Growing up on the outskirts of Esztergom, Hungary’s famed cathedral town 30 miles northwest of Budapest, Zsolt Hernádi often wondered whether he would ever visit Slovakia, just across the Danube. A bridge that had connected the banks of the river was destroyed during World War II, and in the Communist era that followed, there wasn’t much interest in promoting contacts between the two peoples.
“Building bridges between countries became a powerful symbol for me,” says Hernádi, now 44 and chairman of Hungarian oil company Magyar Olaj-és Gázipari, or MOL Group.
The bridge between his hometown and Slovakia was finally restored in 2001. By then MOL had already crossed into Slovakia to begin the takeover of Slovnaft, the national oil company (in which it bought a 36 percent stake in 2000) and was planning further expansions in Central and Eastern Europe -- “building more bridges to nearby countries,” as Hernádi puts it.
Whenever it spans an international divide, MOL spreads a capitalist gospel that aims to change creaky, government-owned oil concerns into profitable, efficient private enterprises -- much the same way that MOL, a former state dinosaur, transformed itself over the past six years. “Once you have done it with your own company, it’s a lot easier to do the same with another firm,” says Tamás Dávid, head of research at the Budapest Economics Institute, which studies economic development in Central and Eastern Europe. “MOL has a real advantage over bigger Western oil companies in this respect.”
After acquiring Slovnaft, MOL bought 25 percent of Industrije Nafte, or INA, Croatia’s national oil and gas company, in 2003. It hopes to gain majority control when most of INA’s remaining shares are privatized later this year. And plans are afoot to invest in Bosnia’s biggest oil concern, Energopetrol Co., and possibly in a string of gasoline stations in Romania. At home MOL owns 52 percent of Tiszai Vegyi Kombinát, or TVK, a leading petrochemical company, but has no plans to buy additional shares.
With its market capitalization topping $11 billion, MOL has grown big enough that talk of its combining with some other regional oil company or being taken over by a supermajor has ceased. Last year merger negotiations between MOL and Poland’s Polski Koncern Naftowy Orlen, or PKN Orlen, a slightly smaller, regional rival, collapsed because, according to Hernádi, the Polish government refused to curtail political interference in the oil company’s management. With oil prices -- and profits -- soaring since then, there is no shareholder pressure on MOL to merge or be acquired. Officials at PKN Orlen did not respond to repeated e-mail requests from Institutional Investor seeking comment.
“It’s really a nonissue at this point,” says Toomas Reisenbuk, head of investment at Tallinn, Estoniabased Trigon Capital’s Trigon Central and Eastern European Fund, which holds about $10 million in MOL shares in its $230 million equity portfolio. “We don’t think any regional consolidation involving MOL is likely in the next three to five years.”
By then, Hernádi figures, the roughly 10 percent discount at which MOL, as a Central European company, has been trading against stocks of major oil concerns will have disappeared. “We need five more years to show that this company deserves the same valuation as the big Western European or American firms,” he says. “At that point, if a supermajor is willing to pay what our shareholders consider a fair price, so be it.” Thanks to a stock
option plan that is unusually generous by Hungarian standards (and controversial in the country), MOL’s top executives will be able to walk away multimillionaires. But Hernádi hopes that major shareholders will resist any future takeover offer, no matter how tempting. His ultimate goal is to maintain MOL’s independence while building it into the region’s biggest industrial company, with one of the highest profit margins of any oil enterprise in the world.
Reaching that target will be an upstream struggle, literally. Until now, because of its modern, efficient refineries, MOL has made most of its profits from downstream operations. But the company produces only 25 percent of its oil from diminishing Hungarian fields and imports the rest, mostly from Russia.
“We have convinced the market that we can be a very good refinery operator and oil products distributor,” says Michel-Marc Delcommune, 56, MOL’s Belgian-born chief strategy officer, who joined the company in 1999 after a long career at PetroFina, the Belgian oil concern that was acquired that year by France’s Total. “The challenge now is to build our credibility in exploration and production.”
That challenge is all the more daunting because of MOL’s dependence on Russia for 80 percent of its oil imports. Officials of the company were stunned when its main partner, Yukos Oil Co., was recently dismantled and its boss, Mikhail Khodorkovsky, jailed after a confrontation with Russian President Vladimir Putin. MOL has also had to accept a new partner in its key Siberian oil joint venture: Yukos was forced to sell its 50 percent share in the project to Russneft, another Russian oil company.
MOL quickly made up its Yukos losses by signing a five-year delivery contract in 2004 with Lukoil Oil Co., now the leading Russian oil producer and retailer, for 5 million tons of oil annually. “That was very nicely done,” says Andrey Ryjenko, a London-based senior banker for the natural-resources sector at the European Bank for Reconstruction and Development. “We have been quite impressed by the way MOL goes about developing its business.”
Even as it struggles to achieve a balance between downstream and upstream operations, MOL has emerged as the class oil act in Central and Eastern Europe, where its main competitors are PKN Orlen and Austria’s OMV. OMV, the largest of the region’s fuel companies, with an $11.25 billion market cap, has total reserves of 1.4 billion barrels of oil equivalent, about five times as much as MOL, but MOL’s refineries have higher profit margins. PKN Orlen has by far the biggest domestic market, thanks to Poland’s 40 million inhabitants, but the state-controlled company has suffered through frequent changes of management, a reflection of strong government interference in its internal affairs. “That’s why our merger talks fell through,” says Hernádi. “Since the start of negotiations with Orlen, I met three, maybe four different chairmen -- and five or six Treasury ministers.”
For investors, MOL has become the most attractive of the three regional companies. Over the past decade the company’s market cap has multiplied tenfold. Net income for the first quarter of this year was $379.7 million, 37 percent more than it was for the same period in 2004, while revenues rose 23.5 percent, to $2.77 billion. In mid-June the company’s share price reached a historic high of 17,300 forints ($84). And MOL is awash in cash since the sale last year of its Hungarian natural-gas operations to E.ON Ruhrgas International, a subsidiary of German energy behemoth E.ON. MOL received $1 billion up front but stands to make as much as $2 billion more if E.ON decides to buy all of the Hungarian company’s gas assets. According to Hernádi, these revenues will be used to buy majority control of Croatia’s INA if it becomes available. They will also be invested in
upstream operations in Russia and Kazakstan, then returned as dividends -- “a real must, because the payout to our shareholders has been low in the past,” says the MOL chairman.
Investors haven’t been bothered by the low dividends, however: Foreigners own 56 percent of MOL’s shares, up from 35 percent in 2001. Heavyweights like Allianz, Capital Group Cos., Fidelity Investments and Franklin Templeton Investments have each purchased chunks of as much as 5 percent. “MOL benefits from being one of the few large-caps in Central and Eastern Europe and from having high liquidity,” says Sylwia Szczepek, Frankfurt-based manager of the DWS Europe Convergence Equity Fund, which holds E23 million ($27.7 million) in MOL shares -- almost 10 percent of its portfolio.
Foreign funds have favored MOL as a proxy for investing in Hungary, but local investors consider the stock their best way to ride the rising oil market. “Oil consumption per capita in the region is only half that of Western Europe, and MOL is already making very high profits,” says Jeno Nagy, Budapest-based fund manager for ING Investment Management Hungary, which to date has bought $56 million of MOL shares for its mainly Hungarian investors.
MOL’s surprising emergence as a top-flight company was the result of a sink-or-swim economic liberalization policy implemented by Hungary after the collapse of Communism. The company began in 1991 as a government monopoly created out of 11 state agencies involved in hydrocarbon production, refining and distribution. In 1995 nearly 20 percent of MOL was sold to the private sector, and the Hungarian fuel market was flung open to foreign rivals. “To encourage competition, the government ordered that our best-located MOL gas stations in Budapest be sold to the supermajors,” says chief strategic officer Delcommune. That’s why even today MOL’s slice of the Budapest market is a modest 26 percent, compared with its 44 percent share of the national market.
After four more privatization stages, the last one in 2004, the government has been left with only 12 percent of MOL’s shares. But transforming the company’s culture proved more difficult than changing the ownership structure. “This was a company dominated by engineers,” says chief executive officer György Mosonyi, 55, who joined MOL in 1999 after a career as an engineer and manager at Royal Dutch Shell Group’s Hungarian and Central and Eastern Europe subsidiaries. “Market economy concepts such as profit and loss and shareholder interests were unknown here.”
MOL’s embrace of capitalist reforms began in earnest when Hernádi was appointed chairman in 2000. Short, stocky and ebullient, he briefly considered becoming a veterinarian like his father. “But once I delivered a calf,” he recalls, reenacting the scene by pulling both hands toward his chest, “I decided there had to be more interesting ways to spend my life.” He opted for an economics degree and became a banker in 1986. Over the next dozen years, Hernádi rose to become deputy general manager at the Commercial and Credit Bank Co. (where his boss was Sándor Csányi, now chairman of OTP Bank, Hungary’s leading bank) and then CEO of the Central Bank of Hungarian Savings Cooperatives. “When I was asked to join the MOL board, I told them I knew nothing about the oil business,” says Hernádi. They didn’t care. It was his lengthy managerial experience -- unusual in post-Communist Hungary and especially for someone so young -- that interested them.
“I figure that at any company the management problems you face are 80 percent the same,” says Hernádi. Maybe it’s a statistical coincidence, but by his own estimate, he solved most of MOL’s problems by replacing 80 percent of the top 50 managers over the past five years. MOL was notorious for being closed to outsiders. Hernádi brought in executives from other industries and countries. Besides the Belgian Delcommune, the most prominent non-Hungarians in the company are Iain Patterson, a British citizen who sits on the board, and Ray Leonard, an American in charge of exploration and production for MOL’s operations in Russia. Rigorous attention was paid to bottom-line results -- and to getting the share price to rise. Of roughly 1,000 projects then under way at the company, managers were ordered to give priority to the 200 most profitable.
MOL’s biggest problem -- and least profitable operation was its natural-gas business. With prices heavily regulated by the government, the company’s gas division ran up $1 billion in losses in 2001 alone. To handle that costly challenge, Hernádi was promoted from chairman of the board to executive chairman, with greater authority over day-to-day management and a brief to negotiate a better price deal with the government.
“Hernádi is viewed as a rather political figure,” says Tamás Pletser, a Budapest-based energy analyst at Erste Bank Investment Hungary. “He has had excellent relations with the last few prime ministers, both conservative and socialist.”
Hernádi insists that his reputation as a pal of politicians is exaggerated. There have been rumors about his allegedly close ties with former prime minister Viktor Orbán, the charismatic and controversial leader of the right-wing Fidesz party. When television news broadcasts announced Hernádi’s elevation to MOL chairman, he was described as Orbán’s best friend. “My wife was so startled that she dropped her cooking on the kitchen floor,” recalls Hernádi. He says that although he met Orbán when they both were students at the Budapest University of Economic Sciences in the 1980s, the future prime minister was already an organizer for the conservative cause, while Hernádi preferred socialist circles. “I’m political only in the sense that I’ve learned to cooperate with people no matter what their politics,” he says.
This pragmatism has served MOL well. The company had been plagued by management changes whenever a new government took office. But since Hernádi became chairman, all political interference in the company’s affairs has ended. More important, he helped convince a Socialist Partyled coalition government, despite its populist concern over rising energy bills, to deregulate natural-gas prices in 2004 and allow MOL to begin selling its gas business to E.ON Ruhrgas. Subject to approval by the Hungarian government and the EU, which is expected before the end of this year, the agreement turns over MOL’s gas trading and storage units to the German company. “Because of the way the deal is structured, we have several
options on how much more to sell to Ruhrgas and when,” says Hernádi. The biggest decision MOL faces is what to do with the 5,000 kilometers of gas pipeline that it still owns. The company has until 2007 to decide whether to sell the pipeline at a price it finds attractive or to continue operating it.
By shedding its natural-gas operations, MOL is concentrating on its core business -- oil -- both at home and abroad. That single-minded focus began in 2000 with the acquisition of one third of Slovakia’s Slovnaft. By last year MOL owned 98.4 percent of Slovnaft’s shares, purchased for a total of $850 million. “The idea, initially, was that it would take eight years to fully integrate Slovnaft and MOL,” says Delcommune. “But since the beginning of 2004, we are one company.”
According to CEO Mosonyi, the integration process was turned over to Slovnaft’s existing managers; those who failed were shown the door. “About 85 percent were successful and stayed on,” he says. Mosonyi attributes the holdover rate -- much higher than that achieved by MOL during its own transformation -- to time spent at the outset discussing “mutual taboos and stereotypes,” such as Hungarians’ reputation for arrogant impatience and their perception of Slovaks as unsophisticated dawdlers. English, no matter how badly spoken, became the official language. Even at MOL headquarters in Budapest, says Mosonyi, “we speak only English, just to make it clear to everybody that the future of the company is international.”
The most important business hurdle in the integration process was convincing Slovnaft managers that their prize refinery in Bratislava, the Slovakian capital, should help supply nearby western Hungary, while MOL refineries in northeastern Hungary would service the southeastern Slovakian market. “One of the things MOL has achieved at Slovnaft is making sure the right product is delivered to the right place at the right time,” says the EBRD’s Ryjenko.
Though MOL was initially criticized by market analysts for overpaying for Slovnaft, the deal now looks like a bargain. Last year Slovnaft accounted for half of MOL’s profits. The key reason is Slovnaft’s state of-the-art refinery, which complements MOL’s own. “It’s the refinery margins that are pulling the profit cart at MOL,” says ING fund manager Nagy.
Most of these refinery margins are linked to the lower-priced Russian oil that MOL imports through the Friendship Pipeline System, built during the Soviet era. Because Russian oil, known as Ural, has a higher sulfur content than light, sweet North Sea crude, called Brent, it has historically sold at a discount of $1 to $2 a barrel. Only 20 percent of refineries worldwide can turn Ural oil into the high-quality fuels that meet environmental standards in the U.S. and the European Union, but all MOL refineries are able to convert Ural. And with oil prices rising, the differential between Ural and Brent has increased to more than $6 a barrel since the fourth quarter of 2004. “That means a lot of extra profit for MOL,” says József Miró, an equity analyst at Budapest brokerage Cashline Securities.
The Slovakian government, which slammed MOL and Slovnaft with a E35.5 million fine in February for allegedly overcharging Slovakian clients, contends that is too much profit. According to the Slovakian Finance Ministry, since October 1, 2004, Slovnaft has increased its fuel prices in Slovakia by 4.9 percent, compared with only 2.4 percent in the neighboring Czech Republic. “The government has to protect its citizens and businesses from unlawful profiteering,” says Peter Papanek, a Finance Ministry spokesman in Bratislava.
Hernádi vigorously denies the accusation of overcharging and has threatened to take the case to the EU’s antitrust commission. In Hungary opinion in the press and the business community has tended to dismiss the Slovakian action as politically motivated. “The government there isn’t very popular, partly because a lot of people accuse it of favoring foreign investors over domestic businesses,” says Cashline analyst Miró. Hernádi also blames nationalism. “In any country, when the oil industry is privatized, many people feel a part of their body has been cut away,” he says.
MOL may have to gird itself for a similar reaction in Croatia, where it is trying to gain control of state oil and gas company INA. According to Ante Babi´c, head of economic planning in the office of Croatian Prime Minister Ivo Sanader, the government intends to keep a 25 percent share of INA. An additional 21 percent of the stock will be divided equally among INA employees, the Yugoslav war veterans’ fund and the
recently created private pension fund system. The remaining 29 percent of shares that MOL is hoping to add to its own 25 percent stake may instead be tendered as an IPO later this year. The shares could eventually end up with a strategic investor like MOL, says Babi´c, “but first, we want to let the market determine the value of those shares.”
Nonetheless, MOL believes that it has the inside track at INA. It has used its minority stake, purchased in 2003 for $505 million, to claim two seats on INA’s board, appoint the chief financial officer and learn as much as it can about the company. The conditions the Croatian government is attaching to further INA stock sales will probably discourage bids by other oil concerns. “I cannot imagine that any company besides MOL would be interested in the future privatization of INA,” says CEO Mosonyi. “Any third party would make life miserable for everybody, so I’m quite sure that in the end the Croatian government will find a political solution that will make it possible for us to take over a majority of INA.”
Thus far MOL and its regional rivals have stayed clear of each other’s expansion moves. PKN Orlen encountered little competition in its successful 2004 bid for Czech oil and petrochemical company Unipetrol; OMV faced no serious contenders when it purchased Romanian oil concern Petrom last year. And neither PKN Orlen nor OMV is showing much interest in contesting MOL in Croatia. “All three companies have their hands full with the assets they have bought in the region,” says Róbert Réthy, a Budapest-based equity analyst with CA IB Securities.
Although a takeover of INA plays a major role in MOL’s downstream expansion plans, the Hungarian company is giving equal priority to increasing its exploration and production activities, especially in Russia. MOL asserts that it has a cultural edge over Western companies there because many of its oil engineers learned Russian and worked at Russian oil production sites during the Soviet era. Even Hernádi, who, like most students of his generation, despised the obligatory Russian-language classes at school, says he can still reel off some Red Army songs after a few vodkas.
But the Russians are probably more impressed by MOL’s engineering expertise. “A common strategy for a foreign firm in Russia now is to find little oil fields that a major Russian company is too busy to bother with and then increase production through new technology,” says S. Douglas Stinemetz, a partner at Houston law firm Haynes and Boone who specializes in Russian energy deals. “Once you’ve done that, you take your compensation in oil or sell it back to the Russian company.” And MOL has some new technology to dangle in front of the Russians.
Ever since petroleum was discovered in Hungary in 1937, Hungarian engineers have had to cope with low-volume production at the country’s 130 oil fields and resort to advanced recovery techniques. MOL has been at the forefront of tertiary recovery, using carbon dioxide to force up leftover pools of a diminishing oil deposit. “Companies that have access to production areas in Russia but don’t have our specialized operating skills and capabilities will turn to players like MOL,” predicts Zoltán Áldott, 37, MOL’s head of exploration and production.
MOL, however, is just as vulnerable as the supermajors to sudden shifts in Russian oil politics. The Hungarian company’s largest upstream project was 50 percent of a joint venture with Yukos as its original partner to produce oil at the Zapadno-Malobalyk, or ZMB, field in Siberia. MOL helped the ill-fated Russian company raise production from 19,000 barrels a day in 2003 to more than 50,000 barrels a day this year.
But in March, Oleg Vitka, the head of the MOL-Yukos joint venture, was arrested after local prosecutors charged the subsidiary with allegedly extracting oil faster than was authorized. MOL has denied the charge, and Vitka, who was released after a few weeks, remains head of the joint venture. Then in May, MOL announced that another Russian oil company, Russneft, had bought Yukos’s 50 percent stake in the ZMB joint venture at an undisclosed price. According to MOL, the disturbances have not caused any curtailment in exploration and production at the ZMB field, which accounts for almost half of the Hungarian company’s oil output. MOL also says it is undeterred by the uncertainties of investing in the former Soviet Union. “Our upstream investments will focus on existing operations in Russia and Kazakstan,” says Áldott. Those investments accounted for close to $300 million in capital expenditures last year and, he says, “could double if we find new production areas.”
A doubling in MOL’s oil output would almost certainly close the valuation gap between the Hungarian company and the supermajors. It would also make MOL’s senior executives quite wealthy by Hungarian business standards. Under a controversial stock option plan approved by shareholders in September 2003 the 20 most-senior MOL executives are as a group allowed to purchase a total of 1,200 convertible bonds, with a nominal value of $65 million, that can be converted into common stock over the next five years. During that five-year period, the exercise price for the options is based on the previous six-month average share price. By contrast, in stock option plans in most EU countries, the exercise price is set annually, based on the average share price over the previous six to 12 months. “Personally, I’ve never seen this kind of incentive plan in Hungary,” says Cashline analyst Miró.
MOL senior executives can offer their convertible bonds as collateral to get loans -- mainly from OTP Bank, the largest bank in Hungary -- that can be used when they exercise their options to convert the bonds into shares. OTP would be repaid with the profits.
According to MOL’s 2004 annual report, as of the end of last year, Hernádi owned 34,160 shares, worth $2.87 million, and 104 convertible bonds totaling an additional 188,574 shares, currently worth $15.8 million. Hernádi insists that the MOL stock option plan was launched at the suggestion of
major shareholders. “They told us they would be happier if the biggest part of our compensation was linked to higher share prices,” he says. “OTP’s stock option plan is even more generous than ours, and it’s one of the biggest reasons the bank has performed so well.”
Some market analysts agree that MOL’s stock option plan has provided similar incentives to the oil company’s managers. “My only concern is what will make them work as hard as they have in the last five years,” says CA IB Securities’ Réthy.
Hernádi says his own motivation would come from remaining chairman of one of the few sizable Central European companies not swallowed up by a multinational. “This region needs some independent companies,” he says. That’s an appealing notion to many of his fellow Hungarians. But considering that most MOL shareowners are foreigners, it may prove to be one bridge too far for Hernádi.
