GOS TO PURSUE PHASED PRIVATIZATION OF OIL COMPANY

UNCLAS BELGRADE 001013

SIPDIS

SIPDIS

E.O. 12958: N/A
TAGS: PREL ENRG ECON EINV SR
SUBJECT: GOS TO PURSUE PHASED PRIVATIZATION OF OIL COMPANY


SUMMARY AND COMMENT
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1. The GOS will move forward on a draft privatization
strategy for state-owned oil and gas company Naftna
Industrija Srbije (NIS) submitted by adviser Merrill Lynch,
according to the head of the privatization steering group.
In a recent meeting, Slobodan Sokolovic, Assistant Minister
of Energy and Mining, confirmed that the GOS will approve the
strategy in all its key aspects at its council of ministers
meeting on July 6. The strategy calls for a three phased-
approach to privatization under which the strategic investor
initially would purchase a minority share in the oil company,
but with full management control, with a more-or-less
guaranteed right to acquire a majority stake.


2. This strategy is certainly second best to an immediate
sale of majority ownership to a private investor.
Unfortunately, various political interests have once again
prevented taking the most direct path to a fully free-market
situation. That said, if the GOS actually moves forward with
this plan, the sale of NIS, whose revenues are more than
eight percent of GDP, would be a major step forward in
decreasing state control over the economy. END SUMMARY AND
COMMENT.

DRAFT PRIVATIZATION STRATEGY SUBMITTED
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3. Econoffs met with Slobodan Sokolovic on June 20 to
discuss the Government's view of the draft privatization
strategy of NIS. Sokolovic, who also leads the GOS steering
committee on privatization, described a three-phased approach
to privatization that will include an immediate change in
management control of the company. He said that he expects
the Government to approve the strategy as presented at its
July 6 session. This tender likely will open in October,
after Merrill Lynch prepares the documentation necessary,
Sokolovic said.


4. The strategy lays out three phases. The first phase
calls for selling 35 percent of NIS as an integrated company
to the strategic partner with a complete transfer of
management control. Sokolovic explicitly said that
management control will include investment decisions, with no
veto power remaining with the GOS. After the initial
transaction, the state of Serbia will have 40 percent in NIS,
the potential buyer 35 percent, Serbia's Share Fund, 18
percent and NIS workers, 7 percent.


5. Phase two, to take place in three years, will permit the
strategic partner to purchase an additional stake in the
company to bring its share up to 51 percent. Sokolovic said
that this would be guaranteed as long as the strategic
partner meets certain benchmark investments, the key one
being the investment of USD 300 million to bring refinery
products up to European standard. The final phase would
allow the strategic partner to purchase the remaining stake
in the company after Serbia joins the European Union (EU).


6. When econ chief asked how the buyer would be guaranteed
majority ownership in phase two, Sokolovic said that such
specific elements had not been fully defined; Merrill Lynch
will make recommendations on this and other implementation
issues. However, one solution could be an Initial Public
Offer (IPO).


7. Sokolovic said that the reasons why the GOS does not want
to sell the majority in NIS immediately can be explained by
the GOS objectives in carrying out the privatization: to
retain an integrated oil company that can compete in the
region, and to create a dynamic company that will also
promote growth in other parts of the economy. Other
objectives include creating a competitive market and
attracting strategic investors who will invest and modernize
the company and produce Euro-quality products. Sokolovic
acknowledged that the two-phase strategy was intended to
guarantee the government that the investments take place
before it authorizes the majority transfer.


8. On June 19, Merrill Lynch presented the strategy to the
NIS Managing Board and NIS Trade Union. The Board allegedly
fully accepted the strategy, despite its intense media
campaign to stave off privatization through a variety of
stratagems: sale of a low percentage to a consortium,
"first-modernization, then-privatization," etc. (Merrill
Lynch reports having consistent problems in getting data out
of the company.) On the other hand, Sokolovic said that the
trade union only expressed interest in the distribution of
shares for union members, e.g., when they would be able to
cash them in.


9. According to terms of reference for the privatization
advisor, in the second phase Merrill Lynch will present a
detailed analysis of all aspects of the privatization:
operational, financial and legal due-diligence; environmental
review; valuation of the company and preparation of the
tender documentation. Merrill Lynch is responsible for
preparing each phase of the transaction process to give
potential investors a clear picture of the privatization
process.


10. The final, implementation phase, will encompass the
following: launching and managing the bidding process;
managing the due-diligence; collection and evaluation of
bids; managing and/or conducting negotiations; preparing of
the Final Legal Documents and advice on and support the
closing of the transaction.

OTHER OUTSTANDING ISSUES TO BE RESOLVED
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11. Other controversial issues like whether to let
consortiums bid on the tender, the amount of social program,
or compensation, for workers to be released, and how to value
shares in the second transaction, will be worked out by
Merrill Lynch in the next phase of their work, Sokolovic
said. He said that Merrill Lynch will seek to define
conditions under which consortiums could participate in the
tender without the fear that NIS will be split into parts
after privatization.


12. With regard to regulatory issues, Sokolovic explained
that some sort of import tax for crude oil and oil products
will be maintained for another three to four years after
privatization of NIS, to give NIS and a future strategic
partner more time to modernize its refineries ahead of
privatization. The decree banning imports will be replaced
by an import excise that will decline over time, while
pricing will become an automatic mechanism that will no
longer require Ministry of Finance approval. (However, the
Government only days ago extended its decree banning
companies other than NIS from importing oil derivatives,
except euro diesel 4, through the end of 2010.) (Note:
Prominent economist Kori Udovicki, a former central bank
governor, attacked the GOS's move to extend the decree, but
in the same statement she also called for a declining tax to
replace it, similar to what Merrill Lynch has proposed.)


13. When asked whether the Ministry was concerned that a
decline in oil prices over the next few years could impact
the valuation of the company three years down the road,
Sokolovic said that Merrill Lynch's projections foresee the
price of crude oil and refinery margins remaining high over
next five years. Sokolovic mentioned that the Petrohemia
complex in Pancevo, which is linked in every way to
processing of oil in the refineries, will be privatized
separately from NIS, but Merrill Lynch will handle the
process in parallel with NIS privatization.

POLT