Hellenic Petroleum — IMO 2020 on the horizon

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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 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%.

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 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.

This complexity and integration means that Hellenic’s refining margin compares well to its European listed peers, especially after the Elefsina 2012 upgrades.

Our base case benchmark margin assumptions are shown in the graph below and reflect an improving benchmark in 2020 due to the forecast impacts of IMO 2020, offset by the impact of new global refining capacity additions in the longer term. We assume an average margin over-performance relative to ELPE benchmark of $6/bbl in FY19 and in FY20 (this is relative to an FY18 over-performance of $6.2/bbl). We have conservatively assumed a fairly moderate impact from IMO 2020, but there is a significant amount of uncertainty on the precise margin impact given unknowns such as compliance, scrubber installations, relative crude discounts and refinery flexibility. We expect to adapt our assumptions as markets evolve over the course of FY19 and FY20.

ELPE received €284m of sale proceeds in Q418 on completion of the disposal of its 35% interest in DESFA. The board of Hellenic has confirmed that net proceeds will be directed to reduce net debt and fund a €0.25/share special distribution.

We believe ELPE’s excess cash, FCF and DESFA sales proceeds will be used to reduce debt, including the company’s €325m five-year Eurobond maturing in July 2019. Net debt should continue to fall in the absence of major investment over and above maintenance capex, with net debt/EBITDA remaining well below 2x.

Other uses of FCF include increasing investment in growth, which ELPE has set out as the development of the company’s renewables business, conversion unit debottlenecking and margin improvement. Current guidance is for combined growth capex spend of €300–400m over the next three to four years. Our net debt forecasts above include this spend, but conservatively do not include a material margin contribution from renewables in FY19 and FY20 given the construction timelines for greenfield renewable projects. Renewable investments are likely to span the wind, solar and biofuel sectors, while margins and returns on investment have the potential to be robust based on renewable peers in Greece. Wind and Solar projects in Greece offer the potential for stable, long-term cash flows in Greece based on a combination of feed-in tariffs and power purchase agreements. We expect management to provide more details on this aspect of the business in due course. Management currently expects maintenance capex, growth capex and the impact of IMO 2020 to provide the basis for a company that can generate adjusted EBITDA in excess of €1bn pa (excluding IFRS 16 impacts); this is relative to our FY20 EBITDA forecast of €847m.

We believe the ongoing sale process for 50.1% of Hellenic (from the combined Greek government and Pan European Oil holding of c 80%) is likely to limit short-term infrastructure investment beyond optimisation spend, but management has set out ambitions for reinvestment in the company’s assets once this process is complete. Greece has short-listed Glencore and Vitol as bidders, with the sale process currently anticipated to be completed in Q119. Recent press reports suggest that Glencore is seeking to partner with a US fund, and Vitol to partner with Sonatrach ahead of binding offers. Valuation of the 50.1% will likely act as a benchmark for equity markets and will likely be a key short-term driver of the share price.

Chairman and CEO Efstathios Tsotsoros is a professor at the Panteion University in economic development and social transformation. He has extensive experience in management positions in the public and private sectors as well as in local government. He has been director of PPC, board member and CEO of the Business Reconstruction Organization, vice president and general manager of the Athens Regulatory Plan and Environmental Protection Organization, board member and CEO of various companies in the private sector and founder, chairman and CEO of the Broadcasting Group Alpha. He was also an advisor to the minister of energy, to the Athens mayor and to the president of the Greek Technical Chamber and has occupied the post of the chairman of the National Committee of Programme Agreements and Development Contracts.

CFO and Deputy CEO Andreas Shiamishis holds an economics degree and is a fellow (FCA) member of the Institute of Chartered Accountants in England and Wales. His previous roles include positions at KPMG and Diageo. From 2000 to 2002 he worked as CFO at LEVENTIS Group and took over as chief financial and IT officer at Petrola Hellas in 2003. After the merger of Petrola Hellas with Hellenic Petroleum, in 2004 he took over as CFO. He is a member of the Hellenic Chamber and of the Corporate Finance Faculty of the ICAEW.

Refining margins: along with all refineries, the major risk to earnings is volatility of refining margins. As a price taker, Hellenic can do little to mitigate this in the short term. In the longer term improvements of the refineries are capital intensive and take many years. However, Hellenic will also benefit from increases in refinery margins. As we discuss in the report, we think margins in Europe will compress in the long term.

Concentration risk: the bulk of Hellenic’s earnings are generated at the three refineries. Any incident that stops the refineries from operating (such as an unplanned outage) could have a material effect on cash flows. This is mitigated to some extent by the three separate sites and the other material businesses (not least marketing).

Oil price: an increase in the oil price could have a material effect on the refinery earnings and balance sheet.

Greek risk: Hellenic has significant export businesses and its production is entirely fungible for international markets. Greek country risk is a factor when considering cost of capital and domestic product demand.

Equally, we note that the Greek economy has a lot of potential to grow, and Hellenic Petroleum would be well placed to benefit from increased economic activity through the marketing, power and chemicals divisions. Increased tourism would help the refining and trading segment.

FX rates: Refining is a US dollar business (margins are quoted in US dollars) and so lower costs in US terms (as costs are in euros) have benefited earnings (and cushioned the poor refining environment in 2011–14). While we do not forecast currency swings, fluctuating exchange rates will have an earnings impact.

We value ELPE using a blend of DCF, levered and un-levered multiples arriving at a blended valuation of €9.22/share, up slightly from our last published €8.90/share. Adjusted EBITDA forecasts for FY19 are little changed, but sector multiples have increased, driving our higher valuation. Changes to Edison forecasts are shown in Exhibit 16.

ELPE trades at 5.7x FY19 EV/EBITDA and 3.6x FY19 P/CF compared to the European group on 5.3x and 6.1x, respectively. FCF yield is higher than that of peers at 20.5% in FY19e and EV per complexity adjusted barrel lower than that of peers at $1,502/bbld.

We see potential for ELPE to trade at a premium valuation on demonstration of its ability to benefit from the refining flexibility, integration and complexity to maintain margin over-performance in FY19 and FY20. Our DCF is based on discounted cash flows to 2025, using an 8% cost of capital. We incorporate a terminal value, which assumes the unwinding of working capital and minus 1% terminal growth.

ELPE currently trades at premium to the peer group at current forecasts, which are highly sensitive to underlying refining margin and over-performance assumptions. On a complexity adjusted basis ELPE trades at a discount despite the flexibility offered by its current refining configuration.

An overview of the key changes to our forecasts is provided below. Key impacts include IFRS 16, which moves fuel station rental expense from operating expense to asset depreciation and financial expense; this is the key driver of increased marketing EBITDA.

Edison forecasts are ahead of consensus for FY19 and FY20, with adjusted EBITDA 6% and 8% higher, respectively. Material differences in analyst estimates can be expected in light of recent benchmark margin and over-performance volatility as well as uncertainty heading into 2020. It is unclear whether analysts are including the impacts of IFRS 16 for FY19. As discussed earlier, ELPE has provided details on key growth levers that define a path to delivery of adjusted EBITDA of over €1bn. These include energy efficiency, digital transformation, debottlenecking, additional conversion units and renewables growth.