Inter Market Perspective

Transcription

1 Inter Market Perspective Research Entity Number REP Pakistan Energy Demise of furnace oil is underway; outlook not entirely negative We think concerns over FO demand for power and its repercussions for Energy sector are valid. The decline in FO demand will accelerate hereon, and potentially more than halve by While OMCs and 2002 policy IPPs will be most negatively affected, the future of Refineries will not be as bleak as seen in the recent episode, in our view. With reduced Target Prices, we maintain Buys on PSO, APL, HUBC and NPL. Amidst a massive influx of new power capacities, we think Gencos and inefficient IPPs will shut down beyond FY18. In the long run, it will be in the country s interest to sustainably use 1,000MW of the existing FO plants. Most efficient FO based IPPs (incl. NPL & NCPL) will thus continue partial operations beyond 2021, in our view. PSO will see steepest earnings decline in coming years amid ultimate phase out of FO imports, albeit with a significantly improved cash profile. HASCOL and APL have the kind of FO customers that are least affected in the present scenario. Refineries will be supported by GoP (ensuring minimum 1,000MW of FO based power), in order to sustain reliable supply of other fuels in the country. FO demand collapse is real and imminent The recent episode of GoP ordering abrupt shut down of FO based power plants confirms that power demand growth has not kept up with the influx of new power capacities in Pakistan. As such, the sheer amount of new power plants (~16,000MW) being added during FY19-23F can more than replace the 3,600MW of expensive FO generation. Therefore, we expect FO based generation to decline by ~20% in FY18, and decline by more than a half by FY21, making way for much cheaper new hydel/coal/lng based plants. However, we assume that the GoP will support local refineries and maintain FO based generation at a level that absorbs c. 3m tons of their FO output (1,000MW). Risks include higher oil prices and inadequate transmission capacity to absorb the surge of new power, in which case GoP will have to ration FO based generation more strictly, in our view. Most efficient plants will survive but with lower dividends The most inefficient FO based generation (fuel efficiency below 35%) will be axed first, in our view. These include state-owned Gencos, Lalpir and Pakgen Power among the IPPs, which sum to about 1,200MW of power generation Policy plants (incl. HUBC base plant) will see sub-60% utilization during FY19-21 and may be utilized only minimally (<30%) thereafter. However, GoP will still have to honor their capacity payments. The situation is most negative for NPL and NCPL, because their O&M/fuel savings will dwindle amid low utilization levels. However, they can maintain dividends of PRs2.0/sh in the worst case. The 1,000MW FO-based generation, that we estimate will remain beyond FY21, will represent only the most efficient plants (details inside). PSO will be the most affected OMC We expect FO sales by OMC to fall from 9.6mn tons in FY17 to 7.8mn in FY18 and ultimately 3mn tons FY21 onwards. In the face of declining demand, PSO will be the most negatively affected OMC; because it imports 70% of the FO consumed in Pakistan these will be adjusted first. Secondly, bulk of its power sector sales go to Gencos and 1994 Policy IPPs, not to the most efficient ones that will outlast this scenario. In contrast, customers of APL and HASCOL either come in the latter category or are non-power sector. Refineries will require GoP support Oil refining in Pakistan has long been a GoP supported sector. For instance, it will not remain viable without the deemed duty on HSD. Keeping them running is of national interest, in our view. Besides maintaining a minimum level of diesel/petrol supply, Pakistan saves ~ US$2.0bn of FX at c. US$50/bbl. Also, Attock Refinery consumes half of Pakistan s indigenous crude oil. What about circular debt? Two things are worth considering. First, replacing FO based generation will not completely alleviate circular debt from the power sector not without privatizing discos and addressing other structural frailties. Second, with most FO based plants not running, honoring their capacity payments will be cumbersome for any government that tends to maintain twin deficits (not to forget the huge stock of outstanding dues). ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 13 & December 2017 Muhammad Saad Ali, CFA saad.ali@imsecurities.com.pk Abdul Samad Khanani abdul.samad@imsecurities.com.pk Ailia Naeem ailia.naeem@imsecurities.com.pk Revised IMS estimates PRs/sh. HUBC Buy FY18F FY19F FY20F TP New EPS Old EPS Change -1% -1% -7% -3% New DPS NPL Buy FY18F FY19F FY20F TP New EPS Old EPS Change -7% -7% -5% -22% New DPS NCPL Neutral FY18F FY19F FY20F TP New EPS Old EPS Change -3% -6% -5% -31% New DPS PSO Buy FY18F FY19F FY20F TP New EPS Old EPS Change -6% -10% -13% -11% New DPS APL Buy FY18F FY19F FY20F TP New EPS Old EPS Change -1% -1% 0% 1% New DPS HASCOL U-R FY18F FY19F FY20F TP New EPS UR Old EPS UR Change -2% -6% -6% To find our Research on Bloomberg, please type - IMKP <GO>

2 Overview Amidst a foreseeable surplus of power capacities and GoP policy, furnace oil based power demand is set to decline steeply to make way for cheaper power generation. We expect FO based generation to decline by ~20% in FY18, and potentially more than halve by FY21. In the long run, we expect that GoP will maintain about 1,000MW of FO based power generation, as a policy. Gencos and inefficient IPPs (PKGP, LPL) will be shut down after FY18, in our view. Other IPPs (HUBC base, KAPCO) will see declining offtake; most efficient IPPs (NPL, NCPL) will remain relevant beyond FY22, though at sub-optimal utilization. PSO will be most affected OMC given the lion s share in this market. APL and HASCOL will see slower decline in sales as their customers will be less affected by GoP policy. Refineries will be supported by GoP, in our view, in order to maintain reliable supply of other fuels in the country and contain import burden. Higher oil prices and inadequate new T&D capacity to support new generation are risks to our thesis, in which case FO generation could fall more steeply than projected. For IPPs that are shut down, timely capacity payments will be a risk, in our view, notwithstanding GoP's contractual obligations. IMS Projections FY17A FY18F FY19F FY20F FY21F FY22F FO based power MW 3,569 2,936 2,038 1,816 1,452 1,139 OMC FO sales K tons 9,599 7,821 5,553 4,994 4,229 3,297 Source: OCAC, NEPRA, IMS Research HUBC: Operating under 1994 policy, the base plant's contribution to the earnings (~70%) will remain immune to lower dispatch factor. We don't forecast a major decline in dispatch factor of the efficient Narowal power plant during FY18F/FY19F. NPL, NCPL: Being efficient, they stand to lose as utilization levels will be consistently much below 80% in future (FY18-22 avg. 65%). But they may keep generating beyond FY21 if GoP policy is to maintain ~1,000MW FO power in the long run. LPL, PKGP: Inefficient and may not generate at all beyond FY18, but that is earnings positive for them insofar they get timely capacity payments from the power purchaser. PSO: Will see steepest earnings decline but cash flows will improve significantly. We foresee rerating of a much leaner and cash-based company. APL: Least affected OMC courtesy refinery integration and bulk of FO sales to Attock Gen, an efficient IPP high on the priority list of FO generation. HASCOL: Also an importer, so will see decline in sales. But it was gearing towards other fuels before this event. Will have excess FO storage capacity, which can be lent to others. Refineries: GoP should support this sector, as demand for other fuel have not waned and imports burden needs to be considered. The North of the country is especially most vulnerable to shortages. 2 P a g e

3 Generation mix by fuel (FY17 vs FY21F) 6% 23% 10% 30% 30% Hydel Coal FO 1% Gas RLNG Others 18% 14% 8% 6% 26% 28% Hydel Coal FO Gas RLNG Others Source: IMS research, NEPRA FO based generation set to decline but stabilize beyond FY21 MW 4,000 3,500 3,000 2,500 2,000 1,500 1, FY16 FY17 FY17 FY21F Cumulative power capacity additions & surplus - deficit MW 18,000 17,000 16,000 15,000 14,000 13,000 1,320 3,689 5,009 FY18F FY19F 7,649 FY20F 10,559 FY18F FY19F FY20F FY21F FY22F FY21F MW 12,000 10,000 8,000 6,000 4,000 2,000 Capacity additions - Rhs Demand Supply IMS research, NEPRA - FY22F FY23F FO will be relegated to an alternative fuel for power The mix of future power supply in Pakistan Until end of FY17, Pakistan generated 107,070GWh of electricity (12,000MW; excluding K- Electric); however it had an existing installed capacity of ~24,000MW. Bulk of the power supply came from hydel plants, followed by thermal plants (FO and gas) and little from Nuclear and other renewable sources. Ministry of Power reports line losses of about 17% (partly responsible for the demand deficit and blackouts in the country). Thermal sources are expensive due to hefty imports and chronic gas shortage. Other constraints affecting full utilization of existing capacities include sporadic water availability for hydel plants, infrastructural shortcomings with existing power T&D network oft-cited to be incapable of supplying more power, and lastly cash-flow constraints (circular debt). Between FY17-23, planned power projects are expected to add cumulative ~16,000MW to the grid, at a weighted average tariff that would be approximately 50% lower as compared to FO based generation, by our estimates. These include potential hydel based and several coal based plants under the CPEC (see Table below). Upcoming power projects Projects Name MW Fuel COD SSRL Mine Mouth 1,320 Local Coal CY18 Port Qasim Electric Company Coal Fired 1,320 Imported Coal CY18 Tarbela Ext 4 1,400 Hydel CY18 Neelum Jhelum 969 Hydel CY18 Engro Thar 660 Local Coal CY19 Lucky Electric 660 Local Coal CY19 Siddiqson 350 Local Coal CY19 Sachal Wind Farm, Jhimpir, Sindh 50 Wind CY19 HUBC (CPHGCL) 1,320 Imported Coal CY20 HUBC (Thar mine mouth) 330 Local Coal CY20 ThalNova Power Thar Ltd 330 Local Coal CY20 Thar Coal Block Power Generation Company Ltd 1,320 Local Coal CY20 Karot Hydropower Station, AJK & Punjab 720 Hydel CY21 Suki Kinari Hydro power Station, KPK 870 Hydel CY21 Dasu Dam 4,320 Hydel CY22 15,939 Source: CPEC official website 1,000MW FO based generation compulsory We expect FO based generation will decline by 20% YoY to ~3,000MW in FY18. The recently commissioned 1,320MW Sahiwal coal power project operated at a utilization level of 55% during 4MFY18, while the 3,600MW RLNG based plants operated at 30% utilization level. With additional LNG terminals being added leading to higher utilization of these LNG based plants, coupled with commissioning of 1,320MW of Port Qasim coal based plant, FO generation is set to decline further during 2HFY18. Thereafter, additional coal based plants (6,000MW) and hydel based plants (8,000MW) will accelerate the decline until FY22. FY24F FY25F FY26F FY27F Inefficient plants to phase out first; most efficient one will remain MW 3,500 3,000 2,500 2,000 1,500 1, , FY17 FY18F FY19F FY20F FY21F FY22F Pakgen, Lalpir and Gencos HUBC Base Plant NPL, NCPL and Narowal KAPCO RFO 3 P a g e

4 Merit Order: list of priority of power dispatch FO based IPPs Capacity (MW) Utilization - FY17 Liberty % KAPCO - I % NCPL % NPL % Attock Gen % Atlas Power % KEL % Narowal % Lalpir % KAPCO - II % Pakgen % Saba % HUBC 1,200 63% Gencos 2,273 40% Total 6,680 53% Source: NEPRA Dispatch Factor - NPL 100% 80% 60% 40% 20% 0% 72% 72% FY17 80% 79% 78% 77% 76% 75% 70% 70% FY18F FY19F Dispatch Factor - NCPL 100% 80% 60% 40% 20% 0% 76% FY20F Dispatch Factor - Old Dispatch Factor - New 50% 50% FY21F FY22F 80% 79% 78% 77% 76% 76% 75% 70% 70% FY17 FY18F FY19F FY20F Dispatch Factor - Old Dispatch Factor - New 50% 50% FY21F FY22F NTDC s Merit order decides the priority of power off take based on least cost and it will also determine which plants go out between FY19-21 and which ones remain until the end. Henceforth, the FO based generation may likely decline from 3,500MW in FY17. However, even with cheaper generation capacity available we rule out complete and abrupt shut down of FO based power plants. The decision to do so may adversely impact the local refineries, resulting in fuel crisis in the country. We assume FO based generation to stay at least 1,000MW beyond FY21 in order to maintain demand for the 3mn tons of FO produced by refineries in Pakistan. Transmission bottlenecks to worsen the FO based situation Transmission bottlenecks in the system may likely result in demand-supply gap to continue despite generation supply surplus. This could mean greater curtailment of FO based generation than what is necessary. We highlight, Lahore to Matiari transmission line (capable of transmitting 4,000MW) is expected to come online in FY19. Till then, however, the new coal capacities in South may largely risk lower dispatch from HUBC s base plant, in our view. Who gets a fair share of the pie? FO based generation may be axed to one-third beyond FY21, but the dispatch factors from all IPPs are unlikely to go down in a linear fashion. We expect the FO based generation from IPPs to be a function of merit order and transmission network ability. GENCOs, Lalpir and Pakgen Power, contributing 1,200MW of generation at 42% utilization levels may be the first to phase out beyond FY18. NPL and NCPL are less likely to face the brunt of complete shutdown, given they have been consistently near the top on the dispatch order. KAPCO, with dual fuel engines, may potentially shift to RLNG based generation, given new LNG terminals materialize. In this regard, the current supply of 600mmcfd is enough to generate about 2,500MW (assuming 70% utilization of the 3 RLNG based power plants). Nishat IPPs: Being efficient will make them count We incorporate lower dispatch factors for NPL and NCPL (5 year avg. 65% vs 80% earlier) in our assumptions, which may result in 3yrs earnings to decline by 5-7% for NPL and NCPL respectively. Downward revision in dispatch factors reflects significantly in earnings because this would mean lower fuel and O&M cost savings for the two plants. Note that 70% of O&M payments to IPPs under 2002 Policy (NPL, NCPL and HUBCO Narowal) are derived from Variable O&M payments, which are function of their dispatch factors. For NCPL, the decline in profits will be lower than NPL, as it is heavily reliant on short term borrowing for fuel needs; thus lower dispatch may also result in potential savings from lower or no financing. The plants are expected to operate at 60%-70% utilization till FY21. We anticipate dispatch factors of these plants to take a major hit and operate at 50% beyond FY21, as new coal and hydel based capacities begin operating full fledge. Our new TP for NPL and NCPL are PRs39/sh and PRs31/sh respectively, which warrant a Buy for NPL. We also highlight that even with 0% utilization rate, these plants should maintain dividends of PRs2.0/sh insofar government honors the capacity payments in a timely manner, in this scenario. This would emanate from the ROE component in their tariff, which are not affected by their utilization levels. Financial Estimates for Nishat twins NPL (PRs) FY17A FY18F FY19F FY20F TP New EPS Old EPS Change - -7% -7% -5% -22% DPS NCPL (PRs) FY17A FY18F FY19F FY20F TP New EPS Old EPS Change - -3% -6% -5% -31% DPS Source: Company Accounts, IMS Research 4 P a g e

5 Dispatch Factor - HUBC base plant 80% 60% 40% 20% 0% 65% 67% 67% 67% 67% 67% 65% FY17 67% 67% FY18F 1,800mmcfd of LNG may add to the system Potential LNG terminals FY19F 53% FY20F Dispatch Factor - Old Dispatch Factor - New Dispatch Factor - HUBC Narowal 80% 60% 40% 20% 0% 45% 40% FY21F FY22F 71% 71% 70% 69% 68% 67% 71% 65% 65% FY17 FY18F FY19F 50% 50% 50% FY20F Dispatch Factor - Old Dispatch Factor - New FY21F FY22F Capacity Fatima Group, Shell Gas BV, Gunvor Group Ltd and Engro Elengy Terminal Ltd 600 Lucky Group, Sapphire and Halmore 600 PakGas port and Fauji Foundation 600 Total 1,800, News reports LPL/PKGP: Imminent shutdown; timely capacity payments is a risk Given capacity surplus in the system, complete shutdown of Pakgen and Lalpir power plants cannot be ruled out as they are among the most inefficient IPPs (fuel efficiency ~35%). Being inefficient, Pakgen Power and Lalpir Power faced fuel losses of PRs2.02/1.89 per share while operating at an average utilization levels of 53/50% in CY16. We flag that in effect, the plant closure may result in positive impact on the earnings and payout ability. However, we highlight that any upside in their earnings and dividends depends upon timely capacity payments, which is a risk. Note that NTDC has failed to clear outstanding receivables of IPPs (reportedly at PRs205bn). Also recall, despite London Court of International Arbitration (LCIA) deciding in favor of IPP s demand of PRs14bn in Jun 18, the issue still remains unresolved. HUBC: Least affected and many safe attributes The dispatch factor for HUBC base plant will likely bear the brunt of transmission bottlenecks in the immediate term. Also, being a relatively low efficiency plant (~38% vs ~46% for NPL and NCPL), the dispatches from HUBC base plant will likely face a steep decline towards FY21 and become minimal until its PPA expiry in FY27. However, the earnings decline comes from downward revision in Narowal (fuel efficiency of ~46%). It is worth mentioning, however, Narowal presently contributed 20% to HUBC s FY17 consolidated earnings which will shrink to 13% following the commissioning of ongoing expansion projects. Our new earnings for FY18/19F therefore do not reflect major downward revision. Our new TP for HUBC is PRs146/sh, offering an upside of 56% and dividend yield of 9%. Risk will be (i) delays in capacity payments at a time when they need financing for the expansion projects and (ii) dividend cuts. HUBC (PRs) FY17A FY18F FY19F FY20F TP New EPS Old EPS Change - -1% -1% -7% -4% DPS Source: Company Accounts, IMS Research KAPCO: Likely conversion to LNG until PPA expires Capacity payments likely to continue for operational plants: KAPCO has ~900MW of multi fuel fired gas turbines, and ~400MW of steam turbines, organized into three blocks. The plant ran at 65% utilization in 4MFY18, with gas based generation contributing onethird of that. Being under 1994 Power policy, KAPCO s bottom line remains immune to decline in dispatch factor (i.e. little impact on earnings), given GoP honors the capacity payments. Being multi fuel power plant and having the ability to immediately switch to LNG improves KAPCO s chance of continued capacity payments, enabling it to sustain its dividend stream. New LNG terminals to improve gas availability for KAPCO: We highlight that (i) any additional LNG terminals or (ii) technical glitches in 3,600MW RLNG based power generation may result in greater gas availability for KAPCO. Currently, two to three 600mmcfd LNG terminals are under consideration. Note that, KAPCO has corrected 30% in 3M, even though it maintained its historical payout of 90% in FY17 with a dividend of PRs9.05/sh while payouts of NPL, NCPL and HUBC were under pressure. Better gas availability and any new Gas Supply Agreement may bring the scrip in limelight, in our view. 5 P a g e

6 Significant decline in OMC sales FO has been a major component of OMC sales Power sector is the largest consumer of petroleum products after Transport. This is because most large power capacities which emerged in the 1990s were based on furnace oil (FO), at which time international oil prices was not thought to be a big concern. FO has been fueling over 30% of the power generation in Pakistan, a share which has been growing since early 2000s amid uninhibited decline in indigenous gas reserves and limited hydel capacity. It is therefore the largest petroleum product by sales in Pakistan. Of late, this has been checked by LNG supply and new capacities. But, given oil prices above US$100/bbl and the country importing 70% of its FO demand, this was not a sustainable policy. It often led to almost insurmountable macros issues balance of payment and fiscally the circular debt. As a result, GoP drew public and private investment towards setting up of new power capacities on cheaper and indigenous fuel sources (LNG and coal). These plants have started coming online in 2017 and the future planned capacities will be enough to replace the existing FO generation, albeit in a phased manner. FO volumes to shrink as share of total OMC sales (mn tons) Power sector FO sales to see steep decline (mn tons) F 2019F 2020F 2021F 2022F F 2019F 2020F 2021F 2022F FO Volumes Total Volumes FO sales to Power Sector Other Sectors Source: OCAC, IMS Research Source: OCAC, IMS Research New Assumption of FO Volumes (k tons) F 2019F 2020F 2021F 2022F Industry 9,263 9,000 9,599 7,821 5,553 4,994 4,229 3,297 PSO 6,174 6,343 7,014 5,416 3,365 2,818 2,506 1,614 APL 1, HASCOL Shell Others , OCAC Furnace oil imports to come down significantly (mn tons) Refinery FO production F 2019F Imported FO 2020F 2021F 2022F Product mix of various OMCs (FY17) 100% 80% 60% 40% 20% 0% Industry PSO APL Shell Hascol FO HSD MS Jet fuel Lubes Others Source: OCAC, IMS Research 6 P a g e

7 PSO has had the lion s share; hence it stands to lose the most PSO dominates the FO market with c. 75% market share. This is because of several structural reasons: (i) being state owned, it is the sole supplier to govt owned generation companies (Gencos), (ii) it has exclusive fuel supply agreements with the largest FO based plants which emerged in the 1990s, and (iii) for years, only PSO has had the financial muscle to import petroleum products in Pakistan while FO had a large deficit. Despite refinery integrations with PRL and Byco, PSO s FO relies mostly on imports, which will decline drastically in future. Even if PSO improves refinery offtake to offset lower imports, most Gencos and IPPs that PSO supplies are low on the NTDC Merit order list; hence they will be axed first. Having said that, PSO would continue to be the preferred supplier of imported FO, in case of power demand seasonally exceeding supply. Other OMCs will benefit relatively speaking from the overall decline in FO volumes, because they had earlier experienced shrinking FO sales which were becoming more concentrated. Importantly, their customers majorly comprise of the leftover FO demand. As a result of gradual post phase out of FO, we think PSO s market share will shrink towards c. 45% in the long run, all else the same. Other OMCs however are diluting the PSO s infrastructure advantage. We believe OMCs who have higher refinery integration would continue to see rise in their market. We highlight APL, Total-Parco and Byco to be the key beneficiaries where their FO market share would grow to 18%, 13% and 10% from 8%, 5% and 4% respectively. FY10: PSO dominated FO market share FY17: 2002 Policy plants reduced PSO s share FY22F: PSO to lose big in a smaller market 4%2% 5% 9.23 mn tons 1% 7% 6% 13% 9.60 mn tons 31% 3.30 mn tons 49% 89% 73% 8% 12% PSO APL Shell Hascol Others PSO APL Shell Hascol Others PSO APL Shell Hascol Others Long-term utilization of FO plants FO Dep based capacity Plants LT Supplier Gencos 2,273 0% PSO KAPCO 783 0% PSO HUBC 1,200 30% PSO Kohinoor % PSO Lalpir 350 0% PSO Pakgen 349 0% PSO Saba 126 0% Hascol, Others Attock Gen % APL Atlas % APL and Others NPL 195 APL, Hascol and 50% Others NCPL % Others HUBC Narowal Liberty % Source: NEPRA, IMS Research % Others Hascol, APL and Others What kind of FO sales is 1,000MW equivalent of? With additional coal and hydel capacities coming online in next 3-5 years, we believe FO based power generation would eventually be curtailed down to the extent that locally produced FO is fully consumed, which is equivalent to about 2.9mn tons p.a., implying c. 1,000MW of sustainable power generation on FO, beyond While power sector would only consume c. 1.8mn tons of that, rest of the demand would come from other industrial sectors like cements, textiles and chemical sectors for their captive power needs. This would keep the wheel moving for local refineries without disrupting their supply of other petroleum products. While enforcing generation from expensive FO would amount to subsidizing the refineries, we believe the costs of importing other petroleum products could be much larger otherwise. Hence, Pakistan s FO consumption will bottom out at c. 3.0mn tons per annum, in our view. Risk to our thesis will be oil prices so high in future such that demand from industries will evaporate. 7 P a g e

8 Margin/ton on key OMC Products Margins are lowest on FO (PRs) MS HSD FO FY14 3,031 2,223 2,133 FY15 3,153 2,662 1,460 FY16 3,194 2, FY17 3,275 2,880 1,170 FY18F 3,413 3,001 1,287 FY18F GMs % 4.8% 4.6% 3.5% Source: OCAC, IMS Research APL has highest refinery integration K tons FY14 FY15 FY16 FY17 ATRL FO Production NRL FO Production APL FO Sales 915 1, APL's share of 96% 122% 83% 85% Refineries Source: OCAC, IMS Research PSO will initially be a net loser; but LT benefits should override Major earnings decline due: FO contributed 30% on average to PSO s gross profit between FY12-17; this will shrink to 7% by FY22F, going by our estimate of industry s FO volumes. As a result, our FY18/19F estimates fall by 6%/10% to PRs48.24/ FO used to be the highest margin product given margins of up to 3.5% of ex-refinery price (not recently after the oil price plunge since FY14). The decline in FO profits could have been moderated by the commensurate decline in finance costs (FO entails significant borrowing courtesy circular debt); however, the offsetting effect is modest because PSO has significant foreign currency borrowings (FE-25) at low interest rates and partially protected from exchange rate volatility. Earnings volatility will increase hereon: Looking ahead, PSO s profits will become more vulnerable to oil price volatility and thus inventory losses because of lower FO margins, due to heavier share of petrol and diesel in its revenue. Also, FO has a natural hedge to the exchange rate because of deregulation and biweekly pricing; PSO can pass on the impact of exchange losses in FO prices. With lower FO sales, PSO s exposure to exchange rate gyration will also increase earnings volatility. Could it be a blessing in disguise? We think so. FO has also been the central cause of PSO s biggest problem, circular debt. Lower FO sales would mean more cash sales and lower exposure to the power sector (this development will not materially affect the structural frailties in that sector given the substitution to LNG and imported coal, in our view). More cash earnings would give PSO the leverage to choose its own course enter new growth markets, challenge competition more assertively, invest in branding and explore opportunities for vertical integration (in refining, for example). However, we are mindful of the significant outstanding balance of circular debt (over PRs250bn). Lower significance in power sector could affect their bargaining power with GoP for the settlement of this large amount, in our view. Nonetheless, despite steep earnings decline for a few years, PSO could be in for a major rerating. It has historically traded at as high as 35% discount to market multiples because of its exposure to circular debt and meager payouts. Both of these factors can change materially (payouts are already on the rise). We have a Buy stance on PSO with a new TP of PRs390/sh (41% potential upside). PSO FY17A FY18F FY19F FY20F TP (PRs) New EPS (PRs) Old EPS (PRs) Change - -6% -10% -13% -11% New Volumes (k tons) 7,014 5,416 3,365 2,818 Old Volumes (k tons) 7,014 6,565 5,799 5,763 Source: Company Accounts, IMS Research APL is relatively immune to steep decline in FO sales APL stands to be the least affected OMC where decline in FO sales would not be as acute as for the overall industry or PSO. Reasons include: (i) integration with group refineries which are expected to maintain their current sales, (ii) exclusive supplies to Attock Gen which is one of the most efficient FO based plant as per the Merit order (half of its FO sales to this related party), and (iii) significant sales goes to non-power sector customers in Punjab. We believe APL, which currently sells c % volumes of its group refineries, would enjoy higher market share once imports are curtailed. We estimate 50% of APL s FO volumes go to Attock Gen an 156MW group IPP, which also stands highest on the Merit Order list which would ensure first priority to APL s FO sales in the market. Moreover, APL s diversified product mix (include products like Bitumen and Lube oils) has least reliance on FO in terms of profitability. Even in case of no FO sales, our EPS estimates drop by 10%. 8 P a g e

9 APL FY17A FY18F FY19F FY20F TP (PRs) New EPS (PRs) Old EPS (PRs) Change - -1% -1% 0% 1% New Volumes (k tons) Old Volumes (k tons) Source: Company Accounts, IMS Research HASCOL s import based model to be tested HASCOL which has recently become the second largest OMC by volumes relies mostly on imports. Though HASCOL enjoys refinery integrations with PRL and Byco, we believe heavy reliance on imports, lack of balance sheet strength, PSO s strategic position as a state entity and uncertainty from seasonal FO demand would keep HASCOL at a distance in gaining higher FO market share. Though HASCOL derives most of its profitability from retail fuel HSD/MS, imminent decline in FO sales contradicts the view of building additional FO storage capacities, in our view. FO constitutes c. 25% of HASCOL s volume, if removed completely, would have an earnings impact of c. 12% on CY18F EPS and 7% on overall valuations, in our view. It may be possible that HASCOL monetizes its excess FO storage to lend to refineries or other OMCs running out of storage in lean periods. HASCOL CY17A CY18F CY19F CY20F TP (PRs) New EPS (PRs) UR Old EPS (PRs) UR Change - -2% -6% -6% New Volumes (k tons) Old Volumes (k tons) Source: Company Accounts, IMS Research HASCOL Storage Facilities under construction Sr. No. Location Province HSD (tons) PMG (tons) Furnace Oil (tons) Total Product Capacity (m.ton) 1 Hub Balochistan 49,500 1,000-50,500 2 Thallian Punjab 32,000 36,000-68,000 3 Machike B Punjab 34,000 46,000-80,000 4 Kotla Jam Punjab 5,100 4,500-9,600 5 Shikarpur Extension Sindh 10, ,400 6 ZY CO Extension Sindh ,000 Grand Total (Under Construction) 131,000 87,500 6, ,500 Source: Company presentation 9 P a g e

10 Refineries will keep getting GoP support FO make up for c. 30% of industry throughput Refineries in Pakistan have a combined capacity of 18.9mn tpa and annually produce about 2.9mn tons of FO, which is c. 30% of the country s annual FO consumption. Importantly, Pakistan refineries are predominantly simple hydrocracking refineries i.e. they are not complex enough to process low value added products like FO and Naphtha to more value added ones like middle distillates (diesel, gasoline, kerosene) or petrochemicals. However, recently commissioned Isomerization unit converts Naphtha to Motor Gasoline. NRL has been superior in this regard as it has a Lube refinery and can convert FO to lube base oil, asphalt and other non-energy products. Also, refineries have fixed storages of each product they produce. Recent episode of GoP closing down FO plants created a disruption among local refineries, as FO storage capacities were almost full and they had to resort to low utilization levels to contain production of unwanted FO. The situation was compounded by PSO having imported six cargoes of FO in anticipation of peak demand ahead of elections in The problem was reportedly most acute for Attock Refinery, which cannot process FO further (unlike National Refinery) and was running out of FO storage. Though GoP has directed partial resumption of FO plants in Dec 17, which would draw down their FO inventory, but this episode would likely repeat in future particularly in low demand periods. But, the problem will not be as acute for local refineries because now imports will fall substantially. Refinery Size by capacity (in mn tons) FO contribution in local production 12% 10% 17% 12% 24% 18.9 mntons 38% 2.89 mntons 21% 14% 2% 24% 14% 3% ATRL BYCO ENAR NRL PARCO PRL Source: OCAC, energy year book & IMS Research ATRL BYCO ENAR NRL PARCO PRL Source: OCAC &IMS Research Sector is already protected by GoP Refining sector will not be viable in Pakistan without government support. They are inefficient by global standards because plants are old and of primitive technology. For instance, a major contributor to their profitability is the deemed duty on HSD (previously GoP had placed such duties on other petroleum products as well, the removal of which significantly diminished their profitability). Most refineries run at full capacity due to perennial demand deficit for petroleum products. Also, growth in demand in the past decade has not been reciprocated by new refining capacities in the country (presumably due to lower GoP support than in early 2000s). Further, Pakistan imports Arab Light crude oil which is of a heavy quality (i.e. it produces high quantity of FO and less middle distillates like gasoline). Upgrading the refineries i.e. adding units to process unwanted FO into other more useful products - will entail hefty outlay (recent Isomerization and Desulphurization projects cost US$ mn per refinery), notwithstanding construction period. Hence, existing refineries will be allowed to continue producing FO in order to run at near full capacity and ensure maximum supplies of petroleum products, in our view. 10 P a g e

11 Significant importance from BoP perspective Keeping local refineries running is of paramount importance. Pakistan saves c. US$2bn of FX at US$50/bbl oil prices, if refineries continue their operations. Also, not utilizing local refineries will dissuade indigenous oil production by local E&Ps (who are becoming less risk averse and tapping more risky territories in the country in search of hydrocarbons), who may have to export the crude oil possibly at compromised prices. If Pakistan is on course to set up its first Naphtha cracker, local refining production will have to remain healthy. Thus, notwithstanding the attached costs, local refineries are of significant economic importance. GoP allowing resumption of FO based generation in December is a testament to our claim that GoP will keep supporting the Refining sector. Refineries are better off if they operate (all figures in US$mn) FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 Value of Refinery Output 5,516 6,874 7,646 8,644 9,430 6,979 4,121 4,956 Value of Crude Input 5,331 6,783 7,596 8,675 9,328 6,692 3,904 4,525 Net Gain/Loss (31) Local Crude Consumed 1,612 2,034 2,465 2,664 3,035 2,132 1,146 1,508 Total FX savings 1,797 2,126 2,515 2,632 3,138 2,419 1,363 1,939 Source: PBS, OCAC & IMS Research Short-term remedy could be new storage capacities Besides upgrading refinery product slates, which could turn to be a costly move, refineries would need to manage their FO based inventories on account of more seasonal power dispatches. Recent episode suggests that low demand months like Nov-Feb, may continue to witness greater shutdowns of FO based capacity. However, the recent shut down was just for a month, we believe magnitude of such events would continue to heighten, going forward. While we expect refineries will fulfill most of the FO demand in the longer term, we believe inventory management along with more working capital requirement and building more storages could be upcoming challenges for the local refineries. Storage Capacity of Refineries (metric tons) ATRL BYCO NRL PRL PARCO TOTAL HSD 20,700 66,000 32,000 18,196 55, ,596 Days Sales HSFO / LSFO 45,400 28,000 34,000 19,842 34, ,242 Days Sales MS 17,400 13,900 4,500 8,499 16,300 60,599 Days Sales 149 2, NAPHTHA 20,200 30,500 33,500 17, ,400 Days Sales LPG ,276 3,266 Days Sales JP-1 11,000-5,800 2,478 15,800 35,078 Days Sales JP-8 2,500-3,000 2,296 4,000 11,796 Days Sales CRUDE 91, , , , , ,900 GRAND TOTAL 217, , , , ,676 1,476,369 Note: PARCO storage shown above does not include storages at Korangi, Faisalabad, Machike & Mehmood Kot totaling 165,100 M.Tons. Source: OCAC, Refineries 11 P a g e

12 Risks worth considering Perspective Circular debt will not go away but build up should slow We do not think that gradual reduction of FO based generation will alleviate the problem of circular debt from the energy sector, even if costs per unit of FO diverges widely from coal and natural gas. The key to this assumption is LNG, which will not only replace FO in power generation but gradually also natural gas, so IPPs will still be consuming expensive gas. Secondly, unless structural issues of the power transmission and distribution network are addressed, there will always be inadequate T&D network, line losses and nonrecoveries. Thus, privatization of power discos and turnaround stories like K-Electric are prerequisite. Transmission network frailties and delays It is crucial to note that the influx of new power ought to be supported by similar quantum of new T&D capacities because the existing network may not be able to take on greater load. As such, government will have to ration FO based generation more strictly and thus our assumption of minimum FO based generation may not hold true. Higher oil prices will accelerate the substitution. The higher the oil prices the more the government will be discouraged to maintain FO based generation. Only theoretical guarantee for capacity payments As highlighted above that it will be fiscally cumbersome on the government to pay the capacity payments to IPPs which are no longer generating power. We estimate GoP annually pays between PRs60-100bn of capacity payments to FO based IPPs, which broadly are growing at the rate of the exchange rate. However, it is possible that the government passes on this burden to the consumers by imposing a surcharge in the power tariff. GoP s ability to make these payment will be tested when repayments of CPEC related projects become due beyond FY21. Nonetheless, IPPs are protected by sovereign guarantees and can use international arbitration to ensure that GoP meets its commitments. 12 P a g e

13 We, Muhammad Saad Ali, CFA, Abdul Samad Khanani and Ailia Naeem, certify that the views expressed in the report reflect our personal views about the subject securities. We also certify that no part of our compensation was, is, or will be, directly or indirectly, related to the specific recommendations made in this report. We further certify that we do not have any beneficial holding of the specific securities that we have recommendations on in this report. Ratings Guide* Upside Buy More than 15% Neutral Between 0% - 15% Sell Below 0% *Based on 12 month horizon unless stated otherwise in the report. Upside is the percentage difference between the Target Price and Market Price. Valuation Methodology: We use multiple valuation methodologies in arriving at a Target Price including, but not limited to, Discounted Cash Flow (DCF), Dividend Discount Model (DDM) and relative multiples based valuations. Risks: Please refer to page 12. Disclaimer: Intermarket Securities Limited has produced this report for private circulation only. The information, opinions and estimates herein are not direct at, or intended for distribution to or use by, any person or entity in any jurisdiction where doing so would be contrary to law or regulation or which would subject Intermarket Securities Limited to any additional registration or licensing requirement within such jurisdiction. The information and statistical data herein have been obtained from sources we believe to be reliable where such information has not been independently verified and we make no representation or warranty as to its accuracy, completeness and correctness. This report makes use of forward looking statements that are based on assumptions made and information currently available to us and those are subject to certain risks and uncertainties that could cause the actual results to differ materially. No part of the compensation of the author(s) of this report is related to the specific recommendations or views contained in this report. This report is not a solicitation or any offer to buy or sell any of the securities mentioned herein. It is meant for information purposes only and does not take into account the particular investment objectives, financial situation or needs of individual recipients. Before acting on any information in this report, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. Neither Intermarket Securities Limited nor any of its affiliates or any other person associated with the company directly or indirectly accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. Subject to any applicable law and regulations, Intermarket Securities Limited, its affiliates or group companies or individuals connected with Intermarket Securities Limited directly or indirectly may have used the information contained herein before publication and may have positions in, or may from time to time purchase or sell or have a material interest in any of the securities mentioned or may currently or in future have or have had a relationship with, or may provide investment banking, capital markets and/or other services to, the entities mentioned herein, their advisors and/or any other connected parties. 13 P a g e

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