Hellenic Petroleum: IMO 2020 On The Horizon
Edison | Mar 22, 2019 08:11AM ET
Changes to bunker fuel regulation to be implemented on 1 January 2020 by the International Maritime Organization (IMO) will have major implications for both the refining and shipping sectors. Shipping costs will rise, sour crude discounts will widen, high sulphur fuel oil (HSFO 3.5%) demand will collapse, being replaced by increased demand for ultra-low sulphur fuel oil (ULSFO 0.5%) and marine gasoil (MGO 0.5%). In this note, we outline some of the options shippers and refiners are likely to consider ahead of 2020. We continue to believe that Hellenic Petroleum SA (AT:HEPr) is well placed given its high middle distillate yield, above average complexity and crude slate flexibility. Our valuation of €9.22/share (from €8.90/share when we last published) is based on a blend of DCF, EV/EBITDA and P/E multiples. Edison’s FY19 and FY20 financial forecasts include management guidance on the impact of IFRS 16.
Uncertain macro environment: Refining flexibility key
Ahead of IMO 2020, there is still significant uncertainty around shipping compliance levels, quantifying scrubber installations, and the ability of the refining sector to shift over 3mmbd of product output from HSFO 3.5% to ULSFO 0.5% and MGO 0.5%. Given this uncertainty, we believe that refining flexibility and complexity are valuable qualities. ELPE’s above-average composite Nelson complexity index at 9.2, ability to process heavy/sour crudes and low fuel oil/high middle distillate product yield place it in a strong position to take advantage of an evolving macro environment.
Changes to short-term forecasts
We make changes to our short-term forecasts to reflect our updated refining and petrochemical margin forecasts. This includes weather-related impacts on Q119 refining margins and weaker petrochemical margins. Edison’s FY19 EBITDA forecast increases by 5% to €746m, which we estimate will rise to €847m in FY20. Our EBITDA forecasts now include the anticipated positive impact of IFRS 16.
Valuation: Blended DCF and multiple €9.22/share
Our valuation is based on a blend of DCF, EV/EBITDA and P/E valuation approaches. ELPE trades at a small premium to the European peers at 5.7x FY19 EV/EBITDA versus the sector on 5.3x, and 8.7x P/E compared to the European sector on 9.2x. The refining peer group, including Hellenic, re-rated in Q418/Q119 as crude prices stabilised and in anticipation of IMO 2020 gains.
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Business description
Hellenic Petroleum (ELPE) operates three refineries in Greece with a total capacity of 341kbd, and has sizeable marketing (domestic and international) and petrochemicals divisions.
Investment summary
Flexible, complex European refiner
Hellenic Petroleum operates three refineries in Greece with a total capacity of 341kbd and has sizeable marketing (domestic and international) and petrochemicals divisions. Two of the refineries (Aspropyrgos and Εlefsina) are complex, integrated and provide significant flexibility of feedstocks/throughput. The third, Thessaloniki, is small and simple but houses Hellenic’s petrochemicals units, which have significant Greek and Mediterranean sales, and complements Hellenic’s refining system. In addition to refining and petrochemicals, ELPE is active in the fuels marketing, power and gas sectors. It is looking to build out its renewable power generation capacity over the course of the next five years.
Strategy: Growing renewables investment
Hellenic’s strategy continues to evolve, with the aim of increasing refining competitiveness through energy efficiency initiatives, procurement optimisation and leveraging digital technology across all group activities. In addition, over the next five years c €300–400m of capex is earmarked for growth projects. This includes conversion unit debottlenecking, margin improvement and investment in the group’s renewables strategy. We believe this will include investment in the Greek wind, solar and biofuel sectors. We expect management to provide details of precise investments, margin expectations and power generation capacity in due course. Management estimates that the combination of competitiveness improvement and growth projects described above could deliver an incremental €150–200m in EBITDA post-investment which, combined with management’s anticipated IMO 2020 impacts, has the potential to deliver group adjusted EBITDA in excess of €1bn beyond 2020.
Blended valuation of €9.22/share
Edison’s valuation of ELPE is based on a blend of three approaches: DCF, FY19 P/E multiple and FY19 EV/EBITDA multiple. ELPE trades at an FY19e P/E of 8.7x relative to European peers of 9.2x, and 5.7x FY19e EV/EBITDA relative to 5.3x. ELPE’s premium EV/EBITDA could reflect its peer-leading dividend yield. Dividends to be paid in FY19 include a €0.25/share special dividend based on DESFA sale proceeds. Key sensitivities include refining margins assumptions, both short- and long-term. A ±10% move in benchmark margin has a ±8% move in our valuation.
FCF to be directed towards debt reduction and dividends
We expect ELPE to be significantly free cash flow (FCF) generative in the absence of major upgrade spend, with FY19 FCF of €535m and FY20 FCF of €626m. Excess cash generation and DESFA sales proceeds offer the ability to de-leverage and fund a special return to shareholders of €0.25/share to be paid in FY19. While opportunities exist to maximise margins through optimisation of existing installed capacity as macro conditions evolve, we expect decisions on major upgrades or expansion to be deferred until completion of the sale of a majority stake in the company.
Risks and sensitivities
A tender process is currently underway for the sale of a 50.1% stake in Hellenic; binding offers are expected in early 2019 and are likely to act as key valuation benchmarks for the equity market. Competition remains robust within the refining sector with more than 2mmbd of new refining capacity ramping-up from Q418, potentially putting a cap on margins and driving down Middle Eastern crude differentials. We see this as a threat to small, lower complexity refineries in high-cost jurisdictions.
A year to IMO 2020 – laying out the options
IMO 2020 overview
Stronger controls on the sulphur levels in vessel exhaust gases will come into effect in January 2020 as environmental legislation for shipping catches up with existing policy in other heavy industry. On 1 January 2020, shippers will be compelled to use marine fuels with a sulphur content of less than 0.5% (from current 3.5%) for all international shipping outside certain emission control areas; specific coastal areas impose stricter limits. As of today, c 80% of fuel within the global shipping fleet is heavy HSFO rather than low sulphur marine fuel, or distillate-based light fuel oils. It is widely expected that shippers will shift to using ultra-low sulphur fuel oil (ULSFO 0.5%), or MGO 0.5% as an alternative driving a significant expansion in the gasoil to HSFO price spread from the start of 2020. With c 3.5mmbd of HSFO currently being produced within the global refining complex, we expect IMO 2020 to have a significant impact on crude and product price spreads.
Forecasts from integrated oil companies and the IEA show the anticipated shift in product demand post IMO 2020. The IEA estimates a slightly slower transition away from HSFO, on the basis of non-compliance in the shipping sector during the early years of IMO 2020 implementation.
Options for the shippers
In order for shipping companies to be compliant with IMO 2020 there are three main options under consideration, which we describe below. Industry experts estimate that the shift in fuel cost for the industry as a whole will cost c US$60bn per annum over the period 2020–23. In general, the shipping industry is keen to pass this cost on to the charterer, while testing alternative solutions such as exhaust gas cleaning systems and LNG in order to remain competitive.
Installation of exhaust gas cleaning systems (scrubbers)
Scrubbers offer an ‘instant-fix’ for the shipping industry, but are possibly the least environmentally friendly option. Increased fuel consumption, resultant higher CO2 emissions and water pollution and lack of industry experience are key considerations. However, at a cost of c US$7–10m per ship, and with the ability to continue to operate on HSFO 3.5%, there is potentially a significant advantage available to shippers that deploy this solution and exploit deeply discounted fuel costs.
The payback period for investment in scrubbers will depend on the size of vessel and the discount at which HSFO 3.5% trades relative to compliant fuels. Industry experts estimate a payback of less than a year assuming a c US$200/mt (metric tonne) differential between HSFO 3.5% and ULSFO 0.5%.
Other major downsides of the use of scrubbers include the costs of maintenance, operation and cleaning, loss of vessel capacity, and potential fines if performance fails to meet specification.
Retrofitting vessels to LNG fuel
LNG retrofits are considered a high capex option that provides certainty of emissions compliance, but the lack of fuelling infrastructure at major ports is currently a major deterrent. Hapag-Lloyd estimates the cost for conversion to LNG at US$25–30m per ship.
Shift to compliant fuels
The current preferred option among the shipping industry is to switch to compliant fuels such as ULSFO 0.5% or MGO 0.5%, meeting the requirements of IMO 2020. The price impact on charter rates will be significant and shippers are devising various formulas by which they can pass on higher fuel costs to customers while remaining competitive and maintaining margins. Hapag-Lloyd estimates the cost per 20-foot equivalent unit (TEU) could be an incremental $128 to $415 depending on transport route and underlying fuel prices.
How refiners are reacting to a shift in feedstock pricing and product demand
Increasing crude flexibility
Feedstock accounts for c 80% of refining costs and crude flexibility remains a key lever when looking to maximise margins in the face of crude price and product demand volatility. Most refineries are configured to operate within a relatively narrow quality window, which may limit their ability to exploit lower-priced crudes without affecting plant performance.
Heavily discounted sour crudes may present an opportunity for complex and flexible refineries able to increase sour feedstock while limiting HSFO residues. Refineries dependent on light-sweet crude feedstock are likely to be less robust, in the absence of hardware changes, assuming a material widening of the sweet-sour crude spread.
With IMO 2020 on the horizon, we expect refiners to have been through the process of analysing crude flexibility within plant tolerances, and scoping plant upgrades in order to assess the potential returns. Refineries are likely to be assessing crude flexibility within existing facility constraints, but pressing the button on large capital projects (such as cokers or deep conversion units, which can cost billions of dollars and take many years to engineer and construct) is unlikely to occur until there is greater visibility of the direct impact of IMO 2020 given the uncertainties.
ELPE’s refining capacity, complexity and flexibility
ELPE operates three refineries that together account for 341kbd capacity and 65% of the Greek refinery output. A composite Nelson complexity index of 9.2 gives an indication of the complex’s flexibility and ability to produce a high percentage of light products from every barrel. The refineries are linked, allowing better integration to best take advantage of their strengths of location, size, storage and complexity.
The complex has a high degree of flexibility; since 2014 it has been able to flex its gasoline yield between 20% and 24%, while middle distillates have been between 50% and 58% of yield (working at full capacity). Fuel oil yields are fairly low (10–13%) and there are no plans to undertake large projects to add further units to the complex at this time. The company has a large storage capacity (41.8mmbbl) and can take advantage of trading opportunities.
ELPE’s low fuel oil yield and complexity should ensure the group is well placed for IMO 2020 and the anticipated switch in demand from HSFO 3.5% to ULSFO 0.5% and MGO 0.5%. ELPE plans minimal changes to crude processing at Elefsina and Thessaloniki ahead of IMO 2020 as neither refinery produces HSFO. Aspropyrgos, on the other hand, presents an opportunity to reduce high sulphur feed and replace this with lower sulphur crudes, switching current output from 24% HSFO to just 4% HSFO.
Options may exist to take advantage of heavily discounted high sulphur crudes; however, desulphurisation is a catalyst intensive and expensive process, which is likely to limit the appeal to upgrade sour crudes unless we see a material widening of the sweet-sour (Brent-Dubai) spread.
The graphs below show ELPE’s current group-level bias towards heavy crude feedstock, high middle distillate output and low fuel oil output. Current HSFO yield stands at 10–12%.
Refinery: Integration and flexibility
Aspropyrgos refinery is the largest in Hellenic’s portfolio and is one of the most modern refineries in Europe (it was built in 1958). Significant upgrades were completed in 1986 (residue conversion project, FCC, mild hydrocracker, visbreaker and CCR units), 1999 (capacity increased to 148kbd) and 2004 (upgrade of conversion units). From 2014, heat and power have been supplied by natural gas (rather than fuel oil), reducing costs and increasing flexibility. The result is a refinery able to produce high levels of gasoline. It is connected to Elefsina via pipeline.
Elefsina is Hellenic’s most complex refinery and has a refining capacity of 100kbd. A €1.4bn upgrade in 2012 added a 39kbd hydrocracker, a 20kbd thermal cracking unit (flexicoker, which gasifies coke for internal heat and power generation and reduces the need to export/sell coke produced elsewhere in the refinery) and a vacuum distillation unit, increasing the Solomon complexity to 13.9 from 1.5 (and the Nelson complexity to 11.3). Its large storage capacity (20.7mmbbl), coastal location and connections (to Aspropyrgos refinery and crude terminals at Pachi and Megara) make it a good trading and logistics hub. The refinery can take heavy, high-sulphur crudes and products. As a result, its middle distillate yield is over 75%.
Thessaloniki is the smallest and simplest refinery (hydroskimming) type and has a storage capacity of 8.8mmbbl. It is the only refinery in Northern Greece (Aspropyrgos and Elefsina make up a southern Greek hub) and supplies both the domestic market and neighbouring countries. A 2011 upgrade renovated distillation units, increased storage capacity and added a 15kbd CCR unit. Thessaloniki also provides feedstock (including residues) to the Southern (NYSE:SO) hub and reforms naphtha from Elefsina (to gasoline).
ELPE’s refineries are at the smaller end in comparison to European refinery capacities, but we note that the combination of ELPE’s two more complex refineries (integrated through pipeline connection) would equate to a combined capacity towards the top end of the group.
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