would allow to preserve if not actually strengthen the “geopolitical” lever. In addition, there are certain purely operational advantages for Russian producers. Most importantly the logistics of tanker supplies through the Black Sea, Neftochim’s current refining setup allowing it to process Russian oil blends (e.g. Urals), etc. Obviously Rosneft and Gazprom (via its oil subsidiary Gazpromneft), the two powerful Russian energy clans would be front-runners. Both have assets abroad and firm state backing.
- ▪ Rosneft in particular has emerged as the foremost Russian producer and one of the world’s largest. Lukoil was invited at senior government level to participate in the privatization of 19.5% stake in Rosneft, a transaction preliminarily valued at c. U.S.$ 11 billion. This invitation seems to have gone cold, with Rosneft stake apparently being acquired by bona fide foreign investors. Rosneft has been quite active in its deal-making recently, especially with the mammoth acquisition of Essar of India. So we would have ranked it as a prime contender for Lukoil’s European assets if it wasn’t for one considerable impediment: its precarious legal position in Europe. The litigation and arbitration efforts of the shareholders of Yukos against the allegedly illegal takeover of their assets by Rosneft have yielded no practical results so far, and even suffered setbacks, but the risk is unlikely to go away. In addition, Rosneft is under international sanctions since 2014. Rosneft’s direct ownership over a major asset in the EU may create the risk the asset is seized at some point in future. This of course wouldn’t prevent Rosneft to acquire a desired asset, as it could resort to “equity partners” that would likely acquire control.
- ▪ Gazprom (via its subsidiary Gazprom Neft), on its part is already present on the Balkans, with its acquisition of NIS Petrol in Serbia, and has been rolling out a chain of gas stations in Bulgaria too. Acquiring a Bulgarian (perhaps packaged with a Romanian) refiner would allow it to firm up a truly dominant market position in the region. Strictly speaking, Gazprom’s standing as monopoly gas importer should disqualify it from increasing its energy footprint in Bulgaria by even a tiny bit. Considering past experience however, it is not unlikely that the Bulgarian anti-trust regulator takes a more considerate approach since oil and gas are different markets.
- ▪ Other Russian producers, e.g. Tatneft, owned by the government of Tatarstan, and the ultra-secretive Surgutneftegaz have no significant oil assets abroad, but still could serve as possible acquisition vehicles. Independent and smallish Russian producers, e.g. Russneft, are even less likely buyers for Neftochim. A transaction involving a second-tier Russian name may actually suggest covert involvement of one of the majors.
National oil companies from the former Soviet Union. Companies like Sokar, the Azerbaijani national oil champion, and Kazmunaigaz (KMG) of Kazakhstan have both oil supplies in the region, and interest to expand their business. KMG already has regional presence via Rompetrol in Romania, and it also operates with a chain of gas stations in Bulgaria. It is possible KMG would seek to expand its regional footprint. Combined with the current Rompetrol assets, it can build dominant presence in both countries. Sokar also has eyed Bulgaria earlier, including pondering the acquisition of Petrol, a local chain of gas stations, which was also a wholesale buyer of Sokar fuels. They are possible buyers yet the seller (and not only Lukoil, but senior government circles i.e. what is usually referred to as the Kremlin) may be unwilling to let them in a regional market where Russian companies have near dominance. It is possible, in case the buyers trade Lukoil for important assets elsewhere.
Gulf Buyers. In general, it is much less likely that the Russian counterpart would open up a market where it enjoys strong and traditional dominance for new entrants, especially ones which have their own upstream production in close proximity. So buyers from the Gulf countries, including Iran, which is publicly Russia-friendly, are unlikely to be even short listed in bidding. The same, only stronger, goes for exotic (from a narrow Bulgarian perspective) buyers from India, Malaysia, Vietnam, Venezuela (whose oil company is particularly strained), etc.
International oil companies. Both Neftochim and the Bulgarian (and Balkan) market in general are low in the list of priorities of oil companies from Western Europe and North America. First, the market is small. Second, such companies typically have operations in EU countries and are eligible to import to Bulgaria, subject to resolving the excise depot issue. Third, western companies are much less, if at all, able to make use of Neftochim’s monopoly standing, and are not interested in the “geopolitical” aspect of the Bulgarian operation. Lastly, the recent “billion-dollar” upgrade of Neftochim refining facilities is reportedly inflated in value and plagued by operating problems. An international oil company may recognize much less value in it than what Lukoil claims. We will also add here smaller oil companies from the EU, e.g. ENI, OMV, MOL, Hellenic, Ina, etc. They have refining capacity nearby and probably won’t be interested to participate on their own behalf.
Grand bargain with China. On the face of it, a Chinese oil company may try to gain a foothold in the EU, but again from Lukoil’s (and actually broadly Russian) standpoint it would involve some sort of “geopolitical” grand bargain, where the Chinese would need to trade it off against a significant interest somewhere else. The touted-up strategic partnership between Russia and China, if it’s real at all, would not suffice for a deal. In theory the Chinese may exchange it for a partnership stake in upstream projects in the Gulf (e.g. Iraq) or elsewhere (Africa, Central America) but again, there are too many moving parts to realistically consider this scenario. And the Chinese are not known for generously letting others in their projects, nor of paying top dollar for acquisitions. Nor does Bulgaria rank particularly high on their agenda.
In conclusion, if Neftochim and other Lukoil’s Bulgarian businesses change hands at all, their new owner will in all likelihood be either Russian, or under strong influence from Russia. The main issues with its operation therefore, including anti-competitive behavior, doubts (to put it politely) over tax compliance, and continued influence over the Bulgarian government and affairs, would persist, if not actually worsen. And they may well worsen, e.g. in case the buyer is a Russian state-owned actor like Rosneft.
Bulgaria’s National Interest
The discussion above presents a very clear case where the national interest lies. Let us summarize what are the key areas of concern.
Independence from foreign influence. Bulgaria is on the receiving end of the “geopolitical” lever, i.e. by definition it works not only against country’s economic interests but also against its very political independence. The Bulgarian government must consider Lukoil’s business not in isolation but together with country’s massive overall dependency, energy and otherwise, on Russia.
Competition. Again, Lukoil’s non-competitive market standing and behavior so far raises the long-term fuel prices in Bulgaria, reduces citizens’ real disposable income, and depresses business’ competitiveness. The competition, or rather the lack thereof, is a major impediment for the Bulgarian economy, second possibly only to the weak rule of law.
Tax compliance. The extra profits that Lukoil generates in Bulgaria are exported in full — Lukoil has reported a tax loss for one and a half decades of its operations in Bulgaria. Even worse, the incomplete metering of oil products allows substantial underreporting of the fuels sold domestically, and quite possible evasion of VAT and excise tax, which make up the bulk of fuel’s price at the pump. The Bulgarian citizens, businesses and government therefore subsidize Lukoil’s already very profitable operation
Operational prowess. In the interest of Bulgaria is that the new owner has significant operating experience and technological prowess, and does not cut corners in respect of environmental and social aspects. So far, despite the proclaimed billion-dollar upgrades Lukoil failed to curb pollution from its refinery, which is reportedly attributed to “budget savings” and incomplete installation.
In conclusion, the national interest very clearly is that all this stops. Very clearly the worst case is that a Russian participant (and specifically Rosneft) takes over from Lukoil. The best case is that an international oil major, like Exxon Mobil, Shell, or BP comes in. Lukoil’s exit from Bulgaria represents a rare chance when the Bulgarian authorities have significant leverage and may contribute to such best outcome. The government, and we mean all branches of the government — executive, legislative, and judicial — therefore must engage in a coordinated effort to this end. Such effort may combine several approaches:
- ▪ Scrutiny and thorough review from various relevant regulators, including anti-trust, energy, environmental, etc. All these agencies have willingly or unwillingly have neglected Lukoil as subject of regulation;
- ▪ Establishing tax compliance. Like described above, a thorough truly independent tax audit may uncover very substantial deficiencies in Lukoil’s taxation;
- ▪ Law-enforcement review of Lukoil’s activity including possible criminal intent in breaching competition and tax regulations, and not less importantly, suspected money-laundering.
Our initial review on Lukoil’s operations indicate that the possible infringement of competition and tax laws for the years since Lukoil acquired Neftochim may be commensurate or exceed the value of Lukoil’s Bulgarian operations. The sheer leverage that Lukoil and Russia have, including at personal level, however virtually guarantee that the government is most likely to assist Lukoil to achieve its desired objectives rather than pursuing the Bulgarian national interest.