Time to step things up

Interview with CEO, NIS and Deputy CEO, Gazprom Neft, Kirill Kravchenko.

Gazprom magazine

Economic miracle

— Kirill Albertovich, how is it that NIS – which in 2009 was on the edge of bankruptcy – has, in such a short time, turned itself around to become a profitable company, able not only to pay dividends to shareholders but also to actively expand its business in the Balkans?

— It’s certainly the case that when we first came to the company, its situation was highly precarious. The first move we made in correcting this was to fundamentally change the whole approach to doing business. We did this with maximum transparency, in order to eliminate any possibility of corruption. We got down to cutting costs. One of the most complicated problems was optimizing the headcount. Government in Serbia was in a constant state of flux, and each time a new party was elected that party’s own people would be sent to fill senior roles at NIS. And these, naturally, brought with them an entirely new team. But those colleagues they were supplanting remained with the company – they were just moved to different roles. Consequently, by the time we appeared in Serbia NIS had already accumulated several generations of politicians – and their troops, at considerable cost to the company. However, agreements between the company’s shareholders – the government of Serbia and Gazprom Neft – meant that just cutting out excess personnel for the sake of it wasn’t possible: people left the company entirely voluntarily and, moreover, were very well compensated. So achieving real change was far from simple. But it was worth it, since optimizing the headcount became a major factor in improving business efficiency.

Kirill Kravchenko, CEO of NIS j.s.c
Kirill Kravchenko, CEO of NIS j.s.c

Concurrently with this, we set about optimizing production processes, introducing new technologies and management strategies across all aspects of the business. We began to extend our production, and began releasing products to European standards. The entire profit we made in the first four years was used to liquidate previous losses (which, at the time of our arrival had reached almost €450 million) and reinvested in development. This allowed us to bring NIS out of its critical state, make the company profitable, and turn it into a steady, viable operation. This year NIS, for the first time in many years, paid out dividends on the basis of the 2012 year-end results, in the order of 25 percent of net profits. We are only required, incidentally, to pay out a minimum of 15 percent but it’s my view that that figure could, without any impact on business development, and subject to shareholders’ approval, be increased to 20 percent – a normal level for the region we’re working in.

I’d like to talk a bit, separately, about NIS’ contribution to the national economy. Over the past three years the company’s tax payments have funded almost 13 percent of the country’s budgetary income, and generated about eight percent of Serbia’s GDP. I think these data are enough to illustrate the importance of NIS to the stability of the country’s financial system and its economic model. Against a background of severe unemployment, which in Serbia is close to the 30 percent mark, we are active in recruiting young professionals – and, in terms of working conditions, the award of “Serbia’s Best Employer,” which our company has won twice, says it all.

—Do you expect profits to increase further?

— We’re currently showing a very high sales–profitability ratio but, having said that, we’ve already reached a level at which further increasing profits is going to be somewhat more complicated.

— And what does that depend on?

— In large part, on taxes. For example, for the first six months of this year we paid a third more in taxes than in the same period last year. At the same time, the price of gas, which comprises a third of our business in the upstream sector, has fallen by 40 percent. So even matching our 2012 financial results is going to take considerable effort. And that’s our task – getting as close as possible.

— How do you view NIS’ operating results?

— The company has doubled production of hydrocarbons in comparison with 2008, although the preceding two decades had seen steady decline here. Last year we extracted 1,763 mtoe, and in 2013 we plan to increase production by five percent. Two thirds of this volume is oil, and the rest is natural gas, which supplies about 20 percent of Serbia’s domestic consumption. In terms of volumes, this is quite low, but in terms of profitability – it matches the profit achieved in Russia on production of 15 million tons. Hydrocarbon production in the Balkans, as in Europe as a whole, is a pretty profitable business sector, in contrast to refining or sales. This is easily explained — the tax burden is often concentrated on the highly developed downstream sector while, at the same time, taxes on exploration and production are a fraction of this: oil and gas reserves in the majority of European countries are not that extensive, so it is essential that exploration and production is stimulated through low taxation.

Refining last year constituted 2,142 million tons of oil, and the adjusted plan for 2013 puts this at 3,112 million tons. We had stopped processing feedstock on a tolling basis as early as 2010, so today about one third of this is NIS’ own oil, with the rest obtained on the market. The main source of imported feedstock for refining is the Croatian JANAF pipeline, running from the Adriatic coast to the border with Serbia. We have two refining facilities – in Pančevo and Novi Sad. The nominal capacity of the first refinery is 4.7 million tons per year. The second refinery is currently under reconstruction. Next year we expect refinery throughput at Pančevo to be in the order of 3.3–3.4 million tons, and in 2015 3.7 million tons.

In terms of sales of petroleum products in Serbia we have almost reached market saturation – NIS today supplies more than 70 percent of the domestic market. So if there is going to be any further sales growth, it’s likely to be minor. On the other hand, we are planning to increase sales considerably outside Serbia, through sales via premium distribution channels in neighboring countries.

Growth strategy

— What do you envisage in terms of NIS’ further development strategy?

— The process of stabilizing the business is now complete, and we are confident we are now ready to turn to bringing to fruition the various obligations we have taken on. The issue is not the conditions we had to meet on buying NIS – these have already been met – but the obligations we have taken upon ourselves, in order to meet our strategic objectives. Specifically – investing in the order of €1.5 billion in the company’s development over the next three years. And we are now in a position to do this without breaching good corporate governance on indebtedness, operating instead on the basis of our own working capital.

In many respects we are today the No. 1 company in the region, but we do still need to scale up. The shareholders have set us the task of transforming NIS, as the national oil and gas company, into a fully fledged, international, vertically integrated energy holding, active across all business sectors. NIS’ development to 2020 envisages increasing the company’s annual production to a minimum of five million tons of oil and gas per year (crude oil equivalent), refining to five million tons, and sales to five million tons of petroleum products. In other words, we have to have the greatest possible resource base. We have worked out what volumes NIS might extract from its current fields, and realized that it is not going to be enough to allow the achievement of our strategic goals. So we are continually increasing our investment in geological surveys and prospecting throughout Serbia, and we have already been able to halt the reduction in our resource base and achieve an increase in oil and gas reserves in relation to the volumes extracted. In addition to this, a decision has been taken in this respect on the importance of developing the entire Panonski oil and gas basin – which is to say, in practically all countries neighboring Serbia. We have been granted concessions in Hungary, Romania and Bosnia, in which seismic surveys have already been undertaken and where exploratory drilling is just coming to an end. We plan to announce the results of these activities before the end of this year. We anticipate that geological prospecting in neighboring countries will yield positive results and, indeed, are currently bringing to fruition a whole range of projects there: in Hungary and Romania, for example, we have not one, but several.

— Do you plan to further extend exploration and production abroad?

— Absolutely. The region does have potential for hydrocarbon production, and that is currently the most profitable element of the oil and gas business. In the next few years that is precisely where the greatest investment will be. Indeed, by 2020 we plan to source at least half of the company’s aggregate recoverable hydrocarbons from beyond Serbia’s borders. We anticipate some small growth in hydrocarbon production in Serbia next year (2014) – in the order of about one to two percent. But it’s possible, depending on the results of our exploration and production projects abroad, that NIS’ production data might be revised upwards.

Rules of survival

— How do you expect to fulfill your adopted strategy in the refining sector?

— We’ve completed the first stage of modernizing the refinery at Pančevo and, over the past year, have completely switched production to Euro-5 motor fuels. The Nelson Complexity Index (NCI) score at our refining complex has risen to 8.9 – which is higher than the average for Russian enterprises (5.1) and even the EC (6.1). Depth of refining has increased from 70 to 83.7 percent.

According to the Solomon Index (an indicator of efficiency), we significantly outstrip Russian refineries on all indicators except for energy efficiency. This has always been NIS’ weakest point, but we plan to bring this up to an acceptable level over the next two to two and a half years. Nonetheless, we understand that the European downstream sector, in contrast to Russia’s, is subject to considerable oversupply of fuels, intense competition, and heavy taxes. In order to survive here we have to not only improve the efficiency of our refining facilities, but also, whether we like it or not, continue modernizing them. Therefore, concurrently with the vital reconstruction we have just successfully completed, we have allowed for several additional projects in order to bring our refining facilities to an even more competitive level. I’m talking here about increasing the depth of refining and the output of light petroleum products, as well as efficiency indicators such as energy consumption, operational readiness, and cost reduction. All of these initiatives are not yet so essential in Russia but here, it’s a question of survival.

— What projects, specifically, do you plan to implement in refining?

— One of our two refineries, in Novi Sad, is not just being modernized, but rather redeveloped for the production of base oils. This project is unique in Europe. New facilities will allow us to produce both paraffinic and naphthenic base oils. The latter is available in Europe only through Swedish company NYNAS Naphthenics, considered the world leader in naphthenic base oil production. But they obtain this product through the use of imported raw materials which are delivered in Europe from Venezuela. NIS in Serbia has access to its own source of a unique oil, Velebit, suitable for production of both paraffinic and naphthenic oils. Investment in establishing a new complex at Novi Sad has reached almost €130 million, to be brought into production at the end of 2016. Consistent with our plans, capacity at the modernized facility will be in the order of 180,000 tons of product per year, with a range comprising eight kinds of base oils (four naphthenic and four paraffinic), as well as 250 kinds of products. It is expected that the sheer uniqueness of this range of products will ensure it a wide market: 20–30 percent will be sold in the Balkan region, and the rest – in other countries throughout Europe, the CIS, the Middle East, Africa, Turkey, and so on.

After completion of the base oil refining complex, NIS will join the ranks of Europe’s 25 leading refineries (based on the Nelson Complexity Index). In the meantime, we are also looking at the possibility of further modernization at Pančevo, which envisages the refining of heavy oil residues. There are several options here, the most fundamental of which concern the construction of complexes for either ultra-deep hydro-cracking or delayed coking. The question of whether we do this (i.e., redevelop Pančevo), and precisely how, is one our shareholders must address before the end of this year. If the response is positive then, based on the experience and know-how we have gained in the previous phase of refinery modernization at NIS, we can move pretty swiftly to implementation on this project.

— How far will these projects go in improving the profitability of refining at NIS and ensuring its “survival”?

— In terms of the total tax burden on the oil and gas business, Europe is broadly comparable to Russia. But, as I’ve already said, the tax burden on the downstream sector is considerably higher here, and on the upstream sector – considerably lower. So the majority of European refineries are operating at zero margins. Prior to our arrival, the NIS refinery complex was running at a loss; but thanks to the reconstruction and modernization we have undertaken, we’ve been able to bring the downstream sector back into the black. The margin at the Pančevo refinery is currently zero (the enterprise isn’t running at full capacity), but we are getting closer to the European average. We expect our processing facility to go into the black by 2016, once base oils go into production at Novi Sad. And we can significantly increase margins once the second phase of modernization is completed at Pančevo, assuming our shareholders take the decision to go ahead with construction of a new deep-conversion complex. Once this is brought into production we can achieve an annual output from the Pančevo refinery of around 4.5–4.5 million tons of oil and, together with production of base oils at Novi Sad, the effective annual output from the NIS refinery complex will be in the order of five million tons.

And there’s no question that, concurrently with this, we have to actively develop our retail network. Without development of retail sales channels, refining in Europe is doomed, given the intensity of competition. Companies from Russia, the Middle East and America are already sending their own products here. And in wholesale channels we are already seeing price wars in an attempt to force competitors out of the market. Retail – it’s the only guarantee of being able to sell your product at the highest possible margin.

The importance of retail

— What plans does NIS have regarding the development of distribution – and, in particular, retail – channels?

— Once we’ve got the refining complex to optimum capacity, 60 percent of petroleum products will be supplied to the domestic market and 40 percent to markets outside Serbia. We intend to maintain our share of the wholesale market at roughly the same level as it is now – 73 to 78 percent. This year, we plan to sell, in total, around 2.5 million tons of petroleum products on the domestic market – and this, as I’ve already said, is just about market saturation. As regards retail – in Serbia NIS currently has in the order of 336 filling stations and a further three are currently being constructed or modernized. In the next three years we plan to bring the number of directly owned filling stations up to 800. But only half of these will be in Serbia – the rest will be abroad. We’ve already entered the retail markets in three neighboring countries: in Bosnia we’re operating 36 filling stations, in Bulgaria 28 (with three more under construction), and in Romania – 10 (plus 18 stations under construction). Mind you, we’re not limiting ourselves to just these countries, but are considering other regions for development of the NIS retail network. We expect to gain at least a 10 percent retail market share in key neighboring countries. Although, in places, our market share could be still higher. In Bosnia, for example, it could be in the order of 15 percent, since we have bought an existing filling station network from Austria’s OMV.

We’ll also be developing our logistics strategy concurrently with retail. In particular, we have a network of oil storage facilities in Serbia, but European legislation requires us to have facilities not just in the region, but also in each individual country in which we have filling stations. So we’ve already purchased oil storage facilities in Bulgaria and plan to build in Romania (we’re currently renting); a similar project is currently being developed in Bosnia. If we do go into other countries then this too will involve not just filling stations but storage facilities also.

— And why is NIS so active in entering retail markets abroad?

— The ultimate objective of our marketing strategy is to ensure the sale of at least 70 percent of NIS’ light petroleum products through our own network.

— Which countries in the region show the most favorable conditions for development of the filling station network?

— All of the countries here are completely different, and each requires an individual approach. Of course, we associate our best prospects with those countries whose markets we are already active in. But there are a further two or three countries of interest to us. The decision of whether to enter these or not will have to be taken by the shareholders.

— In terms of the resource base and hydrocarbon production, Romania is one of the best endowed countries in the region. This isn’t likely to disrupt development of NIS’ business there?

— You mustn’t forget that Romania’s population is about 20 million and, accordingly, the retail market there is considerably larger than in other countries in the region. In addition to which, mountains divide the country into two halves. Virtually all of the main refining and retail assets are located in one of these. And the other (as it happens, abutting Serbia and Bosnia) clearly doesn’t have adequate supplies of fuel. Thanks to this, NIS can take a leading position here. Plus we have very convenient logistics in place for fuel delivery here.

— What brands will your filling stations be operating under in Serbia and beyond?

— In Serbia our stations generally operate under the NIS Petrol brand, but abroad they generally operate under the GAZPROM brand. In the Republika Srpska (part of Bosnia) we use both brands. The first of these is used for budget filling stations competitive with networks such as MOL, and the second is used for the premium sector, comparable to OMV stations. The European market has clear segmentation here, which isn’t yet so apparent in Russia. People who value fuel quality and a broad range of services are prepared to pay more. We are positioning the GAZPROM brand very carefully as a premium product. Experience shows that consumers, across all social groups, trust that brand. I can only add that the GAZPROM fuel card is used for refueling not just by commercial companies but also by government agencies and political organizations throughout those countries in which the network operates.

— NIS is active in natural gas vehicle fuels. How is that sector developing currently?

— We have two LPG production facilities, at our main refinery at Pančevo and our mini-facility at Elemir. Their total capacity meets about 40–45 percent of the country’s total consumption. But a proportion of this is bought outside, which means that NIS’ current domestic market share is closer to 55–60 percent. Our objective here too, as for benzene and diesel fuels, is to increase this to a minimum 70 percent. So, accordingly, we are planning some discrete refurbishment at the Pančevo facility and an increase in its utilization rate. We envisage a limited amount of investment at the Elemir refinery. Our plan is to meet at least 60–65 percent of the country’s domestic demand through our own production. These facilities, of course, aren’t sufficient to allow the export of LPG, so the issue here is only one of supplying the domestic market.

A number of advantages

— Tell us about diversification at NIS. Why has the company got involved in the electricity and other sectors?

— Given NIS’ many unique advantages, particularly in terms of its location and its influence throughout the region, development in this sector was a logical addition to our core oil and gas business. We’re expanding our E&P projects and expect this to lead to an increase not just in oil production, but also in natural gas. We currently supply around 20 percent of the Serbian market, and this proportion could increase to a quarter, even taking into account the fact that the South Stream project will run across Serbian territory. However, we won’t be able to supply more than this volume at viable prices, and sending Serbian gas for export isn’t technically possible. Electricity produced from gas can be used for our own needs and to sell on the Serbian market, in neighboring countries, and even for export to Western Europe. Incidentally, full liberalization of the Serbian power market is expected in early 2015, and we want to be ready for it. So the decision was taken that NIS would, together with our partners, participate in two major generation projects.

The first of these envisages the reconstruction of a combined heat and power (CHP) plant at Novi Sad, in which NIS holds a 24-percent share, and the construction there of two new generating units with a combined-cycle capacity of 480MW. Total installed capacity, moreover, will reach 715MW, with maximum annual electricity output of 2,7130GWh. NIS’ partner in this project is Slovakian company GGE. The second project is being implemented in partnership with LLC Gazprom Energy Holding. This involves the construction of a 200MW-capacity CHP plant at Pančevo, with annual production capacity of 1,350GWh. Incidentally, we are also planning to extend our cooperation with LLC Gazprom Energy Holding in other areas – specifically, in improving the energy efficiency of our various enterprises.

In addition to this, we are also independently implementing MiniCHP projects at our oil and gas extraction sites. One such installation has already been launched, at Sirakovo in July. We plan to put a further seven into operation before the end of 2013, and expect to complete this project by the end of 2014. The total capacity of all installations is 40MW.

— And why did NIS join the Plandiste wind-farm project earlier this year?

— In Europe, establishing a mechanism to offset GHG emissions through the generation of “green” energy is considerably more cost-effective than paying for CO2 emissions quotas. The Plandiste wind-farm, incidentally, is the first and most significant wind-power generation project in Serbia. The 102MW-capacity plant will be brought into operation at the end of 2014. Total investment is €160 million, but our company’s investment (we hold a 50-percent share) won’t exceed €25 million. This is because we were able to put in place a financing structure whereby guaranteed future energy supply was used as collateral, meaning that we were not required to take on additional bank debt. We are trying to use similar structures in other projects, allowing us to concentrate financial resources on developing our core business.

— By “other projects” – do you mean the recovery of non-traditional oil and gas resources?

— Partly. It includes developing non-traditional gas reserves, shale oil, tight oil, high-viscosity oil, coal-bed methane, and so on. We’re still experimenting in these areas.

— Are you doing anything on the development of shale oil deposits?

— In terms of those districts that might be of interest productively, we can talk about Aleksinac ,in south-east Serbia, where shale oil reserves are estimated to be about two million tons. We don’t exclude the possibility of our participating in its development. In terms of a partner – Russia’s JSC Atomenergoproekt might be able to participate in supplying technology. But no final decision has been taken as yet.

— Are you considering the possibility of implementing coal-fired power generation projects?

— NIS is examining the potential possibility of implementing a project for construction of a CHP in the Kovin coal mine area.

Kirill Kravchenko was talking to Denis Kirillov.

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About NIS

НИС је једна од највећих вертикално интегрисаних енергетских компанија у југоисточној Европи. Основне делатности су истраживање, производња и прерада нафте и гаса, као и промет широког асортимана нафтних деривата. Више на страни nis.eu

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