Wednesday, March 11, 2020 / 01:54
PM / Fitch Ratings / Header Image Credit: Centre for European Reform
European refiners' profitability could benefit from the second quarter due to the recent price drop as refining margins are usually negatively correlated with oil prices, Fitch Ratings says. The impact will not be immediate as a sharp drop in oil prices will result in large inventory losses in 1Q20, which could weigh on full-year cash flows and leverage metrics.
The impact of coronavirus could complicate supply and demand dynamics in the refining sector: it is already causing lower demand due to flight cancellations, a decline in the shipping sector and reduced car traffic in areas hit by the virus. We do not expect our ratings on European refiners to be affected solely by the recent downturn in oil markets.
If oil prices were to recover quickly, refiners would face a more challenging operating environment caused by demand losses due to the coronavirus outbreak.
It takes a refining company an average of a month to process oil supplied to its storage tanks. While refining companies can pass changes in crude oil prices on to end customers, this is usually only possible in cases of smoother changes in oil prices. A sudden drop in oil prices generally results in high short-term cash losses on selling oil product inventory as costs of these inventories were high while market oil product prices have declined. Lower oil prices lead to significant working capital inflows offsetting the short-term negative impact from high-cost inventory destocking at the level of cash flow from operations.
A similar scenario developed during the previous downturn in oil prices in 2014-2016. A sharp drop in oil prices in December 2014 led to depressed cash flows and poor leverage metrics in 4Q14, affecting full-year results. However, the impact of lower oil prices was visible in 2015, when refining margins and cash flows were at record levels and leverage metrics were at the lower end of rating expectations.
An increase in demand coming from lower oil product prices is unlikely in the current macro environment due to the coronavirus outbreak. However, low oil prices should help refiners to defend their margins even if coronavirus continues to weigh on demand. The price war between major oil producers should put refiners in a good position to negotiate favourable pricing and payment terms on short-term supplies, with a positive impact on profitability and working capital levels.
Sudden swings in cash flows are more difficult for weaker refiners such as Corral Petroleum Holding (CPH) or KMG International NV (KMGI). However, CPH has recently refinanced its payment-in-kind bonds and has sound liquidity. KMGI continues to rely on short-term funding, as does Turkish Tupras, which relies on short-term funding and uncommitted credit lines from domestic banks, a general feature for large Turkish corporates with good access to bank funding. Nevertheless, even these issuers should be able to withstand the short-term effects from the price drop as liquidity impacts are likely to be temporary.
Stronger investment-grade European refiners, such as PKN ORLEN, MOL Hungarian Oil and Gas Company, and CEPSA, are well funded and will easily cope with volatility in oil and refining markets.