Document of

The World Bank

FOR OFFICIAL USt ONLY

1.4.). 3O5'&-Hi),. ft No. 7674-EU

STAFF APPRAISAL REPORT

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

APRIL 3, 1989

Industry and Energy Operations DivisionCountry Departument IVEurope, Middle East and North Africa Region

This document has a restrkted didribton and may be used by recpiebl ooly in the performance oftheir official duties. Its contents may not otherwise be disclosed wtbodt Wodd Bank authoization.

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CURRENCY EQUIVALENTSCurrency Unit - Forint (Ft)

AVERAGE EXCHANGE RATES(Forints per US$)

1983 1984 1985 1986 1987 1988 1989 (Feb)

US$1.00 * Ft 42.7 48.0 50.1 45.8 47.0 50.0 52.0

WEIGHTS AND MEASURES

Metric System

Bbl - Barrel (= 0.159 cubic meters)CM - Cubic Meter (=35.3147 cubic feet)GJ - Gigajoule (=0.948 x 10' Btu or 238.8 x 103 Kcal)PT - Petajoule (=106 GJ)KCal - Kilocalorie (=3.968 Btu)MWh - Megawatthours (= 860 x 103 Kcal)Toe - Tons of oil equivalent (= 10 million Kcal = 39.68 million BTU)T - TonsM - ThousandMM - MillionB - Billion

ABBREVIATIONS AND ACRONYMS

AAEF - State Authority for Energy Management and SafetyCHP - Combined Heat and PowerCMEA - Council for Mutual Economic AssistanceEEO - Energy Efficiency OfficeEOR - Enhanced Oil RecoveryERR - Economic Rate of ReturnGNP - Gross National ProductICB - International Competitive BiddingLRMC - Long Run Marginal CostMIS - Management Information SystemMOI - Ministry of IndustryMVMT - Hungarian Electric Power TrustNBH - National Bank of HungaryNOMP - National Office for Materials and PricesOEGH - National Energy AuthorityOKGT - Hungarian National Oil and Gas Trust

FISCAL YEAR

January 1 - December 31

FM amfficL UW ONLY

STAFF APPRAISAL REPORT

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

TABLE OF CONTIENTS

Page No.

LOAN AND PROJECT SUMMARY ........................................ i - iii

I. INTRODUCTION ......................................... 1

II. THE ENERGY SECTOR ......................................... 2

A. Overview 2B. Energy Supply and Demand. 3C. Sector Issues. 5D. Sector Objectives and Bank Strategy .11

III. THE OIL AND GAS SECTOR .13

A. Background 13B. Trends 13C. Production Costs .16D. Gas Transport and Distribution .17E. Petroleum Strategy .18

IV. THE HUNGARIAN OIL AND GAS TRUST ............................ 18

A. Organization and Staffing .18B. Operational Autonomy 20C. Development of Key Functions .21D. Accounting, Management Cotitrol and Finance .23E. Financial Performance .26F. OKGT's Performance under the First Petroleum Project 27

V. THE PROJECT .28

A. Project Objectives and Scope .28B. Rationale for Bank Involvement ......................... 29C. Project Description .29

This report is based on the findings of appraisal and post-appraisal missionsthat visited Hungary in June and November 1988. The missions comprisedMessrs. N. Fostvedt (task manager), R. Berney, N.K. Krishnamurthy, A. Mantri,and M. Montes (staff) and R.A. Mills and A. Smit (consultants). The energyconservation component was appraised separately by Messrs. R. Heath and D.Caplin.

This document has a restricted distribution and may be used by recipients only in the performianceof their official duties. Its contents may not otherwise be dischsetd without World Baknl authorization.

Pate No.

1. Energy Policies .... ................... .............. 292. Oil and Gas ...... ........ *. . . . ...................... 30(a) Institutional Development ....... .................... 30(b) Specialized Equipment .............................. 31(c) Subprojects . ............... ....................... 313. Energy Conservation .......... ...... .................. 35

D. Project Cost and Financing .................. ... ..... . 36

VI. PROJECT IMPLEMENTATION .................................. 38

A. The OKGT Loan ....... .............. ..................... 38B. The NBH Loan .......................................... 39C. Energy Sector ......................................... 40D. Lending and Onlending Terms ............ .. .............. 40E. Environmental Impact ................. .. ................. 43F. Supervision Plan ....... ............. ................... 44G. Status of Project Preparation ........... .. ............. 45

VII. PROJECT BENEFITS AND RISKS ................................ 45

A. Project Benefits ....................................... 45B. Project Risks ........................................ 47

VIII. AGREEMENTS REACHED AND RECOMMENDATION ..................... 47

ANNEXES

1 List of Documents in Project File .......................... 50

2-1 Agreements on Energy Policies .............................. 512-2 Selected Energy Prices ..................................... 562-3 2roposed Consumer Price Increases .......................... 57

3-1 Oil and Gas: Production and Reserve Statistics, 1970-2000 ... 583-2 Planned Oil and Gas Production, 1988-2000 ................. 593-3 Cost of Hydrocarbon Exploration and Production, 1979-1987 .- 603-4 Historical Gas Consumption and Supply Balance, 1979-1987 .... 613-5 Average and Peak Gas Demand, Supplies,

and Supply/Demand Balances 1989-2000 ...................... 62

4-1 Letter on OKGT's Institutional Strategy ......... .. .......... 634-2 OKGT Organization Chart .............................. . .704-3 OKGT - Head Office Organization ............................ 714-4 OKGT Subsidiary Companies .................................. 724-5 OKGT - Income Statements, 1983-1992 ........................ 734-6 OKGT - Balancp Sheets, 1983-1992 ........................... 744-7 OKGT - Cash Flow Statements, 1983-1992 ..................... 75

Page No

ANNEXES

5-1 OKGT - Consultancy Assign.e.ts and Training ....... .......... 765-2 List of Specialized Equipment ............... 795-3 Development and Production Subprojects ..................... so5-4 The Szeghalor Subproject . ..... . .. . . . . . . .... . '905-5 Underground Gas Storage Component . .................. et ..... 935-6 Gas Pipeline and Compression Components ... ............... 96

6-1 Estimated Disbursement Schedules ..... 101

7-1 Pipeline and Storage Subprojects - EconomicJustification ... 102

MAP IBRD 21399

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

LOAN AND PROJECT SUMMARY

(A) LOAN FOR OIL AND GAS DEVELOPMENT

Borrower: Hungarian National Oil and Gas Trust (OKGT).

Guarantor: Hungarian People's Republic

Amount: US$100 million equivalent.

Terms: 15 years, including a five-year grace period, at ;heBank's standard variable interest rate. OKGT would pay tothe Guarantor a premium of 10% per annum over the Bankrate on the outstanding amount of the Bank loan.

(B) LOAN FOR ENERGY CONSERVATION

Borrower: National Bank of Hungary (NBH).

Guarantor: Hungarian People's Republic.

Beneficiaries: Industrial and other enterprises.

AmounL: US$10 million equivalent.

Terms: 15 years, including a five-year grace period, at theBank's standard variable interest rate.

Onlending Terms: Subloans will be denominated in Forints witn NBH takingthe exchange risk. The loan will be onlent to theparticipating banks for a maximum period of 12 years,including a grace period not exceeding three years, atNBH's prevailing refinancing rate or at the prevailingBank rate plus a 20% mark up, whichever is higher. Thisamount will be onlent to commercial sub-borrowers foreligible subprojects at rates determined pursuant to eachbank's lending policy statement agreed with the Bank underenergy conservation o- industrial restructuring loans.The subloans would thus carry an adequate interest spread,interest rates that are positive in real terms and do notinclude a subsidy, and be for a maximum period of 12years, including a grace period not exceeding three years.

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(C) THE PROJECT

Prolect Objectives: The main objectives are to support: (i) significantimprovements in the policy and institutional framework ofthe energy sector including appropriate pricing coupledwith subsidy elimination, restructuring of the coalmining sector and improved power investment planning;(ii) development of the oil and gas sector through thegradual restructuring of the national oil and gas company(OKGT), the opening of the sector to foreign investmentand the financing of high priority investments; and (iii)the preparation of an updated energy conservation programand financing of related investments.

Proiect Description: In addition to support for energy policy reform, theproject has two components: (i) under the OKGT loan tofinance high-priority investment subprojects in oil andgas field development, upgrading and enhanced recovery,underground gas storage and pipeline networkimprovements, as well as specialized exploration andproduction equipment, technical assistance and training;and (ii) the NBH loan to finance energy conservationsubprojects through a line of credit.

Project Benefits: The project would improve energy sector policies,strengthen investment planning, prepare an energyconservation program, strengthen the natic-ial oilcompany, open the petroleum sector to foreign investmentand achieve a re-orientation of oil and gas explorationpolicies and practices that could possibly reducesignificantly the expected rate of decline in economicdomestic oil and gas production. The project wouldfinance high priority investment subprojects, mostly forproductini of hydrocarbons and conservation of energy.Overall benefits would be substantial in terms of theresulting improved economic decisions by energy users,higher domestic economic production of oil and gas andlower imports than without the project.

Project Risks: The inherent te, nical risks with the oil and gassubprojects are Urly low due to very detailedpreparatory work. The main project risk is that theenergy policy issues could become more difficultpolitically to implement than now expected, and that theorganizational changes at OKGT or their impact would bedelayed. These risks are within acceptable limits inview of the analysis and dialogue that has taken placeand the overall commitment to policy and institutionalreform. The Project also provides consulting support andwill require consistent Bank follow-up.

- iii -

Proiect Cost:

Local Foreitn Total----- (USI million)--

0KGT

Field developuent etc. 364.1 79.6 443.7Undergrowtd gas storage 50.5 17.8 68.3Pipeline improvements 63.3 6.9 70.2Exploration equipment - 10.0 10.0Technical assistance and training 1.5 4.0 5.5Price contingencies 43.6 8.7 52.3

Subtotal 523.0 127.0 650.0

NBH

Energy conservation 20.0 10.0 30.0

Total 543.0 L 17 Q

Financing Plan:

IBRD - 110.0 110.0Domestic Loans - OKGT 25.0 - 25.0Domestic Loans - Energy

conservation 4.0 - 4.0OKGT 498.0 27.0 525.0Sub-borrowers 16.0 - 16.0

Total 543 0 It"

EstimatedDisbursements:

IBRD FY1990 1991 1992 1993 1994 1995------------ (USS million)---

A. OKGT

Annual 7.0 18.0 27.0 26.0 17.0 5.0L.:mlative 7.0 25.0 52.0 78.0 95.0 100.0

B. NBH

Annual 0.3 0.9 1,6 3.2 3.0 1.0Cumulative 0.3 1.2 2.8 6.0 9.0 10.0

Economic Rate of Return: The preappraised OKGT subprojects show an ERR ofbetween 17S and several hundred percent. Aminimum of 18S will be required for the energyconservation subprojects, well above theestimated opportunity cost of capital, and inline with ongoing energy conservation projects inHungary.

Map: IBRD 21399

STAFF APPRAISAL REPORT

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

I. INTRODUCTION

1.01 Hungary's economy is relatively energy intensive, in spite of amodest domestic resource base. Up through the end of the 1970s, energy demandgrew rapidly as a result of the development of energy intensive industries andprices below economic costs. In order to meet this demand, energy hasaccounted for up to 15X of total national investment over the past 15 years,Cor about half of national investment in industrial plant and equipment, andfor about two-thirds of the total investment financed by the Governmentbudget. In the present decade, the Government's policy has shifted towardsmore effective demand management, including significantly higher prices forsome energy carriers. As a result, the demand growth rate has declined, butthere is a strong need to reduce this rate further, to utilize existingresources more effectively and to optimize new investment while increasinginvestment efficiency. The efficient management of the energy sector is thusvery important for Hungary's future economic development.

1.02 The Bank has supported the Government's policy shift in the pastdecade through four energy sector projects: two Energy Conservation projects(Loans 2317-HU and 2709-HU), a Petroleum project (Loan 2398-HU) and a Powerproject (Loan 2697-HU), all of which are in various stages of implementation.These projects have proceeded well. There have been significant improvementsin the Government's energy policies, but some significant sectoral problemareas remain, including the expected decline in domestic oil and gasproduction and the energy pricing structure which encourages consumptiongrowth.

1.03 The proposed Project will support the Bank's continued energy policydialogue with the Government. It includes agreements on energy policymeasures, including a firm program for energy price increases to eliminatedistortions in the pricing system. The Project also initiates a program forthe institutiotal development of the Hungarian National Oil and Gas Trust(OKGT) together with the early reorientation of its exploration activicies andmethodology, and it will nelp prepare the opening of the oil And gas sector inHungary to foreign investment. The Project comprises tvo loans that finance(i) through OKGT, investments for the development of existing oil and gasfields together with supporting investments in underground gas storage,domestic oii and gas pipelines and oil and gas exploration; and (ii) throughthe National Bank of Hungary (NBH), energy policy technical assistance andsubprojects for energy conservation in continuation of the Bank's successfullines of credit for this purpose. The amount of the second loan is estimatedto cover only a modest percentage of the total demand in Hungary for energyconservation investments. For the eligible components, the loan for OKCTwould finance 73Z of OKGT's foreign exchange requirements and l5X of totalcosts.

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II. THE ENERGY SECTOR

A. Overview

2.01 Role of Eneray Sector. The energy sector is central to Hungary'sdevelopment process and accounts for a major share of the central Government'ainvestment requirements. Over the past 15 years energy investments haveaccounted for up to 15S of total national investment, about half of theinvestment in industrial plant and equipment, and about two thirds of theinvestment financed by the central Government budget. Even with this highlevel of energy investments, Hungary has had to rely on imports for a largeshare of its energy needs. In 1987, net imports accounted for 48S of totaldomestic primary energy consumption. Hungary's energy resource base islimited, and the domestic production of fuels may decline significantly overthe next decade due to high costs of operation for coal and a declining rateof new discoveries fo- oil and gas. The rate of growth in energy demand hasbeen declining since the late 197Gs, but energy consumption in relation to GNPis still substantially higher than for most industrialized market economies.

2.02 Energy Institutions. The energy sector is under the jurisdiction ofthe Ministry of Industry (MOI). Within MOI, the National Energy Authority(OEGH) supervises and coordinates energy sector activities. The NationalPlanning Office influences the aggregate investment and the choice of majorinvestment projects in each energy subsector within Lhe context of thepreparation and updating of the indicative national five-year plan and annualdevelopment plans, and the National Office for Materials and Prices (NOMP), inconsultation wi.h the economic ministries and other concerned interests, setsconsumer and producer energy prices with the approval of the Council ofMinisters. The main energy supply institutions are: (i) the HungarianNational Oil and Gas Trust (OKGT), whose activities cover the entire range ofoil and gas exploration and production, refining, transport, storage andretail distribution of products; (ii) the National Power Company (MVMT) whichis responsible for 97X of the country's electric power generation anddistribution; (iii) the Mining Association, made up of seven independentregional coal mining companies and one mining equipment supply company; and(iv) various municipalities involved in district heat supply systems.

2.03 Government Strategy and Objectives. Up through the 1970s, Governmentpolicy, including low energy prices, encouraged energy intensive industrialinvestment and thus high energy demand growth. The resulting demand was metthrough expanded energy imports from the USSR coupled with large newinvestments for increasing electricity generation and the domestic productionof primary fuels. This policy began to change in the late 1970s as rapidlyrising world energy prices highlighted the urgent need to restructure theeconomy towards a lower level of energy dependence.

2.04 The Government's present economic program for the next decade aims atan income elasticity of demand for energy far lower than it has been in thepast, in order to contain energy investments within the macro-economic

investment capabilities of the country. This would permit more substantialinvestments in the directly productive sectors of the economy. At the presenttime, there are several critical issues for the energy sector: (i) how toconstrain the growth in energy demand (particularly for electric power) to alevel that can be met with the limited investment resources that will beavailable for the energy sector; (ii) how to price energy carriers(particularly natural gas and coal) among alternative users and provide forappropriate levels of interfuel substitution in each energy using sector,(iii) how to determine and adjust the least cost investment program in ther-ower sector to meet the expected growth in electricity demand; and (iv) howto strengthen the institutions that produce ener,gy, so that they can improvetheir ability efficiently to plan and implement economic least cost investmentprograms. The problems and policy options for the energy sector are reviewedbelow. The salient energy policy issues are addressed under the Projectthrough support for appropriate policy actions. The policy agreements,reflected in Annex 2-1, are summarized in paras 2.25-2.28.

B. Energy Supply and Demand

2.05 Energy Supply. Hungary's energy resource base consists mainly ofcoal, oil and natural gas. Coal reserves include 210 MMToe of black coal, 275MMToe of brown coal and 230 MMToe of lignite. The production of black andbrown coal was 16.7 million tons (MMT) in 1987, while imports (coal,briquettes and coke) were 3.5 MMT. Coal production is expecLed to decline asthe reserves of currently operating mines are depleted, since much of thereserves are uneconomic to produce at current international prices, Ligniteproduction was 6.4 MMToe in 1987. There is considerable potential forincreasing the production of lignite for mine-mouth power plants, if suchplants should be on the least cost investment path. Proven recoverablereserves of hydrocarbons are about 27 MMT for crude oil and 135 billion cubicmeters (BCM), corresponding to 108 MMToe, for natural gas. About half of thepresent oil and gas reserves will be produced by the end of the century. Thedomestic production in 1987 of 2.7 MMT of crude oil, gas liquids and LPG wassufficient to meet 302 of domestic liquid hydrocarbon requirements, whileproduction of 7.0 BCM of gas (5.6 MMToe) was sufficient to meet 582 of gasrequirements. Both oil and gas production are expected to fall in the 1990s.There is a minor amount of domestic hydroelectric production, and some lowtemperature geothermal energy is used for household and agricultural heatingpurposes. There may also be some potential for geothermal power production.Power production from a recently completed 4 x 440 MW nuclear complex wasabout 11 million MWh in 1987, about the same volume as electricity importsfrom the USSR.

2.06 Between 1995 and 2010 the domestic production of energy is planned toincrease by 302, most of which is currently planned to come from new nuclearpower plants. The Bank projects that hydrocarbon production under presenttrends could fall by about 3.7 MMToel', to be made up by an equivalentincrease in net imports, almost entirely through the increase in natural gasimports from the USSR. Nuclear electricity production would be increased bythe equivalent of 6.9 MMToe through the addition of two new 1000 MW plants atPaks, planned for completion in the late 1990s. Solid fuels production willdecline due to the expected fall in undergrouad coal mining.

I' Bank estimate; the Government at present projects a decline of 2.6 MMToe.

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2.07 Energy Demand. Energy demand grew rapidly in Hungary in the 1970s, butbegan to slow in the early 1980s as the Government begasn to raise domesticenergy prices while also introducing energy conservation policies. Energyconsumption increased by 371 between 1970 and 1975, by I17 between 1975 and1980, and by 6Z between 1980 and 1985. As a result of the new pricing andconservation policies, the elasticity of demand with respect to GNP, which wasslightly above 1.0 in the 1970s, declined to 0.61 in the first half of the1980s. Between 1985 &nd 1987 total energy consumption grew by only 2.21, andthe elasticity of demand declined further to 0.46. This declining trend isencouraging, but energy consumption is still relatively high. In 1987 grossconsumption was approximately 13,450 Petajoules (33.5 MMToe), corresponding toan energy consumption of 1.63 Toe per US$1000 GNP. This consumption level islower than comparable CMEA countries, e.g., Poland (1.76 Toe per US$1000 GNP),but considerably higher than that of industrialized countries such as Belgium(0.53) and the Federal Republic of Germany (0.42).

2.08 Energy Balance. Hungary's energy balance for 1987 is summarized inTable 2.1, below. It shows that domestic production accounts for only 54% ofgross energy used, with about a third coming from coal, a third trom natural gasand the remainder from electricity (nuclear) and crude oil. On the import side,about a third is oil and oil products, about a quarter is natural gas, and theremainder is made up of fossil fuels and electricity. For electricity, lessthan half was generated with fossil fuels; 29Z was generated through primarymeans (nuclear and a small contribution from hydro) and 26% was imported fromthe Soviet Union. On the demand side, 60X of the energy is consumed by theproductive sectors and 40Z by the household and communal sectors. Forelectricity, the consumption of the productive se,tors is about 641. On theother hand, the household sector accounted fo, most of the direct consumption ofsolid fossil fuels (67%). Of the energy consumed in the productive sector in1987, State owned industries accounted for abolut 601 of the total, (mostly forthe chemical, metallurgy and machinery subsectors).

Table 2.1: Summarized Energy Balance - 1987(in Petajoules)

UseEx- ''

Source ports and Total Pro- IncreasesProd- Imp- Trans- Avail- ductive Consum- induction orts formation able Sectors ption Resources

Coal/Lignite 255 50 (241) 64 13 56 (5)Coal Products - 32 72 104 47 64 (6)Crude Oil 76 265 (342) (1) - - (1)Petroleum Products 34 81 158 273 166 111 (4)Natural Gas 230 165 (191) 203 124 75 5Electricity 112 106 119 336 216 121 -Biomass 14 - (2) 12 L 11 -

Usable Heat 177 177 120 56

Total 21 = ) 1j_U _i& =2 __

l Hereof, exports are mostly for petroleum products (73 PJ).

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2.09 Iungary's present energy strategy is based on the assumption that itcan further reduce the growth rate of energy demand to a level substantiallybeiow what it has been in the past. Thus, the Government's basic planningscenario calls for an income elasticity of demand of 0.33 for all energy andof 1.0 for electricity. If the elasticity of demand can be kept this low,then Hungary's target economic growth rate of 3Z per year would require onlyan annual growth of 12 in total energy supply and 3Z in electricity supply.However, containing the demand growth to this low level without supplyrestrictions would require systematic demand management with three maincomponents. First, industrial energy demand would have to be reduced throughthe closing or rationalization of energy-intensive industries, as plannedunder the ongoing industrial restructuring efforts supported by the Bankthrough industrial sector operations. Second, the energy pricing structurewill have to be improved considerably, and third, the Government's energyconservation program must be continued and systematized. The latter twopriorities are addressed under the Project.

C. Sector Issues

2.10 Energy Pricing. The prices paid by the productive sector ("producerprices") for energy resources were raised substantially between the late 1970sand 1987. Heating oil, residual fuel oil and naptha prices were reduced in1986, in order to reflect the falling international oil prices. Presentenergy prices are shown in Annex 2-2. Producer prices for petroleum productsare substantially above international spot market prices except for heatingoil, which is between 10% and 20% below the international price (depending onspecification). The price of diesel fuel is particularly high (about US$250per ton), reflecting the Government's determination to discourage its use fordiesel fired electricity generation. The electricity price for the productivesector is expected to be in line with the present estimates of long runmarginal cost (LRMC) for power. However, this will be verified when a newLRMC study is available in mid 1989.

2.11 The average prices paid by the household sector ("consumer prices")have risen at a slower rate than have producer prices. For social reasons theGovernment has been slow in passing on to consumers the world market priceincreases except for automotive transport fuels. The Government has beensteadily increasing nominal energy prices to households since 1983; thus,between July 1985 and July 1987, the consumer prices for coal and briquetsincreased on average by 16%, prices for heating oil rose by 29Z, for naturalgas by 17Z, and for electricity by 23Z. Nevertheless, the ratio of consumerprices to producer prices fell between 1980 and 1988 for all coal qualitiesfrom 62Z to 54%, for natural gas from 80Z to 68% and for electricity from 83Zto 55%. Only for heating oil has the ratio moved in the opposite direction,from 95% to 189%, and here the reason was primarily the decrease in theproducer heating oil price in 1986. The Government's stated policy is toeliminate all energy price distortions and to bring the price of all energycarriers into line with their economic costs. The implementation of thispolicy will require substantial increases in consumer prices (includingelectricity), which are planned to take place over at most the next five years(through 1993). While the consumer prices were not increased in 1988, theywill be increased by up to 35Z or more in 1989, as part of a determined effortto eliminate consumer subsidies related to energy. The price increases arelikely to be greatest where existing prices are the furthest out of line witheconomic costs. Annex 2-3 shows the program for the improvement of the

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consumer energy prices. Following the substantial increases expected for1989, the program would phase out discrepancies in all energy consumer pricesat the latest by 1991 for natural gas, night electricity country wide, and daytime electricity in rural and smaller urban areas, and at the latest by 1993for coal, district heating and electricity in Budapest and other large cities,in view of the large initial gap between prices and economic costs in thesecases. There will be an annual review of the Government's progress inreaching these targets.

2.12 The electricity price structure in Hungary also needs to be improvedin two major respects. First, the regional tariff structure containsdifferences that are substantially greater than can be justified on economicgrounds, with prices in Budapest of one half that of smaller towns. Second,the price of night electricity may now be below the marginal (short-term) costof production, possibly even just in terms of the direct fuel cost. Marginalprices need to be brought in line with appropriately defined marginal costs.At this time the electricity tariffs cannot be compared to LRMC, since thesewill depend on the final decisions about the power least cost investmentprogram, which is currently under review in the context of the ongoing Powerproject (Loan 2697-HU). The evaluation of the least cost power investmentstudy and the associated LRMC will be completed by June 30, 1989. In additionto the LRMC of producing and distributing electricity, it is necessary for theGovernment also to estimate the short term peak and off-peak costs ofproducing electricity, and the regional cost differentials of supplyingelectricity to smaller scale consumers. Under the Project, the Governmentwill prepare, building on the LRMC study, and subsequently implement a newtariff policy in which the tariff structure is more closely in line with LRMC,and the peak/off peak and regional anomalies are eliminated.

2.1.3 Producer gas prices are also on average in line with internationalprices, although the industrial gas pricing structure includes preferentialprices for the fertilizer industry, which are above the border price, but lowrelative to prices charged to all other gas and fuel oil users. However, theGovernment intends to keep the preferential price at or above the borderprice, and will eliminate the differential over the next plan period.Finally, the demand for gas is highly seasonal, while the natural supplypattern is nonseasonal. Under the Project, the Government will prepare andimplement during 1989 a gas tariff policy with an appropriate seasonaldifferential in order to pay the cost of meeting peak winter gasrequirements.

2.14 Changing world market energy prices (primarily based on crude oilprice changes) present an additional problem for Hungary, particularly sincemuch of its energy comes from the CMEA under terms that delay the impact ofworld energy price changes.'" At the present time, domestic prices arechanged only after the NOMP decides that world price changes are likely topersist for an extended time. In the future the Government will examine localvs. international prices every three months and increase the local priceswhenever these fall below the international level.

2.15 Investment Programs and Planning. In mid-1987, the necessity ofbringing deficit spending under control caused the Government to reevaluatethe entire public sector investment program and make significant changes inits planned investment targets. Total energy investment was reduced by a

"' The so-called Bucharest formula, based on five-year rolling averages.

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total of Ft. 20 billion for the last three years of a five year investmentprogram, where the original average annual investment target was Ft. 38billion. This represents an average reduction of a little more than 251 forthe remaining period. These cuts included a Ft. 7 billion cut in coal mining,a Ft. 7.3 billion cut in hydrocarbon production and distribution, and a Ft.6.1 billion cut in electricity generation and distribution. Following thesecuts, for the years 1988-1990 total investment in energy is planned at Ft.113.9 billion (in 1988 prices), increasing from Ft. 34.3 billion in 1988 toFt. 42.2 billion in 1990, as shown in Table 2.2. The average of L._e threeyears represents 151 of the total investment in the Government sector in1988. During the period there will be a substantial shift in the structure ofinvestments, away from the coal sector and towards the electricity sector.Coal investment will fall from 15.71 to 11.1% of total energy sectorinvestment, while electricity generation, transmission and distribution willrise from 45.8% to 52.61. This shift is in line with the current policy ofswitching from reliance on coal and lignite based power plants to nuclearplants. The shift may be even more pronounced in the next five vear plan,when most of the investments are expected to be made for the two new Paksnuclear plants, which are planned to come on stream between 1995 and 1997.Investment in the coal sector will fall, in line with the decline ininvestment in the higher cost underground coal mines.

Table 2.2: Energy Sector Investment Program, 1988-1990(in billions of Forints)

Sector 1988 1989 1990 Total Z

Coal 5.4 5.1 4.7 15.2 13.3Oil and Gas 6.9 7.3 7.4 21.6 19.0Refinery 1.9 2.0 3.0 6.9 6.1Pipelines 2.9 2.5 3.4 8.8 7.7City Gas Distribution 1.1 1.2 1.5 3.8 3.3Electricity Generation 6.2 8.2 10.1 24.5 21.5Electricity Distribution 9.5 11.3 12.1 32.6 28.6Conservation 0.4 0.1 0.1 0.5 0.4

Total Energy 34.3 l7.7 LQM

Source: National Planning Office.

2.16 Hungary now faces the problem of how to use its limited investmentresources most efficiently, while still providing sufficient energy tomaintain reasonable economic growth. To accomplish these goals in the energysector, the Government recognizes the need to (i) contain demand growththrough appropriate pricing, energy conservation and demand managementpolicies; (ii) optimize its medium-term investment and import strategy forpower generation and distribution within the context of a policy that presumesthe use of large scale nuclear power generation plants; (iii) rationalize itsinvestment, production and import strategy for the coal sector, (iv) optimizeits natural gas distribution and storage program, consistent with the goal ofimporting more energy resources in the form of natural gas from the USSR; and(v) take the steps necessary to minimize the expected decline in domesticpzoduction of oil and gas.

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2.17 Electricity Investment. Most of MVMT's installed generating capacityof about 6,900 MW is supplied by a small number of large scale power plants.70% (4,800 MW) of capacity is supplied by steam plants, including two largeoil/gas fired plants, one lignite fired plant, eight plants with capacitiesbetween 100 and 250 MW, and about two dozen small plants, some of which supplyboth electricity and district heat. 25Z (1,760 MW) is supplied by nuclearpower from four units at Paks, about 3% (200 MW) is from combustion turbines,and 2% (140 MW) is from hydro. Imports of 10.8 billion kWh/year from theSoviet Union represent about 29% of the total net supply of 37.2 billion Kwh.This level of imports is expected to continue for the next twenty years, basedon long-term contracts. Prices for this power can be expected to remainfairly stable over this period, since much of it is being paid for throughHungarian participation in the Soviet power investment program. It appearsunlikely that Hungary will be able to obtain any significant increase in itselectricity imports from the USSR in the foreseeable future; nor can Hungarycount on increasing imports from its other neighbors, most of whom may facetheir own power deficits in the 1990s.

2.18 Nuclear power is expected to play a critical role in meeting Hungary'sfuture energy needs. In 1988 it is estimated to account for about 27% ofdomestic generating capacity (1,760 MW out of a total 6,600 MW) and about 30Xof total consumption. In accordance with its decision to rely on the nuclearoption for the major increases in electricity supply in the 1990s, theGovernment has signed an agreement with the USSR and other CMEA countries forthe construction of the two new 1,000 MW plants, which the Government projectsto come on stream in the mid to late 1990s. These two plants will increasegenerating capacity by almost 30%. Therefore, with the exception of theNorthern Danube hydro plant, which will produce power for Austria for loanrepayments, no other additional large scale generating facilities are plannedin Hungary. The remaining portion of the investment program consists ofnumerous smaller projects, e.g., for the rehabilitation of existing plants andthe upgrading of the power distribution system. However, if the nuclearprogram should suffer some delays (as is likely since the plants are of newdesign with major components coming from several CMEA countries), or ifelectricity demand grows faster than at the planned rate of 3% per year,Hungary may experience a rapid deterioration of reserve generating capacityfor peak power requirements and a concomitant fall in system reliability bythe mid-1990s. The rapid and substantial consumer price increases now plannedby the Government will be needed along with a strengthened conservationprogram if Hungary is to avoid having to increase substantially its powergeneration investments in the early 1990s.

2.19 The expansion of generation capacity tlhrough combined cycle gas basedpower or combined heat and power (CHP) plants appears to provide the bestopportunity for increasing the responsiveness of the power system to increaseddemand during the period before Lhe large scale nuclear plants come onstream. Combined cycle technology has the shortest investment lead time (lessthan three yeaLs), and could therefore provide the opportunity for Hungary tochange its electricity generation program quite rapidly. In many cases, suchinvestments could best be undertaken in the context of improving districtheating systems through investments in combined heat and power plants, as hasbeen initiated under the ongoing Power project. Further opportunities forconverting district heating plants to CHP operations will be evaluated underthe Project. MVMT is In the pro-ess of revising its long term least costinvestment prograni in response to rapidly changing constraints on the

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availability of energy carriers, including changes in the availability ofdomestic and imported coal and gas, and possible changes in nuclear powerplant time schedules. The new least cost investment program, to be completed4.n the context of the ongoing Power Project, will be received by the Bank byJune 30, 1989. MVMT will need to revise its investment program from time totime in order to keep abreast of supply and demand changes. These revisedprograms will be discussed with the Bank under the Project.

2.20 Oil and Gas. The prospects for domestic oil and gas production arereviewed in Section III of this report. Briefly, Hungary's producing regionsare considered to be well explored and no new very large fields are expectedto be found. The smaller size of new discoveries, along with the need forsubstantial investments in secondary and tertiary recovery processes for olderoil fields, can be expected to lead to increasing marginal costs for oil andgas production. Since proven reserves are being depleted at a faster ratethan new reserves are likely to be discovered, oil and gas production isexpected to decline substantially in the 1990s. However, it is possible thatmodifications of the present exploration methodology, supported through theProject, and the involvement of foreign oil companies under a contractualframework to be prepared under the Project could ameliorate the decliningtrend. It is important for Hungary to maintain its level of investments inoil and gas exploration, production and distribution. During projectpreparation, the Bank has analyzed the major components of the oil and gasinvestment program. In addition to the subprojects to be financed under theProject, the most important other investments are a refinery reformer projectand an underground storage project, both of which are good investmentprojects. Crude oil imports from the USSR have been severely restricted since1980, but gas imports have been growing rapidly to meet the hydrocarbondeficit. Gas imports grew from 0.4 MMToe in 1975 to 4.0 MMToe in 1987, andare expected to reach 6.4 MMToe by 1995, whereas the imports of crude oil andproducts are expected to remain stable at the current level of 8.4 MMT. Thedemand for imported gas could be further increased if the planned nuclearpower plants should be delayed. The viability of a gas based power expansionoption would, however, depend critically on Hungary's ability to increase thevolume of gas imports from the USSR over and above the current plannedlevels. These imports may have to be paid for in hard currency at worldirarket prices. Substantial advance planning would be needed to ensure thatrequired quantities of additional gas would be available and sufficien' gastransmission and storage facilities created.

2.21 Coal. Known reserves of hard coal and of lignite are equal to about170 years of production at present operating levels. The ratio of reserves toproduction for brown coal is about 60 years. However, the quality of most ofthe reserves is quite low, and the cost of producing them is high byinternational standards. For black coal the problems are particularlydifficult; most unexploited seams are deep and highly fractured and mostcontain low quality coal with an energy content of at best 65Z ofinternationally traded steam coal (3,800-4,200 Kcal/Kg vs. 5,900-6,500Kcal/Kgl') and a high sulfur and ash content (2-3% and 20-30Z respectively).Given today's technology and prices, economically recoverable reserves in thehard coal mining areas now under exploitation are, therefore, probably closerto 30 years of production at current levels. For brown coal, the problem is

I' 15.8-17.5 GJ/ton vs. 24.5-27.0 GJ/ton.

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primarily that much of the unexploited reserves are associated with extensivewater incursions. This limits their economic utility since pumping largequantities of water is expensive and can cause serious secondary environmentalpollution problems. With lignite, the problem is one of minimizing additionaltransport costs to power generation facilities. The coal investment programcontains two large investments for new mines; the Government will have thesereviewed by international consultants (para 2.22) before undertaking anysubstantial investments. Otherwise, the investments are largely for theexpansion or continued operation of existing mines.

2.22 The Government's strategy for the coal sector is based on the explicitrecognition that each mining company must be responsible for its ownoperations, and that all mining companies will have to produce in a profitablemanner. The Government's strategy calls, therefore, fcr the elimination ofall operating suboidies to the mining enterprises by end 1990. To accomplishthis the Government has already initiated the restructuring of the sector, andseveral mines have already been closed. A restructuring plan has been agreedin the context of tranche release for the Industrial Sector Adjustment Loan.The ceatral theme of this plan is the shift from a quantitative productionprogram directed by a central planning authority, in which costs were almostincidental, to an economically rational program, in which individual miningcompanies make their own production and investment programs, and areresponsible for ensuring that the resulting production operations areprofitable. As a result, companies will be encouraged to undertake newinvestments only when these investments can earn an acceptable rate ofreturn. The plan will include a reduction in subsidies from Ft. 7.9 billionin 1988 to Ft. 2.7 billion in 1989 and to Ft. 0.8 billion in 1990, with nosubsidies thereafter. In addition, the plan presents a list of mines to beclosed, and establishes minimum economic criteria for new coal investments.The plan will finally include studies by international consultants of the coalpricing structure and of two large proposed investment projects, and thepreparation of a detailed program for the sector restructuring (within thecontext of the general restructuring plan) including a mine by mine programfor efficiency improvements or closings. Under this program, Governmentinvestment support will be limited to large scale investments that thecompanies cannot finance on their own. The level of such support is expectedto decline considerably from a peak in 1989 of Ft. 3.6 billion. The Sank willsupport the preparation of these studies and the implementation of theprogram, which will be monitored through the Project.

2.23 Energy Conservation Policies. The energy intensity of Hungary'seconomy began to fall only in the 1980s, as the Government started to takeserious eneigy conservation measures in response to the second world oil priceshock of 1979. The main policies of the national energy action plan preparedat that time and still in effect were the promotion and implementation ofenergy demand management programs, supported by higher energy prices for allproductive sectors, lines of credit to support energy rationalizationinvestments (both for energy conservation and inter fuel substitution), theregulation of energy consumption at the enterprise level through theintroduction of a system of permits for expanded industrial energyconsumption, improved inspections of energy using equipment, and the promotionof energy wastage awareness campaigns. Under the energy action plan,enterprises are required to monitor regularly their energy use and toundertake detailed analyses of specific energy consumption of each

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manufacturing process, so that they can identify measures needed to improveenergy use efficiency. The BAnk has supported these efforts through twoenergy conservation loans 'or industrial retrofitting and energy efficiencyinstitution3l strengthening (Loans 2317-HU and 2709-HU), and this will becontinued through a component of the Project. In addition, the Governmentwill also examine the potential for energy conservation in the household andcomunal sectors including district heating, and develop and subsequentlyimplement recommendations for changes in policies and practices.

D. Sector Objectives and Bank Strategy

2.24 The Bank has for some years maintained a wide-ranging dialogue withthe Government on energy policy issues. In this period, there have been manyclear improvements in the Government's energy policy, although significantproblems remain. It is therefore important to continue the dialogue and toseek significant concrete steps, supported by appropriate lending aimed atpromoting efficient development of the sector resources within an environmentof limited investment resources. A recent review of the Hungarian energysector (available in Project Files) concluded that the major sector issuesrelated to the pricing structure, the structure of the coal subsector andrelated high subsidies, the need to improve power investment planning, theneed to conduct active demand management to contain energy demand growth to alevel which can be provided within a tight national investment budget, and theneed to slow down the expected decline in oil and gas production. The reviewalso concluded that given the potential impact of rapidly declining domesticproduction of oil and gas, lending priority at this time should be given tothis subsector. The Project will address directly the identified major sectorissues. Subsequent sections of this report discuss measures to strengthenOKGT and to adjust its approach to petroleum exploration, measures to open theHungarian oil and gas sector to the involvement of international companies,and the expected benefits of investment subprojects primarily for oil and gasdevelopment, gas storage and energy conservation.

2.25 The Bank's energy policy discussions with the Government have focussedon the policy principles and actions shown in Annex 2-1, and the Governmenthas undertaken the following:

(a) The basic energy pricing principle will continue to be to bringthe prices of all energy carriers up to the level of theireconomic costs;

(b) The policy will be maintained that no industry shall receiveenergy at a price below economic cost;

(c) Domestic and international prices will be compared at leastquarterly and domestic prices increased whenever they are lower;

(d) A system of seasonal natural gas prices will be introduced in thesecond half of 1989 and the remaining preferential industrialprices will be eliminated gradually over the next plan period;

(e) Consumer energy prices will be increased significantly before thenext heating season (October 1989), with an expected weightedaverage increase of more than 202. All consumer energy pricedistortions will be eliminated by 1991 at the latest except for

1 .. . . I ; I 1 - t- Avr t- i 4 r ID,i- 4- t9

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and the other large cities, where the distortions will beeliminated at the latest by 1993. The prices will be increased soas to reduce the relative difference to economic prices inapproximately equal annual installments. The progress in thisrespect will be reviewed annually with the Bank;

(f) The power tariff structure will be brought more closely in linewiti. actual long run marginal costs, and the anomalies forpeak/off peak and regional tariff rates will be eliminated;

(g) A new petroleum taxation system has been introduced with effectfrom fiscal year 1989;

(h) A new and more simple technical oil and gas regulatory frameworkwill be introduced; and

(i) Major changes in the energy investment program will be reviewedwith the Bank.

2.26 During project preparation the coal sector was also discussed in somedetail. A further development of the ongoing restructuring plan has beenagreed, formally in the context of the tranche release for the IndustrialSector Adjustment Loan. The Bank will support and monitor the implementationof the plan through the Project.

2.27 The Government has also undertaken to prepare recommendations(including the underlying analysis) for discussions with the Bank andsubsequent implementation in the following areas:

(a) Tariff metering for presentation by October 31, 1990;

(b) Non-pricing measures that could be taken to improve the efficiencyof energy production and utilization in the household sector, forpresentation by December 31, 1989;

(c) Winter/summer gas price differentials, for presentation bySeptember 30, 1989;

(d) Regional and day/night power tariffs, for presentation by October31, 1990.

2.28 The terms of reference for the analyses underlying these efforts havebeen agreed.

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III. THE OIL AND GAS SECTOR

A. Background

3.01 Petroleum Geology. The geology of Hungary is comprised mainly of avery young and relatively undisturbed sedimentary basin (the Pannonian basin,which extends into neighboring Romania and Yugoslavia), with underlying olderand strongly deformed formations. Well-developed reservoir rocks have beenidentified in most of the Pannonian sediments, showing good permeabilities andporosities, and sealing shales are present over most or the area. Subsurfacetemperatures are exceptionally high, with a temperature gradient usuallydouble the world-wide average, although recent exploration results indicatemore local variations than previously assumed. These high temperatures havecaused rocks to reach thermal maturity and start to generate oil both earlyand at relatively shallow depth. Consequently, the deeper horizons arepredominantly gas prone because the heat decomposes the oil into its lighterfractions. Deep drilling financed under the first Petroleum Project hasestablished that the deeper horizons are highly deformed and faulted, makingit very difficult to obtain good seismic profiles even with the most advancedtechniques, and adversely affecting the hydrocarbon storage properties ofpotential reservoir rockcs. To date, few commercial oil or gas discoverieshave been made in Hungary below 3,200 m.

3.02 Exploration History. Early petroleum exploration started in Hungaryin the 1920s, and the first commercial oil discovery was made in 1937. After1948 the industry was nationalized and the Hungarian National Oil and GasTrust (OKGT) became subsequently (1957) th-e entity responsible for all oil andgas operations in the country. Continued exploration efforts revealed thepresence of additional prospective areas, and it became readily apparent thatthe younger formations, mainly consisting of sands, shales and marls, extendedover a large part of Hungary and represented the logical exploration target.Ccnsequently, the deeper pre-Pannonian strata have remained relativelyunexplored. In the last forty years, OKGT (including its predecessors between1948 and 1957) has explored intensively the Pannonian basin, especially in theareas in the southwest and southeast. (In the northwest surface gravel layersand in the northeast tuff layers have until recently hampered seismicrecording.)

B. Trends1'

3.03 Oil and Gas Reserves. As of January 1988, OKGT had a total of 198 MMTof oil and 189 BCM of gas as in-place reserves, from which 28 MKT of oil and118 BCM of gas could be considered to be recoverable reserves. This is shownin Table 3.1.

/ The Bank and OKGT have reviewed the status of reserves and projecteddiscoveries and production in considerable detail, as a result of which aBank consultant produced a comprehensive evaluation that is available inproject files.

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Table 3.1: Oil and Gas Reserves as of January 1, 1988

Remaining RemainingDiscovered Reserves Potential

In Recover- Ctumulative In Recover- In Recover-place able production place able place able

Oil (MMT) 263.7 94.5 66.2 197.5 28.3 175.5 37.3Recovery Factor () 35.8 14.3 21.3Gas (BCM) 316.0 244.1 126.6 189.4 117.5 218.8 157.0Recovery Factor (X) 77.3 62.0 71.7COa(BCM)-L 45.7 33.8 4.8 40.9 29.0 25.7 19.7Recovery Factor (x) 73.9 70.9 76.6

Total (MMToe)2' 4 17 4J L2Q L A

Total original in place reserves, OKGT estimate 1045.4 MMToeDiscovered 625.4 MMToeRemaining potential to be discovered

I-' COz is included for completeness.

-X In view of the approximative status of oil and gas reserve estimates anequivalence of one ton of oil to 1,000 CM of natural gas has beenaccepted for this report, whereas by calorific value one ton would beequal to 1,153 CM of natural gas of 9,400 kcal/CM.

Source: OKGT

3.04 Table 3.1 shows that the present recovery factors are as low as 14% foroil and 622 for gas, due to the advanced state of production from manyfields. These reserves corresponded to 16 years of production for gas and 15years for oil, at the 1987 production levels. Annex 3-1 shows that by thismeasurement the oil reserves have increased somewhat in recent years, whilegas reserves have decreased from a recent high (1981) of more than 20 years.There are sophisticated approaches to estimate the total quantity of oil andgas that may have been generated in a basin, by considering the total quantityof source rock available and hydrocarbons expelled, trapped and retained.However, all such estimates are open to considerable margin of error. ForHungary, OKGT's most recent estimate is that the original in-place(geological) reserves were 1,045 MMToe. This estimate appears reasonablebased on present knowledge, although other and considerably higher estimateshave also been made. It shows that there is still a considerable potentialfor future oil and gas discoveries in Hungary, with an estimated 420 MMToe ofin-place oil and gas reserves yet to be discovered. Accordingly, there isgeological justification for continuing the exploration efforts in thecountry, although Hungary is now a mature oil and gas producer. However, itis likely that a continued successful exploration effort will require amodified methodological approach and the increasing use of the most moderntechniques for data acquisition and analysis, as discussed in para 4.10.

3.05 Production. There has been a steadily increasing trend in domestic gasproduction, from 3.6 BCM in 1970 to 6.4 BCM in 1980 and to a peak of 7.8

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BCM in 1985, followed by two years with production of about 7.3 BCM(Annex 3-1). For 1988 the production was only 6.6 BCM, as a result of a mildwinter combined with a stable gas off-take from the USSR. Oil production, onthe other hand, reached its virtual peak as early as 1978 at 2 MMT per annum,a level that has been kept virtually unchanged from year to year until adecline to 1.9 MMT in 1987 and 1988. In addition, there is an annualproduction of about 0.7 MMT of natural gas liquids and LPG.

3.06 Discoveries. The reasons for the stagnation and incipient decline inoutput can be found in OKGT's rate of new discoveries. New gas discoveriesreached a peak of 10.8 BCM in 1977, and have declined somewhat unevenly sincethen, down to an average of only 3.3 BCM per annum for the period 1985-87, orabout 451 of average production for this period. The basic trend has been thesame for oil, with annual new recoverable discoveries after 1975 at between101 and 90X of annual production. For both oil and gas there have in additionbeen upwards evaluations of existing fields; however, this is expected to beless influential in the future due to the more accurate methods now being usedfor the initial reservoir assessments. While there are considerable annualvariations in the discovery figures, as is normal in the industry, thedeclining trend is unmistakable, as is also demonstrated by the discoveriesper meter of exploraticn wells drilled. For the period 1975-79 the averagerate (oil and gas combined) was 51.8 Toe per meter drilled, this declined toonly 30.0 Toe per meter for the period 1981-85 and an estimated 21.5 Toe forthe period 1986-88.

3.07 The declining trend in discoveries is a result of the fact thatHungary is a mature oil and gas producer, where about 60% of the(conservatively) estimated oil and gas reserves in place have already beenfound. In particular, it is likely that most or all of the large conventionalstructures have been discovered, and thus that future discoveries of suchstructures will be of an increasingly small size. In addition, OKGr's recentexploration of the deeper horizons has shown these to be very difficult;accordingly, for th' time being not much exploration effort should be expendedon these horizons, and any projections of future discoveries should prudentlylargely exclude the possibility of commercial discoveries from them. On theother hand, OKGT has concentrated virtually its whole exploration effort onthe search for conventional structures (anticlines), whereas it s likely thatthere could be considerable reserves in subtle and stratigraphic traps, whichrequire a more integrated exploration approach. A main objective of theProject is to assist OKGT in the reorientation to this end of its explorationapproach, with the concomitant methodological and organizational changes. Inaddition, Hungary's exploration effort would also benefit from a greaterdiversity of technical approaches than can be found inside one organization,for which reason the participation of foreign oil companies on reasonableterms would be very useful. Hungary has in the past few years welcomed jointventures in various economic sectors. However, the general framework for suchventures is not sufficient for a petroleum exploration/production contract.For that reason, OKGT has not been able to follow up on some approache3 fromforeign companies. Under the Project, OKGT has acquired the services of anexperienccd contract consultant to draw up, in close consultation with OKGT, adraft contractual petroleum framework. This will then permit OKGT toestablish a policy for foreign exploration and production investments and tonegotiate effectively with interested parties.

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3.08 Exploration Forecasts. The forecasts for future discoveries arebased on a continuation of present trends; an unexpected large dis1covery orpositive impacts of new exploration methodologies would therefore lead tohigher discoveries than now projected. On the basis of present trends, forthe period until the year 2000 OKGT should be able to discover an average of22.2 Toe of recoverable oil and gas combined per meter drilled. As a result,for the period 1989-2000, OKGT should be able to discover 36 BCM of naturalgas (512 of the discoveries in the previous comparable period) and 5.5 MMT ofoil (651).

3.09 Production Forecasts. The projected production is the sum ofproduction from existing fields and (with a time lag) from new discoveries.Annex 3-2 shows the Bank's projected production distribution per year for theperiod 1988-2000. In this period, OKGT expects to produce 50% of thepresently known recoverable reserves, with primary production of oil fromexisting fields dropping from 1.7 MMT per year to as low as 0.1 MMT, while forgas the production from these reserves would decline from 6.6 BCM to 1.4 BCMper annum. For oil there is also the possibility of additional productionfrom enhanced recovery methods (EOR). However, such methods are generallyexpensive; the quantity of oil that can be economically generated willtherefore depend heavily on the oil prices. At present it is assumed that bythe year 2000 the production by EOR methods will be 0.3 MMT/year, which willnot be su.ficient to make up for the expected decline in primary production.For OKGT to keep up a reas,nable level of production it is therefore crucialthat new discoveries can be made and put into production.

3.10 Based on the expected new discoveries shown in para 3.08, andassuming a five-year delay between the initial evaluation of a disco%ery andthe completion of production facilities, OKGT should by the year 2000 be ableto produce from new reserves 3 BCM of gas (net of inert gases) and 0.6 MMT ofoil. In total, this would in that year give a gas production of 4.4 BCM (612of the 1987 level) and 1 MMT of oil (52%). This drastic decline in oil andgas production would take place in srite of an exploration and developmentprogram on par with that of the past few years, and demonstrates the need forOKGT to try and develop new approaches to exploration and to encourage theinvestment in the sector by outside companies.

C. Production Costs

3.11 The exploration and production costs over the period 1979-1987 areshown in Annex 3-3. In constant prices, oil producticn costs (includingexploration) have increased by 641 since 1979, and gas production costs by831. The present average costs are Ft 2,235/Tor. for oil, equivalent to aboutUS$6.42/Bbl, and Ft 1,200/MCM (US$0.75/MCF) for gas. While these figuresshould be treated with some caution, they do show that on average theproduction costs in the country are still far below world market prices.However, the favorable averages cover a wide variation from field to field,and some fields appear already to be working at a loss when compared to importprices. In addition, the marginal costs for new production are likely to besignificantly higher than the averages, caused mostly by increased productioncosts, reflecting the trend towards smaller fields which are normallyrelatively more expensive to put into production. This trend, coupled withthe projected decline in production, makes it imperative for OKGT to improveits control of exiloration, development and production costs. The Project

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provides for the development of a modern management information system andincreased attention to economic aspects in the exploration and developmentdecision process.

D. Gas Transport and Distribution

3.12 Gas Consumption. The requirements for gas transport and storagefacilities depend on the demand for gas. In Hungary domestic grossconsumption for natural gas increased from about 9.7 BCM in 1979-80 to about13 BCM in 1986-87, or at 4.32 p.a. In the future, total net gas demand(excluding gas injected into underground storages) is estimated to increase to13.7 3CM by 1991-92, to 14.1 BCM by 1994-95, and to 15 BCM by 1999-2000.Domestic production of gas increased from about 6.1 BCM in 1979-80 to about 7BCM in 1986-87. Concurrently, imports of gas from USSR increased from about3.5 BCM to about 4.8 BCM in order to meet the growing deficits in total annualdemand. Supplies from the USSR are relatively restricted during the wintermonths, while the minimum imports (under a take-or-pay type supply contract)during the summer have resulted in nominal surpluses in availability overdemand. OKGT has already developed three depleted gas fields atPusztaederics, Kardoskut and Hajduszoboszlo as underground storage.acilities. Gas surpluses available during summer months are being injectedinto these three reservoirs, and withdrawn during winter to balance overallgas supply and demand. This arrangement has worked well during the past yearsas shown in Annex 3-4.

3.13 The pattern of demand varies significantly between the summer (April- September) and winter (October - March) months, with the winter averagedaily demand about double that during the average summer day. Within thewinter period, peak demand during certain days averages about 37X more thanthe winter average daily demand. The estimated total demand, pattern ofseasonal demand, and winter daily peak demand for the future years is shown inAnnex 3-5. These large seasonal and diurnal fluctuations in demand imply theneed for expanding the current underground storage capacities. An estimate ofincremental storage .apacities required to balance demand and supplythroughout the year, consistent with gas availability from domestic productionand imports, is also shown in Annex 3-5. This expansion will be supportedthrough the Project.

3.14 Gas Pipeline System. The first pipelines in Hungary were constructedin the 1940s. During the 1950s, with the new fields coming into production inEast and Southeast Hungary, additional pipelines were laid to link with theBudapest area and the northern part of the country, and in the 1960s, pipelinelinks were established to Western Hungary. Imports of gas from USSR commencedin 1975, and compressor stations were established in the late 1970s atBeregdaroc, Leninvaros and Varosfold to handle increased imports from USSRmeant for Yugoslavia, but supplied originally by Huagary from its southernfields in exchange. (At present, virtually all Soviet deliveries toYugoslavia are handled separately from Hungarian production.) With increasingdomestic gas demand, new pipelines were required linking Hajduszoboszlo withEndrod in the South and Beregdaroc in north end in mid-1980s, therebycompleting the second transport route for the Soviet gas to South and WestHungary, linking all the producing fields in South Hungary. Currently, alittle over 4,400 km of trunk gas pipelines are in place serving practicallyall major towns and industrial consumers. Operations of the extensive

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pipeline system are being conducted reasonably efficiently using systematicnetwork analysis, which is al30 used for new pipeline investment justification.

E. Petroleum StratMs

3.15 In spite of the fact that Hungary is a mature producer, investmentsin exploration are still justified. The involvement of foreign companieswould be a very useful supplement to Hungary's own efforts through OKGT; thepreparatic .ader the Project of a contractual framework will make it possibleto negotiate equitable contracts with any interested companies. However, mostof the investments in oil and gas in the country will under any circumstancesbe done by OKGT, which must place special emphasis in three areas: (i) thebroadening of exploration methodology to search effectively for hydrocarbonstructures other than just anticlines; (ii) the improved efficiency andattention to project economics of exploration, development and productioninvestments to meet the expected continued increase in costs; and (iii) thehandling of increasing imports of gas from the USSR by a strengthened domesticgas pipeline system and expanded underground storage facilities. Thesepriorities are addressed under the Project.

IV. THE HUNGARIAN NATIONAL OIL AND GAS TRUST

A. Organization and Staffing

4.01 Overview. The Hungarian National Oil and Gas Trust (OKGT) wasestablished in 1957 as the entity responsible for all activities in thenationalized oil and gas sector. It has since then built up a solid trackrecord in exploration and production, pipelines, refining and distribution.In addition to direct oil and gas activities the Trust also covers industrialactivities such as the design and fabrication of pipelines and themanufacturing of specialised equipment. OKGT has a total of 46,350 employeesand total assets of about US$ 2.5 billion equivalent. During projectpreparation, there was an intensive dialogue between OKGT and the Bankconcerning institutional development issues. OKGT's program in this regard isreflected in its Letter on Institutional Strategy to the Bank from OKGT'sPresident and Chairman of the Board of Directors, which is shown in Annex 4-1and discussed below. Broadly, it outlines a policy of institutionaldevelopment that aims at (i) increasing OKGT's operational and legal autonomyand flexibility, (ii) strengthering the emphasis on OKGT's core oil and gasactivities, (iii) modifying the organizational structure more towards thattypically followed by international integrated oil companies, (iv)strengthening OKGT's econo,lic assessment of oil and gas operations and (v)developing a new and more integrated approach to oil and gas exploration.

4.02 Legal SLatus. OKGT is organized as a Goverr-ment trust, responsiblefor all oil and gas activities in Hungary, and reporting primarily to theMinistry of Industry. However, under the Government's traditional frameworkfor managing and controlling its enterprises, OKGT has had only a limited andat times unclear degree of autonomy, e.g., with investments subject to theapproval of Government bodies and with complicated capital flows between thecentral Government and OKGT. In practice, this has made it difficult for OKGTto develop appropriate and consistent internal criteria for the allocation ofinvestment funds between competing activities. Under the evolving company

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framework"' in Hungary, OKGT now intends to review with the Government waysof turning the Trust into a corporation with a clearly defined equity base anda Board of Directors. OKGT and the Government will complete their review ofthis matter by December 31, 1989, and promptly thereafter discuss theirconclusions with the Bank.

4.03 Organization. Annexes 4-2 and 4-3 show OKGT's organizationalstructure. The Tru.st is the parent institution for 23 operating companiesthat cover the whole spectrum of petroleum activities from exploration torefining, distribution and sales, in addition to coaistruction and design,pipeline installation and the manufacturing of specialized equipment. Thecompanies have their own management but in practice their autonomy is quitelimited, for two reasons. First, most important decisions are passed on tothe central Trust administration, which also handles activities such asfinancing, and second, OKGT's own autonomy is quite limited. OKGT'srianagement Board comprises the top managers of the various OKGT companies,headed by OKCT's President. However, there is also a Supervisory Board thatis appointed by the Ministry of Industry and comprises representatives ofoutside organizations. It meets from time to time to ensure that OKGT isfulfilling its supply obligations and is being operated in accordance withregulations. The central office is divided in three main sections, eachheaded by a Deputy General Manager, for (i) exploration, production andmanufacturing, (ii) for refineries and local gas distribution, and (iii) foraccounting and finance.

4.04 The individual companies are organized along functional andgeographical lines (see a complete list in Annex 4-4). For exploration andproduction, the most important companies are the Geophysical ExplorationCompany (GKV), the Lowlands Petroleum Exploration Company (KV), LowlandsHydrocarbon Production Company (NKFV), Transdanubian Petroleum Company (KFV)and the Hungarian Hydrocarbon Institute (SZKFI). GKV is responsiblenationally for all seismic data acquisitioa, processing and interpretation.In the area east of the Danube river, KV and NKFV are responsible forexploration and development, respectively, with KV handling drilling andlogging, and NKFV being responsible for field development, production, gasimports and supply to large customers including gas utilities. In the lessactive area west of the Danube KFV combines the responsibilities forexploration and production. SZKFI carries out theoretical and appliedresearch and pilot projects in exploration, development, processing andpetrochemistry. OKGT's general contracting company, OLAJTERV, is responsiblefor engineering studies and design and for construction supervision.

4.05 OKGT's organization of its subsidiaries can in some ways be comparedto the divisions of an international oil company. However, the division ofresponsibility between these companies creates some overlap and duplication ofactivities, the company structure appears somewhat inflexible, and the fact

--' The Government recently passed the Jaw of Association, which permits theestablishment of several different forms of enterprises including privateand mixed companies. However, this law is not applicable to existingState enterprises. The Law of Transformation, which is intended to bepresented to Parliament by mid-1989, will enable State enterprisesspecifically to convert to these company forms.

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that OKGT has in-house many of the functions such as seismic and drilling thatinternationally are normally handled by separate service companies, createscomplications in the organizational structure. For these reasons, it is nowimportant for OKGT to assess systematically the roles and functions of itssubsidiary organizations. A first step has been the recen' concentration ofall oil and gas activities (except local gas distribution companies and SZKFI)in the "hydrocarbon verticum", representing OKGT's core, buabiess activities.OKGT now plans to strengthen its emphasis on these activities, while thecompanies outside the verticum (local gas distribution companies and the"background" industrial companies) are expected to become increasinglyindependent and may get over time a more diversified ownership. In addition,GKGT will initiate a systematic institutional development process and willtake concrete steps in the organization and definition of responsibilities foroil and gas exploration, development and production.

4.06 Staffing. OKGT's staff is well educated and trained, and in severaldisciplines technically of international levels, although hampered by the factthat OKGT has been somewhat outside of the international technicalmainstream. Under the first Petroleum Project, significant training, traveland consulting services have served to familiarize OKGT's technical staff moreclosely with international developments. These efforts will continue underthe Project, which will finance training in Hungary by foreign consultants andOKGT training ab;oad in the form of seminars and industry familiarization.OKGT's staffing is on the high side when compared to other oil companiesinternationally, even though as a State oil company it also includes a numberof services that internationally are handled by separate contractors. Moreimportantly, with the projected decline in discoveries and production, OKGTwill inevitably be faced with the task, within the next few years, of startingto shrink its staff strength. This could easily mean that experience andexpertise that has been built up through the years at considerable cost may belost. To try and prevent this, and to develop a broader business foundation,OKGT intends to initiate efforts to develop an export business for petroleumexpertise and services. OKGT has no experience in this regard and no namerecognition internationally, but does possess a large workforce skilled invarious di.ciplines (inexpensive by international standards), a centralEuropean basis and through its CMEA connections it is well placed to develop amarket in Eastern Europe. In order to initiate this process, OKGT as a firststep will undertake an audit of its capabilities by international consultants,who may be financed under the proposed loan, in order to determine better itspossible competitive strengths and to prepare a market strategy.

B. Operational Autonomy

4.07 OKGT is responsible for working within annual and five-year plans.The preparation of these plans is initiated at the company level; thesubmissions are consolidated at OKGT headquarters and then modified andapproved by the Government. in recent years there has been a trend towardsmore operational autonomy for OKGT. At present about 30% of all investmentsby amount are carried out without requiring Government approvals; theremaining 70% require specific authorization from the Government, includingvery large investments like a refinery or pipeline expansion, but alsoinvestments of a more moderate size that the Government wants to evaluate.The Government and OKGT expect that the trend towards increased autonomy ininvestment decisions will continue.

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4.08 However, in addition to the control exercised through the annual andfive-year investment plans, various Government autho.ities have beenexercising close control over OKGT's operations in other and more restrictive

; ways. First and foremost, the Central Geological Office in the Ministry of; Industry approves all exploration programs as well as any material

modifications to these programs, and its approval is also required (at leastnominally) in order for OKGT to move from one phase of a program to the next;most importantly, from exploration to development. This office has placed

E heavy emphasis on maximizing information from a field and subsequently onmaximizing production, with insufficient regard for time and cost factors. Therequirements of the Geological Office together with OKGT's own practices haveled in a number of cases to an excessive number of wells drilled and to longdelays in putting fields into production. Now, discussions are at an advancedstage in Hungary for the rationalization of the regulatory framework. Underthe evolving new regulations, the responsibility for day-to-day operationswill be placed more clearly on OKGT, which is expected, inter alia, to becomeable to move from one phase to another in the exploration and developmentprocess without outside prior approval.

C. Development of Key Functions

4.09 Longer Term Perspectives. OKGT is fully aware that the expecteddecline in discoveries and production over the next decade will present theorganization with very substantial challenges, requiring new methodologies,improved efficiency and organizational flexibility. Accordingly, it is OKGT'sintention to initiate a process of institutional development that will overtime move its organization and procedures in the direction of otherinternational integrated oil companies. This would, inter alia, involve theestablishment of OKGT as a corporation together with internal changes,including a clear separation between its core and non-core activities, thecore being the present hydrocarbon verticum. The non-core activities would betreated more independently. Conceivably, OKGT might involve outside partiesin the ownership of some of these companies. At the same time, OKGT'sautonomy should be increased through the establishment of a corporate Boardthat would represent the shareholder(s), through a more transparent tax systemand from 1989 the elimination of Government investment support.

4.10 Exploration and Production. The organization of OKGT's exploration,development and production suffers from the separation of functions along thephysical aspects of the activities. This is not conducive to the integrationof the various technical disciplines, to setting economic priorities or toinducing efficient use of resources. Inter alia, exploration suffers from thecompartmentalization of activities and drilling operations tend not to givemaximum benefit because geological considerations are not given sufficientweight. Accordingly, OKGT has decided to modernize the organization of itsexploration and production activities, in order to facilitate the integrationof the various technical disciplines, strengthen accountability and improvedecision-making. These changes, reflected in the OKGT Letter on InstitutionalStracegy, are as follows:

(a) The responsibility for exploration activities will be placed onintegrated exploration teams that will be organized centrally inthe organization, have access to modern interpretation equipmentand have the full responsibility for exploration decisions;

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(b) The service activities (primarily seismic and drilling) will beorganized in separate units that will, in the longer run, have tocompete with outside service companies and would also be expectedto try and develop outside business;

*c) The responsibility for day-to-day operations of operating fieldswould remain with local production companies, but these would besupported by a centrally located integrated production team,working in close cooperation with the exploration teams, and whichwould concentrate on the analysis of selectively chosendevelopment and production problems;

(d) The economic analysis of investment projects would be emphasizedalready at the exploration stage, by having an analysis atconvenient decision-points of possible prospects and their likelyrange of economic outcomes. The investment criteria wouldstipulate that OKGT would only proceed with those prospects thatwould meet minimum criteria.

4.11 In pursuance of the above objectives, OKGT is taking the followinginitial actions:

(a) Exploration Teams. The first such teams have already beenestablished with a qualified team leader, and will be supported bya consultant exploration manager that will be used heavily at theearly stages and subsequently on a part-time basis. Team leaderswill be given responsibilities and authority similar to that ofexploration managers with international oil companies, includingfull responsibility for surveys and drilling operations;

(b) Production Team. A production team, located in close physicalproximity to the exploration teams, will be fully established andin operation by December 31, 1989;

(c) Service Units. OKGT will reorganize its drilling, well completionand logging activities into special units that will operateindependently in ways similar to that of international servicecompanies, and there will be a new description of theresponsibilities of the geophysical company (GKV). OKGT willpresent to the Bank by December 31, 1989 for review and discussiona study of these organizational changes;

(d) Work Stations. The availability of modern work stations is a mustfor the effective utilisation of the integrated teams. These willbe installed first at GKV, which will be responsible for thetechnical supervision and maintenance of the stations and for theorganization of data bases. Later, the teams will be equippedwith similar stations;

(e) Projections. OKGT prepares at present forecasts for discoveriesand production, but different units of OKGT may use somewhatdifferent figures for their planning purposes. It is importantfor OKGT to strengthen and integrate better its technicalplanning. In 1990, OKGT will undertake an assessment of its

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in-ground reserves. At that time, it will also prepare year-by-yearprojections for oil and gas discoveries and production, domesticdemand and imports, and will review these with the Bank by October 31,1991. Subsequently, these projections will be updated annually andused for all planning purposes.

D. Accounting, Management Control and Financek'

4.12 General. OKGT's accounts follow detailed norms and regulationsestablished by the Ministry of Finance within Hungary's general accountingframework. This framework suffers from a number of weaknesses. The emphasisis control for tax and other compliance purposes rather than to provideadequate information. The development of accounting concepts lags behindinternational standards. Also, the system of detailed central control meansthat companies have inadequate scope to modify standards to suit theirparticular industries, and there are no overall OKGT accounts (except asrequired by the Bank). For accounting purposes, 0'.GT's companies prepareindividual statements, which are consolidated as follows:

(a) The eleven companies in the hydrocarbon group ("hydrocarbonverticum"), which are involved in drilling, seismic, oil and gasexploration, production; transportation, refining and marketing ofoil products are consolidated as one grcup (also including a CO2production company);

(b) The gas utility companies are consolidated as one group;

(c) Finally, the hydrocarbon, gas companies and remaining companies("background industries") are consolidated as the Trust accounts,for the purpose of presenting financial statements to the Bank.

4.13 Management Information System. The present accounting system does notprovide as accurate and timely information as required for OKGTdecision-makers. Therefore, under the Project OKGT will develop a modernmanagement information system (MIS), utilizing the services of qualifiedinternational consultants. Terms of reference have been agreed with OKGT.Invitations to bid will be sent out shortlyfor an MIS study that will beund'rtaken in two phases; first a diagnosis (to be completed by June 30, 1990)and second, the preparation of an initial MIS for high priority areas (to beinitiated by January 1, 1991). Some of these priority areas have tentativelybeen identified as management reporting, financial management and projectionsand operational information for exploration, development and production andfor the day to day management of imports and production.

A detailed report is available in Project Files.

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4.14 Investments. OKGT's investments (1983-87) and projected investments(1988-92) are as follows:

Table 4.1: OKGT - Investment ProAram(in current Billion Forints)

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992------------ Actuals----------- -----------Projected------------

Verticum 7.32 6.85 7.05 8.80 10.81 10.54 12.98 11.88 16.07 12.86Gas companies .38 .54 .61 .67 .79 .83 .56 .51 1.02 1.08Other .25 .20 .22 .27 .33 .38 .21 .24 .31 .32OKGT Total jj2 La.2 ZJA 2.1 ".9 "A U.z2 1 1.Zm1_. Lkd

of which Foreign Exchange:1.27 .46 .72 1.92 1.60 2.79 3.72 3.49 2.05 1.62

4.15 For the years 1988-90 the investment program has been prepared inconsiderable detail and has been reviewed with Government authorities in thecontext of the five-year plan revisions. It can therefore be consideredfirm. For the subsequent years, the figures represent OKGT's expectedrequirements. (Under the Project, the Bank will review annually with OKGT itsinvestment program, as discussed in para 5.11.) Within the overall program,the investment figures for the hydrocarbon verticum consist of the componentsshown in Table 4.2 below. These figures include only the required newequipment; manpower and operating costs of exploration programs are excluded.

Table 4.2: OKGT (Hydrocarbon Verticum) - Investments(in current Billion Forints)

1988 1989 1990 1991 1992

Exploration and Drilling Equipment 2.17 1.22 .68 1.37 1.11Development 3.81 5.09 4.96 5.75 4.16Pipeline Construction 1.22 2.13 1.27 2.18 2.36Petroleum Refining 1.75 2.49 3.78 4.68 2.49Underground Gas Storage .93 1.23 .68 .99 1.72Carbon Dioxide Production .13 .35 .09 .14 .05Storage, Transportation .35 .26 .23 .36 .37Lube Oil Production .14 .15 .15 .50 .50Other .04 .06 .04 .10 .10

Total Verticum ;0A15 I. 11.88 ____ 128

4.16 These figures show that for the period 1989-92 OKGT would invest atotal of about US$1,161 million equivalent, of which US$1,075 million for thehydrocarbon verticum. At least about US$218 million of these investmentswould be in foreign exchange.

4.17 Financing. Until 1985, the investment programs were financed mostlyby State loans. Direct contributions from the Government have since then beenof less importance, although additional indirect support was provided throughthe system for production taxes. As discussed in para 4.24, this system hasnow been changed, and OKGT is expected from 1989 to be able to finance all itsinvestments from its own resources and direct borrowings. Or this basis, OKGTprojects its financing (,or the Trust as a whole) as shown in Table 4.3.

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Table 4.3: OKGT Financing Plan (1988-1992)Zin Million Forints)

Sources 1988 1989 1990 1991 1992

Co wercial Banks 911 1,340 2,080 4,785 4,467World Bank-" 1,807 1,709 1,888 1,010 580Own resources1' 7,790 10,200 7,669 10,712 9,213State Loans 747 - - -Municipal Sources 498 - - - -Other International loans- - 500 1,000 900 -

}11753 13Z749 12.637 17.407 L1L260

Includes the proposed loan, Loan 2398-HU, the associated B-loan andsubprojects under energy conservation lines of credit.Own resources include profit, depreciation, production development fundand resource and exploration fund.

3' Primarily from the CMEA Development Bank for oil refinery investments.

4.1.8 Transfers to the Government. OKGT has been a major source of revenuefor the State treasury through the Differential Production Turnover Tax(royalties) which is charged on its production and imports. The tax onimports is charged in order to equalize for OKGT the cost of domesticproduction and imports from the USSR; it has been declining as a result of thedecline in world market prices. The financial transfers are shown in Table4.4. In 1987, OKGT made payments of Ft. 43.5 billion and had receipts fromthe Government of Ft. 12.3 billion. This pattern is likely to be changed from1989 onwards, since OKGT will now be taxed on its profit rather than onproduction and will also no longer receive any Government investment support.

Table 4.4: OKGT - Transfers to State Treasury-'(in Million Forints)

1983 1984 1985 1986 1987Payments

Local DPTT 32,667 31,938 30,465 26,107 24,502Import DPTT 34,611 32,188 26,904 12,262 10,102Other Payments 6,504 8,169 8,241 5,731 8,941

Total Payments LLZL2 7X,29 k1.kl 4 4

Receipts

Price 518 544 175 121 177Imports 4,427 788 333Res. and Expl. Fund 4,251 4,571 5,880 6,736 6,690Investment retention 3,848 3,628Other Support 41 8 391 935 91

Total Receipts 6.46 4= 13.26 1L. IL=Net Transfers 67,318 65,763 52,349 30,300 31,252

'i-' In addition, OKGT also collects sales taxes for the Government. Thesehave increased from Ft. 11.5 billion in 1983 to Ft. 39.7 billion in 1987.

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E. Financial Performance

4.19 Financial Statements. Annexes 4-5 to 4-7 show OKGT's actual (1983-87)and projected (1988-92) financial statements. The audited statements showthat OKGT's operating costs, inclusive of production taxes, have ranged from90.41 to 931 of net revenues. Real costs have been increasing in this period,but this has been off-set by a reduction in production taxes. OKGT's debt hasbeen low, ranging from 19% to 22X of equity. OKGT's debt-service coverageratio has consistently been above 1.5:1, and the current ratio has been wellabove 2:1. However, there have been significant variations in the latterratio from year to year, and OKGT's working capital requirements can also besubject to considerable fluctuations during a year, both on its own accountand because it collects substantial amounts in taxes for the Goverrment. Atthe same time, with the recent developments of the Hungarian financial sectorthere are now more opportunities for imprcved returns on short-term funds.All these factors imply a need for OKGT to strengthen its working capitalmanagement and planning; this will be addressed through the study of itsmanagement information requirements.

4.20 Since 1986, OKGT has also been preparing consolidated financialstatements for the hydrocarbon verticum. These show that the verticum hasshown better performance than the Trust as a whole, due to the fact that thelocal gas supply companies, which are excluded from the verticum, barely breakeven. Thus, in 1987 the verticum had a profit before tax of Ft. 9.3 billionout of the profit of Ft. 10.3 billion for the Trust as a whole. Within theverticum, 901 of profits appear to be accounted for by the refineries; this iscontrary to what has been the experience internationally and is probably atleast in part a result of the taxation system and the (tax-induced) internaltransfer prices. With the ongoing revision of the taxation system, OKGTshould be able gradually to improve the internal allocation of costs andrevenues. The proposed MIS study should also be helpful in this regard.

4.21 Projections. As explained in para 4.24, OKGT's taxation system hasnow been changed with effect from 1989. Under the new system, the netafter-tax profit will be substantially higher than was previously the case.The projections show that OKGT's finai.,ial perform'ance will remain strong. By1992, the projections show profit after tax at 7% of net revenues, the currentratio at 2.3:1, the debt-service coverage ratio at 2.8:1, and a debt-equityration of 16:84. The return on equity at that time is projected at 9.81; thisis considerably above the recent actuals as a result of the change in thetaxation system.

4.22 Ratios. Under Loan 2398-HU OKGT undertook to meet the followingstandards: i) profit before taxes in relation to the resources used of atleast 8X; ii) provisions for exploration a-d field development of 80% percentor more of its actual expenditures for such activities; iii) long-term debtservice coverage ratio of at least 1.5; iv) current ratio of at least 1.5; andv) long-term debt to equity ratio not exceeding 60:40. OKGT has beensatisfactorily meeting these ratios, and will continue to do so, except forthe provisions for exploration and development. These were a way of ensuringthat OKGT could retain in-house sufficient funds for primary exploration.With the new tax system, these provisions are no longer required. Also,profits will be measured after the special profit tax on primary productionand related to average total assets (excluding projects under construction).

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On this new basis, OKGT's profit should be at least 15% of assets, in orderfor it to generate sufficient funds for investments. The projections showthat OKGT's profit will be above this level through 1992.

4.23 Audits. OKGT has an internal audit group, which operates under a workprogram approved by OKGT's President. The function of this group is to verifythat OKGT and its subsidiaries operate within the guidelines issued by theGovernment, and to investigate specific issues for OKGT's management. UnderLoan 2398-HU, OKGT has provided annual accounts in a format approved by theBank and audited by an external auditor appointed by the Minister of Finance.- he auditing profession in Hungary is still under development; however, OKGT's1iEditors have carried out a reasonable amount of work that has been acceptablefbr the Bank. OKGT will continue to prepare annual financial statements in aformat acceptable to the Bank, and will have these audited by an acceptableexternal auditor. OKGT will also consider whether to utilize an internationalfirm for its audit work, taking into account the expected increase in itsinternational orientation.

4.24 Petroleum Taxation. Until now, the method of taxing petroleumproduction was very complex and lacking in transparency. For that reason, theGovernment has recently introduced a new system for the taxation of theproduction of the country's hydrocarbon resources. Briefly, there will nolonger be any royalties or quasi-royalties on domestic production, and nofurther need for special exploration and development funds to retain resourcesfor these purposes. Rather, OKGT will calculate its gross profit fromdomestic production, deduct all exploration investments, and on the remainderpay a special petroleum profits tax (initially of 44.8%). The profit afterthis tax will be subjected to normal company income tax. This system appearsin line with international taxation practices of the petroleum industry, andshould, inter alia, make it easier for OKGT to determine the sources of itsprofits and losses.

F. OKGT's Performance under the First Petroleum Project

4.25 The first Petroleum Project, for US$90 million equivalent, becameeffective in June 1984.'' As of December 21, .988, an amount of only US$4.7million remained undisbursed. The project has financed the drilling of deepexploration wells, the rehabilitation and developments of several gas fieldsand pilot enhanced oil and gas recovery subprojects, in addition to technicalassistance and training. The deep drilling component has revealed that thepre-Pannorion sediments are more difficult than previously expected, beinghighly faulted and fractured and with a very high temperature gradient. Whilediscouraging, the results of these wells mean that OKGT can for the time beingconcentrate its exploration efforts on the more shallow horizons. In otheraspects, the project has been very successful. The first increases inproduction from some of the upgraded fields have been achieved and until theend of 1987 some 8 MMToe of extra hydrocarbons had been produced, representing

1/ There was also a B-loan in Yen and US$ at a value at that time (1984) ofUS$24.3 million equivalent. This loan has been disbursed to NBH, andOKGT has been utilizing it to finance foreign exchange expenditures inconnection with the subprojects under Loan 2398-HU.

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a gross production value of about US$70 million. The first pro.duction fromenhanced oil recovery (EOR) projects has also been recorded.

4.26 Most importantly, OKGT's technical operations have improved as aresult of the project. This includes the first ever integrated basin studywhich has been done by the US Geological Survey, thereby introducing a muchmoxe modern approach to petrolewm exploration, and helping to prepare OKGT forunderta4ing future such studies largely with its own human resources.Drilling operations are showing an increase in efficiency with better mudcontrol, cementing and fracturing, leading to higher well stability andimproved productivity. Seismic quality and quantity have improved greatly;thus, OKGT's premier crew with modern instruments financed under the loan hasrecorded production in excess of 100 km/month, while 40 km/month wasconsidered a good production in 1984. Under the Project, OKGT will continueto use international consultants and to train its staff in Hungary and abroad,and will also acquire additional specialized equipment. This will help toconsolidate and develop further the progress achieved under Loan 2398-HU.

V. THE PROJECT

A. Proie ct Objectives and Scope

5.01 The main Project objectives are to support: (i) significantimprovemeAts in the policy and institutiohal framework of the energy sectorincluding appropriate pricing coupled with subsidy elimination, restructuringof the coal mining sector and improved power investment planning; (ii)development of t~he oil and gas sector through gradual restructuring of thenational oil and gas company (OKGT), opening up the sector to foreigninvestment and financing of priority investments; and (iii) preparation of anupdated energy conservation program and financing of related investments.

5.02 The Project is composed of two Bank loans for a total of US$110million equivalent as follows:

(a) US$100 million equivalent to OKGT to finance thedirect convertible currency component of investmentsubprojects for oil and gas field development,upgrading and enhanced recovery, underground gasstorage for winter gas, pipeline expansion andmodernization, as well as for exploration andproduction equipment and for technical assistanceand training in the areas of oil and gas operations,exploration, data storage, field and basin studies,geothermal development, management informationsystem, contract preparation, exploration promotion,export of petroleum services and expertise andinstitutional strategy and development;

(b) US$10 million equivalent to the National Bank ofHungary (NBH) to finance energy conservationsubprojects through participating commercial banksin continuation of the ongoing lines of credit forthis purpose.

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B. Rationale for Bank Involvement

5.03 Since it started lending to Hungary in 1983, the Bank's strategy forassistance has focused on supporting Hungary's program of structuraladjustment in the economy, to make it more efficient, flexible and marketresponsive. A significant portion of Bank lending has been to supportindustrial policy reforms, through industrial adjustment landing andinvestment lending with strong policy components. To be successful, theindustrial reform process needs to be supported by complementary reforms inadjoining sectors in the economy, which the Bank is supporting through"hybrid" projects that combine subsector and enterprise restructuring withsupport for important policy changes. This is the objective of the proposedProject.

5.04 Hungary's main present development objective is to increase economicefficiency and competitivenees as the key to sustainable growth. In order torealize this objective, the Government must exercise firm macroeconomicdirection while letting market processes and signals replace centralcontrols. The energy sector plays a central role for the economicrestructuring process. The Bank's energy lending and concomitant policydialogue have resulted in significant improvements in energy policies and havesupported the strengthening of the performarnce of sector institutions, in linewith the development objectives. Continued Bank support is now important orthe sector policy framework to mature in line with overall GovernmentobAtctives, and for the leading sector enterprises to strengthen theircapabilities and autonciny while at the same time parts of the sector would beopened for international investment.

C. Project Description

1. Energy Policies

5.05 The Project supports the energy policy confirmations and actionsdetailed in para 2.25, including the following: (i) corsumer energy priceswill be increased substantially in 1989 and all consumer energy pricesubsidies will be eliminated within three to five years depending on the typeof energy carrier; (ii) the power tariff structure will be brought in linewith economic costs; (iii) seasonal gas prices will be introduced in thesecond half of 1989, and the remaining preferential industrial gas prices willbe eliminated gradually over the next five year plan period; (iv) a newpetroleum taxation system is being introduced from 1989; (v) a new and moresimple technical oil and gas regulatory framework will be introduced; (vi)major changes in the energy investment program will be reviewed with the Bank;and (vii) the Bank will support and monitor the implementation of the coalrestructuring plan.

5.06 In the context of the Project, the Government will undertake thefollowing analyses in order to develop proposed action programs fordiscussions with the Bank and subsequent implementation: Tariff metering,non-pricing measures to improve the efficiency of energy production andutilization in the household sector, winter-summer gas price differentials,and regional and day/night power tariffs.

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2. Oil and Gas

(a) Institutional Development

5.07 OKGT is a large and important institution in Hungary's economy, but isnow faced with the substantial challenge of having to adapt to an expectedtrend of declining oil and gas production and increasing costs, while at thesame time having to finance its investments on its own out of internallygenerated resources or direct borrowings. In order to meet this challenge.OKGT will initiate under the Project a process of institutional development,with the objective of turning itself into an sutinomous, integrated oilcompany with a more international focus for its operations. As part of thisprocess, OKGT will take early action in two areas: (i) it will introduce amodernized management information system (MIS); and (ii) it will reorganizeoil and gas exploration and development activities, placing service activitiesin separate units and creating integrated exploration and production teams.

5.08 The Project will also support the efforts started under Loan 2398-HU(para 4.26) to strengthen OKGT's technological expertise through the use ofconsultants together with staff training (including industryfamiliarization). Annex 5-1 shows the program of technical assistance andtraining financed under the Project, which is summarized below:

Table 5.1: OKGT Technical Assistance and Training

Cost (US$ 0OOs)Foreign Local Total

(i) Organization and Institutional 2,200 650 2,850(ii) Technological Development 1,300 650 1,950(iii) Training 500 200 700

Total 6.0 50

5.09 OKGT has signed a consulting contract for the study of exploration andproduction contract economics (in order to establish a framework forinvestment by international companies). The following activities that areparticularly important for OKGT's institutional and technological developmentwill also be undertaken: (a) the first phase of the management informationsystem analysis will be completed by June 30, 1990 and the second phase willbe initiated by January 1, 1991; (b) a contractual framework including a modelcontract will be in place by December 31, 1989; (c) an exploration managementadviser will be recruited by September 30, 1989; (d) a draft strategy forOKGT's service export potential will be completed by December 31, 1990; (e) aconprehensive field development ex-post study to review present practices andsuggest areas of improvement will be concluded by June 30, 1990; and (f)initial analyses of OKGT's well stimulation, drilling, completion and testingpractices aimed in particular at upgrading OKGT's practices where requestedwill be completed by June 30, 1990. The framework for this technicalassistance has been agreed with OKGT, including the terms of reference formost of the studies. At the beginning of each year OKGT will prepare anannual training program that will be reviewed with the Bank.

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(b) Specialized Equipment

5.10 OKGT needs specialized modern equipment in order to upgrade itsexploration and drilling activities. Such requirements, which are not linkedto specific investment projects, include equipment to improve the quality andefficiency of geophysical data acquisition and processing, well logging andwell testing, including rig spare parts and well stimulation equipment. Ofthe total equipment and spares requirements of about US$25 million equivalent,high priority items amounting to "5S$10 million have been included forfinancing under the Project, as b..own in Annex 5-2.

(c) Subproiccts

5.11 General. OKGT's investment program consists largely of small andmedium sized projects, which in general show a reasonable return ofinvestment. However, the program priorities may change at frequent intervalsas a result of new exploration results, re-assessments of projects in thepipeline and price and cost developments. OKGT will review annually with theBank its five-year investment program and current investment priorities, withemphasis on the hydrocarbon verticum. OKGT estimates that during the period1989-1992, it will have oil and gas development projects (includingunderground storage and pipelines) for an amount cf about Ft. 45 billionequivalent. The Project will finance direct foreign exchange costsforsubprojects with an estimated total cost of Ft. 27 billion, or about 60% ofthe total upstream oil and gas investment projects. These subprojects wereselected based on their relat.vely advanced stage of preparation and theirexpected economic benefits, and are typically those that OKGT gives thehighest priority. During project preparation, several subprojects weredropped from OKGT's investment program and many of the others (including someof the largest) have been reformulated as a result of the discussions with theBank. The subprojects fall in three categories, which are discussedseparately- (i) field development, including the upgrading of existing fieldsor the implementation of enhanced recovery methods; (ii) underground gasstorage, in order to supply the winter demand for gas; and (iii) improvementand upgrading of the gas transmission system in Hungary.

5.12 Field Development, Upgrading and Enhanced Recovery. The Project willfinance a series of investment subprojects for the development of provendiscoveries or the continuation of oil and gas production from existingfields. These subprojects are summarized in Annexes 5-3 and 5-4, on the basisof detailed evaluations that are available in project files. Table 5.2 belowsummarizes the subprojects that are acceptable and will be included in theProject as eligible for financing:

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Table 5.2: Develovunt Sub roects1'(US$ million equivalent)

Subproiects Total Cost Foreign Exchange ERR ' Purpose

Sueghalom 149.0 26.5 181 DevelopmentTaslar 42.6 3.1' 30S Gas enrichmentLiszo-Inke/Lovaszi 54.6 17.4 171T' Gas enrichmentNagylengyel 60.0 8.3 221 Enhanced oil recov.Endrod 18.8 0.9 above 100l UpgradingAlgyo 45.4 7.2 931 UpgradingBarcs-West 19.4 4.4 811 DevelopmentKozepalfold 13.9 5.5 501 UpgradingDemjen-Kelet 9.9 3.2 311 Enhanced oil recov.Kiskundorozsma 14.2 1.0 40% DevelopmentUlles 13.1 2.0 above 1001 UpgradingCsanadapaca 2.3 0.1 above 1001 DevelopmentPusztafoldvar 0.1 0.1 681 Enhanced oil recov.Kaba-Del 0.5 0.1 above 1001 Development

Total 4LL. 2A1

I' Exclusive of price contingencies.Z/ Most of the ERRs were calculated before final cost reductions in the

estimates; the present figures therefore underestimate the likely returnon investment.

3/ Foreign exchange financing under the Project; in addition, an amount ofUS$12 million equivalent is expected to be financed under the B-loanassociated with Loan 2398-HU.

4' This ERR is considered the minimum for the project after reforrmilationswere done in consultation with the Bank. However, OKGT is evaluatingsome possibilities for improving project economics further.

5.13 The above subprojects, which are reviewed in Annex 5-3, cover a rangeof activities, including field development, upgrading, gas enrichment (of lowcalory gas), enhanced oil recovery and enhanced gas recovery. With oneexception (para 5.14), the subprojects are ready for implementation, based onvery detailed plans prepared by OKGT and reviewed extensively by the Bank.However, OKGT will present the following subproject reports for discussionwith the Bank: (i) for Demien-Kelet at the end of 1989 (end of ongoing pilot)and end of 1991 (with two years' production experience); (ii) for Nagylongyelafter two years of production history (1990). For two subprojects, specialconfirmations have been reviewed: (i) for Barcs-West that the pipelinecarrying gas will be routed safely with regard to the risk of contamination,and (ii) for Kiskundorozsma that OKGT will model the field with a dualporosity, dual permeability model. As a result of the subproject discussionswith the Bank, in many of the subprojects the estimated total costs, as wellas the foreign exchange requirements, have been reduced through the moreeconomic utilization of existing facilities, reduced number of new wellsrequired, and in some cases, a less ambitious development plan focussing moredirectly on the most economic producing horizons. At the same time, severalquestions have arisen as to OKGT's development and drilling practices; thesewill be addressed through the more ge'neral technical studies to be uidertaken

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under the project. For a few of the subprojects some additional refinement ofthe development plans will be undertaken prior to full development; however,this will not affect the viability of the subprojects or their timing. Table5.2 shows that many of the subprojects have very high rates of return; this isnot unexpected for investments aiming at, for example, prolonging the economiclife of a field where most investments have already taken place. The largerinvestments also show a fully satisfactory return.

5.14. The largest of the proposed subprojects, Szeghalom, which is also themost complicated and potentially the most rewarding, is not yet ready forimplementation. It is clear that this subproject will be implemented, butwork is still under way to determine the most advantageous developmentapproach. The subproject shows at present an estimated production of 4.3 MMTof liquids (oil and condensates) and 8 BCM of gas, corresponding to 4302 and163?, respectively, of Hungary's total projected crude oil and gas productionin the year 2000. It is the only subproject in OKGT's investment program thatcould by itself make a large addition to the domestic hydrocarbon production.As discussed in Annex 5-4. work is now under way to finalize the developmentconcept, costs and benefits. Foreign consultants have been recruited by OKGT(at the Bank's request) to examine alternative concepts and present a revisedoptimum development plan. Their final conclusions and recommendations shouldbe received by OKGT by June of 1989. In the meantime, under very conservativeassumptions the Bank estimates the ERR of a likely development plan at closeto 18X. It is expected that this subproject will be financed under theProject; however, in order to ensure that the optimum development plan will beimplemented, the subproject will be autho.ized for disbursements only based ona complete development plan acceptable to the Bank.

5.15 Underground Gas Storage. Hungary's need for increased undergroundgas storage capacity to meet winter demand was discussed in paras. 3.12 -3.13. On this basis, OKGT intends to prepare under the Project severalexisting fields for underground storage. Annex 5-5 summarizes the estimatedoverall supply/demand balance, including the role of each proposed storagefacility in achieving the balance. For determining the most appropriate andeconomical sites for additional capacity creation totalling about 1,400-1,500MCM, OKGT has investigated geologically suitable formations/horizons in 5fields (Hajduszoboszlo, Tatarules, Zsana, Tazlar and Nagylengyel), besides theformations/horizons already being operated as storage points in thePusztaederics, Kardoskut and Hajduszoboszlo fields. A total of 26 variantshave been studied, and ranked by unit cost of storage for each variant. Basedon the ranking, the four most cost-efficient variants have been selected forthe proposed development. These comprise: (i) expansion of the Pusztaedericsstorage facility by 130 MMCM (in addition to the ongoing expansion from 100MMCM to 200 MMCM to be completed in 1988) taking its total capacity to 330MMCM; (ii) rehabilitation of the current Kardoskut facility (150 MMCMcapacity) to prolong its useful life beyond 1990, and its expansion by 70MMCM, taking its total capacity to 210 MMCM; (iii) expansion of theHajduszoboszlo field storage capacity by 600 MMCM to 1,400 MMCM (thisexpansion is alre3dy under way and will not be financed under the Project);and (iv) development of the currently producing Zsana field as storage poinLwith initial capacity of 500 MMCM. OKGT's approach and methodology fordefining the sites for incremental capacity creation have been bothcomprehensive and systematic, and are satisfactory. The timing of the plannedcommissionilig of each of the expanded/new capacities is appropriate andccnsistent with the requirement to balance supply and demand.

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5.16 Physical facilities to be created for the expanded/new gas storageswill include: (i) drilling of additional wells for injection and withdrawalof gas; (ii) short-distance pipelines from each new wells to central gasprocessing facilities; (iii) expansion of central gas treatment/compressionstations; and (iv) short-distance pipelines to main, trunk gas transmissionlines. The characteristics of storage formations, physical facilities to beinstalled, capital costs, and ERR for individual subprojects are described inproject files, and sumzarized in Annex 5-5. The storage subprojects arelisted in Table 5.3:

Table 5.3: Gas Storage Subproiects'(US$ million equivalent)

Subprojects Total Cost Foreign Exchange ERR

Pusztaederics 7.2 0.5 53.3Kardoskut 8.6 2.0 24.9Zsana 52.5 15.3 54.62'

Total _.3 7l.8

t-' Inclusive of physical contingencies.2' Includes all avoided costs, whereas the ERR for the other two subprojects

are based only on the avoided cost of fuel transport. (These ERR werecalculated before OKGT revised downwards some of th:- cost estimates sothat the ERR are likely to be even higher than shown in this table.)

5.17 Gas Transmission System Improvement. Under the Project, the emergingbottlenecks in gas compression facilities to handle increased volumes ofimported gas, and in some sections of the gas transmission network areproposed to be removed. Additionally, the current infrastructure and supportfacilities for efficient operations and control of gas transmission anddistribution system would be expanded and modernized.

5.18 More specifically, OKGT intends to expand capacity along theEndrod-Varosfold section of the gas pipeline system by installing a line of800 mm diameter line to the existing 600 mm line in order for the system to beable to supply the increasing demand in western Hungary. (The pipelinesections are shown on the attached map.) At the same time, OKGT would like toprovide a northern loop to its pipeline network by connecting Gyor toPilesvorosvar, also enabling gas supplies to smaller towns along the way fromthe proposed 600 mm pipeline. Also, the Beregdaroc compression station,located at the Hungary-USSR border, receives Soviet gas and compresses thetotal volume to levels adequate for transmission through the existing trunkpipelines. The facilities at the station are adequate for present levels ofimports; however, with the projected increase in gas imports the stationcapacity will be expanded to eliminate the risk of major gas supplyinterruptions.

5.19 The components in this regard would also include the modernisationand expansion of the gas odorization system (to detect possible leaks), the

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modernization of the gas metering system (to improve throughput measurementsand billing at transfer points with gas utilities), modernization oftelecommunications system (to improve OKGT's communications within Hungary andwith the exterior) and modernization of the telemetering system (to strengthenOKGT's ability to manage the entire gas and crude oil pipeline systems).While no meaningful economic rate of return can be calculated for thesecomponents, they are clearly necessary for OKGT to operate its extensivepipeline system in a safe and efficient manner. The pipeline andcommunication components are discussed in Annex 5-6 and are summarized inTable 5.4:

Table 5.4: Pipeline and Communication Subprojects(US$ million equivalent)

ForeignSubprojects Total Cost 1/ Exchanse Purpose

Endrod-Varosfold 24.b 1.1 Pipeline expansionPilisvorosvar-Gyor 25.1 1.0 New pipeline segmentBeregdaroc 2.8 2/ 1.8 Compressor upgradingGas Odorization 2.4 0.1 Gas transmission upgradingGas metering 5.5 1.8 Gas transmission upgradingTelecommunications 3.1 0.4 Gas transmission upgradingTelemetry 6.7 0.7 Gas transmission upgrading

Total Z7.2 6.9

li-' Inclusive of physical contingencies.2/ This is the first phase of the Beregdaroc expansion project. The

financing of a possible second step may be addressed later on the basisof an OKGT feasibility study. This possible second phase has not beenincluded in the Project cost estimates.

3. Energy Conservation

5.20 General. The specific objectives of the energy conservationcomponent of the Project are to: (a) promote the development of appropriatepolicies, technologies and the institutional framework to help strengthenfurther the country's energy rationalization program; (b) hold down Hungary'senergy import costs by reducing energy consumption of enterprises in theindustrial and other sectors; and (c) to initiate a review of measures neededto promote energy conservation in the household and communal sectors. TheBank has supported energy conservation in Hungary through two loans; these arepractically fully utilized and there is a continued high demand for this typeof investment funding. Accordingly, under the Project a loan of US$10 millionwill be made to NBH in order to permit the continuation of these successfullines of credit. The objective of this loan is to help reduce the energyconsumption of enterprises in the industrial and other sectors, and to promotethe development of appropriate technologies to help strengthen the country'senergy conservation policy.

5.21 Eligibility. The component will provide a line of credit of US$10million equivalent to continue NBH's energy conservation facility throughparticipating commercial banks. These banks will onlend on a first-come

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first-served basis to industrial and other enterprises for subprojects aimedat direct energy savings, or for background industry subprojects theproduction of energy efficient materials and equipment. The loan will financethe direct foreign exchange costs of such investments, and will also financeenergy monitoring equipment required by enterprises and institutes tostrengthen their ability to monitor energy use effectively and carry outenergy audits. The subprojects should also meet the following criteria: (a)except for background industry subprojects, at least 501 of estimated benefitsshould be from direct energy savings and reduced energy costs; (b) they shouldhave a financial and economic rate of return of at least 182 in line withsimilar subprojects in Hungary; and (c) the sub-borrowers' present andprojected financial statements should show a debt/equity ratio of not morethan 65:35, a debt service coverage ratio of at least 1.5:1 and a currentratio of at least 1.3:1. The maximum subloan amount from the component wouldbe US$1.5 million equivalent.

5.22 Credit Demand. All participants in the ongoing lines of credit haveconfirmed the existence of continued strong credit demand, in spite of thefact that the Government removed with effect from January 1, 1988 the specifictax incentives for energy conservation. The heavy demand has been confirmedthrough a survey in November 1988 of potential users of the proposed creditline extension. This partial list shows a total of 52 investment subprojectswith a total cost of US$100 million, of which the estimated foreign exchangecontent is US$48.5 million equivalent. In the case of 15 of the potentialsubprojects, with a foreign exchange content of US$11.3 million equivalent,applications have already been presented to commercial banks. The greatmajority of the proposals are for foreign exchange requirements of well belowUS$1 million each, typically for selected instruments and equipment, and forinvestments to improve the energy efficiency of existing operations throughreduced energy losses, improved metering and energy monitoring, waste heatrecovery and more energy efficient production systems. Out of the subprojectsin the pipeline, 30 are expected to have an overall ERR of more than 181,based on a return from energy conservation alone of more than 101. Thesesubprojects would require foreign exchange financing of about US$22 million,and show an estimated average energy saving of 231 terajoules (5,540 Toeequivalent) per US$1 million onlending.

D. Project Cost and Financing

5.23 Project Cost. The total project cost is estimated at about US$680million equivalent, as per Table 5.5:

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Table 5.5 : Proiect Costs(in Ust million equivalent)

Local ForeiRn Total

(a) OKGT

(i) Technical assistance andtraining 1.5 4.0 5.5

(ii) Equipment - 10.0 10.0(iii) Field development,

upgrading and enhancedrecovery 364.1 79.6 443.7

(iv) Underground gasstorage 50.5 17.8 68.3

(v) Pipeline improvements 63.3 6.9 70.2Subtotal 479.4 118.3 597.7

(vi) Price contingencies1' 43.6 8.7 52.3

Total OKGT 523.0 127.0 650.0

(b) NBH

(vii) Energy conservationsubprojects 20.0 10.0 30.0

Total Project Costs IU& LIL2 680*0

I' Estimated in accordance with the Bank's price projections at 32 p.a. for1988-1990 and 41 thereafter.

5.24 The project costs for the OKGT components have been estimated based onthe detailed subproject data shown in previous paragraphs. Physicalcontingencies average around 101; however, these have been set separately foreach subproject based on the degree of uncertainty as to subsurface conditionsand equipment requirements. All local costs have been converted into USS atthe average exchange rate for 1988 (US$1 = Ft. 50); local and foreign costshave then been subjected to price contingencies in line with the Bank'spresent price projections. The exploration and production equipment costs arebased on current 1988 prices. The estimates for studies, consultancyassignments and training are based on typical current costs for suchassignments. It is assumed that there will be a substantial, althoughdiminishing, involvement of foreign consultants in the geological basinstudies. The estimate for training is based on OKGT's p.st requirements andthe need for OKGT management and staff to continue the familiarization withinternational petroleum organization, standards and practices.

5.25 Project Financing. A summary of the financing plan for the Project isshown in Table 5.6:

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Table 5.6 : Proiect Financing Plan(in US$ million eouivalent)

Local Foreign Total

IBiD - 110.0 110.0OKGT Domestic Loans 25.0 - 25.0Energy Conservation

I ~~~Domestic Loans 4.0 - 4.0OKGT 498.0 27.0 525.0Sub-borrowers 16.0 - 16.0

Total 532 JW6

5.26 The foreign exchange requirements for the OKGT subprojects and othercomponents now identified are US$127 million, or 27% above the proposed loanamount. Accordingly, OKGT will have to exercise continuous control over itsforeign exchange utilization, and the exact composition of actual subprojectexpenditures uider the Bank loan will depend on OKGT's priorities betweensubprojects that all meet rigorous minimum economic criteria. The Bank willreview periodically with the OKGT its foreign exchange requirements andpriorities. OKGT intends to seek foreign exchange resources from NBH for theamounts that would exceed the proposed loan. In that case, the Bank loanwould finance 74X of OKGT's subproject foreign exchange requirements and 15Xof total subproject costs. OKGT would finance all local currency requiremertsfrom its own generated resources and locally borrcwed funds; this is notexpected to create any problems.

5.27 The local currency requirements under the energy conservation loan areexpected to be met from locally borrowed funds (202) and from the ownresources of the enterprises (80X). Since this loan represents a creditfacility for financing of enterprise investments which will be appraised bythe banks, these estimates can only be indicative at this stage. It is basedon past experience and a review of the present pipeline of potentialprojects. The Bank would finance the foreign exchange requirements.

5.28 The energy sector analyses proposed undertaken in the context of thisProject (para 2.27) will be financed directly by the implementing Governmentagencies. These studies will require only very modest amounts of foreignexchange for specialized outside expertise, including for the household energyconservation study. NBH will provide any necessary foreign exchange to carryout satisfactorily the sector analyses.

VI. PROJECT IMPLEMENTATION

A. The OKGT Loan

6.01. The proposed US$100 million equivalent loan will be made directly toOKGT. Within the Trust, the Deputy General Manager (Exploration and

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Production) will have overall project management responsibility and willsupervise the implementation of each component and subproject with the help ofa project group consisting of the Directors of Production, Exploration,Development and AGEL (OKGT's supply subsidiary). The Deputy General Manager,Economic, will be responsible for the MIS ntudy; otherwise, the project groupwill be responsible for all technical assistance activities, supplemented asneeded by other designated staff of OKGT's Central Office and the producingcompanies. All studies will be undertaken under terms of referencesatisfactory to the Bank, and for each study OKGT would promptly review withthe Bank the results and proposed follow-up actions. The project group willmanage the acquisition of exploration and production equipment, and will fromtime to time review with the Bank the implementation of the acquisitionprogram in light of OKGT's evolving priorities.

6.02 The investment subprojects will be implemented by the pxoductioncompanies (KFV and NKFV) and the gas transportation company (GOV) under thesupervision of the project group. These companies have a qualified andexperienced staff that is fully capable of carrying out the subprojects underthe development plans already agreed with the Bank. OKGT will review with theBank the implementation of the subprojects from time to time, and will inparticular inform the Bank promptly of any material modifications insubproject concepts, 'esign or development programs and/or in the expectedtechnical or economic subproject justification. For the Szeghalom subproject(para 5.13) no disbursements (except for any possible preparatory studies)will be made before there is a final developmert plan satisfactory to theBank. In addition, in view of the evolving nature of OKGT's investmentpriorities it may during implementation substitute other development,upgrading, enhanced recovery, underground storage or pipeline upgradingsubprojects with the prior agreement or the Bank based on a firm feasibilitystudy and other documentation as reasonably requested by the BanLk.

B. The NBH Loan

6.03 The Bank loan for energy conservation will be made to NBH. Proceedsof the loan will be onlent by NBH to participating commercial banks forrelending to enterprises for eligible energy conservation investmentprojects. The onlending arrangements will be regulated by subsidiaryfinancing arrangements between NBH and each participating commercial bank.Prior to effectiveness of the NBH loan, the subsidiary financing arrangementshall have been duly authorized with at least one participating bank. Thesubprojects will be prepared by the enterprises themselves with assistance, asnecessary, from the domestiL design and research institutes. The technicaland economic appraisal of the subprojects will be carried out by thecommercial banks (with assistance from AEEF as required) in accordance withthe methodology agreed under ongoing energy conservation credit lines; a copyis available in the project files. Evaluation of the enterprises will be theresponsibility of the commercial banks. The first subproject appraised byeach commercial bank will be subject to prior review by the Bank beforeimplementation is undertaken, except for those banks that have alreadyutilized the existing energy conservation lines of credit. Eligible bankswill be those classified as eligible full service banks under the IndustrialRestructuring Projects. Most of the subprojects would be small and wouldconsist of modifications to existing facilities rather than large-scale new

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production facilities. The subprojects can therefore be satisfactorilyimplemented by the enterprises using either their own staff or localorganizations for design and construction work, and assistance from vendorsfor the installation of imported equipment. The commercial banks will provideclose supervision and monitoring during implementation.

C. Energy Sector

6.04 The sector analyses described in para 2.27 will be carried out underterms of reference agreed with the Bank. They will be implemented by thefollowing Government agencies: MVMT (tariff metering and regional andday/night power tariffs), OEGH (household energy study) and OKGT(winter/summer gas pricing). These entities are fully qualified to managesuch studies.

D. Lending and Onlending Terms

6.05 OKGT Loan. The loan to OKGT will be for 15 years, including fiveyears of grace, at the Bank's standard variable interest rate, and will berepaid under a fixed amortization schedule. The loan will be guaranteed bythe Government, and OKGT will pay the Government a guarantee fee equivalent to101 of the Bank interest rate, as under the first petroleum project. OKGTwill thus be taking the foreign exchange risk.

'5.06 NEH Loan. The loan to NBH will be for 15 years inc-luding a five-yeargrace period, under a fixed amortization schedule and at the Bank's standardvariable interest rate. NBH will take the exchange risk on its loan, passingon the funds in forints. For financing the subprojec~ts under the energyconservation compcnent, NBH will, as under other onlending projects, onlendthe Bank loan proceeds to the participating banks at the prevailing Bank rateplus a mark-up of at least 201 (comprising NBH's processing costs and apremium to cover the foreign exchange risk) or its rediscount rate, w,icheveris higher. In practice, NBH would make the funds available to the banks atits rediscount rate, which is currently 141 and therefore considerably higherthan the Bank's current rate plus 20Z (at present 9.3Z). In turn, eachparticipating bank will set its interest rates for subloans on the basis ofprinciples which are contained in its policy statement, and which have beenassessed as satisfactory by the Bank under the Industrial Restructuringprojects. Subloans will have a maximum maturity of twelve years includingthree years of grace. The participating banks will repay the funds onlent byLhem to the beneficiary enterprises on a back-to-back basis. Subloanrepayment surplus over the Bank loan repayment requirements of NBH will beonlent again by NBH to the participating banks for financing of subprojectseligible under the Project.

6.07 Disbursements. The proc.eds of the proposed two loans will finance upto 1001 of eligible direct foreign exchange expenditures for goods, services,and training. In view of OKGT's foreign exchange requirements well in excessof the loan amount any allocation of its loan :s necessarily tentative;however, Table 6.1 shows a likely allocation of the Bank loans.

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Table 6.1: Allocation of Bank Loans(in US$ million equivalent)

Category Amount S Financint

A. OKGT Loan

(i) Technical Assistance,and training 3.5 l00S of foreign expenditures

(ii) Specialized Equipment 10.0 and 100S of local expendi-(iii) Field Development, upgrading tures (ex-factory) for goods;

and enhanced recovery 63.0 and l00S of foreign expendi-(iv) Underground gas storage 12.0 tures for consultants'(v) Pipeline improvements 5.0 services and training(vi) Unallocated 6.5

Total 100.0

B. NBH Loan

(i) Energy conservationsubprojects 10.0 1002 of foreign expenditures

and lOOZ of local expendi-Total Project 110.0 tures (ex-factory) for goods;

and lOOZ of foreign expendi-tures for services

6.08 Disbursements for contracts valued at less than US$200,000 equivalentwill be on the basis of statements of expenditures (SOEs) which detail theindividual transactions. The documentation to support these expenditures willbe retained by OKGT and NBH, respectively, audited by independent auditorsacceptable to the Bank, and be available for review by the Bank upon request.Applications for withdrawal against contracts valued at more than US$200,000equivalent will be fully documented.

6.09 To facilitate disbursements from the Bank loan, OKGT and NBH wouldestablish revolving fund accounts. The Bank will make initial deposits ofUS$7.0 and 2.0 million, respectively, into these accounts, which would beequivalent to about four months of disbursements under the respective loans.For replenishment of the revolving funds, OKGT and NBH would submit withdrawalapplications for replenishment for amounts not less than US$1.0 million.

6.10 It is anticipated that the Bank loans will be disbursed over asix-year period, which is in line with the standard disbursement profiles forBank loans covering similar projects in the EMENA region. However, theprofiles have been adjusted to reflect the expected retroactive financing andthe advanced state of subproject preparations under the OKGT loan as well asthe experience under the previous OKGT and energy conservation loans. Underthis disbursement forecast, the loans would be fully disbursed by mid-1995.On that basis, the closing date for the two loans is proposed to be December31, 1995. The estimated disbursement schedules are shown in Annex 6-1.

6.11 Retroactive Financing. A number of eligible subprojects and technicalassistance components under the OKGT loan are at an advanced stage of

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preparation. Expenditures for such contracts prior to Bank approval of theloan could possibly amount to as much as US$10.0 million. All such contractswill be reviewed by the Bank, to ensure that they follow Bank guidelines forprocurement. On this basis, the loan provides for retroactive financing forup to US$10 million, representing 102 of the Bank loan for OKGT.

6.12 Procurement. For the OKGT loan, the procurement of goods and serviceswill be the responsibility of OKGT through its own supply subsidiary,OKGT-AGEL. Under the first Petroleum project, all procurement has beenhandled through a Government trading company; however, for most types ofprocurement OKGT-AGEL is well equipped to handle procurement on its own. TheGovernment and OKGT have confirmed that the use of an outside trading companywill not be required for any types of procurement under the OKGT loan.(OKGT-AGEL, at its option, will always be able to draw on the expertise oftrading companies as and when useful.) All procurement will be undertaken inaccordance with the Bank's procurement guidelines. ICB will be used for goodspackages with an estimated value of more than US$150,000 and internationalshopping based on at least three price quotations for packages belowUS$150,000. There will be an aggregate limit on international shopping of 20%of the OKGT loan amount. For items of a proprietary nature, where timing iscritical or where compatibility with installed equipment is required, directcontracting may be applied. Prequalification will be applied selectively tocomplex packages as appropriate. Hungarian manufacturers competing under ICBwill be eligible for a 152 preference on the CIF value of the bids or theamount of custonis duties and taxes, whichever is lower. Consultants will beselected in accordance with the Bank's guidelines for the selection ofconsultants.

6.13 Under the first Petroleum loan, OKGT has been forwarding all itsprocurement decisions to the Bank for prior review. The good experiencesunder this loan show that such extensive prior reviews are no longernecessary. Accordingly, under the proposed loan, all bid packages for goodsabove US$1 million equivalent will be subject to the Bank's prior review, andprior approval will be required for any exceptions to the limit forinternational shopping. Below the above threshold, no prior review will berequired.

b.14 NBH. Proceeds of the Bank loan will only be used to finance directlyimported services equipment and goods. In line with arrangements for otherline of credit projects in Hungary, equipment contracts with an estimatedvalue of US$150,000 or more will be let under ICB procedures and contractswith a value of less than US$150,000 will be let through internationalshopping based on at least three price quotations. There will be an aggregatelimit on international shopping of 20Z of the NBH loan amount. For items of aproprietary nature, where timing is critical or where compatibility withinstalled equipment is required, direct contracting may be applied. Allprocurement will be via the standardized bid documents developed for theSecond Energy Conservation Project. NBH will continue to use the EnergyEfficiency Coordination Office, established under loan 2317-HU and locatedwithin the EEO in Budapest, as required during project ;mplementation. Bankprior review will be carried out for contracts with an estimated value ofUS$1.0 million and above. Since procurement arrangements have workedsatisfactorily under both the first and second Energy Conservation projects,this limit is considered satisfactory.

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6.15 Reporting and Auditing. All project accounts, revolving funds,statements of expenditure and the financial statements of OKGT, the commercialbanks and project beneficiaries will be audited at the end of each fiscal yearby independent auditors acceptable to the Bank. Short form annual auditreports for the preceeding fiscal year will be available to the Bank no laterthan by the end of June of each year. The audit reports for the OKGT and thebanks will be submitted to the Bank, the audit reports for other accounts willbe retained by NBH and (for beneficiaries) by the participating banks forreview by Bank supervision missions. The audit department of the General Bankand Trust Co., which has been undertaking audit activities for Bank financedprojects, has satisfactorily been formed into an independent share company(now named Audit Rt). Further, several international audit firms areestablishing operations in Hungary and are expected to become involved in theauditing of project beneficiaries.

6.16 OKGT has been reporting regularly to the Bank on the activities underLoan 2398-HU. The reporting format has been modified for the Project and maybe revised further from time to time as required. For the energy conservationsubprojects, NBH will coordinate and submit to the Bank within sixty daysafter the end of each semester semiannual progress and procurement statusreports prepared by the individual commercial banks and which will review allthe subprojects under implementation in this lcan. Each commercial bank willalso prepare a completion report on every subproject which it has financedunder this loan w_thin six months after the completion of the subproject; suchreports will be made available to the Bank for review during supervisionmissions. NBH will also send with its report semiannual reports from OEGH onthe progress of the energy sector studies. In addition, an overall coupletionreport on each loan will be prepared by NBH and OKGT, respectively, within sixmonths after the closing date of each loan.

E. Environmental Impact

6.17 There are several important environmental problems in the energysector, which are being addressed gradually by the Government. Hungary is asignatory to the United Nations protocol of the 1979 convention on long-rangetransboundary air pollution for the economic commission for the European areawhich was signed in 1985. Coal fired power stations are significantcontributors for air pollution; improvements are being made as these are beingrehabilitated, included under the Bank's Power project (Loan 2697-HU). Thereis also significant air pollution from automotive gasoline, which has a veryhigh lead content. This will be reduced by 60% under a refinery reformproject that will be implemented shortly. All energy conservation subprojectsto be financed under the Project will be assessed by the participating bankson their compliance with satisfactory environmental standards in conformitywith Hungarian environmental and occupational safety and health regulations.The Government places high priority on the quality of the environment and iscarrying out its laws and regulations in compliance with pollution controlguidelines for air pollution and solid waste set by the National Authority forEnvironmental Protection. These guidelines have been reviewed by the Bank andare considered satisfactory. Most or all of the energy conservationsubprojects would be for the upgrading of the activities of existingenterprises and could have a positive environmental impact by reducing energywaste.

-44 -

6.18 The Bank has initiated a collaborative study with the Government onenvironmental issues in Hungary. Within the energy sector, this study willexamine, inter alia, the wisdom of fuither hydro electric development on theDanube river. There, the Government is reviewing its decision to continue theimplementation of the Gabcikovo-Nagymaros barrage project, which is undertakenin cooperation with Czechoslavakia and with financing from Austria. Theagreement with Czechoslovakia on this project dates back to 1977 and thefinancing agreement with Austria to 1986. The project involves the creationof a large reservoir east of the Slovak city of Bratislava and theconstruction by both partners of a dam and hydroelectric power generatingsystem, involving the diversion of the Danube and a second barrage 200 kmdownstream at Nagymaros. The project has been criticized on the grounds thatit will destroy scenic beauty, affect the acquatic population of the Danube,and possibly affect the water table. No Bank loans are financing the projector associated investments, and the present loans do not involve any financingof power investment in Hungary.

6.19 All OKGT subprojects have been reviewed, inter alia, for theirenvironmental impact. In general, the Bank has found that OKGI payssatisfactory attention to the environmental aspects of its operations,including safety of operations, treatment of effluents, and location offacilities and pipelines. Many of the present subprojects will take place inexisting fields, where production has been under way for several years underfully adequate conditions. There are special risks under two subprojects, asdiscussed in Annex 5-3, where sour gas and the existence of CO2 incombination create unusual corrosion and embrittlement problems. OKGT willacqui.e appropriate consulting expertise in this area. Also, OKGT hasconfirmed that in the case of the Barcs-West subproject, the pipeline will berouted so that there will be no residences or public buildings within the 100ppm area of H2S concentration should the pipeline rupture or a blowoutoccur.

F. Supervision Plan

6.20 In order to ensure a clear understanding of Project objectives andimplementation as well as effective follow-up by the Bank, the framework ofthe Project supervision plan has been agreed, on the basis of which a detailedplan will be developed and reviewed with counterpart agencies during an earlysupervision mission. The plan will include: (i) the schedule of key Bankimplementation inputs and the (substantial) skill mix required; (ii)specialist staff input for review of technical assistance components,subproject reviews and procurement documentation; (iii) aspects of the Projectthat requir special Bank attention during supervision; and (iv) the Hungariancontribution to implementation and supervision including monitoring andreporting.

6.21 However, while the details of the supervision plan remain to be workedout, it is clear that successful implementation requires significant Bankparticipation. In particular, Bank support will be important for (i) theGovernment implementation of the energy policy actions, with particularemphasis on the energy pricing reform, the very difficult coal restructuringprogram and the policy studies; (ii) OKGT's ambitious and importantinstitutional development program, including the reorien.:ation of itsexploration activities and organization; (iii) the difficult Szeghalomdevelopment, including a careful review of the forthcoming consultants' report

- 45 -

and subsequent field development program; (iv) the various technicalconsultancy assignments for OKGT; and (v) the work of the contract consultantto recommend and help implement a satisfactory framework for the involvementof international companies.

C. Status of Project Preparation

6.22 The project is in an advanced state of preparation and is ready forimplementation. The energy conservation line of credit represents acontinuation of two successful previous lines of credits; a few modest changesin the lending scheme from these credits have been made in order to ensureconsistency with the Industrial Restructuring lines of credit. The energyeconomic analyses have been agreed, as have the energy policy principles andactions (Annex 2-1). The OKGT subprojects have been prepared in detail,except for the Szeghalom subproject on which disbursements will be made onlyonce there exists a detailed development plan satisfactory to the Bank.However, this uncertainty concerns the optimum development plan, and not theviability of the su'bproject. The OKGT institutional development componentshave been agreed as reflected in OKGT's Letter on Institutional Strategy.

VII. PROJECT BENEFITS AND RISKS

A. Project Benefits

7.01 The Project will support the continuation of the ongoing energy sectorpolicy dialogue which has already resulted in significant improvements in theenergy policy framework. In the context of the Project, there will besignificant improvements in: energy pricing structure, bringing consumerprices gradually to the same level as producer prices and thus eliminatingenergy-related subsidies I'; removing the pricing preferences for certainindustries; and abolishing (following detailed analyses) power pricinganomalies for certain regions and in peak-off peak pricing. Together withsteps to strengthen power investment planni-g thes measures will provide animproved framework for energy users, restrain the growth in energy demand andencoulage rational inter-fuel substitution. Studies under the project willalso permit a Lhorough review of piesent energy conservation policies and laythe foundation for the subsequent preparation of a revised demand managementprogram.

7.02 The coal restructuring program supported under the Project willeliminate subsidies from the Government's budget, establish criteria for thesupport of new investments and promote the closing of uneconomic minestogether with a rationalization of the surface activities and administrationof the mining companies. The Bank will review annually with the Governmentthe implementation of this program.

1/ An energy pricing impact study (1987) found that there would be onlymoderate impact of even very substantial energy consumer price increaseson inflation and on income distribution.

- 46 -

7.03 The Project will result in a significant strengthening of OKGT as thenational oil and gas company, and in particular permit the improvedutilization of its existing technical expertise through organizationalmodifications and a more modern methodological approach to exploration.Together with the opening of the petroleum sector to international oilcompanies on a risk basis, this should make it possible for Hungary to reducethe rate of decline of domestic oil and gas production from what is projectedbased on recent trends, and would help improve the economic utilization ofresources in exploration, development and production.

7.04 The OKGT loan will finance high priority investment subprojects in theareas of field development, upgrading and enhanced recovery. The economics ofmany of these subprojects have been improved considerably during theevaluation process. These subprojects now would in aggregate result in anincremental production of 27 MMCM of gas (equivalent to 3.7 years ofproduction at the 1987 level), 8 MMT of oil (4.2 times) and 5 MMT of liquids(6.5 times). A rough estimate indicates that at its highest point (1994),production from the Project would represent more than 302 of all oil and gasproduced in Hungary.

7.05 These subprojects have been evaluated economically using the Bank'spresent crude oil price projections (plus $0.50 per bbl for estimatedtransport costs). On this basis, the subprojects show ERRs ranging from aminimum of 17% to several hundred percent. The ERRs remain above 12% evenwith lower price (US$2 per bbl lower) or production estimates. The smallersubprojects, which are basically for the improvement or maintenance ofproduction from eYisting fields, show typically very high ERRs.

7.06 The Project will also finance high priority OKGT investments inpipeline debottlenecking and upgrading and to expand Hungary's underground gasstorage capacity, permitting the delivery of gas in the high demand winterseason. The gas storage subprojects have been compared to the alternative ofliquid fuel imports in the winter months (Annex 7-1). The storage subprojectsshow ERRs of between 25X and 551. The capital investment of debottleneckingthe Beregdorg compressor station can be recovered in one year of operation,and that of modernizing gas metering in about two years. The economicbenefits of the investments in gas pipeline expansion cannot be estimatedreadily, in the absence of any other alternative for gas transport.However, it can easily be demonstrated that even modest nutional tariffincreases would cover the costs of these expansions.

7.07 The loan for energy conservation investments will assist Hungary inachieving overall energy savings, and thus red-ce investment needs of theenergy sector, as well as the energy import bill. Since this is a line ofcredit, the ERR cannot be precisely determined in advance. The eligibilitycriteria will ensure a minimum ERR of 18Z; a sample of previous suchsubprojects showed ERRs typically in the 25X-35X range, with some subprojectsmuch higher. The physical investments will also help improve investmencefficiency through technology transfer to Hungary. The use of economic andfinancial rates of return caiculations by the commercial banks will helpreinforce the soundness of the investment decision making process in Hungary.The selection procedures for subprojects and sponsoring enterprises will beimproved through appropriate eligibility criteria.

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B. Proiect Risks

7.08 The OKGT subproject risks are moderate in view of their thoroughpreparation and OKGT's long experience in project implementation. Asignificant reduction in the border price for oil would reduce benefits;however, on the other hand it may well be an underestimate to calculatebenefits at the present Forint exchange rate, since Hungary would require verysubstantial amounts of foreign exchange in order to purchase internationallythe amounts of oil and gas now expected to be produced domestically from thesubprojects. A more important risk will be that the energy policyimprovements would be more difficult to implement than now assumed (e.g., forsocial or political reasons), or that the OKGT institutional developmentprogram should take longer to implement and yield expected results. Theserisks are considered to be within acceptable limits in light of the analysisand dialogue that has preceded the Government and OKGT undertaking the relatedcommitments and the overall commitment to sustained policy reforms. Further,the Project provides for carefully designed consulting support and studies,and planned consistent Bank follow-up.

7.09 Thie technical and financial risks to the energy conservation componentare considered moderate, since the physical investments will mostly concernexisting plants and commercially proven technologies, representing relativelylimited investments at the enterprise level. Most of the subprojects will beaimed at the reduction of energy costs in existing installations and will notinvolve increases in production or sales. They do not create any additionalmarket and financial risks. The main risk of this compcnent would arise ifthere were to be a further very significant fall in energy prices, leading toa limitation of demand for energy conservation investments. Such a fall isconsidered unlikely in the foreseeable future.

VIII. AGREEMENTS REACHED AND RECOMMENDATION

8.01 The signing of a subsidiary financing agreement between NBH and atleast one participating bank will be a condition of effectiveness of the Bankloan to NBH (para 6.03).

8.02 At negotiations agreements were reached with the Government that itwill:

(i) carry out the agreed energy policy principles and actions (paras2.25 and 2.26);

(ii) carry out the agreed sector policy analyses, review theconclusions with the Bank and implement the appropriateconclusions thereafter in a timely manner (para 2.27).

8.03 At negotiations, agreement was reached with the Government and OKGT tocomplete by December 31, 1989 the review of ways of turning OKGT into acorporation, and promptly thereafter to discuss the conclusions with the Bank(parA 4.02).

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8.04 At negotiations, agreement was reached with OKGT to:

(i) carry out its institutional development policies, with agreementreflected in its Letter on Institutional Strategy (para 4.01);

(ii) carry out the initial organizational changes for exploration andproduction (para 4.11);

(iii) carry out its analysis of the MIS system requirements by June 30,1990 and initiate its implementation by January 1, 1991 (para4.13);

(vi) continue to meet prudent financial ratios (para 4.22);

(v) continue to prepare annual financial statements and to have theseaudited by an acceptable external auditor (para 4.23);

(vi) carry out the agreed activities for institutional andtechnological development (para 5.09);

(vii) prepare an annual training program to be agreed with the Bank(para 5.09);

(viii) review annually with the Bank its five-year investment program andcurrent investment priorities with emphasis on the hydrocarbonverticum (para 5.11);

(ix) present special reporting two subprojec'.s (para 5.13);

(x) undertake disbursements for the Szeghalom subproject only subjectto a complete development plan acceptable to the Bank (para 5.14).

8.05 At negotiations, agreements were reached with OKGT and NBH, asappropriate, on subproject eligibility criteria (NBH, para 5.21), onlendingterms (NBH, para 6.06), and disbursement and procurement procedures (paras6.08-6.14).

8.06 At negotiations, the following confirmations were also received:

(i) from the Government and OKGT of the principles and timetable forthe new technical oil and gas regulatory framework (para 4.08);

(ii) from OKGT concerning aspects of the Barcs-West and Kiskundorozsmasubprojects (para 5.12), and the implementation arrangements forthe OKGT loan (para 6.01);

(iii) from NBH concerning the implementation arrangements for the NBHloan (para 6.03).

8.07 On the basis of the staff appraisal and the abovp mentionedagreements, the Project is considered suitable for Bank loans of US$100million equivalent tc, OKGT and US$10 million to NBH, respectively, for 15years, including 5 years of grace, at the Bank's standard variable interestrate. It is recommended that revolving funds of US$7.0 million and $2.0

- 49 -

million, respectively, be established (para 6.09), and that retroactivefinancing be permitted for up to US$10 million for the OKGT loan (para 6.11).The loans will be made to OKGT and NBH, respectively, with the guarantee ofthe Government.

I

- 50 -

ANNEX 1Page 1 of 2

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

Selected Documents Available in the Project File

A. The Energy Sector

A-1 Energy Sector Policy Paper; Yellow Cover Report dated April 8,1988

A-2 Energy Sector Policy Paper - Executive Summary (May 1988)

A-3 Energy Prices (December 19, 1988)

B. The Oil and Gas Sector

B-1 OKGT: Present State and Possibilities of Increasing OilRecovery in Hungary (1988)

B-2 OKGT: Long Term EOR Concept of the National Oil and Gas Trust(1984)

B-3 OKGT: Foundation of the Necessity and Actuality of EnrichingPlants (undated)

B-4 The Ministry of Industry: Use of Natural Gas in the HungarianPeople's Republic (1986)

B-5 OKGT: Exploration of Hydrocarbons

B-6 OKGT: Comparative Investigation of the Possibility ofSatisfying Peak Demands in Natural Gas Consumption (1988)

B-7 Hungarian Mining Laws and Orders

B-8 Consultant Report on Petroleum Exploration and Production inHungary

C. OKGT

C-1 OKGT: Establishing Decision

C-2 Financial Report on OKGT

C-3 OKGT Head Office: Organization of Study Teams

D. Oil and Gas Subprojects

D-1 Endrod Field; OKGT and consultant's reports

- 51 -

ANNEX 1Page 2 of 2

D-2 Ulles Field; OKGT and consultant's reports

D-3 Demjen-Kelet Field; OKGT and consultant's reports

D-4 Kozepalfold Field; OKGT and consultant's reports

D-5 Csanadapaca Area; OKGT and consultant's reports

D-6 Barcs-West Field; OKGT and consultant's reports

D-7 Kiskundorazsma Field; OKGT and consultant's reports

D-8 Liszo-Inke Fields; OKGT and consultant's reports

D-9 Szeghalom Field; OKGT and consultant's reports

D-10 Nagylengyel Field; OKGT and consultant's reports

D-ll Tazlar Area; OKGT and consultant's reports

D-12 Kaba-Del Oil Field; OKGT report

D-13 Fcldvar-Also III (Pusztafoldvar field); OKGT report

D-14 Algyo Field; OKGT report

D-15 Updated Subproject Cost Figures (November 1988)

D-16 OKGT: Possibilities of Underground Gas Storage in Hungary (1988)

D-17 Barcs-West: Unitization Agreement

D-18 Report on Gas Storage, Transport and Expansion/Modernization ofInfrastructures

D-19 Kardostuk: Underground Gas Storage; OKGT report

D-20 Other Transport and Storage Subprojects; OKGT reports

E. Terms of Reference

E-1 Szeghalom: Terms of Reference

E-2 Terms of Reference Agreed at Negotiations

F. Energy Conservation

F-1 Government of Hungary: Report on the Comparison of EnergyResource Developments and Energy Conservation Projects (1988)

F-2 Documentation for Energy Conservation Lines of Credit

- 52 -

ANNEX 2-1Page 1 of 5

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

Agreements on Energy Policies

Background

1. The characteristics of the country are the determining factors for thecomposition of the energy sector. Even with a substantial energy investmentprogram, Hungary must rely on imports for about half of its primary energyneeds. The primary domestic energy production is about one third coal and onethird natural gas, with the remainder split primarily between hydrocarbonliquids and nuclear power. Given the limited domestic supplies ofhydrocarbons and increasing costs and environmental problems of coal andlignite production, the Government plans to shift an increasing share of itsgrowing primary energy requirements to nuclear power production. By some timein the first decade of the next century, nuclear power might account foralmost one third of total primary energy production. However, the demand forhydrocarbons will continue to rise and there is a pressing need to ensure thatthe anticipated drop in the domestic production of oil and gas is kept to aminimum level consistent with economic investment and production.

2. The expected key issues of the next decade are the following: (i) Howto constrain the growth of energy demand to a level that can be met with thelimited investment and foreign exchange rsources that we have available; (ii)How to price each energy carrier to alternative users in order to provide forappropriate levels of usage; (iii) How to design a least cost investmentprogram to -eet the expected growth in electricity demand once all energycarriers have been economically priced; (iv) How to strengthen the energyproducing institutions and improve their ability to plan and efficientlyimplament economically viable least cost investment programs. TheGovernment's energy policies will address these issues.

Demand

3. The Government's basic energy planning scenario calls for a reductionin the income elasticity of demand from the level of about 1.09 in the 1970sto a level of 0.3 in the 1990s. It has already made considerable progress inthis respect, reducing the elasticity to about 0.46 in the last few years byintroducing price increases and energy conservation.

4. As part of the industrial restructuring effort, which aims atincreasing reliance on competitive market mechanisms and market signals topromote efficiency, innovation and financial discipline, the Government plansto implement a substantial shift in the structure of industrial production,away from unprofitable and highly energy intensive industries and into lessenergy intensive industries. This program has already begun.

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ANNEX 2-1Page 2 of 5

5. Besides adjusting energy prices to their economic costs, theGovernment is also going to continue the energy rationalization program in theproductive sectors, and to take measures to improve the structure of energyutilization in the household sector. As part of the household energyrationalization effort it intends to carry out a detailed analysis ofhousehold electricity demend patterns (already being undertaken by MVMT) and asecond study on non pricing policies for rationalizing district heating andother househo'd and communal energy consumption patterns, to be undertakenunder the direction of OEGH.

PricinR Policies

6. The Government's energy strategy is to provide the economicallyefficient development of domestic energy resources and to restrain energydemand through optimal energy pricing and energy conservatio.:. The basicprinciple in energy pricing is to bring the prices of all energy carriers upto the level of their economic costs:

The economic cost of crude oil and oil products isequivalent to the market price in the major relevantmarkets (the spot price in the southern Mediterranean oildepot ports).

For natural gas, the economic cost is the energyequivalent cost of fuel oil.

Price comparisons between local and international spotmarket prices for hydrocarbons will be undertaken atleast every three months and prices will be adjusted, iflocal prices fall below international prices.

For coal, the economic cost is the main market price plustransport costs to Hungary.

For district heating and electricity, it is the fulleconomic cost (including e.g., an adequate return oninvested capital, fuel costs and all operating anddistribution costs) of additional production facilitiesas these facilities are commissioned and added to thesystem.

7. For the prices paid by all users of energy in the productive sector(productive user prices) the Government's policy is that no industry shouldreceive energy at below its economic cost. This policy has already been fullyimplemented since productive user energy prices have already been brought upto at least their economic cost. In January 1989, the Government increasedthe average coal price paid to the coal mining companies by 15Z and theaverage

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ANNEX 2-1Page 3 of 5

coke price by 172. It has also ensured that the power company (MVMT) will becompensated for the increase in costs for producing electricity and steam forother productive sector users by increasing the average price of power andsteam for the productive sectors by 4X. The total impact of these prod.acerprice increases will be to allow a reduction in subsidies to producers ofabout 5 billion forints.

8. In order to compensate for the underground storage costs of naturalgas and the costs of building peak capacity facilities, the Government hasinitiated a study of the appropriate winter/summer gas pricing differentials,and based on its conclusions, it intends to establish a system of seasonalprices for natural gas in the second half of 1989.

9. The Government intends to eliminate preferential prices for someindustries that are unrelated to the differential costs of supplying theenergy carrier. These prices will not be below economic costs. It isintended to reduce gradually the limited preferential treatment that currentlyexists so that it will be completely eliminated during the next five year planperiod.

10. In line with the overall subsidy reduction program of the Government,it also intends to bring prices of energy delivered to private consumers (thehousehold sector) up to the level of economic costs. However, since some ofthe prices are currently as low as one third of the relevant estimatedeconomic costs, the price increases will have to be implemented in a series ofsteps. The Government has decided and announced to significantly increase theaverage consumer energy prices, to be effective before the beginning of thenext heating season (October 1989) at the latest. These price increases willbe applied differentially to reflect the present gaps between the economiccosts and the prevailing prices. The Government plans to continue thisprocess of gradual price adjustments in approximately equal annual incrementsso that all consumer energy price distortions will be eliminated and consumerprices for all energy carriers will not be lower than their economic costs andthe relevant producer prices, over the period 1989-1993; by no later than 1991for several important energy carriers, and no later than 1993 for theremainder. Within this timeframe, the Government will eliminate the relativegap (in percent) between actual and economic prices in approximately equalrelative installments. The intention is that for those items where the gapsare relatively smaller to eliminate them over the 1989-1991 period (naturalgas, power night tariffs and power day tariffs in rural areas and urban areasoutside of Budapest and of the other large cities). The Government willreview from time to time the estimates for economic costs used for determiningactual price adjustments. A study of the LRMC is being carried out by theHungarian Electric Power Company (MVMT) under the ongoing Power project (LoanNo. 2697-HU); this will be presented to the Bank not later than June 30,1989. Building on this, the Government will prepare a study of the regionaland day/night power tariffs with a view to modify the existing tariff

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ANNEX 2-1Page 4 of 5

structure. For coal, it is in the process of recruiting consultants thatwill, inter alia, analyze the coal pricing structure in Hungary. The programfor price increases will be adjusted in consultation with the Bank to reflectthe outcome of these studies. The Government will review with the Bank,around May of each year, the updated prices and economic cost estimates foreach energy carrier.

Coal

11. A program has been agreed formally under the tranche release for theIndustrial Sector Adjustment Loan (Loan 2965-HU). It will provide for theelimination of subsidies, the closing of uneconomic mines, and theestablishment of min-mum criteria for new investments. The agreed programprovides for follow up and monitoring by the Bank under the Energy DevelopmentProject.

Oil and Gas Policies

12. The Government is in full agreement with OKGT's program for the nextfew years as described in OKGT's Letter on Institutional Strategy (Annex 4-1)and will support as necessary the implementation of this program.

13. OKGT is subject to state reguldtions and control in the areas ofdevelopment of newly discovered reservoirs, environmental protection andspecific safety-related day-to-day work practices. The review of the present,excessively detailed, system is going on, to be finalized before the end of1989. Based on the results thereof, a more simple regulatory framework willbe introduced shortly after the completio;. of the review. This new systemwill place the responsibility for operational decisions more clearly on OKGT.

14. The method of taxing petroleum production has in the past been verycomplex and did not encourage efficient behavior. In January of this year,the Government introduced a new taxation system which is based on the taxationof the profits of hydrocarbon production. In conjunction with theintroduction of this new taxation system, which will encourage OKGT decisionmakers to make more rational decisions in the areas of exploration, productionand transport, OKGT will also assume full responsibility for financing all ofits required investments from its own profits and commercial sources withoutrecourse to the State budget.

Energy Conservation Policies

15. In order to achieve the objective of reducing the growth in energydemand, besides adjusting energy prices to the economic costs, the Governmentis also going to continue the energy rationalization program in the productivesectors and to take measures to improve the structure of energy utilization inthe household and communal sectors. As part of the household and communal

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ANNEX 2-1Page 5 of 5

energy rationalization effort, it will carry out a detailed analysis ofnon-pricing policies for rationalizing district heating and other householdand communal energy consumption patterns, to be undertaken under the directionof the National Energy Authority (OEGH). The Hungarian Electric PowerCompany(MVMT) is going to carry out studies on household electricity demandpatterns, the economic costs for distributing electric power to the variousregions in Hungary for small scale consumers in urban and rural areas, and forproducing electricity in peak and off-peak periods. On the basis of thesestudies, the Government intends to eliminate the present anomalies forpeak/off/peak and regional tariff rates for household consumers, and to bringthe entire tariff structure in line with actual long-run marginal costs. Inthe meantime, it is taking steps to adjust the rates that are clearly furthestout of line, especially daytime tariffs for Budapest regional consumers andfor night electricity, country wide.

- 57 -

ANNEX 2-2

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

Selected Energy Prices(in Ft. per Gigajoule)

1980 1983 1985 1986 1988

Consumers

Coal 26.8 30.6 43.1 43.1 47.2Briquettes 37.7 44.6 54.7 54.7 57.0Coke 57.0 73.9 100.0 100.0 100.7Fuelwood 51.7 67.9 82.2 82.2 89.0LPG summer 79.7 87.6 95.6 95.0 111.5LPG winter 70.7 87.6 131.5 131.5 153.5Natural gas 59.6 87.6 76.0 76.0 86.6Heating Oil 70.8 113.6 176.1 176.1 227.3Electricity - Budapest 287.0 270.9 317.8 337.1 348.0

Producers

Hard Coal N.A. 72.4 80.3 86.5 96.5Brown Coal 57.7 70.2 86.1 101 0 111.5Lignite N.A. 50.9 65.7 70.7 75.3Crude Oil 143.7 200.5 200.5 162.8 126.9Naptha 183.3 244.9 244.0 151.1 163.1Gas (large) 74.9 121.5 125.5 135.8 143.6Gas (int.) N.A. 94.9 99.0 105.4 112.7Gas (fert.) N.A. 114.6 84.0 97.4 94.3Diesel Oil 197.5 257.7 257.7 "57.7 295.0Heating Oil 92.6 160.9 160.9 138.1 113.2Resid. Fuel Oil 79.7 147.6 47.0 134.7 107.7Steam Heat 95.0 191.9 161.1 175.0 189.1Electricity 347.1 448.5 514.8 570.3 634.0(Large users)

Source: National Planning Office. A more detailed listing is available inproject file.

- 58 -

ANNEX 2-3

HUNGARY - ENERGY DEVELOPMENT AND CONSERVATION PROJECT

Plannd Cansurr Price Inereares

EstimatedEconomic Average Average ExpectedCost Price Price Levels of Averageas of as of in X of Prices in X of01/01/89 01/01/89 Economic Economic Prices as of(a) Price May 30

(021991 1990 1991 1992 1993

(Forint/gigajoule) X (X)

Coal 160 47 30 50 67 84 100Gasoline (ft/liter) 10 24 230 At or above 100Heating Oil 129 278 180 At or above 100Natural Gas 132 100 72 90 100 100 100Electricity (Day)-Budapest 958 347 36 57 71 85 100-Other Large Cities 958 472 49 62 75 87 100-ather Urban Areas 958 569 59 80 100 100 100-Rural Areas 958 681 71 85 100 100 100Electricity (Night) 362 250 69 85 100 100 100District Heating(Ft/dm2/y) 106 34 32 52 68 84 100

(a) Economic prices estimated as follows:

CoaJ: Production cost for high quality consumer coal. The economic price of coal will be reviewedunder the forthcoming coal study to be comissioned by the Government.Heatina Oii: International Rotterdam fob pricesNatural Gas: Based on CIF Algerian LNG (to France of Ft 3.315 per MCM plus 40% distribution cost.Electricity (day): Industrial low voltage tariffs.Electricity (niaht): Industrial night tariff average. (The regional and day/night tariffs forconsumers are subject to further study.)s.trict.Hea.t: Price required to cover full costs.

N.A.: Not applicable since prices are already above economic costs.

- 59 -

ANN 3-1

_ _a_ _ _ ! ___________

'6W ~~ Tet f I_. Years efSeceveteble Fiael Pe tien bceverinb)e rpq,. Piocgien

MIMIL

1974 3.42 126.9 31.4 23.41971 3.47 .42 11.6 29. 1.41 .60 21. 11.1972 4.21 2.39 116.4 24.I 1.1 .24 26.6 11.61972 4.97 S.4" @9.6 21.9 1.77 2."4 21.2 11.91974 i .3 5.21 169. 26.7 1.76 .94 20.4 11.41975 S.16 4.53I 116: 26.4 1.73 5.18 27.6 11.41974 4.21 7.58 1.41 169.4 17.0 1.5 .99 1.2 24.1 14.11977 6.73 10.63 1.66 111.6 14.5 1.92 .31 1.2 24.6 13.51976 7.51 9.76 1.51 11.4 15.1 2.6 .31 1.2 21.9 12.91979 6.72 9.07 1.46 122.1 I.2 2.3 .5S 1.2 24.5 12 419 4 4.43 2.5 1.51 12S.3 19.5 2.61 .27 1.2 24.7 12.11961 4.24 4.15 2.68 124.1 26.3 2.92 Y3 I.s 23.7 11.71952 6.85 4.11 2.69 129.6 18.9 2.62 *0 1.S 22.3 11.6I9S2 .71 5.49 2." 126.4 19.1 2.00 .16 I.S 21.6 16.2I1944 7.18 4.31 2.64 128.2 17.9 2.61 1.11 1.S 24.4 12.1I95S 7.4 6.35 2." 129.4 17.1 2.61 1.61 1.5 21.4 13.2194 7.14 2.49 -1.14 12i.9 17.1 2.64 1.14 4.5 29.4 11.11957 7.24 1.67 -1.4" 117.5 14.2 1.91 O.6 6.3 25.3 14.6

ISU421 4.59 2.2 6.2 112.9 17.1 1.9 0.6 0.6 24.4 12.4969 6.31 5.5 0.6 116.6 13.2 1.9 0.1 1.6 24.9 13.7

199 9.e5 S 6.6 64.5 11.S 1.7 .S .6 24.6 11.61991 4.51 3.6 e.4 161.1 IS.I 1.4 6.5 6.6 25.1 11.I1992 4.9 3.4 0.4 SO.S 14.2 1.4 6.5 6.4 24.; 11.619"l 4.71 3.6 0.4 96.2 14.3 I. 0.1 6.4 24.4 14.119"4 .34 3.6 6.4 93.2 14.4 1.1 0.5 0.4 24.6 14.61"S 1.79 3.0 6.4 9.4 11.7 1.1 6.1 0.4 23.4 11.7

9 S:.4 2. 4.4 47.2 17.2 1. 0.4 6.4 22.9 11.31"7 4.74 20 6.:4 54.5 18.1 1.4 6.4 0.4 22.3 1S 9996 4*.5 2.0 6.4 51.7 16.4 1.3 0.4 6.4 21.S 1.6:999 4.12 2.6 6.4 51.4 1.1 1.2 0.4 5.4 21.4 17.5

2606 4.44 2.6 0.4 79. 17.' 1.6 6.4 0.4 21.2 21.2

1974-57 52.97 7061 26.0) *7.1 23.79 .49 16.3 .1.3I949-60 79.99 24.6 4 . -31.4 17.7 1.S 5.4 -S.2

1/ Combustible Uss only. Inert come engnts not included.I/ Crude oil proction only, lSutiu gas ce_nts not included.I/ Volue for I94 are oesected to be actual fiqurem. The 10w gas production Is due to a mild winter and is not Causd by a decline in

PrI ts ion cape ty.Notes: (Si Histeric correction figures were given in five yoar totals anW these were divided into eno year valueS for this t&ble.

1( S,e f thc historic data d not add up. due to incnsistesces in date definition and evaluation. This *robl_has bn resolved for the most recent years and for the proe0cttlons.

jM5a: OKGT. However. forecasts have ben produced by the bank, and these are for *nS different from thoe of lCGT in theouter years.

- 60 -

ANNEX 3-2

iIM 1' I=2 Im I21] 111 Jil Jil 1.12 1115 1.2 J i .m ian

A. 55LJ.-]

From know fields 6.59 2/ 3.35 9.05 6.81 6.49 6.11 5.36 4.29 3.06 2.44 1.95 1.62 1.44

From new fields - - - - 41 ii LU LJU L~U LII LB ?L I LU

Total L.U L.U SU 1.1. 1.3 "I 1.1A II LU "I LU LU LUM

Laow calory gas 1.90 1.90 2.00 1.70 1.90 1.40 1.20 1.30 1.20(Cambustible part isincluded in totals)

B. Gil NW)

Fro known fields 1.55 1.63 *. 1.24 1.29 6.10 1.10 0.90 0.50 0.60 0.40 0.30 u.10

from new fields 0.15 0.17 0.38 0.34 0.26 0.41 0.60 0.64

Frau COR ii QLU L.ZI 2II LI_. LI L.. _t.z. n.j "i 2II LII L

Total ]A .J Ina5 la" Lau JA I=% I." I- LII LU LAS

C. LUIfLid PredUc(thousand tons)

From known filds 79S 752 750 670 593 520 450 370 340 310 250 250 220

From new fields - - - ZI iI in1 lAS 111 inI 111 12 21 1

Total au1 au1 21 25. 22. 21 m 2 Ml au fml LA S

1.! The figures represent ProJeCted physiCal Maxim; actual Production could be less due to mild winters or external

supplies.

Estimatei based on three quartersn actuals.

C/ Low production due to a mild winter.

S1a/ h: mrission estimates. (OK6T's present estimates are identical for oil; somewhat higher for gas.)

- 61 -

ANNEX 3-3

fM~ DWOEVELNST £10 alU6CENTTO Fmjcr

Cotse 1n Current Ft Co-ts in Censtant Ft. cas

X SA C Ex ! t QU_L9 _ d 1 Lr d X 1 S Otl Prod 21S Rfactor ,9 Expl/lair £aaLLL gjL.ErALZ2g_ AL.kA1L IIZIIDA [hU P..rnd GULJrn TOta hal1 A Prod(Ft/TOE) (Ft/Ton) (Ft/HCN) (Ft/TOE) (Ft/Tor) (Ft/"C)

1979 241.0 756.0 364.0 111.4 433.3 1359.3 654.5 53

1960 271.1 165.6 637.4 129.2 420.5 1652.7 96S.6 37

1961 302.1 1103.8 654.6 135.1 446.0 1636.9 970.6 39

1962 333.1 1157.3 GS5.3 144.4 462.0 160S.2 910.3 43

1963 379.6 1392.2 790.7 154.9 490.6 1800.1 1022.4 33

1964 327.2 1573.3 803.7 167.6 390.7 187W.i 959.6 33

1965 317.7 1716.0 1032.2 179.S 354.6 1917.3 1152.o 27

196 429.0 1962.6 1196.6 169.0 4S4.4 2060.4 1266.0 31

19A7 457.6 2234.6 1200.3 200.3 45W.6 2234.6 1200.3 32

1/ Exploration Costs: Total exploration expenditure/total oil & gas produced2/ Oil Production: Includes exploration3/ Gas *roducton: MC includes exploration

Notes: (1) Finding costs of new reserves expressed in exploration costs/quantities found per year fluctuateuidely as there are large variations in new reserves found in different Years. The finding costsfor oil in 1960 were 626 Ft/ton, in 1985 381 Ft/ton and in 19"6 1097 Ft/ton.

5gig: OKGT

- 62 -

ANNEX 3-4

I~~~~~~~~~~~~~~ML If C LY

~ ~AA3~ a/ ~i~Ie 4R. t0lf Cominstte t ri_ una owrd. Transit| Consusrrs a2 Ccrol xttsUS tn5 20 b/ In=^ Prndurtto IrM orts1L G&MA b1 l tI9d

1979-N 0 (Wintor>t 5,034 171 87 5.292 3.813 1. 38 82 9 5,2921950 (5ummarld/ 3,741 271 359 4.371 2.267 2.094 - 10 4.371

198e-41 (W) 5,653 259 107 6.019 3.814 1.894 291 13 6.0191981 (S) 3.736 221 410 4,367 2,189 2.18I - 12 4,367

1931-82 (W) 6.065 195 39 .299 3.891 1.521 565 is 6,29ISS2 CS) 4,091 113 376 4,5S0 2,527 2.036 1 16 4*, U

1982-83 (W) 5.970 137 83 6.190 4,018 1.944 192 34 6,1901983 (5) 3.930 160 431 4,521 2.422 2,074 a 17 4,521

19U3-84 (W) 6,401 200 26 6,627 3,963 1.95U 677 37 6.6271954 (5) 4,317 1i5 331 4.813 2,825 1,952 S 31 4,813

1984-85 (W) 6,225 ;326 47 6,496 4.207 1,712 523 56 6,4981951 (S) 4.188 .05 901 5,294 2.959 2,293 - 42 5,291

1985-86 (W) 7,160 2*5 so 7,455 4. 4U 2,011 897 61 7.4551936 (S) 4,119 IS7 938 5.254 2.906 2,304 3 39 5,254

IvUG-87 (W) 7,372 2S2 102 7,726 4,110 2,496 I1,05 64 7.7261937 (S) 4.088 12i 1,033 5.248 2,905 2.279 16 48 5,248

1987-IS (W) 7,115 204 94 7,453 4.048 2,529 S16 60 7,453198 8 S) 3,781 160 I,0o1 4.954 2.321 2,532 1 52 4,U42

IL/ Includes supply to electricity generation units of HVT,. industry, and houshold consufarS.

hk Quantities stored in depleted formations at PusUtaederics. KardoSkut. and HNadusaobosalo fields. Reinjectionduring winter for balancing denM, and supply in winter.

C/ October I - March 31

4/ April 1 - Septmogr 30

v/ frm masur_mnt tug,erature corrections.

SgW=: OltGT

- 63 -

ANNEX 3-5

tl t 14 ^ " tl * U 0 0 1. v t7 I t tI! T 5

atily Pak Local Prod. Pe Tetl Deficit Tg t ri Stfttly ftbly Avra * Oatly atily 0t o P ys mWty in Place A

xsCsnR r 11n Fn Awrs_ Olly Su_ly In-iatar) f_ Re_ _an

I919-9 twinter) 6 IU0 44. U 6e l 7.lle 38.43 21.S7 1 :74 Gasz"@ (Sumr) f-M umAi51 14.23 -Total 12 34e 5.5U 14 3 1.1 34.7

ne14-91 (Winter) S. ON 1.54 r 7.* 6.610 44. 21541 1264 u31991 (Summer) 4ILL- 3.251 nilS - -Total 13.300 34.52 14.390 42

1991-92 (Winter) 9.3l4 54. 3Z 68.74 7.65 41.35f 27J31 2. 191 I,,19`2 (Summr ^ ]414 2 fUf-& - -Total 13.64e 27.U 13.730 37.6 U

192-93 (Winter) 91,S* SI." 7t l9 7,*29 *2.27 29.32 2,2"* 1,1261993 ( Sumr 1 4,3 iLL. - 2 i 7~ --Total 13,91a 3aie1 14150ed1i a 77 a

I994-1S tWIsnter) 9.974 5ulon 73.s 1 7.0140 d2.i 9 310 2 2.i82 1n33i1995 (Su_r) 4*100 22 - 6-260 114999 - -

Total1.0 3. 114 347

IM-U000 (winter) 10 f46 56.24 77.23 2 211 44.28 52 U5 2. U 1.4U0ZoU (Summr) 4-8 L 5 ^ 2 LM x UA - 7

Total 496 40e UGn 14 ffO 40.99

j/ AWrex_gte estorae caoctios required in addtion toexistng total Storage cap1ty of l,5 ""M. Plane incr_netalStara" 4xaseons- HatduAsioosale: 600 *0 In 1989f0 Kardsut: 70 1M In 1991 Puntuederics: Go 1" n 1"2-"UV Zs&", SU0 1M n I992-93

SgU OG(T

- 64 -

ANNEX 4-1Page 1 of 7

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

Letter on OKGT's Institutional Strategy

Mr. Eugenio F. LariDirectorCountry Department IVEurope, Middle East andNorth Africa RegionThe World Bank1818 H. Street N.W.Washington, D.C. 20433

Dear Sir:

I am writing this letter in reference to the proposed EnergyDevelopment Project, in order to present the objectives and work program forthe development of the Hungarian National Oil and Gas Irust (OKGT).

As you know, OKGT has been associated with the World Bank (the Bank)for several years through the Bank's first Petroleum Project for Hungary (Loan2398-HU). In the context of that project, significant improvements have beenmade in the technical capabilities of our petroleum exploration anddevelopment staff, through the acquisition of modern equipment and consultingservices and the opportunities for our technical staff to developinternational contacts and familiarize themselves with modern internationalpetroleum practices. At the same time, the deep drilling results obtainedunder the project have helped to clarify the prospects for oil and gasproduction, and have put into perspective the very large challenges ahead forthe Hungarian oil and gas industry. We have obtained useful experiences inthe areas of cost management, economic analysis and international competitivebidding as well. I would now like to take this opportunity to share with yousome of the steps that OKGT plans to take over the next few years (basicallyfrom now through 1992) in order to meet the present challenges.

1. Background

Briefly, we must expect that OKGT will face very significantchallenges over the next decade. Hungary's oil and gas production is expectedto decline since the country is now a mature producer, the regional

-65 -

ANNEX 4-1Page 2 of 7

distribution of exploration efforts and production is unlikely to remain as atpresent, average and marginal costs will increase and the internationaltechnological progress is likely to continue. OKGT is now independent ofGovernment investment financing. Its investment possibilities depend on thetaxes imposed by the Government. At the same time, the international pricelevel for petroleum, which increasingly will determine OKGT's own referenceprices, is likely to fluctuate widely and could remain low for a number ofyears, necessitating flexibility and attention to investment and productioncosts. These trends will mean that it will become increasingly important forOKGT to continue to improve capabilities and performance, in technical andeconomic terms, within tight resource constraints. While OKGT's individualtechnical expertise will need continued improvement in line with internationaldevelopments, the most important issue is how this expertise is organized andutilized. This calls for a systematic process of institutional development,with emphasis on increased flexibility, integration of technical disciplinesand accountability at the various levels of the organization.

In Hungary, during the past 50 years Llearly 13 million meter of wellshave been drilled, most of these since 1948, and numerous discoveries havebeen made despite the geological conditions, e.g., the abnormally highformation pressures and the high temperatures. OKGT has developed moderntechnologies and practices, some of which have been utilized in Europe, theMiddle East and North Africa. Enhanced recovery methods have been developedat home, where we have been carrying out a continuous activity since the 1950sof secondary and tertiary methods. OKGT has also developed solid experiencein underground storage and pipeline operations.

2. Overall Objectives

OKGT will operate mostly in Hungary, but will endeavour at the sametime to attract foreign capital, and to seek business opportunities outsidethe country. It will become an integrated petroleum industry company,organized along functional lines for the finding, production, refining andselling of oil, gas and products. This will be complicated by the fact thatOKGT has developed in-house service activities that elsewhere are offered byservice companies.

Increasingly, operational and investment decisions must be taken onthe basis of profitability criteria, and the institution must aim at beingefficient, responsive and flexible. Although it is expected that theGovernment will remain the owner of OKGT's equity capital (fully or in part),OKGT's operational autonomy will grow in line with the economic developmentsin the country.

3. Principles and Guidelines

An institutional development process is required, because thechallenges and increased dependence on markets means change. OKGT wants tomanage change through a systematic process of institutional development,rather than being subject to sudden shocks as the result of unforeseenchange. OKGT's development process will be managed and directed inside the

- 66 -

ANINEX 4-1Page 3 of 7

Trust, with the active involvement of top management. To support the; institutional development OKGT intends to develop a modern management

information system, utilizing consulting services to be financed from theproposed loan.

4. Legal Status

OKGT, which has been existing since 1957, is at present organized as aGovernment trust with 22 companies and one subsidiary, engaged in various oiland gas activities plus manufacturing activities that have sprung out of theoil and gas sector. We intend to work with the Government in order toincrease OKGT's formal and factual flexibility and operational autonomy, inline with developments elsewhere in the economy.

5. Present Organization

The present organization is based on the Government's establishingresolution of 1986 and by OKGT's statute related to this. On this basis wehave now separated between the core and the non-core activities. The 22companies of the Trust are divided into three groups: The 11 companies in oiland gas exploration, production, transport, refining and marketing, are in ourwords the vertically related companies (verticum), whose managementconstitutes one unit also from the financial point of view. The second groupincludes the five gas supplying companies. These have independent management,but there is a certain interrelationship in their economy in some aspects, andthey face the State budget as a group. Finally there are six companies inbackground industries (machine manufacturing factories, the pipelineconstruction company, the design company and the research institute) - whichhave their independent economic management, are taxed independently and haveno financial relations with either of the two previous groups. OKGT willcontinue to develop the concentration on .ts core activities, and as a logicalnext step we will assess the management structure for the hydrocarbonverticum. Due to its nature the "verticum" needs integrated management. Inthe case of the gas supplying companies, the control role of OKGT is limitedmostly to the determining of quotas, settling of price matters andcoordination of development. Finally, when facing the background industries,the Trust is much more an organization placing orders, than one being incontrol.

6. Organizational Development

As for the future we wish to deal first of all with the changesexpected in the legal status. It is our intention, when permitted by thefuture legal framework, to transform OKGT into a joint stock company. (Oncethis framework is in place one question to be resolved is which State entityshould be exercising the rights of the shareholder.) In the early years, thetransformation of OKGT into a joint stock company would be beneficialprimarily for the possibility of improved autonomy and accountability. From afinancial point of view the benefits of joint stock companies might comeprimarily from new joint venture stock companies and conceivably from theinvestment of other interests in the ownership of some of OKGT's backgroundindustries.

- 67 -

ANNEX 4-1Page 4 of 7

We therefore think that among OKGT's present companies it would beconvenient first to transform some of the background companies and possiblysome of the gas supply companies. The question is more complex in the case ofcompanies vertically related, but even in this group we are investigating thematter.

In general, the institutional development program will accompany thedevelopment of OKGT's legal structure and will aim at improving the efficiencyof our operations and of our resource utilization, will strengthen ourtechnological expertise and improve the integration of technical disciplinesand the accountability at various levels of the organization. The process ofsystematic institutional development will be carefully planned, so that itwould cause no unnecessary disruption in day-to-day operations. OKGT willdraw on professional consulting expertise in organizational development andwould like the support of the Bank in the formulation and implementation ofits institutional development program.

7. Information Systems, Accounting and Budgeting

In order for decision makers at various levels of the organization totake correct decisions, they must have access to information that is timely,accurate, properly defined and well presented. Therefore we intend to haveundertaken a diagnosis of nur management information system (MIS) in theinterest of its further improvement. We would utilize the services of ahighly qualified international consulting firm for a two-phased study thatwill aim at the analysis of the existing information system and its subsequentimprovement. In this regard the diagnosis will determine top management'spriorities and a program for the improvement of the information systemincluding a modern management reporting system, improved management of liquidresources and the operational and financial information in oil and gasexploration, development and production.

We expect that this work will be undertaken over the next few yearsand that it will be followed by further steps to improve and broadencontinuously our MIS in accordance with the transformation of OKGT'sorganization. We intend to select and have the consultant start working in1989 with the second phase to commence in 1990.

OKGT will cooperate with the competent authorities in helping tomodernize and confirm those Hungarian accounting standards which are relevantto OKGT. The prevailing Hungarian rules and regulations, which naturally haveto be adhered to by OKGT, are different from the international norms inimportant aspects; accordingly, in some cases it may be necessary for OKGT todevelop dual accounting systems. In particular with the expected decliningaverage size of new discoveries and increasing average costs it is veryimportant for OKGT to make its operations more economic and to focus itsoperational decisions more on the relevant expected economic costs andbenefits.

- 68 -

ANNEX 4-1Page 5 of 7

8. Economics of Operations

OKGT will analyze its procedures for the economic analysis ofinvestments in exploration, development and production. We intend to extendthe use of economic investment calculations to the exploration and developmentprocedures and in the future we shall only undertake such investment projectsthat are economic for OKGT, based on the available information.

9. Internationalisation

OKGT will face an increasing internationalisation of its operations.In the short run, this will be most pronounced for the acquisition ofhigh-quality modern technology and equipment, and we also intend, inter alia,to make increasing use of foreign consultants, training opportunities,equipment and service subcontractors.

At the same time, Hungary would also clearly benefit, primarilythrough a greater diversity of technological/methodological approaches, ifqualified international oil companies would undertake exploration/productionin the country under acceptable risk contracts linking rewards with results.In our opinion, while OKGT will clearly remain the dominant oil company inHungary, we ourselves would also benefit from some competition at the margin.In order to facilitate this, we have recruited a consultant in petroleumcontract economics who is preparing an outline of contract types suitableunder Hungarian legislation and contractual practices. We expect to discussthese contract types and our preferred selection with the Bank not later thanJune 30, 1989 and to have a model contract ready and approved by the necessaryauthorities not later than December 31, 1989, including an appropriate policystatement on the role of foreign companies in Hungary's oil and gasexploration and production. We would expect that the same framework couldalso be used for any small-scale oil and gas ventures by domestic entitiesoutside of OKGT.

10. Exploration Policies

Traditionally, OKGT's exploration effort has been oriented, with veryconsiderable success, towards the pursuit of structural traps (anticlines).As a result, it must be assumed that by now most important such traps havebeen discovered, and that future discoveries of this type wi.l by and large beof an increasingly smaller size. It is therefore important for OKGT now toreorient a substantial portion of its exploration effort towards more subtlestratigraphic traps, the mapping of which requires that staff of differenttechnical disciplines work closely together as teams under qualifiedexploration managers, who should have the appropriate authority overexploration decisions. Moreover, the identification of stratigraphic trapsrequires for a start integrated basin or sub-basin wide geological studies. Afirst such study was carried out for the Bekes basin under loan 2398-HU by theU.S. Geological Survey with promising results, and a second study is now underway by the same consultants for the Kisalfold basin. OKGT intends to continuewith such studies, relying increasingly on OKGT's own staff, but drawing oninternational experts for special expertise and also as resource persons,e.g., for the preparation of work programs and at project completion.

- 69 -

ANNEX 4-1Page 6 of 7

The results of the deep exploration drilling under Loan 2398-HU havedemonstrated that for the time being the prospects are not promising fordiscoveries below about 3,200 m. Consequently, OKGT will orient the bulk ofits exploration efforts at more shallow horizons, only maintaining a limitedresearch-oriented program towards greater depths.

It is important for OKGT's exploration program that there is a properbalance between geological analysis, seismic, and exploration drilling, whileat present there is a bottleneck in the preparation of drillable prospects.It is our intention to expand the number of exploration staff (geologists andgeophysicists) and to provide them the tools to handle more data and to ensurethat only fully evaluated, economic prospects will undergo explorationdrilling.

11. Technical Organization

We consider it necessary to realize the better integration oftechnical disciplines. The completion of this work will take time, besidesthe organizational changes, there are problems to be solved of physicalfacilities and lack of staff mobility.

It is necessary to provide our technical staff with modern tools andequipment. In this respect a considerable development has taken place,especially in consequence of the development realized under 2398-HU.

At the actual stage of exploration in Hungary it is very important tointegrate all the technical disciplines involved in exploration andproduction. For this purpose exploration and production teams and workstations will be established. The first exploration teams have already beenformed with qualified team leaders and are in the process of becomingacquainted with their new tasks. A production team, located in close physicalproximity to the exploration team, will be fully established and in operationby December 31, 1989. We will give team leaders and some team membersappropriate training with international oil companies and consulting supportby experienced exploration managers. Team leaders with be givenresponsibilities and authority similar to that of exploration managers withinternational oil companies and this authority will include fullresponsibility and accountability for surveys and drilling operations. TOR'sfor the team leader function will be prepared accordingly.

The geophysical company (GKV) is responsible for the running of thefield crews, VSP surveys and efficient data processing. It will be suppliedwith all modern tools and equipments to make it capable to work at a highfield technology, processing and interpretation level. In the near futurework-stations will be installed in the center of GKV. Later on theexploration and production teams will also be equipped with similar stations.The technical supervision and maintenance of these work-stations and theorganization of data bases will be by GKV. GKV reports to the OKGT directorof exploration. We will make a new description of GKV's responsibilities toreflect the changes in its tasks. We plan to reorganize our present drilling,well completion and logging activities into special units and operatingindependently in ways similar to that of international service companies.

- 70 -

ANNEX 4-1Page 7 of 7

We will complete and present to the Bank by December 31, 1989 forreview and discussions a study of these organizational changes. On the basisof these discussions and by the recommendations of the study, we willsubsequently take all required measures on our part to implement the changes.

Through the exploration teams we plan to establish closer supervisionof the drilling companies that are drilling exploration wells. The productioncompanies will exercise this supervision during the drilling of productionwells. This supervision will ensure that the wells are drilled according tothe issued instructions (rather: agreed drilling programs). In order toimprove the quality of its operations OKGT will revise, in part with help ofconsultants, its technical and operational standards, incentive systems andtechnical documentation requirements.

12. Conclusions

We believe that the actions outlined above will go a long way tostrengthen OKGT's ability to meet the very significant challenge ofmaintaining a reasonable level of economic oil and gas production in Hungary,improve considerably the longer-term efficiency and productivity of oilexploration, development and production, strengthcn our technical capabilitiesand modernize our approach to oil and gas exploration, and lay the foundationfor the export of Hungary petroleum expertise. Very clearly, theorganizational and other steps must be well prepared and carried out in partby the help of ou-side expertise. We will in this regard keep the Bankcontinuously informed of our plans and the progress of execution, plan todiscuss these steps regularly with you and we would very much welcome theactive support of the Bank in the preparation and implementation of thevarious measures.

The Bank and OKGT have by now cooperated for several years on thestrengthening of the oil and gas sector in Hungary and with encouragingresults. The present program represents a natural, albeit ambitious,evolution for OKGT and is the result of intensive efforts on the part of Bankas well as OKGT staff. We appreciate the ass.stance that the Bank hasextended us under the first Petroleum Project. In continuation of thiscollaboration, I request the Bank to extend a loan of US$100 million to OKGTfor oil and gas development and exploration. This assistance would help us indeveloping OKGT as an integrated petroleum company, improve our technical andfinancial performance, and thus help support the Government's program ofeconomic stabilization and structural reform.

With best regards,

Istvan ZsengellerPresident, OKGT

- 71 -

NUGY DEVELOPMENT AND CONSERVATION PROJECT UNNEX 4-2

OKGT Organization Chart

xcT GeNgAL WSM i

--$ebuty General KUMange Mining Gemity General Manager, echnica IP ma tor erm

Geeopysical Exploration I aCw Petrol lI y Ssi o te _ i

[Lowland PetroleuM Laslorati K onrm Petrhleu

I~~~~~V1 ~~~~~~I .p~np I~

Zala PetroleumL, _ W_I______Y ____________Tisza Pe r o

Ireaetiinm Cmanv (KFVI I Refine Iry OT

Transdamutan Ptratrlem AFI o Petrleum Products

Gas a" Oil Transportat01- I

uNotern Lowlands Gas

Pe tro mt wISrVl m h LWnf * f S

Trumsdanubn fttrlole South Transanutgon Gas

Lowland Petroleu eacrinA No3 h Transeaglean Gas'M AK&I"NLJWZ

Mpelte CoIstrtlon Middle Transdanugan Gas

mI nWiw HJydOAroaro Caron Otoxide ProguctionGeneral o iSnvI autn __I

GSNa cmrctn an

-I w f- fOAJE VI OGI

_ 72 -

- ANNEX 4-3ENERGY DEVELOPMET AND CONSERVTION PROJECT

CUT UsaO OffPINONOwat eie ln

_ I.' __= I

_ " ~ ~ ~ ~ ~ ~ ~ ~~~~~~1 _pswb swd ,"_, _ewo Trees, _ ,-

j 2 °-"-' | @ St 3121 -se-c O b il c-am-o_21__________ffie L.1 il 4 1 lon m

2L Scts -oa ou--me Poo l _l l_Dev _4-Inv, ' 4- I 2"! -r. l_t'I .'inae 1m9em 1212 1P_, s_,l GyC_ CS ? m iii t" ttt r

I I Omwep Trl P'mqow OS..ina I ...-

: w ' , 5 t! sj_ _ ''- ........ ._

;321lS t_ c{ smGi 2ss *111 42 iom* OS_lll ottPosI i _ _- '3gO.nv~a9Ci*1 ,_,._C 321 ._.y Cm, . .

I''1~~~~~~~0 _ f§_I'tt IIrral pr4o_ i4 uS_iaosoooo omm,,1 22 I C IT . _ , _9C ._ l 1 t2§>.1u9"* Cm OegW 0 -22 .__ -.

u20,m mw _ _ erase n3l rh -I -42 1.2.

251 iew10.90 33 ri 06 I I Im I" I *esCetC1222 _t 1- 1sC 54.9Cmlu I6 I~O ^-9 .19C

* jOlseetee r C2 ....,. . .. _ .,1eL Im

___________ 5 '2T1.2} ". 1 _0 C

431 61 1.01..I3 I I4Sg I£me _ _1

432 welter* $469Cm

233 ?0am __________

,, O-"''i n. w.Ce_-. 140C

t231 1__gm _C 04 - - - - -- J

1 1 t,'1 '-- I4C I4I IlmmfI

mosmiest ~ ~ ~ ~ ~ ~ ~ 41 4emeg 4C

442 _c,.. I I0

2iLebr IEd I196 9Cg9eg.~ 445 1469Cm *er SS"9ICq

141 19* 1minn

L, 2sL_ _ S§r "-| | |Ui}| ~ ~~~~~1_ * 9Cm

-73 -

ANNEX 4-4HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

OKGT Subsidiary Companies

Name Initials Town

Hydrocarbon Exploration,Exploitation and Transportation

Geophysical Exploration Company* GKV BudapestLowlands Petroleum Exploration Co.* KV SzolnokLowlands Hydrocarbon Production Co.* NKFV SzolnokTransdanubian Petroleum Company* NFV NagykanizsaGas and Oil Transportation Company* GOV Siofok

Refining and Marketing

Danube Petroleum Refinery* DKV SzazhalombattaKomarom Petroleum Refinery* KKV KomaromZala Petroleum Refinery* ZKV ZalaegerszegTisza Petroleum Refinery* TIFO LeninvarosAFOR Petroleum Products Trading Co.* AFOR Budapest

Gas Supply

Southern Lowlands Gas Company DEGAZ SzegedNorthern Lowlands Gas Company TIGAZ HajduszoboszloSouth Transdanubian Gas Company DDGAZ PecsNorth Transda.iubian Gas Company EGAZ GyorMiddle Transdanubian Gas Company KOGAZ NagykanizsaCarbon Dioxide Production Company SZTV Repcelak

Machine Manufacturing,Construction, Installation

Petroleum Machine Works, Budapest BKG BudapestTransdanubian Petroleum Machine Works DKG NagykanizsaLowlands Petroleum Machine Works AKG OroshazaPipeline Construction Company DVV Siofok

Technical Developmentand Miscellaneous

Hungarian Hydrocarbon Institute SZKFI SzazhalombattaGeneral Contracting and DesigningCompany for the Oil Industry OLAJTERV Budapest

Supply Subsidiary of the HungarianNational Oil and Gas Trust* AGEL Budapest

* Members of the Hydrocarbon Verticum.

! 74-

ANNEX 4-5

_ nr_~tsmt St 45-1992(1'Z ion FX@rlnts)

19421 1984 185s 1on 1"7 Is" I"9 19 1991 1"9:. uiVi_ - _--_-- ___ -- ACTUAL -------------- ----- --- FOAST

Sales Me~ fi basic activities 1/ SSO611 S2.4U 64. 29M 59. le Sf.749 57.ISI 19.8O4 61.44 64. 2U ".916Sale$ h mae faro non-basic aetivities I/ IIS.797 121.944 122.823 110.788 134.4S7 13S.413 39.923 145.481 IS2.130 118.521Consuer price equalization I/ 4.949 5 2 3 S 0 0 0 e a

Gaoss Sftevee 171.318 174.387 187.134 177,891 191.239 192.182 198.978 207.181 218.336 225.467LOsS Sales tax 11.921 1'.2' 4 18."8 28.211 39.767 4S.47 46.197 47.U 47.U4 47.342

met owve 155.421 1I8.179 170.47S S1.84 151.102 147,116 152.281 160.U11 169.212 173.121

It. COST OF SALES

material used 13S993 10.83 11,787 5.948 9,2S1 9,419 9, 80 9. 40 9.99 10.1lfEnergy used in oroduction 31397 4.7U8 3,932 4.131 5,207 S,682 5.24 5. 69e sUl 6.037Labour (mncl. wa9s. social securityl 3.755 4.7'2 5.90U 6.133 6,590 7n990 4,310 6.842 8.91U 9.347Oeerciation 4.492 4.970 5.629 5.927 6.340 6.067 6.674 7.202 7.98" 5.838tntert Expense 3.589 3.725 4.136 1.741 3.SO1 3.61S 4.042 4.328 4.399 4,173Other Costs I/ 11.574 10.967 12.987 1 196 17.222 16.227 17.604 .310 20.310 21.129Pdroe tion taxes S'/ 33.48 31.177 30.40 4 22.2S9 20.S74 15.787 a- -e. e- OAllocation nd Provisions 0/ G6U 547 656 4,222 5.450 5.559 s.671 5.784 1.90 S 6.O18Cost of fesale Goods directly sold 77.6"1 78.563 81.44U 75.475 66.106 64.366 6.44S 69.849 73.556 77.722Inc Idecr I in inventory (9101 337 1.303 (2.303 3160 160 (2001 140 39 IU

Total Production and Operating Costs 148.6U O 148,774 IS5.211 144.449 141.1S 13717554 123.677 130.336 137.589 144.69e

111. PROFIT

Profit before tax 1.031 9.405 12.264 7.191 10310 9.9f2 28.602 29.746 31.18U 34.e22iunicipal taxes 1.023 1,411 1,54u 941 I.S4 0 0 a a 0SOG Loan ftay_nt and other Obligation 95O 'I5 1,4 '1 1.6S3 1,783 S00 0 0 0 OSPI Profit Tax on Production 9 44t (on 60 oercent revenus due to Pr,du tion) 0 7.5SI 7S31 6.384 8.984Profit after Sol Profit Tax 21.052 21.893 23,319 25.e48Plrovision for profit toxns 1,94 3.132 3 718 1.079 3.18 3193S 10,526 10.94? 11.8U9 12.124Current years profit after tax 2.867 1.704 5.197 31S3O 3,306 5,527 10,526 10,947 11,119 12.524

1/ asic activities include products sold internally, abroad and for foreign Trade organizations, Industrial Services. 60 Services.J/ mn-asic activities include construction. transportation. 1_7c_rcial activities.2/ Consumer price *eAlisation elisinated 1/l/Al.I/ Other costs includ mintenace costs. wags and nn-mtorial sOrvices.5/ Proution taxes are royalties paid by CKGT to the Goverant. eliminated 1/1/89.0i/ Allocations e_ *rovidsions includ expenitures for research and exploration.

75 -

ANNEX 4-6

mimimVtLmgU a ~iMITIM PpJErT_I- a1ai 1hoet4 1eas-1992Imillion FOrintil

1943 1964 1961 1960 197 19U 19e 1990 1991 19"2

ASSETS -ACTA -------------------- ---------------- FORECAST------------------

Cash and oesits 5.430 s.995 0.351 3.930 4.105 3.097 3.656 3.929 4.375 4.325

Accgimts receivables 11,497 13,989 13.719 11,U01 12.757 l1.4U il.305 12.207 13.593 3.438

Inventories 23.943 23.135 22.327 22.69 23.112 20.,14 20.591 22.117 24.627 24.345

Other Current Assets 9fl 2.192 2.464 3.102 3.108 2.799 2.769 2.974 3,312 3.274

Total Current ASSetS 41.839 4s.709 44,661 41.44U 43.0e2 38.7990 38.835 41.226 4.5W7 45.335

Gross Flxed Assets 81,733 69.917 91,199 101.265 109.592 121.345 133.479 ";!."I 159,293 171,997

LeSS * Accumulated Oepreciation 23.642 26.92S 29.92 33,055 35.US 40.044 44.046 ;6.06 S2,567 S6.759

Net Fixed Assets 56,691 62.992 65,307 68.210 73,707 81,301 89.431 97,591 106,726 115.236

Projects under construcm on 9.295 6.101 6,432 7,300 9.360 9.222 11.729 9,556 10.696 9,90

Other Assets 61 al1 857 920 I.OS 1.169 1.286 1,403 1.534 1.657

Total Fixed Assets 60,196 69.904 72.596 76.430 84,122 91,691 102.446 106,554 118,957 126,53

Total Assets 110.035 115,613 117.457 117.878 127,204 130.490 140.829 149,781 164,63 172,248

LIAIL1 ItES

Short-term loans 3.400 4,230 3.09 5,30 2.370 2.370 2.370 2.370 2.370 2.557

Accounts Payable 3.00 3.609 6,611 S.127 3.660 3.353 3.557 3,941 4,274 4.611

Accrued ExeSe 243 326 604 459 497 450 153 53 Sal 626

Provision for Ihinc pal & other taxes 4.587 6.407 30 (1.504) 3.519 3.223 3.327 3,496 I,690 3,892

Lfol-ter -debt (due within I yr) 3.397 5.053 4.262 4.214 5.060 4,440 4.948 5.928 6,723 7.350

Other LIabliltieS (due within I yr) 9SI 1.011 995 1,023 773 708 751 832 902 973

Tota Current Liabite5 16.244 20.902 1S,909 14,36S ISASS 14.5S0 15.437 17,105 18.546 20,009

Provisions and non-current Lialliti*es 104 757 572 921 1,079 95 1.049 1,162 1.2U 1,159

Long-term debt 20.05 20. 963 22.560 22,015 21.16S 20.06 24,013 27.038 2S.543 23.445

EOUITY. FUNOS AMC RESERVES

Fund for fixed ASSetS 40.498 41,067 42.530 44.652 49,922 51,656 52.284 S4,452 62.791 66.901

Funds for current asset 22.612 22.490 22.U7 20.026 20.756 21.477 21,783 22.639 26,106 27.815

Reserves 1.33 19 226 270 1,205 1.247 1,262 1,31S 1.516 1.01S

Intrest Funds 577 439 1.04 2,452 2,190 2.2U 2.293 2.355 2.754 2,934

Other Funds 4.695 S.00S 6.412 9.U37 11.675 12.01 12.227 12.735 14.,US 15.646

Current years ProfittlosS( after tax 2.U67 3,706 5.197 3,536 3.106 5.527 10,S26 10.947 11.65 12.524

Total Eausty and Funds 73.062 72.971 70,336 60.557 89,0s4 94,254 100,330 104,476 119.S12 127,415

Totai Liablltles.EQuity.Funds & Beserves 110.035 115.613 117,457 117,578 27.204 130,490 140.,29 149.781 164.663 172,246

- 76 -

ANNEX 4-7

OKGf- rasih Flow £A~t 9319t 4llto forn ntsi

1"93 9U4 16 19" '9,37 193e 99 19 19"1 1993_- AA _U _- -------------- FO6CAST ---------------

SOUKESProfit After Tax 2.U7 3.706 5.197 3.535 3.306 .5527 IO51.6 10.947 11.619 12.524Allocations an Provisions I .16 1,293 1.214 196 173

a) To techntical oeveloo -nt fund 721 979 864 33b) Other Provisions 467 314 3s5 163 173

Long term loans received 5.352 S1.31 6.353 4.664 5,540 S.197 S.063 6,124 6.721 7.956Oeterition 4.492 4,970 5.629 5.927 6.140 6.067 6,674 7.283 7,965 8.600State equity and fants 6,36 10 494 11.749 12.105 14,511 11.934 Is.027 14.129Other sources 3 740 4,512 S,437 3I.29 7. 56 3.729 4.311 4.S2G 3.41J 4.576Short term loans received 17,561 15.124 20.641 832 5.140 6.700 6.214 S.90 4.519

Incr.(Oecr.)ln other current liabilitieS 3,SO9 6.(26 (10.10F '1507; 4-623 4 ,711 4.S10 4.906 5.004 5.104Total Sources 21,14S 44,501 35,21; I 132 40.497 42,480 52.S22 S1.983 55.683 57,707

USESTrrnsfers to State Audqgt 1,910 2.466 2,523 3.530 3.431 3.935 10,526 10.947 11.659 7.524Expenditures tech. de & other fund SO 979 6. 366 6.3S2 7 001 7,312 7,719 8.105 8,110 S 936

&)From tecnnical development fund SOs 979 864 20 1: 10 sblFrer Other Funds S5.12 6.332 6,939 7.342 7.714 8.105 8,110 8.936

Reu)unt of long term loans 3.123 3,401 4,244 4,649 4.481 4.347 5.043 S.673 5.364 4.924Investinnt/repolc~nt of Fixed ASsetS *.477 7.241 7,140 9.017 11.6251 1,753 14,949 12.102 13.632 12.704

a) World Safn Pro)ects 265 336 3.0U2 3.6S1 3.167 3.873 4.931 4.020 4 .4" 4.192bl Other 3.212 6.929 4.051 5.392 8.418 7.S;S 10.016 8.162 9.133 S.112

Short term loans reoaid 17.021 16.642 19,047 4,471 4.694 4,929 5.175 s.434 5,706Incr.(Oecr.)in Current ASSets exCl Cash 2.111 51456 (7.3361 1.006 1,434 1,462 1,492 1.521 1,152 1.163Current Year leonus 384 1.209 321 300 212 300 310 311 340 350Incr l0ecr.1 in Cash 116 3SO (2.4151 170 1,100 ISO 156 148 130Other uses 3,630 6.134 4.761 10.916 7,673 7,13I 7. SO 7 904 9,043 10.651

Total Uses 21.14S 44.501 35.217 2,4U2 40 .497 42.480 52.622 S11963 5S,683 17.707

RATIO AIALYSISCurrent Ratio 2.6 2 2 2.8 2.9 2.7 2.7 2.1 2.4 2.S 2.3Return GO Assets In Operation I/ 7.7 8.1 10.5 7.6 6.6 8.7 13.0 12.7 12.0 11.9aeturn On Resou ces Employed I/ 7.6 10.4 13.1 7.4 10.0 9.1 24.2 23.2 22.6 22.9Oebt Service Coverage Ratio 1.1 1.7 1.6 1.6 1.7 1.9 2.3 2.3 2.1 2.8Debt S oI Oebt + Equity ) 22.5 22.0 22.0 21.0 19.0 18.0 19.0 21.0 18.6 16.0Eouity S of ( Debt * Equiy 7 7.6 70 . 76.6 79.0 81.0 S2.0 81.0 79,6 32.0 34.0Return on Equity 3.9 S.l 6.6 4.4 3.7 1.9 10.5 10.5 9.3 9.SProfit after Spl. Tax/(Avg. Total rsets excluding projects under constructionl 17.0 16.e 16.3 16.0Profit After Tax AS S Met Revenu 1.3 2 .3 3.1 2.3 2.2 3.6 3.6 6.4 6.9 7.0Cost Of Sales As S et Revenue 96". 94.1 92.6 91.3 93.2 93,3 93.3 S1.6 81.3 30.9

1/ Profit after tax + interest expense AS S of net fixed assets and net working capital,2/ Profit **fir. tax as a of net fixed assets. inventories and salaries and wages.

- 77 -

ANNEX 5-1Page 1 of 3

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

OKGT - Consultancy Assignments and Training

1. The following consultancy assignments and training have beenidentified for the Projecti':

Subject Dates Costs (US$ 000)Start Finish Foreign Local Total

(i) Organization and Institutional

(a) Management InformationSystem 9/89 12/92 1,500 500 2,000

(b) Contract Economics 1/89 12/89 150 50 200(c) Organizational Development Not yet defined 200 50 250(d) Export Potential 6/89 6/90 150 20 170(e) Exploration Team

Technical Assistance 7/89 12/91 200 30 230Subtotal 2,200 650 2,850

(ii) Technological Development

(f) Field Ex-Post(Kiskunhalas) 7/89 03/90 300 50 350

(g) Water Treatmentand Corrosion 7/89 03/90 200 50 250

(h) Well stimulation, drillingcompletion and testing Not yet defined 300 50 350

(i) Geological Studies Not yet defined 500 500 1,000Subtotal 1,300 650 1,950

(iii) Training

(j) Training 6/89-12/94 500 200 700

TOTAL 1Q

L-' In addition, the cost estimates for a few of the subprojects includetechnical assistance assignments that are oriented towardssubproject-specific questions.

-78 -

ANNEX 5-lPage 2 of 3

2. Notes

(a) Management Information System.TOR are being revised by OKGT and will be agreed at negotiations. Thefirst phase of the study diagnosis will then start around September 1989.

(b) Contract Economics.The consultant has initiated his work under TOR agreed with the Bank.The cor.tract may be extended into 1990 if necessary to supportnegotiations with companies and/or exploration promotion.

(c) Organizational Development.Support for OKGT's development process. It is expected that consultantswill be recruited for specific tasks as required. TOR will be preparedlater, as required.

(d) Export Potential Study.This would provide an audit of OKGT's potential strength for thelonger-term development of export of petroleum services and expertise,and would also, as required, help to prepare an initial marketingstrategy. TOR will be agreed later.

(e) Exploration Team Technical Assistance (incl. traininR).Apart from training the exploration and production teams in integratedinterpretation and supporting team managers in carrying out theirresponsibilities, this consultancy will have two major additionalobjectives by assisting OKGT in:

- the forthcoming study for reappraisal of remaining reserves ascarried out every five years. This will start by the end of 10°9; and

- the introduction of economic decision criteria and procedures forexploration and development, including the calculation of standardexploration, drilling and development costs and the description ofminimum size exploration and development targets as a guidance forfuture operations. TOR will be agreed later.

(f) Field ex post (Kiskunhalas).This study will critically analyse the exploration, development andproduction history of a medium size field for OKGT to improve itsoperations in the future. TOR have been agreed.

(g) Water Treatment and Corrosion.This will also cover consultancy for cathodic protection andembrittlemer,t from HzS containing gas, as there otherwise would beconsiderable overlap between similar topics. TOR: two sets of activitieshave been agreed.

- 79 -

ANNEX 5-1Page 3 of 3

(h) Well Stimulation etc.May be done in one or two studies of OKGT's present practices, withfollow-up to assist in the development of more modern practices. TORhave been agreed.

(i) GeoloRical studies.Geological studies will continue during the next project. Theirgeography and scope will depend on further exploration results and theinterpretation thereof. Some areas have been identified provisionally:

Ha,dusag/Bihar: Relatively underexplored with until now one gas fielddiscovered in 1959.Kiskunsag: A productive basin; a compilation of all data and thoroughanalysis of the remaining potential is required.Nyirseg: A basin in the North East extending into Czechoslovakia andthe USSR in which countries it is producing. In part of the areatuffs hamper geophysical data collection.

It is the intention that these studies will be more and more carried outby OKGT exploration teams with foreign consultancy only assisting forspecial components. TOR will be agreed as the study areas aredetermined.

(j) This will consist of training in Hungary by foreign consultants, andtraining abroad of OKGT management and staff in the form of trainingcourses and seminars, participation in specialized industry conferences,and industry familiarization including on-the-job training with foreignoil companies. OKGT will prepare yearly training programs under theProject.

- 80 -

ANNEX 5-2

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

List of Specialized EquivMentL'(US$ million)

Total OKGT Of which:'Requirement To be financed:

1990 1991 1992 Total

1. Geophysical

Telemetric instrument 0.42 0.42Field vibrators 4.00 4.00Computer hardware 0.50 0.50

Subtotal 9.82 0.42 4.50 4.92

2. Well logging

Diplog/duel induction etc. 3.67 0.70 0.07 0.77

3. Well testing and supplies

Blowout preventors 0.16 0.16Drill collar and jar 0.10 0.10Wedge, instruments 0.22 0.22Torque monitoring 0.08 0.08Tubing wrench 0.16 0.16Fraser 0.06 0.0oTwin drum winch 0.19 0.19Lubricating pipe/safety 0.22 0.22Fracturing equipment 1.01 1.01Acidizing equipment 0.50 0.50Sand mixer 0.40 0.40High pressure compressor 0.80 0.80Sand concentrator 0 14 0.14

Subtotal 11.23 0.30 3.74 4.04

4. Laboratory equipment 0.57 0.27 0.27

Total equipment ZLibL .92 Q2Z ILO.O

1i- Exclusive of price contingencies.L' These items have been identified as having the highest priority.

- 81 -

ANNEX 5-3Page 1 of 10

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

Development and Production Subproiectsu'

A. Barcs-West

1. Tvpe: Gas field development

2. Company: KFV.

3. Purpose: To equip the field for a two-year production test, andgather sufficient data to prepare an optimum exploitation plan.

4. Special Features: The field straddles the Hungary-Yugoslaviaborder. A satisfactory unitizat!on agreement has been reached (available inproject files). The subproject will stimulate and test three wells, and equipthe field (on the Hungarian side only) for a two-year production test. Theeconomics of the subproject have been based on the assumption that no morefield development will be done, and assuming the smallest realistic reservesize.

5. Status: Ready for implementation. Disbursements should take placein 1989 and 1990, with a tail dragging possibly into 1992.

6. ERR: 81.2X. Not sensitive to lower prices. The benefits are theproduction of 874 MMCM of gas and 493 MT of condensates.

7. Environment: There is a special risk because of H2S content at50-150 ppm. There is estimaced also a high CO2 content. In coacbination,these two gases present a severe corrosion and hydrogen embrittlementproblem. Therefore, the containment and transportation of this gas must bedone with special planning and care (see item 9).

8. Procurement: No special issues.

9. Confirmation: OKGT has confirmed that the pipeline carrying the gaswill be routed in such a way that there will be no residences or publicbuildings within the 100 ppm area of H2S concentration should the pipelinerupture or a well blow-out occur. (In addition, consultancy in cathodicprotection will be undertaken under the Project.)

/ For the subprojects discussed in this Annex, "Bank Financing" is showninclusive of physical contingencies.

- 82 -

ANNEX 5-3Page , of 10

10. Bank Financing: US$4.4 million equivalent.

B. Ulles

1. Type: (i) Gas field upgrading, and (ii) oil field development. Thebenefits would be of (i) 2.7 BCM of gas and 290 MT of condensates, and of (ii)145 MT of oil.

2. Company: NKFV

3. Purpose: (i) To install coolers to keep produced gas temperatures atpermissible levels, and (ii) to place oil pools on production before reservoirenergy is depleted by gas production.

4. Special features: None

5. Status: Ready for implementation. Analysis has been improvedfollowing Bank comments.

6. ERR: Above 580Z. The benefits would be the additional production of145 MT of oil, 290 MT of condensate and 2.7 BCM of gas.

7. Environment: Some H2S in gas, but not enough to cause fatalitiesif a rupture should occur. Consultancy re embrittlement required underBarcs-West would also be useful for Ulies, since hydrogen embrittlement willoccur from any concentration of H2S.9

8. Procurement: OKGT has been planning to acquire progressing - cavitypumps typically used in Canada for heavy crudes. However, these particularpumps are not successful with high gas/oil ratios as at Ulles. OKGT shouldconsider alternative types. Otherwise no issues.

9. Confirmation: (a) OKGT will utilize a consultant to examine theembrittlement question, and (b) will investigate the possibility of convertinggas wells to oil wells, reducing gas production rates if necessary.

10. Bank Financing: US$2.0 million equivalent.

C. Demien-Kelet

1. Type: Enhanced (tertiary) oil recovery with combustion drive.

2. Company: NKFV

3. Purpose: To finance the fire-flooding tertiary recovery from thisdepleted field.

- 83 -

ANNEX 5-3Page 3 of 10

4. Special Features: (a) Has been reworked based on previous Bankcomments. (b) Implementation is supposed to proceed through 1996, althoughinvestments after 1993 are not included for Bank financing. (c) There hasbeen sufficient pilot testing to forecast benefits, but the estimate ofoperating costs is somewhat uncertain because no experience has yet beengained after breakthrough of the combustion front.

5. Status: Ready for implementation.

6. ERR: 31.02. However, results of a current pilot should be reviewed(end 1989) before comitting significant funds (item 9). A reduction ofUS$2/bbl would give an ERR of 25.6X. The benefit wouid be the recovery of 455MT of oil.

7. Environment: No special features.

8. Procurement: No special features.

9. Conditions and Recommendations:

(i) Conditions: This is a challenging and technically advancedsubproject. Therefore, OKGT will report to the Bank at twospecific decision points: (a) end 1989 (end of ongoing pilot):Discussing evaluation in comparison to present estimates forproductivity and recovery increments, sweep efficiencies,production characteristics and operating costs in wells afterbreak-through of the combustion front, and that no noxious gasesare being produced; (b) end 1991 (with two years' productionexperiencc. and before major investment in equipment), evaluatingexperience with existing compressors before acquiring new ones.

(ii) Confirmation: OKGT will review staffing requirements, and willconsider reducing it to the estimated minimum (30 staff).

10. Bank Financing: US$3.2 million equivalent.

D. Szeghalom

Will be discussed separately, due to its size and complexity.

E. Algyo Field

1. Type: (i) Oil and gas field upgrading, together with (ii) acquisitionof maintenance and construction equipment, and (iii) expanded waterfloodingand investments to accelerate production.

-84 -

ANNEX 5-3Page 4 of 10

2. Company: NKFV

3. Purpose: (i) Upgrading: To replace obsolete or worn-out equipmenttogether with equipment required to continue production under changingconditions such as increasing water-cut. Without such investments, productionwill at least be curtailed severely. (ii) Maintenance and constructionequipment: Required to continue field operations. (iii) Extensions andaccelerations: It is expected that OKGT will be successful with itswater-flood extensions due to advantageous permeabilities and NKFV's goodexperience with this method.

4. Special Features: None

5. Status: Ready for implementation.

6. ERR: 92.5Z. Each component has been evaluated separately todemonstrate economic justification. Given the combination of increasedproduction and accelerated production the physical benefits are not calculatedwith exactness, but might be around 1.6 BCM of gas, 1.6 MMT of oil and 420 MTof condensates.

7. Environment: A long established field. No unusual considerations.

8. Procurement: No special issues.

9. Confirmation: (i) OKGTr will take steps Lo prevent contamination ofuncontaminated reservoirs'', and initiate training in watertreatment and corrosion protection; (ii) OKGT will review the generalproduction practices of the Algyo field, since it is possible thatthere is scope for a more generalized increase in production rates.

10. Bank Financing: US$7.2 million.

F. Pusztafoldvar

1. Type: Enhanced gas recovery

2. Company: NKFV

3. Purpose: To enhance gas recovery by re-pressurizing the reservoir.

4. Special Features: None

¢' It appears that injection water has not been properly treated; as aresult, there is H2S in the gas because sulphate-reducing bacteria havebeen injected into the reservoirs.

- 85 -

ANNEX 5-3Page 5 of 10

5. Status: Ready for implementation.

6. ERR: 68X. The benefit is the recovery of an additional 64 MMCM ofgas.

7. Environment: No risks.

8. Procurement: No issues. Bank financing would be used for a down-holeflow meter (only about US$12,000).

9. Conditions and Recommendations: None.

10. Bank Financing: $12,000 million equivalent.

G. Nagylenayel

1. Type: Enhanced (tertiary) oil recovery.

2. Company: KFV

3. Purpose: To recover additional oil from the depleted Nagylengyelfield with CO2 induced gas cap displacement, followed by a second cycle ofnatural water drive.

4. Special Features: Production predictions are based, conservatively,on the results of two pilot tests. Nevertheless, there is still a risk, hardto quantify, because the C02 injection is for OKGT a novel process that isdependent on the geometry of the porosity. For that reason, it is importantthat stock be taken at logical decision points.

5. Status: Ready for implementation.

6. ERR: Following Bank comments, investment costs have been reducedthrough more economic development plan. The project benefit is forecast to bethe recovery of 1.9 MMT of oil. The ERR is 22.4%, and is sensitive to priceand production shortfalls. Thus, a constant price of US$15 per bbl would givean ERR of 15X. On the other hand, some possible benefits such as thepossibility that the gas would become valuable through continued enrichmentthrough recycling have not been included.

7. Environment: No special aspects.

8. Procurement: No special issues.

- 86 -

ANNEX 5-3Page 6 of 10

9. Condition: Two years of production history from an ongoing phase Iwould be available before significant Bank funds would be utilized(1990). A comparative report on the results of this phase will beprovided to the Bank before any major contracts for this subprojects.

(ii) Recommendations: None

10. Bank Financing: US$8.3 million equivalent.

H. Tazlar

1. Tvpe: Gas enrichment and enhanced oil recovery.

2. Company: KFV

3. Purpose: (i) To produce and upgrade gas reserves which contain COz,and (ii) to utilize the CO2 .y-product to enhance oil recovery from thenearby Szank field.

4. Special Features: None

5. Status: Ready for implementation.

6. ERR: 30.2Z, conservatively estimated. The benefits would be therecovery of an additional 475 MT of oil, 23 BCM of gas and 112 MT ofcondensate to the end of year 2002 (and there would be additional benefitsafter that time).

7. Environment: No special features.

8. Procurement: No special issues.

9. Conditions and Recommendations: None.

10. Bank Financ,ng: US$15.1 million equivalent, of which US$12 millionunder the B-loan and US$3.1 million under the new Project.

I. Liszo-Inke

1. Type: Gas enrichment.

2. Company: KFV

3. Purpose: To upgrade the high COz gases in these fields.

4. Special Features: None

- 87 -

ANNEX 5-3Page 7 of 10

5. Status: Technically, the subproject is ready for implementation.During evaluation, it has gone through a number of permutations, since theeconomics of this subproject were in doubt, and it was tied to the developmentof the nearby Lovaszi field, where the Liszo-Inke COa would be used forpressure maintenance. After improvements in the field development plans,involving fewer wells and greater: concentration on the most economic producinghorizons, the combined project shows a satisfactory return.

6. ERR: The project shows a rate of return of 172. The benefit wouldbe the production of 1.5 BCM of sales gas (after enrichment).

7. Procurement: No special issues.

8. Environment: Some H2S may need disposal if it cannot be left inthe sales gas stream.

9. Conditions: None.

10. Bank Financing: US$17.4 million equivalent.

J. Csanadapaca

1. Type: Oil and gas field development.

2. Company: NKFV

3. Purpose: Develop and exploit the reserves in several small fieldswith several oil and gas reservoirs.

4. Special Features: None

5. Status: Ready for implementation.

6. ERR: Benefit is the production of 75 MT of oil and 475 MMCM of gas.These subcomponents show ERRs of 7042 and 86.3X, respectively.

7. Environment: No unusual considerations.

8. Procurement: No special features.

9. Conditions and Recommendations: None

10. Bank Financing: US$O.1 million.

- 88 -

ANNEX 5-3Page 8 of 10

K. Kaba-Del

1. Type: Oil field development

2. Company: NKFV

3. Purpose: (i) Complete and equip a suspended well for water disposal;(ii) drill an infill well.

4. Special Features: None

5. Status: Ready for implementation.

6. ERR: The benefit will be the production of an additional 75 MT ofoil from the infill well, whereas no tangible benefit has been assigned to theinstallation of the water disposal facilities. The ERR becomes extremely high.

7. Environment: No special features.

8. Procurement: No special features.

9. Conditions and Reconmmendations: None.

10. Bank Financing: US$O.1 million equivalent.

L. Kiskundorozsma

1. Type: Oil field development. It was originally presented as anenhanced oil recovery subproject using pressure maintenance with waterinjection. However, about 752 total expenditure is for drilling andcompletion, which explains the reclassification.

2. Company: NKFV

3. Purpose: (i) To complete field development; (ii) to enhance oilrecovery with pressure maintenance by water injection.

4. Special Features: A total of 55 wells have been drilled in thisrelatively small field of which 45 are within the production area. Now, OKGTplans to drill another 16 wells under the subproject. Eventual well spacingwould be as low as 40 acres (16 ha). A study of the sensitivity of theeconomic indicators to investments in wells is required. Also, the practiceof drilling new wells for injectors is common in Hungary, whereasinternationally it is usual to convert producing wells to injectors. Thisfurther makes it necessary to look at the proposed drilling program.

- 89 -

ANNEX 5-3Page 9 of 10

5. Status: Not quite ready for implementation. Consideration must begiven to the number of wel.l (part 4). In addition, this reservoir is a dualporosity - dual permeability type and the production and recovery underpressure maintenance cannot be accurately forecast without a model that willsimulate this system. A proper model is desirable before the development plancan be finalized.

6. ERR: Subject to modelling exercise, ERR has been calculated at70.1X, with benefits in the form of the recovery of an additional 1.5 MMT ofoil, with an ERR under US$2 less/bbl of 58.5Z. This may be revisedconsiderably following modelling (acceleration investment), but development isclearly justified.

7 . Environment: No special considerations.

8. Procurement: No special considerations.

9. Confirmation: OKGT will model the fieid with a dual porosity - dualpermeability model and optimize w-ell densities.

10. Bank Financing: US$1.0 million.

M. Endrod

1. Type: Gas field upgrading.

2. Company; NKFV

3. Purpose: To maintain gas production by (i) installing gas coolers,(ii) installing compression and refrigeration, and (iii) drilling sevenproduction wells.

4. Special features: A very large number of wells has already beendrilled, and there should also be possibilities for comingling zones(producing simultaneously from several zones).

5. S'atus: Ready for implementation, except for the drilling component.

6. ERR: Calculated at 137.81. The benefic would be the additionalproduction of 2.8 BCM of gas.

7. Environment: No issues.

8. Procurement: No issues. An updated detailed list of items isreqvired.

9. Confirmation: OKGT will analyze the possibilities of utilizingexisting wells and of comingling producing zones.

- 90 -

ANNEX 5-3Page 10 of 10

10. Bank Financing: US$0.9 million equivalent, now that suitablecompressors have been identified in Hungary.

N. Kozepalfold I-'

1. !ID: Gas field upgrading.

2. Company: NKFV

3. Purpose: To maintain production through (i) the installation of gascoolers and compressors, and (ii) the drilling of two prouuction wells.

4. Special features: It appears that exploratory drilling is stillgoing on to establish field boundaries. This is not required; field limitscan be determined from production tests.

5. Status: Ready for implementation.

6. ERR: Benefits are the production of 3.3 BCM of gas that could not beproduced without this equipment. The ERR is 49.7Z.

7. Environment: No unusual issues.

8. Procurement: No issues.

9. Confirmations: OKGT will consider ways of comingling in lieu ofadditional wells and also the possibility of substituting additionalcompression for wells or vice versa.

10. Bank Financing: US$5.5 million.

^' Kozepalfold II has been withdrawn by OKGT.

- 91 -

ANNEX 5-4Page 1 of 3

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

The Szeghalom Subproject

1. Type: Oil and gas fieid development.

2. Company: NKFV

3. Purpose: (i) To finance the development drilling and equipping ofthe field together with a gas plant and associated facilities; (ii) To exploitthe field using lean gas recycling to maximize the recovery of the oil andcondensate.

4. Field description: The Szeghalom field is Hungary's most importantrecent discovery. It is a complicated field with two hydrocarbon pools:Halom-l and -2. The Halom-l pool has a large gas cap overlying a thin oilleg, while Halom-2 has a small gas cap overlying an oil leg. The reserves inthe gas caps are of the retrograde condensate type, which means that if thepressure is reduced, hl;her molecular weight components (the most desirable)will begin to condensate and will remain in the reservoir. The pools arehydrodynamically connected through the acquifer, and the field isover-pressured. This probably means that the acquifer is limited and will notmaintain the original pressure if the pressure is drawn down, or may possiblyencroach completely and replace voidage.

5. Obiectives: The objective of an exploitation plan must be tomaximize recovery while maintaining minimum profitability, meaning maximizingnet present value (with due regard for risk) under a minimum rate of return(122). This means in this case, inter alia, that oil must be produced first,but this is not easy since serious problems with gas-coning and water-coningcan develup in fractured reservoirs nf this type, and the water table willrise if the voidage is not replaced.

6. Development History: Due to its complexities, the field has beenstudied for some time. By end 1987 OKGT proposed to the Bank to injecthigh-CO2 gas in lieu of the produced liquids. However, such a scheme wouldhave a significant risk - the injected fluid could "finger" quickly toproducing wells, bypassing the reservoirs. Rather, the Bank suggested todevelop a reinjection scheme, to avoid the COz contamination problem. Atthe same time, the Bank pointed out that there are still uncertaintiesconcerning the porosities of the basement portion of the reservoirs due toinadequate coring. Estimates range from 1% from core analyses to 8.6X asinterpreted from well loSs. More cores are clearly required, together with animproved model. OKGT has utilized a cross-sectional model to predict thedisplacement efficiency of the injected gas. However, the accuracy of the

- 92 -

ANNEX 5-4Page 2 of 3

models is questionable because of the uncertaiuty surrounding the rockproperties. An equation of state, compositional model must be run and, ifthere is both matrix porosity and permeability as well as fracture porosityand permeability, which is likely, a dual-porosity, dual permeability modelmust be used.

7. Status: Due to the above uncertainties, the sub-project is not yetproperly defined. However, it is very clear that a sub-project will betechnically and economically viable; the question is which one. At theinstigation of the Bank, foreign consultants have been recruited to evaluatethe data, define the needs for additional data (in particular cores), run thenecessary state-of-the-art models (possibly dual porosity - dual permeabilitymodels) and assess four alternative development schemes:

a) Primary recovery only;b) Pressure maintenance with C02 ;c) Pressure maintenance with reinjection;d) Utilizing the field also as a gas storage reservoir, pumping in

dry gas from the USSR in the summer and recovering the gas (withsome liquids) in the winter.

8. It is likely that alternative (a) wou'd give the highest ERR, but thelowest NPV. OKGT is rightly very reluctant ' embark on such a scheme, whichwould mean leaving valuable liquids in the b.;und. No data are yet a-ailablefor alternative (d), which was identified conceptually originally by Bankmissions (although for a different field); however, it is quite possible thatthis will turn out to be the most advantageous alternative. Betweenalternatives (b) and (c), the former would have the higher return, but also ahigher risk. For that reason, the Bank's tentative assessment in thefollowing paragraphs is based, conservatively, on alternative (c).

9. The Reinjection Alternative: It is a problem in Hungary that manyfields appear to have an excessive number of wells. So also for Szeghalom,where already 80 wells have been drilled, of which 35 can be used forproduction. Another 50 wells are proposed drilled; however, OKGT shouldjustify this more closely. In particular, wells in excess of those requiredfor gas production must be justified economically on the revenue from oilproduction only. With this caveat, some development investments can be madealready at this stage because the initial stages involve further projectdefinition and initial developments basically similar under all alternatives.The Bank does not want to delay such investments, but would want to followclosely the subproject.

10. Project Implementation: Investments will continue into 1994, but95Z would be completed by the end of 1992. The subproject would consist ofthe drilling of production and reinjection wells plus the installation ofsurface facilities including compressors for gas reinjection.

11. The consultants (para. 7) have been hired by OKGT under terms ofreference satisfactory to the Bank, and Bank staff will follow closely their

- 93 -

ANNEX 5-4Page 3 of 3

work. Their conclusions and recommendations should be available by aboutApril/May 1989; on this basis OKGT in consultation with the Bank shouldprepare a revised optimum implementation program, ucing the model to chooseexploitation techniques, select well locations, and optimize the size of t'lesurface facilities.

12. Proiect Benefits: Operating income will continue to the year 2015.Annual income would drop substantially in 1992 when re-injection would start,and increase to its highest level in year 2002 when gas recycling wouldcease. There is a possibility for increased rate of return if C02 recyclingcould be done; barring this, however, the rate of return in estimated at17.9X. A 25% reduction in price or in production would give about 132. Theproject would give a total production of 830 MT of oil, 3.5 MMT of condensatesand 8 BCM of gas.

13. Project Risks: Once the present uncertainties have been removedthrough the consultants' study, the risk would not be important because thedevelopment technology exploitation procedures are known.

14. Environment: No special features.

15. Procurement: No special features.

16. IBRD Financing: US$26.5 million equivalent, corresponding to 182 oftotal project cost. About 70Z of IBRD financing would be for three naturalgas driven compressor units.

17. Discussion: This is the only proposed subproject of aay size where asignificant amount of work remains before the subproject will be definedfirmly. This involves an amount of uncertainty as to project design, costsand benefits. However, the delay in finalizing the development concept isreasonable in view of the complexity of the subproject and the need for OKGTto acquire expert foreign assistance (financed under the first PetroleumProject). Also, this is the only currently known opportunity for OKGT to makea large addition to the Hungarian domestic hydrocarbon supply; the involvementof Bank staff has in this regard helped identifying the sources ofuncertainty, and the continued Bank involvement will be useful in the finalformulation of the subproject.

18. The expected benefits of the subproject would be very important forOKGT's effort to maintain a reasonable level of production. The presenteconomic rate of return is high enough to give confidence that the Szeghalomsubproject will be implemented within the period of the proposed loan. TheBank should therefore include this subproject as eligible under the loan.

19. Conditions: There will be no withdrawals for subproject investments(apart from studies) until OKGT presents a revised development plan thatbuilds on the consultants' report and is satisfactory to the Bank;

- 94 -

X 5-5Page 1 of 3

UNIGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

Underground Gas Storage Component

I. PUSZTAEDERICS FIELD

1. The Upper Nova reservoir began to be converted to gas storage from1972. Five of the six production wells were converted to injection wells, 12additional wells drilled by 1975, and surface facilities (consisting of twoelectricity-driven compressors of 1,840 KW rating, used interchangeably forinjection at 140 bar pressure, and in the gas withdrawal mode as recompressorto 40 bars for input into gas trunk pipeline, and anti-freeze injectionsystem) intalled by 1979. The reservoir was filled with gas and brought up toits upper operating pressure in 1981, and has been in operation as a storagefacility since then. This so-called Phase 1 development of the field hasresulted in mobile gas storage capacity of 100 MMCM. Through the Phase 2development, due for completion in late 1988, the mobile gas storage capacitywill be increased from 100 MMCM to 200 MMCM, by developing the Lower Novareservoir. Five additional wells have been drilled taking the total numbersof wells to 22 of which 7 will be dual-completed. Both the reservoirs willoperate in the same operating pressure regime.

2. As a sub-component of the Project, the storage capacity will beincreased from 200 MMCM to 330 MMCM, by changing the operating conditionsalone, reducing the lower operating limit of reservoir pressure from 92.8 bars(Phase 2) to 58.9 bars. Consistent with the expanded capacity, and for highercirculating rate at peak demand withdrawals of about 3.2 MMCM per hour: (i)three new production wells will be drilled, and one of the existing wells willbe recompleted; (ii) two new gas compressors will be installed; (iii) theexisting glycol treatment system, and the ammonia refrigeration systemcapacities will be expanded; and (iv) additional new pipelines for gascollection from wells to gas treatment facilities and for linking to the maingas transmission lines will be installed. Project investments will commencein 1990 and completed in 1992, and the facility is expected to be operationalby the summer of 1993.

II. KARDOSKUT (PUSZTASZOLOS) FIELD

3. Physical facilities for converting the 5 reservoirs into storagepoints were completed in 1978 which included: (i) 9 additionalinjection/withdrawal wells; (ii) 2 reciprocating compressor units withcapacity of 17,400 cm/hr each; (iii) expansion-type gas dehydration systemwith 50,000 cm/hr capacity; and (iv) auxiliary support facilities. Totalstorage capacity rea .hed 150 MMCM, and peak injection/withdrawal rate reached1.2 MMCM per day by 1986. These storage points serve to store the excesssumner gas from the neighboring Szeged fields for supply to Southern lowlaudsmarket in winter.

- 95 -

ANh'"EX 5-5Page 2 of 3

Project Subcomponent

4. Based on reservoirs performance data, analyses and simulationmodelling, A-1 and 2, B-2 and 6 reservoirs are assessed as suitable forexpansion by increasing the operating pressures range. For the envisagedstorage expansion by 60 MMCM to 210 MMCM, the Project subcomponent willinclude the following physical facilities: (i) Drilling of 7 additionalproduction wells; (ii) Transfer 3 nos. of 1,500 HP compressor sets fromHajduszoboszlo field to achieve 70,000 CM/hr injection capacity and to replacethe existing two undersized compressors; (iii) replacement of the existingundersized expansion-type dehydration system with glycol treatment facility of100,000 CM/hr capacity; (iv) expansion of Pusztaszolos gathering station, andinstallation of a 5-km line to connect the gathering station to Kardoskut gastreatment facility; and (v) required expansion of utilities systems,maintenance, warehousing, and other auxiliary systems. Implementation of thesub-project compcnents has begun in 1987 while all other parts will becompleted by 1989, the transfer and installation of the three compressors fromHajduszoboszlo facilities will be done after new compressors are procured andready for installation there. The expanded storage facilities at Kardoskut isscheduled to commence operation by the summer of 1991.

III. ZSANA-NORTH FIELD

5. OKGT has studied 6 alternatives for developing the field as gasstorages. The first set of 3 alternatives envisages converting the field togas storage by 1991 when tne reservoir pressure is estimated to drop to about81 bars. Within this set, the variations in scenarios consist primarily ofoperating pressure ranges resulting in gas storage capacities of 500, 1,000and 1,500 MMCM. The second set of 3 alternatives envisages converting thefield as storage facility by 1995-1997 depleting the field till formationpressure drops to 60 bars. Inter-se variations of the alternatives withinthis set are similar to those in the first set. The costs of storage per unitof gas for each of the 6 alternatives have been estimated (in constant 1993'costs) and ranked. OKGT's analysis shows that alternative 6 results inminimum costs uf storage, corresponding to storage capacity of 1,500 MMCM;total number of injection/production wells of 60; operating pressure range of140 bars (max) and 65 bar (min); and peak production capacity of 14.4MMCM/day. However, the optimum alternative will be developed in two phases,with Phase 1 scheduled for completiLn by 1993 with a storage capacity of 500MMCM to be expanded by and after the year 2000 to its ultimate capacity of1,500 MMCM.

6. For the Phase 1 development of the Zsana-North formation as gasstorage, the following physical facilities will be established: (i) drillingand completion of 21 new wells, and recompletion of 5 existing wells;(ii) 46 km of ND 150 mm, and 20 km of ND 800 flow lines; (iii) 2 nos. ofturbo-expander/glycol type dehydration unit of 100,000 cm per hour capacityeach; (iv) 5 nos. of gas engine-driven, reciprocating compressors of 40,000cm/hr capacity each; and (v) utilities systems capacity expansion, and supportsystems rationalization.

- 96 -

ANNEX 5-5Page 3 of 3

own Caen OV Ta/l Omstic Wtliraw_ ls total

197-U (Wint r1(Actual) 7,1S5 04 - - 94 7,4513 4060 2.S37 510 274531it (SuiinrfI(st.) 4.150 670 1SO 175 - .644 5,150 2.558 2. 5. - ISO

I908-So (WI(Pfrojctedl 7,710 9e - - 9o 7.u0e 4,006 2.ss e ,I15 7,U0190 (S) 4.1" 700 ISO 1 - 1.036 5.226 2.320 2.900 u.-20

190-90 (WI .140 100 - 20 0 126 8.264 4,000 3.110 i,ISO 5.2441it (5 4,260 I45 1S5 200 - 1. 60 S.S" 2,0GO 3.300 - S. a"

1990-91 (W 9,000 16s - - - 109 9.106 4,000 3.466 1,709 9,161"1 (S) 4,330 ' .235 L) 200 - SOW 2.500 3.4,0 - 5S.9

19"1-92 (W) 0,310 1s5 - - - ISO 9.460 4.000 3.050 1.816 9.4601902 (S) 4,346 1,13 210 206 - 1.74e 6,0e 2.270 3.016 - 0. 00

lM-9 (WI 9.508 70 - - - 70 9.030 4,000 3.226 18110 9,030IM e(S) 4.350 1,256 216 3M in 1.906 6,336 2,566 3,36 06.330

1993-04 (W) 9,670 IS - - - Is* 10,620 4,060 3.I90 2.130 10.0201004 (S) 4,3e 1256 210 330 300 2.094 6.450 2.500 3.950 - 6.450

1904-95 (WI 9.970 IS0 - - I5S 10.120 4,000 3,880 2.248 10.1201"S (S) 4,110 1.164 216 310 so£ 2.2e6 6.310 2,500 3.810 - S.310

1900-1996 (WI 10.050 ISe - - - 1S 1l,200 4,006 3.S6 2,350 10,260109 (S) 4.140 1210 216 330 500 2.250 6." 2, St 3.500 - 0.394

190-1997 (WI 10,190 1S5 - - - 15 10.2340 4*000 3.940 2,400 10.3401907 4,24. 1,210 210 336 so0 2.25e 6.40 2.500 3,990 - 0.490

1997-196 (WI) 10,20 Io - - - 156 10,420 4.006 4,030 2.4 10 43190 (SI 4.330 1.216 21. 336 S00 2,2s5 6a580 2,500 4.eee - G,594

190-1099 (WI 10.370 IS - - - Ise 10.520 4,000 4,120 2,460 10.5.e909 (S) 4.26 1.216 216 130 500 2.250 6.b70 2.500 4,17 - 6.070

199-2000 (WI 10,440 IS0 - - 1S5 10,610 4,000 4.210 2.400 10.0102e0 (S) 4,100 11,16 216 336 so0 2,256 6.750 25see 4.25s - 6.76n

a/ njection into for_tiOns at: - majdul531ob02lo 111; K - Kardoskut IT P - PusataericS IIU; and 2 -Zsa Ifields. T1kwAtt of incr"sed storage cas&citi to be4 broueht into oeoratiOns at 1I, K, and P fields, and newsto"e caacity at Z field are undorlinGd. New capity at Zsanh to be breught Into operation In 193 Surwill hawe its ultimte capacity of 500 milion CucbiC motors. fully utilized from the sor of I9H. Similarly,gxwaSfid storase capacity at Maljuszloboalo in 19 sumr will have its ulti'te capacity of 1.406 million cubic0etOrs whiCh will be fully utilized from the su_r of 1992-03.

Wincoe: OT

- 97 -

ANNEX 5-6Page 1 of 5

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

Gas Pipeline and Compres3ion Components

I. ENDROD-VAROSFOLD PIPELINE

1. The existing 72-km long 600 m pipeline over this distance currentlytransport part of the imported gas and production from Hajdusloboszlo field towestern Hungary, and to Yugoslavia through the Varosfold compressor station.The line capacity is limited to about 250 MCM per hour. The increasing demandin western Hungary in the future is proposed to be supplied through thesouthern leg of the pipeline system which links Beregdaroc in NE to Varosfoldthrough Hajduszloboszlo and Enrod, leaving the northern leg through Leninvarosto serve the demand in Budapest area and N. Hungary. Consequently, thethroughput in Enrod-Varosfold section is projected to increase to about 630MCM per hour by 1993, and further to about 775 MCM per hour by the late l990s,requiring a parallel line of 800 mm diameter.

2. The installed capital cost for this pipeline is estimated at US$24.6million equivalent, including a convertible currency coirponent of US$1.1million equivalent for the import of pipeline test equipment and instruments.The pipeline is scheduled to be operational by early 1992.

II. PILISVCROSVAR-GYOR PIPELINE

1. The northern part of the pipeline network carrying gas from East andSouth through Budapest terminates at Pilisvorosvar. In the Northwest,pipeline system terminates at Gyor, with the Northwest Trans-Danubian areapoorly connected. Furthermore, with the increasing consumption in Gyor area,deficits are likely to occur because of increasing limited supplies fromWestern fields. The proposed 127-km long 600 mm pipeline will connectPilisvorosvar with Gyor, thus providing a northern loop and enabling gassupplies to smaller towns along the way (Dorog, Labatlan, Tata, Bobolna andKomarom), which at present do not have gas supplies.

2. The installed capital cost r this pipeline is estimated at US$25.1million equivalent, including a con, -tible currency component of US$1.0million equivalent, required for the import of pipeline construction tools andcalibration equipment and instruments. The pipeline is scheduled to beoperational by late 1992.

III. EXPANSION/REVAMPING OF BEREGDAROC GAS COMPRESSION STATION

1. The Beregdaroc compression station is located in the North-East cornerof the country, at the Hungary-USSR border. The station receives importedSoviet gas through the Testeveriseg and Osszefogas pipelines, and compressesthe total gas to pressure levels adequate for transmission through

- 98 -

ANNEX 5-6Page 2 of 5

the existing trunk pipelines to the West and South-West of the country. Thestation facilities were installed in 1976.

2. Physical facilities currently in place include four gasturbine-driven compressors (one of them as a stand-by), gas treatmentfacilities, utilities supply, measurement and overall control systems. Thecapacity of each compressor is about 340 MCM per hour, totalling 1.02 MMCM perhour for the station. Gas imports have increased over the years and hasreached the current (1988) rate of about 0.6 M14CM per hour during sumer days,when imports are higher than in winter days. Although the capacities ofindividual compressors are reduced (derated) by about 10X, due to lower actualgas inlet pressure compared to initial design pressures, the facilities areadequate for the current levels of imports even with only two of thecompressors operating.

3. Domestic gas demand in the country is projected to increase to about14 BCM pe: year by 1993 from the current level of about 12.2 BCM per year.Gas supplies from domestic and imported sources will fall significantly shortof domestic demand during winter months, which is proposed to be filled byimporting larger quantities of gas during summer months and storing them inunderground depleted gas reservoirs for withdrawals during winter months. Gasimports are projected to increase to average rates of 0.89 mmcm per hour by1993 summer months, and to about 0.98 mmcm per hour by year 2000 summermonths, close to the station's current nominal derated capacity.

4. Consistent with the increased imports level, the current stationcapacity will be expanded to eliminate risks of major gas supply interruptionsand to provide operational and maintenance flexibility. The Beregdarocstation currently handles about a third of the total gas consumption in thecountry, projected to increase to over 50 percent of the total by the year2000, and is thus strategically important.

5. An agreement between USSR and Hungary was reached in November 1988 bywhich the Soviet gas supply pressure was increased to about 48 bar from thecurrent level of about 40 bar from end-1988, which will consequently increasethe overall station capacity to about 1.1 MMCM per hour, but still notsufficient to ensure good operational and maintenance flexibility requirementsin the future years. OKGT proposes to change the rotor assemblies of theexisting four compressors, which together with the higher supply pressurearrangements with USSR, will increase the capacity of each compressnr to about0.6 MMCM per hour, sufficient to handle peak import levels till the late 1990swith minimal risks of supply interruptions to domestic markets. Otherinvestment components will include: filter-separators for each compressor;modifications to interstage gas coolers; measurement and controlinstrumentation; telemetry system; and revamping utilities distributionsystems.

- 99 -

ANNEX 5-6Page 3 of 5

6. Total investment has been estimated as follows below: (Ft prices inequivalent US$ x 1000)

Equivalent US$ x 1000Local Foreign Total

(a) Rotor assemblies - 1,264 1,264(b) teed filters & auxiliaries - 316 316(c) Other materials, electricals

and instruments 296 99 395(d) Construction and erection 296 _ 296

Sub-Total 592 1,679 2,271

(e) Contingencies (52) 30 84 114(f) Import duties (25Z) 441 - 441

Installed Cost 1.6 a.76 L

7. The estimate for rotor assemblies are based on firm quotations fromNuovo Pignone, Italy, the suppliers of original equipment, who hadinvestigated the feasibility and proposed the change. Other cost componentshave been estimated by the mission (to be reviewed ad confirmed by CKGT). Theproposed modification will result in improved energy efficiency of compressionthrough reduction in turbine fuel gas consumption from 0.92 of gas volumeturnover to 0.6X. For the projected gas throughput of 7.6 BCM per year by1993, at the Beregdaroc compressor station, the fuel savings amount to 22.8MMCM per year or about rt 102 million per year at imported gas price of Ft4.49 per cubic meter (caloric equivalent of fuel oil at US$100 per ton). Theestimated economic capital cost of about Ft 112 million will thus be paid forin a little over one year. ERR calculations have therefore not been carriedout. The component is expected to be completed in 12-15 months from date ofcontract with Nuovo Pignone for rotor assembly supply. The Bank should haveno objection to this procurement directly from the original supplier.

8. Recent Developments. Recently, OKGT has startaid reviewing thepossibility of a second phase to this expansion. The Bank may also financethe second phase following its review (if satisfactoLy) of a forthcomingfeasibility study.

IV. Expansion of Natural Gas Odorization Facilities

Current System

1. All natural gas transmitted by pipeline and distributed within thecountry, except supplies to chemicals plant and amounts transiting toYugoslavia, is dozed with ethyl mercaptan which imparts a characteristic odorto the gas, enabling easy detect-on in case of any leaks in the transmission

- 100 -

ANNEX 5-6Pagu 4 of 5

system as well as at the consumer end. About 70% of the total gas currentlymarketed is odorized, at 7 main centers and 108 retail distributing nodes.The main odorizing certers serve a limited area covered by the country'spipeline transport network, mainly located on the ring pipeline aroundBudapest, and most of the odorant injection is done at the distribution nodalpoints.

2. Ethyl mercaptan, imported in 200-liter non-pressurized,non-returnable drums is transported to and stored at main centers anddistribution nodes. The odorant is withdrawn directly from the drums andinjected into gas pipelines by locally manufactured Dozelektric units at anaverage rate of 26 cc per cubic meter of gas. About 220 tons of odorant wasconsumed in 1986, costing about US$300,000 equivalent in foreign exchange.

3. The current system suffers from two main drawbacks. First, due topartial separation of the odorant during pipeline transit, additionalquantities of odorant needs to be injected at the farther-out consumptionpoints. Secondly, the current Dozelektric dosage system design gives iise tosignificant fugitive emissions of odorant at the large number of distributionncde injection points which, together with the non-usable empty odorant drums,results in significant pollution problems.

Project Subcomponent

4. A new odorization system has been designed to reduce pollutionproblems, increase system capacity, and reduce overall costs. It will consistof the following: (i) increasing the number of the main centers forodorization from 6 to 14, more spread out in terms of geographic locationaround the country, and relocated at gas transmission pipeline branch pointspermitting more efficient dosage control; (ii) ieducing the number ofdistribution nodes odorizing points from 108 to 67 stations, minimizingpollution effects; (iii) changing the odorant to higher mercaptans (mixture ofpropyl-and butyl-mercaptans), which will not only reduce gas-odorantseparation problems during transmission but also reduce the overall cost ofimported odorant by about 201; (iv) converting the Dozelektric system intoclose circuits, eliminating fugitive emissions of odorant at all dozingpoints; and (v) importing odorant in railway tank-wagons, transporting andstoring at dozing points in larger skid-mounted tanks and modified LPGcylinders, thereby reducing transport costs as well as pollution problems.

5. The expanded facilities will be able to handle odorization of 14 BCMgas, including the option of odorizing also the transit gas to Yugoslavia, ifrequired. Requirements for the expansion facilities will include: (i) onetruck for transporting skid-mounted 21-cubic meter imported odorant containerfrom the leased railroad carrier wagon; (ii) three smaller trucks to transportinland 25-liter odorant cylinders; (iii) new, complete odorization units atthe district centers; (iv) replacement of current Dozelektric units with new

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ANNEX 5-6Page 5 of 5

closed-circuit systems at all distribution nodes (69 nos.); (v) new loadingand unloading pumps (13 nos.); and (vi) 9 nos. storage tanks of capacitiesranging from 2-10 cubic meters.

6. Capital costs for the expansion facilities is estimated at US$2.4million equivalent, including a foreign exchange component of US$0.13 millionequivalent. The expansion and moderaization of the odorizatiorn facilities isprimarily intended to reduce the pollution effects of the curreit system. Thecurrent system's capacity would have to be increased in any case to handleabout 40% increase in gas volumes that need to be odorized by 1995. The newsystem will result in not only expanded dozing system capacity but also inbetter operational control and reduced pollution.

V. MODERNIZATION OF GAS METERING SYSTEM

1. Custor.vr invoicing for gas sales is issentially based on the heatcontent uf delivered gas, as also payments for imported gas from USSR. Gasimports and deliveries are measured by volume meters, converted to standardconditions of temperature and pressure, and unit heat content calculated fromgas analysis or laboratory calorimeters. At present, heating valuedeterminations are carried out infrequently, about once a week, and notroutinely at all receipt and delivery points. Furthermore, volume measurementinstruments are assessed as not accurate, based on spot checks. As a result,the revenue losses/overpayments are estimated at about 12 of total gas handled.

2. The modernization subproject will include:(i) replacement/modification of volume measurement elements to conform to ISOand Hungarian standards, together with installing electro-pneumatictransducers with temperature correction features at selected points; (ii)installation of on-line chromatographs at key locations for gas analysis;(iii) automation of data gathering, transmission, processing and invoicingsystem; and (iv) link-up with the central gas pipeline networktelecommunication system.

3. The capital investment for the subcomponent is estimated atUS$5.5 million equivalent, including a convertible currency component ofUS$1.8 million equivalent for the import of equipment and materials. Byimplementing the subcomponent, OKGT estimates that the revenue underrecoveriesand/or overpaynents for purchased gas will be reduced from the currente-timated 12 on gas volume handled to 0.32-0.52. Even a conservative estimatecf the loss reduction by 252, would translate (on 14 BCM per year gas volumeand Ft 4.47 per cubic meter gas value), to about Ft 156 million per year(US$3.33 million per year). The capital cost would thus be recovered in undertwo years.

-102-

ANNEX 6-1

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION P[OJECT

Estimated Disbursement SchedulesL'

Loan to OKGT Loan to NbHEstimated Schedule Estimated Schedule

As ofFiscal Year Cumulative Z of Cumulative X ofand Quarter Amount Amount Total Amount Amount Total

FY90(II) 3.0 3.0 3 0.1 0.1 1

FY90(IV) 4.0 7.0 7 0.2 0.3 3

FY91(II) 7.0 14.0 14 0.3 0.6 6

FY91(IV) 11.0 25.0 25 0.6 1.2 12

FY92(II) 12.0 37.0 37 0.7 1.9 19

FY92(IV) 15.0 52.0 52 0 9 2.8 28

FY93(II) 14.0 66.0 66 1.4 4.2 42

FY93(IV) 12.0 78.0 78 1.8 6.0 60

FY94(II) 10.0 88.0 88 1.7 7.7 77

FY94(IV) 7.0 95.0 95 1.3 9.0 90

FY95(II) 3.0 98.0 98 0.7 9.7 92

FY95(IV) 2.0 100.0 100 0.3 10.0 100

Based on the EMENA standard disbursement profiles for energy and IDFprojects, respectively, but adjusted to reflect (i) expected retroactivefinancing under OKGT loan, and (ii) experience under first Petroleumprojecz and ongoing energy conservation lines of credit, respectively.

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ANNEX 7-1Page 1 of 3

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

Pipeline and Storage Subprojects - Economic Justification

Gas Storage Subproject

1. The currently operational urderground gas stotage capacity totals1,050 MMCM including: Hajduszoboszlo (800 MMCM); Kardoskut (180 MMCM); andPusztaederics (100 MMCM). The capacity at Pusztacderics field storage isbeing expanded by 100 MMCM, to be completed by end 1988 (outside the Projectcomponeut), taking the operational total storage capacity to 1,150 MMCM by thebeginning of 1989.The current storage facilities at Kardoskut will not beoperable beyond 1990, so that the operable storage capacity from late 1990will decrease to 1,000 MMCM. The Project will rehabilitate and expand thecapacity at Kardoskut to 210 MMCM, expand Hajduszloboszlo and Pusztaedericsfacilities by 600 MMCM and 130 MMCM, respectively, and create new storagecapacity of 500 MMCM at Zsana, resulting in incremental storage capacity of840 MMCM. (In addition, OKGT is also expanding the Hajduszloboszlo reservoirby 600 MMCM, resulting in a total capacity expansion of 1,440 MMCM. Thisfigure is used for the below discussion.) Without the proposed expansion ofstorage capacities, there will be considerable storage of energy suppliesduring winter months, while at the same time being unable to utilize thepotential excess supplies (over demanid) during summer months. Besides theunderground storage, the only other practical alternative for meeting theexcess peak energy demand during winter would be to import and supply liquidfuels (fuel oil/heating oil) in quantities sufficient to meet winter peakswhich corresponds to gas equivalent of 1,440 MMCM. For the liquid fuelsimport option, a total of about 1.17 million tons would need to be imported,stored and distributed during winter. Fourteen of the existing 39 thermalpower stations are designed for gas and liquid (dual-fuel) firing. Suppliesof liquid fuels to these 14 stations can be augmented during winter months, sothat the household and small consumers demand is met exclusively by gas duringwinter peaks. Taking into account the fuel oil storage capacities currentlyavailable at the power stations, and at the refineries, additional fuel oilcapacity of about 0.84 million tons would need to be created to store theincremental fuel oil imports during winter, estimated to cost about Ft 2,740million (about US$58 million). Capital recovery at 8% over 10 years aloneamounts to US$8.6 million per year, or about Ft 3.6 per CM of gas equivalent.The cost of heating the stored fuel oil, at 6% of the heat energy content offuel oil is estimated at Ft 0.3 per CM of gas equivalent, based on fuel oildelivered cost of US$140 per ton and equivalence of 1,230 CM gas per ton offuel oil. The fuel oil handling costs alone is thus estimated at Ft 3.9 per

_ 104 -

ANNEX 7-1Page 2 of 3

CM of gas equivalent, excluding the cost of fuel oil and other storageoperating costs. The price of imported Soviet gas delivered at Beregdaroccompressor station on the border is based on 3-year rolling average price ofMediterranean market fuel oil on caloric equivalence. While the lag effectwill cause the gas price to vary compared to fuel oil spot market price fromtime to time, over the long term the price of gas delivered in Hungary may beconsidered equal to fuel oil price in Mediterranean source market. However,the fuel oil import option will result in additional cost due to transportwhich is estimated at *S$40 per ton fuel oil or Ft 1.61 per CM gasequivalent. Thus, the total incremental cost of fuel oil import option isestimated at Ft 5.5 per C'l, representing the avoided economic cost by theunderground storage option. The economic benefits of each of the fourproposed gas storage subprojects measured against the cost of the next-bestalternative (fuel oil import) is estimated as under. Considering only theavoided cost of fuel oil transport (Ft 1.61 per CM), the estimated ERR are:Pusztaederics III: 53.2%; Hajduszoboszlo: 23.4%; Kardoskut: 24.9%; andZsana VI.1: 13.6%. For the total avoided cost of Ft 5.5 per CM of gasequivalent, the ERR for Zsana VI.1 (relatively the worst among the four) isestimated at 54.6%.

Pipeline Projects

2. The economic benefits of the investments in the Endrod-Varosfold andPilisvorosvar-Gyor pipelines cannot be directly estimated, in the absence ofany other alternative for gas transport. However, the ERR has been calculatedfor a range of notional revenues to compensate for the capital and operatingcosts of each pipeline, the notional revenues expressed in terms of charge forunit gas volume transported and supplied to consumers. The graph below showsthe ERR as a function of notional revenues.

HUNGARY -Go Plpeline

1~ ~~ __ _ ____________ _

10

010

.e- . .-- o.1 s 6;5

o~~~~~~t or cf _e._ _

- 105 -

ANNEX 7-1Page 3 of 3

Other Subproiects

3. The capital investment in debottlenecking the Beregdaroc compressorstation is estimated to be recovered in about one year of operation, and thatin modernization of gas metering is about two years. No ERR analyses havebeen carried out for these subprojects. Since the benefits issuing from theinvestments in the modernization of telecommunication system, telemetrysystem, and natural gas odorization system are not quantifiable, no ERRanalyses have been carried out for these subcomponents.

Hk 'GARY t *

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