Arsalan Ahmed & Ali H. Zaidi |
48 days to IMO-2020 & the clock is ticking… Refineries should brace for impact!
A Major International Event for Refineries
While Pakistan still reels from the domestically brewed crisis of Furnace Oil (FO) based power generation, there is yet another story that could be devastating for FO. This time however, the dark clouds have risen in the form of a change in international regulations sparked by a drive for environmental sustainability, something that Pakistan cannot reasonably avoid. Earlier in Mar-2018, the International Maritime Organisation (IMO) decided that the marine sector will have to reduce sulphur emissions from the then applicable 3.5% cap to a maximum of 0.5% by Jan-2020. It is expected that the regulation, now widely known as IMO-2020, will result in the largest reduction in the sulphur content of a transportation fuel undertaken at one time. This is only possible by way of installing scrubbers or by shifting from heavier fuels such as High Sulphur Furnace Oil (HSFO) to Very Low Sulphur Furnace Oil (VLSFO). Non-compliance with IMO-2020 requirements could result in serious repercussion such as the ship being detained at port, penalties and being required to obtain compliant fuel.
With consumption levels of FO around the 3.8 million bpd mark in 2017, the marine sector alone generated half of global demand, as per Forbes. The International Energy Agency (IEA) estimates that demand for HSFO will drop from 3.5 million bpd to 1.4 million bpd in 2020. Needless to say, IMO-2020 has the potential to be highly disruptive for the pricing and availability of compliant fuels.
A fall of US$50/ton in prices of Furnace Oil results in a ~Rs27bn loss to the refining sector, keeping other margins constant
FO Prices Barrelling Towards an Abyss
Following the implementation of the regulation from January 1st, 2020, FO prices in the international market (and by extension in Pakistan) are expected to plunge as a significant portion of its demand virtually evaporates on new-year’s eve. And the impact has already become visible: domestic prices of FO have fallen by~33% MoM in Nov-2019. It should be noted that FO is already a negative margin product (GRMs have averaged at -US$6.4/bbl in CYTD) and after this change, the margin is expected to worsen significantly. It should be noted that refinery margins FYTD have been relatively better as these had improved owing to the widespread refinery turnaround ahead of the IMO-2020 deadline. However, these are expected to cool off post Jan-2020.
By Failing to Prepare, You Are Preparing to Fail
While refineries across the globe have been adapting to the changing regulations, Pakistan’s refineries continue to operate on the out-dated hydro- skimming technology which could pose serious challenges in the wake of IMO-2020. We feel it pertinent to point out that not too long ago, on the direction of the government, the sector invested billions of Rupees in Diesel Desulphurisation and Isomerisation projects. Now, with the new regulations, the only viable solution is to again invest humungous sums just to survive in the evolving industry dynamics. So do we take this to be just another day in the capital intensive industry or a massive failure in planning?
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As far as funding for the requisite investment is concerned, looking towards the government would be a dead-end street considering the on-going fiscal challenges. For instance, a cracker unit requires not only 3-4 years but a massive investment of US$500-600mn for a 50k bpd refinery. To give perspective, this amount is even larger than the upcoming tranche from the IMF. That said, the sector will have to find its own route. In this regard, Pakistan Refinery Limited (PRL) has plans to invest nearly US$1bn in a deep-conversion refinery. The best that the sector can expect and reasonably demand from the government is incentives on the installation of cracker units. Even if work starts today, by the time these units come online, larger and more advanced refineries with a combined capacity of 1.1mn bpd (as per media reports) that are already in the pipeline may be operational. It should be noted that the sector currently has a capacity of 0.4mn bpd.
To Make Matters Worse…
A glance at the product mix of the local refineries reveals that FO constitutes about 23% of the aggregate. The fall in FO prices will trickle down on other products, such as Asphalt and Lubes, to which FO is a raw material. In this case, National Refinery Limited (NRL) is expected to take the biggest hit considering its product mix which comprises of 19% FO, 7% Asphalt and 6% Lubes. In terms of market performance, even if we assume that the considerable correction in the oil refining stock prices in recent years reflects the impact of the regulation, the actual impact on earnings is yet to be seen.
Other Considerations
- The spread between light crude and heavy crude will naturally rise as refineries across the globe flock towards obtaining lighter crude. The impact of this increased demand for lighter crude has already started to translate into the spreads. Bloomberg has reported that Arab Extra Light premium over Arab Heavy ballooned to US$4.65/bbl for Asia for Dec-2019 from US$1.05/bbl in Sep-2019.
- The increased fuel costs are likely to translate into higher freight charges. In such a scenario, imports will become slightly more expensive for businesses using imported raw materials. This may lead to inflationary
- Coming back to the issue at hand, what will be the outlook of FO in Pakistan? Needless to say, the power sector will happily embrace the falling prices of FO as a fuel choice would automatically climb the merit-order list. However, whether or not the refineries will be able to sustain selling at such low levels remains the major question.
- On the other hand, Pakistan has already signed contracts for import of RLNG on a take-or-pay basis. If FO surpasses RLNG on the merit order list, it could be catastrophic for the country’s gas infrastructure, particularly when the country’s existing network has repeatedly been overfed to dangerous levels in the recent past, as per media.
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We believe the gravity of the situation demands emergency action from the government. Industry experts (both local and foreign) should be consulted to formulate a strategy to tackle the issue at hand. There are 48 days and the clock is ticking!
This research piece was published from JS Global Capital’s research team.
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Arsalan Ahmed: arsalan.ahmed@js.com
+9221 111-574-111 Ext: 3096
Ali H. Zaidi: ali.zaidi@js.com
+9221 111-574-111 Ext: 3103