Plan for capital restructuring of Grupa LOTOS s upstream segment Prepared by LOTOS Petrobaltic S.A. Development Department / Grupa LOTOS S.A.
1. Rationale and objectives Grupa LOTOS S.A. is a vertically integrated oil company, operating in exploration, production and crude oil processing, as well as in sale and distribution of a wide range of petroleum products. The Company has been listed on the Warsaw Stock Exchange since 2005. Its major shareholder is the Polish State Treasury. Shareholders of Grupa LOTOS S.A. as at December 31st 2016 Through its subsidiaries (LOTOS Petrobaltic, LOTOS Norge, and LOTOS Geonafta) the Company also conducts operations in the Baltic Sea, the North Sea and the Norwegian Sea, as well as in Lithuania, where it is involved in exploration for and production of natural gas and crude oil from onshore and offshore fields. LOTOS is the second largest oil and gas producer in Poland and the only producer of crude oil and associated gas in the Baltic Sea. It is also the largest crude oil producer in Lithuania. Pursuant to the Council of Ministers Regulation of January 3rd 2017, the rights incorporated in Grupa LOTOS S.A. shares are exercised by the Minister of Energy. Ensuring energy security for Poland remains the LOTOS Group s first and foremost priority. 1 With furthering the energy security policy in mind, on December 14th 2016 the Supervisory Board of Grupa LOTOS S.A. approved a new strategy for the Company, which was officially announced by the Management Board on the following day. The strategy was entitled Stability and sustainable growth LOTOS Group Strategy 2017 2022. 1 Letter from the President of the Management Board of Grupa LOTOS S.A. to shareholders published in the Consolidated Financial Statements for 2016. 2
It was developed around the key concepts of stability and safe growth, along two time horizons. In the initial years 2017 and 2018, Grupa LOTOS S.A. wants to focus on stabilising its cash flows, lowering debt, and making progress on running capital investment projects. Next, in 2019 to 2022, the Company is set to further expand its business based on a new portfolio of capex projects and by investing profits generated by completed projects, which will be additionally facilitated by cost discipline, cost savings, and other measures. Some of the objectives identified in the strategy are to: effectively use production licences, gain access to 2P oil and natural gas reserves of 60 million boe or more, step up production to 30 50 thousand boe/day. In the Upstream, Grupa LOTOS S.A. also aims to: optimise financing sources, consistently build a sound and balanced asset portfolio, based on projects in the pipeline, and pursue more field development projects and enhance its portfolio of upstream assets. Planned Upstream capex is PLN 3bn (i.e. 49% of Grupa LOTOS S.A. s total planned capital expenditure in 2017 2022), with an option to commit additional funds from the planned PLN 3.3bn (decision on the allocation of additional funds will be made in 2018). Capital projects in the Upstream segment are expected to result in an annual EBITDA of PLN 1.6 1.8bn by the end of the strategy term. At present, the Upstream segment is organised into three areas: Norwegian Continental Shelf operations, conducted through the subsidiary LOTOS Exploration&Production Norge AS ( LEPN ), Lithuanian operations, conducted through AB LOTOS Geonafta ( Geonafta ), Polish operations, including offshore presence on the Baltic Sea and onshore operations in the Pomerania, Warmia and Masuria regions, conducted through LOTOS Petrobaltic S.A. ( LPB ), which is also the corporate centre and the parent of the other upstream companies. The diagram below presents the current structure of Grupa LOTOS S.A. s Upstream segment. 3
The current make-up of the Upstream segment has evolved through acquisitions and restructuring processes implemented since 2005. The initial stage of the process was financed with internally generated funds, with no external funding sources employed. No barriers to growth were encountered at that point that would result from the need to secure new funding and use debt-related instruments, such as guarantees, sureties, security and collateral. Once consolidation of the ownership structure of Grupa LOTOS S.A. s Upstream segment was complete, with LPB acquiring full operational control of Energobaltic sp. z o.o. and Geonafta, Geonafta s Lithuania assets consolidated and LPB s shipping assets reorganised, certain obstacles to growth emerged, including limited access to sources of finance for capital projects, elevated debt levels, overlapping operational risks, etc. Consequently, LOTOS Petrobaltic s current position is marked by: lower relative contribution to the results of the Upstream segment compared with historical levels, poor bankability and a need for debt refinancing, burden of commitment to the B8 project, including financing support for the B8 SPV, low cost effectiveness per barrel, common management of the Upstream segment, Baltic operations and services, leading to low cost transparency and management dilemmas, lengthy decision-making on capex projects in geographies other than the Baltic Sea. The current position of LOTOS Petrobaltic and its role as the holding company in Upstream restrict Grupa LOTOS S.A. s ability to implement its strategy in the segment: the nature of capital links prevents optimal risk management and causes risks inherent in one area to affect other areas, access to external financing is significantly limited because it relies exclusively on LPB s balance sheet and production assets. This greatly limits options to use project finance solutions to fund capital projects. LEPN must then rebuild its equity base and reduce internal financial burdens in order to regain its ability to raise financing from external sources and optimise its tax position. 4
In addition to the current constraints, it will be important in the context of the new strategy to attain strategic growth objectives, which calls for a capital and organizational structure that would enable: effective implementation and oversight of projects in the pipeline (with the Utgard, Yme, Frigg Gamma Delta, Langfjellet and B4/B6 fields slated to enter the development phase in 2017 and 2018 alone), acquiring/defining new projects options available in the North Sea, Norwegian Sea and, possibly, the Barents Sea. This is a particularly attractive direction due to its considerable production potential, geographical proximity, robust legal and economic environment, and marginal operational risk (a tax refund regime for exploration costs); and raising finance for the projects. In the course of analyses of effective ways to implement Grupa LOTOS S.A. s strategy in the Upstream segment, it was determined that the best solution from the Company s perspective would be to build the segment around a dedicated holding company ( LOTOS Upstream or LUPS ). The company would buy and own all financial assets necessary to implement the strategy (operating companies) and serve as a platform for expanding the Upstream segment, assisting the operating companies with arranging financing for new projects. The operating companies would all operate at the same level of the holding structure, as LUPSowned subsidiaries. This would help to split risks inherent in operations carried out in the individual geographies so that they would not impact one another as is currently the case. Centralising operational oversight within LUPS as the holding company would enable effective verification of operating results across the geographies and fast identification of operational priorities for the Upstream segment. LUPS would also act as a buffer between upstream operations and Grupa LOTOS S.A., a vehicle free from the burdens on LPB s balance sheet, capable of raising capital for its operating subsidiaries. With all subsidiaries placed at the same level in the holding, exercise of corporate governance and decision-making with respect to the subsidiaries would be more transparent from LUPS perspective. It would also maximise the capacity to flexibly respond to their needs, particularly the need for capital to fund expansion projects. In the proposed structure, LPB would be the centre of operator services for the Baltic Sea fields. In the future, the corporate structure of the Upstream segment may possibly include an offshore services company, which could consolidate interests in projects located in Poland, Norway and the United Kingdom as a contractor with access to lower-cost contractor capabilities in Poland. 5
2. Stages of the restructuring and path to the target structure The restructuring plan for Grupa LOTOS S.A. s Upstream segment provides for consolidating the core operations within LUPS as the holding company. This would be achieved by implementing a scenario where LPB would first transfer (sell) shares in Geonafta, LEPN and the Baltic Gas companies to a holding company established specifically for this purpose LUPS. The plan assumes this stage would be completed in the third quarter of 2017 (for a more detailed description of this stage, see the following section). LPB would focus on seeing the B8 project through to completion and increasing operational efficiency. If these objectives were met, LPB would be able to faster exit the guarantees it has provided to LEPN in favour of PKO BP to secure repayment of the facilities provided by the bank. LUPS support in new acquisitions and access to funding sources would help to refinance the PKO BP facilities and extinguish the guarantees provided to the bank. Further stages of the restructuring that could be implemented later on are as follows: establishing an operator and oilfield services company on the basis of LOTOS Petrobaltic, which could provide services to customers other than Grupa LOTOS S.A.: transferring all production projects (e.g. SPV B8) to LUPS, possibly establishing an offshore engineering, operator and design company on the basis of LOTOS Petrobaltic, establishing special purpose vehicles (controlled by LUPS) to carry out new production projects in the UK, Denmark, Netherlands, etc. Regardless of which restructuring scenario is finally approved for implementation, LBP will continue to be involved in production from the B3 field. 3. Overview of the restructuring process Restructuring process by stages 1. The first stage of the internal restructuring of Grupa LOTOS S.A. s Upstream segment would be to establish a subsidiary holding company incorporated as a limited liability company. 6
2. As a next step, LPB would sell its assets to LUPS, consisting of shareholdings in LEPN, Geonafta and the Baltic Gas companies. Funding for the acquisition of these assets by LUPS would be procured by Grupa LOTOS S.A. At this point, the transfer of assets from LPB to LUPS would be subject to securing a number of permits and approvals from public administration authorities (e.g. from the competent government departments in Norway) and financial institutions. 3. If relevant approvals were obtained from the competent ministries in Norway, the existing guarantee provided by LPB for LEPN s obligations on the NCS would expire, and an equivalent guarantee would be issued by LUPS. 7
4. The last stage of the proposed restructuring plan would be to restore a positive balance of LEPN s equity. Intra-group transactions 1. Grupa LOTOS S.A. would provide LUPS with cash (a share capital increase to strengthen LUPS financial capacity) in the amount equal to or higher than the sum of the price paid for shares acquired by LUPS in LPB s subsidiaries (starting with LEPN, then Geonafta and Baltic Gas), tax costs associated with the transaction, and LUPS operating expenses in the initial period. 2. LUPS acquires shares in LPB s subsidiaries from LPB: LOTOS E&P Norge AB LOTOS Geonafta Baltic Gas Sp. z o.o. i Wspólnicy sk Baltic Gas Sp. z o.o. 3. The cash proceeds from sale of the subsidiaries are applied to partly deleverage LPB. 4. The remaining cash is used to restructure and streamline intra-group debt. Benefits and costs The main items of the restructuring costs would include tax costs (tax on transactions under civil law) associated with share capital increases and sale of shares in the subsidiaries, and other costs, which should not exceed PLN 6.6m in total. On the other hand, the restructuring would produce meaningful and measurable financial benefits: significantly improved equity position of LEPN improved financing structure of LEPN (equity/ intragroup financing sources/external financing sources); change of the major shareholder would increase LEPN s ability to raise new finance (given the clean balance sheet of LUPS as the potential guarantor/surety) not 8
only to fund new projects, but also to refinance the PKO BP facilities, expediting the release of LPB from obligations under guarantees/sureties provided to LEPN. Required internal and external approvals The implementation of the plan would require obtaining a number of corporate approvals, both at Grupa LOTOS S.A. and at the individual companies taking part in the transactions: 1. opinion of the Grupa LOTOS Investment Committee on implementation of the restructuring plan and incurring of the expenditure Resolution No. 41/2017 of April 12th 2017 2. Grupa LOTOS S.A. corporate approvals authorising implementation of the restructuring plan, capital contributions to LUPS and payment of dividend by LOTOS Asfalt: Management Board resolution, Supervisory Board resolution, General Meeting resolution, 3. LUPS corporate approvals authorising acquisition of subsidiaries from LPB: Management Board resolution, Supervision Board opinion, General Meeting resolution, 4. LPB corporate approvals authorising sale of subsidiaries to LUPS: Management Board resolution, Supervision Board opinion, General Meeting resolution, 5. LUPS corporate approvals authorising a share capital increase at LEPN: Management Board resolution, Supervision Board opinion, General Meeting resolution, 6. LEPN corporate approvals authorising early redemption of LOTOS Asfalt bonds: Board of Directors resolution, 7. LOTOS Asfalt corporate approvals authorising early redemption of bonds by LEPN and payment of dividend to Grupa LOTOS S.A. (in accordance with the company s articles of association currently in effect): Management Board resolution, General Meeting resolution. In addition to the corporate approvals at Grupa LOTOS S.A. authorising implementation of the restructuring plan, external approvals would also be required, including from the financial institutions which provide financing to LPB and its subsidiaries, and business partners: 1. Approvals from Bank PKO BP: authorising sale of shares in subsidiaries by LPB, authorising early redemption by LEPN of LOTOS Asfalt bonds and, possibly, repayment of other intragroup loans, 2. Approvals from the Industrial Development Agency: authorising sale of shares in subsidiaries by LPB, authorising early redemption by LEPN of LOTOS Asfalt bonds and, possibly, repayment of other intragroup loans, 9
3. Approvals from Bank Polska Kasa Opieki S.A.: authorising sale of shares in subsidiaries by LPB, authorising early repayment by LPB of intragroup loans, 4. Approval from Bank Gospodarstwa Krajowego (on its own behalf and on behalf of the Structural Investment Fund) authorising sale by LPB of shares in subsidiaries, 5. Approval from Nordea Bank, Lithuania Branch, authorising sale by LPB of shares in AB LOTOS Geonafta, obtained on March 20th 2017, 6. Approval from CalEnergy Resources Poland authorising sale by LPB of shares in Baltic Gas Sp. z o.o. i Wspólnicy sk, 7. Approvals from the Norwegian Ministry of Petroleum and Energy (MPE) and the Ministry of Finance, authorising: sale by LPB of shares in LEPN, transfer of guarantees provided to the Norwegian government from LPB to LUPS. LOTOS Upstream Sp. z o.o. LOTOS Upstream was established on January 25th 2017 (LUPS) on the instruction of Grupa LOTOS S.A., with a minimum required share capital of PLN 5,000. Having acquired the company, Grupa LOTOS S.A. formally became its owner on March 10th 2017. The company s articles of association were amended to reflect the intended business object and ensure compliance with new state property management laws. As a result of the implementation of the restructuring plan for Grupa LOTOS S.A. s Upstream segment LUPS would take over from LPB as the leading upstream company. Its key roles and responsibilities would include: development and implementation of growth strategies and objectives for the Upstream segment acquisitions of new projects, restructuring and disinvestment activities, oversight, coordination and support of project execution project risk management development and oversight of security policy, technical supervision (directorate), arranging external financing and intragroup capital transfers, controlling in the Upstream segment, including in particular controlling at LUPS subsidiaries corporate reporting in the Upstream segment. 10
4. Summary A new target capital structure of the Upstream segment would emerge following implementation of the restructuring process. The new structure would offer the following advantages: separation of management functions (LUPS: strategy/finance/risk/project management) from operational functions (LPB) currently centralised in LPB, enhanced risk management and improved effectiveness of coordinated strategy implementation, capital allocation and corporate governance centralised in LUPS, improved operational efficiency in the Baltic region, with an option to spin off and independently grow an operator and oilfield services business, to ultimately serve external customers, increased ability to fund new projects on a project finance basis increased financial capacity and fewer limitations on the use of financial collateral, possible deleveraging of Upstream companies (LPB, LEPN), improved financial cost effectiveness in Norway. 11