EUR 150.00 For Business Accounts Only

PKN Orlen – Hold (maintained), Underweight (maintained), 12M EFV = PLN 101.00 (downgraded)

PKN Orlen

We remain bearish towards the equities of PKN Orlen (Hold + Underweight, 12M EFV of PLN 101.0 per share). While we think the equities are not necessarily fundamentally expensive (since the equities have strongly dropped in the past few weeks) we see very limited positive equity triggers while a bunch of risk factors. Please note that roughly PLN 10.0 per share of our valuation of PKN can be attributed to the merger with Lotos which we continue to think should be value accretive. The problem is that currently we find it highly unlikely that the merger will be finalized this year. Given the uncertainty of the merger and its possible timing, we fear investors will need to focus more on the current challenging macro environment and other multiple risk factors.

Very challenging refining macro environment to strongly hurt PKN Orlen’s EBITDA in 2020? In our view, economic slowdown in tandem with the IMO 2020 regulations have made it very hard for an average refiner. Although we were expecting negative performance of HSFO cracks in 2020, the current cracks at US$ -40 per barrel (vs. roughly US$ -17 per barrel witnessed in 2015-2019) are a negative surprise for us. In this case, the strong price competition with coal and natural gas (at a time of warm winter and slowing energy demand) most probably acted as a strong negative driver for HSFO cracks. As regards diesel cracks, so far these remain broadly comparable in a yoy comparison around US$ 17 per barrel (it seems that the positive effects of the IMO2020 regulations are just offset by negative economic developments). It is no wonder that PKN’s model margin has recently dropped to near break-even levels. In our view, our assumed average model refining margin for 2020 of US$ 3.5 per barrel (including the Ural-Brent differential) is a bearish scenario, nonetheless a realistic one.

In the case of PKN Orlen, the recent widening of the Ural Brent differential will not remedy the situation. In our view, the current very poor refining margins of most REBCO consuming refineries is the main reason for the recent widening of the differential. Refineries in the region are probably struggling to replace some of its heavy high sulphur feedstocks with lighter grades with a view to limiting the production of very unprofitable HSFO. It is therefore very likely that any possible improvement in diesel or HSFO cracks in latter months would lead to a simultaneous narrowing of the differential. The problem is that based on current macro, a wide Ural-Brent differential, even at high levels of US$ 3 per barrel, will not offset the negative effects tied to PKN’s high exposure to HSFO products.

Poor earnings dynamics expected. We believe that our PLN 7 billion EBITDA LIFO estimate for PKN Orlen for 2020 is realistic. Based on our average model margin of US$ 3.5 per barrel in 2020 (including the Ural-Brent differential) we expect a negative refining macro effect of roughly PLN -2 billion. This in combination with expected negative macro effects in the petchem business of roughly PLN -1 billion already translates into a total drop in consolidated EBITDA by PLN -3 billion. Such earnings dynamics will not contribute positively to PKN’s equity performance.

We believe the Company may eventually halt its dividend payments if both acquisitions of Energa and Lotos are executed. Based on our leverage analysis (described below) we think the possible simultaneous acquisition of Energa and Lotos will most probably halt dividend payments given the probable strong increase in leverage. Based on our assumptions, PKN’s net debt could possibly grow to as much as PLN 26.9 billion at the end of 2021, while the net debt-EBITDA ratio would increase to 1.75x, leaving very limited space for dividend payments.

Crude oil prices may not be supportive for the Company’s downstream business this year. We assume that OPEC members will continue to cut crude oil supplies this year. At the same time, we fear that shale oil production in the US will soon stop growing given the dropping numbers of active oil rigs. Furthermore, the recent political tension in the middle East have unveiled additional risks which may be a meaningful factor for PKN’s downstream business this year. It is not hard for us to imagine a scenario in which political factors push crude oil prices over US$ 70 per barrel with a detrimental effect on downstream margins (which are already at relatively low levels).

We are observing a visible slowdown in gasoline fuel demand in the US. The recent weekly data from EIA suggest visible deterioration of refining macro environment already in 4Q19. While the apparent gasoline demand in the US in 1-3Q19 averaged at an impressive 2% yoy growth, the fourth quarter’s dynamic slowed down to nearly 0%. Moreover, the last weeks of 2019 also revealed a negative change in gasoline inventories. Throughout 2019 (with the exception of January) the gasoline stocks in the US were at a lower level in a yoy comparison. Starting from November, however, the gasoline stocks are higher in a yoy comparison – a switch which perhaps perfectly shows the economic slowdown effects.

We remain strongly negative towards the potential purchase of Energa. We think the introduction of electric energy distribution assets into PKN’s group is a controversial idea but it is probably not the worst business concept we could imagine. The main problem with the transaction is tied to future capex uncertainty of Energa (especially the OstroÅ‚Ä™ka C project), the introduction of coal sector exposure and the probable halting of dividend payments by PKN. We remain strongly positive on the planned Lotos acquisition, but the possible purchase of Energa is a misunderstanding, in our view.