Prudent management is the key here

He’s been Caltex’s Chief Financial Officer since 2000 – through two downturns and a period in which the ground rules for the oil refining and marketing industry have been changing profoundly. In an interview with The Star, Simon Hepworth discusses the company’s ongoing fiscal strength and the company’s future.

How does Caltex embark on prudent planning during lean times?

Many corporate strategies unravelling now were premised on a market and economic environment that would continue to be strong. Short memories are a peculiarly human trait and learning from experience is one key to prudent planning.

I came into this role in 2000 when we were at the bottom of the last down cycle. I learned valuable lessons then about the difficulties involved in servicing high debt and accessing new credit from lenders who saw the company and the industry as high risk.

Because of where Caltex found itself at that time?

Absolutely. Refiner margins were at a cyclical low and we had inherited a high debt burden from the Caltex-Ampol merger in the mid-90s. We learned quickly that the bottom of the cycle is not a good place to be when you are laden with debt. We determined that we should always be prepared for the next downturn.

In the upturn that followed, our cash flows were strong, but strong cash flows were necessary to fund the large investments we needed to make in our refineries between 2004 and today.

It’s interesting, too, that during this up cycle, the Board was under some external pressure to borrow more, pay higher dividends, undertake share buy-backs and take higher risks. There’s always a temptation to give in and say we can afford to do all that. But we must always be mindful of the cyclical and volatile nature of the refining industry. We have sought to diversify our cash flows by growing the less-cyclical marketing earnings.

What’s been critical to Caltex is our regular capital structure reviews of historical cash flows and future expectations. Also, for a company of our size, with our cash-flow volatility driven by refiner margins, it is vital to retain a strong investment-grade credit rating. Without that you can’t access funding.

Nobody foresaw the depth of the current credit crunch. Without that investment-grade credit rating, we’d never have been able to access the funding we have. By having a strong balance sheet and an appropriate level of debt, we’ve proactively refinanced in excess of a billion dollars of debt over the past 12 months.

Has overall debt come down?

It’s been up and down with movements in the crude oil price and currency movements, but today we are at pretty much the same level as a year ago. When we develop our business plan, it’s a balancing act: can we afford to invest sufficient money to fund an appropriate growth strategy, while at the same time managing the risks of volatility and a potential downturn? Do we have an appropriately robust business plan that gives enough money to the marketers and refiners to manage and grow their business, but not so much that we put the company at risk?

Managers usually have a good argument as to why they should get another fifty or hundred million. But when you’ve made your decision and established your business plan, you must ensure you have flexibility to pull back, or reduce, your cash outflows to address requirements for contingencies.

Is maintaining a strong credit rating a critical factor in that process?

Absolutely crucial. We recently went to the US to raise money from the US Private Placement Market. This market comprises insurance companies that typically lend money to corporates over long periods, generating interest to match their cash outflows. With the downturn, they’re only lending to companies with very strong credit ratings of BBB+ or above – like Caltex.

Remember, about 35 of the ASX Top 50 have had to raise money from their shareholders by issuing more equity. It’s not for growth, or for re-investing in the business, it’s purely to keep their companies afloat. We’re in a good spot because we’ve retained our credit rating and have plenty of headroom in terms of available facilities versus level of debt. So we can continue through this down cycle to invest in areas of the business we’ve said we want to invest in – strategically, and for the long term.

Obviously, we do occasionally need to pull back. I know some employees reading The Star magazine will say, “Ha! Every year it feels like we are asked to slow spending down,” but when we pull back it’s seldom wholesale cancellation. It’s tweaking round the edges. Our strategy allows that flexibility and positions us well for the next upturn.

And if you’ve got a strong balance sheet it’s at this time of the cycle that real opportunities arise.

Like selective acquisitions?

Yes. Around the world, many companies are undertaking portfolio reviews. When times are tough, some multinationals may say: “Australia is a long way from anywhere, so why are we there?” –

(therefore) assets and opportunities could present themselves. When times are good people tend to spend more. Head count rises, you do more things, spend more money. In down cycles, companies reduce head count and cut back on discretionary expenditure. It’s often knee-jerk and hence destabilising.

Best-practice companies invest at the bottom of the cycle more than at the top. Caltex is prepared and equipped to do that.

We say, let’s look through the cycle, establish an appropriate capital structure and not get over-excited during the good times or too conservative during bad times,

Caltex’s business plan is monitored monthly. We proactively develop contingency plans. In January 2008, for instance, we developed a cash contingency plan which we activated later in the year, saving $150 million. Dates are set on which Caltex will activate contingency measures. When a forecast indicates a parameter – like ratings metrics, loan covenants and cost commitments to market – is likely to be adversely impacted, the next level of the plan kicks in.

What are the biggest challenges and priorities for Caltex?

One challenge is for refining to operate reliably. 2008 wasn’t a great year for us from a reliability perspective. We always put safety first, of course, but refineries have to run as a business. They have to be focused on cost structure as well as reliability. When you have problems with the refinery your cost structure tends to blow out. So that challenge for refining is simple in concept.

For marketing, the priority is to build on the success of 2008, when we had terrific gains in sales values and profitability. We’re going into a tougher environment, so it will be a challenge to maintain that growth and those volumes and margins. The key is not to lose heart, or focus, in this tougher environment and to continue servicing the customer base very well.

To what extent will profitability be affected by margin concerns?

Refineries can only be cash-flow positive and generate revenues if they’re able to operate and survive in a margin environment which is relatively low. If you can’t, you shouldn’t be here. You can’t allow a situation where you generate a lot of cash in two to three years at the top of the cycle but bleed cash at the bottom. That’s not good enough. We must be cash-flow positive even at the bottom of the cycle.

How important is managing costs?

It’s a constant focus. Costs rise every year. People and suppliers want to be paid more. But you cannot allow costs to rise more than your growth in profitability, otherwise you’re on a downward trend. It comes back to whether you have the cost structure and performance to allow you to maintain a positive cash flow through the cycle.

What are some of the other opportunities for Caltex in the short term?

We’re financially strong and being well-positioned at this point in the cycle. Assets may come up for sale. There’s also the natural progression in growing market share and taking customers and volume from the competition while they are more concerned about the impact of the downturn and what their parent entities are thinking.

The Carbon Pollution Reduction Scheme (CPRS) is obviously a challenge.

For us, there’ll be a significant impact. Emissions from the refineries are about two-and-a-half million tonnes of CO2 a year. It looks like we’re going to get 60 per cent and of our carbon permits free, which leaves us exposed to something in the order of a million tonnes of CO2. At $25 per tonne, that’s an EBIT impact of $25 million which goes straight to our bottom line. Given that we’re competing against imported product which doesn’t bear a carbon cost, we can’t pass that on.

The other huge challenge is we have to buy permits for our customers. They emit about 40 million tonnes of CO2. 40 million tonnes at $25 per tonne is in excess of a billion dollars of permits per year! We’ve been successful, along with others, in lobbying for frequent auctions, so you don’t have to fork out $1 billion at once, but that’s a lot of money.

There may also be working capital issues, depending on whether we are required to pay in advance for permits.. And there are other issues around the tax treatment of permits. The timing of when you get the tax deduction can have a big impact on cash flow. We will, of course, seek to pass on this cost to our customers. However, this presents a number of challenges for us.

The compliance bill for the CPRS must also be big?

It’s very large. I recently met the head of carbon practice for a big international bank, based in Paris. He was bemused by the fact that transport fuels are included in the proposed Australian emissions trading scheme. He thought the administrative burden to be placed on oil companies was ludicrous – to buy permits, collect cash on behalf of customers, pay it over and manage the liability. In the European Union, this was seen as too administratively burdensome. They’re managing the transport fuels emissions issue by more direct means, seeking ways to increase the use of public transport and setting CO2 emission targets for vehicles. Caltex proposes taking motorists out of the CPRS and managing emissions through CO2 targets for vehicles and financial incentives for motorists to buy them.

The way the CPRS has been designed, Caltex calculates that by 2025, cumulative emissions from petrol will be the same as without the CPRS and fuel suppliers will have purchased $20 billion in permits and charged them back to customers.

The government is imposing all this administration and cost on oil companies, but it will have no impact on the use of petrol. Even without the excise reduction, petrol prices would rise in the order of 10 cents under a carbon scheme. That won’t change driver behaviour or emissions from cars.

Where is the industry and company heading in the next 20 to 30 years?

We can probably draw some general conclusions. The refining sector, globally, will gravitate to large, sophisticated, high-volume, high-throughput systems. We’re going to see continuing impositions on refineries globally in terms of clean fuels. Australia has some of the cleanest fuels in the world. Other countries, including developing nations over the next 20 years, will follow suit at different speeds. Many smaller refineries around the world will probably close.

Including in Australia?

Over time, yes. And the price of declining crude oil resources and the types of crude available will have an unknown impact on the refining sector over the next 20 years.

I think there’ll be an increasing reluctance by major oil companies to continue operating in Australia. In all likelihood, we’ll see ongoing consolidation of the large, integrated oil companies which means they’ll have increasing focus on the upstream – the exploration and production of crude oil with less focus on downstream, particularly where they’ve got small-scale refineries, such as in Australia.

And a short market will continue in Australia, with growing supply challenges over the long term.

What else do you need to do to underpin Caltex’s future growth?

For any enterprise in the energy sector, liquidity, financial stability and hitting targets are essential. As long as the company is well managed and resourced, and doesn’t over-extend itself, it will grow. The question is: will the opportunities arise that allow it to grow faster than it has been?

Caltex has been expanding through organic growth in sales volumes and by gaining market share. Inorganic growth, so far, has occurred in relatively small lots – buying resellers and so on. Opportunities will arise as the competition makes decisions about whether it wants to be in this market or not.

Prudent management will pay off over the long term. China’s growth rate will accelerate again and provide the stimulus for further growth. Being prepared for lean times when markets are not growing, but being able to ramp back up again when they recover – that’s the key.

 

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