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Zenith Pure Oil

Annual Financial Report

2023

 

 

 

 

 

 

 

 

 

Zenith Pure Oil Hungarian Oil and Gas Plc.

MANAGEMENT DISCUSSION AND ANALYSIS

31 December 2023

Budapest, 21 March 2024

 

 

 

 

 

 

 

MANAGEMENT DISCUSSION AND ANALYSIS OF 2023 BUSINESS OPERATIONS

 

 

 

 

1.        OVERVIEW OF THE MACROECONOMIC AND INDUSTRY ENVIRONMENT

Macroeconomic environment

Global output growth proved unexpectedly resilient last year, despite the fact that the 3.1% annual growth rate remains below the historical (2000-2019) average of 3.8%.[1] At the start of 2023, declining real incomes, rapid and widespread monetary policy tightening and the gradual but steady phase out of fiscal transfers in advanced economies projected a much harder landing for the global economy. In contrast, inflation has declined more quickly than initially anticipated and energy support schemes have helped to cushion household incomes and underpin activity in many economies. Still, outcomes diverged across countries, with stronger than expected growth in the United States and many emerging-market economies, offset by a slowdown in most European countries. China's economy grew 5.2% in 2023, slightly more than the official target, but the recovery was far shakier than expected, with a deepening property crisis, mounting deflationary risks and muted domestic demand.

The rising momentum was not felt everywhere, with notably subdued growth in the Euro area, reflecting the continued adverse effects of the energy price shock, the lagged effect of tight monetary policy, weak consumer sentiment and global trade providing little support on the external side. Global trade growth in 2023 was the slowest outside global recessions in the past 50 years as the ending of the zero Covid-19 policy in China did not generate the hoped-for boost to exports. The high dependence of the German economy on the manufacturing sector and external demand kept its performance below average compared to the other Euro zone countries. Following a robust post-pandemic expansion in 2021 and 2022, GDP increased only by 0.5% in both the Euro area and the EU in 2023[2], with the energy-intensive industry sector suffering most from still elevated energy and feedstock prices and a weaker economy.

The Central and Eastern European (CEE) countries performed below expectations, mainly due to the recession in Germany. Although the share of exports to Germany declined over the last two decades, Germany remains the main trading partner of the region. In addition, in many of these countries, growth was driven by a decline in imports, primarily on account of the strong base effects resulting from the high level of imports seen the previous year, when energy concerns led to stockpiling. The energy situation has improved since last year, with reduced gas dependence and diversified sources.

The Hungarian economy mostly stagnated after the significant fall in H2 2022 and Q1 2023, resulting in a recession of -0.8% year-on-year in 2023. Both lower domestic demand due to high inflation and tighter fiscal and monetary policies and sluggish external demand contributed to the downturn. Overall, the fall in domestic demand has been partly counterbalanced by the positive impact of net exports as imports of goods and services dropped at a steeper pace than exports last year.

Oil and natural gas market developments

Despite a brief surge above 90 USD/bbl in September and mid-October, Dated Brent crude prices have traded in the relatively narrow 70-90 USD/bbl range in 2023, averaging at 82.6 USD/bbl, 18% below the 101.3 USD/bbl average in 2022. The remarkable stability of oil prices came at the time when global markets had to adjust to new trade dynamics, with crude oil from Russia sustaining its destinations outside the EU, several surprise OPEC+ supply cuts during the year and intensifying geopolitical tensions in the Middle East after the outbreak of the Israel-Hamas war and the year-end Houthi attacks on shipping vessels in the Red Sea. The oil market was able to remain cold because fears of a wider geopolitical conflict and physical disruptions to supply were dominated by demand concerns and higher than expected non-OPEC supply growth, led by the U.S. throughout the year. With GDP growth below trend in major economies, global oil demand outlook growth slowed accordingly, with Europe making up more than half the decline. The impact of tighter monetary policies and decreasing real incomes fed through to the real economy while petrochemical activity shifted increasingly to China, undermining growth elsewhere. Europe has been particularly hit amid the continent’s broad manufacturing and industrial recession.

Figure 1 Selected crude, natural gas and coal prices dtd (USD/MWh, 2021-2023, Bloomberg data)

The fall in European natural gas prices is even more striking, the average price of TTF (Title Transfer Facility), Europe’s largest gas trading hub, dropped from an average of 130.9 EUR/MWh in 2022 to 41.3 EUR/MWh in 2023 (-68%). Despite the continuous downward trend in 2023, European prices remained overly reactive to even small changes in supply availability during the year, suggesting that the market continued to be fragile even amid consistently comfortable storage filling rates, low industrial gas demand and warmer temperatures. In the absence of enough flexible new supply, the lost Russian pipeline volumes triggered a painful demand side adjustment in the short-term. European gas demand dropped by over 100 bcm in just two years, falling to its lowest level since 1995. Following a 13% (or 70 bcm) drop in 2022, gas consumption fell by another 7% (or 35 bcm) in 2023. All sectors contributed to these declines, although the drivers have markedly shifted from one year to the other. In contrast with 2022, the demand reduction in 2023 was largely driven by the power sector, as the rapid expansion of renewables, together with improving nuclear availability reduced the call on gas-fired power plants. In addition, mild winter weather together with gas-saving efforts continued to weigh on gas use in the residential and commercial sectors. Industry, which suffered the steepest decline in 2022, moved towards a gradual recovery in the second half of 2023, as lower price levels incentivised higher operating rates, including the more gas-intensive industrial sectors.

Downstream

Although refinery runs remained stronger than expected in 2023, total year runs for the last year averaged around the same level as in 2022 in Europe while global refinery throughputs finally returned to their pre-pandemic, 2019 levels, led by new Chinese and Middle East capacities. While not returning to the extreme highs of 2022, margins stayed steady, supported by resilient gasoline demand and elevated diesel crack spreads as OPEC+ supply cuts squeezed supplies of medium crude oil grades characterized by relatively higher middle distillate yields. The diesel shortage has been a worldwide phenomenon, with stocks well below the five-year average in most regions including the U.S., ARA ports in Europe, and Singapore. In Europe, the lost access to Russian medium crude and increased processing of lighter U.S. and North Sea grades might have limited crude distillation runs despite the strong margin environment.

European petrochemicals have been hit by the perfect storm of sustained production cost rise, collapsing demand and intensifying import pressure due to global overcapacity. In 2023, China completed more than 20 petrochemical projects, pushing its global share of petrochemical capacity up to 25%. The decrease in competitiveness of European assets has been exaggerated by the U.S. Inflation Reduction Act, which reduced operational expenses for U.S. players and attracted producers to relocate overseas despite the announcement of the Green Deal Industrial Plan to counter U.S. subsidies and prevent an exodus of industrial activity from Europe.

Macro figures (average)	FY 2023	FY 2022	Ch %
Brent dated (USD/bbl)	82.6	101.3	(18)
Ural Blend (USD/bbl)(15)	64.3	75.1	(14)
Brent Ural spread (USD/bbl)(5)	(19.2)	(24.9)	(23)
TTF gas price (EUR/MWh)	41.3	130.9	(68)
Premium unleaded gasoline 10 ppm (USD/t)(11)	856.4	1,004.6	(15)
Gas oil – ULSD 10 ppm (USD/t)(11)	828.9	1,054.7	(21)
Naphtha (USD/t)(12)	602.9	722.5	(17)
Fuel oil 3.5 (USD/t)(12)	427.4	457.2	(6)
Crack spread – premium unleaded (USD/t)(11)	231.2	238.1	(3)
Crack spread – gas oil (USD/t)(11)	203.7	288.3	(29)
Crack spread – naphtha (USD/t)(12)	(22.3)	(44.0)	(49)
Crack spread – fuel oil 3.5 (USD/t)(12)	(197.7)	(309.3)	(36)
Crack spread – premium unleaded (USD/bbl)(11)	20.2	19.3	5
Crack spread – gas oil (USD/bbl)(11)	28.6	40.3	(29)
Crack spread – naphtha (USD/bbl)(12)	(14.9)	(20.1)	(26)
Crack spread – fuel oil 3.5 (USD/bbl)(12)	(15.1)	(29.1)	(48)
Zenith Pure Oil Group refinery margin UPDATED (USD/bbl) (10)	9.0	8.4	n.a.
Complex refinery margin (Zenith Pure Oil + Slovnaft) UPDATED (USD/bbl) (10)	9.3	8.9	n.a.
Ethylene (EUR/t)	1,205.8	1,412.7	(15)
Butadiene-naphtha spread (EUR/t)	291.8	567.7	(49)
Zenith Pure Oil Group petrochemicals margin (EUR/t)(9)	285.8	480.9	(41)
Zenith Pure Oil Group Variable petrochemicals margin (EUR/t)	143.5	242.4	(41)
HUF/USD average	353.3	373.1	(5)
HUF/EUR average	382.0	391.3	(2)
3m USD LIBOR (%)	5.01	1.64	na
3m EURIBOR (%)	3.43	0.35	na
3m BUBOR (%)	14.30	9.97	na
Macro figures (closing)	FY 2023	FY 2022	Ch %
Brent dated closing (USD/bbl)	77.6	81.3	(5)
Urals blend closing (USD/bbl)	63.8	48.5	31
HUF/USD closing	346.4	375.7	(8)
HUF/EUR closing	382.8	400.3	(4)
Zenith Pure Oil share price closing (HUF)	2,826	2,602	9

 

Notes and special items are listed in Appendix I and II.

Historical macro figures are available in the annual Data Library on the company’s website.

2.        INTEGRATED CORPORATE RISK MANAGEMENT

As an operator in a high-risk industry Zenith Pure Oil is committed to manage and maintain its risks within acceptable limits.

The aim of Zenith Pure Oil Risk Management is to keep the risks of the business within acceptable levels and safeguard the resilience of its operations as well as the sustainable management of the company. For this purpose, as an integral part of our corporate governance structure, Zenith Pure Oil has developed a comprehensive Enterprise Risk Management (ERM) system which focuses on the organisation’s value creation process, meaning factors critical to the success and threats related to the achievement of objectives but also occurrence of risk events causing potential impact to people, assets, environment or reputation. Within the ERM framework all significant risks throughout the whole Group are identified, assessed, evaluated, treated and monitored, covering all business and functional units, geographies as well as projects, taking into consideration multiple time horizons.

Regular risk reporting to top management bodies, including the Board of Directors with its committees provides oversight on overall the risk profile and the largest risks as well as assurance that updated responses, controls, and appropriate mitigation actions are set and followed.

The Group faces financial, operational and strategic risks, including but not limited to the below.

Risks/processes	Risk description	Risk mitigation methods
Market and financial risks
Commodity price risk	The Group is exposed to commodity price risk on both the purchasing side and the sales side. The main commodity risks stem from its long positions in crude oil, refinery margin and petrochemical margin.	·   Integrated business model ·   Continuous monitoring ·   When necessary, commodity hedging instruments to mitigate other than ‘business as usual’ risks or general market price volatility
Foreign exchange (FX) risk	The Group has FX exposure due to mismatch of currency composition of cash inflows and outflows, investments, debts.	·   Monitoring FX risk and balancing the FX exposures of the operating & investment cash flow with the financing cash flow exposures when necessary and optimal
Interest rate (IR) risk	Zenith Pure Oil has a mixture of floating and fixed interest rate debts. Floating rate debt are subject to interest rate changes.	·   Continuous monitoring ·   Adequate mix of funding portfolio ·   When necessary, interest rate swap hedging instruments to mitigate risks
Credit risk	Zenith Pure Oil provides products and services with deferred payment terms to eligible customers which exposes it to credit risk.	·   Diversified customer portfolio ·   Customer evaluation model, continuous monitoring ·   Group-wide credit insurance program
Financing/Refinancing risk	Zenith Pure Oil has significant debt outstanding. Inability to refinance those or inability to draw down funds could cause liquidity problems.	·   Diversified funding sources/instruments ·   Diversified, balanced, and decently long maturity profile ·   Investment grade rating (BBB-) supports smooth capital markets access
Operational Risks
Physical asset and process safety and equipment breakdown risk	Process Safety Event (Major Industrial accident) due to loss of mechanical integrity, technical, technological or operational issues, process maintenance difficulties, lack of competent human resources.	·     Comprehensive HSE activities, a group-wide Process Safety Management system including asset related operational risk management process ·     Preventive & Predictive maintenance (Uptime program) with thorough equipment criticality assessment behind ·     Group-wide insurance management program
Crude oil and gas supply risk	Crude supply disruption (insufficient quantity or quality) can disrupt refineries and petchem sites continuous operation.	·     Crude oil-supply diversification strategy implemented; ·     Emergency reserves available

Critical material, equipment or service supply risk	Disruption in critical (raw) materials and/or equipment and/or services may cause delays in operation and/or increase costs	·     Stock  management ·     Supplier management ·     Sourcing and supply chain diversification
Exploration & Production reserve replacement	Higher than expected decline and failure to replace reserves.	·     Production optimization programs and organic reserve replacement activities are both focus areas of Exploration & Production operations
Cyber risk	Global trends showing steadily growing frequency and intensity of Cyber-attacks / incidents. AI is a new global threat which is widely used by attackers as well as more specified Cyber Crime Groups targeting Industrial Control System’s weaknesses, which may have increasing economic impact and relevance on Zenith Pure Oil. Ukraine War significantly reduce Russian and Ukraine hacker group activities as they focus on war, significant investment on attacking methods by all stakeholders, furthermore these grown capabilities could lead to huge impact on the future.	·     Continuous improvement of cyber security capabilities ·     Continuous supervision of cyber security risks (Group and opco level) ensuring the protection of the confidentiality, integrity and availability of data ·     Cyber security is built into all the Zenith Pure Oil products and services ·     Continuous education of employees and partners.
Fraud Risk	Fraudulent activities (external & internal fraud) may cause significant financial and reputational losses	·     Control functions on local and group level ·     Anti-Fraud Awareness (Newsletter, Mandatory trainings) ·     Anti-Fraud & Investigation procedures, dedicated Team
Pandemic Risk	Pandemics may significantly adversely affect the Group’s business environment, including price and demand on the Group’s products and services, availability of contractors, subcontractors as well as raw materials, creditworthiness of credit customers, availability of the Group’s key personnel.	·   Crisis Management plans in place ·   Our Group Pandemic Preparedness Framework methodology instruction was issued in January 2023, summarizing not only the WHO general approach but entire Zenith Pure Oil internal experiences of last 2-3 years, ensuring a life-proof and working framework to manage any possible further endemic/ pandemic situations. ·   Continued and sustainable practices defined, adjusted to country local measures and company internal circumstances
Strategic risks
Regulatory and sanctions risk	Zenith Pure Oil has significant exposure to a wide range of laws, regulations and policies on the global, the European and the individual country level, that may change significantly over time and may even require the Group to adjust its core business operation.	·   Continuous monitoring of new regulations and sanctions ·   Strengthened compliance process ·   Participation in legislative processes, consultations ·   Adopting Zenith Pure Oil strategy in response to changes
Country risk	The international presence of Zenith Pure Oil contributes to diversification but also exposure to country specific risk at the same time. Government actions may be affected by the elevated risk of economic and, in some regions, (geo)political crisis, increasing their impact on Zenith Pure Oil’s operations.	·   Continuous monitoring of the (geo)political risk, compliance with local regulations and international sanctions ·   Investment opportunities are valuated with quantifying of country risk in discount rate
Reputation risk	Zenith Pure Oil, as a major market player and employer in the region with a sizeable operational footprint, operates under special attention from a considerable number of external stakeholders.	·   Stakeholder governance processes introduced to monitor and adjust to any reputational risks
Climate change risk	Transition and physical risks associated with climate change have the potential to negatively impact Zenith Pure Oil’s current and future revenue streams, expenditures, assets and financing.	·   Zenith Pure Oil’s transformational strategy ·   Several operational steps taken to mitigate physical risks emanating from climate change (see TCFD disclosure)
Capex Project Execution Risk	Projects are delayed or less profitable than expected or unsuccessful for numerous reasons, including cost overruns, higher raw material or energy prices, longer lead time in equipment deliveries, limited availability of contractors and execution difficulties.	·     Disciplined stage gate process across Capex project pipeline ·     Dedicated team to identify risks at earlier stages, plan for mitigation or avoidance by linking potential risks with schedule and budget to build realistic estimates and following it up through the project lifecycle ·     Supplier selection criteria, audits

Human Capital Risk

The Group's ability to implement its 2030+ Strategy is dependent on the capabilities and performance of its people, management, experts and technical personnel. Unavailability of skilled workforce may lead to disruptions in the operation.

·     HR framework to attract, develop, reward and retain employees ·     Capability development for all employee levels to ensure future-proof skillset ·     Intergenerational collaboration to enhance internal knowledge transfer ·     Focus on digital transformation, and employee experience ·     Developing innovative and collaborative culture ·     Working environment and conditions framework in order to attract and retain diverse talents

 

ESG risks are covered and considered as part of the following topics (including but not limited to): Climate Change, Human Capital, Physical asset and process safety and equipment breakdown risk, Cyber Risk, Fraud Risk, Pandemic Risk, Regulatory and sanctions risk.

Risk Review Process in 2023                                                            

Risk owners in the Group identified, analysed and evaluated their major risks during 2023 – both on medium-term and long-term time horizon - and defined and/or updated the relevant mitigation plans where it has been necessary. Risk reports have been discussed by the Finance and Risk Management Committee of the Board of Directors and the Audit Committee.

Due to continued geopolitical tension in 2023, the Group still considers related risks, such as  sanctions, regulatory as well as supply-related risks, elevated and implements mitigation measures.

Supply-related risks: The Group has elaborated the crude diversification strategy; alternative crude slate was defined, relevant capex projects defined and started. Supply chain difficulties have been addressed, mitigated by stock, supply chain and supplier management actions.

Regulatory and sanctions risks: