Australian Fuel Refining Future On Notice?

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Earnings for both Caltex Australia and Viva Energy are plummeting, as fuel consumption declines markedly across the country. Questions are also raised about the future of Australian refining.

-Declines in demand likely to outweigh higher short-term retail margins
-Caltex still progressing capital initiatives but skewed to the second half
-Continued pressure on margins likely to instigate a review of Australian refining
 

By Eva Brocklehurst

Weakening demand resulting from the coronavirus pandemic will have a significant impact on the earnings of Australian fuel retailers over the next 12-18 months. Hence, both Caltex Australia ((CTX)) and Viva Energy Group ((VEA)) have instigated changes to operations and will reduce capital expenditure.

The main issue for brokers is how quickly earnings will recover. There has been an -80%, or more, reduction in jet fuel volumes and a -40% drop in refiner margins. Retail fuel margins were up 49-77% in the March quarter but there has been a -30% drop in volumes.

A recovery in 2021 is expected for refiner margins and retail volumes, but jet fuel may be slower to take off. UBS reduces 2020 forecasts substantially and expects that declines in demand over the short term will far outweigh higher retail margins.

Credit Suisse assumes an -80% reduction in aviation fuel demand in the June quarter, noting the two companies have exposures of around 20% of volume to this segment. The broker also moderates retail margin estimates from April onwards, based on the assumption reduced economic activity will lead to increased competition and subsequent margin deterioration over the June quarter.

Credit Suisse forecasts a retail fuel margin of around 3.7c per litre in the first half of 2020.

In terms of the balance sheet, Caltex and Viva Energy have plenty of liquidity and no maturities due in 2020. Caltex also has the option of the proposed property IPO and sale of sites. Despite the low level of confidence, the balance sheets are strong and earnings are likely to rebound.

Significantly, the lower refining margins go, the more brokers ponder the long-term sustainability of fuel refining in Australia.

Caltex Australia

Caltex has pulled forward the shutdown of the Lytton Refinery, which Credit Suisse assumes will take place over May and June. Production guidance has also been withdrawn.

Thew company expects refinery operations to recommence after there is a sufficient improvement in refining margins. Morgan Stanley assumes margins of US$7/bbl later in 2020, increasing to a mid-cycle level of near US$10/bbl in 2021.

Caltex provided no update on the bid by Couche-Tard. The latter had indicated it remained in active due diligence as of March 18. The issue is whether the bid will proceed and at what price.

The bid price was $35.25, but Morgan Stanley points out this was before the All Ordinaries dropped nearly -25% over the year to date. The broker assumes Couche-Tard will want to re-price at a lower multiple.

Capital expenditure guidance for 2020 has been lowered to $250m from $300m. Subject to conditions, capital initiatives outlined at the 2019 investor briefing are still being progressed although are now skewed to the second half. This includes the sale of 49% of the retail property and divestment of around 240 retail sites as well as hybrid capital issuance.

There are four Hold ratings and one Buy (Ord Minnett) on FNArena's database. The consensus target is $29.31, that suggest 23.6% upside to the last share price. The dividend yield on 2020 and 2021 forecasts is 4.1% and 5.1% respectively.

Viva Energy

Viva Energy will delay its on-market buyback, having already delayed an off-market buyback, to assess the longer-term impact of the pandemic, which brokers believe is prudent. 2020 guidance has been reduced as the company preserves cash. Ord Minnett notes there is a lean cost base already, reducing the potential for further cost reductions.

Brokers assess the sale of the company's interest in Viva Energy REIT ((VVR)) was well timed, providing $680m in proceeds as a buffer. Morgans considers the decision to delay the buyback and keep the extra cash on balance sheet is a smart move that means the business should weather the current crisis.

If pressure on refining margins persists, several brokers suspect a strategic review of the Geelong facility is likely. Morgan Stanley estimates the refinery lost nearly -$50m during the first quarter of 2020.

Australian refining is under challenge because the cost structure is higher and there is less ability to blend crude versus competing refineries in Asia. In addition, capital will be required around 2025 to move the Geelong facility to a low sulphur fuel production. Ord Minnett agrees the longer-term outlook for the Geelong refinery is in question, noting the capital expenditure required over the next few years.

Morgans considers the stock is starting to trade at an attractive discount to valuation but remains cautious as the crisis is only in the early stages and there is going to be a substantial decline in demand across all segments of the business.

The database has two Buy ratings and four Hold for Viva Energy with a consensus target of $1.71, that suggests 26.4% upside to the last share price. The dividend yield on 2020 and 2021 forecasts is 2.4% and 5.6% respectively

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