19/01/2018
Pakistan Fertilizer Sector
What Could the New Policy Entail?
• Government is set to announce a new Fertilizer Policy after 17 years. The policy will likely be geared towards farmers.
• Possible measures under the new policy include reduction in GIDC rates, incentives to LNG based producers to prop up inventory levels, allowance for subsidized urea imports, change in gas prices/allocation and change in the subsidy mechanism. We believe that GIDC reduction and change in subsidy mechanism may be the most likely takeaways from the Policy.
• Reduction of GIDC would be a pass through for FFC in the form of lower urea prices, however could be a negative for EFERT as it already does not pay GIDC on concessionary gas.
• Keeping in view, 1) fiscal impact of subsidy, 2) Forex drain from additional imports (LNG/Urea) and 3) LNG capacity constraints, we believe allowance of subsidized urea imports may be on the cards.
• We believe DAP, NP and NPK could see reduced GST rates and proportionate reductions in subsidy rates to improve cash flow management.
• We downgrade our stance to Underweight on the sector as the new policy is unlikely to be positive for bigger fertilizer players and as such the recent rally in fertilizer stocks could be unwarranted.
New Fertilizer Policy In the Making: The Government of Pakistan is set to announce a new Fertilizer Policy which will replace the existing policy issued in 2001. According to the Minister for National Food Security and Research, the policy has been submitted to the cabinet for approval. According to the Minister, the policy could reduce existing GST rates on fertilizers in substitution of subsidies, to improve the cash flow cycle for manufacturers.
Announcement of New Policy Would be Nuetral for Fertilizer Players: Over the past 30 days fertilizer players have rallied in the market on hopes of a positive change in industry dynamics following the new policy. Engro Fertilizers (EFERT) and Fauji Fertilizer (FFC) have rallied by 6.2% and 19.0% respectively over the past 30 days.
We believe that with elections approaching, the new Fertilizer Policy has a high probability of being geared towards farmers rather than the fertilizer players. Possible measures could include removal of GIDC on feed/fuel stock, incentives to LNG players to increase domestic production, allowance for subsidized urea imports, change in gas prices and/or allocation, changes in the subsidy mechanism and reduced GST rates. The measures announced would most likely benefit farmers through lower urea prices and are unlikely to be beneficial for existing fertilizer players.
1. Removal of GIDC on Feed Stock or Fuel Stock:
Currently fertilizer manufacturers pay PKR300/mmbtu GIDC on fuel stock and PKR150/mmbtu as GIDC on fuel stock. Based on rough estimates we believe FFC’s 2016 cost of goods manufactured per bag of urea amounted to PKR953/bag. The cost of feed stock and fuel makes up the bulk of this cost at PKR700/bag. Lastly GIDC (both on fuel and feed) is estimated at PKR381/bag. We believe a reduction in GIDC would be aimed at reducing urea prices, and would be a pass through for fertilizer manufacturers.
However since EFERT does not pay GIDC on its concessionary gas for the Enven plant, a reduction in urea prices could shrink EFERT’s spread as it would not lead to a proportionate reduction in its weighted average cost of fuel.
Roughly speaking at 22mmbtu/ton feed stock requirement, EFERT’s total feed gas requirement is ~150mmcfd. Approximately 55% of the total gas requirement is priced at concessionary rates. An additional 10% is priced at concessionary rates plus GIDC (which is accrued but not paid out). Therefore a PKR100/bag reduction in GIDC translating into a PKR100/bag reduction in urea prices, could cause a PKR50/bag reduction in gross margin for EFERT. This could translate into a 10-12% reduction in earnings for EFERT whereas it would be neutral for FFC.
2. Prop up Urea reserves through subsidized RLNG for LNG Players or imports:
December 2017’s urea inventory is expected to reach around 250,000 tons which increases the probability of imports to increase buffers. While the government has previously resorted to prop up buffers by importing urea, another solution could be subsidizing LNG or re-allocating gas to LNG players. PSO’s LNG price (for transmission) for January 2018 was USD9.9972/mmbtu (PKR1,099/mmbtu). Assuming a break-even level of PKR600/mmbtu (feed stock price) would entail a ~PKR500/mmbtu subsidy. This translates to around PKR550/bag. Assuming 500,000 tons of incremental production, the subsidy would cost PKR5.5bn to the National Exchequer, while the additional import of LNG would drain the Forex reserves by USD110mn.
On the other hand the government can also resort to prop up urea inventory by allowing import of ~500K tons. At an estimated cost of USD255/ton and subsidy of roughly PKR100/bag, this would entail a cost of PKR1bn (on subsidy) for the government and a drain of USD130mn on the Forex.
While the government may opt for either of the solutions, constrained LNG handling capacity (in the short term) may tilt the decision towards subsidized imports. While Neutral from demand perspective for incumbent players, this may reduce pricing power for EFERT and FFC in the medium term.
3. Change in Subsidy Mechanism:
We believe this measure has the highest probability. Similar to the elimination of subsidy on urea and substitution with reduced GST rate, we believe a similar mechanism could be announced for DAP, NPK and NP. This would again be neutral for the fertilizer players as any reduction in cost would be passed on the consumers. Substitution of subsidy to GST would however be cash flow positive for the incumbent players.
Downgrade to Underweight on the Sector: With the recent rally in fertilizer stocks, we see no capital upside particularly with respect to FFC and EFERT, which are under our coverage. The new fertilizer policy has created a certain element of uncertainty for the sector. The policy is likely to be pro-agrarian and be neutral for fertilizer players at best and negative for the players in the worst case. Resultantly, we downgrade to Underweight (from Marketweight) exposure on the fertilizer sector.
