EASTERN EUROPE IS MAJOR OPPORTUNITY FOR OIL INDUSTRY

Thomas Kohlmorgen
Esso A.G.
Hamburg

The joint effort to overcome the political, technical, and commercial obstacles to adequate energy supply in Eastern Europe may pose one of the biggest entrepreneurial challenges of the decades to come.

This article focuses on the former East Germany and Poland, Czechoslovakia, and Hungary. They are the markets most likely to be developed in the near future.

The best data are available on East Germany. Therefore, the forecast material will concentrate on that region. But the trends seen there will apply to the other countries, keeping in mind though, that East Germany was regarded as the most advanced member of the former East Bloc in industrial development.

A look at some key economic data reveals the potential of the oil markets (Table 1). These countries have a land area of 642,000 sq km or 248,000 sq miles and a population of more than 80 million, a third more than the Federal Republic of Germany before reunification. Per capita gross domestic product (GDP) reflects the poor heritage of the socialist economies. The GDPs are even worsening in the short term before a sustained upturn will materialize.

Looking at per capita energy consumption, these countries were real world champions (Table 1). In view of the low standard of living, this is the yardstick for an unbelievable waste of scarce resources and indicates a total lack of respect for the environment.

The real extent of the energy waste is demonstrated by the following comparison: Although combined GDP of the four countries was only about one third of that generated in the Federal Republic of Germany the energy consumption of almost 500 million tons hard-coal equivalent, or 2.5 billion bbl oil equivalent, was nearly 40% higher than in West Germany.

I shall not attempt to define the numerous reasons for this lop-sided development, but there is obviously ample room for energy efficiency and, by implication, reduced environmental pollution.

ENERGY DOWN, GDP UP

Our current assessment is that total energy demand will decrease in Poland and eastern Germany despite a sound GDP growth rate forecast averaging 5% per annum in the second half of the 1990s, at least in eastern Germany. For the first half of 1991, the decline in energy consumption in eastern Germany was 28% vs. last year.

This was a result of the shutdown of inefficient, high-polluting industrial complexes and the first energy conservation measures. The composition of energy demand will change dramatically, copying largely the development Western Europe experienced in the 1960s and 1970s. Oil and gas will gain at the expense of coal and lignite. The future of nuclear power is uncertain and will depend on access to safer western technology (Fig. 1).

The growing oil market provides an irresistible challenge to western oil companies which at home have to cope with declining or at best stagnating oil demand.

Especially interesting is the expected growth of motor gasoline and diesel fuel (Fig. 2). The explanation is obvious: the standard of living will improve and a prime target for spending discretionary income will be a private car. Experience in eastern Germany and, to a lesser extent in the other countries, confirms this expectation.

The growing economy will also require more commercial transportation. Both developments will push bitumen demand for road construction and lube sales for the growing car population. This development is in widening contrast to the existing thin retail station networks operated by state monopolies under the principle: no service, no shops, and no spare parts, from badly maintained installations. They are located off the main roads to provide space for the lines of waiting customers.

The density and quality of the networks are totally inadequate even for today's demand. To use this one-time opportunity to enter a new market and offer to customers the services which they deserve for their good money is a temptation no major oil company can resist.

It is the retail market which predominantly attracts new suppliers. Specialties and petrochemical feedstocks replacing coal-based chemical raw materials will also offer sales opportunities.

SUPPLY STRUCTURE

After World War II the four countries were linked to the Friendship Pipeline system giving them access to Soviet oil fields. The Soviet Union became more or less the exclusive supplier.

Only Hungary has a noticeable domestic production of 55,000 b/d. Payments were made under the East Bloc rubel clearing system up to the end of 1990.

All these countries have sufficient refining capacity. In some cases it has been available for product exports as long as Russian crude was available. Imports of non-Russian crudes by Hungary and Czechoslovakia are possible to a certain extent via pipelines from the terminal of Rijeka in Yugoslavia and to Poland via the harbor of Gdansk (Fig. 3).

With the dramatic decline of Soviet crude export capacity and, on the other hand, with the need of the importing countries to pay for the crude in hard currencies, non-Russian crudes begin to be a real, although physically limited alternative. Pipeline access to western terminals will be a prime objective of Eastern European refiners.

With the exception of eastern Germany, where refineries are subject to privatization or closure, it is too early to forecast the future of the Eastern European logistics system. The refineries will need modernization and upgrading to match a lighter demand barrel. No additional demand for heavy fuel oil is expected because of the highly competitive penetration of natural gas. Also, significant amounts of capital will have to be spent for environmental protection. Whether the state-owned refineries will attract foreign equity or whether processing, exchange, and/or offtake arrangements will be more likely is of secondary importance.

Oil demand will grow and existing processing capacity will be needed if it can be made efficient and environmentally acceptable. But governments that retain unprofitable refineries by subsidies or protectionist regulations will make a severe mistake.

Costly mistakes that the western world has made in the past should not be repeated. Overcapacity in the refinery sector, especially of unsophisticated refineries, is a burden no economy can bear. A healthy mix of crude imports, product imports, and local refinery capacity has turned out to yield optimal results.

Crude supply, however, is at present a crucial question in Eastern Europe. With the decline of export capacity or perhaps the unwillingness of the Soviet Union to sell sufficient crude, alternative supplies have to come from elsewhere; either directly sold by producers or delivered by international companies, or traders.

LARGE GROWTH

This overview shows a significant growth potential in the east European oil markets. The lack of adequate sales outlets makes the retail business the greatest challenge to western oil companies, obviously promising an appropriate reward for the risk to be taken.

The same applies to the heating market with the need to develop technical services and installation contractors. Supply appears to be less urgent but new governments will welcome more competition, more efficiency, and more supply alternatives offered by reliable partners. I should not be surprised if other interested parties were to join the international majors in entering these new markets.

All potential investors are facing the questions always to be answered at the entry of new markets. What are the conditions for foreign companies to become active in Eastern Europe? Is there a positive legal framework? What is the investment climate?

EAST GERMANY

East Germany is, because of its integration into the Federal Republic, a special case. With the exception of the partly unresolved question of land ownership and a sluggish administration, investment conditions are basically the same as in the old parts of the Federal Republic, i.e., no restrictions, no state monopolies.

Instead there is an invitation to invest. The oil market there is on its way to becoming a mirror of the West German market structure. The situation in eastern Germany is the exception insofar as established marketers from West Germany are on their way to developing a full range oil business including acquisition of interest in existing refineries.

Restructuring of the home heating market with oil and gas has started for reasons of convenience and the environment.

It has a large growth potential. Significant changes in the heating market are already under way, with gas and heating oil being substituted for the still widely used lignite (Fig. 4).

Motor gasoline and automotive diesel consumption will grow together with the rapidly increasing car population (Fig. 2). The gasoline-powered car population in eastern Germany is projected to increase from 5.4 million in 1990 to 9.3 million in the year 2000.

The environmental situation will improve with the decline in lignite use and installation of western-type emission control equipment.

For the three other countries, I venture to forecast that investment conditions will approach western standards in the course of this decade because this is one prerequisite for successfully implementing market economics. In the short run, however, the speed of progress will vary and some risks have to be taken assuming that existing problems will find acceptable resolutions. The recent political development in Moscow might accelerate reforms and open business opportunities in the U.S.S.R. as well.

GO, NO GO

Going or not going into an Eastern European market is a major decision.

In the majority of cases, the market entrances will require joint ventures with local,

and this means in most cases, state-owned companies, i.e. monopolistic suppliers of products. This often, offers a solution for the fact that purchase of land is not yet permitted or very restricted for foreigners. Protection of investment, free profit distribution in hard currency, operating management, and other issues of vital importance for an investor frequently call for individual agreements with governments and/or partners. But we expect that the general investment environment will improve steadily because it is in the interest of the governments to attract foreign capital and know-how.

Czechoslovakia has recently suspended regulations demanding a joint venture with a local partner for every foreign investment.

In Poland and Hungary, every company-even if its preferred course is to go it alone-still has to make a principal decision to enter or not. If a company decides to enter, it must accept joint ventures. At a later stage, I am sure this condition will disappear.

But can one run the risk of waiting?

I see a certain repetition of what happened after World War 11 between America and Western Europe. Welcomed by governments and partly supported by Marshall Plan funds, U.S. capital and technological and managerial know-how were transferred to Europe, thereby providing the cornerstone for the Western European oil industry that was to emerge.

A similar development appears now to be taking place between Western and Eastern Europe, with Japan and America mostly involved via European affiliates.

Western companies are willing to enter the new markets. The people and governments of Eastern Europe welcome this contribution to the economic recovery of their countries.

They look for higher quality products, for service from more modern filling stations, and for an improved road system to enjoy driving. This push will in the medium and long-term lead to supply structures that have to be integrated into the international system. The structure will have to be competitive, guarantee supply, and offer adequate marketing opportunities.

Most new market participants will start with joint ventures in the retail sector with a small number of western-type stations.

They will expand their chains when experience meets expectations.

CULTURE SHOCKS

Such joint ventures are a real challenge to both partners. Even though there is full agreement on the objectives of the partnership, the road to meeting them is strewn with stones. The local partner must accept the technical and managerial know-how of the foreign company, share or even hand over the operational responsibility, and at the same time give up the security of a monopolistic seller who never had a reason to consider efficiency, costs, and customer relations.

The foreign partner, on the other hand, must not only develop the business, but he must be highly sensitive with regard to the feelings not only of his local partners but also of politicians, authorities, media, and not to forget, customers.

He must be aware of the fact that he is entering "a different world." Although irreversibly moving towards a market economy system, the legal system, the tax system, administration, the attitude toward work and decisionmaking, the permitting processes, and a lot more, are still largely influenced by the old system.

There is progress but it will emerge slowly. Patience is needed as much as capital.

"Culture shocks" cannot be excluded for both sides. They are another challenge to finding ways for growing together.

I am confident that by the end of this decade the Eastern European countries will have completed the transformation process from the communist centrally planned economy to the market economy system.

Part of this process will be the development of an oil market very similar to the one operating in Western Europe. Most major oil companies and probably others will participate in this competition.

This development will contribute to a better standard of living for people in Eastern Europe-but it means also sound business opportunities for western oil companies.