Karachi, March 06, 2013 (PPI-OT): Refineries: Excitement on deemed duty premature

KASB Securities Limited are not overly excited on the proposal to be tabled in the ECC meeting to lift deemed duty on HSD to 9.0% from existing level of 7.5%.

According to KASB Securities Limited the objective of the same is to incentivize refineries to install desulphurization units.

KASB Securities Limited sees decent likelihood of the proposal being accepted with the hike in deemed duty applicable from Jan-16. However this would be contingent on successful commissioning of HSD desulphurization units by Dec-15.

In KASB Securities Limited views, estimated capex requirements of US$100-150mn, financed through a mix of debt and equity, would be needed to undertake the project with estimated payback of 6-7 yrs, following which deemed duty would be abolished.

While KASB Securities Limited does not formally cover the two, KASB Securities Limited estimates annualized EPS impact of PRs6-7 for ATRL and PRs9-10 for NRL from FY16E onwards.

Proposal under consideration to raise deemed duty from 7.5% to 9.0%

The govt is reportedly considering increasing deemed custom duty built in ex-refinery prices of HSD from 7.5% to 9.0% as part of efforts to provide incentives for investment by oil refineries to produce Euro-II standard HSD. Deemed duty has the effect of inflating Gross Refining Margins (GRMs). The summary for approval of the above increase will be tabled in the ECC meeting on 6th March. While the change will have positive implications for refiners, KASB Securities Limited shares limited excitement, KASB Securities Limited as remain skeptical over time-line.

Implementation will depend on successful commissioning by Dec-15

For refineries, extracting benefits from the proposed increase in deemed duty hinges on successful completion of desulphurization units by Dec-15. If the units are successfully installed, the deemed duty will be increased to 9.0% effective Jan-16 to compensate the refineries for the required project cost.

The duty will be abolished after the cost of up-gradation/installation is recovered. KASB Securities Limited estimates a payback period of 6-7 years. KASB Securities Limited observes that since the increased duty will be applicable from Jan-16, likelihood of ECC approving the same is higher as political considerations should not play a part. Recall that in the past, govt had reduced the deemed duty from 10% to 7.5% in Aug-08 and also removed incidentals from ex-refinery price calculation in Dec-10 in order to penalize the refineries.

PRs6-7/sh and PRs9-10/sh possible earnings upside for ATRL and NRL

Refineries have out-performed the KSE-100 index by 6.1% in 2013-to-date on the back of increased GRM’s (up 37% MoM in Jan/Feb). In KASB Securities Limited views, the latest proposal will not have any immediate impact on earnings. However assuming that desulphurization units are successfully commissioned by Dec-15, KASB Securities Limited estimates annualized EPS impact of PRs6-7 for ATRL and PRs9-10 for NRL. Currently, the sector is not under coverage of KASB Universe.

Where will the financing come for this?

As per KASB Securities Limited discussions with industry experts, the investment cost for HSD desulphurization units is estimated in the range of US$100-150mn (approx capacity 30-40kbpd) and will take 2-3 years for completion. KASB Securities Limited expects a blend of debt and equity financing and possibly a D/E ratio of 80/20 which is manageable given under-leveraged balance sheets of refineries.
Why the need to impose deemed duty on HSD?

Deemed duty was initially provided to offer an incentive for refineries to build diesel desulphurization units and produce Euro-II grade diesel, an environmentally friendly fuel. Euro-II standard diesel contains 0.05% sulphur content, whereas refineries in Pakistan produce diesel with sulphur contents ranging from 0.25%-1.0%. Currently Pakistan is importing 54% of its total Euro-II compliant diesel requirements. 6% of the Euro-II standard demand is met through locally produced diesel while the remaining 40% is not compliant. The government in the past also directed all automobile companies and relevant industries to shift to Euro-II technology.