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Tuesday, February 21, 2017

PETRONM: A strong 4Q in the making?

Author: sumato88 | Publish date: Tue, 21 Feb 2017, 02:18 AM

Petronm and Shell Refining's share price was bashed down yesterday. Checking around and I can't find any reason except the news of new oil refinery to be built in Kedah which I think it is irrelevant as the new refined products are meant for export to China. I also read the comments among the forum members and I think I may offer my 2 cents on the stock.

Firstly, I must declared that I own some Petronm share for sometime. I believe the stock is significantly undervalued (I think the co can make rm200-300m profit a year in 2016 and 2017, which translates to 5-7x PE) as many investors (from what I observed in the forum) kind of confused or misunderstood the business model.

Petronm is an integrated downstream O&G player which owns the oil refinery (process the crude oil into gasoline/petrol fuel, jet fuel, kerosene etc) and the distribution network (petrol stations) to market its refined products to the consumers. Among the two, petrol station is the stable and profitable business where market tend to value this business like a concession. This is evident by the market valuation of Petronas Dagangan which has always been trading above 20x PE.

While for oil refinery, the profit tends to be volatile as the profitability depends on 3 key drivers, namely (1) crack spread (processing margin), (2) crude oil price which will have an impact on its inventory value, and (3) USD exchange rate.

Crack spread can be volatile as it depends on market supply and demand which I gather from my friend who is working in the industry that crack spread has been going up since Nov 2016. From what I understand, crack spread has improved from the avg of USD5/bbl in 3Q16 to USD7/bbl in 4Q16, and now at about USD8-9/bbl. in other words, Petronm's refinery margin will be stronger in 4Q16 and 1Q17 before taking into account the impact on its inventory gain/loss (sometime, overall refinery margin will be weaker even though crack spread remain the same as inventory loss due to lower crude oil price may eat into its refinery margin, this was what happened in 3Q16)

For the inventory gain/loss, like it or not, it is part and parcel of the oil refinery business as the refinery always hold some inventory (usually about 3-4 weeks inventory) to make sure the refinery has sufficient input material to process. Hence, when the crude oil price goes up, oil refinery will profit from the inventory gain, and vice versa. The good news for Petronm is crude oil price has been recovering from less than USD50/bbl in Sept16 to about USD55/bbl now. Hence, 2 out of the 3 key earnings drivers for the refinery biz are in Petronm's favour.

Lastly, we have to evaluate the impact of USD to Petronm's profitability. This is, in my view, the most difficult part to estimate. But if we take a cue from the historical trend, we can conclude that PetronM has a net long exposure on USD after taken into account its hedging position, As i noticed that Petronm always report net forex (both realized and unrealized) and derivatives gain when USD strengthen against Ringgit. Again, USD has been strengthening since Nov16 (+7% in 4Q16 vs 3Q16) which is another positive earnings driver for Petronm's refinery biz.

With all the key operating environments working in favor of Petronm, I would expect a record profit in 4Q16, and very likely a stronger profit in 1Q17 which serve as a key rerating catalyst for the stock. So what is the fair valuation for the stock?

Conservatively, we can assume 10x PE, a valuation between Petdag and Shell refining as it owns both of the marketing and refinery business which was separately owned by the 2 companies.

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