Cover Story: Delicate balancing act in a tough Covid-19 environment

This article first appeared in The Edge Malaysia Weekly, on December 21, 2020 - December 27, 2020.
Cover Story: Delicate balancing act in a tough Covid-19 environment
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The Edge: Third quarter results show that losses have narrowed. But the cumulative nine months’ losses amounted to RM19.9 billion, with impairments of RM32 billion. Why the huge impairments? Is it reflective of the assets that Petronas has?

Tengku Muhammad Taufik: Let me explain the impairment first … When we recognised the impairments, it is in the order of magnitude that everybody else in the industry has recognised. As a proportion, this RM32 billion is about 10% to 11% of our assets and carried PPE (property, plant and equipment). There are some others who have made investments at the high end of the cycle but still have really positive and optimistic price curve outlooks. They have written down — relative to their PPEs — around 18% to 19%. Almost a fifth of their values have been wiped out.

We are around the median of everywhere. We have seen Shell write down, we’ve seen other NOCs write down — Equinor, ENI, TOTAL — everyone who’s carried this kind of order of magnitude of assets, of 8% to 12%. So we are not outside of this band. It is unfortunate that some people think it reflects that we have made bad calls. If we have made bad calls, it means the entire industry has made bad calls. Because at that point in time, when people undertook these investments, expectations were that the US$70 to US$80 per barrel future price range was well maintainable and securable. But the reality is there is an onset of a supply glut, shale producers coming online, and now, the dissipation of demand due to the pandemic, the acceleration of energy conversion. All of these converged in one go has forced everybody to look back.

And that’s the kind of order of magnitude you are getting out of the impairments. You do need to see the line that really matters is the Ebitda this year. If Ebitda this year has started to wane and deteriorate for a prolonged period of time, it can’t fund, it can’t reinvest, and it can’t pay out (but that is not the case for Petronas). You know our results, and we were starting off at the base of a really healthy cash balance. Cash flow from operating activities (CFFO) and Ebitda — those are the metrics that I would advise people if they want to look at the energy industry. These are the metrics that are really going to matter within the next two to three years.

 

Do you expect more impairments?

It all depends on the outlook, if there is a recovery. You see Petronas Dagangan doing well, Petronas Gas doing well ... those are the listed companies which work on the back of contracts and retail markets reaching out, and volumes picking up. What’s not listed is upstream. What’s not listed is our refineries, our LNG plays. That’s where our capital is quite heavy, and when we announce our results and people have a degree of surprise and say, hey, how come when we see Dagangan or Petronas Chemical having a good quarter, what happened?

There are parts of the business which are not listed, where we have to recognise, and LNG, as I mentioned to you, in a year where, by and large, the price was at US$3 to US$4 per Mmbtu. Maybe the last two weeks, someone can say to me that they can secure US$9 to US$11 per Mmbtu deal, but by and large, it’s only US$3 to US$4. You are going to start thinking if you are carrying assets to produce LNG later on, what you’ve deployed now — going back to the very definition of impairment — the future economic value of what you’ve deployed is not going to be there. So, that’s one dimension.

There are possibilities of future impairments, refining margins, if they don’t pick up, but you already know the world needs to see that transportation returns, and with vaccinations, the economy can pick up. It is still a guessing game but if the world is going to be inoculated, travel restrictions lifted and producing industries require power and consume natural gas, then demand could come back full swing. I really have seen our refinery segment very much in line with anybody else, showing only 70% to 78% utilisation rates. If we’re all at suppressed utilisation rates for a prolonged period of time, of course you are going to expect there’s going to be [further impairment].

 

What was your utilisation rate before the pandemic?

It would have been north of 90%, so you’ve been seeing easily a 15% to 20% drop of utilisation because you don’t want to have a run rate that creates a tank-top. And then you get to have to sell distressed cargo, so that’s why there is value in managing Petronas’ integrated value chain — from oil production to LNG, retail, refinery and chemicals. You have the ability to swing this, but net-net result, parts of this have to run lower, so this is where refineries have had that kind of utilisation rate on display. I’d like to say that I can do a 100% insulation against future impairment, but the outlook can be priced and the kind of demand return will determine whether impairments will happen. On the flip side, if it does recover, you would get write backs, so that is the bit that we have on the industry cycles here that people don’t realise.

 

People will cast attention on your assets in Canada and your mega project in Pengerang.

Some people have levelled a very harsh judgement on Canada being a mistake. Why did you go into Canada? Investment decisions for something like Canada are made at the time, FIDs were entered into given the available information and market outlook at that given point in time. What do we have in Canada? We have 53 trillion cubic feet (Tcf) in our core joint venture, held in perpetuity. We have proven resources and resources and that is accessible for an LNG plant. What has happened here is we pre-spend in order to feed an LNG plant. But the LNG plant, the Pacific NorthWest, did not manifest itself because of the number of conditions imposed by both state and federal [authorities]. Does this mean that this asset is a loss? I don’t think so because Petronas quickly, and in a very rapid fashion, found some homes for the volume in the LNG Canada venture.

That’s one draw, but we are also taking part in LNG Canada (where Petronas partnered with Shell), which will absorb about 1.25 Bcf/d in totality after also pumping for the domestic requirement. This gas resource is very competitive even relative to a very depressed index price. We can still make money putting them into the domestic North American market. It is just that it will take longer to break even. And of course, given this outlook, and you apply the impairment rule that I’ve mentioned earlier, of course there will be adjustments.

Let’s deal with Pengerang. Pengerang was an Economic Transformation Programme undertaking, and I will be very open ... when we undertook this 300,000 barrels per day refining facility, the economics all were very optimistic, because the conditions at that time afforded it. When we had the Pengerang undertaking launched, it was announced to be a US$27 billion undertaking, and at the heart of it, a joint venture with Saudi Aramco. The refining margins (gross margin per barrel) at that point was north of US$30 to US$40. Today, for something dealing with that kind of sour crude and that kind of product slate, we are probably looking at half of that. In dealing with something of that nature, you are going to have to have belief and collaborations between the partners, to say you’ve got to bring this and start defraying the cost of operations as soon as possible.

We’ve got to get to start up. Pengerang is aimed to have a start up hopefully within the first quarter of next year. We will then start having to consider whether the capital structure fits the purpose under these new operating parameters. Than we have to do what we need to do. But again, the outlook for Pengerang is not the best at this juncture, like any other refinery. And we’ve had, across industry, a slew of people rationalising, shuttering in or even shutting down. The simpler refineries are sometimes now just holding on to just get that cash cover, to make sure that the next barrel can be paid. It is a tough time to start a refinery, but thinking about if there is a recovery in demand, Pengerang, with the intent of moving into specialty chemicals, it is a naphtha play, it provides us the avenue to move into that reach.

I know the view is quite grim for refining, I think the one thing that distinguishes Petronas, just like any other longer-term player, is that if there’s a cycle that comes out of it, we just have to make sure that we are as lean as possible and as effective as possible at this bottom thrust.

 

There has been talk that the relationship with Saudi Aramco is strained?

Joint venture partners, just like any marriage, have tough patches. This is a particularly tough patch. If you think of any married couple having to scrounge along and make ends meet when the going gets tough, and it is very lean, this is it. Of course they are now questioning, wait a minute, I didn’t have this outlook when I undertook this. Do I stay, do I go, do I tell the partner can you get on with it? Of course there’re all these demands but I can tell you, that the CEO-to-CEO channel is very much alive and active. I have had direct interaction with the CEO of Saudi Aramco and he said, ‘When we entered and FID a project together with a partner, particularly with a partner with a stature like yours, we are here to make things work. Yes we’ve had rough patches, we will look, I have to go back to my board, but as a management team from Saudi Aramco, I’m glad to hear that you have confidence we will start up, we will be with you, and we will see how things pan out in this coming year.’ The rough patch is project delivery. But they have good experience in running refineries … this is Saudi Aramco we are talking about.

 

So Aramco will remain?

As far as I am aware, at this time I am talking with you, Aramco is still with us.

 

Now, result wise, what is your full-year expectations?

We’ve had nine gruelling months. Let’s not kid ourselves, even before Covid-19, we already had that low refining margin and very depressed natural gas prices. If you look at Q3 on its own, there is a stark difference from Q2. We have already climbed up with revenue, revenue went up to RM41 billion, the preceding quarter was RM34 billion. The Ebitda margins climbed up almost a full 10%, we were at 25% to 26% in Q2, we came up to 34% in Q3. If you exclude the impact of impairment, we had actually returned in a single quarter to profitability.

What this pointed out was the team driving really hard to find alternative homes for products, making sure you deal with your cargoes and not dispose of them at a depressed price. Get the right market that is willing to pay for the right price. And it has yielded. But the market landscape is not pretty. Now, the full accounting IFRS results will still show that now, we’re standing at a narrower loss, but it is still a loss. It has already been a large loss, because of the large impairment hit in Q2 and Q3. Q3, we went into a loss after tax of about RM3.37 billion.

I’m going to tell you that with two quarters (Q2 and Q3) like this, we are going to take a massive wormhole in Q4. Let’s be realistic about it. I would admit overhauling this result in Q4 is going to be a tough task. We are doing our best … yes, there has been a spurt of improvements in prices, but I think the trajectory is pointing that this is going to be one of those years where Petronas just would like to forget. With regard to its results, I think getting us back to the black would be a very tough undertaking.

 

This will be the first loss for Petronas?

I believe so.

 

That goes back to the question of explaining to your shareholder the need to balance dividend and capex. The dividend policy should always be on the basis of affordability to pay. You are seeing probably the first loss experience since Petronas was set up in 1974 and your net cash is depleting.

We had net cash of RM61 billion and at this point, you will know that the demand of servicing capex. The government is fully aware, and Petronas reports to the shareholder regularly. I am thankful to the shareholder for according me an audience on a monthly basis. I upkeep developments, key capex, immediate challenges, and if there are issues that need to be aware of and tackle. That is consultative tradition stretching way back.

It is very clear to them (the government) that the results trajectory this year is not fantastic, and we have been significantly impaired because of the assets being written down. The PM knows that these are non-cash transactions. He also knows that the cash flows are still forthcoming. The CFFO, you can still see that it is still being maintained.

The board is very rigorous now in addressing this. We are very mindful that the Company’s Act requirement... solvency before declaring any dividend, is fulfilled, or else the board will be breaking the Company’s Act clause. I will tell you right now when we spoke about the current and cash ratios, and I told you that this is no longer something of a piece of information, they are actually drilled down into our ability ... to meet our ability to service the next 12 months’ obligations.

 

How much buffer do you keep?

We set a minimum cash balance as a rule. That addresses working capital cover, the commitments both of the front of servicing dividends, because they are not all paid in one go. We also know that there are scheduled royalties and taxes, all of these, we outline to the board and lay it up and say, look, I hold on to this level because that is what I need. And then, I have capex commitments I know that I have to service, because there is a call from partners in continuity of project delivery, and we determine these minimum cash balance numbers and say, are we okay?

If we are satisfied, and the cash solvency ratio is also fulfilled, we will say, okay, we can consider this payment. It is always the case of the government asking the board to consider, it is never an imposition. The discussions are quite robust, and we will demonstrate how much we need to service this. This year, the extra RM10 billion (on top of the RM24 billion) was very much a Covid-19 driven event. I know that it has just been brought to a sharp focus because we have been dealing with two significant ‘asks’ from our shareholder. Last year, there was the additional RM30 billion special dividend to service the GST refunds.

This kind of dialogue happens. We have interfaces with the Ministry of Finance, I speak to the prime minister. Profitability isn’t great, this is the kind of cash flow from operations you can expect. A continued lower profitability and pronounced ‘asks’, those are just a very bad combination for the longevity of any business. Our shareholder understands this, which is why it is an ‘ask’ around affordability. There is an appreciation that we are to make sure that the value of hydrocarbons is maximised. There is an appreciation that we actually ensure that the engine that is called Petronas continues to run, and we cannot keep this engine running without fuelling it sans investments.

The government knows we have to plough it back in, which is why, even if it goes into international forays, they understand why we are hunting for molecules. They understand why we are expanding our core. They understand why we are making these investments and continue with the capital programme so that I can continue generating returns for the shareholder. The appreciation is there, but this year is just completely outside the parameters of normal business.

The PM recognises that Petronas has to reinvest so that it can de-risk future revenue streams. You can’t do that out of thin air, you have to reinvest and get into new businesses. But if I have to de-risk it and also diversify, I’ll need to step into things that are more utility or infra-type profiles. That is not going to give the level of returns as before, but it is going to ensure longevity. The task handed to Petronas is to make sure that this new portfolio lasts for a very long time because the challenge I put to the 48,000 Petronas staff worldwide is let’s make sure we have a 50th, 60th, 70th ... 100th anniversary, and that needs investments.

So, the combination to this is tough. We are going to be a bit pressured, with generating cash flow from operations. But we need to put capital where longevity is assured. So they understand that. It is continuous education, information and re-education, but the government understands.

 

In meetings with your predecessors, there were views that Petronas cannot give more royalty to the oil-producing states. You seem to have taken a different route now?

Let’s just put it this way. It seems to be a different route, but what really has been considered is that the 1974 federal law applicable to the industry has been upheld. The constitution asks of Sarawak around its ability to impose certain things like sales tax, which has been imposed. However, the commitment by both sides to ensure the pie grows has also been confirmed. So, it is not an easy time, particularly the convergence of these factors which I just expounded upon, where you have lower oil prices.

The oil and gas industry in Malaysia started over a century ago but it has managed these hydrocarbon resources for 46 years. So, a lot of these fields are late in life and maturing, and we need new plays, and new plays are not exactly easy. They are in deeper water with higher CO content. What investors need is a climate for investment that is stable, that is transparent and clear.

I took a pragmatic approach, with the consent of the board and shareholders. The longer we had an issue with dissent and confrontations with producing states, the worse it would have been. We can’t grow the pie, so no one gets anything. Second, in allowing the participation of the state in the revenues that these states generate out of the oil and gas industry that engenders better stability and visibility around the imposition of things such as sales tax, the board concurred that it had to be a pragmatic and commercial approach.

The recent signing with the Sarawak government is a commercial solution to the agreement, rather than having gone through and contested this legally. Perhaps some quarters have levelled the accusations at me or the board of Petronas giving in. It is not. The aim is to make sure the business pie gets larger and that these states want participation.

I would assume that the same will apply to Sabah and Terengganu as well?

We have to deal with these states one at a time. I want to just stress for the record, our relationships with the state governments, they are long and there have been colourful patches, but they are strong. So, we move forward together.

 

Petronas divested stakes in MISC Bhd and KLCC Property Holdings Bhd. What’s going on?

This is an ongoing portfolio optimisation. We look at the dividend stream, at whether we need to hold this much. We turned around and asked if that capital could be unlocked to fund our step outs and expansion of our core. What we did recently, as announced in Bursa by the companies, was that we lowered our stake in MISC to 51%, slightly lower than KLCC. I think these were natural parts of monetising our stakes.

The use of the proceeds is very clearly demonstrated to the board. We want to help churn it back into a larger capital pot, fund our capex for the cash generators, the core expansion and the step outs as well. I don’t think we have done anything sinister. We actually do this portfolio review every year. Sometimes we act on it, sometimes we exit, sometimes we enlarge. The listed companies are a lever at the end of the day also to think about our overall investment portfolio.

 

So this is not because you have to pay the additional RM10 billion to the government as dividends?

On record, the use of proceeds is being churned back to cash generators to be deployed in the domestic market where the returns could be better. We also help to expand the cores. We look at partly funding JVs that are going to be put in place, especially the chemicals. This is not something we are doing ... sell to ... [pay the government extra dividends] … no.

 

I mean that’s the talk in town.

That’s the ongoing narrative right? This is why ... the timing is unfortunate. I mean we try and time this. When they [the government] ask for RM10 billion, you don’t time it. You don’t tell your shareholders, ‘When you ask me can you time it?’ I can’t do it that way. So, those things emerge.

 

What about the bonds that you raised earlier this year?

You are asking the right person. At that point in time, I was the CFO.

 

But why the need to raise bonds, and the [bad] timing?

Are you familiar with the maturities of our bonds? There is one coming in 2020. The other one is in 2022. If you recall, just before that there was a bond that also matured in the prior year. [So] we had to look at our capital structure at that point in time to avoid bunching up.

We don’t want maturities to come and bunch up. As far as what we wanted to do, we also wanted to term out and try and match. If you have a copy of the prospectus, the idea is to make sure the investment return meets our capex being deployed against the revenue generation.

At that point in time, the closest tenure was that because our reserves life index pointed to north of 38 years. So, we took the longer end of the curve. It was at that juncture that we tapped the market with all these imperfections happening. And it is unfortunate that it is very close to that. We also had a number of competing IOCs and I believe Indonesia also went.

So, we had to make sure the timing was as optimal as possible to try and get the kind of tenors where there was appetite. Relative to today, of course, if you look at the interest rate environment, that would have been priced higher, which was what you pointed out.

But at that point in time, we had no way of knowing because there was no full implication of Covid-19 happening. The intention was to match maturities, to avoid bunching up. So, it is a capital structure that actually had very dedicated use of proceeds. Part of which were for Canada, which was at the longer end of our capex deployment.

 

What were the implications of the Fitch downgrade recently?

That downgrade happened because there was a sovereign downgrade. The net result was that they even acknowledged our standalone credit profile four notches above ... But because of a rule that Fitch takes, that if you contribute above x% of revenue to the government, we cannot unlock you. You’re stuck at the hip. And every time there is a correction, that does bring you down. From the perspective of Petronas, when I say that we like to enter the market in a position of strength, first we show off our fundamentals.

By the way, Moody’s still rates us on a standalone higher than the sovereign. The investors know you’re getting a lower risk underlying investment, which has to be accorded a price higher so they get better returns. So for them, it’s an attractive paper.

But in this context, dealing with a downgrade, I think naturally there will be a cost implication. But again, we will have to also ensure that the awareness of the potential subscribers is improved — why this thing happens. It is technical rather than anything fundamental.

But the quality, the recurring quality of Ebitda, our cost-optimisation efforts, our resilience, our very conservative financial policy, needs to be brought to the fore. That’s the bit of story that we’ll need to go back to investors.

 

So that [the downgrade] will raise your credit cost right?

It will, of course, naturally.

 

Would that mean that it may restrict Petronas when it comes to fundraising?

From a perspective of having to go to the market to maintain a capital structure that is optimal for us, we will have to deal with it. It won’t restrict us from re-tapping the market. There are many fundamental issues that we have to deal with. We may have to contemplate going to the market on a ‘candy’ — Canadian dollar-denominated [issue].

From a perspective of trend to hedge our liabilities against the assets, you would do it in any case. The cost is something that we will have to tackle. The fundamentals here is that we have underlying assets, which in the context of Canada, 53 tcf of gas , this kind of reserves-like index, this kind of emissions, this kind of ready market, and this is what we can sell it at.

They need to understand that more than they go back to a sovereign that has been notched down. It is unfortunate. Of course it is very difficult sometimes to explain to people who rarely see us because we are not regular issuers. It is being debated and the board is saying maybe you don’t need to go big, but tap the market a little bit more frequently because they need to know you better. You do know that there are certain conurbations in the market, perhaps sometimes even a BBB can get a decent price. We have to be a lot more nimble and time our entry into capital markets.

You mentioned that Petronas will always keep a threshold level of cash or capital. Can you reveal that amount? Because your cash balance is around RM141 billion.

RM141 billion is the number the press loves to pick up. But you have to understand what’s really available is that you have to strip out what’s in the listed companies because we cannot unilaterally tap on that anyway.

And when you talk about the actual available cash, the number to really hone in on is the one that the holding company has. In your earlier question, you pointed out that there is net cash of RM61 billion, right? That’s what you need to pick up on because that’s the number that has to not only support subsidiaries as their initial investment but also one that services dividends. So, that’s the number that needs to be tracked.

We are comfortably above that. I’m not going to tell you the exact number. But we are comfortably above the minimum cash balance — the threshold set by our board. But if we keep up the pattern of dividends where we are now, it’s not going to be sustainable. I have to make sure part of that money gets into new investments or else I won’t have new recurrent generators.

I believe the government is already exploring other avenues to increase its base of income and tax collection targets. A lot of people do not realise that over the years since we started contributing to the government in 1976, total revenue [including from other oil companies] in the form of royalty [including state governments], dividends, petroleum income tax, corporate tax and export duties have reached RM1.2 trillion.

As a shareholder, the government has every right to demand a return. But the government as a shareholder also recognises continuity and the sustainability of its investment.

 

You said if the current dividend pattern keeps up, then your cash, minimum cash requirement, would not be enough. What is the spectrum here?

We can’t keep contending with the surprises [of asking additional dividends in non-Covid-19 years]. We expect in the next five years our spending is going to be north of RM200 billion — 55:45 split domestic and international. So, we need to feed that.

 

But do you have a projection of how much the government will potentially need?

That one is a shareholder decision that will be brought to the board for consideration.

 

What are you going to invest in to ensure the longevity of Petronas’ portfolio?

We are looking for non-traditional. As a management team, we have deliberated and set targets for Petronas that can be encapsulated in what we call ‘MFT 50 30 0’ — Moving Forward Together 50 30 0. That is 50% improvement in cash flow from operations in five years, despite a very tough operating environment. That means new revenue as well as cost containment ... 30% revenue from non-traditional sources. When I say non-traditional, it doesn’t mean that I am embarking on something new. It means that even with existing products, I can go to new markets. And it is wrapped around on a longer term of net zero carbon emissions by 2050.

So, for longevity, Petronas needs a portfolio that is targeted around being MFT 50 30 0 compliant, one that is superior performing and one that is still relevant. I need to reinvest too. That’s the kind of dynamic that we are looking at. So that does mean looking at things that are close to home such as solar. We have started with a foray in India, trying to replicate the distributed solar model more and more in Asia-Pacific. It does mean that we start considering other low wind turbines solutions for our offshore facilities. Instead of consuming the gas we produce, we replace it with wind. So, the gas that you don’t burn to run your turbines out there, you can sell.

It also means taking certain calculated steps into things like hydrogen. We already started with speciality chemicals two years ago and this year, we also announced the LG nitrile JV, the resin that goes into safety glove production. We also extend that value chain within speciality chemicals to other items, from wood and complementary products to food supplements. Traditionally, we have tried to put step-out investments at around 5% to 7% of our total capex. But if I’m going to accelerate it, it will need to be anywhere between 12% and 14%, so means doubling it within a five-year horizon.

Therein lies the tricky equation. I have to manage two engines — the core engine that helps fund the growth and the new one that will mature at the point where engine one says, ‘Now I have to take a back seat’. It is a phasing. It also depends on your view of energy transition direction and at what pace it is going to come.

 

Covid-19 is all about resetting. So, what is Petronas’ ‘never let a good crisis go to waste’ moment?

We have learnt that the way we operate may not be the most exposure-sheltered and efficient way. Because, think about it, we have to rethink. We’ve learnt that we can still continue with reduced manning — not to say that I’m going to do anything with the workforce, but reduce the manning deployed on site.

We are also reducing our carbon footprint, reducing energy consumption and, more importantly when you’re offshore, logistics solution. You have to get people out there, you have to send supplies, but all of this is being rethought. We can be a lot more targeted around maintenance because we’ve learnt that using anything, a combination of sensors and predictive repair regimes, that we can time this and make sure our cost compression really lives out and gets deployed.

We’ve also learnt the footprint of our people being in office. I don’t think we really drew the line around essential customer-facing, operations-facing before this. But we have learnt that people are a lot more nimble and agile than we had previously envisaged. When push comes to shove, even our marketing people, they will find ways to ensure contracts are closed, contracts are concluded and customer engagements happen.

That means we have probably been quite remiss in neglecting certain things that we could have done differently. And on those fronts, we are going to pick this up. When we recover from the pandemic, there is one initiative called Forward — how teams are set up. Sometimes, businesses are obsessed with organisational structures. Actually, now when you know you want an outcome, you assemble the talent. It doesn’t matter that the person is from a different discipline. Deploying capital is also accompanied by the deployment of people in a very different way.

We also learnt that — this is the one that I think is a lesson worth holding on forever to — understand your customers and they will stick with you through a crisis. Because when we don’t understand our customers, that’s when they turn around and say, ‘There is really no partnership here. We’ll move on and find someone else who will do it with us’. So anywhere, from our LNG business to our commercial clients in dealing with our petroleum products, those are the kinds of lessons we have to hold on to.

 

 

 

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