This public offer of equity shares by Reliance Petroleum Ltd (RPL), the group's first visit to the primary market in the last 12 years, can be considered favourably for investment. The project is well-planned and backed by good reasoning, and the group's experience of commissioning and running the large capacity, state-of-the-art refinery at Jamnagar is a big positive.
The biggest risk to our recommendation would be a delay in commissioning the refinery by the set deadline of December 2008 as time-to-market will be critical for this export-oriented project.
Multinational competitors are already talking about the same opportunity that RPL has spotted and it is only a question of time before they embark on similar projects to supply high-quality fuel to the American and European markets.
RPL is a 80-per cent subsidiary of Reliance Industries and given the track record of the group in merging subsidiaries with itself, a similar action in the case of RPL some time in the future cannot be ruled out, especially because the two companies are in similar businesses.
Investors should also note that performance-linked appreciation in the stock is more than three years away and an investment now should necessarily be with a long-term perspective. Our recommendation is not linked to possible speculative gains on listing.
WHY ANOTHER MEGA REFINERY?
The new 29-million-tonne (5,80,000 barrels-a-day) refinery will be housed in a special economic zone adjacent to the existing refinery of Reliance Industries and supply exclusively to the export market, specifically the United States and Europe.
It will be a technologically advanced refinery, more advanced than the existing one, and will be capable of processing the heaviest and sourest of crude oils to produce high quality refined products. The associated feature of the project will be a polypropylene plant of 9 lakh tonnes.
The entire project, designed to capitalise on the twin aspects of increasing demand in the West for high quality products that meet stringent emission standards and the widening gulf between the global prices of heavy and light crude oils, rests on two major pillars.
First, the best quality crude oils have already been discovered and tapped. These crude oil grades trade at high premium in the world market and are low on sulphur and light in density. The newer crude oil finds and hence, future output, would be of lower grades that are high on sulphur (sour) and heavy in density.
Most of the existing refineries worldwide that were set up in the latter part of the last century are designed to process high quality crude oil grades.
To process the heavy, sour crude grades that are now increasingly floating in the market, these existing refineries have to invest in upgrading their secondary processing and conversion capabilities. There is a place for new refineries that are complex enough to process the so-called "dirty" crude oils and yet produce the highest quality petrol and diesel to meet the stringent emission norms that are constantly evolving.
And that brings us to the second pillar. Quality norms for transportation fuels in the US are set to become more stringent with ultra-low sulphur diesel and petrol free of MTBE (methyl tertiary butyl ether, a carcinogen), which the old refineries are not capable of producing.
This opens up an opportunity for those willing to invest in new facilities designed to make products capable of meeting the advanced norms. Europe and large markets in Asia such as Korea, Japan and China are following suit with similar norms.
SEIZING OPPORTUNITY
The combination of refineries that can process low-grade crude to produce high-grade products is the window of opportunity (read accompanying story) that RPL is seeking to exploit. Of course, it does help that the gap between product demand and refining capacity worldwide is narrowing and refinery utilisation rates are running at their highest levels in the last two decades. Demand could outstrip refining capacity in the next few years as tightening product norms lead to shutdown of old refineries that cannot match the new requirements. But how are the margins?
PROFITABILITY EQUATION
This is the interesting part of the entire business. Heavy and sour crude oil grades trade at a sharp discount to the superior light and sweet variety and this gulf has been widening the last couple of years. In 2005 the price differential between the Arab Light and Arab Heavy grades, for instance, was as high as $5 a barrel.
Gross refining margin, that is the difference between the total value of finished products and the cost of the crude oil, can be lucrative where a refinery has the capacity to use the cheaper low-grade crude oil to produce the superior-grade products that sell at a premium.
This is exactly what RPL is endeavouring to do. The product slate of RPL's refinery will be tilted more in favour of high-margin, in-demand products such as petrol, diesel, kerosene, alkylates (high-octane additive to gasoline that commands a premium in the market) and petroleum coke.
CAPITAL INCENTIVES
The only catch here is that the capital costs of setting up such a high-complexity refinery is higher than a normal one. Compared to a capital cost of $24/barrel/day for the existing refinery of Reliance Industries, the new one of RPL is expected to cost $28/barrel/day.
This is where the benefits of being located in a special economic zone (SEZ) kick in. The project will be entitled to duty-free imports of capital equipment and crude oil; it will be exempt from duties on exports of products; from excise duty on products purchased from within the country; from service tax on taxable services rendered to it by others and, finally, from all stamp duties on land transactions and loan agreements.
In addition to the above, 100 per cent of profits derived from exports will not be subject to income tax in the first five years and this will fall to 50 per cent in the next five. These benefits, put together, will go a long way in boosting the refining margins and reducing the capital cost for RPL's project.
WHY A SEPARATE COMPANY?
The main reason for implementing the project through a separate subsidiary company appears to be its location in a SEZ. The different business model of the company, catering as it does to a predominantly export market, and the opportunity for unlocking value through a separate vehicle and give an opportunity for investors to participate in it, are put out as other reasons for implementing the project through a new company.
From the perspective of a Reliance Industries shareholder, it is good that the project is not on its books for the simple reason of its size and quantum of investment. Though Reliance Industries will still be investing Rs 8,280 crore to acquire 80 per cent of RPL's equity, the debt of Rs 15,750 crore will not be on its balance-sheet.
Importantly, the risks associated with setting up and commissioning a Rs 27,000-crore project will not weigh down on the balance-sheet or the stock price of Reliance Industries.
OFFER DETAILS
In all, 135 crore shares will be on offer of which 45 crore shares are available for retail investors. The price band will be between Rs 57 and Rs 62 and retail investors have the option of paying Rs 16 per share on application. The offer is open from April 13-20.