During slumps in the price of oil, integrated oil and gas majors frequently rely on downstreams operations, such as gasoline distilling and distribution, to stabilize the profitability of their overall operations. Large and sudden dips in the price of oil often lead to an increase in the "cracking spread", or the difference between the cost of the primary input (barrels of oil) that goes into gasoline and other distillates and the sales price of these derived products, due to the "stickiness" of the price of gasoline. The frequently experienced lag in the decrease of the price of gasoline relative to the price of oil has bolstered oil majors through prior oil slumps.
The Colombian oil and gas giant, Ecopetrol S.A. (NYSE:EC), is no different in this regard. The company has significant refining operations. This business assisted the company in preserving its financial and operational stability in 2015, a turbulent year when the company's upstream activities were negatively affected by low international prices for oil and gas.
Refining historically has been a substantial but low margin segment of the company's overall business. Ecopetrol supplies the bulk of the gasoline consumed in Colombia, but until now its exports of refined products have been limited. After a long period of refurbishment and a multibillion dollar investment, Refineria de Cartagena, S.A. (Reficar), the company's refinery in Cartagena, Colombia finally began to come online in October 2015, and should be fully operational by the second half of 2016.
This facility should greatly increase the company's refining throughput going forward. It should also improve the company's refining margins, both because the new refinery has a world-class efficiency and because it can process crude into complex, high value products. Unfortunately, there were significant cost overruns which will limit the modernization project's overall profitability after the costs of servicing the debt undertaken to fund the project are taken into account. The worst case scenario is that Reficar will have a neutral to slightly negative impact on Ecopetrol's overall financial performance going forward, although management remains cautiously optimistic that Reficar may ultimately prove to be a boon for the company.
The cost overruns are already discounted into the market price for Ecopetrol common stock. Even if the market has already taken these costs into account, the cost overruns do raise a number of issues with respect to planning, managerial and subcontractor expertise, and possible (although not as of yet specifically identified) instances of corruption that are part of an ongoing, large-scale investigation in Colombia.
Ecopetrol has two main refineries, as well as a smaller plant oriented towards specialty petrochemical products. The first refinery is Reficar in Cartagena, Colombia, on the Atlantic coast of Colombia and close to key maritime transportation links.
Reficar recently underwent an overhaul, which led to considerable controversy as detailed below because of massive cost overruns. The project is now finished, however, and Ecopetrol is sequentially activating the refinery's new units. The Crude Unit, the back-bone of the refinery, was activated in October 2015, operating for the time being at half of its estimated capacity, or between 80 and 90 mbd of crude per day. In February 2016, the Delayed Coking Unit was started up, producing fuel gas, LPG (liquefied petroleum gas), naphtha, diesel and petroleum coke for export.
The Cracking unit and the Naphtha Hydrotreater also came into production in February. The Cracking Unit will produce liquefied petroleum gas, propane-propylene, naphtha, light cycle oil and arotar (for tire production). The Naphtha Hydrotreater will remove the sulphur from gasoline. The Alkylation unit will be activated in April of 2016. In the second half of 2016, all units should be operational, with a throughput of 150 mbd and up to 165 mbd. The conversion factor of crude into refined products is expected to be an impressive 97%.
Although Ecopetrol's refinery production has historically been oriented towards the local market, Reficar will have an increasing focus on high margin products destined primarily for export. The first fuel export took place in November 2015, for a total of 200 thousand barrels of virgin naphtha and 50 thousand barrels of JET A1 aviation fuel going to the United States and the Caribbean. As Reficar increases its exports of high margin products, Ecopetrol's refining margins can be expected to materially increase.
Ecopetrol's second large refinery is the Barrancabermeja facility. This facility has a greater throughput than Reficar, but it is not as versatile and its crude-to-product conversion levels are lower, recently at 72%. The Barrancabermeja facility produces approximately 225,000 bpd of various fuels, such as regular and premium unleaded gasoline, diesel fuel, kerosene, jet fuel, aviation fuel, LPG, fuel oil and sulfur.
Like Reficar, Barrancabermeja was scheduled to undergo a massive modernization program. However, in light of market conditions, the company's desire to focus on upstream projects, and the cost overruns experienced at Reficar, Ecopetrol recently indicated that it would suspend capital improvements at Barrancabermeja.
Ecopetrol also has two small refineries (Apiay and Orito), and also owns Polipropileno del Caribe S.A. (Propilco). Propilco is a petrochemical producer, and a captive customer of Reficar, with which it is adjacent. Ecopetrol is trying to sell Propilco, whose margins are steady but below Ecopetrol's consolidated business margins. The purpose of the sale is to bolster the company's consolidated balance sheet by unloading secondary businesses. A sales price range of between USD$1.2 billion and USD$1.5 billion has been mentioned in the Colombian press, but no definitive buyer has been identified or agreements finalized.
Refining - a Low Margin, but Substantial Business for Ecopetrol
Ecopetrol's refining operations are significant. In 2015, the company's refining and petrochemical sector comprised 44.62% of overall revenues. In 2014, 35.2% of the company's overall revenues were refining-related.
The company's refining operations are primarily oriented towards the local market, with 84.3% of the company's refining and petrochemical revenues in 2015 sourced from local sales, as compared to 79.7% in 2014. Indeed, Ecopetrol supplies the bulk of the gasoline and other refined products consumed in the local market in Colombia.
For Ecopetrol, refining historically has a been a steady, though low-margin business. The company's EBITDA margins from refining tend to be significantly below the company's overall EBITDA margins. In 2015, Ecopetrol's refining segment generated an EBITDA margin of 8.2%, compared to an overall EBIDTA margin of 34.7%. In 2014, the same pattern can be seen. For that year, the EBITDA margins were 5% for refining, and 37.2% overall.
The price of gasoline in Colombia is not altogether determined by market forces. It is determined by a complex formula that takes into account both the cost of oil in international markets and a utility-like profit margin for the refiner and gasoline distributors. The objective is to limit subsidies while at the same time putting a brake on sharp cost increases. Ironically, because of the heavy tax load on each gallon of gasoline and other factors, the price of gasoline in Colombia can be substantially higher than in the U.S. mainland, despite quasi-price controls.
The company's refining operations are generally steadily but not spectacularly profitable. For 2015, the refining and petrochemical segment contributed 7.8% of the company's overall operating profits. For 2014, the segment contributed only 1.7% of the company's overall profits.
The table below contains key information about the refining segment's recent financial performance. For comparison purposes, the company's corresponding consolidated information is also included.
With the activation of the now ultra-modern Reficar refinery, it can be expected that a significantly larger portion of the company's overall refining capacity will be oriented towards the export markets. Its margins should improve both because of a higher refining conversion per barrel of oil and because of an emphasis on more complex products.
A Satisfactory Performance in 2015
Ecopetrol's refinery segment performed well in 2015. The upgraded Reficar facility was only in partial operation starting October 2015. Given its scale, the Barrancabermeja refinery therefore was primarily responsible for the company's refinery-related revenues and other financial performance for the year. Barrancabermeja produces about 72% of the distillates consumed in Colombia.
The table below details that refinery's run-rate and efficiency. This information is important because the efficiency with which a refining facility is operated is a key component of its likely profitability. As can be seen, the Barrancabermeja facility is a large facility, with a run rate in 2015 of 221.9 mboed. Its efficiency and complexity are however moderate.
Barrancabermeja: Refinery Runs, Utilization Factor and Production
As can be seen, in 2015 the Barrancabermeja facility achieved a utilization factor of 79.6% in 2015, as compared to 80.1% in 2014. Modernized Reficar is expected to significantly beat this utilization rate, through lower down time across the board.
The conversion factor of the Barrancabermeja facility is moderate, and tends to fluctuate percentage-wise from year to year around the mid-70s. The conversion factor measures the percentage of crude that is converted into various products relative to waste material. Given the cost of a barrel of crude, the conversion factor can be crucial in establishing overall refining margins, not only because a higher conversion factor means that less dollars per barrel are being wasted but because a higher conversion factor generally means that the refinery can produce more complex, high-margin refined products.
Ecopetrol has for some time considered a potential modernization of the Barrancabermeja refinery, with a view towards enhancing the facility's utilization and conversion rates and to also improve its ability to handle extra-heavy and heavy grade crudes lifted from local oil fields. The plan envisaged a USD$7 billion capital expenditure to implement the project. Because of market conditions and the cost overruns at Reficar, Ecopetrol recently announced that it would suspend until further notice the Barrancabermeja modernization project.
Even though the revamped Reficar was only partly operational commencing in late 2015, the year was a good one for the company's refining segment both from a financial and operational perspective. Costs per refined barrel fell.
The company's overall refining margins increased 15.6% between 2014 to 2015, from USD$14.8 per barrel to USD$16.8 per barrel. The increased margin largely results from lower costs, brought about in part by the depreciation of the Colombian peso ("COP"). The company slashed its per barrel cash operating costs from USD$7.22 per barrel to USD$4.37 per barrel.
This USD$2.85 per barrel difference is 56.8% accounted for by the depreciation of the COP relative to the USD, while the rest is accounted for by the net effect of increased efficiencies and variations in volume. The USD accounts for 17% of Ecopetrol's refining costs. The rest of the costs are incurred in COP, and therefore a depreciated COP greatly assists the company in relieving its refining cost burden.
The Colombian peso, the USD value of which is correlated with the price of oil and other commodities, was on average 2,743.39 COP per USD$1 in 2015 as compared to 2,000.33 COP per USD$1 in 2014. The COP to USD exchange rate was 3,073 COP per USD$1. We can therefore expect that the positive impact of the depreciation of the COP on the company's refining margins will continue into 2016.
Ecopetrol: Refining Margins
The improved capacity, overall run rate and conversion efficiency of Ecopetrol's refining segment should significantly improve in 2016 relative to prior years, as a result of the coming online of the Reficar facility, and therefore per barrel margins should significantly improve going forward.
The Reficar Controversy
Reficar is now one of the largest and most efficient refineries in Latin America, due to a long-standing modernization project that cost in excess of USD$8 billion, and is now competitive with major refineries in the United States. Reficar reopened late last year, after a multi-year overhaul meant to more than double its capacity to 165,000 barrels per day. Although it is a medium-sized refinery by capacity, and smaller by that measure than Ecopetrol's Barrancabermeja facility, it is a highly complex facility. The upgraded refinery has a 97% conversion factor, as opposed to its 75% conversion factor prior to its upgrade. It wastes very little crude, and is capable of producing a wide variety of refined products of broad qualities and complexity, including diesel, regular and high octane gasoline, jet fuel, propylene (for Ecopetrol's adjacent propylene refiner Propicol), paraffin, and metallurgical coke.
Refineria de Cartagena, S.A. (Reficar)
The agreed upon budget for the modernization of the Reficar plant was US$3.993 billion. The modernization of Reficar was implemented by Chicago Bridge & Iron Company N.V. (NYSE:CBI), which was hired by Glencore International A.G., the Swiss mining conglomerate, for the job. Glencore has limited experience in refineries, but a presence in Colombia as part owner of Cerrejón, one of the largest coal mines in the world located in the Atlantic coast of Colombia. Glencore at one point owned 51% of Reficar, but in 2009 withdrew from the refinery modernization project, selling its ownership interest in Reficar back to Ecopetrol so that Reficar again became wholly owned by Ecopetrol.
By the time that Glencore withdrew from Reficar, CB&I was already in charge of the modernization project. CB&I controlled all aspects of contracting for that project, including subcontracting. For reasons that are not altogether clear, Reficar's contract with CB&I was changed from a "turnkey" contract, where CB&I would have to assume cost overruns, to a contract whereby Reficar would reimburse CB&I for excess costs.
The final price tag of the project came in at USD$8.016 billion, or USD$4.023 billion over budget, for which Ecopetrol (through Reficar) is now responsible. Widespread accusations have been made against CB&I in Colombia, where the cost overruns became a political scandal. Large overruns were identified in a number of those subcontracts, for which Reficar was (and not CB&I) became ultimately responsible. Of 2,460 subcontracts, 18% registered cost overruns in excess of 100%, including contracts with Foster Wheeler (now part of Amec Foster Wheeler PLC) that exhibited cost overruns of 143%, from USD$95.2 million to USD$231 million, and a scaffolding contract that saw cost overruns in excess of 37,528%.
The allegations that have been raised in Colombia against CB&I are sundry and varied. Questions have been raised about its expertise in the refinery business. CB&I lacked the expertise to carry out the project, acted incompetently in its implementation, and should have never been hired by Glencore for a project of this scope and magnitude. The issue of fraud and outright corruption also is being actively investigated.
CB&I in its defense has stated that its implementation of the project was affected by a number of factors outside of its control, including most notably work strikes. The Reficar modernization project was plagued by work stoppages, and there were incidents of large scale vandalism. A strike in 2013 is estimated to have cost the project as much as USD$500 million. There were also a number of issues that were not anticipated. For example, entire teams of welders had to be flown in from the Philippines because enough skilled local craftsmen could not be identified or trained quickly enough.
The cost overruns at Reficar will have an impact on its rates of return. The project came at a price tag in excess of 100% of budgeted costs. Whether that renders the investment uneconomic is another question. Ecopetrol now has in Reficar one of the most modern and efficient refineries in Latin America, with a capacity of handling a broad array of crude grades, and a processing capacity of between 85,000 to 165,000 barrels of oil per day.
The initial estimate was that the project would achieve a USD rate of return of 15%. After the overruns, the updated estimate is a rate of return of 4.3%. This is unfortunate, but hardly catastrophic. Unfortunately, the interest on debts assumed to cover costs related to the project is 5.5%, and therefore the refinery now entails a projected loss of 1.15% to Ecopetrol per year. The ultimate profitability (or lack thereof) of the refinery complex will of course ultimately depend on market conditions and the efficiency with which it is operated.
Annual revenues from the facility are nonetheless estimated at between USD$7 billion and USD$8 billion. Cash free flow to Ecopetrol from its ownership in Reficar is projected at USD$600 million to USD$700 million per year, the bulk of which will be applied towards debt reduction with a view towards retiring the debt in 8 years.
The Reficar incident has created a political furor in Colombia. Ecopetrol has for the time being soured on additional downstream investments. It will not undertake further investments in Reficar. The old refinery of Reficar is essentially being mothballed, while the newer installations are being activated and will be utilized. When economic conditions improve, the company may however seek to modernize that older plant as well and bring its additional production capacity in line.
Ecopetrol has also recently indicated that it will not pursue in 2016 the modernization of its Barrancabermeja refinery, which it will however eventually have to do for competitive reason. It is nonetheless a safe bet that CB&I and Foster Wheeler will not be offered additional substantial contracting opportunities in Colombia, at least with Ecopetrol.
The bulk of Ecopetrol's capital expenditures for 2016 will instead be focused on the upstream sector of its business, and in particular in developing the Pacific Rubiales fields the company inherited from Pacific Exploration and Production Corp.
To pay for the Reficar project, Ecopetrol (through Reficar, with which it consolidates its balance sheet and as a guarantor) assumed US$3.07 billion in bank loans, primarily from the U.S. Export-Import Bank. Ecopetrol is a very large enterprise, and although this debt is considerable it does not "break the bank". Ecopetrol's balance sheet remains conservative, as discussed in my previous article here. However, in an attempt to preserve its investment grade credit ratings, the company has embarked on a relatively small-scale asset divestment program and plans to slash costs.
In particular, Ecopetrol plans to sell its Propicol plant, which is immediately adjacent to Reficar, and which was projected to benefit from the upgrades to Reficar. Propicol will in any event remain as a more or less "captive" customer of Reficar and the latter's massive annual tonnage production in propylene.
The Reficar cost overruns are currently under investigation by independent Colombian prosecutors. This investigation encompasses all major current and part participants in the Reficar modernization project. Home raids targeting executives of CB&I and Reficar have been carried out. It is however premature to come to any firm conclusions as to what exactly happened at Reficar. Despite sundry allegations, specific instances of corruption have not yet been identified.
Investigators have however accused CB&I of destroying or transferring data from hard drives containing critical information, and failing to provide the required information and data not only as contractually required but as mandated by law. A failure to cooperate with Colombian investigators may in itself constitute a criminal offense in Colombia.
Independent prosecutors are probing the issue of corruption, and not negligence. The issue of negligence would however be raised in a likely arbitration between CB&I and its subcontractors (including Foster Wheeler) and possibly Glencore, on the one hand, and Reficar, Ecopetrol, and possibly the government of Colombia, on the other hand. Counterclaims have already been anticipated.
The issue ultimately will in all likelihood be amicably resolved in some fashion or another, unless the corruption probes reveal "smoking guns", in which case a full-fledged Brazil-style political crisis could result.
The President of Colombia, Juan Manuel Santos, has made his personal opinion on the matter clear. He has assured in a speech at the Port of Cartagena that no fraud took place, and believes that the failings are simply due to "poor planning" and poor "execution". He is, of course, an interested party, and so his opinion should be taken with a grain of salt. The current investigation reaches to the very top of Ecopetrol, and includes its CEO, Juan Carlos Echeverri, a former government minister and Santos appointee.
Whatever the outcome of the current investigations, from the standpoint of an Ecopetrol investor or prospective investor, certain important points should be made. First of all, the uncertainties surrounding Reficar are over. The numbers are in, whether or not the cost overruns or a portion of them can be recovered in arbitration. The market has long discounted the problems at Reficar on the price of the common shares of the company. Secondly, the impact of Reficar on the overall health of Ecopetrol should be limited. Ecopetrol is a large company, with vast resources. The profitability of one of its projects has been compromised. However, its consolidated balance sheet remains robust, and its most recently reported consolidated financial performance was satisfactory despite an adverse price environment for oil and gas.
Refining has traditionally been a substantial but low margin business for Ecopetrol. The company has historically focused on supplying the local market in Colombia. With the coming online of the modernized Reficar refining facility, the company's overall margins from this business segment should improve. Reficar is a world-class facility and has a stunningly high 97% conversion factor, allowing it to produce in addition to gasoline and other fuels higher margin, complex products such as coke petroleum and high quality jet fuel destined for export.
The modernization of the Reficar facility is now over, although the refinery's upgraded units are now coming sequentially online, a process which should take into the second half of 2016. The initial budgeted cost for the project was slightly below USD$4 billion. The final price tag for the project was slightly over USD$8 billion.
The cost overruns are now the subject of large-scale civil and criminal investigations in Colombia. Instances of corruption have not yet been specifically identified, although allegations of incompetence against all involved in the Reficar upgrade project, including in particular the subcontractors, but also former and current and managers of Reficar and Ecopetrol, abound.
The rate of return of the Reficar refurbishment project is lower due to the cost overruns. It is not clear whether the project's rate of return will be sufficient to cover the cost of the debt assumed to finance the required investment. The market has however already discounted this into the price of the company's common shares.
What is however clear is that Ecopetrol now counts with a world-class refinery facility that will significantly improve the company's overall refining throughput and margins. Ecopetrol's management remains optimistic that despite the poor implementation of the refurbishment, the facility will generate substantial cashflows for the company going forward that may justify the investment despite the cost overruns.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.