Urea sector needs pooling of many reforms apart from gas pooling. Ratings. May 29, Impact on urea manufacturing companies

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1 May 29, 2015 Ratings Urea sector needs pooling of many reforms apart from gas pooling The Cabinet Committee on Economic Affairs (CCEA) approved a major policy initiative to supply gas at uniform price to all urea manufacturers on the gas grid through a pooling mechanism. Thus, the different rates at which all urea manufacturers source domestic and imported gas would average out and supply of gas to all manufacturers would be at a uniform delivery price. The plant-wise gas requirement is expected to be assessed and delivery of gas to all manufacturers would take place from a common pool operator. Fertilizer plants consumed around million metric standard cubic metres per day (mmscmd) of gas for manufacturing urea in FY15 which comprise mmscmd of domestic gas and mmscmd of regasified liquefied natural gas (RLNG; imported).the domestic gas is priced at USD 5.18/million metric british thermal unit (mmbtu) w.e.f. April 1, 2015, till September 30, 2015, and the price of R-LNG depends on the contract and spot purchase and varies from USD 12/mmbtu to USD 20/mmbtu. The uniform delivery price in case of pooling mechanism is expected to be around USD 10/mmbtu. Furthermore, CCEA also expects that the pooling mechanism would also result in saving in subsidy outgo. Impact on urea manufacturing companies With this recent move, urea manufacturers with higher proportion of RLNG in urea production will get gas at reduced price and hence, will have reduced cost of production and in-turn, lower subsidy receivables. However, companies with higher proportion of domestic gas in urea production will be affected adversely and will have higher subsidy receivables. The variation in the final urea manufacturing cost is the result of two factors: (1) gas cost which is a mix of domestic gas and RLNG and (2) conversion efficiency or energy consumption level measured in Gcal/MT of urea. With the uniform delivery price, the cost of production would vary only with variation in energy consumption level. At present, the energy consumption level varies from 5 Gcal/MT to 8 Gcal/MT, based on different vintage of the plant and hence uniform delivery price would increase competition and encourage improvement in plant efficiency. Gas pooling is a step towards.. CARE expects that the recent policy intervention is a step towards decontrol of urea or to bring urea under the ambit of nutrient-based subsidy (NBS) scheme over the medium to long term. Furthermore, in the absence of guaranteed buy back scheme, the plants to be set up under new urea investment policy (NUIP) would have clarity on gas pricing with more cost effective pooled gas as compared with the use of only RLNG. In addition to pooling, the energy consumption norms of all urea manufacturers on which the 1

2 variable cost is computed for subsidy should also be revised considering present energy consumption level. In May 2015, GoI has come up with New Urea Policy 2015 which would categorise 30 urea units in three group of energy consumption level of 5-6 Gcal/MT, 6-7 Gcal/MT and more than 7 Gcal/MT. The policy would incentivize to cut energy consumption level so that less energy efficient units improve the operating efficiency. Constraint of inadequate subsidy budget to continue The concerns related to insufficient subsidy budget is likely to continue in light of limited breathing space available to Government of India (GoI) due to fiscal concerns and insufficient domestic gas availability. The Department of Fertilizer (DoF) had requested Ministry of Finance for additional allocation of Rs.32,677 crore in addition to the budgetary allocation of Rs.77,070 crore in FY15 to clear the subsidy arrears. The budget deficit was not met through special banking arrangements (SBA) in FY15 and was subsequently paid from FY16 fertilizer subsidy budget. Exploring import of urea: a cautious approach towards subsidy rationalization In CARE s view the recent policy should be modified to allow individual fertilizer companies to import urea, may be through present designated entities. This could result in substantial amount of savings in subsidy outgo in near to medium term in the present scenario of reduced international price of urea. Furthermore, in CARE s view, the domestic gas availability for urea manufacturing at present should be allocated on pro-rata basis to all companies and for balance manufacturing capacity a mix of manufacturing through RLNG and import should be adopted for supply in the domestic market. In FY15, out of total urea consumption of million metric tonne per annum (MMT), MMT was from domestic production and balance 8.74 MMT was through imports. The average f.o.b. price (black sea) for urea in April 2015 was USD 259/MT and the same remained in the range of USD /MT in FY14 and FY15. The landed cost could add up to another 30 USD/MT. The manufacturing cost based on the domestic price guidelines (USD 5.18/mmbtu) and energy consumption of Gcal/MT (average of 27 domestic gas-based urea units) is way below the international price. However, allocated domestic gas for urea is inadequate for entire domestic production. Ministry of Petroleum and Natural Gas expects sizable amount of gas discovery by However, the priority of urea-based units is also expected to shift from first place in allocating the additional gas Urea sector needs pooling of many reforms apart from gas pooling 2

3 reserves discovered in near to medium term. Hence, RLNG has to be used for part domestic production. The manufacturing cost increases with RLNG which could be seen below: Exhibit 1: Cost of production of urea with different rate of gas Cost of production (USD/MT) Cost of gas (USD/MMBTU) Assumptions: Energy consumption of Gcal/MT is assumed, mix of domestic and imported coal is assumed for power and steam generation, exchange rate USD/INR taken at 60. If gas is also used for power and steam generation than the cost of production would further increase as effective RLNG energy cost is higher than coal Furthermore, as per the issue raised and addressed in recent Parliament sessions, the farm gate price of urea is not expected to increase from the present level of Rs.5,360 per MT (USD 89.33/MT at USD/INR exchange rate at 60) and hence, the increase in cost of production with usage of RLNG has to be absorbed by subsidy. International demand and supply scenario of urea: an opportunity to reduce subsidy To increase urea import to replace it through domestic production using RLNG, the surplus international availability of urea has to be seen, as the limited surplus availability could increase the international price and wipe out potential price benefit as reflected in table below: Exhibit 2: Global demand-supply scenario of urea (MMT of urea) Supply Capacity Potential supply* Demand Fertilizer demand Non Fertilizer demand Total demand Potential surplus availability Source: International Fertilizer Industry Association. *potential supply is equal to production capacity multiplied by highest achievable operating rate. As per the data shown above, the import could be increased up to some extent. Furthermore, the potential supply could be more than the stated figure as the operating rate for the newly commissioned capacities was low in China and other countries in past two years due to subdued demand growth and additional capacities. The savings in subsidy with increase in import of urea, up to 75% of worldwide potential surplus available, instead of domestic production through RLNG is shown below: Urea sector needs pooling of many reforms apart from gas pooling 3

4 Landed cost of RLNG (USD/mmbtu) Exhibit 3: Savings in subsidy with import of urea Landed cost of Urea (USD/MT) Savings in subsidy in CY (in Rs. Crore) Scenario 1: Scenario 2: ,444 2,134 2,572 2,614 Scenario 3: ,014 2,978 3,588 3,648 As shown in the above table, the savings increases with increase in landed cost of RLNG. At landed cost of RLNG below 10 USD/mmbtu and of urea more than USD 300/MT, it is beneficial to produce urea through RLNG as compared to imports. Incremental capacities to come up with revival of sick units and NUIP Government s focus to encourage setting up new capacities and revival of sick units is a welcome step to attain self-sufficiency in urea production in long-term however in-lieu of high cost of RLNG the purpose of reduction in subsidy may not be attained. Complete reliance on imports for shortfall is also not feasible as the supply dynamics could also change in near to medium term. Need for long-term off-take agreement or joint ventures projects in gas-rich countries Efforts to set-up manufacturing units through joint ventures (JV) in gas rich countries (where gas cost is around USD 3/mmbtu) should be accelerated as more than 70% of the cost of production of urea comprises gas cost. One of such arrangement is already in place with Oman India Fertilizer Company (OMIFCO) under long term off-take agreement (2 MMPTA) till FY20 and which has costing as low as USD per MT of urea. At present, GoI is facilitating to set up urea/ammonia Joint venture (JV) project in Iran with capacity of 1.3 MMTPA. However, the project is still under consultation stage to identify an Iranian JV partner for a long time. Hence, the efforts for setting up of JV projects in gas rich countries need to be put on fast track. Furthermore, such arrangements could also be explored with Chinese entities where around 70% of urea manufacturing units are based on low cost coal gasification technology. As per the latest estimates, China s urea production capacity is 81 MMTPA, while its domestic use and export together is only 65 MMTPA leaving the balance as surplus capacity. Long-term off-take agreement or JV projects could ensure availability of supply but prices would remain market linked. Nevertheless, the same is likely to be cost effective compared to domestic plants running on RLNG. Urea sector needs pooling of many reforms apart from gas pooling 4

5 Overseas JV projects for securing raw materials are already in place for fertilizers like di-ammonium phosphate (DAP) due to its decontrolled nature. However, with the regulated nature of urea, participation from private manufacturers for overseas JV is very minimal. Need of sovereign support for overseas projects GoI should try to encourage setting up such overseas projects for urea/ammonia and provide sovereign guarantee, at least till payback period, to mitigate adverse effect from any factors such as political unrest and introduction of new laws prohibiting production as cost and time involved in such projects is substantial. Coal gasification technology is cost effective albeit with concerns over environment With the use of cost efficient coal gasification technology which is operational in China, efforts should also be made to set-up new urea units in coal rich states instead of setting of gas based units to save on manufacturing cost. One such initiative is under consideration for revival of Talcher unit of Fertilizer Corporation of India Ltd. However, environmental and regulatory issues may need to be sorted out before adoption of coal gasification technology. Allow free import of fertilizer urea GoI has allowed import of urea for industrial purpose under open general license (OGL) in April 2015 and hence, modification of rules for import of fertilizer urea could also mitigate few concerns such as heightened subsidy bill. However, any amount of substitution of domestic production by imports faces large amount of uproar due to adverse effects to direct and indirect employment which restrict the government to go bold on reforms. Credit perspective Gas pooling to the extent of domestic gas availability would benefit the players which operate largely on RLNG. However, shifting the balance urea capacity on pooled RLNG would lead to a production cost which is higher than imported urea. Hence, the direct import of urea, in line with the OGL for industrial urea, by fertilizer companies through market or under long-term off-take agreement or JV projects would reduce the subsidy bill in light of lower international prices of urea as compared to manufacturing through RLNG. This would reduce the overall subsidy requirement and would also result in lower subsidy receivables and improvement in liquidity of fertilizer companies. Urea sector needs pooling of many reforms apart from gas pooling 5

6 Contact: Naresh M. Golani Kaushal Vaidya Sr. Manager Dy. Manager Disclaimer This report is prepared by Credit Analysis & Research Limited (CARE Ratings). CARE Ratings has taken utmost care to ensure accuracy and objectivity while developing this report based on information available in public domain. However, neither the accuracy nor completeness of information contained in this report is guaranteed. CARE Ratings is not responsible for any errors or omissions in analysis/inferences/views or for results obtained from the use of information contained in this report and especially states that CARE Ratings has no financial liability whatsoever to the user of this report. Urea sector needs pooling of many reforms apart from gas pooling 6