Reviewing the Hungary Bid Round

2014 Bid Round

The latest invitation for tender for concessions was announced by the Hungarian Ministry of National Development on 17 June 2014 and closed on 1 October 2014 (2014 Bid Round).

The 2014 Bid Round once again made available a total of 7 blocks, comprising:

• 1 block for geothermal (Battonya)
• 6 blocks for oil & gas exploration and production (Ebes, Nádudvar, Western Nagylengyel, Eastern Okány, Western-Okány and Újléta).

Oil & Gas Blocks - Winning Bidders

On 21 November 2014, the Hungarian government announced the winners of the 2014 Bid Round, once again without saying whether each of the 7 blocks received more than one bid. However, we do know that a total of 8 bids were submitted, with Western-Okány oil & gas block not being awarded as it received no bids at all, so by deduction only 1 block would have received more than one bid, unless it was for geothermal.

The winning bidders were conditionally awarded the following oil & gas blocks:

• The Eastern Okány block to MOL, Hungary's national oil & gas company.
• The Ebes block to an affiliate of Vermilion Energy Inc. of Canada.
• The Nadudvar and Újléta blocks to O&GD Central Kft, a portfolio company of private equity investor Warburg Pincus
• The Western Nagylengyel block to Hungarian Horizon Energy an affiliate of Aspect Holdings LLC, USA

Review of 2014 Bid

Whilst there was an improvement in the number of bids submitted this time around, we remain of the view that the latest bid round remained a relatively muted affair. The biggest issue seems to be the quality of the available blocks, but additionally there remain real concerns over access to and availability of relevant data to potential bidders. The good news is that there are changes scheduled to be introduced which will make such data available more easily and this will of course assist potential bidders better review and analyse the concession blocks being made available.

As a brief reminder, the winning bidder has 60 days (with an extension of an additional 60 days) in which to negotiate and execute the concession agreement after which it must establish a concession company in Hungary within 90 days.

Negotiations are currently under way between the winners of the 2014 Bid Round and the Ministry of National Development and therefore we expect that these concession agreements will be executed in the coming weeks.

The oil & gas block winners of the 2013 Bid Round have now executed their respective concession agreements and set up their respective concession companies, and should have also submitted their work programs/technical operating plans (TOP) to the relevant mining authorities for approval. The concession companies can only start their activities once the TOP has been approved.

Looking Ahead

Bidders agree to pay a minimum fixed concession fee and also agree to  pay a minimum fixed amount of 19% by way of royalty rate, but they can undertake to pay a higher amount of concession fee as well as a higher percentage royalty if they wish (in both cases to improve their chances of winning).

In Hungary, royalty rates are calculated based on a formula that is strictly linked to the average Brent oil prices in December 2007 which was approximately USD$91 and is payable in HUF. So not only does the change in oil prices affect the effective royalty rate, but so too does the FX exchange rate. The current Brent oil price has now fallen to about USD$67 (as of today), representing a fall of approximately 40% since January 2014, and expectations are for a continuing downward trend.

Taking into account the continued strengthening of the USD, notwithstanding the possibly artificial strengthening of the HUF towards the end of this year, then both of these elements make the effective royalty rate higher in Hungary, regardless of whatever amount may have been agreed by the bidders in their winning bids. This is simply because the base value for the calculation is artificially high.

Whilst the relevant government decree provides for a bi-annual review of the base value, to date there has been no action taken following such review, so that the base value remains pegged to December 2007. The next review is scheduled for December 2015, but based on past performance there is no guarantee that there will be any change.

With the recent, and continuing, fall in the Brent oil price, there is mounting pressure on the oil & gas industry in terms of their investments in new exploration activities, as well as of course the amount of royalties and other taxes payable on production activities. Some industry commentators make clear that the need has never been greater for a re-balancing of portfolios to take into account exploration risk and declining production revenues.

In some countries, such as the UK, there has been a small, but welcome relief with a slight reduction in applicable taxes provided to participants in the North Sea, where ageing oil fields with declining production require higher investment to continue to operate.

However, other countries are yet to make similar reductions, but it is likely that there may have to be some special measures introduced to stave off a potential hiatus from new exploration activities in the longer term if oil prices remain low, particularly in those countries where declining oil prices will have a much greater impact on such activities, such as those with limited or expensive potential as well as declining production.

Some industry commentators have cited an oil price of USD$ 65 as the level below which financial viability of new exploration activities becomes a real issue, and now that level has almost been reached, it will be interesting to gauge market reaction. Certainly a number of companies have already announced cuts to their capital development program and Reuters estimate global oil and gas exploration projects worth more than USD$150 billion are likely to be put on hold next year as plunging oil prices render them uneconomic, and that was based on a USD$80 oil price!

Such special measures may include a review of the amount of the concession fees payable in Hungary, although with continued pressure on the government’s fiscal budget, combined with the continued appetite for increased taxes across the economy generally, such relief should not be expected to be forthcoming any time soon.

Additionally, there are concerns amongst some lenders that their loans may be at risk, with it proving difficult in some cases for such loans to be syndicated to the wider marker. In other case, lenders are selling off their loans where they can with a consequent increase in activities of specialised finance vehicles in buying up distressed loans.

There are also concerns being raised by various financial authorities that the quantum and extent of bad debts could be much higher than previously envisaged with the continuing fall in oil prices, and they are also considering the possible impact on the wider economy if such debts do indeed turn out to be bad.

Over and above these fiscal issues, there is of course the ongoing geo-political and energy supply issues which impact on the oil & gas industry generally, but particularly those in Central & Eastern Europe.

With the recent announcement by Russia that South Stream will not go ahead, and disregarding potential theories over strategies to overcome EU raised hurdles, this still raises a number of questions for affected countries, particularly Hungary, who was in favour of proceeding, given its seemingly special relationship and agreements with Russia concerning the purchase and storage of gas, and the interrupted supply of gas to Ukraine.

Whilst Hungary is unlikely to ever be in a position to cover anywhere near all of its energy requirements, we believe it should be looking more favourably on the oil & gas sector to help it reap whatever it can whilst it can, notwithstanding any possible expansion to its Paks nuclear plant and the promise of cheaper energy.

All of these factors will impact, to a greater or lesser extent, on Hungary’s oil & gas sector and whilst it is not realistic to expect any material changes to the current environment, it is to be hoped that such factors will be considered and taken into account for the future.

2015 Bid Round

The third bid round is expected to be announced by the Hungarian Ministry of National Development in the first half of 2015 (2015 Bid Round) and we would expect it to offer a similar number of blocks.

Despite some sensible and practical changes having been made prior to the 2014 Bid Round, all indications are that the same fiscal terms and conditions will again be used in the 2015 Bid Round.

If there is more data made available for the 2015 Bid Round, this will at least allow potential bidders to better understand the potential of the blocks to be made available, which in turn will help optimise the amount of the concession fees to be paid by them, which of course may be to the benefit of the Hungarian government.

However, it stands to reason that if oil prices continue their downward trend and geo-political issues remain a factor, then oil & gas companies will naturally, and in some cases be obliged to, remain cautious in their exposure to new exploration activities as, unless they can obtain a return on their investment, their appetite for new exploration is likely to be diminished, which would not bode well for the 2015 Bid Round.

Steven Conybeare

Steven Conybeare is with Conybeare Solicitors (London & Budapest) and can be contacted via e-mail (steven@conybeare.com) on +36 1 577 9936 or +44 870 753 0925