Pakistan Research

Refineries | Detailed Report

Research Entity Notification Number: REP-107

May 29, 2016

Refineries

MARKET WEIGHT
Severe challenges ahead

 Global refining industry surplus to balloon further: With the share of light crudes and
condensates bypassing refineries set to rise, existing surplus in global refining industry
is expected to swell further with net oil importing countries planning capacity
expansions to meet growing domestic demand and Middle Eastern players enhancing
their footprint in value added products. Nevertheless, demand growth is likely to trail
behind supply growth amid limited fiscal rooms for fuel subsidies in non-OECD.

 Ineffective ex-refinery pricing regime: The latest ex-refinery pricing formula that links
the price to PSO’s landed cost of imports of previous month does not compare
favorably with daily international crude oil pricing and weekly domestic crude pricing,
causing large volatility in Gross Refining Margins. The formula should be reassessed
with more frequent price revisions.

 Duties’ contribution to profitability is unreasonably high: Under current structure,

only 7.5% deemed duty is available to domestic refineries. Even at current price levels,
the domestic refining industry is absorbing nearly PKR 12bn annually. The government
has gradually abolished deemed duties to move towards deregulated environment.
Removal of the remaining HSD duty can cause serious damage to profitability.

 Consumption of refined products is set to enter a period of muted growth: The govt.
is currently importing around 400mmcfd of LNG to meet domestic requirements,
which already seems to have eased energy crisis significantly. News reports suggest
govt.’s plan to ramp up LNG imports to 2.4bcfd in next two years. TAPI gas pipeline is
also scheduled to supply 1.3bcfd of natural gas by 2020. Subsequently, we see
consumption patterns shifting in favor of natural gas and away from liquid
hydrocarbons. Furnace oil is likely to be worst affected as domestic market may turn
into a surplus from deficit currently.

 Growing environmental concerns may call for further investments: While global
trends are shifting towards development of Euro VI standards, domestic refineries are
currently installing Euro II compliance equipments. Strict environmental concerns shall
result in more stringent quality benchmarks and refineries shall be required to invest
in infrastructure without any guarantee for benefits.
Fatiq Bin Khursheed
+92 (21)35296888-2302  Up-gr adation projects to enhance profitability: Most of the refineries have already
 +92 (21)35296924 commissioned Isomerization plants which will convert low margin Naphtha into high
 [Link]@[Link] margin gasoline; however, installation of DHDS plants is still underway which will
 [Link] entitle refineries to additional 1.5% deemed duty on HSD.

Optimus Capital Management (Private) Limited does and seeks to do business with companies covered in its
research reports. As a result, investors should be aware that Optimus may have a conflict of interest that
could affect the objectivity of this report. Investors should consider this report as only a single factor in
making their investment decision. See last page for Analyst Certification and other important disclosures.
Refineries | Detailed Report May 29, 2016

Table of Contents

Product spreads rather than prices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

A brief history of ex-refinery pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

Gross Refining Margins – Past & Future. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Duties – Strong earnings contributor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13

Consumption – History repeating itself . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16

Need for new refineries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19

Understanding lubes segment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25

Up-gradation projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28

Euro emission standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .30

Domestic Refineries Profile. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31

Appendix. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36

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 Refineries | Detailed Report May 29, 2016

Product spreads rather than prices

Demand and supply fundamentals determine product spreads

While it’s a common perception that the direction of crude oil and/or refined products’
prices deter mines refineries’ profitability, we assert that this is only partially true because
spreads play a more critical role. Refined products, like crude oil, are also commodities with
separate markets. Ther efore, product spreads or crack spreads are a function of demand
and supply fundamentals.

Strong demand supports margins The link can better be understood through r ecent example of historic crude oil price crash
irrespective of price levels of 2014. More than a decade low international crude oil prices triggered a new demand
wave for downstream petroleum products, which resulted in refined products’ prices
dropping at a slower pace than crude oil itself. Thus, towering crack spreads, particularly
gasoline and naphtha, were seen in almost all regions of the world.

Product spreads also cyclical

Since product spreads are determined under market demand and supply forces, the same
are subject to cycles. As mentioned above, low prices provided a boost to demand and
caused abnormal expansion in crack spreads. The lofty margins proved to be the reason for
As demand is cyclical, margins are their own destruction as refiners all over the world geared up to exploit the dividends of
also cyclical robust downstream demand. However, demand growth failed to keep pace with supply
growth, leading to sharp contraction in crack spreads. Gross Refining Margins (GRMs) of
many of hydro skimming refineries have already entered into red. However, the invisible
hand of market forces shall come into effect and take off loss making capacities offline,
thereby bringing equilibrium back to the market.

Chart 1: NWE Brent Monthly Gross Refining Margins Chart 2: NWE Brent Annual Gross Refining Margins

16 8
USD/BBL USD/BBL

12 6

8 4

4 2

0 0
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
Jan-16

(4) (2)

(8) (4)
Brent (Hydro Skimming) Brent (Cracking) Brent (Hydro Skimming) Brent (Cracking)

Source: IEA Source: IEA

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 Refineries | Detailed Report May 29, 2016

Domestic ex-refinery prices are linked to cost of imports

The current domestic ex-refinery pricing regime is linked to international markets through
import parity pricing, wherein PSO’s actual import costs exclusive of incidentals are
Import parity pricing with prices considered benchmark for calculation of ex-refinery prices. The for mula entails basing ex-
linked to PSO’s landed cost of refinery price on PSO’s actual import costs of the previous month exclusive of incidentals. In
imports of previous month case of unavailability of actual imports costs, the prices are calculated in line with previous
formula which keeps average Arab Gulf FoB price as the benchmark, excluding incidentals.

The prices are revised on a monthly basis. In addition, the domestic refineries (except
PARCO) are required to submit the price differential on HSD between import parity based
ex-refinery prices and actual PSO’s imports based ex-refinery prices. The refineries are
required to do so in light of the differenc e between the sulphur content of HSD imported by
PSO and that of produced by domestic refineries (except PARCO).

While PSO’s weighted average landed cost is used as ex-refinery prices, following
methodology is used in case of no imports by PSO.

Monthl y a vera ge of FoB pri ces as published in Pla tts Oilgram (Arab Gul f Ma rket)

+
Monthly Marine Frei ght as published by London Tanker Brokers Panel (LTBP)

+
Premium / Discount as published in Platts Oilgram

=
C&F Price

+
Import Incidentals: Actual as per PSO Imports (MS and HSD only) excluding ocean losses

+
Customs / Deemed Duty: 7.5% on HSD

=
Ex-Refinery Price

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 Refineries | Detailed Report May 29, 2016

A brief history of ex-refinery pricing

Before June 2000, ex-refinery prices were determined in accordance with import parity
pricing which included Arab Gulf FoB price adjusted for freight and insurance. Adjustment
for ocean losses was allowed in March 2001. Arab Gulf FoB price was used as benchmark
since PSO imported bulk of the petroleum products from Kuwait Petroleum Corporation
under Government to Government contract.

Ex-refinery prices r evised on a However, the government adopted a new import parity pricing formula, administered by Oil
fortnightly basis Companies Advisory Committee (OCAC), in July 2001 which was aimed at tracking
movements in international oil prices on a fortnightly basis. Under the new for mula, import
parity prices were calculated as the sum of an average of past fifteen days of mean Arab
Gulf FoB price published on Platts Oilgram and premium, freight, and incidentals.

Guaranteed return formula replaced with tariff protections in 2002

The refineries operated on a guaranteed return basis prior to July 2002, with floor and
ceiling of 10% and 40% respectively. The guaranteed return regime was only applicable to
Ceiling and floor on returns fuel refineries and therefore, NRL’s lube operations were not subject to this regime. In July
abolished and replaced w ith 2002, the government abolished the concept of guaranteed profitability (except PARCO),
deemed duty protections introduced duty protections on four products, but retained the ex-refinery pricing
methodology. The refineries were allowed to pocket 10% deemed duty on HSD and 6% (5 %
deemed duty + 1% surcharge) on SKO, LDO, and JP-4.

ATRL, NRL, and PRL had approached the government for abolishing the guaranteed r eturn
structure and replacing it with an import parity pricing with duty protections. The objective
of the proposal was to allow the refineries to operate on a self financing basis, rather than
relying on the government for financial subsidies.

Cash dividend payout restrictions imposed

Dividend caps imposed with At the same time, the government restricted refineries from paying cash dividend in excess
outstanding paid up capital as at of 50% of the paid up capital, with the balance transferred to a special reserve account.
July 2002 as the benchmark Again, NRL’s lube operations remained exempt from this restriction.

Interestingly, dividend capping applies to the amount of paid up capital outstanding as at

1st July 2002, where subsequently increase in paid up capital owing to bonus and/or right
issues is not eligible for calculation of maximum dividend. The purpose of dividend

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 Refineries | Detailed Report May 29, 2016

restriction and special reserve was to raise capital for up-gradation of plant and equipment
to meet international standards for refined products.

Duties abolished to move towards deregulation of markets

In an effort to move towards deregulated market mechanism, the government eliminated
deemed duties on LDO and SKO in FY2008 Budget. Likewise, it also removed deemed duty
on JP-4 in FY2009 Budget, however, reduc ed it to 7.5% on HSD in August 2008. The 7.5 %
deemed duty is still being absorbed by refineries. Further, the government also revised the
pricing regime of Mogas by linking it to MS RO N 95 and calculating the r equired MS RO N 87
on a unitary method.

In June 2011, the government notified deregulation of MS, HOBC, LDO , and Aviation Fuels.
The der egulated ex-refinery prices were subject to a ceiling of PSO’s actual import parity
prices of the previous month. In case of unavailability of PSO’s imports, the ex-refinery
prices are to be calculated according to the previous formula excluding incidentals.
Conversely, OGRA continued to determine the prices of SKO and HSD.

Ex-refinery prices of HSD were deregulated in the same manner in September 2012. Last
modification was made in April 2013 when the government asked domestic refineries
(except PARCO) to submit the price differential between import parity pricing and PSO’s
actual imports based pricing.

Frequent changes in pricing formula coupled with elimination and reduction in deemed
Frequent changes in pricing r egimes
duties have had serious implications for the profitability of domestic refineries. As explained
create an uncertain economic
later, domestic refineries pocketed handsome profits thanks to deemed duties before they
environment
were abandoned. Nevertheless, the environment has turned much more volatile post
elimination and reduction in deemed duties as visible in Charts 3 and 4.

Chart 3: Pre-Tax Profits Excluding Other Income Chart 4: Pre-Tax Profit Margins (Excl. Other Income)

20 6.0%
PKR BN
5.0%
15
4.0%
10
3.0%

5 2.0%

1.0%
-
2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

0.0%
2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

(5)
-1.0%

(10) -2.0%
Pre-Tax Profit Excl. Other Income Pre-Tax Profit Excl. Other Income (% Revenue)

Source: Company Accounts, Optimus Source: Company Accounts, Optimus

The sample includes ATRL, NRL, and PRL

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 Refineries | Detailed Report May 29, 2016

Domestic crude oil is priced on a weekly basis

Since Pakistan produces limited quantity of crude oil / condensate to the tune of
Arab Light USD/ BBL
approximately 4.1MMT per annum as against refining capacity of 13.3MMT excluding
Dubai 45.0
Byco’s new refinery, domestic refineries have to rely on crude oil imports for meeting their
Oman 40.0
requirements. The black gold is imported from Arab Gulf given its proximity and political
Average 42.5
relations. Moreover, mid country and south based refineries account for all of crude oil
Transportation 2.5
imports since ATRL processes only indigenous crude oil.
Base Price 45.0
Yield Differential 1.0
Domestic Price 46.0
Domestic crude oil is priced on a weekly basis with an average price of Dubai and Oman
crudes serving as the benchmark adjusted for transportation cost and yield differential.
Yield differential can be calculated as the difference between the final gross worth of
refined products that can be produced from Arab Light and crude being priced. Calculations
under a hypothetical scenario are provided next for a better understanding.

Prices Arab Light XYZ Field

Product Value Value
USD/ BBL (A) Yield (B) Yield (D)
(C = A x B) (E = A x D)
Naphtha 40 14% 5.6 15% 6.0
SKO 52 14% 7.3 12% 6.2
HSD 50 20% 10.0 25% 12.5
FO 28 48% 13.4 45% 12.6
Loss 4% - 3% -
Gross Products
36.3 37.3
Worth
Yield Differential
1.02
(E - C)

Current ex-refinery pricing regime needs to be revisited

The current applicable ex-refinery pricing formula designed under the idea of deregulation
of markets has in effect failed to achieve its purpose. The formula does not adequately
Pricing frequency of refined capture the running international GRMs owing to innate limitations. The ex-refinery prices
products should be matched with are fixed for a month and linked to an average of international prices of the previous month
that of crude oil
whereas domestic crude oil prices are set on a weekly basis. Therefore, sharp rise in
international crude oil prices hurts domestic players by squeezing their spreads while sharp
drop in prices lead to massive inventory losses. Thus, we believe the current pricing formula
needs to be revisited and price revisions should be done on a fortnightly basis.

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 Refineries | Detailed Report May 29, 2016

Gross Refining Margins – Past & Future

Just as the financial markets look at international crude oil prices as an indicator of oil and
gas upstream profitability, they focus on refining margins, Gross Refining Margins (GRMs),
as an indicator of downstream profitability. These margins can simply be calculated as the
difference between gross final worth of basket of refined products and price of crude oil.

Since crude oil as well as refined products trade in both physical and financial markets,
Volatility has increased over the GRMs have a very volatile nature and the volatility has increased over the years following an
years
increase in volatility in crude oil prices. Though GRMs vary from refinery to refinery, they
present a good indication of trends in sector profitability.

Chart 5: Brent Cracking GRMs vs Brent Crude Oil Chart 6: Brent Cracking GRMs vs World Oil Demand

8 120 8 100
USD/BBL USD/BBL USD/BBL MBPD
7 7 95
100
6 6
90
5 80 5
85
4 4
60 80
3 3
75
2 40 2
70
1 1
20
0 0 65
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
(1) - (1) 60
Brent (Cracking) GRMs Brent Crude Oil (RHS) Brent (Cracking) GRMs World Oil Demand (RHS)

Source: IEA, Bloomberg Source: IEA, Bloomberg

Demand is the most dominant factor influencing GRMs

While crude oil prices seem to bear a decent correlation of 0.48 with GRMs, global oil
demand appears to be an even better influencer of GRMs with a correlation of 0.67. A
positive correlation between GRMs and crude oil prices seems surprising given the fact that
crude oil serves as the feedstock for refineries.

However, rising crude oil prices bode well for complex refineries by widening the spreads
between transport fuels and heavy fuels. In the short term, switching of transport fuels is
difficult in the absence of alternatives; never theless, fuel oil can be substituted with natural
gas and coal in many parts of the world. Chart 5 defies the myth that rising crude oil prices
hurt GRMs, as the period (2003-2008) of sharp increase in global crude oil prices coincided
with some of the healthiest years on record for refineries.

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 Refineries | Detailed Report May 29, 2016

Moreover, refined products’ demand seems to be the most crucial determinant of GRMs.
The abnormal expansion in margins between 2003 and 2008 can be attributed to the robust
Demand strength supports margins demand growth in non-OECD region that outweighed the decelerating trend in demand in
and vice versa OECD countries. Further, margins have collapsed when trends pointed towards weakening
demand. Besides, analysis of historical data also suggests that GRMs are also affected by the
level of inventories. Low stock levels amid strong demand cause widening of margins and
vice versa.

A look at international trends in GRMs

GRMs remained under pressure for most of the 1990s, led by a host of negative factors such
as downstream capacity additions in Middle East, famous Asian financial crisis, Russian
financial crisis, and lack of storage capacities. After the dust of nationalization of oil assets in
Overcapacity keeps margins oil exporting countries settled, the National Oil Companies (NOCs) starting expanding their
depressed in 1990s
footprint in the downstream industry to r educe their reliance on International Oil
Companies (IOCs) which left IOCs with abundant capacities. Resulting refining capacity glut
forced IOCs to dispose off their capacities.

Moreover, Asian financial crisis coupled with Russian financial crisis and expectations of
Chart 7: Brent (Cracking) Margins
global economy slipping into deflation had a significant toll on global oil demand, which
5
USD/BBL
even pulled cracking refining margins into red. Crude oil supplies remained strong in the
4
face of weak demand which caused storage tanks to hit capacities. Lack of storage capacity
3 forced gasoline tanks to store heating oil in August 1998. Likewise, gasoil inventories also hit
2 capacities.
1

Mixed trends in early 2000s

0
Jul-00

Jul-01

Jul-02

Jul-03
Mar-00

Mar-01

Mar-02

Mar-03
May-00
Jan-00

Nov-00

May-01

May-02

May-03
Jan-01

Nov-01
Jan-02

Nov-02
Jan-03

Nov-03
Sep-00

Sep-01

Sep-02

Sep-03

(1)
GRMs posted decent r ecovery in 2000 and 2001 in the wake of economic recovery in United
(2)
Brent (Cracking) States together with robust demand growth from emerging Asia. However, the recovery did
Source: IEA not last long as surplus industrial capacity in United States caused an economic slowdown.
Moreover, 9/11 attacks also dented margins by pulling down jet fuel demand.
Chart 8: Brent (Cracking) Margins

12
USD/BBL

10 2004-08: China fuels the engine of demand growth

8
GRMs entered into an extended phase of strength on the back of robust economic growth
in emerging economies, particularly China and India. Demand for distillate fuels remained
6
lofty on account of heavy industrial growth, fuel switching to oil from natural gas, and
4
Japanese nuclear constraints.
2

Furthermor e, expansion in refining capacity trailed behind growth in refined products

Apr-04

Jul-04

Apr-05

Jul-05

Apr-06

Jul-06

Apr-07

Jul-07

Apr-08

Jul-08
Jan-04

Jan-05

Jan-06

Jan-07

Jan-08
Oct-04

Oct-05

Oct-06

Oct-07

Oct-08

Brent (Cracking)
demand, thereby supporting margins expansion. Though high oil prices adversely impacted
Source: IEA
demand growth in OECD countries, it was overshadowed by strong non-OECD demand.

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 Refineries | Detailed Report May 29, 2016

Fuel subsidies in non-OECD also supported margins

Sustained high prices began hurting demand, though only marginally, in 2007. The easing
demand was witnessed in OECD countries where consumers are more responsive to
demand due to market based pricing mechanisms. However, largest and fastest growing
non-OECD countries had capped end user prices, thus insulating consumers from price
shocks and fueling demand growth.

2009: GRMs crash as high prices shrink OECD demand

World oil demand ended lower than previous year in 2008 for the first time since 1983, on
the onset of global recession, led by drop in OECD demand while non-OECD demand
Chart 9: Brent (Cracking) Margins
remained strong. 2009 was largely the same, with another year of demand contraction,
driven by lower OECD demand. Adding salt to the wounds, significant refining capacity
additions in Middle East, China, and India exerted supply pressures at a time when demand
growth was dismally low. Though margins recovered steeply in 2010 thanks economic
recovery in US and strong Chinese demand for gasoil, they fell sharply in 2011 on account of
intensifying Euro zone debt crisis amid possibility of sanctions on Iran.

In 2013, margins improved on the back of sharp recovery in demand growth led by higher
oil demand from Japan in the wake of nuclear outages, problems with natural gas supplies
leading to higher oil based electricity generation in Mexico, Northern Africa, and Middle
Source: IEA
East, and improvement in European economy. In 2014, GRMs came under pressure once
again by reason of economic slowdown in China and Middle East supply disruptions keeping
crude oil prices elevated.

2015: Crude oil price crash triggers a new demand wave

The historic crude oil price crash of 2014 prompted by OPEC’s decision to defend market
share in the wake of growing swiftly growing non-OPEC production led by US shale tight oil.
Chart 10: Brent (Cracking) Margins
The crude oil prices had dropped to lows of USD 50 per barrel in January 2015 from a peak
12
USD/BBL of USD 110 per barrel in June 2014. Nearly a decade low prices triggered a new of demand
10 across the board with US, China, and India leading way.
8

6
Gasoline was the highest in demand product with its crack spreads stretching abnormally to
4
as high as USD 25 per barrel. Moreover, naphtha also witnessed an unusual surge in
2 demand owing to robust demand from petrochemical sector, taking its crack spreads into
0
green after a patch of at least four years. However, demand for diesel and fuel oil remained
Aug-14

Aug-15
Jun-14

Jun-15
Apr-14

Jul-14

Apr-15

Jul-15
Mar-14

Dec-14

Mar-15

Dec-15

Mar-16
Feb-14

May-14

Feb-15

May-15
Jan-14

Nov-14

Jan-15

Nov-15

Feb-16
Jan-16
Sep-14

Sep-15
Oct-14

Oct-15

weak by reason of frail economic fundamentals in Euro zone.

Brent (Cracking)

Source: IEA

Nevertheless, tall GRMs in 2015 proved to be the r eason for their own destruction as
refiners in all the regions geared up to reap the dividends of strong demand. Consequently,

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 Refineries | Detailed Report May 29, 2016

supply growth outpaced demand growth and resulted in sharp contraction in margins.
Mainly, diesel has seen towering inventories amid higher capacity runs by Chinese teapot
refineries post increase in their crude oil import quotas. Likewise, gasoline spreads, though
still strong, have also experience steep correction.

GRMs expected to recover in medium term

Demand outlook looks buoyant in medium ter m as China and other countries with high
dependence on coal shift to diesel consumption before moving to natural gas over the long
run. While high refinery runs are likely to continue in China, India, and Middle East, subdued
margins are likely to pull down runs in US, Europe, and Japan. Subsequently, despite
expected short term weakness in margins, we expect r ecovery in medium term supported
by pickup in demand.

Long run outlook remains a concern

Expected overcapacity remains the major concern facing the industry. While net oil
importing countries are expected to enhance refining capacities for strategic reasons and
Development of CTL and GTL lower reliance on international markets, Middle Eastern countries are projected to add
technologies to shrink refineries’ capacities in order to further footprint in downstream segment. At the same time, the share
market shar e of light crude oils and NGLs currently passing through refineries is set to reduce with the
advancement of Gas-To-Liquids (GTLs) and Coal-To-Liquids (CTLs) fractionation
technologies.

Non-OECD countries have been taking advantage of recent oil price crash to reduce end
user fuel subsidies, which have been the major source of demand growth in the last decade.
Reduction in fuel subsidies coupled with in increasing focus towards fuel efficiencies in a bid
to lower carbon emissions shall keep pace of demand growth below capacity growth.
Consequently, with surplus capacity anticipated to rise, refining margins are likely to remain
under pressure in the long run.

Domestic GRMs have exhibited greater volatility

Domestic GRMs have remained more volatile, as visible in Chart 7, on account of frequent
changes in ex-refinery pricing regimes along with changes in deemed duty structures.
However, Chart 8 exhibits some surprising trends with pre-tax profits of refineries (NRL,
ATRL, PRL) excluding other income and running GRMs calculated from prevailing prices
moving in opposite directions, as the case is visible in 2010 and 2012. We believe the
abnormality can be explained through lagged pricing system in Pakistan wherein ex-refinery
prices are set in line with international prices of the previous month but domestic crude oil
is priced on a weekly basis.

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Refineries | Detailed Report May 29, 2016

Massive decline in 2009 profitability can be attributed to colossal inventory losses that the
refineries recorded in the wake of crude oil price collapse. In addition, lube operations
constitute a substantial portion of NRL’s profitability, where base oil prices tend to respond
with some lag to changes in crude oil prices.

Chart 11: Brent Cracking GRMs vs Domestic GRMs Chart 12: GRMs vs Pre Tax Profits Excl. Other Income

9 9 20
USD/BBL USD/BBL PKR BN
8 8
15
7 7

6 6 10

5 5
5
4 4

3 3 -

2 2
(5)
1 1

- - (10)

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015
2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015
(1)
Brent (Cracking) GRMs Domestic GRMs Domestic GRMs (LHS) Refineries Pre Tax Profits (RHS)

Source: IEA, Bloomberg, OGRA, Optimus Source: Bloomberg, OGRA, Annual Reports, Optimus

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 Refineries | Detailed Report May 29, 2016

Duties – Strong earnings contributor

Prior to 2002, the three refineries operated under guaranteed returns which resulted in an
average annual subsidy of PKR 4.3bn from FY1998 to FY2001. However, tariff protection on
four topping products post abolition of guaranteed return regime allowed the three
refineries to operate on a self sustaining basis.

At present, deemed duty is only available on HSD to domestic refineries. 7.5% deemed duty
PKR 2.3/lit is the increase in HSD on HSD is adding roughly PKR 2.3 per liter to the final price at current levels. As per the
price due to 7.5% deemed duty, latest available energy yearbook, domestic refineries produced approximately 4.3 MMT of
which is being absorbed by r efiners HSD in FY2014, which means the annual pre-tax profit to domestic refineries is about PKR
11.9bn assuming the same levels of production (working provided below).

Furthermor e, it should be noted that the benefit of deemed duty has declined with the
decline in international prices. As per our estimates, HSD duty generated an enormous PKR
30.6bn in annual pre-tax profit for refineries in FY2014 when international crude oil prices
averaged over USD 100 per barrel.

Production Price Revenue EPS

Duty Impact Duty PKR/USD
(Tons) (USD/BBL) (PKR Mn) Impact
Industry 4,307,179 7.5% 46.7 104.8 11,891 N/A
ATRL 576,616 7.5% 46.7 104.8 1,592 12.7
NRL 852,436 7.5% 46.7 104.8 2,353 20.0
PRL 620,508 7.5% 46.7 104.8 1,713 4.0

Production Price Revenue

HSD Duty Impact Duty PKR/USD
(Tons) (USD/BBL) (PKR Mn)
FY2006 3,283,141 10.0% 64.5 59.9 9,529
FY2007 3,235,050 10.0% 76.3 60.7 11,258
FY2008 3,562,352 10.0% 107.6 62.6 18,053
FY2009 3,256,156 9.7% 91.2 78.5 16,966
FY2010 3,142,275 7.5% 81.9 83.9 12,174
FY2011 3,244,138 7.5% 105.1 85.6 16,454
FY2012 3,227,974 7.5% 126.3 89.4 20,561
FY2013 3,866,250 7.5% 123.9 96.8 26,154
FY2014 4,307,107 7.5% 122.4 102.9 30,614

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Recent duties do not benefit refineries

The government had imposed regulatory duty of 5.0% in February 2015, which was
Product Additional Duty
extended in 7.0% in May 2015. Further, the government also imposed regulatory duties on
Crude Oil 2.0%
crude oil as well as other POL products in FY2016 federal budget in an attempt to raise
Motor Spirit 2.0%
additional revenue to reduce fiscal gaps.
Kerosene Oil 2.0%
HOBC 2.0%
High Speed Diesel 2.5%
Light Diesel Oil 2.0% However, domestic refineries are not entitled to any benefits arising from these duties. The
Furnace Oil 7.0% players are required to submit the pricing differential due to these additional duties to the
Aviation Fuels 2.0% government. Taking production levels of FY2014 as the benchmark, a brief working of the
additional revenue available to the government from imposition of new duties is provided
below.

Production Additional Revenue

Industry Current Prices*
(Tons) Duties (PKR Mn)
Motor Spirit 1,582,504 2.0% 53.3 1,512
Kerosene 173,723 2.0% 48.4 141
HOBC 13,843 2.0% 53.3 13
HSD 4,307,179 2.5% 46.7 3,961
LDO 54,100 2.0% 45.5 37
FO 2,925,707 7.0% 195.5 4,198
Aviation Fuels 688,220 2.0% 48.9 578
Total POL Products 9,842,415 10,440
Crude Oil Consumption 11,757,653 2.0% 38.3 7,044
Payable To Government 3,396
Government Revenues 17,484
* Prices are in USD per barrel except for the price of Furnace Oil which is USD/Ton

Besides, the government also earns 7.5% duty on imported HSD. Pakistan imported nearly
3.2 MMT of HSD in FY2015, which at current price levels would generate additional revenue
of about PKR 8.8bn annually. The new GST r egime wherein the government has started
announcing GST in fixed PKR/lit terms rather than percentage ter ms does not lead to
additional GST on duties. Had the government continued with its percentage GST structure,
it would have generated an additional PKR 3.3bn as sales tax on duties, at current effective
GST rates.

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POL products earn huge sums for the government

Petroleum products have always remained one of the highest revenue streams for the
government. Imposition of new duties has further elevated the government’s income from
petroleum products.

OMC Sales Revenue

FY2015 Duties Current Prices*
(Tons) (PKR Mn)
Motor Spirit 4,867,807 2.0% 53.3 4,650
Kerosene 175,540 2.0% 48.4 142
HOBC 22,856 2.0% 53.3 21
HSD – Local** 4,394,545 2.5% 46.7 4,042
HSD – Impor ted 3,184,921 10.0% 46.7 11,717
LDO 43,241 2.0% 45.5 30
FO 9,279,635 7.0% 195.5 13,314
Aviation Fuels 688,220 2.0% 48.9 578
Total POL Products 22,656,765 34,494
Crude Oil Consumption 11,757,653 2.0% 38.3 7,044
Corporate Tax on 7.5%
3,805
deemed duty to refineries
Government Revenues 45,344
* Prices are in USD per barrel except for the price of Furnace Oil which is USD/Ton
** HSD – Local number has been derived by subtracting total imports from total consumption

Again, had the government retained percentage GST regime instead of fixed PKR/liter, it
would have generated an additional PKR 12.0bn as income from sales tax on duties on
crude oil and petroleum products at current price levels, taking total government revenues
to PKR 57.3bn. In addition, hundreds of billions are also generated in the shape of GST on
POL products.

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Consumption – History repeating itself

Total energy products’ consumption has grown at a CAGR of only 2.1% from 17.0 MMT in
2002 to 22.3 in 2015. Despite growing population and energy needs, the low consumption
growth can be credited to increased use of natural gas in place of petroleum products,
Oil consumption growth remained particularly MS, HSD, and FO. Natural gas supply increased manifold post 2000 on the back
constrained owing to exponential of production ramp up from some of the largest fields such as Sawan, Miano, Latif,
growth in natural gas consumption Zamzama, Qadirpur, etc. which together with discounted pricing incentivized greater use of
the resource in place of liquid hydrocarbons. Resultantly, total products consumption
declined from 17.0 MMT in 2002 to 13.4 MMT in 2004, before embarking on upward
trajectory. Approximately 70% of the total consumption growth over the period under
review can be explained by the growth in MS consumption.

Chart 13: Energy Products’ Consumption Chart 14: Motor Spirit Consumption

25 5.0
MMT MMT

20 4.0

15 3.0

10 2.0

5 1.0

- -
2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015
Energy Products' Consumption MS Consumption

Source: OCAC Source: OCAC

Robust Motor Spirit consumption

Motor Spirit consumption remained subdued between 2002 and 2007, growing at an
unimpressive CAGR 1.1% despite healthy automobile sales by reason of greater use of CNG
Strong gasoline consumption thanks in transport vehicles as a result of growing price disparity in the wake of sharp increase in oil
to CNG shortages and decent prices. Nonetheless, consumption has shown a strong CAGR of 19.5% since then with the
automobile sales emergence of CNG shortages. Rec ent decline in oil prices has provided a boost to its
consumption given persistence of CNG outages across the country and record automobile
sales. First ten of FY2015 have already witnessed a handsome consumption growth of 24%.

Muted HSD consumption growth

HSD consumption, on the other hand, has remained constrained, growing at a dull CAGR of
0.5%. Between 2002 and 2007, consumption growth was hit hard by the growing use of
cheaper CNG in transport vehicles. However, post 2007, growth was restrained by the

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removal of hefty subsidies and availability of cheaper smuggled Iranian product. Moreover,
use of imported LNG by power plants is also restraining the consumption growth.

Power sector behind FO consumption

Power sector remains the biggest consumer of furnace oil in Pakistan. As visible in Chart 11,
FO consumption dropped sharply between 2002 and 2004 as a result of abnormal supply of
natural gas which induced greater use of natural gas by power plants and industries.
Chronic circular debt keeps FO However, the tr end started picking up pace once again post 2004 and reached a pinnacle of
consumption growth in check 9.0MMT in 2010 led by strong energy demand growth and emergenc e of natural gas
shortages. Since 2010, furnace oil consumption has remained a severe victim of chronic
circular debt issue and its consumption has remained restrained despite intensifying natural
gas shortages. The off-take improved to a new high of 9.6MMT in 2014 after the
government injected massive liquidity into the energy chain in June 2013 in an attempt to
eliminate circular debt problem.

Chart 15: High Speed Diesel Consumption Chart 16: Furnace Oil Consumption

10 12
MMT MMT

10
8

8
6
6
4
4

2
2

- -
2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015
HSD Consumption FO Consumption

Source: OCAC Source: OCAC

Natural gas supplies set to increase immensely

The government started importing 200mmcfd of LNG from April 2015 and the number has
doubled to 400mmcfd from April 2016. Currently, LNG is being supplied to Fertilizer, Power,
and CNG sectors and the energy crisis seems to have eased to a significant extent.
Moreover, work on TAPI gas pipeline has already started and the government is also near
awarding second LNG ter minal contract. Pakistan would import nearly 1.3bcfd of natural
gas from TAPI project. Resultantly, natural gas supplies are set to increase manifold and may
remain at a discount to oil products.

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Gas supply growth to keep oil consumption growth in check

The demand for energy, on the other hand, is likely to trail behind supply growth. Structural
issues in the economy remain unresolved which shall resist setting up of new and/or
expansion of existing industries. With demand growing at a slower pace than supply, the
government may keep its price at a discount to r efined products’ in a bid to maximize its
consumption. Moreover, government’s focus on power generation remains skewed towards
Consumption patterns to shift in
coal and/or imported gas. Existing power plants are gradually moving towards the two
favor of natural gas on account of
price discount energy sources while industries are also switching to the same. Consequently, we expect
refined products’ consumption to enter a period of low growth/decline as consumption
patterns change amid limited growth in total energy demand.

We expect MS consumption to remain strong on the back of decent automobile sales.

However, replacement of HSD by natural gas in power plants and heavy transport vehicles
shall keep its consumption growth restricted. On the other hand, replacement of furnace oil
by imported gas in power plants and industry is likely to cause sharp decline in furnace oil
demand. Pakistan imported about 6.0MMT of furnace oil in 2015; yet, the changing trends
may result in furnace oil market turning into a surplus.

Exporting furnace oil is not a viable option

Surplus furnace oil will need to be exported; however, exporting is not a viable option due
to double transportation costs involved in importing crude oil and exporting the final
product. Going forward, we believe the demand for furnace oil is set to weaken globally
with increased focus on reduction in carbon emissions and lower in-take by bunkers.

FO Export Example
Crude Oil - FoB USD/bbl 40
AFRA “ 2
Crude Oil - C&F (a) “ 42

FO - Crack Spread “ (12)

FO Price (b) USD/ Ton 188
AFRA “ 16
FO Price - C&F (c) “ 204

Loss on Local Sale (c – a) USD/bbl (11.6)

Loss on Export Sale (b – a) “ (14.0)

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Need for new refineries

Currently, ther e are 6 oil refineries operating in the country with an aggregate capacity of
18.8MMT in 2014. These refineries process imported as well as domestically produced
crude oil. Refineries processed a cumulative 11.8MMT of crude oil in 2014, with the share of
imported crude standing at 67%. PARCO is the largest domestic producer with a market
share of 39%, followed by NRL with a share of 20%. Though Byco’s new refinery has the
largest capacity, its utilization has remained quite low for various reasons.

Capacity Crude Processed Refined Products

Refineries (FY2014) Utilization
(MMT) (MMT) (MMT)
Attock Refinery 1.96 1.96 100% 1.90
Byco – Combined 7.19 0.90 13% 0.86
ENAR 0.33 0.32 97% 0.31
National Refinery 2.71 2.33 86% 2.26
Pak-Arab Refinery 4.50 4.61 103% 4.43
Pakistan Refinery 2.10 1.64 78% 1.63
Total 18.79 11.76 63% 11.39

The domestic refineries met roughly 54% of the country’s total refined products’ demand
whereas the installed capacity stands around 89% of the total consumption. Refinery
utilization levels have remained low post 2008 when massive inventory losses and sharp
PKR devaluation hit the sector badly. Current average utilization is pulled lower by PRL and
BYCO, while others continue to operate near full capacity.

Refined Products (MMT) ATRL NRL PRL BYCO PARCO ENAR TOTAL
Motor Spirit 344,320 164,418 156,074 66,180 851,512 - 1,582,504
Kerosene 47,646 - 2,441 - 87,509 36,127 173,723
HOBC - - - - 13,843 - 13,843
HSD 576,616 852,436 620,508 414,397 1,785,321 57,901 4,307,179
LDO 1,477 4,448 - 3,494 44,681 - 54,100
FO 449,016 514,979 487,131 276,211 1,135,291 63,079 2,925,707
Aviation Fuels 173,820 138,391 142,263 - 316,091 14,794 785,359
Naphtha 236,352 248,001 182,461 73,152 - 137,690 877,656
LPG 5,647 7,416 37,110 8,129 147,661 - 205,963
Energy Products 1,834,894 1,930,089 1,627,988 841,563 4,381,909 309,591 10,926,034
Lube Oil - 199,571 - - - - 199,571
Asphalt 50,979 108,556 - - 17,907 - 177,442
Others 13,888 16,969 - 21,507 30,815 - 83,179
Non-Energy Products 64,867 325,096 - 21,507 48,722 - 460,192
Total Products 1,899,761 2,255,185 1,627,988 863,070 4,430,631 309,591 11,386,226

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Nearly one-fourth of the product slate of the industry is tilted towards low value furnace oil.
Though Pakistan is a large consumer of furnace oil currently, gradual shift towards coal and
natural gas is likely to hit badly its demand. Resultantly, domestic refineries need to
upgrade their infrastructure that allows further cracking of furnace oil into lighter and value
added products. Recently, refineries have installed Isomerization units that will convert low
margin naphtha into high margin motor spirit, thereby further improving the product slate
in line with domestic demand.

Minimal FX savings from existing refineries…

Import parity pricing formula with duty protection to domestic refineries implies that it is
cheaper for the country to import refined oil products than crude oil itself, as evident from
minimal foreign exchange savings explained in the table below. Local crude oil processing is
not competitive due to obsolete machineries and technologies together with lack of
economies of scale.

At a benchmark crude oil price of USD 40 per barrel,

POL Products Imports Unit Value

HSD – Impor ts Tons 3,184,921
HSD – Price USD/bbl 50
HSD – Imports USD Mn 1,198

FO – Imports Tons 6,040,904

FO – Price USD/bbl 28
FO – Imports USD Mn 1,134

MS – Imports Tons 3,124,661

MS – Price USD/bbl 54
MS – Imports USD Mn 1,443

JP – Imports Tons 75,000

JP – Price USD/bbl 52
JP – Imports USD Mn 32

Total POL Imports (A) USD Mn 3,806

Crude Oil Imports Unit Value

Crude Oil Imports Tons 8,254,337
Crude Oil Price USD/bbl 40
Crude Oil Imports (B) USD Mn 2,461

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POL Domestic Production Unit Value

HSD – Production Tons 4,458,357
HSD – Price USD/bbl 50
HSD – Value USD Mn 1,676

FO – Production Tons 2,928,140

FO – Price USD/bbl 28
FO – Value USD Mn 550

MS – Production Tons 1,591,439

MS – Price USD/bbl 54
MS – Value USD Mn 735

JP – Production Tons 798,403

JP – Price USD/bbl 52
JP – V alue USD Mn 340

SKO – Production Tons 172,225

SKO – Price USD/bbl 52
SKO – V alue USD Mn 71

LDO – Production Tons 49,380

LDO – Price USD/bbl 48
LDO – Value USD Mn 17

Imports Savings (C) USD Mn 3,390

Naphtha Exports Unit Value

Naphtha Exports Tons 965,454
Naphtha Price USD/bbl 40
Naphtha Exports (D) USD Mn 344

If there were no r efineries,

Crude Oil Exports Unit Value

Crude Oil Exports Tons 4,113,228
Crude Oil Price USD/bbl 40
Crude Oil Exports (E) USD Mn 1,226

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FX Savings / (Loss) USD Mn

Oil Imports – Current (F) A+ B– D 5,924
Oil Imports – Assuming No Refineries (G) A+ C 7,196
Crude Oil Exports (H) E 1,226
FX Savings / (Loss) F–G +H (46)

Instead, the government would earn additional 7.5% duty on imported HSD which amounts
to PKR 11.7bn at current prices, if there were no refineries.

…however, refineries are crucial for strategic reasons

Despite minimal FX savings from existing refineries, strong refining sector is needed for
strategic reasons. Pakistan imports almost all of its crude oil and refined products from
Middle East, where political unrest has significantly increased in recent years, ther eby
raising the risk of supply disruptions.

External supply disruption risk can Many countries around the world maintain strategic petroleum reserves equivalent to as
be lower ed by establishing strategic much as 90 days of import cover to be used in times of any unanticipated external supply
crude oil r eserves and strong disruptions. Building crude oil storages shall be considerably less costly than building
refining sector storages for all of the refined products. Subsequently, refineries can ensure timely
availability of refined products.

Better technology required to process light crude from North

Northern r egion’s crude oil/condensate production has risen sharply thanks to two new
finds of the region, namely Nashpa and Tal blocks. The two blocks are located adjacently in
the district of Attock in Khyber Pakhtunkhwa. The output from these fields is quite lighter
than that of other areas/regions, and requires better technologies for its processing.

Moreover, ATRL is the only refinery located in close proximity which has already been
running above 100% utilization for some time. For these reasons, some of the output
needed to be exported. The country started exporting crude oil on a recurring basis for the
first time in June 2014. Nevertheless, ATRL has installed a pre-flash unit recently with a
capacity of processing nearly 10,000bpd which should allow processing of lighter crude
currently being exported.

Chart 13 shows that Pakistan’s oil and gas exploration history has remained concentrated in
two regions. Discovery of Chanda oil field in 1998 opened up a new exploration avenue in
Kohat sub-basin. However, the province has largely remained unexplored due to inadequate
security conditions in the region. With Operation Zarb-e-Azb yielding positive results, we

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believe exploration is likely to pick up pace and may result in an increase in crude
oil/condensate production. Moreover, OGDC plans to ramp up development activity in
Nashpa field, country’s largest oil field, which should lift production from the region.

Chart 17: Regional Crude Oil / Condensate Production Chart 18: Pakistan Crude Oil / Condensate Production

70 100
KBPD KBPD
90
60
80
50
70
40 60

30 50
40
20
30
10 20

- 10
Jul-09

Jul-10

Jul-11

Jul-12

Jul-13

Jul-14

Jul-15
Mar-10

Mar-11

Mar-12

Mar-13

Mar-14

Mar-15

Mar-16
Nov-09

Nov-10

Nov-11

Nov-12

Nov-13

Nov-14

Nov-15
-

2010

2011

2012

2013

2014

2015

9mFy16
North South

Source: PPIS Source: PPIS

Chart 19: Pakistan Exploration Map

Source: PPIS

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PSO plans for a 200,000bpd refinery

PSO’s new Managing Director, Sheikh Imran Ul Haq, expressed plans for setting up a
200,000bpd refinery in Pakistan in an interview with Bloomberg, which would help
strengthen the company’s supply chain and reduce the risk of external supply disruptions.
However, we believe the management needs to be cautious of the demand outlook when
Only deep conversion r efinery entering refining sector. With furnace oil consumption set to decline dramatically, we
makes sense in the backdrop of believe setting up a hydro skimming refinery would be a loss making proposition. Besides,
products’ consumption outlook the consideration should also include surplus capacity available with BYCO ’s new refinery,
which can address nearly a quarter of refined products’ demand.

In this backdrop, we believe setting up a deep conversion refinery may help, which would
have product slate skewed towards gasoline and diesel, the two products likely to remain in
deficit even after incremental natural gas supplies. If PSO installs this 200,000bpd refinery
and BYCO runs its new refinery at full capacity along, Pakistan may see a surplus of refined
products, which can be transported to China through CPEC rails/roads. China remains a
large net importer of gasoline and diesel.

A Pak-China Gwadar refinery can be win-win game

China Pakistan Economic Corridor (CPEC), a part of China’s One Belt One Road Initiative,
carries various energy and infrastructure related projects in Pakistan. We believe the
projects’ list should also include a deep conversion refinery, which would support both the
countries. Pakistan would import crude oil and process it into refined products, mainly
diesel and gasoline. It would benefit Pakistan’s external account by converting crude oil into
high spread products and exporting surplus products to China.

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Understanding lubes segment

Lube base oil is a raw material that is blended with additives to produce lubricants of
various grades and qualities. Transport sector is the largest consumer of lubricants with
nearly 90% of the overall demand share. Being a deregulated segment, lubes remain one of
the most profitable segments for the oil refining industry. NRL is the sole producer of lube
base oils in Pakistan and thus enjoys a distinct competitive edge over its competitors.
Statistics reported, however, show marked differences between lubes production and
consumption, which we believe can be attributed to the unorganized sector.

Chart 20: Lubes Sales Chart 21: Lubes Production

160 210
KTONS KTONS
140 205
200
120
195
100 190
80 185

60 180
175
40
170
20 165
- 160
2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014
Lubes Sales Lubes Production

Source: OCAC Source: OCAC

NRL prices its LBO in line with import parity prices, a brief example of which is provided
below.

Lube Base Oil Pr icing

C&F USD/Ton 550
X-Rate PKR/USD 104.75
C&F PKR/Ton 57,613
Custom Duty 10% 5,761
Excise and Taxation 0.85% 490
Import Charges 4% 2,305
Import Parity PKR/Ton 66,168
Import Parity PKR/lit 59

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NRL enjoys tariff protection on LBO imports

Besides maintaining the status of sole lube base oil producer in the country, NRL also enjoys
the benefit of tariff protection from imports. The duty has made significant contributions to
the company’s profitability over the years as shown below. However, with crude oil prices
shrinking to less than half, the absolute number of duty protection has also come down. As
per our estimates, NRL is earning roughly PKR 1.1bn (after tax) annually from duty
protection at current price levels. Nonetheless, we believe the company has taken
advantage of the oil price collapse and not fully passed on the benefit of low prices to
consumer, thereby magnifying margins. The exceptional margins are visible in the income
statements of past four quarters.

Production Price Revenue

LBO Duty Impact Duty EPS Impact
(Tons) (USD/Ton) (PKR Mn)
FY2006 199,327 20% 722 1,723 14.0
FY2007 206,121 20% 838 2,098 17.1
FY2008 202,983 20% 868 2,206 17.9
FY2009 195,424 10% 906 1,390 11.3
FY2010 194,644 10% 827 1,350 11.0
FY2011 198,843 10% 1,104 1,879 15.3
FY2012 200,236 10% 1,249 2,235 18.2
FY2013 200,609 10% 1,044 2,028 16.5
FY2014 199,571 10% 993 2,041 16.8

Post reduction in and elimination of deemed duties on refined products, NRL’s fuel segment
hardly breaks even whereas entire net profitability originates from lubes segment.

Chart 22: NRL Earnings Contribution Chart 23: NRL Lube Profitability vs Base Oil Price

100 80 1,400
PKR/Share PKR/Share USD/Ton
80 70 1,200
60
60 1,000
50
40 800
40
20 600
30
- 400
20
2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

(20) 200
10
(40) - -
2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

(60)
NRL Lube Earnings NRL Fuel Earnings NRL Lube Earnings (LHS) Base Oil Price (RHS)

Source: NRL Accounts, OPEC Source: NRL Accounts, Base Oil Report

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Understanding Lube Base Oils

Lube Base Oil (LBO) is derived through complex distillation and refining of crude oil, which
when added with nearly 10% of additives yields finished lubricants. LBOs are categorized by
American Petroleum Institute into give groups, i.e. Group I, II, III, IV, and V. The first three
groups are extracted from refining of crude oil whereas Group IV is chemically synthesized
and Group V includes all other base oils.

Group I
Group I base oils are least refined and therefore cheapest ones. While some of the Group I
oils are used in automobiles, they are generally consumed in less demanding applications.

Group II
Group II base oils are manufactured through hydro cracking due to which they are more
refined and costly than Group I oils. They are mostly used as motor oils.

Group III
Group III base oils are severely hydro cracked and more refined than Group II oils. Although
made from crude oil, Group III oils are sometimes also called synthesized since they are
blended with additives and marketed as synthetic or semi-synthetic products.

Group IV
Group IV base oils, also polyalphaolefins, are chemically engineered synthetic oils. They
have a much broader temperature range and well suited for use in extreme conditions.

Group V
Group V base oils are primarily utilized in the creation of oil additives. They are not base oils
themselves, but add beneficial properties to other base oils.

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Up-gradation projects

The government had allowed refineries the benefit of deemed duty on HSD, LDO, JP-4, and
SKO, in 2002 in an attempt to help them raise capital for up gradation of their capacities.
However, the incentive for capital investment diminished after the government reduc ed
deemed duty on HSD and abolished on other three POL products. In March 2013, the
Refineries up grading plant and government announced an incentive of 1.5% additional deemed duty on HSD to expedite
equipments to meet Euro II the process of installation of Isomerization and Desulphurization plants. The additional duty
standards introduced in 1996 shall remain applicable till complete deregulation. Latest deadline for executing the above
mentioned projects is June 2017.

ATRL has already completed installation of both the units, whereas NRL expects projects’
completion by mentioned deadline. Further, PRL has commissioned Isomerization plant but
work on DHDS plant unit is still underway. However, PARCO already has both the plants.

Our analysis suggests that while Isomerization economics is healthy, Desulpurization

economics is not very impressive. The additional 1.5% deemed duty does not provide
adequate returns on capital. However, a combination of the two projects makes some case.
Sample cases for NRL and ATRL are presented below.

National Refinery (N RL) Calculations

Total Investment PKR Mn 35,000

Debt " 24,000
Equity " 11,000

6M KIBOR % 7.0%
Interest Cost PKR Mn 2,088
Additional Cost " 149

Additional MOGAS Tons 190,000

Isomerization Revenue PKR Mn 2,559

DHDS HSD Tons 534,000

Desulphurization Revenue PKR Mn 415

Total Revenue PKR Mn 2,973

Total Cost " 2,237
Net Cash Inflow " 737

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Surprisingly, NRL’s considerably high project cost makes its investment case less attractive
relative to ATRL.

Attock Refinery (ATRL) Calculations

Total Investment PKR Mn 25,000

Debt " 22,000
Equity " 3,000

6M KIBOR % 7.0%
Interest Cost PKR Mn 1,914
Additional Cost " 177

Additional MOGAS Tons 230,000

Isomerization Revenue PKR Mn 3,097

DHDS HSD Tons 580,000

Desulphurization Revenue PKR Mn 450

Total Revenue PKR Mn 3,548

Total Cost " 2,091
Net Cash Inflow " 1,456

Removal of dividend caps is not linked

While it is widely believed that the government had linked dividend restrictions to up
gradation of refineries, our findings suggest that though the government had imposed
dividend restrictions in 2001 to accumulate capital in special reserves account, removal of
the cap was not linked to anything. Instead the refineries have been raising the issue of
removal of dividend caps with the authorities for some time now, which has remained
unaddressed thus far. Nonetheless, we believe the government will most likely accord to
the request as it will also generate some tax revenue.

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Euro emission standards

Growing concerns over environmental quality and health have led to development of
stringent benchmarks for carbon emissions. The government has already directed the
refineries to produce unleaded gasoline and Euro II compliant diesel. On the other hand,
global standards are now moving up to the level of Euro VI. Going forward, we believe
greater concerns over environment will result in stricter quality benchmarks and refineries
would be required to upgrade their infrastructure to meet the standards against no
guaranteed benefits.

1993 1996 2000 2005 2009

Gasoline
Euro I Euro II Euro III Euro IV Euro V
Aromatics, Vol%, Max No Limit No Limit 42 35 35
Olefins, Vol%, Max No Limit No Limit 18 18 18
Benzene, Vol%, Max 5.0 5.0 1.0 1.0 1.0
Oxygen, Wt%, Max 2.5 2.5 2.7 2.7 3.7
Sulpur, ppm, Max 1000 500 150 50 10
RON, Min 91 91 91 91 91
RVP, kPa 35-100 35-100 60-70 60-70 60-70
Lead, g/lit, Max 0.013 0.013 None None None

1993 1996 2000 2005 2009

Diesel
Euro I Euro II Euro III Euro IV Euro V
Poly Aromatics, Vol%, Max N/A N/A 11 11 11
Sulpur, ppm, Max 2,000 500 350 50 10
Cetane Number, Min 49 49 51 51 51
Density @ 15C, kg/m3 820-860 820-860 845 845 845
Distillation, T95C, Max 370 370 360 360 360

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Domestic Refineries Profile

Attock Refinery (ATRL)

ATRL is the pioneer of crude oil refining in the country, with its operations dating back to
Chart 24: ATRL Shareholding Pattern
1922. The r efinery has been gradually upgraded with new technologies to meet
international standards. The refinery was setup as a result of first oil discovery at Khaur in
Punjab in 1915, which flowed an average of 5,000bpd of crude oil / condensate. The
33% refinery was expanded for the first time post Dhulian oil discovery in 1937. The refinery has
almost always processed crude oil produced domestically. Prior to significant jump in
northern crude oil production, crude oil from south had to be transported upcountry
61% through bowsers or tankers. Existing refining capacity has capability to process lightest to
4%
heaviest crudes with API gravities ranging from 10 to 65.
2%

Attock Oil Company Limited Attock Petroleum Limited Foreign Shareholding Others

Source: Zakheera Isomerization / Desulphurization projects installed

ATRL has recently commissioned its much awaited Isomerization and Desulphurization
Chart 25: ATRL Product Slate (FY2014) plants along with a pre-flash unit and a captive power plant at a cost of approximately USD
250mn. Isomerization unit has a capacity of 7,000bpd to reduce benzene and sulphur from
0% 0% 1%
3%
Naphtha and convert it into high margin gasoline. Diesel Desulphurization unit has a
12% 18%

Motor Spirit capacity of 12,500bpd to reduce sulphur content and produce Euro-II compliant diesel.
Kerosene

3% 0%
HOBC
HSD
Moreover, Pr e-flash unit shall enhance refining capacity by nearly 25%.
9%
LDO
FO
Aviation Fuels
Naphtha
LPG
Lube Oil
Asphalt
Large investment portfolio
30% Others
24%
Besides refinery operations, ATRL also has a sizeable investment portfolio with investments
th
0%
in both listed and unlisted companies. The market value of investments as of 27 May, 2016
is approx. PKR 16.0bn or PKR 187/share, with unlisted investments priced at face value. The
Source: PEY
company receives dividend income from its investments, which over past six years made an
average decent contribution of 59% to total profitability.

ATRL Investments Shares Held Market Price Market Value

Listed Investments
National Refinery 19,991,640 371 7,427
Attock Petroleum 18,144,138 429 7,785
Unlisted Investments
Attock Gen 7,482,957 100 748
Attock Information Technology 450,000 10 5
Attock Hospital (Private) 200,000 10 2
Total 15,966

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National Refinery (NRL)

NRL was initially setup as a lube refinery in 1966. The plant had the capacity to process
Chart 26: NRL Shareholding Pattern
nearly 540,000 tons of crude oil per annum to produce 76,200 tons of LBOs per year, at a
cost of PKR 104mn. In 1977, the scope was extended to install a new fuel refinery with a
capacity to process roughly 1.5 million tons of crude oil per year at a cost of PKR 608mn,
25%
31% which was later expanded to 2.2 million tons after a revamp in 1990 at a project cost PKR
Attock Refinery Limited
125mn. In order to cater to growing demand for LBOs, the management decided to install a
Pakistan Oilfields Limited
Islamic Development Bank second lube refinery with a capacity of producing about 100,000 tons per annum of LBOs in
Foreign Shareholding
Others
1985. The refinery was installed at a cost of approx. PKR 2.1bn. Its capacity was further
4%
expanded by 15,000 tons per annum as a result of a revamp project in 2008. It is pertinent
25%

15%
to highlight that unlike first lube refinery which processes crude oil to produce LBOs, second
lube refinery is connected with the fuel refinery and takes up reduced crude oil from fuel
Source: Zakheera refinery as its feedstock. Moreover, NRL is the sole producer of LBOs in Pakistan.

Chart 27: NRL Product Slate (FY2014)

1%
0% Lube operations provide a cushion against volatility in fuel
0%
5% 7%
As discussed earlier, fuel refineries in Pakistan have remained victims of volatility due to
9%

frequent changes in pricing regime, inadequate pricing formulae, and obsolete technology
0%
Motor Spirit
Kerosene

11%
HOBC
HSD
and equipment. In this backdrop, NRL has a competitive advantage over its peers with large
LDO
FO lube operations, which enjoy deregulated status as well as duty protection. Since 2010,
38% Aviation Fuels

6%
Naphtha
LPG
where fuel operations have reported an average loss per share of PKR 7/share, lube
Lube Oil
Asphalt operations have earned a handsome PKR 48/share.
Others

23%

0%

PKR/Share 2010 2011 2012 2013 2014 2015

Source: PEY
Fuel EPS (8.9) 9.7 (1.5) (2.6) (35.5) (1.0)
Lube EPS 49.9 72.5 34.2 38.2 47.5 47.4

Work on up-gradation in progress

NRL has awarded the EPC contract for Isomerization and Diesel Desulphurization plants to
Chinese contractors, who have started the ex ecution of the same. With capacities of 16,000
tons per month and 11,000bpd, both Isomerization and Diesel Desulphurization plants are
expected to be completed at a cost of USD 349mn. Despite smaller capacities of the two
plants in comparison with ATRL, the project cost compares unfavorably with that of ATRL’s,
which has completed both the plants along with a captive power plant and a pre-flash unit
at a combined cost of approx. USD 250mn.

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Pakistan Refinery (PRL)

PRL is a hydro skimming refinery designed to process various imported and local crude oil to
Chart 28: PRL Shareholding Pattern
meet the strategic and domestic fuel requirements of the country. The Refinery has a
capacity of processing 47,000 barrels per day of crude oil into a variety of distilled
petroleum products such as Furnace Oil, High Speed Diesel, Kerosene oil, Jet fuel and Motor
26%
30% gasoline etc. The Refinery is operating at two locations. Main processing facility is located at
Shell Petroleum (London)
Korangi Creek with supporting crude berthing and storage facility at Keamari. Initially, the
Pakistan State Oil
Chevron Global design capacity of the Refinery was to process 1 million tons of crude oil annually, which
Hascol Petroleum
Others
was subsequently expanded to 2.1 million tons per annum.
14%

22%
8%

Isomerization installed, DHDS underway

Source: Zakheera The company has successfully commissioned its Isomerization plant at a cost of
approximately USD 50mn, which will double its gasoline production from existing 12,000
Chart 29: PRL Product Slate (FY2014)
tons per month to 24,000 tons per month. The plant shall improve company’s product slate
0% 0% 0% in favor of high margin products. Moreover, installation of DHDS plant is underway to meet
2%
11%
10% 0%
0% Euro-II standards. The management is also working on a conversion technology that would
Motor Spirit
Kerosene
convert furnace oil into higher margin middle distillates. The two projects are expected to
9% HOBC
HSD
be completed at a combined cost of USD 400mn.
LDO
FO
Aviation Fuels
Naphtha
38%
LPG
Lube Oil
Asphalt
Unimpressive product slate
30% Others

PRL had one of the most unimpressive product slate in the industry with only 10% of the
0%
output in the form of gasoline and a hefty 30% as furnace oil. However, share of gasoline is
set to increase with the commissioning of Isomerization unit. Nonetheless, absence of any
Source: PEY
non-energy products in the output mix is a cause of concern. Non-energy product markets
are deregulated in Pakistan and refineries enjoy decent margins. We believe the company
needs to install non-energy producing units such as asphalts and/or lubes to improve its
production profile.

Negative Equity
PRL had retained earnings of PKR 6.5bn in June 2008, which dropped to PKR 1.8bn in June
2009 and negative PKR 1.1bn in June 2010 as a result of reduction in and elimination of
deemed duties. Further, unappealing product slate with nearly one-third of the output
concentrated in negative spread yielding furnace oil also dampened profitability. We believe
further investments in technology up gradation and setting up of non-energy units are much
needed for continued survival of the company.

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Pakistan Arab Refinery (PARCO)

Commissioned in the year 2000 and built at a cost of USD 886 million, PARCO Mid-Country
Chart 30: PARCO Shareholding Pattern
Refinery (MCR) at Mahmoodkot near Multan adds 4.5 million tons per annum (100,000
BPD) to the country’s refining capacity. The refinery was established under 1994 petroleum
policy which granted a minimum guaranteed return of 25% (net of tax) for a period of eight
years if completed by the year 2000. Moreover, the floor and cap of 10% and 40% return
did not apply to the refineries setup under the policy. In addition, the government also
40%
lowered the amount of equity required for setting up a refinery from a debt to equity ratio
Govt. of Pakistan
Emirate of Abu Dhabi
of 70 : 30 to 80 : 20.
60%

The Refinery has a refining capacity of 100,000 BPD of a mixed Arabian Light/Upper
Zakhum/Murban crude slate, which is transported to the Refinery site by PARCO’s existing
Source: PARCO
pipeline System from Karachi. Further, PARCO was the first refinery to meet government’s
Chart 31: PARCO Product Slate (FY2014) directives of installing a DHDS plant to produce Euro-II compliant diesel. The management

0%
1%
1%
commissioned a DHDS plant in 2010 with a maximum capacity of 26,000bpd, at a cost of
0%

7%
3% USD 132mn. Furthermore, the management has also investment USD 32mn to setup an
19%

Motor Spirit Asphalt Air Blowing Unit for the production of road and industrial grade Asphalt. The unit
Kerosene
HOBC makes PARCO the second manufacturer of Asphalt in Pakistan, after Attock Group.
2% 0% HSD
LDO
26% FO
Aviation Fuels
Naphtha

Oil Transportation
LPG
Lube Oil
Asphalt
Others

1% 40%
PARCO’s pipeline network, together with its subsidiary PAPCO, covers a distance of approx.
2,000 kilometers from Karachi to Machhike near Lahore. The 870 kilometers long Karachi
Mehmoodkot Pipeline, commissioned in 1981, carries crude oil for processing by the MCR.
Source: PEY
Additionally, PARCO commissioned a refined products pipeline in 1997 to transport diesel
Chart 32: PARCO Pipeline Network and kerosene oil to Faisalabad and Machhike near Lahore. Besides, PARCO’s subsidiary,
PAPCO, owns the mega White Oil Pipeline that was installed at a cost of USD 480mn to
transport imported diesel upcountry. The pipeline also serves the purpose of diesel storage.

Oil Marketing
Along with oil refining and transportation, PARCO also has an oil marketing joint venture,
under the name of Total Parco, with TOTAL SA of France. Recently, Total Parco also acquired
the assets of Chevron Pakistan to become the third largest oil marketing network of the
country. The total network includes about 765 retail outlets.

Source: PEY

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Byco Refineries (BYCO)

Byco has two refineries in Pakistan, under the names of Byco Petroleum and Byco Oil. Byco
Chart 33: BYCO Shareholding Pattern
Petroleum is the old hydro skimming refinery that was setup in 2004 in Mouza Kund,
Baluchistan. The refinery has a total capacity of processing 1.74 million tons of crude oil per
annum. The second r efinery with the largest capacity in the country to the tune of 5.5
million tons of crude processing was commissioned in 2013; however, its utilization has
remained low for various reasons. Furthermore, Byco is the only refinery with an oil
marketing license as well.

What went wrong in 2009

Byco Petroleum suffered a sharp loss to the tune of PKR 10bn in 2009 which pulled its
Source: BYCO retained earnings into red zone. The company has not yet been able to recover from those
losses. The company recorded a massive FX loss of about PKR 4.3bn in 2009 by reason of
steep PKR depreciation against USD. Byco approached SBP for early retirement of its LCs but
Chart 34: BYCO Product Slate (FY2014)
was denied due to fragile FX reserves position of the country. In addition, absence of an
1%
0% 0% efficient inventory management system led to huge inventory losses following crude oil
3% 0% 0%

0%
8%
8%
price crash of that time. The management imported crude oil through FOTCO and
Motor Spirit
Kerosene
transported it to its refinery site through bowsers, due to which it carried large amount of
HOBC
HSD inventories to lower the risk of supply disruption. Further, at that time, Byco sold most of its
LDO
FO products to PSO which delayed payments due to chronic circular debt issue. Resultantly,
Aviation Fuels
32% Naphtha
LPG
Byco’s cash cycle extended to roughly 120 days.
48% Lube Oil
Asphalt
Others

0% Changes to strategy
Source: PEY
Having learned from the 2008 debacle, Byco has arranged both funded and non-funded
working capital lines, as opposed to only non-funded lines at that time. Moreover, LCs are
established for a 30 day credit period, which lessens the risk of FX losses. In addition, the
management has also enhanced its focus over its oil marketing arm and supplies a portion
of its products through its marketing channel which leads to early realization of cash. Lastly,
Byco does not rely on PSO anymore for most of its products’ sales in order to reduce the risk
of single customer.

Up-gradation projects
The management has installed an Isomerization unit with a highest capacity of 12,500bpd,
which would cater to naphtha produced from both the refineries. However, commissioning
of DHDS plant is still underway.

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Appendix – 1

Conversion Factors

Conversions litres/ton bbl/ton

Naphtha 1,415 8.90

Gasoline 1,359 8.55

HOBC 1,338 8.41

Kerosene 1,268 7.98

JP-1 1,285 8.08

JP-4 1,320 8.30

HSD 1,195 7.52

Furnace Oil 1,066 6.70

LDO 1,151 7.24

LPG 1,298 8.16

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Appendix – 2

Oil Refining Diagram

Chart 35: Oil Refining

Source: [Link]

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Analyst Certification
The research analyst, Fatiq Bin Khursheed, for this report certifies that: (1) all of the views expressed in this report accurately
reflect his personal views about any and all of the subject securities or issuers; and (2) no part of any of the r esearch analyst’s
compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the
research analyst in this report.

Disclaimer
This report has been prepared by Optimus Capital Management (Pvt.) Ltd. [Optimus] and is provided for information purposes
only. Under no circumstances, this is to be used or considered as an offer to sell or solicitation or any offer to buy. While
reasonable care has been taken to ensure that the information contained in this report is not untrue or misleading at the time
of its publication, Optimus makes no representation as to its accuracy or completeness and it should not be relied upon as
such. From time to time, Optimus and/or any of its officers or directors may, as permitted by applicable laws, have a position,
or otherwise be interested in any transaction, in any securities directly or indirectly subject of this report. Optimus as a firm
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Ratings System
Optimus employs three tier ratings system, depending upon sector’s proposed weight in the portfolio as compared to sector’s
weight in KSE-100 index:

Rating Sector’s proposed weight in portfolio

Over Weight > Weight in KSE 100 Index
Market Weight = Weight in KSE 100 Index
Under Weight < Weight in KSE 100 Index

Ratings are updated daily to account for latest developments in the economy/sector/companies, changes in stock prices, and
changes in analyst’s assumptions.

In addition, Optimus employs three tier ratings system, depending upon expec ted total return (R) of the stock, as follows:

Rating Expected Tot al Return Where;

Buy R > 15%  R = Expected Dividend Yield + Expected Capital Gain
Neutral 0% > R < 15%  ‘R’ is before tax
Sell R < 0%  Time horizon is usually between six months to one year

Ratings are updated daily to account for latest developments in the economy/sector/company, changes in stock prices, and
changes in analyst’s assumptions.

Optimus Capital Management Pvt. Limited 38