[Research] Reimagined Infrastructure

New Zealand's Channel Infrastructure Limited

Not held.

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A sharp Twitter friend of mine once quipped:

The Australian 60/40 is 60% classifieds and 40% infrastructure.

I can’t help but think that the same might apply to our cousins ‘across the ditch’.

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Summary:

• Refinery conversion to strategically placed import terminal in New Zealand’s Northland has led to a reversion to quality not uncommon in similar extraordinary corporate activity,

• This transition leaves room for significant operational leverage over a relatively fixed cost base, although with an expanding asset base,

• Opportunities for organic volume uptake continue, with all commercials agreements linked to PPI, and on a take or-pay-basis,

• Continuing high ROIIC opportunities remain to drive additional returns.

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One of the unintended (or perhaps inconveniently intended) consequences of the West’s move to ‘de-carbonise’ their economies has been outright deindustrialisation and the outsourcing of critical infrastructure elsewhere. In Australia for example, after the closure of the Altona Refinery in 2021 the country was left with only two minor refineries. Even these are kept open for strategic reasons, and with government assistance no less.

While the Pandemic was a catalyst for the closure, or indeed conversion, of many of theses assets, for the past 15 years petroleum consumption has been flat-to-down across the oceanic Anglophone countries. Indeed, the United States consumes a similar amount of petroleum today as it did before the oil shocks of the early 1970’s:

At the same time, parts of Asia have been following a lagging path of industrialisation on the back of more steady demographics and a lower waged labour advantage. More importantly, many states in this region have leveraged these advantages to establish oil refining infrastructure that is often supported by their respective governments. The opposite has been true in places like Australia and New Zealand.

These countries represent costly labour markets, intense regulation and government intervention, as well as having highly motivated parts of their political nation intent on shutting down anything tangentially harmful to the environment. I’m envisaging throngs of angry Baby Boomers marching in solidarity against refining oil, and later driving home in Range Rovers. Much better to let that kind of work happen somewhere else, and enjoy its fruits later. The same could be said about a certain coal infrastructure asset I wrote about earlier this year.

I’ll leave the geopolitics, strategic, and moral questions to others, but a discernible trend has been occurring across the so called ‘developed world’: heavy industrial infrastructure has been transitioning to much lighter, and efficient uses. If refining, for example, no longer needs (or in fact is not economical) to be done domestically and cheaper finished oil products are now being sourced elsewhere, than less intensive infrastructure will be needed to facilitate its import.

These pressures were felt intensely in the early months of 2020 by the board of the then New Zealand Refining Company Limited (Refining NZ or RNZ).

RNZ started life - after appropriate government approval - in 1962 as New Zealand’s only oil refinery. While a few different locations were thrown around initially, construction eventually began at Marsden Point, notable for its immediacy to Auckland and its deep water port. In 1964 the refinery opened with an initial capacity of 65,000 barrels per day. As is common with most critical infrastructure, both the New Zealand public and the major oil importers (Shell was originally tapped to lead the project) initially owned the business.

Major capital works and a general expansion of the Marsden Point facility was undertaken during the 1980’s in response to the oil shocks of the 1970’s. While the Marsden Point expansion was mostly aimed at increasing the efficiency of the refinery (including the development of the world’s first on-site butane deasphalting unit), it also involved the construction of the Wri Oil Terminal and a 170km long pipeline to Auckland.

The expansion project was completed by 1986 and, with minor modifications over the years, the facility remained largely unchanged until the Pandemic. Worthy of note was that before 2021, the last commercial agreements made between RNZ and its three principal customers (BP, ExxonMobil, and Z Energy) was made in 1995. This is another of those interesting situations I have become all too familiar with: ownership by one’s largest customers is anathema to optimisation.

In this particular case, it likely wasn’t such a big deal - the asset was partially strategic (in response to the 1970’s oil shocks) but it was also completed at a time when global refinement capacity wasn’t in a state of seemingly constant oversupply. For a short period of time Marsden Point was probably one of the most efficient refineries in the southern hemisphere. From 1988, after the passage of the Petroleum Sector Reform Act, the marginal cost of importing refined crude products would remain the pricing umbrella for NZR.

Shares eventually came to the open market in the early 2000’s when various owners including the New Zealand public wanted to exit their position. Over the years the conflicting interests between significant customer-shareholders has been relieved but only by serendipity. One can imagine why the authorities would want to exit ownership, but the likes of BP significantly reduced their interest in 2017 for less obvious. This would only be partially prescient.

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Why are returns too low? Firstly, substantial new supply from low cost producers in places like the Middle East, China, India, South Korea, is depressing global and regional margins. These changes are taking place in the context of extraordinary volatility in the global oil market due to Covid-19 which have seen the biggest fall in oil prices since 1991 on the back of the collapse in demand for oil products globally. Notably, dated Brent crude, being one of the crudes we benchmark off, recently dropped to a 21 year low of around USD 13 per barrel. While the logical response for the excess supply we are seeing in oil and refining capacity should be supply coming out of the market, we don’t see this occurring. As global competition has expanded, we have moved from companies competing, to countries competing – in many cases these competitors are effectively national enterprises who don’t operate under the same economic constraints that we do.

Interim Managing Director Paul Zealand, 2020 Shareholder Remarks

Interestingly, this tone was unrecognisable only two years earlier. In 2018, the company achieved multiple consecutive years at the peak of its historic gross refining margin range:

The Gross Refining Margin averaged USD 6.31 for the year (2017: USD 8.02 per barrel) or USD 7.33 when normalised for the 2018 shutdown. This is at the top of its historical USD 4.00 to USD 6.00 per barrel range, supported by global demand growth and our continued progress in optimising the Refinery’s operational efficiency.

2018 Annual Report

Of course, the Pandemic changed all that.

The economics of RNZ’s refining business were subject to the vicissitudes of the international currency and commodity markets. A consistently strong domestic currency could render the company’s products uncompetitive: foreign imports would become more competitive. Volatility in crude markets (like we’re currently witnessing) could have equally disastrous effects, without the benefit that a depreciating currency would bring. If the vagaries of the futures markets didn’t make things hard enough, than consider the perpetual efficiency treadmill these things are required to run on: new technology, processes, and sponsored foreign competition all present continual threats.

This isn’t to mention anything of the ongoing risk of technical and physical disaster. Mike Fuge, now CEO of Contactless Energy, took the reigns at RNZ in early 2018. In the year before, the pipeline that connected Marsden Point to Auckland faced a rupture caused by a digging incident some ten years before hand. The rupture resulted in a government inquiry as well as causing significant site closures during 1H 2018. Fuge would resign a little less than a year after his appointment, departing in March 2020.

The saving grace of RNZ during the early Pandemic’s months was the so called Fee Floor:

The Fee Floor established under Processing Agreements with the Company’s customers provided protection against the impact of both low margins and the lower refinery throughputs. The Fee Floor is a guaranteed minimum level of income in New Zealand dollars, irrespective of the number of barrels processed and refining margins, designed to ensure the Company can continue to operate through periods of low margins.

2020 Annual Report

Independent Director Paul Zealand took the reigns as interim Managing Director in the wake of Fuge’s departure. The coincidental onset of the Pandemic almost immediately catalysed what would be an extraordinary corporate change. In early 2020 RNZ hired Naomi James to take on the role Chief Executive. James had a long stint with Arrium Mining and Materials as Chief Legal Officer before taking on a succession of commercial senior leadership positions. This was followed up with almost four years at Santos where she oversaw initially oversaw governance. Importantly, James headed up a carve off of Santos’s midstream infrastructure assets with the idea of ultimately floating them off separately.

Beginning in mid 2020, James, in conjunction with long time Chairman Simon Allen, led a strategic review of the business. This was at a time when the Marsden Point refinery was experiencing severely depressed refining margins and volumes. In the first place, the strategic review kicked off a ‘simplified refinery model’. This entailed the ceasing of bitumen processing, and a reduction of crude intake by about 18% - it also allowed for management to open negotiations with their major customers about a potential transition to an import terminal.

By year end 2020 RNZ had agreed to in-principle commercial terms for port usage with British Petroleum, and was in ongoing negotiations with Z Energy and Mobil. The terms being floated by RNZ were tantalising:

A lengthy initial term (10+ years), a combination of fixed annual access fees and variable throughput fees linked to actual volumes – targeting total estimated fees (across all customers) of circa $100 million per annum during the initial term – and provision for third party access to unutilised RAP capacity.

The highlight was crucial: the original customer agreements struck in 1995 were exclusive. Otherwise these agreements looked like a very typical combination of fixed recurring fees, and royalty like income tied to volumes.

The strategic review was tied up in 2021. The planned conversion to an import terminal was a fait accompli: shareholders approved the plan with virtually unanimous consent, as did the government, and the company’s creditors. The importance of the transition cannot be overstated, it meant the closure of the historical refinery operations at Marsden Point. This entailed some additional funding and capital work projects (financed oddly enough by a public bond offering), but it also caused a significant reduction in the now redundant workforce. In 2021 RNZ had over 300 employees: today it is 97.

The Marsden Point refinery would ultimately close in early 2022. During the transitionary year of 2021-22, the simplified refining model ran at cost neutral and worked to volumes largely at the fee floor mentioned above. This gave management the time to complete agreements with both Z Energy and Mobil, and the board signed off on the planned conversion. The terminal opened in April 2022 and RNZ became Channel Infrastructure (Channel).

The economics of a well placed, strategic import terminal are typically very good. This is partially because they act as an important intermediary between oil/product importers and the wholesale or retail operations who either distribute the product to consumes or who actually consume it for commercial reasons. In this regard geographical characteristics are important. Naturally there can’t be a port every 15km’s because this kind of infrastructure requires significant investment, but also because it needs government sanction as well. Typically only a select number of locales will meet the logistical needs to service incoming vessels: access to a deep water port, immediacy to critical population/consumption centres, storage facilities, treatment facilities, and integrated supported infrastructure (pipelines). Only 4000 terminals exist outside of the United States.

James elaborated on these very points in her remarks to shareholders in early 2021: