This article first appeared in The Edge Malaysia Weekly, on February 8 - 14, 2016

THE sale of a controlling stake in Shell Refining Co (Federation of Malaya) Bhd at a steep 64% discount to the market price has raised many eyebrows. China state-owned enterprise Shangdong Hengyuan Petrochemical Co Ltd, through its investment vehicle Malaysia Hengyuan International Ltd (MHIL), has sealed a deal with Shell Overseas Holdings Ltd to buy the 51% stake for US$66.3 million or 43 sen a share (RM274.98 million or RM1.80 a share).

MHIL is also making a mandatory general offer to buy all the shares it does not own at RM1.80 a share. Shell Refining shares were trading at RM4.94 before the deal was announced.

The substantially low transaction price does not paint a good picture for Shell Refining, which had returned to the black in the nine months ended Sept 30, 2015 (9MFY2015) after being in the red for four years.

When it resumed trading on Bursa Malaysia on Feb 3, its share price was “gap down”, opening at RM3.50 — 29% below the previous closing price of RM4.94. The stock closed at RM3.50 last Thursday. In less than four weeks, the share price tumbled 72%, or RM2.53.

Like it or not, the minority shareholders will blame Shell Overseas for selling the controlling stake at a “bargain basement price”.

However, Shangdong Hengyuan chairman and general manager Wang Youde disagrees that the acquisition is a steal for the company. He tells The Edge in an email reply: “Though our proposed acquisition price represents a discount to Shell Refining’s share price prior to the announcement of the transaction, the discount to Shell Refining’s book value as of Sept 30, 2015, was significantly narrower.”

Shell Refining’s net asset per share stood at RM1.933. The transaction price of RM1.80 is at a discount of 6.9% over book value.

Wang says the price is fair under the current market conditions and the refinery’s future margin outlook. “We have conducted our own valuation exercise in determining the acquisition price.”

Furthermore, Wang points out that the management is aware that MHIL will need to upgrade Shell Refining’s facilities to meet product quality and environmental requirements in Malaysia, including the Euro IV and Euro V fuel standards.

To a question on the large capital outlay for the upgrading, Wang says future capex will be funded by cash generated from operations and the company plans to tap the capital markets if the conditions are appropriate. “Shangdong Hengyuan has maintained a good relationship with a number of lenders and has already obtained committed financing for the equity acquisition and the refinancing of Shell Refining’s existing debts when they become due and payable.”

According to an oil and gas analyst’s estimation, a refinery that is half the size of Shell Refining and producing 160,000 barrels of oil per day would require about RM550 million to upgrade to Euro V. In the case of Shell Refining, about RM1 billion would be required. “As Euro IV will add to the investment cost, the total investment is expected to be over RM1 billion,” he adds. He opines that MHIL may need to raise funds to finance the upgrades and pare Shell Refining’s debt.

A Shell Refining spokesperson explains that the selling price was the result of a structured and competitive bidding process that included prospective buyers from Malaysia and overseas. “The prospective buyers had to demonstrate that they were technically and operationally capable of operating the refinery to ensure that fuel supply in Malaysia is in secure hands. They also had to commit to investing in the upgrading of the refinery to meet Malaysia’s fuel specifications. Most importantly, they had to have the financial resilience to weather difficult margin conditions and assume significant debt, the spokesperson tells The Edge.

Shell Refining posted a net profit of RM255.29 million in 9MFY15 compared with a loss of RM271.86 million in the previous corresponding period. Nonetheless, chairman Datuk Iain Lo said in a statement that although the group reported positive financial results for 9MFY15 after four consecutive years of losses, it “continues to be pressured by its debt load and the significant investment required to meet Euro IV and Euro V compliance requirements”.

Note that the refiner had a highly geared balance sheet with short-term borrowings of RM1.5 billion, including a foreign currency debt of US$240 million, as at Sept 30.

A fund manager with an insurance fund opines that the capital expenditure commitment should not be a question as he believes Shangdong Hengyuan has the financial muscle to shoulder it. However, he reckons execution and technology could be concerns for investors.

Commenting on operation, Wang reveals that the Chinese state-owned refiner has a long-term business plan for Shell Refining to add more high-value-added chemical products in its product portfolio to improve profitability.

According to him, the new management will formulate a long-term development strategy by tapping Shangdong Hengyuan’s resources to achieve the in-depth transformation, upgrade and sustainable development of the two companies.

“The core pillar in our long-term strategy and any re-optimisation will be complemented by other business partners such as Shell Trading,” he adds.

Wang highlights that Shangdong Hengyuan will introduce its advanced technology to Shell Refining to enable the latter to meet Euro IV and Euro V fuel standards and process a broader basket of crude oil grades to maximise profit.

Shangdong Hengyuan also intends to maintain Shell Refining’s existing supply of products to the Malaysian market while exploring the export of fuel oil and other high-value-added chemical products to foreign markets.

“With our technical and operational expertise, we are confident that we will be able to help Shell Refining strengthen its competitive advantage,” Wang says, adding that the group also intends to retain Shell Refining’s management team and employees.

Founded in 1970, Shangdong Hengyuan was previously known as Shangdong Linyi Country Petrochemical Factory. It focuses on petrochemical engineering, oil refining and subsequent chemicals. The group achieved sales of RMB14.03 billion (RM8.88 billion) in 2014.

For Wang, the stake in Shell Refining allows Shangdong Hengyuan to establish a foothold in Malaysia and Asean, which fits into the group’s expansion plans.

Having seen Shell Refining’s share price dropping like a stone, perhaps the minority shareholders will find comfort in the fact that the new controlling shareholder seems to be committed to upgrading the refinery and cleaning up the balance sheet — which are essential to improving the company’s prospects.

Will Shell Refining regain its glory? Perhaps the more pertinent question should be, will there be any cash call to raise fresh capital to turn the company around?

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