sector study oil gas - pakistan credit rating · pdf filethese include the saudi aramco1, ......

The Pakistan Credit Rating Agency Limited

SECTOR STUDY

OIL & GAS


OIL & GAS

Section I : Profile

Section II: Exploration & Production

Section III: Refinery

Section IV: OMCs

Section V: Gas Distribution

Contents

Section I

Section II


OIL & GAS

1. THE GLOBAL E&P INDUSTRY- OVERVIEW

• State-owned companies and large multinationals dominating the industry

• Strategic in nature

• High degree of government influence

1.1 The global E&P industry is dominated by state-owned oil companies, particularly in the Middle East. These include the Saudi Aramco1, the largest oil corporation in the world and the operator of the world’s largest single hydrocarbon network (the Master Gas System), National Iranian Oil Company (NIOC)2, the world’s second largest oil company, and Abu Dhabi National Oil Company (ADNOC)3. Russia’s industry is dominated by a state-owned company by the name of Gazprom. Gazprom, the world’s largest energy corporation, holds the largest reserves of natural gas in the world. Its proven reserves incorporate around 17% of the world’s total, while it produces about a fifth of global natural gas volumes, allowing it leverage over global prices. Similar national oil companies are in control of E&P activities in many regions of the world due to the strategic nature of the business. In fact, even in countries where state-owned entities are absent, the industry is subject to government influence by virtue of its very nature. Moreover, the sector is also subject to the payment of royalties and taxation which are much higher than those applicable to other commercial industries.1.2 State-owned companies feature prominently in India’s E&P sector as well. These are Oil and Natural Gas Corporation Limited and Oil India Limited. At the same time, there are private and joint venture companies engaged in the business. The Ministry of Petroleum and Natural Gas regulates drilling activities in oilfields. It also oversees the allocation and pricing of gas produced by both the national companies, while the gas produced by private entities is governed by the respective Production Sharing Contracts between the Indian government and the producers.1.3 MNCs: Large multinationals also operate in the sector. The list includes Royal Dutch Shell, ExxonMobil, BP, and Chevron. The first of these is a group of energy and petrochemical companies, operating in over ninety countries and producing two percent of the world’s oil and three percent of the gas. Meanwhile, ExxonMobil is the world’s largest publicly traded oil and gas company, with a presence in six of the seven continents. It benefits from E&P, refining and marketing operations. BP, United States’ largest oil and gas producer, is also an integrated company and carries out E&P operations in thirty countries. Finally, Chevron, another integrated oil and gas company, sources around a quarter of its production from the United States. At the same time, it is the largest resource-holder and producer amongst international oil companies in the Asia-Pacific region. It also operates in Saudi Arabia as the only large international company which has enjoyed a continuous upstream presence in the region. These large multinationals, featuring prominently on the Global Fortune 500 list, enjoy strong credit ratings due to the size and scale of their integrated business model as well as the geographical and operational diversity.

Company Revenues (USD mln) Profits (USD mln)

Royal Dutch Shell 285,129 12,518ExxonMobil 284,650 19,280BP 246,138 16,578Chevron 163,527 10,483

1.4 The year 2009 recorded the much speculated green shoots of recovery in the oil and gas exploration and production (E&P) industry. Oil prices started the year in the mid-30s as the global economy witnessed its sharpest downturn in modern history. This slowdown was manifested in global oil consumption, which fell by roughly 1.3 million bpd during the year, the largest annual decline since 1982. However, prices did rebound in response to

1 The Saudi Arabian government assumed full control of the company by 1980, while its name was changed from the Arabian American Oil Company to Saudi Arabian Oil Company in November 1988. 2 NIOC, established in 1948, operates under the direction of the Ministry of Petroleum of Iran.3 ADNOC was established in 1971 and oversees oil production of more than 2.7 million bpd today. Its operations fall under the purview of the Supreme Petroleum Council, which is chaired by the ruler of Abu Dhabi. It has fourteen subsidiary companies operating in various segments of the oil and gas chain.

EXPLORATION AND PRODUCTION Page 1 of 11June 2011 www.pacra.com


OIL & GAS

sharp production cuts and some signs of economic recovery as the year progressed, hovering around USD 70 per barrel from July to December. The same could not be said for natural gas prices, which faced a tougher time4. In fact, the prices of the blue fuel were often at or below parity with coal, when translated into the cost of generating power. This led to gas displacing coal in the European power generation market.

1.5 While signs of recovery were witnessed towards the end of the year, the volatility in commodity prices affected the E&P industry negatively. Both revenues and profits fell, with the decline being very marked in some markets5. However, equity capital started to flow back into the upstream sector as the year drew to a close and many companies allocated larger exploration budgets for 2010. Nevertheless, a wide divide remained between the haves and the have-nots due to the mixed fortunes of the E&P universe, with the latter facing funding constraints.

2. THE DOMESTIC E&P INDUSTRY PROFILE

2.1. At present, there are twenty six active E&P companies in Pakistan, ten of these local and sixteen foreign. The foreign operators include companies such as BP (UK), Eni (Italy) and OMV (Austria). These operators carry out exploration activities on their own as well as through joint ventures. OGDC remains the dominant player in the segment with a 61% share in oil production and a 23% share in gas production.

3. GOVERNANCE

• GoP retains regulatory control

3.1 The E&P industry is subject to intervention and regulation by governments globally, particularly with reference to the award of exploration and productions licenses and fields, the imposition of drilling specifications, controls over development and decommissioning of fields and, in certain countries, nationalization. The last of these poses risks such as expropriation and cancellation of contract rights.

3.2 In Pakistan, the Ministry of Petroleum and Natural Resources (MPNR), created in 1977, regulates the upstream exploration and production activities through the Directorate General of Petroleum Concessions (DGPC) of its Policy Wing. Prior to the creation of MPNR, regulatory matters pertaining to E&P activities fell under the purview of the Ministry of Fuel, Power and Natural Resources. MPNR is responsible for dealing with all matters pertaining to petroleum, gas and mineral exploration. These include policy formulation, legislation, overseeing geological surveys and coordination of energy and mineral policies.

3.3 MPNR is headed by a Secretary, who reports to the Minister, an elected official. The ministry is organized into four wings – Administration, Development, Mineral and Policy. The selection of the Minister and the Secretary is vulnerable to political influence and, thus, frequent changes in the appointees for the concerned posts have been witnessed.

3.4 The Regulation of Mines and Oilfields and Mineral Development (Government Control) Act, 19486, is the basic policy that governs the sector. Other supplementary regulations, including the Pakistan Petroleum (Exploration and Production) Rules, have also been introduced at various points in time. The ministry has also introduced various policies to promote private interest in the sector, with the first of these issued in 1991 and the most recent being the Petroleum Policy 2009. The latest revised policy seeks to attract increased investment in the E&P sector in order to tap indigenous hydrocarbon resources by providing competitive incentives to local and foreign companies in the form of higher wellhead gas prices, along with a transparent and non-discriminatory licensing and

4 The average US Henry Hub First of Month Index fell to USD 3.99/MMBTU in 2009, a 56% decrease from the record USD 9.04/MMBTU in 2008. Similarly, UK National Balancing Point prices fell to 30.85 pence per therm, which was a 47% drop from the 2008 average of 58.12 pence per therm.5 An Ernst and Young benchmark study, focusing on fifty E&P companies in the United States, reported that revenues declined by 36% in 2009 compared to 2008, while after-tax profits dropped by a phenomenal 97%. 6 This was amended in 1976.



OIL & GAS

contracting system. While the success of this policy remains to be seen, of the previous policies introduced, the 1997 one seemed to be particularly successful since exploration activity, defined in terms of licenses awarded and wells drilled, peaked in the following year.

3.5 While the regulatory backdrop of the E&P sector is improving, MPNR has often been criticized for the efficiency and effectiveness of its operations. Moreover, the strict regulatory control of the government over the sector has resulted in interference which has been the subject of criticism in the past. For instance, government credibility suffered when the GoP asked for producer prices to be decreased after the discovery of commercial reserves between 1995 and 2000. During this time, international oil companies also complained of difficulties faced in remitting earning in foreign exchange. To date, the risk of political interference in the governance of the sector remains high. In the future, consistency needs to be maintained in policy matters in order to attract more foreign investment in the sector. Steps towards this are already being taken through the presence of a more stable policy regime in recent years. However, the risk of politically influenced appointments in the government-owned entities also remains a concern in the sector, although increased media scrutiny has lowered the risk of political interest prevailing over sector interest.

3.6 Due to the environmental risks posed by the activities in this segment, operations are monitored by environmental agencies. Environmental Impact Assessment (EIA) studies are carried out and air and water emissions kept under check. The Central Inspectorate of Mines (CIM) monitors the safety of operations. Under the concession agreements signed with E&P companies, social directorates of the provincial government ensure that the stipulated investment in health, education and other facilities is made in and around the production area.

4. OWNERSHIP

• GoP and large corporations hold significant stake

• Strong business acumen of the sponsors

•

4.1. The E&P sector’s ownership structure is such that the GoP and large corporations hold majority stakes, as is the case globally. The GoP, in particular, enjoys large shareholdings in companies whose combined gas production equals over half of the total gas produced in the country7. However, the government has reduced its initial holdings in exploratory fields over the years and is now privatizing its shares in producing fields. This is in line with its stated policy of gradually privatizing the sector. Given the current pressure on the country’s balance of payments and, in turn, the government, the possibility of further divestment of the GoP’s stake in the sector remains open. However, this remains contingent upon improvement in the risk appetite of global investors as well as higher stock prices of government-owned entities in the sector. At the same time, the commitment of the GoP towards the E&P sector remains high due to its strategic nature and large contribution to the national exchequer8 in the form of royalties, dividends, corporate tax, general sales tax, excise duty and development surcharge. The sector also helps to save precious foreign exchange through import substitution.

4.2. Besides the GoP, large international groups, such as the Pharoan Investment Group, hold ownership interests in the sector. Thus, the E&P sector enjoys a financially strong ownership structure. Moreover, the presence of sponsors with a long history of having interests in the oil and gas chain results in the sector benefiting from the associated strong business acumen.

5. MANAGEMENT QUALITY

5.1 The technical nature of the industry demands specialized management personnel. The industry’s top-tier management consists of a team of professionals having vast

7 The GoP holds majority shareholding in OGDC (85%) and PPL (78%), while holding 40% (20% directly and 20% indirectly through OGDC) in MGCL.8 During FY09, OGDC alone contributed around PKR 87 billion to the exchequer, while PPL contributed around PKR 43 billion and POL around PKR 4 billion.



OIL & GAS

• Experienced management personnel

• Cheaper workforce

• Worker outflow to the Middle East

experience in the energy sector and possessing the desired qualifications. The major portion of the workforce also consists of technically qualified and skilled personnel. Due to the large number of engineering universities and other institutions imparting technical education and training in the country, there is a readily available local workforce for the lower tier of the industry, which is also cheaper in comparison to the workforce in other markets. While new entrants into the industry are generally inducted in this tier, in-house training and promotions allow the development of the middle and top management tiers in the sector. This ensures that these employees have the required industry experience, which is necessary for a specialized field such as oil and gas exploration and production. However, Pakistan’s physical proximity to the Middle East, an oil rich region where exploration and production activities have been rife for several decades now, has resulted in a significant number of skilled workers migrating there to earn better incomes.

5.2 The management of the industry, being recognizant of the growing demands of the sector, has established a Petroleum Research and Training Institute (PRIT)9. This provides a wide range of education and training programs to employees in the sector, as well as fresh graduates entering the industry.

5.3 The American Association of Petroleum Geologists, founded in 1917, established a local chapter in the country, named the Pakistan Association of Petroleum Geoscientists (PAPG) in 1994. The purpose of this body is to advance the study of the earth sciences in relation to petroleum, natural gas and other minerals, and to promote the development of technology in the E&P sector. The organization has over 700 members now representing producers as well as technology suppliers, such as Baker Hughes and Weatherford, in the sector.

6. Systems and Controls• Technology-

intensive industry• Country divided

into different zones based on investment risk

•

6.1. The oil and gas exploration and production process remains both technology and capital intensive. The process is initiated with the identification of a potentially fuel-containing area with favourable geological conditions. An aerial survey is then carried out, followed by a seismic survey, which provides detailed information on geology. If the results are favourable, exploratory drilling activities, aimed at verification and quantification of the hydrocarbon reserve, are pursued10. In case of discovery of viable reserves, appraisal of the field is conducted to determine if it is economically viable to develop it. Production activities are undertaken once the economic viability is established11. These continue till the economically feasible reserves are depleted. A field typically produces for between twenty and fifty years, with economics governing the life of every field. Therefore, the field development plan must match the expected economic environment of the lifetime of a field. In the initial stages of a field’s development, production is usually highest, while operating costs are low. As the field matures, the production cost per barrel increases and maintenance becomes more extensive. Finally, after the reserves are depleted, decommissioning and site restoration of the land to plug wells and remove installations follow12.

6.2. The process explained above poses exploration and drilling risks specific to the sector. Exploration risks include the selection of exploration acreage which could prove to

9 This was initially established as the Oil and Gas Training Institute by OGDC in 1979. 10 The first well drilled in an area that has good geological potential is termed an exploration well. If this results in the discovery of oil or gas (or both), one or more appraisal wells are drilled to decide if, and how, to develop the field. Exploration drilling is a high risk proposition. In some regions, such as the UK sector of the North Sea, the chances of a commercial discovery are as low as 10%. 11 It takes between three and seven years from discovery to production. This period is particularly long in deep water and in new basins with little infrastructure. 12 Provisions for decommissioning costs are recorded on the balance sheet of E&P entities as long term liabilities. Estimates for these are based on the prevailing legal and constructive requirements, and technology and price levels. Actual outflows can differ from estimated cash outflows due to changes in laws, regulations, public expectations, technology, prices and conditions.



OIL & GAS

contain no reserves or economically unfeasible ones. Moreover, inaccuracies in seismic surveys and selection of exploratory well sites remain a risk as well. The process of drilling itself includes the possibility of failure, which results in a negative effect on the earnings of companies in the segment. Entities are also exposed to a variety of drilling hazards, including well blow out and fire. Moreover, entities operating in Pakistan’s E&P sector, in particular, are exposed to the risks associated with political instability and a poor law and order situation. Given Pakistan’s current situation, the risk of terrorism is fairly high too. To mitigate this, the sector has obtained terrorist insurance cover on its material installations.

6.3. To capture the different levels of risk associated with carrying out E&P activities in different regions of the country, one offshore and three onshore zones have been defined in Pakistan. Discount levels, corresponding to the investment risk associated with these zones and the proximity of infrastructure, are included in the calculation of gas prices, so that producers are compensated accordingly. With respect to the onshore, concession-type agreements13 are in effect, while the production sharing mechanism14 has been adopted for the offshore. Under this division of the country into zones, deep offshore zones are offered the highest return since offshore operations result in much higher costs than onshore ones 15. Despite this, Pakistan’s offshore region is relatively under-explored. Very few offshore wells (less than twenty) have been drilled, with no commercial discoveries to date and three sub-commerical discoveries16. However, lately, significant interest has developed in offshore locations amongst local and multinational operators, including Shell and BP. The country’s offshore region can further be divided into the Indus and Makran areas. Indus is considered the world’s second largest delta and has many similarities with several producing deltas in the world. Thus, there is considerable hydrocarbon potential in the offshore region.

6.4. E&P sector entities employ advanced technologies, such as the Production Management System (PDMS), for production monitoring and enhancement. The system allows data to be directly entered from field locations. Moreover, the government has also established a national data repository called Pakistan Petroleum Exploration & Production Data Repository (PPEPDR) to provide convenient online access to interested local and foreign parties. This is in order to encourage investment in the sector by facilitating the availability of necessary data in a standardized format.

6.5. The sector has also established sound supply chain systems to ensure expeditious procurement of materials and machinery. To this end, in-house rosters of pre-qualified manufacturers and suppliers have been developed.

7. BUSINESS RISK

• Strategic importance

• Low crude oil production

• Foreign firms actively taking

7.1. The development of an oil and gas asset is one of the most capital-intensive endeavors in the modern business world. According to some estimates, the largest such projects may require more than USD 15 billion as capital expenditure. Moreover, while the assets typically have long economic lives, they have historically been found to have low rates of return when compared to projects in other industries17. This can be attributed to two main challenges that almost all entities operating in the E&P sector have to confront. The first challenge arises in the form of the risk and uncertainty associated both with future oil and gas prices, which remain inherently more volatile than other product prices, and with

13 Under this, the government grants the investor a license to operate a concession for a specific period. The investor takes title in the oil and, in return, pays the government royalties and taxes as per law. 14 In contrast to a concession regime, under a production sharing agreement, the E&P company is allowed to sell the initial production, known as “cost oil”, to recover costs. The remaining oil, or “profit oil”, is allocated between the state and the investor. These agreements, as they apply in Pakistan, are discussed later on in this report. 15 The costs of an offshore exploration well frequently exceed USD 20 million and can be much higher for deep reservoirs and at times of high rig rates such as prevalent today. 16 Bank of America Merill Lynch (2010). Pakistan Petroleum Limited.17 A Goldman Sachs report has suggested that major oil company assets have an average life span of 21 years, but offer only a 10% return on capital invested.



OIL & GAS

part in production activities

• Linkage to international oil prices

• Volatile prices ahead

• Large receivables on account of circular debt

• Healthy operating margins

estimates of economically feasible reserves. Secondly, conventional technology cannot fully model the behavior of an integrated asset across the entire productive life of an asset.

7.2. The sector’s reserves can be classified into various categories. Of these, proved reserves are attributed to known reserves and can be produced with reasonable certainty under the prevailing economic and operating environment. These can further be categorized as developed and undeveloped reserves, with the latter requiring more capital investment and carrying higher geological risks than the former. At the same time, maintaining a high reserve to production (R/P) ratio, which measures how long reserves can last at current production levels, also remains important.

7.3. The E&P sector is also exposed to reserve replacement difficulties. To sustain operations, existing reserves, which are depleted through operations, must be replaced with new discoveries. Regions that consistently replace the fuel they produce with fresh reserves, and at economic rates of return, are more likely to survive through the business cycle and remain profitable. The Reserve Replacement Ratio (RRR), signifying the reserves added to the resource base in a given year versus that year’s production, is a key factor in this regard. Moreover, total costs incurred in adding and developing a barrel of new resources to the production base also need to be minimized.

7.4. E&P Industry in Pakistan: A ready market exists for both oil and gas in Pakistan due to the very low quantity of crude oil produced locally and the current production levels of natural gas being increasingly unable to meet demand requirements. However, E&P activity has progressed gradually in the country due to numerous issues. These include lack of clarity on the price of associated gas production, prolonged negotiations for the supply of newly discovered gas, a weak infrastructure and a volatile security situation, particularly in the remote Balochistan and Sindh areas. Moreover, political and economic instability has also discouraged international investment in the segment. Despite this, the sector has managed to attract foreign players and, at present, large E&P companies such as BP, MOL (a Hungarian company), Eni and OMV operate in the country. Spurred by revised petroleum policies offering improving returns, a number of these have managed to make significant discoveries in Pakistan in recent years. The confidence of international investors has also been reinforced by the rapid commercialization of large discoveries such as Zamzama, Sawan and Bhit. Moreover, the sector has additional commercial potential which can be exploited using more advanced technologies and field management techniques which are available to international players.

7.5. The level of competition in the sector has increased over the years in line with a higher number of exploration licenses being granted. Moreover, an increase in the number of joint ventures has also paved the way for the entrance of new players in the industry. In order to encourage participation by foreign players, the GoP has tried to maintain a level playing field for both local and international E&P companies. Meanwhile, the sector’s primary customers remain the refineries for oil and the gas distribution companies for gas.


POL 6%PPL 8%

BP 18%

OGDC 56%

Others 12%

Oil Production Share FY10


OIL & GAS

Allocation amongst these customers is determined by the GoP.

7.6. In the 1950/60s, the gas producer prices were determined on a cost plus basis. Later, gas price agreements (GPAs) were signed between the GoP and different E&P companies which introduced guaranteed returns on the equity investments in gas fields. These were later dismantled, with the exception of the GPA for the Mari field, which still allows a minimum return of 30%, net of taxes, on shareholders' funds18. Since 1985, the wellhead gas pricing policy has been revised from time to time. Under the existing wellhead pricing agreements, indexation to crude/fuel oil19 is used. Prices are revised on a biannual basis and the formula is such that the average price of crude/fuel oil during the first six months of the preceding seven months period is taken into account when calculating the price for the following six months. This results in regressive gas pricing, which reduces the volatility of crude/fuel oil prices, although this also results in only fraction of the total benefit accruing from reduced international prices being passed on to end consumers. At the same time, the price at which natural gas is sold to the two gas distribution companies in the country is also subject to the gas pricing policy in effect when the concession was awarded. Meanwhile, crude oil prices are equal to the cost and freight (C&F) price of a comparable crude oil or a basket of Arabian Gulf crude oils, used as the Reference Crude (RC), plus or minus a quality differential between the RC and crude oil produced locally. Thus, the sector remains exposed to the volatility in international crude prices, both for oil and gas pricing.

7.7. To encourage investment in the E&P segment, the government introduced successive petroleum policy documents, which were prepared with the help of international consultants. The first came in 1991. Subsequent policies were issued in 1993, 1994, 1997, 2001, 2007 and, finally, 2009. These were generally altered to introduce a more favourable framework for international oil companies given the competition from other developing countries for investment. These policies have managed to increase the area under exploration, as well as the number of licenses awarded, significantly in recent years. Many of the new licenses pertain to the high cost offshore and Balochistan drilling areas, which implies a much needed deviation from the traditional explorations areas. Geological surveys indicate that if Balochistan’s full potential were to be exploited, Pakistan’s total reserves would increase substantially, thus, sharply increasing the reserve life of the sector. However, the high costs associated with carrying out operations in these areas remain a significant impediment to developing these potential resources.

7.8. Under the latest policy, royalty at the rate of 12.5% of the value of the product is payable to the GoP under onshore Petroleum Concession Agreements (PCAs), while a sliding scale is to be applied for royalty payments under offshore Production Sharing

18 The Mari GPA is still based on a cost-plus formula, and is therefore, absurdly low. Sui and Khandkot (owned by PPL) were also priced on a cost-plus basis, but a market-based price formula was introduced for these in 2002. Meanwhile, the Tullow field has a direct gas sale agreement with WAPDA. 19 Qadirpur gas price, operated by OGDC, is linked with international High Sulphur Furnace Oil price.


FY06 FY07 FY08 FY09 FY100

10

20

30

40

50

60

70

80

90

Wells Drilled


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Agreements (PSAs)20. For gas pricing purposes, a Reference Crude Price (RCP), derived from the C&F price of a basket of Arabian crude oils imported in the country during the first six months of the preceding seven months period, is used, with an upper cap of USD 100/barrel. The increase in the ceiling from USD 36/barrel in the Petroleum Policy 2001 has resulted in an upper cap of USD 5.03/MMBTU versus one of USD 2.99/MMBTU for Zone-I in the 2001 policy. Correspondingly, the caps for the other zones have been raised as well in order to increase local production and lower more expensive imports. As a result of different zones being offered different discount rates and different fields operating under different petroleum policies, the gas prices differ all over the country. Moreover, while the price for most fields in now denominated in USD, there are still some whose price is still determined in the local currency. While the linkage of prices to international prices and their denomination in USD exposes the affected companies to exchange rate risk, the recent PKR/USD parity decline has positively impacted such entities. This has also provided a hedge against the rising cost of imported drilling materials, plant and equipment required by E&P companies.

7.9. Currently, wellhead prices are between USD 1.3-5.9/MMBTU, depending on whether the gas is coming from an old or new field and the petroleum policy under which the field's gas pricing agreement is governed.

7.10. For Pakistan’s E&P sector, exploration, prospecting and development costs represent the highest outflow. Exploratory drilling costs are normally capitalized initially, pending determination of proved reserves, and transferred to development costs if proved reserves are found or charged to income if that is not the case. Development costs, which represent the cost of developing the discovered reserves and brining them into production, are capitalized. They are then amortized from the commencement of production on a unit of production basis, which is the ratio of oil and gas production in a year to the estimated total quantities of reserves at the end of the year plus the production during the year on a field by field basis. (Development costs for Pakistan to be discussed.)

7.11. Salaries and wages also contribute a significant proportion to operating expenses. This is due both to the technical nature of the industry, resulting in entities demanding specialized staff, and the risky nature of the work.

7.12. Performance: Exploration activities have yielded a success rate for Pakistan’s E&P sector of 1:3.4, which is much better than the global average of 1:10. This has resulted in

20 Under this, fields are allowed a four year royalty holiday initially, followed by a 5% rate of royalty for the fifth year, 10% for the sixth and 12.5% afterwards.


Pakistan Exploration Statistics

Exploration Wells 769

Development Wells 1,032

Total Wells 1,801

Drilling Density 1.1

Total Discoveries 233

Overall Success Rate ~30%

Development &Production Leases 148

Potential Oil Reserves (billion barrels) 27

Discovered Oil Reserves (billion barrels) 0.94

% discovered oil reserves 3

Potential Gas Reserves (TCF) 300

Discovered Gas Reserves (TCF) 54

% discovered gas reserves 18


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the local industry offering higher rates of return to investors than those offered by regions with lower success ratios. However, after several decades of exploration, the country is still under-explored and the average size of discoveries has also been small, while the oil production centres are concentrated in the Potwar Plateau of Punjab and lower Sindh.

7.13. The upstream sector has witnessed rising sales over the years. While part of this can be explained by better operational performance, leading to higher production in volumetric terms, international crude oil prices have witnessed a rise as well. This, coupled with the depreciation of the local currency21, has translated into higher realized prices in PKR terms. At the same time, the discovery of new fields and their subsequent development, along with the enhancement of the existing resource base through improved technologies, has allowed the sector to enhance its reserves. However, given that the E&P activity in the country has not been able to keep pace with the increasing consumption of both oil and gas over the years, the reserve R/P ratio remains low, particularly for oil (10). Moreover, drilling targets for the sector as a whole have been missed lately due to security concerns. The improvement of the law and order situation in Balochistan, an area which is believed to be rich in hydrocarbons and is home to Pakistan’s largest gas find, but has been thinly explored, remains particularly important for the E&P sector. In this regard, the success of the recently announced Balochistan package in improving the situation in the province would aid E&P activities there. In the absence of this, entities having a relatively higher number of exploration licenses in Sindh enjoy an advantage over other entities since decades of exploration there have allowed its geology to be well understood.

7.14. Lately, the sector has also witnessed problems due to legal cases being pursued against the development of some fields. The settlement of these is important for the realization of future growth in the sector. It is expected that the government will play a supportive role in this given the shortage of fuel in the country and the GoP’s stated intention to address the supply-demand imbalance. However, currently, delays in projects pose a significant risk to sector earnings.

7.15. Some sector entities are also pursuing selective international expansion in order to improve and their reserves and production profile. In this regard, joint ventures have been established abroad with foreign players. The sector is also in the process of evaluating further opportunities for overseas exploration22.

7.16. Operating and exploration and prospecting expenses of the sector have also depicted a rising trend over time. Certain operating and capital expenditure-related expenses are incurred in currencies other than PKR, thus, allowing the expenses to rise in line with PKR depreciation. Moreover, companies have also acquired expensive production enhancing technologies recently. Despite this, the sector has continued to record healthy margins23 and its operating costs remain relatively low when compared to other markets. Furthermore, finance costs have been insignificant due to low leveraging, allowing the bottomline to remain intact24. The sector’s generally high margins have afforded it the luxury of accumulating cash reserves for capital intensive exploration activities. Moreover, the industry’s prime developed assets offer attractive cash flows to sustain further exploration and development activities. This is particularly important since it is hard to avail external funding for this purpose due to the very risky nature of the business. The risks are accentuated by the fact that oil prices do not necessarily move in tandem with

21 From 2005-2009, the rupee depreciated by an average of 3%. 22 For instance, PPL has an interest in an exploration license in Yemen in a joint venture with the Austrian OMV. Meanwhile, OGDC is also in the process of evaluating opportunities for overseas exploration, particularly in North and West Africa and Eastern Europe. Apart from diversification within the sector, PPL has also recently expressed its plans to diversify into the power sector. The company has submitted an Expression of Interest to the Private Power Infrastructure Board for setting up a 225MW thermal power plant according to news reports.23 Operating margins were 63%, 67% and 40% for OGDC, PPL and POL respectively during FY09. 24 Net profit margins for FY09: OGDC: 42%; P0L: 40%.



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production costs. Instead, they are likely to remain volatile in the near future given that global oil demand recovery seems fragile. Any reversal in the upward trend is likely to have a negative impact on the E&P sector in Pakistan given its linkage to international prices of the commodity.

7.17. The upstream sector is currently at the end of the prevailing circular debt issue in the oil and gas chain and is, thus, accumulating receivables both from refineries and gas distribution companies. The large amount of receivables has translated into a higher number of receivables days and caused cash flow constraints, resulting in the sector’s development plans becoming suspect to the availability of financing and dwindling dividend payouts. It has also reduced surplus cash available to the sector, thus, causing interest income to decline. OGDC has been the worst affected in the sector since well over half of the sector’s total circular debt-related receivables are reflected in its balance sheet 25. While the overall cash flows of the sector are manageable for now, further accumulation of receivables may risk balance sheet leveraging, especially since entities in this industry cannot delay payments to suppliers or the government. In this regard, the government has embarked upon a structural reform program in the power sector from where receivables are stemming. However, complete settlement of the issue is expected to take some time.

7.18. In order to encourage further exploitation of indigenous gas reserves, MPNR has recently released a draft policy for the exploration and development of the existing tight gas reserves26 in the country, after taking into consideration the proposals of the upstream companies. Under the draft policy, MPNR has provided a list of third party specialists, as well as criteria for management of mixed production of tight and conventional gas from a single well based on flow rates, to facilitate the process from the time of reservoir declaration to the certification of a commercial discovery. In order to compensate producers the higher costs associated with producing tight gas, a 40% premium has also been proposed over the respective zonal price. If the policy is successfully implemented, both the R/P ratio and RRR of the sector could improve considerably, given that some tight gas reserve studies have estimated the total gas potential from this source to be more than the country’s existing gas reserves. OGDC and PPL are expected to be the key beneficiaries of this policy. Given Pakistan’s relatively limited crude oil potential, with proven oil reserves having a limited life of ten years, the sector continues to focus on gas production, in the absence of new major oil discoveries, to support its growth.

8. FINANCIAL RISK

• Low leveraged industry

• Strong market capitalization

8.1. Globally, the upstream sector tries to maintain a low leveraged capital structure as well as a high degree of liquidity in order to mitigate the risk arising from the inherent volatility in oil and gas prices. In Pakistan, the sector does enjoy a low level of debt, with short-term borrowings being very low due to the absence of self-liquidating assets in the sector. In fact, some players are still unleveraged. Moreover, liquidity has also remained high in the industry. Healthy profitability has allowed entities to pay out high dividends and retain enough cash to accumulate strong reserves at the same time. However, the circular debt issue has been threatening to alter this by putting pressure on the sector’s liquidity profile. If it continues to persist, the industry may have to resort to bank borrowings in order to meet capital expenditure targets. This is a serious concern since the cost of borrowing for exploration purposes is high due to the high risk associated with the business.

8.2. The upstream sector has been able to attract the interest of local investors. The major local players27 are all listed on the country’s stock exchanges and have remained actively traded. The total market capitalization of these stands at around PKR 828 billion28

25 OGDC’s trade receivables have crossed PKR 82 billion in FY10 compared to PKR 56 billion recorded last year. Out of this amount, PKR 47 billion are receivables against gas sales, while the remaining are due from gas and power companies. 26 A tight gas reserve is one which cannot flow naturally at a commercial rate under conventional methods and requires sophisticated technologies for extraction.27 This refers to OGDC, PPL, POL and MGCL.



OIL & GAS

and the sector has generally outperformed the KSE-100 index. The sector has also been able to secure the interest of international investors through international listings29. Thus, it has available an avenue for funding that other industries have been unable to target to date.

8.3. Lately, the government has also expressed its intentions to issue convertible or exchangeable bonds for the sector. While this is an additional funding option available to the sector, it could potentially dilute the sector earnings, while increasing the free float, in case of the issue of convertible bonds. Moreover, it would also increase the interest cost for the entities concerned.

28 OGDC is the biggest company on the benchmark Karachi Stock Exchange 100 index, with a market capitalization of around PKR 602 billion.29 OGDC was able to do this through a secondary offering in the form of Global Depository Shares (GDS) in 2006, which attracted a very positive response on the London Stock Exchange.


Section III


OIL & GAS

1. THE GLOBAL REFINING INDUSTRY – OVERVIEW

• Capacity increasing• Refining

margins compressed

1.1 Crude oil is virtually of no use in its raw form. For it to have any real value, it has to be processed into products such as gasoline, lubricants and furnace oil (FO). This processing is carried out in hundreds of refineries across the globe. It involves breaking up the chemical bonds that link the chains of hydrocarbons in crude oil and redesigning these links to create useful end products. The demand for these useful products has increased in line with economic growth over the past few decades. In order to cater to the rising demand, global refining capacity has also witnessed an increase. Today, the global refining capacity stands at 91 million bpd1, with around one fifth of this in the United States. China (9.5%), Russia (6.2%) and Japan (5.1%) also contribute significantly to the worldwide capacity. The Organization for Economic Co-operation and Development countries, accounting for half of the global capacity, dominates the industry on a regional basis. Meanwhile, higher capacity and declining consumption have pushed utilization down to 81.1%, the lowest rate since 1994. Refining margins have also witnessed a corresponding decline as demand for oil products has fallen in the wake of the economic slowdown worldwide. These margins are expected to remain subdued in the near future as a result of increasing capacity and fragile product prices. A recent trend of taking exit from the refinery (mid stream) industry by major integrated oil groups globally has been observed.

1.2 Amongst Pakistan’s neighbors, India has a refining capacity of around 3.6 million bpd, representing almost 4% of the world capacity. The capacity has grown considerably over the past decade (1999: 2.2 million bpd) and is around twelve times Pakistan’s present refining capacity of 0.3 million bpd. There are a total of twenty refineries in India, with the state-run Indian Oil Corporation owning half of them. However, the government is now taking initiatives to increase private investment in the sector. These include allowing hundred percent foreign direct investment in private refineries and twenty six percent in government-owned entities. Such initiatives, coupled with the lower capital costs in the country, have led India to be seen as an emerging global refining hub.

1.2.1 Pricing for the refining sector in India was previously based on the Administered Pricing Mechanism. However, this was dismantled in 2002 following the government’s declaration to move towards a market-determined pricing regime. Instead, pricing was based on the import parity pricing principle. Later, in 2006, the refinery gate pricing regime was again changed and these prices are now calculated based on the trade parity pricing mechanism. At the same time, the Petroleum and Natural Gas Regulatory Board (PNGRB) was established in 2007 to regulate the downstream oil and gas sector, although it does not control the pricing policy.

2. THE DOMESTIC REFINING INDUSTRY - PROFILE

2.1 At present, the refining industry in Pakistan has an annual capacity of around 13 million tonnes per annum and comprises seven refineries. PARCO, NRL and PRL process most of the imported crude oil, along with some crude oil procured locally, while ARL processes only local crude oil. Moreover, the existing refining capacity is not sufficient to meet local requirements. Historically, Pakistan has been meeting around 40% of its petroleum product requirements through imports. This percentage has further increased in recent years and during FY10, Pakistan’s import of refined products was around 11 million tonnes, contributing around 58% to the total consumption of these products in the country. On the other hand, exports amounted to 1.5 million tonnes only and included products such as naphtha, jet fuels and a limited amount of HSD, FO and Motor Spirits.

3. OWNERSHIP• Direct and

indirect shareholding of the GoP

3.1 Given the capital intensive nature of refining operations, the sector usually lends itself to sovereign and large corporate groups’ ownership. This is the case in Pakistan as well, where the ownership of the refining sector of the country is dominated by GoP and large, integrated oil companies. The government has a significant stake in the sector through its direct and indirect investments in two of the refineries. At the same time, the

1 As at the end of 2009, according to the BP Statistical Review 2010.

Refining Page 1 of 9June 2011 www.pacra.com


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• Large oil companies holding significant stake

Emirate of Abu Dhabi, represented by Abu Dhabi Petroleum Investments LLC, also enjoys partial ownership in the refining sector, along with the Attock Group. The group, in turn, traces its ownership to the Pharaon Group, which is engaged in diversified activities internationally, including oil exploration and production, refining, cement production and real estate. Thus, the involvement of the government on one hand and large oil corporations on the other affords the refining industry financial strength to a degree that is not enjoyed by other sectors, such as textile and cement. The involvement of the GoP in the ownership of the sector has also allowed it to exercise considerable influence over the industry’s operations.

Refinery Name GoP (%) Public (%) Oil Companies (%)

Others (Financial

Institutions, etc.)

PARCO 60 - 40 -

NRL - 9 51 40

ARL - 10 58 33

PRL* - 20 60 20

Byco 40* a change in ownership may occur soon

4. GOVERNANCE

• OGRA regulating industry

• OCAC quasi-regulator

4.1 The Oil and Gas Regulatory Authority (OGRA) regulates the refining sector of the country. It announces ex-refinery prices, based on the import parity prices of the respective products, on a monthly basis in accordance with changes in international prices. However, the detailed price calculations are not available publicly, which has sometimes resulted in OGRA attracting criticism for its lack of transparency in adjusting prices. Refineries have also voiced concerns in the past about the ex-refinery prices allowed to them being lower than the actual prices at which the respective products are imported. Meanwhile, questions have also been raised on the regulator’s stance concerning the protective duty on High Speed Diesel (HSD).

4.2 The sector’s management has also argued that its governance in matters such as assuring the profitability of the refineries needs to be improved. Given the cyclical nature of the industry and the inherent volatility in refining margins, refineries have advocated for a regulatory structure under which they are assured a guaranteed return. In the past, this was provided to the refineries to ensure their economic survival, but was abolished in the early 2000s.

4.3 The GoP enjoys a say in governance matters, not only through OGRA, but through representation on the Board of Directors as well in some cases. However, the risk of politically motivated intervention in the sector is mitigated by the simultaneous presence of representatives of other stakeholders.

4.4 The Oil Companies Advisory Committee (OCAC) represents the refineries and the OMCs at various forums in matters of common interest, thus, allowing interaction between oil companies and the government. It, thus, acts as a quasi-regulator and develops suggestions pertaining to the oil and gas sector for the GoP, besides collecting production data for the sector and coordinating import activities. The body consists of the representatives of five of the country's refineries (PARCO, NRL, ARL, PRL and BPPL), ten OMCs and one pipeline transportation company.



OIL & GAS


• Technically qualified management personnel

5.1 Oil refining is a complicated process and thus, requires highly technically skilled employees. The top management of the sector comprises seasoned professionals with strong track records in their respective fields. Turnover in this tier is comparatively low due to strong group associations.

5.2 The major portion of the workforce also consists of technically qualified and skilled personnel. Due to the large number of engineering universities and other institutions imparting technical education and training in the country, there is a readily available local workforce for the lower tier of the industry. While new entrants into the industry are generally inducted in this tier, in-house training and promotions allow the development of the middle and top management tiers in the sector. This ensures that these employees have the required industry experience, which is necessary for a specialized field such as refining. Moreover, the organizational structure of entities operating in the sector is generally divided along functional lines, ensuring clear segregation of duties and responsibilities amongst management personnel.

6. SYSTEMS AND CONTROLS

• Technology-intensive industry

• Mostly hydroskimming refineries

6.1 The refining sector imports most of the crude oil (~70%) that it processes. A major portion of the imported oil is transported via oil tankers owned by PNSC. PARCO, NRL and PRL, which process most of the imported oil, have entered into ten year contracts with the national shipping company for their transport needs. The pricing for the contracts is based on the Average Freight Rate Assessment2 rates and World-scale points, as per international practices. These contracts are valid till 2013 and are expected to be renewed since transport by PNSC is preferable given the strategic importance of the imports and the government’s say in the matter.

6.2 The imported crude is received at the Karachi Port Trust, which has three oil piers, only one of which handles crude. The refineries also own crude storage facilities at four locations – Keemari, Korangi, Morgah and Muzaffargarh – with around two-thirds of the total storage capacity in Karachi.

6.3 Once the crude oil reaches the refineries, its processing depends on the complexity of the refinery, which is measured by the Nelson Complexity Index3. In a topping refinery, crude is separated into its constituent products by atmospheric distillation. Such refineries produce naphtha, but no gasoline, in contrast to hydroskimming refineries, which are more complex and, thus, able to produce gasoline as well. The cracking refineries add another level of complexity by using vacuum distillation to remove the lighter fractions from the oil. These fractions are then further processed into useful products like gasoline and diesel. The lighter products are recoverable at the lowest temperatures, followed by the middle distillates and, finally, the heaviest products. The bottom fraction (residue) left behind by vacuum distillation can be fed into a coker4, in case of a coking refinery, to produce more fuels for transportation. Thus, the more complex refineries maximize the output of the most valuable products by reprocessing the heavier fractions into lighter products.

6.4 The quality of the crude oil5 dictates the degree of processing required to achieve

2 This is an international freight billing system composed of the weight average of independently owned tanker tonnage. Under this, the London Tanker Brokers’ Panel determines rates for various size categories of tankers. 3 This index assigns a complexity factor to each major refining unit based on its complexity and cost in comparison to crude distillation, which is assigned a complexity factor of 1. Thus, a refinery with a complexity of 10 on the Nelson Complexity Index is considered ten times more complex than crude distillation for the same amount of throughput. 4 A coker is a furnace where high temperatures are used to ‘crack’ the long chain, heavier residue hydrocarbons into ‘gas oil’ containing shorter hydrocarbon molecules. 5 Crude oil with a similar mix of physical and chemical characteristics, usually produced from one reservoir, field or sometimes even region, constitute a crude oil “stream”. Most simply, crude is categorized by its density and sulphur content. Less dense or lighter crudes normally produce a higher proportion of light hydrocarbons, while denser crudes require additional processing to improve their product slate. Meanwhile, high sulphur crudes are undesirable.



OIL & GAS

the optimal mix of crude output. Resultantly, price differentials between crude oils are a function of the relative ease of refining these and the different mixtures of products that they can eventually be refined into. Hence, those crude oils which produce a more valuable yield and can be treated by a large number of the world’s refineries command a premium over others. The West Texas Intermediate, the U.S. benchmark for crude oil, has a relatively high natural yield of desirable naphtha and gasoline and so, demands a premium price. In contrast to this, almost half of the simple distillation yield from Saudi Arabia’s Arabian Light, the historical benchmark crude, is in the form of a heavy residue, which must be either reprocessed or sold at a discount.

6.5 Currently, most of the country’s refineries are old, classified as hydroskimming. The one exception to these is PARCO, which utilizes more complex technology, allowing it to benefit from a product slate having a better yield. However, the sector tried to improve its plant technology to optimize product slates6. Currently, the refining sector is focusing on hydro-desulphurization of diesel in order to meet Euro II specifications7, with which the refineries, again with the exception of PARCO, are still not compliant. However, this requires heavy investment and refineries have raised considerable hue and cry over this, demanding that the present deemed duty on diesel be raised so that they have sufficient funds available for investment. Certain refineries are also in the process of constructing isomerisation units to reduce benzene in motor gasoline.

6.6 The refining sector does not enjoy one central location in the country. Instead, of the five main refineries in the country8, two are located in Karachi, one in Mahmood Kot near Multan, one in Rawalpindi and the last in Lasbela (Balochistan). The two located in Karachi (NRL and PRL) enjoy the advantage of being able to access the imported crude easily. Meanwhile, the country also has a pipeline infrastructure in place which allows for the transportation of imported crude oil to the refinery9. At the same time, the location of some refining capacity in the north has allowed the sector to easily secure crude oil supplies from northern fields. This is important since logistical costs are otherwise substantial, especially in lieu of less than optimal infrastructure facilities in the country.

6.7 The refining sector enjoys some degree of integration with the downstream oil marketing segment. PARCO has a 40% stake in TOTAL PARCO Pakistan Limited (TPPL), an oil marketing company through which it markets upto 25% of the products of its mid-country refinery. Meanwhile, the Attock Group, which is the main sponsor of NRL and ARL, also has majority interest in Attock Petroleum Limited, the retail arm of the group’s oil and gas business. In fact, the group is the only fully integrated corporation in the oil and gas industry of Pakistan.

6.8 The sector utilizes different technological solutions to manage its operations. Some refineries make use of Enterprise Resource Planning (ERP) solutions to streamline planning and coordination across business lines. Meanwhile, SCADA is utilized to ensure that the pipeline system operates smoothly. Moreover, the sector has detailed predefined policies, pertaining to a wide range of issues such as pricing determination, supplier selection and safety, in place, resulting in a sound control environment.

6.9 Refineries normally need to undertake routine plant-wide maintenance after every 6 NRL’s plant consists of three refineries, two of which are lube refineries, allowing it to produce high margin Lube Base Oils (LBOs). Meanwhile, ARL’s plant configuration allows it to process crude oils having a range of densities (10-65 API), which, in turn, produce a range of products. The density of crude oil is generally measured by its API gravity. The two have an inverse relationship, with the lower density crude oils having a higher API gravity. Light crudes are generally those with an API gravity over 40.7 These specifications require that sulphur content in diesel not be greater than 500 parts per million (ppm). 8 These are PARCO, NRL, ARL, PRL and BPPL.9 PARCO has an 864 kilometers long pipeline extending from Karachi to Mahmood Kot. Prior to the commissioning of the refinery, the pipeline was mainly utilized for the transport of white oil products.



OIL & GAS

eighteen months. This is planned in advance and usually lasts for around thirty days. Since refineries normally consist of a series of complexes, the maintenance is carried out in a phased manner, so the complete refinery does not have to shut down. However, excessive plant maintenance or unplanned outages in operations result in lost production capacity and foregone income, which can significantly affect financial results. In recent years, Pakistan’s refining sector has been able to avoid such shutdowns.

7. BUSINESS RISK

Cyclical industry

Capital intensive in nature

Shortfall in local refining capacity

High Speed Diesel and Furnace Oil dominating production mix

Protective duty on High Speed Diesel and lubes

High capacity utilization in the past

Circular debt issue prevailing

7.1 The global refining industry is fragmented, highly competitive – both on a regional and global basis – and capital intensive, with long lead times for projects. Expansions usually require three years at a minimum, while the construction of a new refinery entails four to five years. The maintenance cost for refining plants is also very high. Apart from routine maintenance, more extensive turnarounds are required every four to five years. Moreover, in case of a change in environmental rules, expensive modifications are required. Furthermore, strategic projects to improve the product slate of refineries or control the cost of its crude slate also involve substantial amounts of capital. Thus, barriers to entry are high.

7.2 Refining, like most of the oil and gas chain, benefits from economies of scale due to the large portion of fixed costs. Size also creates ease in accessing capital markets. At the same time, diversification, with reference to crude suppliers, product mix and geography, aids in ensuring stable earnings for entities operating in the industry. Downstream integration, contributing to internal efficiencies and less volatile margins, remains a positive factor for the industry too.

7.3 The industry’s revenues, as well as costs, are vulnerable to global and regional commodity prices, which remain beyond the control of any one issuer. Thus, the refining sector is a price taker on both the raw material and end-product sides. Gross Refining Margins (GRMs), defined as the differentials of the product and the feedstock, mostly crude oil, prices, remain a function of macro factors. This inability to control prices at either end of the value addition chain is a key risk for the sector. In fact, the refining industry is inherently cyclical and influenced by factors such as global and regional economic growth, which influences product demand, seasonal changes in demand and the industry’s own patterns of investment, surplus and shortage. Entities operating in the sector find it economical to add capacity when refining margins are high. However, when demand declines, this results in surplus capacity and resultantly, depressed margins. Margins for companies are also a function of the proportion of light or high-value products, such as gasoline, diesel and jet fuel, in the respective refinery’s product yield. As a result, refineries producing large amounts of residual fuel oil have lower GRMs than those producing a higher proportion of light products. Moreover, refineries which are able to process large volumes of heavy crude oil benefit from widening light/heavy spreads.

7.4 The worldwide economic boom over the past few years caused demand for refined products to rise and outstrip supply, resulting in margins following an upward trajectory. This, in turn, allowed refineries to bridge capital spending for expansionary as well as new projects and gradually, capacity expansions were announced. However, the upward rising trend of refining margins reversed and they fell drastically in 200910 due to decreased demand for oil products in the wake of the global economic downturn and new refining capacity, mostly in Asia Pacific, coming online. In the Far East, margins were particularly affected, averaging close to zero in Singapore.

10 The British Petroleum global indicator refining margin, which averaged USD 6.5 per barrel during 2008, declined to USD 4 per barrel.



OIL & GAS

7.5 Currently, Pakistan’s total refining capacity is thirteen million tonnes per annum against an annual national petroleum products’ consumption of around twenty million tonnes. The industry produces motor gasoline (petrol or gasoline), HSD (gas oil), FO, Light Diesel Oil (LDO), High Octane Blended Component (HOBC), aviation fuels, kerosene, naphtha, Liquefied Petroleum Gas (LPG) and lubricants. HSD and FO, with a combined share of over 60%, dominate the production mix.

7.6 With consumption being greater than production, there is a supply shortfall in the industry, which has to be bridged through imports. Moreover, the existing refineries were originally configured to maximize fuel oil and motor gasoline production. However, with the introduction of CNG as an alternative fuel in the transportation segment, motor gasoline demand has declined. At the same time, both HSD and FO demand have witnessed a rise. The increase in HSD demand is primarily attributable to the transport sector, which is the largest consumer of HSD (91%). Meanwhile, the rise in FO demand has been on the back of increased quantities been demanded by the growing power sector, which already consumes 93% of the total FO volume in the country. Presently, large imports of both the fuels are bridging the gap between local production and consumption. However, the government intends to introduce refineries configured for higher HSD and FO production, through deep coking technology, in the future. This remains critical for the country, given that demand is expected to continue its upward trajectory in the future and imports of refined products are already leading to a massive import bill. In this regard, plans of establishing three new refineries in the country are in the pipeline. These include the Khalifa Coastal Refinery (KCR), Indus Refinery (100,000 bpd) and a new refinery by Bosicor (120,000 bpd). KCR is to be a deep conversion refinery and would have a capacity of 250,000 bpd, making it the largest refinery in Pakistan. However, it requires massive investment due to which work on the refinery is currently at a standstill. The successful establishment of these three refineries will introduce twenty one million tonnes per annum of additional refining capacity in the country, making the country a net exporter of POL products. However, no substantial progress has been achieved towards the actual construction of these refineries yet. At the same time, securing future supplies of feedstock (crude oil) for the sector is important as well. At present, given Pakistan’s limited crude oil production, most of the crude is imported from the Middle East. While there have been no major supply disruptions in the past, the high degree of supplier concentration and the political fragility of the region does pose a risk.


15%2%0%

35%

1%

28%

10%7%2%

Oil Refineries Production Mix - FY10

Petrol Kerosene HOBCHSD LDO FOAviation Fuels Naptha LPG


OIL & GAS

7.7 Due to the fact that Pakistani refineries are generally simpler and older, the sector’s margins remain lower in comparison to the industries of those countries where refineries are more complex. However, the sector enjoys regulatory support to some extent at present, although the government has been gradually withdrawing this. Domestic refineries (exclusive of PARCO) were allowed to operate on a cost-plus basis with a guaranteed rate of return on equity (with a floor and cap) until July 2002, while PARCO was allowed a budgetary subsidy of around PKR 8 billion annually11. As part of the gradual phasing out of government support, the guaranteed return formula for domestic refineries was abolished in 2002. At present, the import parity pricing formula12 is in place to ensure that the prices for refined products reflect, as closely as possible, the true cost of imports. These are based on the average monthly Arab Gulf free-on-board (FOB) prices, as published on Platts13. Since these prices are published in US Dollars, the refining sector remains vulnerable to exchange rate risk, with depreciation of the local currency increasing its revenues. However, this risk is mitigated to some extent by the fact that crude oil prices, which largely determine the direct cost component of the sector, are also denominated in US Dollars. At the same time, a rise in crude oil prices leads to inventory gains for the sector, while a reduction causes the reverse to happen. Recently, the National Commodities Exchange Ltd. has introduced crude oil future contracts in the country. While volumes remain low at the moment, these futures, if utilized by the refining sector, would provide a hedge against crude price fluctuations.

7.8 Refineries still benefit from a protective duty on HSD14, the cost of which consumers bear since there is no outflow of funds as such from the GoP. This deemed duty, which reportedly allowed refineries to earn PKR 80bln from 2002 to 200915, was reduced to 7.5% from 10% in August 2008. The argument employed by the GoP in favour of the reduction was that the key objective of deemed duty was to enable refineries to accumulate funds for diesel hydro-desulphurization projects. However, apart from PARCO, refineries did not accomplish much on this front in the past and so, became the subject of criticism. The sector’s management continues to dispute the reduction. The rationale for the presence of the protective duty on HSD needs to be reviewed and a cost benefit analysis performed to determine if it is actually justified. At the same time, the sector is also allowed a 10% duty on Lube Base Oils (LBOs), which makes the lube segment very lucrative. However, given that a virtual monopoly exists in this segment, the refining industry, as a whole, does

11 PARCO did not utilize the guaranteed return allowed to it after the first four years of operations till 2008, after which it expired. 12 PARCO’s formula, specified in its Implementation Agreement, results in the refinery being allowed slightly higher prices than those allowed to other refineries. This differential is adjusted in its Inland Freight Equalisation component. 13 Platts is a global provider of energy and metals information. 14 Refineries were also allowed deemed duties on jet fuel, kerosene and LDO at one time, but these were withdrawn under modifications made to the pricing formula from time to time. 15 Based on figures provided by PARCO, a 2.5% decrease in deemed duty results in a decline of PKR 1/litre in the ex-refinery price of HSD.


Petrol Kerosene HSD LDO FO Aviation Fuels0

1,000,0002,000,0003,000,0004,000,0005,000,0006,000,0007,000,0008,000,0009,000,000

10,000,000

Refineries Production and National Consumption - FY10

Production Consumption

Tons


OIL & GAS

not benefit from this duty. These custom duties are included in the pricing formula, so the GoP also earns revenues through their collection on imports. In a recent move, Planning Commission has recommended the removal of deemed duty.

7.9 Refineries have also been demanding a review of the motor gasoline pricing mechanism. Previously, the formula was linked to the average monthly price of Naphtha, as published on Platts, with a premium of USD 60/MT. However, it was changed in July 2008. It is now linked to the average monthly price of MS 95 RON, as published on Platts, and converted to MS 87 RON price by unitary method. This, at times, produces negative margins for motor gasoline, which previously used to produce positive spreads.

7.10 The sector’s performance has been volatile in recent years, while high capacity utilization has remained important in order to minimize per barrel operating costs. Throughput levels of over 80% have been achieved, although the prevailing circular debt issue has caused a decline in these recently. Since 2004, the sector benefited from high global GRMs, although it could not take advantage of the widening light/heavy spread. This, coupled with the 10% deemed duty on HSD, allowed refineries to post healthy results. However, crude oil prices depicted sharp volatility during FY09. With petroleum product prices fluctuating as well, refining margins were affected. This, along with foreign exchange losses against crude oil purchases due to PKR devaluation and the pricing revisions by the GoP, resulted in the sector’s performance being impacted negatively. Cash flows, which remained largely positive in the past, also suffered. These were further impacted by liquidity problems arising on account of the inter-corporate debt issue, with oil marketing companies (OMCs), particularly Pakistan State Oil (PSO), owing large amounts to the refineries. Some refineries have been unable to effectively manage their working capital needs, especially since payments against imported crude oil cannot be delayed for long, resulting in a net receivables position. The sector has raised interest claims against OMCs on these receivables and also received counter claims from local crude suppliers, to whom payments have been delayed in return. However, these mark-up claims have not been recorded in the financial books since the parties involved have not recognized the overdue payments as debt. borrowings had to be resorted to and thus, the leveraging of the sector has increased lately.

7.11 At present, the sector remains ill-prepared to handle a prolonged downturn in


Performance Analysis NRL ARL PRL

9M11 FY10 9M11 FY10 9M11 FY10 9M11 FY10129,194 110,186 81,935 88,184 86,229 76,658 29,184 48,506

7,174 6,333 961 (509) 1,483 (630) 683 667110 695 1 308 139 1,134 1,608 2,335

4,846 3,284 1,950 126 51 (2,975) (562) (1,616)EPS 60.6 41.1 22.9 1.5 1.3 (85.01) (1.43) (4.12)Gross Margin 6% 6% 1% -1% 2% -1% 2% 1%Net Margin 4% 3% 2% 0% 0% -4% -2% -3%

Byco

Sales (mlns)Gross Profit (mlns)Finance Cost (mlns)Net Profit (mlns)

Parco NRL ARL PRL BPPL Dhodak ENAR0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Capacity Utilizations - FY10


OIL & GAS

GRMs without active government support. In this regard, it has been pressing the government for revisions in the regulatory structure. A Judicial Commission was also appointed by the GoP to look into the matter. While the refineries have been demanding a return to the earlier guaranteed return mechanism, the GoP’s stance on the issue remains unclear, as witnessed through conflicting reports in the media. Some reports have talked about a refining margin that is fixed in percentage terms, resulting in any losses being unrecoverable through pricing or from the GoP. Supporters of this proposal argue that the refining sector has to bring in efficiencies itself in order to survive. Others have also proposed the replacement of the deemed duty on diesel with a per barrel processing fee, fixed in dollar terms, on diesel. This would allow refineries to improve their balance sheets for future expansions and upgradations. It remains to be seen how the GoP decides to revise the current formula, if at all. However, given the constrained fiscal space of the government, it seems unlikely that the GoP will agree to a guaranteed return or per barrel processing fee formula which requires it to pay the refineries. Moreover, much hue and cry has been raised over the large amounts of profit booked by the sector in previous periods, resulting in political pressure to introduce unfavourable regulatory changes for the industry now.

8. FINANCIAL RISK

Low leveraged sector

Historically high liquidity

Circular debt issue prevailing in the sector

8.1 The overall leveraging of the refining sector remains low, signifying financial flexibility. This is particularly important since excessive financing needs to be avoided for smaller refineries, such as the ones in Pakistan, since the associated costs cannot be allocated over a large product base. Two of the refineries (NRL and ARL) remain debt-free, thus, enjoying equity based capital structures which enhance their risk absorption capacities. The sector’s risk absorption capacity has been further enhanced by the mandatory minimum requirement to retain any profit after tax from refinery operations that is above 50% of the paid-up capital at that time in a special reserve 16, which is to offset future losses or make investments in expansion or upgradation projects.

8.2 Recently, some refineries in the sector have resorted to large borrowings, particularly short-term in nature, to cope with the circular debt issue. The associated high interest expense has also impacted coverages. Given that it is difficult for refineries to obtain funding through both the debt and equity capital markets when refining margins are under pressure, a prolonged downturn in GRMs could not only dampen profitability of the sector, but also put further strain on its working capital management if the circular debt issue persists simultaneously.

8.3 The sector has traditionally enjoyed a high level of liquidity, as evident by large cash balances. These are necessary given the large payments which need to be made against crude purchases and the ongoing need for cash in the sector. Lately, some refineries have also reduced their dividend payout in the wake of the circular debt issue, so that sufficient cash can be retained for refining operations.

8.4 The fact that all the major refineries, with the exception of PARCO, are listed on the country’s stock exchanges and enjoy relatively strong market capitalization highlights their ability to raise funds from the capital markets if the need arises.

16 ARL retained PKR 260 million during FY09 and PKR 1,862 million during FY08 under this requirement.


Section IV


OIL & GAS

1. THE GLOBAL OIL MARKETING INDUSTRY - OVERVIEW

• Fragmented despite presence of large players

• Challenging operating environment in recent times

1.1 The global oil marketing sector is fragmented with a substantial number of players, despite the presence of large international participants. The leading players (ExxonMobil, Shell, BP and Total) benefit from economies of scale, a high degree of vertical integration and geographical diversification. 1.2 The operating environment in the oil and gas sector was no exception to the overall challenging environment in the global oil and gas industry in recent years. The fluctuation in crude oil prices translated into volatility in end product prices. After touching the historic highs of USD 147 per barrel in July 2008, crude oil prices plummeted to USD 32 by Jan 2009. Moreover, reduced consumer spending resulted in lower retail fuel demand, while demand by certain commercial sectors was impacted as well by the global economic crunch. 1.3 In India, the government controlled the pricing of petroleum products through the Administered Pricing Mechanism (APM) till April 2002. It was then abolished and replaced by an import parity pricing formula, while subsidies were offered on Liquefied Petroleum Gas (LPG) and kerosene because of their importance as cooking fuels for the country’s low income population. These were to be removed between 2005 and 2007, but are understood to be still in place. Meanwhile, under the new pricing mechanism, retail prices for petroleum products were to fluctuate in line with changes in the price of the country’s crude basket. However, the Indian government has often been criticized for not allowing this to happen in reality. While global crude prices have appreciated significantly since the implementation of the import parity pricing regime, this increase has not necessarily translated into a rise in the retail prices of ‘sensitive’ products such as petrol, diesel, LPG and kerosene, with the latter two witnessing minimal price increases. Thus, in practice, the government has protected local consumers by controlling upward revisions of petroleum product prices by Oil Marketing Companies (OMCs)1. Following the recommendations of the Rangajaran Committee in 2006, the import-parity pricing regime was replaced by the trade-parity pricing mechanism, which is based on the weighted average of import and export parity prices. Nevertheless, the government continues to maintain an effective control on petroleum product prices.

2. THE DOMESTIC OIL MARKETING INDUSTRY - PROFILE

2.1 There are eleven OMCs in Pakistan. Of these, Pakistan State Oil (PSO), with a market share of ~70% and a retail network of around 3,600 outlets, is the largest. During the 1990s, PSO entered into long-term fuel supply agreements with Independent Power Producers (IPPs), as a result of which it still dominates the market today. The other large players in the segment are Shell Pakistan Limited (SPL) and Chevron Pakistan Limited (CPL), formerly known as Caltex Oil Pakistan Limited. In 2003, after a series of changes in the ownership structure, SPL is now the second largest OMC in the country, as well as the market leader in the lube segment. Meanwhile, CPL's retail network consists of 598 outlets. Moreover, PSO, SPL and CPL, along with PARCO, have ownership interests in Pak-Arab Pipeline Company Limited

1 This has resulted in the accumulation of “under-recoveries” by OMCs. This is a notional measure of the difference between the trade-parity cost of refined products paid by OMCs and their realized sales prices.

Oil Marketing Page 1 of 7June 2011 www.pacra.com

71%

11%

5%5%

4%4%

Market Share (2009-10)

PSO SPL CPL APL TPPL Others


OIL & GAS

(PAPCO), which operates a cross-country pipeline system to transport HSD upcountry from Karachi.

3. GOVERNANCE

• Gradual deregulation process

• Fuel oil and diesel prices deregulated

• OGRA announcing prices of other products

• OCAC quasi-regulator

3.1 The government tightly controlled the OMC sector till 2000. Since then, reforms have been introduced gradually. These included the deregulation of fuel oil and diesel prices (which contribute around 86% of national consumption) the revision of petroleum product prices on a monthly basis to reflect changes in international prices, the rationalization of distributor and retailer margins, and the privatization of LPG assets. These measures have served to make the sector more competitive, although the level of competition is still considerably low due to the presence of dominant industry participants with top three OMCs having 87% market share. Moreover, the freight pool in practice to ensure equalization of POL prices across the country has often been criticized as inefficient. In this regard, the promotion of a more efficient scheme through competition in inland transportation and elimination of the freight pool has been proposed at various times.3.2 The Oil Companies Advisory Committee (OCAC) represents the refineries and the OMCs at various forums in matters of common interest, thus, allowing interaction between oil companies and the government. It, thus, acts as a quasi-regulator and develops suggestions pertaining to the oil and gas sector for the GoP, besides collecting production data for the sector and coordinating import activities. The body consists of the representatives of five of the country's refineries, ten OMCs and one pipeline transportation company. In 2001, the government authorized OCAC to review, fix and announce the prices of petroleum products on a fortnightly basis in accordance with the import parity pricing formula as part of the sector’s deregulation process. Therefore, between July 2001 and April 2006, the representative body was responsible for reviewing and announcing ex-depot prices of POL products. In April 2006, this function was transferred to the Oil and Gas Regulatory Authority (OGRA), which acts as a semi-independent regulator for the sector now. However, OGRA’s Chairman and three other main members are all appointed by the federal government, thus, giving it indirect control of the sector.

4. OWNERSHIP

• GoP holds major stake

• Large oil companies holding significant stakes

4.1 The GoP has a major stake in the oil marketing segment, not just as a policy maker and regulator, but as an owner as well. GoP holds 44% share in the largest OMC of Pakistan, PSO. Given the sector’s strategic nature, it enjoys a high degree of support and commitment from the government.

4.2 Large oil groups, both local and foreign, also hold significant stakes in the OMC sector. Their involvement in the industry not only lends it financial strength, but also ensures that it benefits from the strategic and operational guidance provided by those having the requisite experience.



5.1 The management team of the industry consists of qualified professionals with local as well as international experience. The presence of foreign players in the sector has also aided in attracting individuals with the necessary qualifications and experience. To ensure effective oversight of operations and strategy formulation, the industry players have established various management-level committees. Meanwhile, entities in the industry are


Name % of Holding44.40%

NIT 25.90%Foreign Companies 3.60%Individuals & Others 26.10%

PSO – Pattern of sharholding as at June 30,2010

GoP


OIL & GAS

organized along functional lines.

5.2 Some of the sector’s senior management has experienced several changes in the past few years due to government interference, which remains a risk in the future. Meanwhile, the sector has also witnessed organizational restructuring in recent years, which has been viewed positively and has increased operational efficiencies. Focus on human resource development has increased through various in-house and external training sessions. 5.3 The sector has well defined organizational structures with clear segregation of responsibilities. Day to day operations of entities are divided into four broad functional areas namely i) Marketing ii) Supply Chain iii) Finance and IT iv) HR and Services. Each of these functional areas are headed by Executive Directors.

6. SYSTEMS AND CONTROLS

• Vast infrastructure for operations

• Pipeline network in place for white oil products

• SAP ERP software in place

6.1 The sector’s operations are carried out through a vast infrastructure consisting of oil terminals (for import purposes), storage installations, depots and a supply chain supported by a strong tank-lorry fleet, railway wagons and pipeline networks. Fuel oil is imported only at the Fauji Oil Terminal and Distribution Company (FOTCO) jetty at Port Qasim. Besides fuel oil, diesel and crude oil are also imported at the same jetty. The FOTCO oil terminal is capable of handling 9 million tonnes of furnace oil annually and is designed to cater for additional berths to meet the petroleum products requirements of Pakistan. The construction of these is necessary since the FOTCO jetty, in particular, is already handling more cargo than its maximum handling capacity. Moreover, if imports increase, port congestion could result and supplies could be disrupted. At the same time, diesel is also handled at the Kemari (in Karachi), Machhike and Faisalabad terminal stations as well as the Korangi pumping station.

6.2 A large portion of the products are transported by tank lorries. These lorries have different capacities and age. These are largely owned by individuals and small firms. To minimize pilferage, a large number of lorries are fitted with tracker devices. The fleet is used both for short-haul secondary distribution within cities and medium-to-long-haul shipments across the country. There is also a pipeline system in place in the country for the transportation of refined products such as diesel. This system is linked to the ports (Port Qasim and Kemari) as well as to some refineries and provides for the transportation of products upcountry. The smooth functionality of the pipeline system is ensured through a sophisticated telecommunication and supervisory control system (SCADA). To protect the pipeline network from external corrosion, a cathodic protection (CP) system has been installed along the length of the cross-country system. In remote areas, where electric supply is not available, solar electric power is used in some CP stations, along with backup diesel generators. With the commencement of the White Oil Pipeline Project (WOPP), a new pipeline from Port Qasim to Mahmood Kot, in 2005, along with the previously existing Mahmood Kot-Faisalabad-Machhike pipeline, white oil products are now entirely moved via the pipeline system from Karachi to the north of the country. Previously, tank lorries were used for this purpose.

6.3 The sector has comprehensive procurement policies in place to ensure competitive bidding processes. Moreover, the sector has also been focusing on Total Quality Management (TQM) lately. In this regard, mobile quality testing units have set up in different regions to conduct quality checks at retail outlets. These are equipped to perform different functions, including detecting the alcoholic content in motor gasoline.

6.4 SAP Enterprise Resource Planning (ERP) software features prominently in the sector, with most entities either having implemented it or in the process of doing so. Entities have also developed standardized manuals pertaining to the entire chain of operations from supply management to the audit function. The foreign players also benefit



OIL & GAS

from the implementation of group policies and procedures which have been developed according to international standards.

7. BUSINESS RISK

• Oligopoly-based structure

• Lack of integration

• Reliance on transport and power sectors as major consumers

• Circular debt issue prevailing in the industry

• Volatile industry

7.1 With an annual consumption of around 18 million TOE, Petroleum, Oil and Lubricant (POL) products account for around one-third of Pakistan’s modern energy consumption. Consumption of petroleum products has recorded sharp increases during the past three decades and registered an annual compounded growth rate of 5.2% from FY05 to FY10. This trend continued in FY10 and has been primarily attributable to a rise in fuel oil and, more recently, motor gasoline sales. Natural gas supply constraints have consistently contributed to a rising need for fuel oil for power generation purposes. Moreover, reduced hydro-electric potential in some years has also supported the increasing demand for fuel oil. At the same time, motor gasoline sales, which witnessed a decline previously due to increased reliance upon Compressed Natural Gas (CNG), have also depicted an increasing trend in recent years. This rise was particularly marked in FY10 (27% increase over the preceding year) due to large growth in car sales, gas shortage leading to interruptions in CNG availability and frequent power outages resulting in extraordinary use of generators. The increase in POL products consumption is expected to continue in the future, especially due to rising demand for fuel oil in order to meet the country’s electricity needs.

7.2 The sector’s products can be broadly categorized into white oils, black oils, and lubricants and chemicals. The first category includes motor gasoline, Kerosene Oil (SKO), High speed Diesel (HSD) and Jet Petroleum (JP-1). Black oils include Light Speed Diesel (LDO) and Furnace Oil (FO). The lubricants and chemicals category includes Lube/Greases, LPG and chemicals.

7.3 Oil consumption in the country is highly skewed, with nearly 87% being attributable to HSD and furnace oil FO. Only 43% of HSD and 39% of FO are produced locally, with the balance being imported. The total amount of products being imported is now over eleven million TOE, with over 90% being imported by a single player.

7.4 Currently, the sector operates on an independent marketing model with eleven participants, although, given the huge market share (80%) of the two largest players, its structure is oligopoly-based in reality. The participants include local as well as international companies. While competition from smaller OMCs has increased following the introduction of the deregulation process in the early 2000s, the threat to the prevailing oligopoly in the sector remains low, as evident by the stability of the largest player’s market share over the years. However, sector entities have focused on product differentiation and brand management in order to compete in recent years. The sector has also modernized its retail network and implemented customer service systems, besides the development of alternate revenue channels. These include petroleum product cards, such as loyalty, corporate and prepaid cards, auto car wash facilities and convenience stores. The importance of the non fuel retail segment has increased in recent years in the wake of tight retail fuel margins. Meanwhile, the sector lacks benefits of integration, with only three small OMCs being supported by refineries controlled by their respective groups. More integrated business models are likely to emerge though if the proposed deregulation of freight costs is implemented since it would allow OMCs with integrated structures to compete favourably on lower freight cost.

7.5 Most petroleum products are sold ex-depot, but gasoline, diesel and kerosene are marketed through retail outlets. Many of these also sell CNG, which has become a serious competitor to gasoline. The petroleum infrastructure is dominated by PSO, which has over 1 million tonnes of storage capacity, representing over 80% of Pakistan’s total storage capacity, and also enjoys the advantage of having entered into long-term fuel supply agreements with independent power producers (IPPs) in the 1990s when other OMCs were



OIL & GAS

not interested in supplying fuel oil to IPPs. Besides PSO, Shell, Attock Petroleum Limited (APL) and Caltex are the main OMCs. The sector has increased both its retail outlets and storage capacity over the years. At present, the three largest players (PSO, Shell and APL), in terms of their markets shares, have a combined retail network of around 5,000 outlets.

7.6 The transport and power sectors are the major consumers of POL products, with a 49% and 42% share, respectively, in total national consumption. FO or HSD2 is supplied to the power sector under fuel supply agreements, which are long-term in nature3. Annual minimum volumes are guaranteed under the agreements, thus, assuring the OMCs of the specified demand. The pricing for the fuel is based on the ex-refinery price, plus a few other components, as explained below. Transportation cost is included in this. While the agreements specify that payment for the fuel is to be made at least ten days in advance, the prevailing circular debt issue in the energy chain has resulted in a tacit commercial understanding under which payments are being delayed indefinitely. Meanwhile, aviation fuel is also provided in bulk to refueling facilities at airports across the country.

7.7 Retail prices of POL products comprise the import parity price, inland freight equalization margin (IFEM), OMC and dealer margins, and taxes (customs duty, petroleum levy and sales tax). These are adjusted every month in accordance with the movement in international prices. In the past, petroleum product prices have, at times, been considerably higher than import parity levels due to the petroleum development levy (PDL), which was a variable figure. In times of low international prices, such as during FY09, the GoP raised the surcharge to earn large amounts through it. In contrast, during periods when international prices were fairly high, the surcharge was relatively low and, in certain cases, subsidies were even provided by the GoP to keep end user prices roughly constant. This prevented the full cost of the import prices from being passed on to the consumer. As a result, government revenues, a significant portion of which has been contributed by petroleum levies, have remained vulnerable to international oil prices. The GoP replaced the petroleum development levy with the petroleum levy in FY10. This has been fixed in absolute terms, so any increase or decrease in international oil prices is now being passed directly on to customers. Meanwhile, OMC margins are fixed at 4% and dealer margins at 5% for all retail products, with the exception of HSD, whose margins are fixed in absolute terms (PKR 1.35/litre for OMCs and PKR 1.5/litre for dealers). The fixed margin on HSD limits the upside earning potential for OMC, specially in times of high prices. GoP is mulling over deregulating end product prices to create a level playing field and enhance competition in the sector. Moreover, a proposal to abolish IFEM has also been put forth for budget FY12. If implemented, it would result in varying product prices at different locations and benefit integrated players and refineries located near major consumption centres.

7.8 In line with the increasing consumption of POL products, particularly FO, in the country, the sector has witnessed rising sales, in volumetric terms, over the years. This volumetric increase, coupled with the upward trend in petroleum prices, has translated into growing revenues, although this growth slowed down lately due to the general slowdown in the economy and its ensuing impact upon the POL consumption in the country. At the same time, the volatility in oil product prices has sometimes caused inventory losses to the sector. Moreover, the sector is also exposed to exchange gains/losses due to its heavy reliance on imports, which are denominated in US Dollars. This exposure caused exchange losses during FY09 and FY10, thus, dampening the sector’s profitability. Both the sector’s overall gross margins and net margins have remained volatile, with the net margin having been pushed into the red zone in some periods.

2 HSD is supplied to gas-based power plants, which are provided gas for nine months and are required to run on HSD for the remaining three. 3 These range from ten to thirty years.



OIL & GAS

7.9 The circular debt crisis remains a serious concern for the OMCs in the country due to their exposure to the power sector, which has continuously defaulted on its payments. This problem has largely stemmed from the disparity between the power costs and tariffs. Prior to FY08, electricity tariffs were not increased in line with the rising generation costs, resulting in a significant cost-tariff differential. Moreover, the sharp increase in FO, which, along with gas, is one of the two main fuels for electricity generation in many power plants, prices during 2HFY08 and 1HFY09 aggravated the situation since it increased the subsidy provided to consumers. Thus, with the distribution companies unable to collect the differential amount from the government as well as payments from some customers in a timely manner, payments to power producers were delayed. These producers, in turn, could not make payments to the fuel suppliers (OMCs and gas distribution companies) on time, resulting in the delayed payments by the OMCs to the refineries and by the distribution companies and the refineries to exploration and production entities.

7.10 Currently, the GoP is regularly revising the power tariff in line with international oil prices and gradually eliminating the subsidy to consumers as well, so that circular debt is prevented from accumulating in the future. However, the issue persists despite several rounds of power tariff hikes and the issuance of Term Finance Certificates by the government to clear the dues. In this regard, further measures need to be undertaken in order to completely eliminate inter-corporate debts which are outstanding on account of previous cost-tariff differentials.

7.11 The oil marketing sector suffers from a net receivables position in the circular debt chain4. This has caused the industry players to rely heavily on borrowings, particularly short-term facilities, to manage its working capital needs. The resulting high financial charges are now impacting the sector's margins, particularly in the case of FO, a large inventory of which has to be maintained by the sector due to its strategic need and the length of the import process. With delayed payments on account of FO sales to the power sector and the increasing amount being spent to manage supplies, the FO segment has started to produce negative margins, which has dissuaded many OMCs from carrying out operations in this segment.

7.12 For some entities in the sector, a significant portion of the high financial charges relates to interest accrued on overdue payments to refineries. At the same time, interest income has not been accrued on the overdue receivables. Instead, it is only recognized when the receivables, along with the interest payments, are actually collected. This conservative approach of recognizing interest expense as it is accrued, while only recognizing the corresponding income on a cash collection basis, should result in a beneficial impact on the sector once the circular debt issue is settled.

7.13 The government owes substantial amounts in Price Differential Claims (PDCs) on imports and PDL refunds to the OMC sector. In 2007, OMCs were asked by the Director General Oil to import motor gasoline to cater to the rising local demand and did so, confident that they would be paid the PDCs arising from the difference between the ex-refinery and imported cost of the product. However, the amount remains outstanding to date and the relevant ministries have yet to issue official notifications for the settlements of these claims.

7.14 The volatile nature of the sector continues to remain an area of concern for the sector. The risk of unfavorable changes in international oil prices as well as the regulatory regime, a slowdown in the domestic economy, higher water and gas availability, leading to lower fuel consumption, and increasing CNG usage pose challenges for the industry,

4 As of June 30, 2010, PSO alone had receivables of PKR 111 billion due from major power generation companies and the Pakistan International Airlines versus PKR 81 billion owed to local refineries. On the other hand, Shell’s exposure to the circular debt issue remains limited due to its relatively smaller share in the FO segment and its insistence upon receiving advance payments.



OIL & GAS

although the last of these is not a serious concern any longer due to gas supply constraints. However, there has been much speculation regarding regulatory changes. Latest news reports suggest the abolition of the IFEM mechanism. Although this would bode positive for market competition, OMCs who do not enjoy the benefit of backward integration might suffer since margins might have to be sacrificed in order to retain market share.

8. FINANCIAL RISK

• Moderate to high leveraged sector

• Funding mismatch

• Strong market capitalization

8.1 The sector is moderate to highly leveraged. However, a large portion of the borrowings is short-term in nature, which has created a funding mismatch since some of these have been deployed towards funding long-term assets. This could create problems if another liquidity crunch occurs in the banking sector, leading to entities being unable to roll over borrowings easily, and/or if the circular debt issue persists.

8.2 The sector enjoys strong market capitalization and its shares are actively traded on the stock exchanges, reflecting its ability to raise equity financing in case the need arises. Some entities, having large free floats, are included in the KSE-30 index.

8.3 In line with the volatile profitability of the sector, its cash flows have remained unstable as well. Lately, inventory and exchange losses, coupled with the circular debt issue, have resulted in pressure on the cash flows. This has caused some entities to scale down capital expenditures and cut dividend payouts too.


Section V

The Pakistan Credit Rating Agency Limited OIL & GAS

1. THE GLOBAL GAS DISTRIBUTION OVERVIEW

• Expensivetransport options

• Gazprom – the largest distributor

1.1 Gas is transported in two ways: through pipelines or in the form of Liquefied Natural Gas1 (LNG), with both being expensive options and demanding lengthy construction and investment payback periods. Gas transportation is much more costly than oil movement, due to the nature of the commodity. Of the two ways of transporting gas, pipelines prove to be the less expensive option where short distances are involved. However, since the routes of LNG-carrying vessels are flexible, unlike pipelines which are fixed assets, LNG can easily be transported to markets offering higher prices, thus, making its supply more price-sensitive. Within the LNG market, Qatar is the largest supplier, while Japan is the largest importer. The physical flexibility of LNG supply has resulted in markets that were once regional being turned into global markets so that prices are now influenced by international factors. One such market is the North America, which is now starting to interact with the international market. 1.2 In many parts of the world, gas prices fluctuate broadly in line with international oil prices. Historically, this has been the result of gas competing with oil-based products for heating in the domestic sector and with furnace oil for heating and steam generation in the industrial sector. Thus, gas pricing contracts take into consideration the energy supply and demand situation to a certain degree. 1.3 In Europe, apart from the United Kingdom, gas pricing contracts are linked to oil prices such that average oil prices for six to nine months are used, thus, leading to lower gas price volatility. However, this results in gas prices trailing oil prices with a time lag of one to three months. In the United Kingdom, gas is delivered against the National Balancing Point2 Index, where supply and demand comes into play. Meanwhile, in North America, oil-based contracts remained in use till the early 1980s, after which gas fundamentals started determining prices. These included factors such as industrial demand, gas storage levels and pipeline use and availability. Today, in the North American market thousands of producers, independent marketers, pipeline affiliates, local distribution companies and end users compete to buy and sell gas at wellheads and hubs. This is in contrast with Russia, where there is one major state-owned company, Gazprom, which holds licenses to over half of the country's reserves and also owns the mainline gas transmission system. The sheer magnitude of Gazprom's operations make it the world's largest gas production entity. While there are other independent gas producers in the country, their production is insignificant in comparison to that of the state giant.

1.4 Amongst Pakistan's neighbouring countries, China's gas sector is dominated by three state-owned companies. Operating in both the upstream and downstream segments, the companies account for over three-fourths of the country's production. However, the gas network is fragmented, with various local transmission and distribution companies enjoying regional monopolies. Meanwhile, prices are regulated and differentiated based on the regional pipeline system and the consumer category. China, like Pakistan, has allowed the fertilizer sector to pay lower gas rates. Meanwhile, India's gas sector, like that of China's and Russia's, again has state-run companies as its main players. The Gas Authority of India enjoys an effective monopoly over gas transmission and distribution operations. Prices are regulated as well, with gas being produced by the state entities sold under the Administered Pricing Mechanism3 framework.

1 LNG is natural gas that is cooled down to -161 degree Celsius to make it liquid. Following this, it is transported in specially-designed ships, with the liquid being converted back to gas at its point of arrival.

2 Pricing at this trading point is usually compared to the Henry Hub in the United States, which is the trading point for the New York Mercantile Exchange natural gas futures contracts. Comparison between the two hubs allows the direction of LNG spot prices to be determined since they are two of the most liquid trading points in the North American and the European markets.

3 This is based on the retention price concept. Under this, refineries, oil marketing companies and pipelines are GAS DISTRIBUTION Page 1 of 8June 2011 www.pacra.com


2. THE DOMESTIC GAS DISTRIBUTION INDUSTRY PROFILE

2.1. The domestic gas distribution is composed of two main entities - SNGPL & SSGC. SNGPL, Sui Northern Gas Pipelines Limited serves the northern region of the country, while Sui Southern Gas Company maintains a line network in the South, primarily the two large cities, Karachi and Hyderabad.

2.2. Both companies are responsible for transport of gas through their network, from the extraction field to industries and consumers. Pakistan is one of the few countries where gas is distributed to the domestic market through pipelines which are maintained by the distribution companies. The gas supply is metered at the consumption-end for billing purposes.

3. GOVERNANCE

• Tightly regulated sector

• Ogra – main regulating authority

• Fixed margin incentives in last policy

3.1 On the regulatory side, the long-term vision for the sector envisages producers competing for large consumers. The transmission and distribution companies (T&D) would only be involved in the transport of pipeline gas, instead of being responsible for selling it as well. Meanwhile, the presence of an independent regulator would ensure competitive market behaviour.

3.2 Instead, the Ministry of Petroleum and Natural Resources (MPNR), created in 1977, regulates the upstream gas exploration activities, while OGRA regulates downstream (sales) operations. MPNR is responsible for dealing with all matters pertaining to petroleum, gas and mineral exploration. In this regard, it has recently issued the Petroleum Policy 2009. The revised policy seeks to attract increased investment in the E&P sector to tap indigenous hydrocarbon resources by providing competitive incentives to local and foreign companies, along with a transparent and non-discriminatory licensing and contracting system. However, while the success of the latest policy remains to be seen, previous policies have not proved to be very effective in attracting investment in the sector. Meanwhile, MPNR has often been criticized for the lack of efficiency and effectiveness of its operations.

3.3 Meanwhile, OGRA consists of a Chairman and three members, with one each responsible for oil, gas and finance. All the members are appointed by the GoP. Since independent regulation in strategic industries such as the oil and gas sector is a relatively new concept in the country, there seems to be a lack of professional expertise in this area. In this regard, the role of organizations such as the World Bank remains important in the initial years of the creation of independent regulators. .

3.4 One of OGRA's most important functions remains the determination of the revenue requirements of the T&D companies and, thus, the prescribed rates for the sale of gas. The OGRA Ordinance outlines the legal structure for determining separate prescribed and sales price of natural gas, with the difference between the two accruing to the government as Gas Development Surcharge (GDS). However, the sales price is sometimes influenced by political, social and other factors, rather than being directly linked to the economic cost of providing the gas. This divorces the retail price determination mechanism from the stated aim of promoting economic efficiency in the sector. In the long run, the distinction between policy and regulatory matters needs to be emphasized and the role of the government restricted to policy formulation, while OGRA should be allowed to regulate the industry independently. Moreover, private sector representation needs to be increased in the industry in order to promote transparency and limit political influence in decision making.

3.5 The governance of the sector is also made difficult by the inherent conflict of interest present in the industry due to its very nature. While most other industries have profit maximization as their sole target, the fact that the gas sector provides a service that is an essential commodity and the right of all citizens means that profit maximization cannot be the only consideration while formulating rules and

compensated for operating costs and guaranteed an after-tax return of 12% on net worth.GAS DISTRIBUTION Page 2 of 8June 2011 www.pacra.com


regulations. This conflict comes particularly into play where issues such as providing gas to economically unfeasible areas arise4. In such cases, it seems unjustified to govern the industry in a manner which result in the gas utilities having to bear the losses associated with providing gas to these areas.

4. OWNERSHIP

• GoP and large corporations hold significant stake

4.1. Pakistan's gas sector remains largely under the control of the government. Although the government's stated policies have emphasized higher private sector participation, it has often seemed unwilling to relinquish control of the sector. The GoP has majority stakes in both the regional T&D monopolies (SNGPL: 55%; SSGC: 64%), although there has been some talk of the privatization of these once reforms are initiated. The government also holds majority shareholding in Oil & Gas Development Company (OGDC: 75%) Pakistan Petroleum Limited (PPL: 78%), while holding 40% (20% directly and 20% indirectly through OGDC) in Mari Gas Company Limited (MGCL). These three companies combined produce over half of the gas in the country. Besides the GoP, large international groups, such as the Pharoan Investment Group, hold ownership interests in the sector. Thus, the gas sector enjoys a financially strong ownership structure.

5. MANAGEMENT

QUALITY


• Cheaper workforce

• Worker outflow to the Middle East

5.1 The technical nature of the industry demands specialized management personnel. The industry’s top-tier management consists of a team of professionals having vast experience in the energy sector and possessing the desired qualifications. The major portion of the workforce also consists of technically qualified and skilled personnel. Due to the large number of engineering universities and other institutions imparting technical education and training in the country, there is a readily available local workforce for the lower tier of the industry, which is also cheaper in comparison to the workforce in other markets. While new entrants into the industry are generally inducted in this tier, in-house training and promotions allow the development of the middle and top management tiers in the sector. This ensures that these employees have the required industry experience, which is necessary for a specialized field such as oil and gas exploration and production. However, Pakistan’s physical proximity to the Middle East, an oil rich region where exploration and production activities have been rife for several decades now, has resulted in a significant number of skilled workers migrating there to earn better incomes.

5.2 The management of the industry, being recognizant of the growing demands of the sector, has established a Petroleum Research and Training Institute (PRIT)5. This provides a wide range of education and training programs to employees in the sector, as well as fresh graduates entering the industry.

5.3 The American Association of Petroleum Geologists, founded in 1917, established a local chapter in the country, named the Pakistan Association of Petroleum Geoscientists (PAPG) in 1994. The purpose of this body is to advance the study of the earth sciences in relation to petroleum, natural gas and other minerals, and to promote the development of technology in the E&P sector. The organization has over 700 members now representing producers as well as technology suppliers, such as Baker Hughes and Weatherford, in the sector.

5.4 Recently, the government has instigated some changes in the top managements of both the companies. The primary reason for bringing in new managers is to make both the companies more responsive to market requirements.

4 This concerns unaccounted for gas losses, which are discussed in detail later in the report.5 This was initially established as the Oil and Gas Training Institute by OGDC in 1979.

GAS DISTRIBUTION Page 3 of 8June 2011 www.pacra.com


6. SYSTEMS AND

CONTROLS

• Technology-intensive industry

• Country divided into different zones based on investment risk

6.1. The gas exploration and production process remains both technology and capital intensive. The process is initiated with the identification of a potentially gas-containing area with favourable geological conditions. An aerial survey is then carried out, followed by a seismic survey, which provides detailed information on geology. If the results are favourable, exploratory drilling activities, aimed at verification and quantification of the hydrocarbon reserve, are pursued. In case of discovery of viable reserves, appraisal of the field is conducted to determine if it is economically viable to develop it. Production activities are undertaken once the economic viability is established. These continue till the economically feasible reserves are depleted. Finally, after the reserves are depleted, decommissioning and site restoration of the land to plug wells and remove installations follow.

6.2. The process explained above poses exploration and drilling risks specific to the sector. Exploration risks include the selection of exploration acreage which could prove to contain no reserves or economically unfeasible ones. Moreover, inaccuracies in seismic surveys and selection of exploratory well sites remain a risk as well. The process of drilling itself includes the possibility of failure, which results in a negative effect on the earnings of companies in the segment. Entities are also exposed to a variety of drilling hazards, including well blow out and fire.

6.3. To capture the different levels of risk associated with carrying out E&P activities in different regions of the country, one offshore and three onshore zones have been defined in Pakistan. Discount levels corresponding to the investment risk associated with these zones are included in the calculation of gas prices, so that producers are compensated accordingly. Under this mechanism, deep offshore zones are offered the highest return since offshore operations result in much higher costs than onshore ones.

6.4. Due to the environmental risks posed by the activities in this segment, operations are monitored by environmental agencies. Environmental Impact Assessment (EIA) studies are carried out and air and water emissions kept under check. The Central Inspectorate of Mines (CIM) monitors the safety of operations. Under the concession agreements signed with E&P companies, social directorates of the provincial government ensure that the stipulated investment in health, education and other facilities is made in and around the production area.

6.5. The two gas utilities in the country are integrated in the sense that there is an interconnecting grid which ensures that there is no interruption in the pipeline network of the two entities. The main grid caters to the large urban cities from Karachi to Peshawar. North of the Sui field, SNGPL operates it, while south of Sui, SSGC is the responsible entity. There is also another field, Mari, which is independently operated by MGCL since 1965 and caters to fertilizer and power plants in physical proximity of the field.

7. BUSINESS RISK

• Strategic importance

• Linkage to international oil prices

• Volatile prices ahead

• Fixed operating

7.1. Supply and Demand Dynamics: The demand-base for natural gas has witnessed impressive growth (6.8%) from FY05 to FY10 (1,157bcf to 1,127bcf) with SNGPL's market much larger than that of SSGC since the former has a larger franchise area and contains more urban centres, where demand for gas is higher. There are also seasonal fluctuations in demand and the country experiences a shortage during the winter months due to heating requirements6. A significant market demand, existing in terms of furnace oil substitution as gas is normally the cheaper fuel, remains unmet. Thus, the gas sector remains supply deficient, with the supply-demand gap expected to widen in the future.

7.2. Economic theory dictates that in a free market, gas prices be much higher than 6 A 2003 World Bank study estimated that the amount of foregone sales in the power sector alone stands at 65 bcf per

annum, which was equivalent to USD 225-250 million in fuel oil imports (in terms of prices prevailing at that time). GAS DISTRIBUTION Page 4 of 8June 2011 www.pacra.com


margins otherwise in case of a shortage, as is the case in Pakistan. However, a regulated pricing model, defining the pricing mechanism for various players in the chain, has evolved in the country over the years.

7.3. Gas Producer (E&P) Pricing: In the 1950/60s, the gas producer price were determined on a cost plus basis. Later, gas price agreements (GPAs) were signed between the GoP and different E&P companies which introduced guaranteed returns on the equity investments in gas fields. These were later dismantled, with the exception of the GPA for the Mari field, which still allows a minimum return of 30%, net of taxes, on shareholders' funds. Since 1985, the wellhead gas pricing policy has been revised from time to time. Under the existing wellhead pricing agreements, indexation to crude/fuel oil7 is used.

7.3.1. To encourage investment in the E&P segment, the government introduced successive petroleum policy documents. The first came in 1991. Subsequent policies were issued in 1993, 1994, 1997, 2001, 2007 and, finally, 2009. Under the latest policy, royalty at the rate of 12.5% of the value of gas is payable to the GoP. For gas pricing purposes. A Reference Crude Price (RCP), derived from the C&F price of a basket of Arabian crude oils imported in the country during the first six months of the preceding seven months period, is used, with an upper cap of USD 100/barrel. The increase in the ceiling from USD 36/barrel in the Petroleum Policy 2001 has resulted in an upper cap of USD 5.03/MMBTU versus one of USD 2.99/MMBTU for Zone-I in the 2001 policy. Correspondingly, the caps for the other zones have been raised as well in order to increase local production and lower more expensive imports. As a result of different zones being offered different discount rates and different fields operating under different petroleum policies, the gas prices differ all over the country. Moreover, while the price for most fields in now denominated in USD, there are still some whose price is still determined in the local currency. While the linkage of prices to international prices and their denomination in USD exposes the affected companies to exchange rate risk, the recent PKR/USD parity decline has positively impacted such entities. This has also provided a hedge against the rising cost of imported drilling materials, plant and equipment required by E&P companies.

7.3.2. Currently, wellhead prices are between USD 1.3-5.9/MMBTU, depending on whether the gas is coming from an old or new field and the petroleum policy under which the field's gas pricing agreement is governed.

7.4. Movement in gas prices tend to have limited impact on the profitability of the distribution companies as they are compensated by the GoP on the basis of their operating assets8. The compensation mechanism was designed to incentivize the two companies towards enhancing their distribution network. As public entities, it was their prime responsibility to ensure that the distribution network reaches regions, some of which which might be financially unfeasible to serve.

7.5. T&D Pricing: OGRA determines prescribed gas tariffs for SNGPL and SSGC. The former is allowed a 17.5% return, as agreed with the World Bank, while a 17% return, as per the agreement with the Asian Development Bank (ADB), is provided to SSGC9. Prescribed rates do not correspond to retail rates and so, the difference between the two results in GDS, as mentioned earlier. While retail tariffs are

7 Qadirpur gas price, operated by OGDC, is linked with international High Sulphur Furnace Oil price.8 As per OGRA provisions, SSGC & SNGPL earn a fixed annual return before tax on net average fixed operating assets

(SSGC 17%, SNGPL 17.5%) excluding financial and all non-operating charges. Any UFG losses (as determined by OGRA) are then deducted from the return formula to arrive at earnings before interest and tax.

9 While SSGC has already paid off the ADB loan that covenanted the 17% return on assets, the license issued by OGRA includes a provision for the 17% return, thus, allowing the guarantee to continue despite the complete repayment of the ADB facility.



identical for both companies, the prescribed prices differ due to the difference in returns and allowable expenses for the concerned entities. Since the companies earn guaranteed returns on their average operating assets, a higher level of capex, leading to increasing assets, is beneficial for their profitability. However, an adequate supply of gas remains critical for this to happen, since the pipelines are only considered operating assets once gas passes through them. In recent years, the utilities have had to curb their expansion plans due to limited gas supply.

7.6. Under the Natural Gas Tariff Rules, 2002, the gas utilities are required to submit their Estimated Revenue Requirement (ERR) for each financial year to OGRA by December 1 of the preceding year. Final Revenue Requirement (FRR) is determined later after the auditor's initialed accounts for the year are available. In determining the revenue requirements, OGRA has also established certain benchmarks to promote efficiency in the gas transmission and distribution process. These include Unaccounted for Gas (UFG) losses and human resource (HR) cost benchmarks. UFG refers to the difference between the total gas purchased during a financial year and the total gas supplied to consumers and include operational losses such as leakages and gas theft. To provide incentives to the utilities to reduce these losses, OGRA introduced a UFG sliding scale in FY04. This allows the entire UFG loss below the lower limit to be adjusted in the respective utility's return. If the loss level is between the upper and lower limit, 50% of the loss above the lower limit is borne by the utility, while the entire loss above the upper limit is funded by it. These losses have a significantly detrimental impact upon the profitability of the two utilities. This can be judged from the fact that during FY10, one percent UFG of the two companies, calculated using average prices for the said financial year, resulted in annual revenue losses of PKR 3 billion.

* Subject to final verdict of the Honorable High Court of Sindh

Since the losses remain a function of the price of gas, increasing prices have translated into higher losses, in absolute terms, in recent years. The managements of both companies continue to dispute the benchma'rks determined by OGRA and have repeatedly taken up the issue of a revision in the scale with the authority. In its decision on a petition filed by both companies, OGRA fixed the amount of UFG losses at 7% in Sep-2010. Meanwhile, the HR benchmark allows a certain cost to be adjusted in the revenue requirements, while any savings or losses are shared equally between the companies and consumers. The HR benchmarks are different for the two companies since the network size and customer base for the two vary.

7.7. Distribution Losses: Gas losses remain a major area of concern for the utilities. The causes for these can be grouped into two categories: one is leakage and the other gas measurement. The rate of leakage depends on the gas pressure and the size of the hole. It increases with time if the hole is not located and repaired. Meanwhile, gas lost through measurement errors or the lack of measurement can be very difficult to detect at times. Both causes combined have resulted in UFG percentages of around 8% for the utility companies in recent years. The entities have undertaken UFG control programs to minimize the effect of the related disallowances by OGRA. Pakistani authorities have also requested the World Bank to provide the country a USD 250 million loan under the Natural Gas Production Enhancement and


UFG Losses9MFY11 FY10 FY09 FY08

OGRA Benchmark 7%* 7.00% 4.8-5.5% 5.1-6.0%SSGC (Actual) 9.80% 7.95% 7.90% 6.60%

SNGPL (Actual) 12.11% 9.63% 8.05% 8.04%


Efficiency Project. The project's aims include reducing UFG loss levels by replacing pipelines and modernizing metering and control systems. Such assistance has also been provided to the gas distribution segment in the past. For instance, the Asian Development Bank provided funds to SSGC under the Sui Southern Gas System Rehabilitation and Expansion Project.

7.8. Performance: The transmission and distribution network of the gas utilities has recorded significant growth of 9.3% during FY04-09. Over half of the total network is spread over Punjab, while around 27% caters to Sindh. Balochistan remains the least developed province with respect to the gas distribution infrastructure.

8. FINANCIAL RISK

• Moderately leveraged

• Cashflow pressure from circular debt

• Funding mix includes foreign donors and loan agencies

8.1. Inter-corporate debt: The utilities' exposure to the power sector – Water and Power Development Authority (WAPDA) and Karachi Electric Supply Corporation (KESC), in the case of SSGC – has made them a part of the prevailing circular debt chain in the industry. This has resulted in a liquidity crunch, increasing the quantum of debts and resulting in higher financial charges, which have dampened the profitability of both utilities lately. Since the power sector is unable to recover dues, mostly from government entities, and subsidy payments have not materialized on time from GoP, the gas distribution companies have incurred high receivables, which have been transferred to the E&P companies. The circular debt represents an unnecessary drag on the distribution chain where the companies argue that they have no choice but to carry this burden.

8.1.1. SSGC is also owed dues from SNGPL. This is under a policy guideline issued by the GoP to maintain uniform gas prices for consumers throughout the country. Accordingly, pursuant to an agreement between the two utilities, the company with the lower weighted average cost of gas is required to pay the other an amount such that the overall weighted average rate of wellhead price of both is the same. This results in SNGPL normally having the lower cost of gas and, thus, having to pay SSGC.

8.2. Leveraging: Both the companies are moderately leveraged. However, due to the continuing circular debt in the past two years, the average leveraging of the sector has increased.

8.3. Funding Sources: The energy sector has traditionally been able to attract funding from international organizations such as the World Bank, ADB and United States Agency for International Development (USAID). Pakistan has received more than USD 20 billion in loans since joining ADB in 1966. Of this amount, around 20% has been provided to the energy sector. Similarly, the World Bank has provided significant loans under the Private Sector Energy Development Project (USD 150 million in 1988 alone and USD 250 million in 1994 alone). Furthermore, from 1982-87, around a quarter of US economic assistance was directed towards the country's energy sector. On the planning side, USAID also helped the government in creating an energy wing within the Ministry of Planning to assist in developing a national energy strategy.

8.4. ADB's first project in the country's gas sector was the Sui-Karachi Gas Pipeline


FY10 FY09 FY08 FY10 FY09 FY08Turnover 107,736.78 108,151.09 74,625.79 161629.828 168933.831 124155.033Gross Profit 2,799.98 (558.57) 5,387.56 5612.963 17596.492 15047.572Operating Profit / (Loss) (400.77) (5,093.26) (1,931.89) 9145.373 861.763 1870.714Financial Charges (2,347.11) (2,341.17) (1,474.64) 4650.154 -653.182 -789.247Net Income / (Loss) 4,399.15 257.48 991.79 2554.563 930.536 2496.768Return on Assets (ROA) 4.0% 0.3% 2.6% 2.0% 0.9% 2.7%Net Debt/Net Debt+Equity 58.4% 68.4% 52.9% 13.8% 19.3% 20.2%

Performance - SNGPLPerformance - SSGC


Project, under which SSGC (then SGTC) was provided funding to increase its transmission capacity from 140MMCF per day to 271 MCCF per day. The bank also played a significant role in merging SGCL and SGTC to form SSGC in 1989.


sector study oil gas - pakistan credit rating · pdf filethese include the saudi aramco1, ......

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