Mr Radev looks East –Part 2

Derogation and dependence

In the first part of this three-part article, we looked at the history of – and the interests underpinning – Bulgarian energy dependence on Russia; at limited progress in reducing it; and at the retrograde attitude implied in a recent Draft Decision of the current caretaker cabinet on the subject of nuclear fuel, one of the three dimensions of that dependence. In Part 2, we look at another dimension, namely oil (including refined oil products), and ask whether the same tendencies are operating there.

Dimension 2: Oil

The answer would seem to be “yes”: what’s going on is very similar indeed.

That busy cabinet of ours produced yet another Draft Decision in late October, this one envisaging the lifting of a ban on the export of fuels refined from Russian crude oil to “third countries” – i.e. countries in and outside the EU.

The background is this. Of the oil refined in Bulgaria most (60%-80%) comes from Russia and pretty much all the refining is done at the Russian-owned Lukoil Neftochim refinery near Burgas. For most EU states, importing Russian crude oil is now barred by sanctions, but back in June Brussels granted Bulgaria an exemption from this ban (or, in EU-speak, a “derogation”).

Now, it may seem a little counter-productive (not to mention tasteless) to have Lukoil Neftochim paying Russia money for the crude it uses and generating profits for a Russian parent company, at a time when Russian forces are bombarding Ukrainian cities. But in fact it made sense of a sort. The Burgas refinery is a big employer; it’s also a big taxpayer (though, as we shall see, certainly not big enough); the Bulgarian market depends on it for fuels it would otherwise have to import, with some impact on the country’s balance of payments; and – a nicely poetic twist – the refinery indirectly exports a lot of the gasoil it produces to Ukraine.

The government of Kiril Petkov, in fact, managed to bring about a sharp increase in the volumes of crude refined there, allowing its exports to cover a significant part of Ukraine’s requirements for gasoil (basically diesel that is used for heavy vehicles and not sold at normal filling stations). Which was quite neat, as said requirements were mainly those of the Ukrainian army.

And that fact was important in “selling” the idea of a derogation to Brussels. While other countries also received derogations, they were the ones depending exclusively on pipelines from Russia for their oil supplies. Bulgaria was the only country supplied by sea to get such an exemption.

Somewhat later – on July 29, just before departing from office – the Petkov government introduced the export ban that its successor now proposes to repeal. Due to come into force on December 5, 2022 (with relevant agencies charged with elaborating a suitable mechanism meanwhile), this in fact applied to exports of fuels refined from Russian crude to EU countries as well as those outside the Union, though it’s only exports to “third countries” that the caretaker cabinet now wants enable.

The ban was meant to close a loophole that Lukoil might have used to circumvent EU sanctions, using that derogation of Bulgaria’s. Perhaps a more important and valid reason for the ban, however, was a deepening crisis over diesel, which Lukoil has traditionally sold outside Bulgaria – and especially in Turkey – through its trading arm Litasco. The ban aimed to block such exports and keep diesel in Bulgaria, benefitting Bulgarian consumers rather than swelling Lukoil’s profits (and Mr Putin’s war-chest).

The European Council’s decision explicitly states that the derogation is temporary and “should take all necessary measures to obtain alternative supplies so as to ensure that imports by pipeline of crude oil from Russia are made subject to the prohibitions as soon as possible”.

Now, the diesel crisis is international – intercontinental, even – and there’s good deal of money to be made in speculative transactions, especially where crude oil is for some reason relatively cheap and refining capacity is available. Which is the case in Bulgaria: Russian Urals crude was, last week, trading at a discount of $23-24/bbl, making it the cheapest crude in Europe. And there’s a widening price differential between petrol (gasoline) and diesel at Bulgaria’s filling stations – which has already reached a record 23 cents per litre!

However, Mr Radev’s government appears not to be bothered by this. Nor by Bulgaria’s obligations to the EU cause and its partners in the Union: the European Council made it clear that Bulgaria’s derogation – like that of other states – was meant to be temporary and was contingent on efforts being made to diversify. Yet there’s not the slightest sign that the caretaker cabinet is doing anything of the sort – by seeking non-Russian oil, for instance, or bringing Lukoil Neftochim to heel through expropriation or assumption of operational control by bringing in external management. No, it’s doing precisely the opposite!?. It’s using the pretext of Ukraine’s dependence on imports from the Burgas refinery to expand the derogation – and thereby expand Lukoil Neftochim’s refined product exports to third countries. The government’s primary allegiance appears to be to Russia’s Lukoil, Russia’s crude, and Russia’s tyrant. Not to Bulgarian consumers or the EU.

To put it another way, the Draft Decision is set to transmute a fairly sensible and well-intentioned EU Derogation on oil and refined products into a scam for transforming sanctioned Russian oil into sanctioned fuels – under Bulgarian government protection – and helping a Russian energy giant generate excess profits. Quite the alchemist, our Rumen!

But let’s be fair. The president is nothing if not consistent. This is the same Rumen Radev who famously refused to allow open Bulgarian military equipment supplies to Ukraine. So why wouldn’t he want to provide that nice Mr Putin with some extra cash?

Quite a lot extra, incidentally, as a few back-of-an-envelope sums will confirm. Assuming the volumes and average prices of the last 12 months, the sum in question appears to be around $5.3 billion a year. It breaks down as follows:

• Roughly $3.6 billion in direct payments for Russian crude;
• $1 billion deriving from the fact that Lukoil Neftochim (or, to be accurate, Litasco) is buying crude at Urals prices but selling the resultant refined products at market prices that are effectively Brent-based;
• At least $700 million lost in taxes to the Bulgarian budget (and as a result going to Mr Putin) because of a sort of transfer pricing effect.

The last item needs a little explanation, so perhaps the reader will excuse a short interlude of nerdiness. The trouble is that Litasco controls all the value streams at both the entry to and the exit from the refinery, leaving it just with tolling payments that do not reflect market benchmarks for refining costs. Refining costs have in fact more than tripled since the war’s outbreak, as there is a shortage of refining capacity in Europe. Yet (perhaps unsurprisingly), Litasco has not adequately updated its arrangement with the refinery to reflect these realities. Simultaneously, the refinery is paying higher-than-market prices for goods and services received via the intermediation of Litasco. As a result, the refinery is making a lot less profit – and therefore paying a lot less profit tax – than it “should” be.

In a sense, however, the situation is even worse than that. Bulgaria’s insistence on playing the softest of softball with the Russians might logically be said to have had an opportunity cost to the Bulgarian budget equal to the value of the refinery itself if all the declared financial losses over the past 15 years are summed up. Just consider what the Romanians did.

In 2015, prosecutors attached to the Court of Appeals of the central Romanian city of Ploiesti – the home of the giant Lukoil Petrotel refinery – seized Lukoil assets worth EUR 2 billion in an investigation over alleged money laundering and tax evasion. Ultimately Lukoil settled the case out of court, but it shows what a bit of aggression can achieve.

Different EU countries have adopted different approaches to minimizing the effects of the ban on Russian crude oil and refined products on the operation of Russian-owned refineries in the EU. The Italian government, citing national security considerations and using EU legislation, has asked Lukoil to consent to an ownership transfer of its ISAB refinery in Sicily, in order not to jeopardise ISAB’s operation. That, indeed, seems to be the only way to avoid compromising the refinery’s 20% share on the Italian fuel market. For, after December 5, ISAB will be unable to take delivery of Russian crude, but at the same time it is unable to finance purchase of non-Russian crude.

As owner of ISAB, Lukoil has turned down offers to buy the refinery and seems to be heading for a direct confrontation with the Italian government. But even apart from the outcome of such a confrontation, the issue of solvency may prove crucial. As a sanctioned company, Lukoil will continue to experience difficulty securing sufficient commercial loans, which means that the refinery will be unable to resolve its solvency problems.

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And in Bulgaria? Here it seems that Mr Radev’s government is trying to resolve Lukoil’s sanctions-related funding issues by – wait for it! – allowing the company extra profit margins and cashflows. Well, maybe it’s just that we Bulgarians lack that fiery Latin temperament. But maybe the problem is that the people at the top are incorrigibly Russophile in form and corrupt in content.

A little digression

Now, the argument above raises two interesting points, one concerning neutrality and the other about the tax treatment of firms in the energy sector. Perhaps A&A readers will forgive me if I digress briefly on these before (in the final part of this article) we go on to deal with the subject of natural gas.

On neutrality: One question that arises is this: haven’t I been unfairly dismissive of our president’s stance on sending arms to Ukraine? I think not. But maybe the point needs to be argued. So here goes.

Mr Radev, of course, claims that, by refraining from giving military aid to Ukraine, Bulgaria has been keeping itself out of the war. That is: observing neutrality keeps us out of trouble. But it must be asked: what neutrality?

We noted above that, over the last 12 months, Bulgaria had, all in all, paid around $5.3 billion for crude oil and refined products from Russia. Add over $2 billion paid for Russian natural gas and around $75 million for Russian nuclear fuel, and you have something like $7.5 billion. That’s payment for energy resources that Bulgaria could have sourced elsewhere if the decision had been made not to fund Mr Putin. Call me cynical, but it seems to me that it’s a funny sort of neutrality that countenances the transfer of $7.5 billion, from a country with a relatively small GDP, to finance one side’s war effort. Yet that’s precisely what Messrs Radev, Borissov and Peevski have done.

On tax and subsidies: Our second point concerns an interesting contrast between how Lukoil Neftochim and power generation companies (gencos) are treated, in respect of financing schemes to support the consumers of their products.

Support for Bulgarian electricity consumers comes from the Fund for Stability of the Energy System, into which all “excess” profits of state-owned power generation companies are paid. State ownership in the sector is quite extensive, so these include the Kozlodui NPP, the National Electricity Company and the Bulgarian Energy Holding – which between them account for most payments into the Fund. There had been proposals in parliament – before the legislative process was so rudely interrupted by the toppling of the Petkov government – to broaden the “tax base” for this fund to include all gencos, regardless of ownership. That would include some profitable companies producing electricity on the basis of coal and of renewable energy sources (solar, wind, etc) – assuming times ever become normal enough for parliament to adopt the proposals.

Now contrast the situation with motor fuels. There is no analogous fund in the oil refining sector: admittedly, that wouldn’t be much use, since the sector consists almost entirely of Lukoil Neftochim and since most of the “excess” profits accrue to Litasco rather than Lukoil Neftochim – and since Litasco isn’t within Bulgarian tax jurisdiction to any meaningful extent.

No, the support mechanism, in this case, is a subsidy of 13 eurocents per litre that comes out of the state budget, which ultimately ends up with traders and the refinery. This arrangement is meant to keep down prices at the pump for Bulgaria’s long-suffering motorists. But it’s not obvious that it does so. So, it’s difficult to avoid the impression that the real effect of the subsidy is to strengthen the refinery’s and some selected fuel traders’ balance sheets. Instead of paying windfall tax, like the gencos, Lukoil Neftochim is being subsidized by the budget.

Readers will not, by now, be surprised to hear that until recently there were no proposals in the parliamentary pipeline to correct this anomaly. And, if they are inclined to ask whether Bulgarian legislators or officials are deploying (or contemplating) any of the internationally well-established methods to deal with transfer-pricing tricks or extend derogation rights only to locally taxable companies, they will probably recognize that the question is rhetorical…

So much, then, for nuclear fuel and oil. What of natural gas? That is the subject of the final part of this three-part article.

Ilian Vassilev