Quadrise Fuels International — Update 15 November 2015

Management continues to focus on those sectors of the US$100bn pa HFO market, where the potential business opportunity is large. The first is the global marine fuel market where Quadrise has developed a marine-specific variant in partnership with Maersk, the world’s largest shipping line. The second is Saudi Arabia, where the ongoing programme with the client will potentially include the bulk of the available heavy residue in the country. The third is a mid-sized refining company, which is evaluating MSAR for steam generation in a refinery complex. Progress to commercialisation in the marine programme is likely to encourage refineries in Asia to adopt the process, supporting sales to YTL PowerSeraya for power generation.

We have revised our estimates to reflect a slippage in the marine, Saudi and global oil major programmes of around one year and the substitution of a refinery refuelling programme for the programme with Ecopetrol. Our model shows this programme ramping up volumes between FY17 and FY18. Our previous model showed the Ecopetrol programme generating commercial volumes of MSAR during FY17. Assuming there is no material delay to this schedule, which assumes that substantial commercial revenues are received from FY18 onwards, our estimates show that no further funding is required for Quadrise to reach profitability.

Oil-spreads – the refinery price ‘spread’ between diesel and HFO determines the economic attractiveness of a switch in converting heavy residue from HFO to MSAR and thus the amount by which MSAR may be discounted with respect to HFO.

Key client/partner risks: although Maersk could terminate its relationship with Quadrise, this decision seems unlikely given the size of its fuel bill and the recent execution of contracts with Maersk and CEPSA. AkzoNobel could also terminate its relationship, but this would not be logical since it would forfeit the potential for significant sales of speciality chemicals, which would offset the considerable R&D costs it has already incurred.

Customer attitude: although Quadrise’s MSAR has been proven in field trials, MSAR still needs to be accepted as a marketable, environmentally friendly and economic substitute for HFO by the power and marine bunker sectors, which are inherently conservative.

Our valuation is based on the NPV of the sum of the cash flows from four key projects over a 15-year period from FY16 to capture their long-term potential. It assumes revenues are derived from a mix of licence fees and royalties, thus incurring minimal capital outlays. We apply specific discount rates to each, resulting in a blended rate of 12.7% with the projects at their current state of development. This gives an NPV of £431m, or 53.2p/share. Applying a lower factor of 10%, as key projects progress towards commercialisation, gives £544m or 67.2p/share.

Quadrise is an AIM-listed oil service company. Its goal is to replace HFO globally with Multiphase Superfine Atomised Residue (MSAR), its proprietary oil-in-water emulsion fuel. The opportunity addressed is substantial since the global HFO market exceeds 450Mt/year, worth approximately US$100bn pa at current low prices. Around 40% of this HFO is used as marine bunker oil, the rest by power generators and utilities, generally in oil-producing economies. The marine bunker oil sector is a primary target because MSAR can contribute not only to reducing fuel costs, but also to meeting the increasingly onerous environmental challenges.

The market for MSAR is proven because more than 60Mt of a first-generation heavy oil emulsion, BP’s Orimulsion, was supplied to the global market between 1993 and 2006, when production was discontinued because of pricing issues. Key members of Quadrise’s senior management team, including chief operating officer Jason Miles, were instrumental in the development and commercialisation of Orimulsion. They have since continued this work in developing a technically improved second-generation fuel, MSAR.

Quadrise is headquartered in London. It has its own independent R&D facility in the UK where it works on process development and product design optimisation.

After refining, 70% of the output is high-value transportation fuel, 30% low-value residue, which is solid at room temperature and, if not processed further, can only be used for limited volume applications such as road surfacing material. Refineries increase the value of this residue by blending it with some of the high-value transportation fuel to create heavy fuel oil (HFO). HFO fetches lower prices than crude oil as traditional refineries typically convert residue to HFO even though this means that over a quarter of the distillate material (eg diesel) that could otherwise be sold as high-value transportation fuels is used in the process.

The MSAR process eliminates the need to blend the heavy residues with distillates to make a product comparable with HFO. MSAR is an oil-in-water emulsion made by mixing the hydrocarbon residue with water and specialised surfactants and mechanically milling the mixture until the hydrocarbon residue is reduced to particles approximately five to 10 microns in diameter. The surfactants, which are supplied under licence by long-term partner AkzoNobel, ensure that the resultant emulsion flow is stable throughout transportation, storage and fuel handling, giving equivalent performance to HFO.

Adoption of the MSAR process means that all of the high-value middle distillate can now be sold as transportation fuel, so that 70% of the total output rather than 50% commands the premium price. Quadrise calculates that for a 200,000b/d refinery, the value of a switch to MSAR is worth up to $100m pa with crude at $50/barrel. Note: the value generated is not linked directly to the price of crude oil, but is a function of the pricing spread between diesel and residue-based fuel oil.

MSAR produces significantly lower levels of black soot on combustion than HFO because the hydrocarbon particles are so small. In addition, a straight switch from HFO to MSAR gives a reduction in NOx emissions of at least 20%. This is helpful in marine bunker fuel applications, where new environmental regulations regarding open ocean operation are being introduced and also for refinery applications.

Quadrise has been engaged with Maersk, the largest marine fleet operator, since 2010 when the two parties signed a joint development agreement, setting out a programme for the development of a marine MSAR formulation. This programme involves specialists from Quadrise, AkzoNobel and Maersk, as well as oil refining companies and major marine engine manufacturers. It is about to enter the final phase required before commercialisation.

In early FY15, Quadrise and Maersk began preparations for the Letters of No Objection (LONO) validation phase. This is a demonstration of the extended use of Marine MSAR in Wärtsilä and MAN powered vessels so that the engine manufacturers can issue LONOs validating the use of MSAR in these engine types. It is the last remaining precondition before beginning commercial use of MSAR. Maersk and Quadrise concentrated on engaging candidate refineries close to major bunker hubs that will be able to produce MSAR cost-effectively in the quantities required, not only for the LONO phase, but also for the initial commercial phase, thus accelerating commercial adoption. This phase took longer than expected because of the unexpected fall in global oil prices, which made it difficult to progress discussions with potential partners that were busy addressing the impact of the changes on their existing activity. In September, however, Quadrise announced that it had executed contracts with Maersk and CEPSA (Compañia Española De Petróleos) relating to production of MSAR for the LONO trial.

An MSAR manufacturing unit (MMU) will be installed and commissioned at CEPSA’s San Roque refinery in mid-calendar H116, subject to local and governmental permitting in Spain. This refinery is near Gibraltar adjoining the Algeciras bunker fuel supply hub, which services European and Mediterranean shipping. The MMU will produce marine MSAR for use in the LONO trials, which will commence as soon as MSAR fuel is available. This phase is expected to last nine to 11 months, depending on vessel operating schedules. Typically, around 4,000 hours of performance data are required to complete the LONO phase.

Once the LONO requirements have been met and other regulatory formalities completed, the early commercial phase should be able to commence in calendar H117, with Maersk and Quadrise progressively implementing a programme to secure supplies to meet Maersk’s nominated requirements. Under the terms of a revised royalty agreement completed in September 2015, Maersk and Quadrise are committed to jointly use all reasonable endeavours to develop the commercialisation of Marine MSAR in the global marine fuels market, fuelling both qualifying Maersk and third party vessels. This indicates that commercial MSAR production output is likely to be much greater than that required solely for Maersk’s requirements, encouraging other refineries close to bunker fuel supply hubs to start MSAR production. The agreement has also been extended so that the expiry date is now the tenth anniversary of first commercial MSAR production following the LONO trials, rather than end-December 2022. We note that the delays in formalising production arrangements with a refinery have pushed back the onset of commercial roll-out by about a year, but are encouraged that Maersk remains committed to the programme and that the new relationship with CEPSA introduces a partner operating from a prime location for supplying marine fuel.

Since it is potentially highly cost-effective for refineries to convert heavy residue into MSAR rather than HFO, they will be able to offer MSAR at a discount to HFO. This potential discount is attractive to fleet operators, which face intense competition over freight rates, because fuel accounts for a high proportion of a fleet’s operating costs. We note that Maersk’s average freight rates were 19% lower during calendar Q315 than a year previously, and shipments grew by only 1.1%, lower than the group had expected.

The potential switch to MSAR is made easier because it can be transported to end-users in the same way as HFO and may be used in conventional diesel engines without the need for major modification or retuning. This compares favourably with liquefied natural gas, which is cited as an alternative marine fuel, but has specialised and expensive storage and handling requirements.

The potential switch to MSAR also brings environmental benefits. The International Maritime Organisation is tightening permitted levels of NOx emissions in Emission Control Areas from 2016 onwards and considering regulating particulate (soot) emissions. A switch from HFO to MSAR would give a reduction in both NOx emissions and production of black soot. This is expected to drive demand for MSAR in the longer term. There are also energy savings associated with the switch because MSAR can be stored and transported at lower temperatures than HFO, reducing the need to heat transportation pipelines, storage tanks and ships. Moreover, the potential cost savings arising from the switch could make a material contribution towards meeting the new regulations being introduced, which require marine fleets to reduce their sulphur emissions. From January 2015, vessels operating in the Northern European Sulphur Emission Control Area (SECA) will be allowed a maximum sulphur content in their fuel of 0.1% compared to 1.0% previously. In January 2012, the International Maritime Organisation reduced the global sulphur cap from 4.5% to 3.5%. This cap will be reduced to 0.5% from either January 2020 onwards or from January 2025, depending on the outcome of a feasibility review to be completed no later than 2018. Currently, the only options available to meet these new environmental standards are to switch from HFO to low-sulphur diesel at a substantial premium, or to install on-board sulphur scrubbing units. The adoption of MSAR as a lower-cost bunker fuel will contribute towards the installation and running expense of scrubbing pollutants from vessel flues.

Maersk is an ideal partner for Quadrise because it operates more than 600 vessels, including its own fleet of 200 vessels, making it the largest container shipping company in the world. These vessels collectively consume around 10Mt of marine fuels (largely HFO) each year, making Maersk a significant potential consumer of MSAR in its own right. Additionally, if Maersk decides to convert its fleet to MSAR, other shipping lines are likely to follow, encouraging refineries close to bunker hubs worldwide to adopt the technology.

Quadrise has been engaged in activities in the Kingdom of Saudi Arabia (KSA) since 2012, when it signed a memorandum of agreement with Rafid Group, giving it a commercial partner in KSA that has long established relationships in the oil and energy industries in the Kingdom. Since then Quadrise technology has been approved for application in client refineries. However, initiatives to create a modest demonstration and reference plant have met with repeated delays, resulting in a slippage of around a year in the programme since our last outlook note. In recent months a more co-ordinated approach has led to confirmation of support at a senior level and the active advocacy of a proposed fast-track, limited scope 'production to combustion' pilot demonstration plant project based at a coastal refining complex and power station designated by the client.

The proposed ‘production-to-combustion’ demonstration involves production of MSAR at a coastal refinery that is close to a large power station complex with aggregate output of 5,000MW. The MSAR produced will be used to fuel a 400MWe thermal power unit for at least one month, enabling the client to assess operation over an extended period. Funding for this phase will be provided by the client. Quadrise expects that a commercial scale 350,000 tonne pa MMU will be installed at the refinery and commissioned by calendar Q216, ahead of an extended combustion demonstration. Currently, Quadrise is undertaking an assessment of the installation engineering requirements and any necessary adaptations of power plant boiler and production capacity for the pilot to go ahead. It is also working with both the refinery and the power plant to ensure that the transfer of MSAR from the refinery to the power plant goes smoothly.

Quadrise is confident that this 'semi-commercial' extended demonstration project will meet all of the defined objectives and represent a 'break-through event' for development of an extensive application programme in KSA. One of the agreed objectives is to advance the application and evaluation of the technology in Saudi Arabia for both refining and power station applications, as part of an assessment of the fit and role of emulsion fuels in KSA’s future national energy strategy.

As a major oil producer, KSA’s economy has much to gain from the adoption of MSAR, because it would release for sale the middle distillate currently used to blend HFO. A significant proportion of this middle distillate is imported. The volume of diesel imported is particularly serious for the Saudi government because domestic prices of diesel are up to 80% less than global prices, with the government effectively subsidising the difference. The substitution of MSAR for HFO would therefore not only substantially reduce the volumes of diesel imported, but also the effective subsidy. Quadrise estimates that the release of these distillates for domestic sale (domestic demand continues to be strong) or export is potentially worth billions of dollars annually at a national level. The cost of the imports and the domestic subsidy are a pressing concern for the government, as is the increasing domestic use of crude oil resulting in reduced revenues from oil sales, supporting interest in a switch to MSAR at the highest levels.

From the standpoint of individual refineries, which are operating in a challenging low-margin environment, MSAR is highly attractive from an economic perspective. The switch to MSAR may be effected relatively swiftly and inexpensively. The MSAR production technology is modular and can be integrated into an oil refinery’s existing operations in less than 12 months without any need for a shut-down to complete a tie-in. The capital expenditure involved is around $50m, giving a payback period of 12-18 months. The alternative approach for refineries to achieve a comparable increase in crude ‘yield’ is to undertake a substantial facility upgrade costing more than $1bn and requiring a materially longer lead time for implementation. There is further benefit from the reduction in carbon particulate and NOx emissions arising from MSAR adoption since the carbon particulates removed from output gases during power generation frequently have to be transported to remote disposal sites, incurring additional expenditure.

The designated refinery currently supplies fuel oil to other large power plants in the region. If the commercial-scale demonstration is successful and the refinery elects to adopt the MSAR process, this refinery would produce up to 5m tonnes of MSAR annually for power generation purposes. This is a substantial opportunity in its own right. Roll-out would take place with minimal capital expenditure for Quadrise, as the participating refinery is expected to bear the costs of purchasing and installing equipment for MSAR production, paying fees on a licence basis to Quadrise for the use of its IP.

Adoption by this major refinery would encourage adoption elsewhere in KSA. Quadrise estimates that because of a shortage of natural gas, over 50% of power in KSA is generated from crude and fuel oil, resulting in 30m tons of oil being consumed each year in thermal power generation. Demand for power in KSA is growing very rapidly. There is insufficient heavy residue produced in KSA to produce sufficient MSAR domestically to meet even current oil-fired thermal power generation requirements. It is possible that, should MSAR production become widespread, KSA could potentially import at least 10m tons of MSAR annually, thus gaining considerable financial advantage from reducing HFO imports.

We note that MSAR is attractive to other oil-based economies that have to import diesel, representing substantial opportunity for Quadrise in the longer term.

Quadrise has identified the substitution of HFO used to generate steam and power in oil refinery complexes as an additional MSAR target market. Substitution of HFO with MSAR presents an opportunity for refiners to reduce costs and potentially generate power and steam for sale to third parties, since refineries frequently have installed power generation capacity in excess of their own needs. Surplus MSAR could also be sold to third parties, for example as marine bunker fuel. As noted in the section on KSA, switching to MSAR would be economically beneficial and relatively simple to carry out.

Quadrise is currently finalising a detailed design feasibility study for a mid-sized refining company, which is evaluating MSAR for steam generation within a refinery complex. Management anticipates that the pilot plant installation will take place during CY16 and that if this is successful, then MSAR fuelling will be progressively extended to several refinery-based utilities.

Quadrise intends to build on this opportunity by identifying a list of similar prospects and then approaching them, using the current project as a reference plant. While each of these projects may be individually modest in scale, collectively they could aggregate to a meaningful business sector.

In an initiative instigated in FY13 to broaden the project portfolio, Quadrise embarked on a programme with an unnamed global oil major to add value to heavy residue streams produced in a proprietary refining process at multiple large-scale process plants. Quadrise has succeeded in converting these residue streams to MSAR. The results so far indicate that Quadrise’s technology will offer a higher-value route to market for the oil major. The relationship is ongoing and the technical scope has been extended. It is likely that successful completion of the LONO programmes with Maersk will encourage this oil major, as well as others, to proceed with MSAR production.

The availability of MSAR to supply the Singapore bunker market would be of benefit to long-term potential consumer YTL PowerSeraya. PowerSeraya is a power utility company based in Singapore, which consumed up to 1.8Mt of Orimulsion emulsion fuel annually until 2006, when production ceased. It continues to view MSAR as an alternative emulsion fuel, agreeing to a further 12-month extension to the memorandum of understanding which covers the basis for cooperation on developing a MSAR supply chain for its Singapore power plant.

Towards the end of calendar FY14, Quadrise submitted a feasibility report to Ecopetrol (the Colombian national oil company) regarding a joint venture to produce MSAR fuel in Ecopetrol refineries for supply and sale in Central America. The adoption of MSAR in Colombia would have improved Ecopetrol refinery economics and provided an opportunity for Ecopetrol to generate incremental revenues from MSAR sales. However, in early calendar 2015 Ecopetrol advised Quadrise that it was freezing all non-essential capital and operating expenditure relating to refining, supply and marketing activities and was therefore unable to participate in the proposed JV. At present, Quadrise is not funded sufficiently to support an operation in which it has to finance extensive capital expenditure and purchase of heavy oil residue, so the project is on hold.

The programme with Ecopetrol had replaced a programme with PEMEX, Mexico’s national oil company. Quadrise has not taken any further action with regards to Mexico as it is not yet clear how far the changes in policy and practices in the country could affect the feasibility and merits of reviving the Quadrise project.

Ian Williams (executive chairman) spent 27 years at Shell, mostly in the downstream business, leaving the group in 1996. His most recent position at Shell was head of strategy & consulting (downstream) for Shell International in London.

Hemant Thanawala (finance director) has over 28 years’ experience as a chartered accountant and was formerly the finance director of AIM-listed Nautical Petroleum. He qualified and practiced at what is now KPMG.

Jason Miles (chief operating officer) spent 12 years developing emulsion fuel projects, initially as a process engineer with BP and subsequently as business development manager for PDVSA, where he implemented various Orimulsion projects.

Over the last 18 months, Quadrise has strengthened the management team as it prepares for the commercialisation phase. Jason Miles is now supported by three general managers, who each take responsibility for the power, marine and refining sectors.

Fuel oil spreads: the refinery price ‘spread’ between diesel and HFO determines the economic attractiveness of a switch in converting heavy residue to MSAR, rather than HFO, and thus the amount by which MSAR may be discounted with respect to HFO. The underlying trend of strong demand for kerosene and diesel compared with stable or declining demand for HFO is expected to maintain or stretch these inter-product spreads. Rising production of shale gas and shale oil is not expected to affect the value-added proposition in Quadrise’s target markets.

Not applicable to all refineries: only one quarter of refineries globally are currently producing residue suitable for MSAR feedstock. However, this still offers substantial scope for MSAR uptake.

Customer acceptance: Quadrise’s MSAR has been proven both in the laboratory, in numerous field trials and in a commercial and technical demonstration in Lithuania. However, MSAR still needs to be adopted as a marketable, environmentally friendly and economic substitute for HFO by the power and marine bunker sectors, which are inherently conservative.

Environmental: changes in environmental restrictions on marine engine emission characteristics play to the advantage of MSAR as a marine fuel. However, environmental and supply concerns may mean that increasing numbers of oil-consuming power stations switch to gas where they can.

Client/partner risk: although Maersk could terminate its relationship with Quadrise, this decision seems unlikely given the size of its fuel bill and the recent execution of contracts with Maersk and CEPSA. Moreover, given Maersk’s current issues with average freight rates, the adoption of MSAR may help regain profitability. AkzoNobel could also terminate its relationship, but this would not be logical, since it would forfeit the potential for significant sales of speciality chemicals, which would offset the considerable R&D costs it has already incurred. The negotiations surrounding the Saudi agreements are complex, involving stakeholders from both petrochemical and power generation industries, so it may take longer for this project to progress to commercialisation than assumed in our model.

Since Quadrise is neither an energy company nor an industrial manufacturer there are no credible peers with which to carry out a multiples-based comparison. Our indicative valuation is therefore based on the NPV of the sum of the potential cash flows from each of the key projects: marine, Saudi Arabia, refinery refuelling and Asia. We apply a separate discount rate to each key programme based on specific project and country risk, in effect applying a blended discount rate of 12.7% to the sum of cash flows. Further progress on any one of the key projects would imply a reduction in the blended discount rate used in our valuation. We model the cash flows over a 15-year period beginning in FY16 to capture the long-term potential of the projects.

Noting that all the projects are still at the pre-commercialisation phase, with delivery volumes and (in most cases) pricing structures under discussion, our model assumes significant commercial revenues from MSAR-Marine and Saudi commencing towards the end of FY17, with Asia and the refinery refuelling project in FY18. By FY20, we estimate that Saudi will contribute 40% of total cash flow, MSAR-Marine 36%, refinery refuelling 12% and Asia the remainder. Each of the cash flow streams is currently derived from licence revenues. Project-related capex will be minimal, even when the programmes enter their commercial phases, because the MMUs required for fuel production will be resold to the refineries producing the fuel. Similarly, working capital requirements will be relatively low because Quadrise will resell the surfactants required in fuel production to the refineries.

Our analysis gives an indicative value of 53.2p/share (£431m) with current perceived levels of risk. We see potential for an uplift in share price beyond this towards 67.2p (10% blended discount rate) as each of the key projects makes material progress towards reaching the commercialisation phase and the blended discount rate is consequently reduced. We have reduced our indicative value range from the 55.6p-69.1p discussed in our November 2014 note. While we model a slower ramp-up in volumes for both the MSAR-Marine and Saudi programmes than previously, we have reduced the risk factor applied to the MSAR-Marine programme to reflect the recent progress made with Maersk and CEPSA.

FY15 losses before tax (excluding exceptions, share-based payments and amortisation) widened by £0.3m to £2.7m. Production and development costs increased as Quadrise prepared for the onset of commercial production.

We have revised our estimates to reflect a slippage in the marine, Saudi and global oil major programmes of around one year and the substitution of the refinery refuelling programme for the programme with Ecopetrol. Our current model shows this programme ramping up volumes between FY17 and FY18. Our previous model showed the Ecopetrol programme generating commercial volumes of MSAR during FY17. Our estimates show losses before taxes widening during FY16, as the increased costs associated with supporting the pilot programmes are not sufficiently offset by the revenues generated by the pilots.

Quadrise owns minority stakes in four Canadian companies associated with emulsion fuels and related technologies and with enhanced oil recovery. These are Quadrise Canada Corporation (20.4% stake), Optimal Resources (9.5%), Paxton Corporation (3.8%) and Porient Fuels Corporation (16.9%). The carrying values of Quadrise Canada, Optimal Resources and Porient had been written to zero by the end of FY14, as all three had been adversely affected by the growth in shale gas production, leaving them with minimal prospects of establishing successful operations. The £1.4m carrying value for the stake in Paxton was left unchanged at end of FY14 since Paxton has a 30% stake in Clean Energy Systems, which had developed a steam gun technology. At the end of FY14, the technology was being actively promoted by Maersk Oil & Gas but Maersk has since discontinued its involvement. The carrying value of the Paxton stake has therefore been written down to zero. We treat this as an exceptional item.

Cash used in operations during FY15 increased by £0.4m year-on-year to £2.7m, reflecting higher production and development costs. Capex of £0.2m was minimal. Cash decreased by £2.7m to £8.4m at the year end. Going forward, the majority of the pre-commercial costs, including the purchase of MMUs to produce MSAR for trials, will be recovered from clients. We therefore model minimal capital expenditure going forward. As the programmes proceed to commercialisation, we model an increase in debtors in line with revenues, supported by some use of working capital finance from FY17 onwards.

The balance sheet is currently free of debt with £8.4m cash at end-June 2015. Property, plant and equipment totalling £0.7m is primarily the MMU purchased during FY12, which will probably be deployed to produce commercial volumes for the Maersk programme. Assuming there are no material delays to the key programmes, so that substantial commercial revenues are received from FY18 onwards, our estimates show no further funding is required for Quadrise to reach profitability. Additional funding may be required at this point as Quadrise becomes engaged in programmes on a tolling basis or ultimately as a refiner in its own right.