Hellenic Petroleum — A look ahead at 2019 after strong Q3 beat

Despite a 20% y-o-y reduction in benchmark margins, ELPE was able to deliver a 19% increase in realised margin in Q318, driven by high refinery utilisation, normalised operations at Elefsina and advantageous crude selection. Over-performance of $7.3/bbl is substantially higher than previous quarters, as can be seen in Exhibit 1 below and, while we do not assume this will be sustained into 2019, it highlights ELPE’s ability to deliver strong profitability during periods of high mechanical uptime and with shrewd feedstock selection. It also demonstrates ELPE’s flexibility, being able to capture margin despite a significant shift in feedstock during the period as Iranian crude imports were curtailed.

Q318 was characterised by weaker y-o-y refining margins across the European refining sector as crude prices continued to trend upwards, and energy/CO2 costs rose. CO2 emission allowance prices have trended down in recent weeks, after more than doubling over the course of 2018, but are likely to remain volatile into 2019.

Several moving parts are likely to drive refining margins through Q418 and 2019, and in our view current volatility and uncertainty is likely to remain. We highlight some of the key drivers below.

Stronger controls on the sulphur levels in vessel exhaust gases come into effect in January 2020 as environmental legislation for shipping catches up with existing policy in other heavy industry. On 1 January 2020, a reduction in sulphur emissions from the current level of 3.5% to 0.5% will come into effect for all international shipping outside certain emission control areas – coastal areas where stricter limits are already applicable. As of today, c 80% of fuel within the global shipping fleet is heavy HSFO rather than low sulphur marine fuels, or distillate-based light fuel oils. Other fuel options available to shippers include LNG, but this currently remains restrictive as a retrofit option, given the upfront capital cost and limited refuelling infrastructure.

We expect that the shipping industry will shift from HSFO to marine gas oil, a distillate-based blend, and low sulphur fuel oil - marine heavy fuel oils with less than 0.5% sulphur. Ultimately, major refineries that have invested in upgrading equipment, including desulphurisation plants, are well placed to meet increased demand for distillate-based fuels and to manage the anticipated reduction in demand for HSFO.

ELPE’s Q318 refinery yield at 52% middle distillates, 21% MoGas, 10% fuel oil, 11% naphtha and 6% LPG demonstrates its bias towards the production of light low sulphur products. Significant investment in Aspropyrgos and Elefsina (Nelson Complexity of 9.7 and 12.0, respectively) provides the capability to convert heavy, high sulphur crudes into middle-distillate product. ELPE’s ration of middle distillate production relative to fuel oil at 5:1 is high based on current feedstock and the company retains the flexibility to introduce lighter, sweeter crudes in order to further decrease fuel oil yield.

ELPE appears to be well placed relatively to older, less complex refineries to take advantage of the 2020 shipping regulation change. However, quantifying the precise impact that marine sulphur controls are likely to have on individual refinery margins is complex. We assume that ELPE benefits from an increase in realised margin in the period beyond Q419 as a result of increased middle-distillate demand, with margins on average $1/bbl higher in 2020 than in 2018. This positive impact is likely to be partly offset by overcapacity in European refining during the period 2018-22, as discussed below.

The IEA forecasts more than 2mmbd of refining capacity additions for 2019, which is higher than IEA forecast demand growth for refined products. The Chinese chemical producer Hengli Group is purchasing crude cargoes ahead of start-up of the group’s new refinery in Q418. The Hengli refinery is expected to be one of the largest in China, with capacity of 400kbd, and is configured to process medium- and heavy-grade crudes. In addition, the Rongsheng 400kbd refinery in eastern China is expected to start up in late 2018, with the owners reportedly purchasing Omani crude in preparation for commissioning.

Elsewhere, Saudi Aramco’s Jazan refinery is also expected to start up towards the end of 2018. Jazan will process 400kbd of crude, largely Arabian heavy and Arabian medium crudes producing gasoline, diesel and petrochemical feedstock. At 300kbd of capacity, Malaysia’s RAPID refining facility is set to start up in early 2019, with first cargoes already received to facilitate plant commissioning. Lastly, at 200kbd the STAR complex in Turkey will produce naphtha, low sulphur diesel, aviation fuel and other products, and was inaugurated in October 2018.

A high degree of petrochemical integration in new refining complexes to meet anticipated strong growth in demand for petrochemical products could have a negative impact on polypropylene margins in the short term.

Looking beyond 2019, OPEC forecasts 7.6mmbd of new refining capacity to come on-stream between 2017 and 2022, with the majority of this new capacity located in developing economies, predominantly Asia and the Middle East. Underlying product demand growth is the key driver of this relocation of refining capacity away from industrialised regions towards emerging economies. Planned capacity additions exceed demand through to 2022, with a capacity surplus in developed regions including Europe.

Overcapacity, a structural decline in European product demand and relatively high operational costs leave low-complexity refineries facing competitive pressures and lower margins.

OPEC projects that the majority of global refinery closures are likely to occur in Europe, which accounts for c 51% of projected global refinery closures in the period 2018-2020e. We expect the focus of closures to be at the small (sub-100kbd), low complexity (less than 5 Nelson complexity index) end of the refining spectrum. IMO 2020 is likely to accentuate this impact, challenging smaller and lower-complexity refineries with higher diesel and low sulphur fuel oil demand, driving a premium for heavy sweet crudes. Discounted HSFO is likely to attract the power generation sector and asphalt/bitumen manufacturers.

The availability and pricing of feedstock remain a key uncertainty, with Iranian and Venezuelan crude flows having fallen dramatically over the last 12 months. Iranian crude loadings were clearly affected by US sanctions, while Venezuelan supply sank under a lack of investment. A potential waiver for the purchase of Iranian crude has been reported for Greece alongside seven other countries; we do not assume that this will have a positive impact on ELPE’s refining margins at this stage as there is little detail on the duration or terms of a potential waiver (Iranian crude fell from 19% of feedstock in Q317 to 3% in Q318).

ELPE retains a diverse crude feedstock geared towards Caspian, North African, Urals and Middle Eastern grades. Urals prices rose relative to Brent as refiners replaced Iranian barrels in August 2018. However, lower demand and refinery maintenance saw the spread widen to $2/bbl towards the end of Q318. Strong Asian demand for Middle Eastern crudes drove prices up in September and October 2018, which is likely to have had a negative impact on ELPE’s benchmarks. The possibility of Iranian crude loadings being subject to a waiver for Asian consumers implies that demand pressure across ELPE’s feedstock may subside in Q418.

We now assume that Brent crude averages 75$/bbl in 2019, and as the year progresses we would expect sweeter crudes to command a premium as we get closer to the implementation of IMO 2020.

We make some modest revisions to our forecasts for FY18 and FY19 post ELPE’s Q318 results. The key impacts include slightly lower refining and petrochemical margins than previously forecast (we were ahead of consensus for margins in H218) for H218 and into 2019. Benchmarks remained volatile in Q318, and material additions to new refining capacity in Q418 and early 2019 are likely to increase competition for feedstock, putting pressure on benchmark margins. Nevertheless, we see potential for ELPE to exceed our FY18 forecasts if Q318 margin over-performance can be sustained.

An overview of the key changes to our forecasts is provided below:

We remain marginally ahead of consensus for FY18 and FY19, with adjusted EBITDA 3% and 1% higher, respectively. Material differences in analyst estimates can be expected in light of recent benchmark margin and over-performance volatility.

The reduction in forecast adjusted EBITDA for H218 and FY18 has an impact on our valuation, which uses a blend of P/E, EV/EBITDA and DCF. The principal drivers of the 1% reduction in our valuation are lower adjusted EBITDA forecasts and a de-rating of the global refining sector, with ELPE’s European peers currently trading at 4.9x FY19e EBITDA.

ELPE currently trades at a small premium to the peer group on the basis of EV/EBITDA multiples at 5.9x and at a discount on FY19e P/E, reflecting the company’s strong balance sheet position. Net debt/adjusted EBITDA for FY19 is forecast at 1.3x after receipt of DESFA sales proceeds.

Below we look at the sensitivity of our adjusted EBTIDA for FY19 of €704m, under varying benchmark margin assumptions.

Our base case benchmark margin assumptions are shown in the table below and reflect an improving benchmark in 2020 due to the impact of IMO 2020, and the impact of new global refining capacity additions longer term. We assume an average margin over-performance of 5.6$/bbl in FY19 and $6.0/bbl in FY20 (this is relative to 9M18 outperformance of 6.3$/bbl and 7.3$/bbl in Q318).