NEWS HUNGARY PETROLEUM PRIVATIZATION LIMITED BY ECONOMIC CONCERNS

Once the leading economic hope of eastern Europe, a newly doubt-filled, postelection Hungary is deciding on limited oil privatization amid strategic worries and falling production.

Those worries contrast with the bright promise seen in Hungary after the collapse of communism.

As of midyear 1993, foreign companies had invested more than $5 billion in Hungary, or more than half of all foreign investment in Central and eastern Europe's formerly Communist nations. The U.S. has extended most favored nation trading and other privileged status in trade to Hungary. In 1992, more than 400 U.S firms were operating in Hungary, up 34% from 1991.

Current economic reform efforts put privatization , including state petroleum privatization, at center stage.

Ex-Communists, now Socialists, returned to power with 54% of the vote in May elections. Although Socialists, they are committed traditionally to free market reforms.

This year's second small sale of state petroleum interests in early June reduced state equity in former petroleum monopoly Magyar Olaj es Gaz (MOL) to 91% only days after the Socialist landslide.

The previous government had included MOL in a group of companies that was to remain more than 50% state owned.

But added to economic reform goals are new strategic goals for a Hungary outside the Council for Mutual Economic Assistance (Comecon). Political uncertainty in Ukraine and continuing problems with the trans-Croatia pipeline to the Adriatic add to domestic concerns about secure energy supplies.

Those concerns arose with the collapse of ruble accounting in Comecon, coinciding with the Iraqi invasion of Kuwait in 1990.

The Hungarian government's attempts to abandon gasoline subsidies just as oil prices spiked backfired in a country with low oil stocks and low hard currency reserves. A taxi drivers' street blockade paralyzed Budapest and threatened to bring down the 6 month old center-right coalition (OGJ, Dec. 31, 1990, Newsletter). Easing of import permit licensing and the will to pass an energy stockpile law stem from this rough free market baptism late in 1990.

ENERGY SUPPLIES

The role of Ukraine and Russia in Hungary's domestic gas needs is growing.

By 2005, Hungary's natural gas production is expected to drop to 70 bcf/year from the current 175 bcf/year while domestic consumption jumps to 490 bcf/year from 350 bcf/year.

In addition, Hungary wants to restart a pipeline carrying Russian gas from the former Yugoslavia, currently shut down because of the international trade embargo against Serbia. Before Yugoslavia's splintering into warring nations, about 90 bcf/year of gas from the former Soviet Union went through Yugoslavia via pipeline into Hungary.

Currently, Hungary supplies one fourth of its oil and half of its natural gas needs. Production currently runs about 34,000 b/d of oil and 677 MMcfd of gas. Total reserves were estimated at yearend 1992 at 130 million bbl of oil and 3.5 bcf of natural gas.

Hungary's geology is unusual.

Like Italy, it has some of the steepest heat-to-depth gradients in Europe. Geothermal hot water is concentrated in a broad southwest-northeast band across the center of the country, where the crust is thinner than normal. Oil and gas drilling at some depths often is uneconomic in this region because of high subsurface temperatures.

Low oil prices, however, place dreams of geothermal energy making a significant contribution to Hungarian power generation essentially out of reach.

Szeged, a southern city, has a twin well district heating system, and about 1,000 of MOL's almost 6,000 nonproductive oil and gas wells can produce warm water. But Institute of Geology researcher Janos Tanacs has so far failed to get western European grants and Agip SpA's geothermal subsidiary Aquater together to mount a $1 million power generation feasibility study in the Szeged area.

Hungary's Mining Bureau was expected to disclose last week the five winners of bids for oil and gas exploration concessions. Interest focuses on a basin in the northeast comer of Hungary's central region between the Danube and Tisza rivers. Four of the five firms are U.S.

Blocks where MOL is working currently are reserved until April 1997, when MOL will have to bid for concessions against foreign firms.

Mining Bureau Vice Chairman Antal Fust expressed exasperation at Hungary's exceptional division of legal priorities between separate mining and concession laws, creating genuine confusion over issues such as pipeline construction and geothermal drilling.

Earlier disputes over who owned data being sold to foreign oil firms out of a government data room in MOL headquarters were resolved, and mineral reserve managers at the Mining Bureau now work with the state run Geological Survey. Ragged edges on the concession and mining laws appear likely to be tidied up soon by the new government.

MOL PROFILE

Still dominating production and refining but with open competition for lubricant sales and service station business, MOL has tested the waters with more than 8% of equity privatized in two issues this year.

MOL has not scheduled any more comprehensive equity sales, contending the next 18 months is too soon for such sales.

MOL, the successor to state owned OKGT, became more centralized in that Oct. 1, 1991, restructuring. It reportedly is trying to tighten control over strongly independent drilling and research subsidiaries. Independently managed successful enterprises such as engineering unit Olajterv are being reluctantly absorbed by MOL.

Hungary's natural gas supply is dominated by MOL, which meets 45% of the country's needs with domestic production and imports the rest, mainly through trading house Mineralimpex.

Local gas distribution companies are owned by municipal councils. These supply networks may be offered for sale much sooner than the bulk of MOL because the councils are desperate for cash. The 367.5 bcf/year of pipeline gas supplied dwarfs the 300,000 metric tons/year of bottled liquid petroleum gas MOL also sells.

Hungarian crude oil is slightly sweeter than Russian crude grades.

While refineries are currently running at less than capacity, MOL is expanding its plastics production. MOL Vice Chairman Bela Sebestyen notes Hungary is the third biggest producer of paraffin wax in Europe, and he maintains MOL's commitment to World Bank partly financed production of 45,000 tons/year of polystyrene.

The country's downstream sector is dominated by the 150,000 b/d Szazhalombatta refinery, where most third party refining takes place. The most underutilized refinery is the 60,000 b/d primary conversion plant at Tizaujveros.

MOL's petroleum equipment generally has evolved into a hybrid of heavy but reliable Russian made housings adapted to take locally made or western precision parts.

With valves, filters, frequency switches, and the like imported from German, Italian, and U.S. firms since 1982, MOL now has enough experience to resell upgrading know-how to Russian drillers and refiners. Petroleum equipment in Hungary is described by MOL as one third western, one third Hungarian, and one third Russian or East German.

MINERALIMPEX

Not slated for privatization soon, 99.8% state owned Mineralimpex is trying to expand out of its traditional role of oil and gas trader.

Former state monopoly oil and gas import/export agent for OKGT, Mineralimpex's strategy is to keep its trading strength, focus wholly on hydrocarbons, and move cautiously into drilling, processing, and retailing to become an integrated petroleum company.

With its trading monopoly gone, fierce trading competition from western majors-but mostly from MOL now buying and selling for itself at last-plus admitted lack of experience in other petroleum sectors, Mineralimpex's goals at first look overconfident. Yet its ambitious plans to help launch an oil futures contract on the Budapest commodity market are taken seriously in the industry.

The rationale is the company's scope.

Mineralimpex is the country's second biggest petroleum concern, notably larger than No. 3 Shell Hungary. Despite MOL's post-1991 freedom to trade for itself, Hungary's two largest natural gas import contracts, with Russia's Gazprom at 70 bcf/year and 105 bcf/year, have remained under Mineralimpex's aegis.

The larger contract is a cash deal for gas from mid-Urals Orenburg field and this year was renewed for 5 years instead of the traditional annual renegotiation. The smaller contract is an intergovernment deal involving gas supplies from Russia's Yamburg field and is in lieu of Russian debt.

While MOL has overtaken its competitor in oil exporting and importing, Mineralimpex retains shares of both businesses that look equally solid and unlikely to shrink further.

Mineralimpex's advantage mainly consists of long established contacts in Russia and other former Soviet republics.

More than a language advantage, Mineralimpex claims the kind of inside relationship that Finnish and Austrian traders made a living out of throughout Cold War decades. Its plan is to use this Russian edge to deal its way into oil sectors it frankly admits to never having touched before.

Mineralimpex has leveraged itself into a small drilling operation in mid-Urals Bashkortostan and a thus-far hampered trading operation in Tatarstan, currently experiencing painful delays about whether Tatar hydrocarbons are too sour and dirty to be commingled into and thus get export access via Russian pipelines.

Mineralimpex privately complains of power politics behind recent rows about landlocked former Soviet republics exporting products across Russian territory.

In pursuing foreign business opportunities, a Mineralimpex official stresses the company's penchant for caution and the modesty of projects so far. But the consistency of Mineralimpex targets is encouraging.

By the end of the 1980s, the company had decisively focused on oil and gas, divesting some small mineral trading businesses, including a brick and clay trading subsidiary. Mineralimpex stresses these sidelines are far behind it, even though they never accounted for more than 15% of its most diversified days in the 1980s.

Although MOL and others are anxious not to be left out, Mineralimpex is generally acknowledged as the prime mover behind putting oil and gas forward trading onto the floor of Budapest's open commodity market, perhaps as soon as November. So far, the market is strongly agricultural, with robust grain and meat contracts, plus newer currency contracts, frequently outtrading the less convincing Budapest stock exchange.

Adding Urals crude and Russian standard gas oil as an energy section of the commodity market is a project for which Mineralimpex set up a foundation and organized a conference last year.

Meantime, Shell Hungary acquired the rest of state trading company Interag it did not own in 1993 and plans to build on a big retail head start the Interag link gave it in Hungary. A local agreement in 1960 with Interag enabled the first franchised filling station to open in 1966, growing to more than 40 by 1989, giving Shell more than 2 decades of visibility with few competitors prepared to endure the nuisance cost of business under communism.

The newly 100% Shell owned company has doubled the 1989 number of service stations.

STRATEGIC SUPPLIES

Hungarian voters' sweeping rejection in May of the conservative coalition in power since 1990 is not seen as a signal for a return to central planning.

No one doubts privatization efforts will continue on some scale. Yet even with the reassuring precedents of Poland and Lithuania, contracts between proven reformers in leadership and unrepentantly Communist local party organizations in the countryside may hamper further reform by a Socialist government.

Still largely rural Hungary is a nation of 60% village dwellers. It looks as though cities voted for Socialists to deliver more capitalism and faster privatization, while villages voted for Socialists to restore the welfare state and slow privatization.

The future for MOL hangs on analysis of what the election results mean for public attitudes toward privatization and emergence of the new government's strategic view of secure hydrocarbon supplies for landlocked Hungary.

Because Hungary is supplied by only two pipelines, one of which is closed because it crosses a former Yugoslav war zone, strategic concerns also could override enthusiasm for privatizating oil.

Hungary already leads the region in oil stockpiling. The state sponsored Association for Crude Oil and Oil Derivative Stockpiling has built 20 days of supply and is on target for 30 days' supply by year end 1994. But this predecessor to a proposed state energy office is still only a plan among some trade officials. State Sec. Istvan Szucs is rumored as a possible energy office head. It would be a comprehensive regulatory successor to today's State Authority for Energy and Energy Safety, still an awkward and politically uncertain amalgam of a fuel burner testing office and general industry watchdog.

The stockpiling association complains of underfunding and costs of debt and rent of storage capacity from MOL, although it has achieved stockpile standards developed by the Organisation for Economic Cooperation and Development and International Energy Agency.

The stockpile and the association's costs are funded by a levy on net imports of crude and refined products. Any company that wants to be an importer or exporter of gas or oil in Hungary must unofficially contact the Ministry of Trade and then approach the Ministry of International Economic Relations for an annual permit, taking often only a couple of weeks to clear.

This relaxed licensing policy is reflected in the number of companies already with permits. About 77 companies count themselves in the petroleum business in Hungary.

Hungary is building a gas pipeline to Baumgarten, Austria, to connect with the western European network. Completion is scheduled for Oct. 1, 1996.

This should close a window of vulnerability with pipelines across Serbia and Croatia currently compromised and supply lines from Russia across the Ukraine sustaining a dependency Hungary wants to reduce. Gas supplies still cross the Serbian border but under strict United Nations observation to make sure that input matches what Bosnia and Herzegovina get at the other end, with Serbia/Montenegro withdrawing no natural gas en route across Serbian territory.

Another potential pipeline supply source, soon to return to normal operations, connects Hungary with the Adriatic, crossing another part of former Yugoslavia, Croatia. Croatian and Hungarian relations are good-too good for Serbian tastes-but 56 km of the pipeline crosses a Serb enclave in Croatia. Oil in the pipeline has not moved since the war began, and the pipeline is hostage to the encircled local Serb group that calls itself the Krajina Republic.

MOL PRIVATIZATION

Outgoing conservative nationalists, the Hungarian Democratic Forum, issued coupons compensating individuals for torture or loss of property the last 50 years as part of the MOL privatization process.

A first round compensation coupon for share exchange left MOL several weeks before elections still more than 95% owned by state holding company AV. Less than 1% of MOL shares went to individuals. The rest went to local councils.

A second round in June, only days after the election, took state interests down to 91%, with more individuals involved.

Earlier mispricing in terms of compensation coupons forced the first 0.99% preference MOL share for coupon exchange to be postponed several weeks in late March. A rate of two coupons for one share rose to two coupons for three shares, each worth 10,000 florints ($97.70) and with fixed interest of 12%.

Declaring on May 6 total assets of 262 billion florints ($2.56 billion), share equity of 98 billion florints ($957.5 million) and net profits of 1.5 billion florints ($14.7 million), MOL disclosed plans to cut 2,000 jobs from its work force of 19,000.

By the time of the second share for coupon swap, the rate had gone back up to one coupon for one share.

Organized between the two halves of the election on May 8 and May 29, the second round of business-as-normal MOL equity sales, a 3.9 billion florint ($38 million) share issue, was scheduled for June 2-17. More than 4.25 billion florints worth of entries made the issue oversubscribed, forcing it to close June 9, with coalition talks for forming a new government barely under way.

POSTELECTION POLITICS

The Budapest Stock Exchange (BSE) at first pushed down coupon prices as if election results threw doubt on all planned privatizations.

But even on the first postelection Monday, May 30, advisers to MOL saw the incoming Socialists as pragmatic enough to speed the company selloff process. BSE compensation coupon selling partly reflected the exchange's undue dependence on compensation coupons as its most liquid commodity in an otherwise thin market.

Speeding the selloff process probably will involve less use of compensation coupon swaps. It also may involve other financial markets in other countries.

Many BSE brokers feel vulnerable. If the Socialists are truly pragmatic, using resources to support a stock exchange underdeveloped even by regional standards might not be a priority.

Not just probusiness for Socialists, the new leaders' pasts as internal reformers opening up Hungarian Communist party policy with free market experiments more than 20 years ago makes them more probusiness than many conservative parties.

Two people typify the new Hungarian Socialist cabinet: the last Communist prime minister before 1990, Miklos Nemeth, and the last Communist foreign minister and current Socialist prime minister, Gyula Horn.

Financier Nemeth, now in London with the European Bank for Reconstruction & Development, turned down a chance to come back as part of the Socialists' victorious return to power, not from political doubts but reportedly for a preference for remaining in England.

Horn is remembered for having made the shrewd decision as foreign minister in 1989 to let East German holidaymakers out of Hungary into Austria, removing border fences along Hungary's part of the Iron Curtain. This prompted a flood of East Germans, leading to the fall of the Berlin Wall and the collapse of Erich Honecker's hardline East German government.

New Hungarian Prime Minister Horn seems to many Germans the non-German after Gorbachev to thank most for German reunification.

Against unrestrained enthusiasm is the view that such reformers as Horn, Nemeth, and Bekesi are only an elite 20% of the party.

Local Socialists, including whole village organizations, are seen as reactionaries. This 80% majority may cooperate less with market liberalization reforms from above than it did 5-6 years ago. There may even be a whole new understanding of what market liberalization means after 4 years of such novelties as unemployment and real wage erosion.

Hungarians feel their former lead in eastern Europe slipping away. They believe they deserve extra support from the West for their early moves toward capitalism, contending that 2 decades of relative wealth within Comecon is not reward enough.

Concrete complaints now are of lost trade in the embargo against the so-called Republic of Yugoslavia (Serbia and Montenegro). Lost oil and gas sales alone cost MOL tens of millions of dollars a year.

Hungary believes it is being the good soldier on enforcing western sanctions but even now bitterly anticipates never getting full compensation. Some kind of special treatment-for enforcing sanctions against Serbia, for Hungary's role in German reunification, even for earlier perceived betrayals-has not arrived to Hungarians' satisfaction.

Despite discreet but steady German gratitude in the form of economic aid, the grudging view that virtue has been inadequately rewarded cannot be ignored by outside investors.

And however impeccable the promarket modernizing credentials of the returned cabinet, it remains likely that the Socialists have been reelected to stop the pain-and if necessary the gains-of freer markets.

Many voters hope for outright reversal. Reversal has credibility in the countryside, as 1968-88 saw farm-led capitalist growth comfortably cushioned from competition by Comecon trade barriers.

The much discussed 10-20% devaluation of the florint is being downplayed, and within a week of electoral victory Horn shocked many Hungarians by uttering the previously taboo "comrade" on live television.

Inaction, rather than reversal, is the most likely danger. Talk that Horn needs the No. 2 party, Alliance of Free Democrats, not to impress foreigners but to offset nostalgia for a centrally planned economy within his own party is hardly reassuring.

Nemeth in London may consider himself well out of a struggle to give Hungarian voters more of the products of capitalism without the risks of free markets.

MOL'S SUBSIDIARIES

MOL's relationship with its subsidiaries augurs against spinoff of entire units.

Planning, exploration, and drilling have been in separate subsidiaries since OKGT days. Now more than 90% owned by MOL, interests in each are to be sold separately but likely will stay under MOL control. MOL spent 8 billion florints ($78.16 million) on exploration in 1992.

Preliminary 1993 figures gave Crude Oil Research (COR), Szolnok, a $1.65 million gross profit.

A COR privatization effort in 1992 was stopped after months of discussions with consultants Credit Suisse-First Boston. Only 15% of COR revenues came from outside MOL, involving Syrian and former Soviet contracts. Rotary, a drilling concern based in Nagykanizsa, also earned less than 15% of its 4.25 billion florint net turnover through exports, these tied almost entirely to projects in Tunisia.

One MOL subsidiary, turnkey engineering and design contractor Olajterv, has very clear ideas on privatization in contrast with other subsidiaries.

Like Mineralimpex it is not up for sale in any usual sense. Now 85% owned by MOL and 15% by managers and local councils, Olajterv is conducting talks with German and Russian companies to sell a 20% interest to one partner. General Director Geza Pap insists the company will stay at least 60% MOL owned.

A German or Russian partner would inject some capital-although with $8.5 million/year gross, Olajterv is not starved for cash-but more important help with access to new markets.

Olajterv is a technical consulting firm that prides itself on careful planning and its ability to design and build facilities across a broad spectrum from refining to exploration and drilling. It has invested in advanced computer technology such as PDMS software and Silicon Graphics workstations.

Like a small number of other Hungarian companies, it behaved under communism as if it had to compete under western quality standards. During 1988-92, while boosting sales, Olajterv cut staff by almost one third, sharply increasing its ratio of engineers to ancillary workers.

MOL owns more than 50% interests in 13 other companies such as Petrogaz and Olajterv, more than 25% in joint ventures with Kuwait's Q8 retail arm and Austria's OMV joint ventures in Hungary, and smaller interests in 67 other companies.

MOL uses 140,000 b/d of its 220,000 b/d refining capacity for its own processing, with the remainder rented out to third parties. Mineralimpex has hired MOL to refine 4,000 b/d of crude into gasoline, gas oil, and fuel oil.

MOL has competition mainly in the retail sector, where it holds a 35% share of product sales and 303 service stations out of a total of 575. That compares with Shell's 20% share and 88 stations and other majors at about 5% each. Mobil and Esso had MOL participation in their networks, and both acquired MOL's interests this year. Other majors in Hungary's retail market are Conoco and Total.

Retail products marketing is an area in which Mineralimpex has clearly indicated it has no ambitions-for now, at least. Already crowded in some observers' view, Hungary's retail gasoline market is said to be of interest to two undisclosed large U.S. companies that want to establish a presence.

The relaunch of MOL's "2000" service station brand will need to be aggressively defended if newcomers are ready to sustain losses to acquire long term market share.

MOL feels hampered by obligations to help collect state fuel taxes-more than 100 billion florints ($977 million) in retail levies alone-yet strengthened by a low debt ratio-more than 80% self-funded investment, with short term debt accounting for the smallest part of the remainder. Insolvent buyers left MOL carrying $100 million of extra debt in 1993.

Plans to float MOL shares on stock exchanges outside Budapest and Vienna are well discussed but still uncertainly scheduled-1995 at the earliest, said MOL's 1993 annual report.

MOL's strongly controlling ownership of its research and planning divisions complements smaller investments. For example, its 15% interest in Pannon-GSM, the Hungarian mobile telephone competitor to the faster-growing Westel 900, has some background in Olajterv's occasional but regular ventures into telecommunications project start-ups.

Many investors want to choose pieces of MOL, but the new government can be expected to stick with the strategy of keeping the family of companies together. The decision to keep downstream and upstream together was made when OKGT became MOL. Separate identities under common ownership for all MOL subsidiaries are unlikely to be tampered with.

The new Socialist government, proreform or not, has less room for maneuvering than an overall majority of seats in Parliament suggests. Other struggles will leave little appetite for breaking up MOL.