A Slippery Patch for Russian Oil

It's having mixed success in Central and Eastern Europe

It was hailed as a historic breakthrough, a signal that Russia was an investor to be courted, not an enemy to be feared. In April, Russian oil major Lukoil (LUKOY ) teamed up with London-based partner Rotch Energy to bid $1 billion for Poland's state-owned Refinery Gdansk, whose network of 300 gasoline stations serves 17% of the Polish market. The refinery would run on Russian oil, and as a sweetener, Lukoil promised that Gdansk's ailing shipyards could build and repair its tankers. In July, the Polish government, starved for ways to scare up jobs, signaled its imminent assent. "We are going to make a deal with Russia," Polish Prime Minister Leszek Miller declared in an interview on Polish Radio.

Six months later, there's still no deal to celebrate. The refinery remains unsold, and Lukoil's chances of success are dimming fast. Nationalistic elements of the press have fanned fears among Warsaw's political elite that Poland was jeopardizing its energy security through such a sale. A backpedaling Polish government is now considering an alternative bid. "We are worried about the leverage the Russians could get," says former Polish Defense Minister Janusz Onyszkiewicz, now a consultant at the Konrad Adenauer Foundation, a German think tank. "We still have a deficit of trust between Russia and Poland," he adds.

Central and Eastern Europe should be natural markets for Russia's biggest companies, especially its resurgent oil producers. But Russian oil is having mixed success in the region. Memories of Soviet domination are not the only reason. Poland, Hungary, and the Czech Republic are gearing up for entrance into the European Union and looking westward for expanded investment ties.

That means the Russians are being mostly relegated to more peripheral markets such as Ukraine and Bulgaria. Their only significant victory came last year when Yukos Oil Co. (YUKOY ), Russia's second-largest oil producer, paid $150 million for a controlling stake in Lithuania's Mazheikiu Nafta refinery. The secret to that deal was political finesse. Ex-British Foreign Secretary David Owen, chairman of Yukos' international division, met personally with Lithuanian president Valdas Adamkus to vouch for Yukos as a transparent, profit-oriented, long-term investor. "They didn't want the refinery to become Russian-owned until they were convinced they had nothing to fear," says Owen, who also agreed to serve on the supervisory board of the refinery. Now Yukos plans to create a Baltic-wide filling station network.

There's plenty of fear elsewhere--and some self-interest, too. Lukoil has been trying to buy control of Refinery Gdansk since April. It seemed like an obvious fit. The cash-strapped Polish government badly needed a deep-pocketed investor to overhaul the aging refinery, which was barely profitable. Western oil majors already had their refinery networks in place, so they weren't bidding. Besides, Lukoil pledged to expand the refinery's capacity by 40%, to 6 million tons a year, and to upgrade the plant to meet tough new environmental standards. The enticement for Lukoil was not only the refinery's domestic filling station network but also its link to a nearby Baltic seaport terminal. And while Lukoil's bid sparked concerns from the refinery's powerful trade unions, no deal-breaking labor protests seemed likely. To show its good will, Lukoil even pledged to arrange for $500 million in annual Russian purchases of Polish agricultural goods.

Then the objections started. The weightiest, according to Polish oil industry and government sources, came from PKN Orlen, Poland's dominant fuel company, which has tight ties to Warsaw's political Establishment. With a network of 2,500 filling stations supplying 60% of the domestic gasoline market, Orlen faced pressure on its profit margins with the entrance of a major player such as Lukoil into the market. Orlen did not respond to repeated requests for comment. But Orlen CEO recently told a local paper that his company wants to drive consolidation in Central Europe.

Lukoil's star sank as the transaction turned into a barometer of the popular mood toward Russia. The daily Polish Rzeczpospolita published a poll reporting that 51% of the public viewed investments by big Russian companies as not in the national interest. After a bitter falling-out with Lukoil, Rotch Energy joined with Orlen as its new partner in a competing bid. The dispute was about "strategy," says Rotch Energy CEO Keyvan Rahimian, declining to elaborate. "We were under no pressure from the Polish government whatsoever," he adds. Malgorzata Ostrowska, Poland's Deputy Treasury Minister, whose department gave an initial thumbs-up to the Lukoil-Rotch deal, insists that it will entertain future Russian bids for Polish assets.

A stung Lukoil maintains it is still interested in the refinery and preparing a new bid. One argument in its favor: If Orlen gains control of Refinery Gdansk, it would control more than 75% of the Polish gasoline market--a prospect that worries independent filling station owners. "The best strategic partner for the Polish oil industry is a Russian partner," says Feliks Jaskiewicz, president of a Gdansk-based consortium of petrol stations. Another possibility is for Yukos to make an offer for the refinery.

Some Orlen customers would welcome a Russian investor in Refinery Gdansk because it would increase the choices available in the market and keep prices at the filling pump competitive. "The Russians aren't my good friends, but business is business," says Warsaw taxi driver Wojciech Michalik as he fills up his BMW sedan at an Orlen outlet. A pragmatic attitude--and perhaps one to which an irresolute Polish government should pay more heed.

By Paul Starobin in Warsaw, with Bogdan Turek in Warsaw and bureau reports

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