August 16, 212 Industry Report (overweight) Rosy outlook for 4Q Refining margins to stay robust through 4Q on limited capacity expansion Refining margins have stayed strong despite the economic slowdown. Although oil refining shares have risen lately, their current valuations should not be considered burdensome as long as refining margins stay strong. As such, refining shares will hinge on whether the recent strength of refining margins is structural or temporary. Daewoo Securities Co., Ltd. Yeon-ju Park +822-768-361 yeonju.park@dwsec.com Grace Kim +822-768-3511 grace.kim@dwsec.com We attribute the current strong refining margins largely to tight supply and demand conditions, although supply disruptions in Japan, Thailand, and the US have also contributed. And we expect refining margins to stay strong through 4Q (though they could undergo some corrections) for the following reasons: 1) Capacity expansion is likely to be limited in 4Q. In light of delays to the launches of operations at new facilities in China, 4Q capacity expansion is likely to reach only 9, bbl/d, which should fall short of the demand increase (3, bbl/d; based on the IEA estimate). 2) Inventory levels are low, and capacity utilization ratios at existing facilities are unlikely to rise further. While capacity utilization ratios at US refineries are already high, European refineries are unlikely to sharply increase their output in light of economic uncertainties and weakened export competitiveness. 3) We anticipate demand to bottom out and gradually pick up. The China Purchasing ManagerÊs Index (PMI), which is closely related to the countryês oil product demand, is showing a gradual recovery. Given limited supply growth, if demand improves, oil refining margins could be stronger than expected. Upgrade to Overweight; Top pick: SK Innovation We upgrade our rating for the oil refining sector to Overweight (from Neutral). Despite recent share rises, we believe that oil refining shares retain room for further upside. And if margins stay strong, earnings at oil refiners could exceed the consensus. Furthermore, if the US economy picks up, their earnings could improve drastically. Since margins of gasoline and naphtha could undergo corrections starting in September, we advise investors to accumulate shares only when shares undergo shortterm corrections. We raised our 3Q earnings estimates for oil refining companies to reflect high oil prices and strong refining margins. We select SK Innovation as our top pick, as the company is likely to generate the strongest earnings momentum in 3Q on the back of increases in oil prices and benzene spreads. US refinery utilization rate (%) 95 Weekly utilization of refinery capacity in US 9 85 8 75 7/1 1/1 1/11 4/11 7/11 1/11 1/12 4/12 7/12 Source: EIA Analysts who prepared this report are registered as research analysts in Korea but not in any other jurisdiction, including the U.S.
August 16, 212 Refining margins to stay robust through 4Q on limited capacity expansion Refining margins have stayed strong despite the economic slowdown. Although oil refining shares have risen lately, their current valuations should not be considered burdensome as long as refining margins stay strong. As such, refining shares will hinge on whether the recent strength of refining margins is structural or temporary. We attribute the current strong refining margins largely to tight supply and demand conditions, although supply disruptions in Japan, Thailand, and the US have also contributed. We expect refining margins to stay strong through 4Q (though they could undergo some corrections) for the following reasons: 4Q Capacity expansion to be limited Low inventories and limited upside risks to utilization 1) Capacity expansion is likely to be limited in 4Q. Although there are concerns over potential massive capacity additions (of around 6, bbl/d) in China, two major refiners, PetroChina and Sinopec, are believed to have delayed bringing on line new capacity to later than 213. As such, 4Q capacity expansion is likely to reach only 9, bbl/d, below the IEA demand growth estimate of 3, bbl/d. 2) Inventory levels are low, and capacity utilization ratios at existing facilities are unlikely to rise further. Capacity utilizations at US refineries are already high, as their cost competitiveness has improved thanks to growing output of tight and shale oils in the US, which has made WTI oil cheaper than Brent and provided low-cost alternatives to fuel oil. Although European refineries have moderately raised their capacity utilization in response to the recent pickup in margins, they are unlikely to sharply increase their output in light of economic uncertainties and weakened export competitiveness. Figure 1. US refinery utilization rate Figure 2. Europe/Africa refinery outage capacity (%) 95 Weekly utilization of refinery capacity in US (mn bbl/d) 5 Europe/Africa refineries outage capacity 9 4 3 85 2 8 1 75 7/1 1/1 1/11 4/11 7/11 1/11 1/12 4/12 7/12 Source: EIA Figure 3. OECD Europe refining product inventory 1/9 7/9 1/1 7/1 1/11 7/11 1/12 7/12 Source: Bloomberg Figure 4. WTI-Brent price and spread (US$/bbl) 16 14 12 1 8 6 4 2 WTI-Brent (R ) Brent WTI (US$/bbl) 3 2 1-1 -2-3 5 6 7 8 9 1 11 12 13-4 Source: IEA 2
August 16, 212 Upside risks to demand recovery 3) We anticipate demand to bottom out and gradually pick up. The Chinese Purchasing ManagerÊs Index (PMI), which is closely related to the countryês oil product demand, is showing a gradual recovery. In the US, a modest pickup in retail sales, employment and housing is also pointing to a potential economic recovery. If global growth, led by the US, turns around, we believe this would benefit the refining sector more strongly than chemicals, given that refining products tend to be traded interregionally unlike chemicals which are more geared towards intra-regional trade. The fact that the recent margin improvement was not accompanied by a pickup in demand suggests any demand recovery amid continued limited supply growth is likely to sustain stronger-thanexpected margins. Table 1. Oil refineries capacity ramp-up plan (bbl/day) Period Company Region Capacity 2Q12 Hindustan Petroleum Corp Bhatinda 18, PetroChina Hohhot 7, MRPL Mangalore 16,345 Repsol YPF SA Cartagena 12, Essar Vadinar 8, Sinopec Jinling 11, Tatneft Taneco Russia 4, Total 76,345 3Q12 PetroChina Niger 2, PetroChina Karamay 2, Rosneft Tuapse Russia 14, A-Oil Russia 2, Tesoro Mandan US 1, Total 21, 4Q12 Sinopec Anqing 7, Marathon Detroit 15, WNR Gallup 2, Total 87, 212 Yearly Total 1,3,345 1Q13 Motiva Enterprises LLC Port Arthur 325, Nagarjuna Cuddalore 12, Petrochina Penzhou 2, Sinopec Maoming 24, Total 885, Source: Industry data Figure 5. Domestic consumption growth of ChinaÊs oil refining products Figure 6. ChinaÊs PMI trend (' tonne) (%) (p) 212 45, Domestic consumption of oil refining products (L) Growth (R) 35 58 211 3 21 4, Median of 25~21 25 56 35, 2 15 54 3, 1 5 52 25, 2, -5 5-1 15, -15 48 2 3 4 5 6 7 8 9 1 11 12 1 2 3 4 5 6 7 8 9 1 11 12 Source: CEIC Source: CEIC 3
August 16, 212 Economic recovery would present further upside to chemicals and lubricants AsiaÊs chemical industry has also been bottoming out. Although weak demand is preventing product prices from rising more meaningfully, higher prices of US and European products have been filtering through to higher prices in several Asian products (EG, PX, PVC, etc.). If US prices further rise on a stronger economy, we believe Asian prices will also pick up with a lag. We especially see strong upside potential to PX prices given tight market conditions. Benzene prices in Asia would also inch higher, providing a boost to 3Q earnings. Lubricants have also managed to maintain robust spreads, despite initial worries over supply growth undermining margins. We believe supply growth has been smaller than previously anticipated due to disruptions in new capacities from Qatar. Figure 7. US red book retail sales index Figure 8. US housing business index (%) (Basis=5) 6 Red book: YoY 8 Total 4 7 2 6 5 4-2 3-4 2-6 1-8 1/8 1/9 1/1 1/11 1/12 1/ 7/2 1/5 7/7 1/1 7/12 Figure 9. PX, benzene spread Figure 1. Base oil Type 1 spread (US$/tonne) 9 PX Naphtha (US$/tonne) 5 (US$) 8 type 1 Benzene Naphtha (R) 7 8 4 6 7 3 5 4 6 2 3 5 1 2 1 4 1/11 7/11 1/12 7/12 9 1 11 12 4
August 16, 212 SK Innovation to display strongest earnings momentum in 3Q Revising up 3Q and 213 earnings estimates We revised up our earnings estimates and target prices for oil refiners to reflect upward adjustments to our oil price and refining margin forecasts for 2H12 and 213. We raised our Dubai oil price forecasts to US$112/bbl for 212 and US$115/bbl for 213 and our Korea complex refining margin to US$9/bbl for 212 and US$1/bbl for 213. Despite the recent share rally, we still see more upside potential to refinery shares. Thus, we upgrade our rating on the sector to Overweight. We select SK Innovation as our top pick, as the company is likely to generate the strongest earnings momentum in 3Q on the back of increases in oil prices and benzene spreads. Raising TP on SK Innovation to W2, We raise our target price on SK Innovation by 18% to W2, from W17, in light of our upward earnings revisions for 2H12 and 213 resulting from higher oil price and refining margin forecasts. Our target price was derived by applying a P/B of 1.1x (an ROE of 11%) to our 213F BPS and corresponds to a 12-month forward P/E of 1x. Even after the recent jump in the companyês share price (on higher oil prices and better margins), the stock is trading at a 12-month P/E of 8x, a multiple that still seems undemanding. This, combined with the potential of strong refining margins driving better-than-expected earnings, represent further upside potential to the companyês stock price. Table 2. Major assumptions for earnings forecast We revise up SK InnovationÊs 3Q operating profit estimate to W787.9bn, mostly due to upward revisions to the companyês refining division which is likely to gain from higher oil prices and solid refining margins. SK Innovation is well-positioned to benefit from higher oil prices because of its above-average inventories relative to industry peers. As for the chemicals division, the company should benefit from stronger benzene spreads given its higher exposure to the product, while the lubricant division is projected to see sales volume growth thanks to capacity expansions. 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12F 4Q12F 11 12F 13F US$/W 112.2 183.9 172. 111. 1131.5 1152. 113. 19. 196.5 1125.9 15. Dubai (US$/bbl) 1.8 11.5 16.9 15.7 116.4 16.2 11. 115. 16. 111.9 115.3 Diesel-dubai (US$/bbl) 18.5 19.6 17.7 18.6 16.3 15.4 18. 19. 18.6 17.2 19. Gasoline-dubai (US$/bbl) 12.6 14.4 17.5 1.4 14.4 13.9 15. 13. 13.7 14.1 14. PX-Naptha (US$/tonne) 77. 53.5 611.3 558.2 565.9 52. 55. 55. 61.8 542. 6. Source: Table 3. Quarterly earnings forecast of SK Innovation (Wbn, %) 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12F 4Q12F 211 212F 213F Sales Total 17,68.4 17,162.1 17,29.5 16,931.1 18,834.2 18,877.4 18,133.7 18,51.3 68,371.1 74,355.7 72,48. Refining 12,242.2 12,12.9 12,589.6 12,556.2 14,379.7 14,562.8 13,34.9 13,735.2 49,4.9 56,18.6 52,251.5 Chemical 3,891.4 4,186.3 3,621.3 3,356.1 3,441.5 3,199. 3,54.6 3,556.3 15,55.1 13,737.4 13,995.2 Innovation 323.7 29. 34.3 288. 275.6 327.6 258.3 258.3 1,26. 1,119.8 1,942.2 Lubricants 611.1 672.9 694.3 73.8 737.4 788. 993.9 96.6 2,79.1 3,479.8 4,219.1 OP Total 1,192. 437.4 861.9 35.7 926.9-15.4 787.9 641.7 2,842. 2,251.1 3,18.6 Refining 715.4 97.4 254.1 174.7 574.8-459.7 381.2 248.7 1,241.6 744.9 935.9 Chemical 242.9 132.9 36.3 92.2 181.9 164.2 198.2 187.9 774.3 732.1 8.4 Innovation 146.4 76.5 13. -7.5 7.2 12.8 19.1 19.1 318.4 391.3 522.8 Lubricants 87.3 13.6 198.5 91.3 1. 87.3 99.4 96.1 57.7 382.7 759.4 OP margin Total 7. 2.5 5. 2.1 4.9 -.6 4.3 3.5 4.2 3. 4.2 Refining 5.8.8 2. 1.4 4. -3.2 2.9 1.8 2.5 1.3 1.8 Chemical 6.2 3.2 8.5 2.7 5.3 5.1 5.6 5.3 5.1 5.3 5.7 Innovation 45.2 26.4 33.8-2.6 25.5 31.4 42.3 42.3 26.4 34.9 26.9 Lubricants 14.3 19.4 28.6 12.5 13.6 11.1 1. 1. 18.7 11. 18. Source: 5
August 16, 212 Raising TP on GS Holdings to W8, We upgrade our rating on GS Holdings to Buy and raise our target price by 33% to W8,. We derived our target price by applying a P/B of 1x (an ROE of 13%; a 2% discount in light of its holding company structure) to our 213F BPS. Despite the recent rally, we believe GS Holdings still has further upside potential, given that 1) at a 12-month forward P/E of 6x, the stock does not appear overvalued and 2) the operation of GS CaltexÊs fluid catalytic cracking (FCC) unit in 213 would add a boost to earnings if refining margins remain strong. GS HoldingsÊ 2Q operating profit came in below expectations at W81.7bn, as GS Caltex incurred an operating loss of W249.2bn amid weak oil prices. However, we expect GS Caltex to post an operating profit of W516.5bn in 3Q on higher oil prices and stronger margins. A pickup in PX margins would drive S-OilÊs share price sharply higher We reiterate our Buy call on S-Oil, but raise our target price by 18% to W13,. We arrived at our target price by applying a P/B of 2.4x (an ROE of 24%) to our 213F BPS estimate. We also revised up 3Q operating profit estimates to W532.9bn to reflect our upward earnings revisions for the refining division in light of high oil prices and robust margins. Despite slower economic growth, PX margins have remained relatively stable thanks to tight market conditions and should see significant upside momentum once the economy picks up. Table 4. Quarterly earnings forecast of S-Oil (Wbn, %) 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12P 3Q12F 4Q12F 11 12F 13F Sales Total 6,817.3 8,25.8 7,86.6 9,264.1 9,36. 8,797.8 9,282.8 9,323.4 31,913.8 36,44.1 36,613.5 Refining 5,738.3 6,513.6 6,188.6 7,519.7 7,294.5 7,124.3 7,66.2 7,747. 25,96.2 29,826. 3,375.6 Petrochem 566.7 915.6 923.3 1,85.4 1,111.4 1,65.6 1,72.4 1,29.5 3,491. 4,278.8 4,115.1 Lubricants 512.3 596.6 694.7 659. 63.1 67.9 55.3 547. 2,462.6 2,335.2 2,122.7 OP Total 646.7 241.8 368.9 375.7 384. -161.3 532.9 454.6 1,639.9 1,21.2 1,886.2 Refining 422.9-14. 15.8 45.9 98.1-481.7 26.1 184.8 47.6 61.3 739.4 Petrochem 93.4 77.2 133.9 143.4 185.3 195.8 162.8 16.3 451.8 74.3 658.6 Lubricants 13.4 178.6 219.2 186.4 1.6 124.6 11.1 19.4 717.5 444.6 488.2 OP margin Total 9.5 3. 4.7 4.1 4.2-1.8 5.7 4.9 5.1 3.3 5.2 Refining 7.4 -.2.3.6 1.3-6.8 3.4 2.4 1.8.2 2.4 Petrochem 16.5 8.4 14.5 13.2 16.7 18.4 15.2 15.6 12.9 16.5 16. Lubricants 25.5 29.9 31.6 28.3 16. 2.5 2. 2. 29.1 19. 23. Source: Table 5. Quarterly earnings forecast of GS Holdings (Wbn) 1Q12 2Q12P 3Q12F 4Q12F 211 212F 213F Sales 2,376.6 2,448.1 2,613.5 2,798.5 8,493.4 1,236.7 1,918.9 OP 233.5 81.7 312.2 266.6 93.4 962.3 1,125. Source: Table 6. Quarterly earnings forecast of GS Caltex (Wbn, %) 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 P 3Q12F 4Q12F 211F 212F 213F Sales Total 1,976.7 11,948.4 11,289.2 12,212.3 11,811. 11,769.8 11,783.5 11,767.6 46,426.6 47,131.9 5,795.1 Refining 9,471.7 1,48.8 9,943. 1,748. 1,335.8 1,184.8 1,184.8 1,184.8 4,643.5 4,89.2 43,779.6 Petrochem 1,55. 1,467.6 1,346.2 1,464.3 1,475.2 1,573.3 1,557.2 1,563.6 5,783.1 6,169.4 5,452. OP Total 753.6 3.4 49. 376. 316.6-249.2 516.5 389.3 1,839. 973.2 1,897.5 Refining 477.6 122. 29.1 255.3 112.5-385.7 328.3 2.1 1,64. 255.3 81.9 Petrochem 276. 178.4 199.9 12.7 24.1 146.5 188.2 189.1 775. 727.9 891.5 OP margin Total 6.9 2.5 3.6 3.1 2.7-2.1 4.4 3.3 4. 2.1 3.7 Refining 5. 1.2 2.1 2.4 1.1-3.8 3.2 2. 2.6.6 1.9 Petrochem 18.3 12.2 14.8 8.2 13.8 9.3 12.1 12.1 13.4 11.8 16.4 Source: 6
August 16, 212 Important Disclosures & Disclaimers Disclosures As of the publication date, Daewoo Securities Co., Ltd. has acted as a liquidity provider for equity-linked warrants backed by shares of S-Oil, GS and SK Innovation as an underlying asset, and other than this, Daewoo Securities has no other special interests in the covered companies. As of the publication date, Daewoo Securities Co., Ltd. has acted as a liquidity provider for the shares of S-Oil and SK Innovation, and other than this, Daewoo Securities has no other special interests in the covered companies. As of the publication date, Daewoo Securities Co., Ltd. issued equity-linked warrants with S-Oil, GS and SK Innovation as an underlying asset, and other than this, Daewoo Securities has no other special interests in the covered companies. Stock Ratings Industry Ratings Buy Relative performance of 2% or greater Overweight Fundamentals are favorable or improving Trading Buy Relative performance of 1% or greater, but with volatility Neutral Fundamentals are steady without any material changes Hold Relative performance of -1% and 1% Underweight Fundamentals are unfavorable or worsening Sell Relative performance of -1% * Ratings and Target Price History (Share price (----), Target price (----), Not covered ( ), Buy ( ), Trading Buy ( ), Hold ( ), Sell ( )) * Our investment rating is a guide to the relative return of the stock versus the market over the next 12 months. * Although it is not part of the official ratings at Daewoo Securities, we may call a trading opportunity in case there is a technical or short-term material development. * The target price was determined by the research analyst through valuation methods discussed in this report, in part based on the analystês estimate of future earnings. The achievement of the target price may be impeded by risks related to the subject securities and companies, as well as general market and economic conditions. (W) GS 14, 12, 1, 8, 6, 4, 2, 8/1 2/11 8/11 2/12 8/12 (W) S-Oil 2, 15, 1, 5, 8/1 2/11 8/11 2/12 8/12 (W) 35, 3, 25, 2, 15, 1, 5, SK Innovation 8/1 2/11 8/11 2/12 8/12 Analyst Certification The research analysts who prepared this report (the Analysts ) are registered with the Korea Financial Investment Association and are subject to Korean securities regulations. They are neither registered as research analysts in any other jurisdiction nor subject to the laws and regulations thereof. Opinions expressed in this publication about the subject securities and companies accurately reflect the personal views of the Analysts primarily responsible for this report. Daewoo Securities Co., Ltd. policy prohibits its Analysts and members of their households from owning securities of any company in the AnalystÊs area of coverage, and the Analysts do not serve as an officer, director or advisory board member of the subject companies. Except as otherwise specified herein, the Analysts have not received any compensation or any other benefits from the subject companies in the past 12 months and have not been promised the same in connection with this report. No part of the compensation of the Analysts was, is, or will be directly or indirectly related to the specific recommendations or views contained in this report but, like all employees of Daewoo Securities, the Analysts receive compensation that is impacted by overall firm profitability, which includes revenues from, among other business units, the institutional equities, investment banking, proprietary trading and private client division. At the time of publication of this report, the Analysts do not know or have reason to know of any actual, material conflict of interest of the Analyst or Daewoo Securities Co., Ltd. except as otherwise stated herein. Disclaimers This report is published by Daewoo Securities Co., Ltd. ( Daewoo ), a broker-dealer registered in the Republic of Korea and a member of the Korea Exchange. Information and opinions contained herein have been compiled from sources believed to be reliable and in good faith, but such information has not been independently verified and Daewoo makes no guarantee, representation or warranty, express or implied, as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein or of any translation into English from the Korean language. If this report is an English translation of a report prepared in the Korean language, the original Korean language report may have been made available to investors in advance of this report. Daewoo, its affiliates and their directors, officers, employees and agents do not accept any liability for any loss arising from the use hereof. This report is for general information purposes only and it is not and should not be construed as an offer or a solicitation of an offer to effect transactions in any securities or other financial instruments. The intended recipients of this report are sophisticated institutional investors who have substantial knowledge of the local business environment, its common practices, laws and accounting principles and no person whose receipt or use of this report would violate any laws and regulations or subject Daewoo and its affiliates to registration or licensing requirements in any jurisdiction should receive or make any use hereof. Information and opinions contained herein are subject to change without notice and no part of this document may be copied or reproduced in any manner or form or redistributed or published, in whole or in part, without the prior written consent of Daewoo. Daewoo, its affiliates and their directors, officers, employees and agents may have long or short positions in any of the subject securities at any time and may make a purchase or sale, or offer to make a purchase or sale, of any such securities or other financial instruments from time to time in the open market or otherwise, in each case either as principals or agents. Daewoo and its affiliates may have had, or may be expecting to enter into, business relationships with the subject companies to provide investment banking, market-making or other financial services as are permitted under applicable laws and regulations. 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