Hellenic Petroleum — Refining estimates and valuation

Monthly movements in underlying benchmark refining margins are complex to forecast; however, it is apparent that the $10/bbl increase in Brent crude over the course of Q417 had a material negative impact on benchmark margins. Hydroskimming margins moved into negative territory in December 2017 through to January 2018 as a result. Stabilisation in crude prices drove a margin recovery in February 2018 and March 2018, and, in line with our underlying Brent crude price assumption for FY18 of $62.1/bbl, we expect margins to improve from March 2018 levels, driven by a fall in oil price from Q118 levels and annual seasonality. Our FY18 volume weighted average benchmark margin of $4.38/bbl is lower than c $5/bbl in FY17, but this is partly offset by higher utilisation in the absence of a major planned turnaround. We forecast refining adjusted EBITDA of €574m in FY18 versus €631m in FY17 for Hellenic.

Stronger controls on the sulphur levels in vessel exhaust gases come into effect from 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, high sulphur fuel oil (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 of and limited refuelling infrastructure.

It is widely expected that the shipping industry will shift from HSFO to marine gas oil, a distillate-based blend, and 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 Q417 refinery yield at 50% middle distillates, 20% MoGas, 16% fuel oil, 9% naphtha and 4% LPG demonstrates its bias towards the production of light low sulphur products. Significant investment in Aspropyrgos and Elefsina (Nelson complexity of 9.7 and 11.3, respectively) provides for the capability to convert heavy, high sulphur crudes into middle-distillate product.

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 $0.75/bbl higher in 2020 than in 2018. This positive impact is likely to be partly offset by overcapacity within European refining during the period 2018–2022, as discussed below.

Longer term, the outlook for European refining remains challenging. Overcapacity, a structural decline in European product demand and relatively high operational costs leave low-complexity refineries facing competitive pressures and lower margins.

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. Global refining additions are forecast to match incremental product demand growth in 2018 based on OPEC projections; beyond this, planned capacity additions exceed demand through to 2022, with a capacity surplus in developed regions including Europe.

Complex, low-cost, middle-distillate-orientated refineries are likely to survive, but increasing competition is likely to have a negative effect on refinery utilisation and margins in the long term – a risk for Hellenic margins unless competitors scale down. 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 2018–20.

Our refining margin and utilisation assumptions attempt to project the impact of shipping regulations and structural oversupply in Europe on Hellenic’s refining margins and utilisation. We forecast margins to remain slightly lower in 2018 vs 2017, but with profitability partially protected by higher utilisation in the absence of major plant turnarounds. Beyond 2018, we forecast a margin recovery in late 2019 through to 2021, reflecting shipping regulation changes followed by a structural decline as overcapacity heightens competitive pressures.

Key changes to our forecasts include marking to market for FY17 financial actuals and H118 benchmark margins, revising our forecast margin assumptions as described in the previous section of this note, updating current peer-group comparable multiples and rolling forward our DCF-based valuation. We also include a lower interest charge for short-term debt liabilities.

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

Edison remains ahead of consensus for FY18 and FY19 adjusted EBITDA at 13% and 10%, respectively. While Bloomberg does not provide divisional EBITDA splits, we believe that this is predominantly due to a higher estimated refining and petrochemical margin for the forecast period. Material differences in analyst estimates can be expected in light of recent margin volatility.

We adjust our valuation to reflect our updated forecasts, roll-forward of DCF and current peer-group multiples. Retaining our approach of using a blended valuation using peer-group PE/ EV/EBITDA and DCF valuations, our valuation moves from €9.3/share to €9.0/share (-3.2%).

Refining margins – along with all refineries, the major risk to earnings is volatility of refining margins. As a price taker, it can do little to mitigate in the short term. Longer-term improvements of the refineries are capital-intensive and take many years. However, it will also benefit from increases in refinery margins. As discussed in this 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) and is particularly advantaged vs single refineries (such as Saras and Motor Oil).

Oil price – an increase in the oil price could have a material effect on refinery earnings and the balance sheet. Increasing oil prices would produce positive inventory effect earnings for the refineries and marketing businesses, while requiring more cash to be locked up in working capital.

Greek risk – Hellenic has significant export businesses and its production is entirely fungible for international markets. However, a fall in Greek demand or market sentiment towards the country may mean reduced sales and a greater risk premium applied to companies in Greece. These could have a detrimental effect on earnings and rating for Hellenic. The Greek economy is growing again but there is disagreement between the IMF and eurozone on what actions are required to continue on a path to greater stability. The incoming head of the eurozone (Mario Centeno) has stated that Greece needs to complete the current programme before any restructuring can occur, yet on 10 December 2017 Christine Lagarde said the debt needs to be restructured soon and hoped that it could be done early in 2018. This is clearly a fluid situation and Greece is not out of the danger zone yet. We also note the state ownership of 35% may be sold down over time as part of Greek economic restructuring.

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 – as we mention in the financials section, a move in the euro versus the US dollar could have a material impact on earnings. Refining is a US dollar business (margins are quoted in US$) and so lower costs in US terms (as costs are in euros) have benefited earnings (and cushioned the poor refining environment in 2011–14). We calculate the average impact (2015–17) to have been around $85m on a pre-tax basis.