Outlook improving for South Korean refining, petrochemical firms in wake of restructuring

South Korea's oil sector is now dominated by just four refiners, which account for around 85% of market share (Fig. 1): SK Corp. holds around 30% of the market; LG-Caltex, 26%; Hyundai-Hanwha, 16%; and Ssangyong Oil Refining, 16%.

The remaining 18% is held by independents. As a typical oligopoly, the four refiners are expected to continue to support margins and bar new entrants instead of competing for market share through pricing. Also, in order to attract and sustain foreign investments, domestic margins need to be kept up. For potential foreign investors, without high domestic refining margins there would be no point in investing capital in this industry in South Korea.

South Korean refining strength - The result, says a report by investment house Credit Suisse First Boston (CSFB), is that South Korean refiners will enjoy the best profits in Asia for the next 2 years even as the region suffers through continuing refining overcapacity.

It says that South Korean refiners' profitability should be the highest in the region due to protected domestic refining margins, a strong demand recovery, and a lack of capacity expansion. Thanks to the unique market structure (an oligopoly without government intervention or outside threat), the South Korean refining margin in 1999-2000 is forecast at $7.70/bbl against a regional average of $0-0.50/ bbl.

Based on a year-to-year demand recovery of 9% in the first 5 months of this year, CSFB now estimates that South Korean year-to-year oil demand growth will reach 8% in 1999 and 5% in 2000. Moreover, minimal capacity expansion-10-40% of the level in the expansion period of 1994-97-should limit the growth in the industry's asset base, thereby raising profitability.

Capital investments by the oil refining industry for 1999 are expected to reach 795 billion won, down 0.2% from the previous year. A recent survey indicated that capital investments will largely be for repair and maintenance and for research and development projects meant to improve product quality rather than for expansion.

In the long term, however, heavy oil cracking and desulfurization capital investments are expected to expand to meet the worldwide trend toward reducing sulfur content. By the end of 2001, South Korea's heavy oil cracking capacity will be expanded by 80,000 b/d to 127,000 b/d, improving the nation's petroleum demand and supply structure. The industry is faced with meeting tightened standards in terms of the sulfur content of heating oil and gasoline, and refiners are expected to expand desulfurization facilities for kerosine and light oil by 80,000 b/d by 2003.

The South Korean indicated cash margin (gross margin after foreign exchange losses and direct costs) stood at $7.10/bbl in May of this year, against the second-half 1998 average of $7.78/bbl. In contrast to the anticipated damage from the crude oil price surge of 35-40% in the first quarter, the four major refiners maintained margins with a concerted 6-11% products price increase in May. But a government oil tax cut of 5% in May, coupled with a strong demand recovery in the first 5 months of the year, enabled the unexpected price rises to go through largely unremarked. Meanwhile, the gap between Singapore and South Korea's margins, in US dollar terms, has widened from roughly $2.25/bbl in 1996-97 to nearly $8/bbl in 1998 and to over $5/bbl in 1999.

The strong profitability is bad news for Asia's other exporters (Fig. 2). South Korea has sold over 800,000 b/d of products in an oversupplied international market so far this year, and firms in the region say that South Korean refineries, protected by high domestic margins, can effectively undercut their competitors. Some even claim that at least one of Singapore's refineries is at risk because of South Korean competition. Moreover, South Korean domestic refining margins are likely to remain high through 1999-2000 due to four major factors: sector consolidation, the government's high oil price policy, unlikely outside threats, and strong domestic demand recovery.

Sector consolidation - Sector consolidation should make refiners' concerted attempts to support margins easier.

That consolidation took its first major step on Apr. 1 this year, when Hyundai took Hanwha's refining division (38.82% of Hanwha Energy) and distribution arm (100% of Hanwha Energy Plaza) on its books as well as $2.5 billion of restructured debts. The move boosted Hyundai's refining capacity to 670,000 b/d. Hyundai is expected to complete negotiations in the near future to sell a 50% stake in the new entity to International Petroleum Investment Co. (IPIC) of the UAE at an estimated cost of $500 million.

In January-May 1999, with the assimilation of Hanwha's facilities and synergies from the merger, the total domestic sales volume of Hyundai-Hanwha rose 15.4% year to year vs. the market's 8.8% rise. The market share of Hyundai-Hanwha rose to 16.5% from 15.5% a year earlier.

Meanwhile, Ssangyong Cement recently announced that it had ended talks with SK Corp. to sell its 28.4% stake in Ssangyong Oil Refining. Instead, it now intends to sell the stake to a Banque Paribas-led financial consortium. Both parties will set the sales price after asset appraisals of Ssang- yong Oil Refining by international institutions. The market expects that Paribas will not pay more than what SK Corp. had proposed earlier this year: $514 million. It is thought that SK had agreed with Ssangyong to buy the 28.4% stake, but that Saudi Aramco, the largest owner of Ssangyong Oil Refining with a 37% stake, opposed the deal on the grounds of a possible conflict between Aramco's interests and what it deemed to be SK's substandard management practices. Saudi Aramco is likely to approve the deal with Paribas this time. Given that the buyer is an investment fund, as long as certain return requirements are met, the impact on Aramco's management control should be minimal. In effect, Aramco should be able to exert more management control over the company due to the absence of pressures from the financially fragile Ssangyong Group. The impact on other domestic refiners, including SK, argues the CSFB report should be positive, because Ssangyong Oil Refining is likely to focus more on profitability and is less likely to resume its traditional role of undermining the oligopoly.

Government pricing policy - The South Korean government has no incentive to attack the high refining margins or give up its indirect control of the domestic pricing system, mainly for these reasons:

• First, the government has benefited significantly more than the oil refining industry from the recent high oil product pricing policy. In 1998, when the domestic retail price rose 38% year to year, the tax component rose 70%, while wholesale prices rose just 28%. The proportion of tax in the gasoline price was 67% in 1998. Partly due to the impact of the won's strength against the US dollar-based crude oil price, the tax component grew 23% year to year in the first 5 months of this year, whereas the wholesale price fell 50% year to year.
• Second, a faster economic recovery and rising oil demand growth are likely to increase the government's tax income base, which is expected to reduce the need to expand the proportion of tax in retail prices. The government will have some room to allow wholesale price increases, on the back of unexpected changes in macroeconomic factors.
• Third, should the government want to lower domestic retail prices due to inflationary concerns, it would be more efficient to lower taxes based on the higher proportion of tax in the retail oil price.

Outside competition - In May, Tiger Oil, an independent local oil importer, announced its planned entry into South Korea's retail petroleum business. It was the first attempt to tap into the domestic retail market since deregulation in late 1997.

Tiger estimated that it could supply imported refined products from China at prices 20% lower than prevailing market levels and has targeted a market share of 2% (200 service stations) by yearend 2000. Tiger owns a 50,000 kl capacity tank farm in Pyongtaek and plans to build another one of the same size at Ulsan at an estimated cost of 6-7 billion won.

Although Tiger is a relatively small player, its attempt at entry has laid bare the barriers facing most future entrants in the South Korean oil market: the South Korean government, the debt overhang at local service stations, and the structural constraints of industry infrastructure.

South Korea is the world's fourth-largest oil importer (with a price tag of $11.2 billion in 1998). Crude and products accounted for 10% of the value of South Korean imports during 1993-98. Even simple changes in sales volumes and prices in the domestic oil market can significantly alter the government's tax income projections, foreign exchange and fiscal policy, and other measures to control the economy. After Tiger's announcement, the South Korean government immediately proposed increasing tariffs on imported oil to 10% from 5%-although the proposal was not enacted and is now being considered for a downward revision to 8%.

Massive loans to service stations by existing refiners could also delay market penetration by outsiders. South Korea has 10,000 service stations, a number that has remained essentially flat since 1997. For a newcomer to enter the distribution side of the business, the only way is to have the existing service stations change their affiliation, or pole sign. However, most South Korean service stations owe very substantial debts to the existing refiners for working capital and the construction costs of the site-an average of 3 billion won for medium-to-large-sized stations. These loans are typically on favorable terms, and if the pole sign is to be changed, the loans are required to be paid back immediately. As such, unless international oil majors enter the market with strong financial power, the number of new entrants and their impact on domestic margins is expected to be minimal. At the same time, the lack of storage facilities and limited access to cheap transportation are likely to erode new entrants' cost advantage. Without storage capacity, newcomers will need to transport the oil products to service stations from ports by tanker trucks, which are twice as expensive as underground pipeline, railway, and vessel transport. Even after building storage facilities-which takes 1-2 years-because the transport infrastructure was built through the collaboration of the Seoul government and existing refiners, new entrants are likely to enjoy only limited access to them.

As a result, believes CSFB, although more independent oil importers are likely to enter into the market in the future, it is likely that these newcomers will prefer to be price-takers rather than price-setters.

Domestic demand - Driving increased profitability of South Korean refiners has been a strong recovery in domestic demand (Fig. 3).

South Korean refined products demand grew 9% year to year in the first 5 months of 1999, driven by a 40% year-to-year jump in the residential-commercial sector. Transportation and industrial-sector demand recovery was relatively slow at 5% year to year and 3% year to year, respectively.

By product type, kerosine demand growth was highest at 61% year to year, after a fall of 38% a year ago. Gasoline growth demand was up 5% year to year, vs. a drop of 10% a year ago.

Diesel demandgrowth-a key for industrial-sector recovery-lagged at 1% year to year, vs. a decline of 30% a year ago. However, since then, diesel demand growth has picked up to over 3% year to year. Moreover, following a residential-commercial sector-driven recovery in first-half 1999, the industrial-sector demand growth is predicted to accelerate in second-half 1999, based on a strong outlook for gorss domestic product growth and gradual pick-up in diesel demand.

Due to 1998's low demand base, South Korea's oil demand recovery should outstrip GDP growth for 1999-2000 (Fig. 4). After passing through a high-growth phase of 18%/year in 1988-93, South Korean oil demand grew in line with GDP in 1994-96. However, the sensitivity of South Korean oil demand to GDP growth (owing to the high oil intensity ratio of South Korea's economy) increased sharply in 1997-98. Especially for 1998, income uncertainty and the government's high-oil-price policy seemed to have depressed oil demand more than what would have been the case under normal economic circumstances.

In 1999-2000, oil demand growth is forecast to once again outstrip GDP growth partly to make up for the overreaction that caused a demand decline in 1998. As a result, CSFB projects South Korean oil demand growth for 1999 and 2000 at 8% and 6%, respectively, vs. GDP growth estimates of 4.1% and 5.3%, respectively.

Petrochemical outlook - The picture for the country's petrochemical sector, on the other hand, is rather less rosy.

A slump in domestic demand combined with severe overcapacity both at home and in the region as a whole have taken a heavy toll on producers. Nevertheless, with domestic demand picking up and a series of high-profile mergers in the pipeline, analysts believe that the worst may be over for the industry.

Earlier this year, Hanwha Chemical and Daelim Industries announced that they had agreed to set up a joint venture to integrate their naphtha crackers at the Yeochon petrochemical complex and to exchange their downstream businesses. The two companies' combined ethylene capacities total 1.2 million tonnes/year-about 25% of South Korean capacity-and they anticipate cost savings of 60 billion won/year. The two companies are also said to be looking for foreign investors-likely either from Japan or the Middle East-to take a stake in their joint venture.

Daelim has low-density polyethylene (LDPE) capacity of 120,000 tonnes/year and liner low-density polyethylene (LLDPE) capacity of 260,000 tonnes/year. Under the deal, this will be exchanged for Hanwha Chemical's 120,000 tonne/year poly-propylene (PP) facilities, which will boost Daelim's PP capacity to 450,000 tonnes/year. In turn, Hanwha Chemical will become South Korea's largest producer of LDPE and LLPDE, as well as its largest chlor-alka* producer, with total LDPE capacity of 371,000 tonnes/ year and LLDPE capacity of 372,000 tonnes/year. The loser in this deal will be Honam Petrochemical, which shares the Yeochon site along with LG Chemical. Honam Petrochemical has been trying to acquire Daelim's petrochemical operations for the last 2 years, but talks collapsed over differences in prices. The Lotte Group, which controls Honam Petrochemical, reportedly offered 600 billion won, while Daelim insisted on 800 billion won.

Although Honam Petrochemical might still try to bid for a stake in the new naphtha cracker JV, Hanwha Chemical is likely to resist such a move, fearing a clash of management interests. As a result, say analysts, Honam Petrochemical might well resuscitate plans it scrapped last year to boost its ethylene capacity from 400,000 tonnes/ year to around 550,000 tonnes/year.

Hanwha Chemical restructuring - The Hanwha Group has come under particular praise from analysts for its aggressive restructuring program over the last 18 months. This includes selling its 24% stake in Hanwha Energy to the Hyundai group for 4 trillion won. The deal has allowed Hanwha to shave its debt-to-equity ratio to 255% from 328%. It says that it is now looking to reduce its debt-to-equity ratio to 180% by yearend. Spin-offs include Hanwha Chemical's high-debt polyvinyl chloride processing and octanol units, which the group hopes it can sell by the end of the year.

The group also recently announced that Hanwha Chemical will be divided into two separate entities as part of its restructuring drive. The upstream operation, which includes its petrochemical operations, will tentatively be named Hanwha Petrochemical, while its downstream operations, which cover production of processed chemical goods such as plastic flooring and automobile parts from petrochemical derivatives, is tentatively to be named Hanwha General Chemical.

Hanwha Chemical will become the country's first listed company to be split since the government introduced a law on corporate restructuring last year to help speed up corporate mergers and acquisitions and to promote specialization. The company is expected to receive significant financial benefits, largely in the form of tax cuts, from the move.

Chemical merger - An even bigger merger is due to take place between Hyundai Petrochemical and Samsung General Chemical (SGC).