Risk Factors and Threats

The operation of Grupa LOTOS, like other businesses of the fuel sector, is exposed to external risks related to the general macroeconomic situation in Poland and abroad. They include primarily the risks resulting from the fluctuation of interest and FX rates, changing prices of raw materials and refining margins, the risks involved in CO2 emission credit prices, as well as the risks from the availability of raw materials and sources of funding.

Moreover, the Company’s operation is strongly affected by risks related to amendments to legal regulations, especially the changes and interpretations of tax law, the modifications of state policy and the resulting strategic aims.

From the business point of view, the risk of losing liquidity and credit risk due to financial and trading transactions are also important.

The following risks stem from the operating activity of the LOTOS Group:

• environmental risks – the risk from a shortage of the sufficient number of CO2 emission credits, the risk of major industrial failures (resulting in abnormal emissions of pollution into air, water and/or ground) and the risk of non-compliance with environmental law provisions (domestic and community),
• process-technological risks – concerning primarily the risks from processed substances, applied technologies, used devices and equipment and operating conditions due to high pressure and temperature parameters,
• health risk – resulting from the exposure of employees to the impact of hazardous and inconvenient factors, related to performed work and the proximity of production processes, which may lead to accidents at work and occupational diseases.

From the perspective of the LOTOS Group’s development strategy, in times of global crisis accompanied by high fluctuations in raw materials and oil product prices as well as FX rates, it is of key importance to complete the 10+ Programme investment in a timely manner and to obtain access to own sources of oil as well as to strengthen the market position and increase sales efficiency.

Key Risks in Specific Operating Areas

Risks related to the 10+ Programme execution

There are a number of risks stemming from the execution of the 10+ Programme that are characteristic for major investment projects. However, irrespective of typical risks due to costs and schedules as well as the provision of the required quality and safety requirements, other phenomena may occur resulting from the global financial-economic crisis in 2009.

Such other risks include:

• the delivery/assembly of faulty devices and materials, resulting in the requirement to repair or replace them and in the increase of costs and delays,
• delays in deliveries of machines and equipment due to economic difficulties faced by sub-suppliers,
• the systematic and progressive growth in material and service prices,
• the bankruptcy of sub-contractors due to various phenomena caused by the global crisis, resulting in delays in the investment execution, forfeiture of payments and the necessity to purchase additional materials,
• the shortage of labour on the Polish market causing the slow pace of work performance and delays in commissioning production systems,
• failures caused by difficult conditions of work performance or non-compliance with procedures resulting in the suspension of work or delays and in exceeding the budget,
• the failure to achieve the complete process criteria of started systems due to latent design defects, resulting in the additional costs of obtaining basic design parameters of the systems or in losing profits,
• the occurrence of unfavourable weather conditions, causing delays and damage to installed equipment,
• protests and objections from individuals and external institutions, resulting e.g. from the impact of the investments on the environment and causing the suspension of work, delays or the issue of administrative decisions,
• accidents caused by difficult working conditions or the high intensity of work in the same area or the failure to meet H&S rules, and
• the temporary suspension of crediting, resulting in the postponement of work due to a shortage of funds.

Risks in the exploration-production activity

Due to the global slump, the strategy of developing the oil exploration and production sector and the plans of its execution may be revised due to required adaptation to the changed economic conditions.

The potential risks in exploration and production are as follows:

• limited access to external financing,
• changing market conditions with regard to oil prices as well as USD and EUR exchange rates,
• limited availability of drilling tools and rigs,
• higher prices of services, drilling work and production plants,
• poor effects of exploration work (documented resources of hydrocarbons lower than forecast),
• operating risks due to the production of hydrocarbons, and
• low efficiency of auxiliary operations that support production processes.

It is noteworthy that in the exploration and production area preventive measures are taken on an on-going basis to monitor the market, increase the value of Petrobaltic’s assets, assess the implemented projects and take decisions based on earlier geologic and resource analyses.

Risks related to raw materials provisions

In 2008, Grupa LOTOS continued its steps, planned in the adopted strategy, of diversifying oil supplies, focusing on two crucial aspects of this strategic aim:

• the safety of petroleum supplies: providing an alternative channel of crude oil supplies with a constant presence on the international oil market, regular contracting of supplies of various oil blends from the sea, with the simultaneous option to radically increase their share in the total supplies of oil to the refinery in the event of hazards to the continuity of supplies from the basic direction, and
• improved competitiveness, owing to the location of the refinery in Gdańsk, by the sea, and the possibility of receiving raw material supplies from two independent channels – Russian oil from the ‘Friendship’ pipeline and various blends of oil available from Naftoport. The suitable selection of blends results from continuous optimization.

Risks in sales

The macroeconomic environment of Grupa LOTOS has a major impact on the sales of its products, especially during the present recession. During an economic crisis, the reliability and liquidity of direct suppliers, which depends on the liquidity of their payers, become particularly important. Therefore, a policy of transaction hedging and receivables monitoring becomes so important.

The application of commercial security rules, as well as the current and future condition of business entities will depend mostly on the policies of financial and insurance institutions. Sharpening the credit policy may cause limitations or no access to securities of commercial transactions, such as sureties, insurance, letters of credit, as well as revolving and investment credits.

The principal risks in the business operation of the LOTOS Group in 2008 and indirectly in 2009 include:

• the falling demand for fuels and other oil products due to the global economic recession, resulting in a growth of income from sales that will be below expectations,
• the appearance of new importers of oil products from various geographical directions, implementing aggressive price policies,
• the aggressive price policy of competitors,
• the decrease in the transit of goods across Poland,
• the lower number of air connections in the world,
• the decline in executed road contracts, and extended tender procedures concerning the implementation of road investments,
• the reduced traffic of ships in Polish ports due to the fall in exports/imports, and
• the development of a market of alternative fuels.

Risks related to financing the operation

At the end of 2008, Grupa LOTOS signed a contract for financing the 10+ Programme. The loan for the 10+ Programme is a long-term credit and is granted by 17 financial institutions of good standing. The repayment of the investment credit will commence in 2011 and will continue until 2021. The securities of the investment credit for financing the 10+ Programme include only the assets and cash flows of the refinery in Gdansk. The collaterals do not cover any assets or cash flows related to oil production, the chain of petrol stations or any other assets located outside the refinery in Gdańsk or any shares of Grupa LOTOS or its subsidiaries. Moreover, the Company uses short-term financing.

The oil production projects were financed in 2008 with own resources of Petrobaltic.

As regards financing, the following risks may be listed:

• The risk of limited access to financing – both that of investments and current financing. In this area, there is a potential risk of the lack of liquidity on the banking market and the problems of banks in providing funds in compliance with executed credit contracts. Another potential risk is due to the possible default of Grupa LOTOS with regard to the credit contract, which would suspend access to crediting.
  The above risk is dispersed because there are more than a dozen banks involved in funding the 10+ Programme investments. Moreover, the situation of individual banks that participate in the financing is being currently monitored by the Investment Financing Office based on available information. So far, no significant hazard has been determined for any further uninterrupted use of the credits. At the same time, Grupa LOTOS is trying to fulfil all its informative obligations and all other requirements set by the banks due to financing. This risk occurs in the event of a significant deterioration of liquidity.
• The risk of maintaining an adequate ratio of the used credit to the value of the pledged stocks.
  The credit for financing the stocks provides for the maintenance of an adequate ratio of the used credit to the value of pledged stocks (the collateral) by Grupa LOTOS. Due to the falling prices of petroleum and refining products, there is a potential risk of raising this ratio above the set maximum limit, which will require the repayment of part of the credit. In such an event, the repaid part of the credit will be available for use only after the value of the stocks maintained by Grupa LOTOS is raised.
• The risk of increasing costs of credit or worse conditions of financing.
  This risk is related to the slump and the tendency of banks to limit available funding.

The risk related to the changes and interpretations of tax law

Grupa LOTOS runs its business in a legal environment where frequent changes of tax law occur. New regulations and changes to the application of existing regulations affect the business of Grupa LOTOS and the type of measures taken, as well as the value of tax liabilities. Due to the numerous amendments to regulations, internal procedures have been introduced in order to comply with legal regulations and to identify and minimise tax risks as well as their impact on the financial statements of Grupa LOTOS. Moreover, any amendments to the law are monitored, which allows the suitable adaptation of internal tax accounting systems.

The Integrated Information System mySAP.com has enabled the risk of errors in accounting to be minimised and time and costs to be saved with automatic data processing. An important factor that has reduced the tax risk is the qualifications of the employees who have specialist knowledge in tax law.

In the fuel sector, the greatest tax risks result from excise tax, due to the value of tax liabilities and complicated legal accounting.
The analysis of the Act on excise tax that came into force on 1 March 2009 and the executive regulations of the Act show that domestic excise tax regulations are highly complicated and detailed. Moreover, various tax authorities apply different interpretations of the same regulations and it is not possible to determine their uniform interpretation. This causes constant risks related to the possible questioning by tax authorities of the correct settlements of excise tax and transactions.

Therefore, the main tax risk areas with regard to excise tax include:

• the application of excise tax exemption for bunker fuel sold by Grupa LOTOS,
• the requirement to obtain permits for the sale (purchase, agency) of products exempt from excise tax due to their use by all suppliers of Grupa LOTOS,
• the introduction of new principles in the turnover (the formalization of procedures) with so-called external depots that are tax service stores run by companies, and
• the application of biocomponent tax relief due to the use of biocomponents by Grupa LOTOS in production.

Strategic legal risks

Strategic analyses are carried out by Grupa LOTOS in cooperation with state administration authorities that are responsible for creating and implementing government strategy for the oil sector. The competent ministries are currently informed of progress in executing the premises of government strategy and the postulated directions of developing the Polish oil sector. Moreover, Polish and European legislation is monitored with regard to the oil sector and opinions are prepared on the drafted and applicable legal acts, particularly with regard to the regulations that concern the obligatory stocks of oil and fuel as well as biocomponents and biofuels .

Risk of sharpening quality requirements for oil products

Grupa LOTOS continues to monitor drafts of new standards and regulations that may affect production and trading activity. Information on any future changes of quality requirements comes from the 222 Technical Committee of the Polish Standardization Committee for oil products and operational fluids. Owing to active participation in the work of sub-committees of the 222 Technical Committee, Grupa LOTOS may give its opinion on the drafts of European standards during their formulation.

Grupa LOTOS gains an additional impact on the level of quality requirements, especially for engine fuels, by participating in the sectoral association, the Polish Organization of Oil Industry and Trade. The involvement in such work significantly reduces the risks due to delays in applying future quality standards in the area of oil products. In 2009, no changes of standards or legal regulations are planned that would sharpen the present requirements for oil products, especially engine fuels.

Environmental risks, process-technological risks and health risks

In order to reduce the probability of undesirable events, including occupational diseases and unfavourable health effects due to work performed by employees of Grupa LOTOS, prophylactic initiatives and actions are focused on.

In accordance with applicable rules of law and internal regulations, the Company systematically identifies the risks present in working stations and occupational risks related to the following factors: noise, vibration, chemical and biological substances, inconvenience due to monitors, explosion hazards and risks due to the incorrect operation of machines and equipment.

The generally applied health and safety precautions and means are aimed at minimising the process-production and health risks.

Grupa LOTOS has utilised in its production processes the technologies and equipment that fulfil the criteria of the Best Available Techniques. The production systems are equipped with suitable safety and protection systems, including BAT techniques and multi-layer protection systems (i.e. prevention, protection and counteraction layers).

Another area of special attention includes the procedural requirements concerning the training of employees in procedures, e.g. complicated equipment and devices or the use of hazardous substances. The system principles and requirements in this regard, in particular compliance with H&S rules and regulations at work, are strictly monitored and executed.

The risk related to the shortage of CO2 emission credits

This risk concerns existing systems and the possible failure to obtain necessary credits for new or significantly modified installations (where the emission of carbon dioxide increases).

In mid 2008 (1 July 2008), a distribution of credits was carried out and a Cabinet Regulation was published entitled the National Plan of Carbon Dioxide Credits Distribution for 2008-2012 in the community system of emission credits trading for existing and modified systems (Journal of Laws, No. 202, Item 1248). In accordance with the applicable law, the above-mentioned credits were distributed in the second accounting period (2008-2012) free-of-charge for all installations covered by the emission trading system.

According to the distribution and based on:

• the first year of the 2nd Plan (2008) that was formally accounted for and
• emission forecasts until 2012

no shortages of emission credits for existing systems are anticipated.

The need for additional credits will occur in the second half of 2009. Grupa LOTOS has a good chance to obtain additional credits due to the implementation of the 10+ Programme. A certain risk comes from the lack of fixed rules for obtaining such credits.

In order to ensure its safe operation, Grupa LOTOS manages the main types of risks, focusing on financial and market threats.

• Financial and market risks are managed by the Financial Risk Management Committee. It is responsible for monitoring and coordinating the financial risk management process in Grupa LOTOS. The main aim is to maximise the result from the market risk management for the set level of risk, to stabilize cash flows, to provide short-term financial liquidity and to support projects aimed at organising funding for the investment activity.
• The raw materials and oil products price risk management is of special importance for the operation of Grupa LOTOS. The concept of managing the raw materials and oil products risk management covers the period until the end of 2010, which coincides with the schedule of the 10+ Programme implementation.
• Moreover, the Committee is responsible for managing the carbon dioxide emission credits price risk, which should comply with the premises included in the ‘Strategy of managing the risk of CO2 emission credits in Grupa LOTOS S.A.’ According to the specific phases of the Kyoto Protocol, it covers the management horizon until the end of 2012.
• FX risk management is carried out according to the premises included in the ‘Strategy of FX risk management at Grupa LOTOS S.A.’ and the management horizon is set by individual budget years.
• The natural currency of the market where Grupa LOTOS operates is the American dollar (USD). This currency is used in quoting market prices of oil and its products. Therefore, Grupa LOTOS carries out most of its operating activity in USD. As a consequence, it has been concluded that the best currency for incurring and repaying long-term credits for financing the 10+ Programme is USD.
• Managing the interest rate risk results from the anticipated schedule of receiving and repaying the credit for funding the stocks and the 10+ Programme. The interest rate risk concerns the value of interest set based on the changeable LIBOR USD rate.
• Liquidity risk management in Grupa LOTOS involves monitoring the forecast cash flows and after that adjusting the maturity dates of assets and liabilities, the analysis of revolving capital and the maintenance of access to different sources of financing.
• Managing the credit risk of financial transaction partners is effected by  current monitoring of the credit exposition in relation to the granted limits. Transaction partners need to have suitable ratings granted by leading rating agencies as well as guarantees of institutions that fulfil the requirement of the minimum rating. Grupa LOTOS executes financial transactions with firms of good standing that have good creditworthiness.
• With regard to managing the credit risk of non-financial transaction partners, the Group verifies all customers who apply for trading credits in terms of their financial reliability. The results of the assessment determine the granted limits. Issues of customer assessment and granted limits are resolved by the Credit Committee established at the beginning of 2009.
• The detailed rules of managing financial risk have been presented in the section concerning financial data.

In 2008, Grupa LOTOS started to prepare for implementing the Integrated Management of Corporate Risks designed to control and integrate risk management in all operation areas of the LOTOS Group. The implementation involved the verification of the risk management condition in specific areas and a workshop for managers dedicated to risk management. The Integrated Management of Corporate Risks should create a single information centre about key risks and standardise the methods of risk management at the LOTOS Group. The implementation has been planned for 2009 and 2010 and will be carried out by the Strategy Office. Key decisions concerning the identified risks and the risk procedures will be resolved by the Strategy Committee.

Furthermore, Grupa LOTOS runs an internal audit responsible for the independent and objective assessments of risk management and internal control as well as for the analyses of business processes. The Audit Office prepares bi-annual and annual reports for the Management Board and the Audit Committee of the Supervisory Board. The reports provide summaries and conclusions from the executed audit tasks and information on the level of implementing the recommendations.

Due to the present macroeconomic situation caused by the global crisis, the Management Board of Grupa LOTOS has taken the decision to intensify measures aimed at providing the liquidity of the Company. The anti-crisis package launched at the beginning of 2009 should provide savings that will significantly improve cash flows in the Company.

The rules and instruments of the financial risk management and the impact of the most important risk factors on specific items of the financial results have been presented in the consolidated financial statements in the explanatory notes.