Moody's: Depreciation of Turkish lira creates headwinds for SOCAR


August 17, Fineko/ On Monday, the Turkish lira exchange rate hit another record low, weakening to about TRY 6.9 against the US dollar, amid growing political and economic tensions between Turkey (Ba2 review for downgrade) and the US (Aaa stable).

The lira strengthened to about TRY6.5 per US dollar on Tuesday, after Turkey’s treasury and finance minister announced a package of measures to support the lira and Turkish banking system. However, exchange rate volatility and the depreciation of the lira, which has lost about half of its value over the last 12 months, will delay the State Oil Company of the Azerbaijan Republic (SOCAR, Ba2 stable) recouping the investments it has made in Turkey that have been largely financed through US dollar denominated funding. SOCAR’s subsidiaries operating in Turkey are also likely to contribute less to SOCAR's consolidated EBITDA in Azerbaijani manat (AZN) or US dollar terms than we initially expected.

The lira has been weakening against the US dollar for several years, depreciating by more than 70% over the last five years and losing more than 40% of its value since the beginning of 2018. Turkey's vulnerable external position, raising the risk of severe pressure on the country's balance of payments, was among the factors behind our decision to place Turkey’s Ba2 ratings on review for downgrade on 1 June 2018.

SOCAR has substantial exposure to Turkey with revenue generated from sales in Turkey comparable to that generated from sales in Azerbaijan (about AZN5 billion in 2017). The company’s noncurrent assets located in Turkey made up 20% of its total assets as of the end of 2017. SOCAR operates in Turkey through its 87%-owned subsidiary SOCAR Turkey Energy A.S (STEAS). STEAS indirectly controls 51% of Petkim Petrokimya Holding A.S. (Petkim, B1 stable), the sole petrochemical producer in Turkey, which has a domestic market share of about 20%. The second asset that STEAS owns, via 100%-owned Refinery Holding AŞ (RHAS), is a 60% stake in SOCAR-Turkey Yatirim AŞ (STYAS), whose key asset is its 100% stake in STAR, a $6.3 billion refinery at the Petkim site. Construction of STAR started in 2011 and the refinery will start operations in October 2018. SOCAR co-owns STAR with the Ministry of Economy and Industry of the Government of Azerbaijan (Ba2 stable), which owns 40% of STYAS.

STYAS’s investments totaled AZN12.2 billion ($7.2 billion) as of 31 December 2017, mainly represented by the noncurrent assets of STAR refinery. The refinery will have a 10 million tonnes/year oil refining throughput, focusing mainly on the domestic market. It will be ramped up during 2019 and produce about 5 million tonnes (mt) of diesel, reducing Turkey’s dependence on diesel imports, as well as 1.6 mt of naphtha, reformate, petroleum coke and liquefied petroleum gas (LPG). The refinery will provide Petkim with 1.6 mt of naphtha feedstock and 270,000 tons of mixed xylene annually under a 20-year offtake agreement. The refinery has been constructed on a project finance basis with about $3.3 billion provided by banks and $3 billion in equity contributions from SOCAR and the government of Azerbaijan. SOCAR injected the equivalent of AZN587 million ($345 million) in equity contributions into the share capital of STYAS in 2017 and we estimate, that it will have to contribute about $0.6 billion in 2018.

Lira depreciation will lengthen the payback period of SOCAR’s investments in STAR in AZN or US dollar terms. STAR’s management in 2017 estimated diesel consumption in Turkey will grow to 25 mt by 2019 from 22 mt in 2016 (more than half of demand is satisfied by imports). Although demand for chemical and petrochemical products is strong in Turkey, and consumption is likely to continue growing, there is a risk that the refinery will not be able to fully pass on higher feedstock costs of imported crude oil in local currency terms to domestic consumers of oil products. This may compress our EBITDA estimates of STAR once it is ramped up (about $350 million-$450 million per year), while the revaluation of debt will increase debt servicing costs in local currency terms, delaying when SOCAR can start benefiting from the STAR project via dividends received. STAR is accounted for as a joint venture under the equity method in SOCAR’s financial statements, which will limit the direct impact of lira depreciation on SOCAR’s leverage. However, lira depreciation will lead to a revaluation of the foreign currency debt raised by STYAS to fund STAR's construction and reduce the net asset value in STYAS attributable to SOCAR.

As Petkim is a consolidated subsidiary of SOCAR, lira depreciation leads to a revaluation of largely foreign currency debt at the Petkim level (Moody’s adjusted debt of Petkim was equivalent to $1.4 billion as of 31 December 2017), which, if not fully offset by commensurate EBITDA expansion, will raise SOCAR’s leverage. As a naphtha-based chemical producer, Petkim is exposed to volatility in crude oil prices, which have a high correlation with naphtha prices. About 80% of Petkim’s cost base relates to raw material purchases, mainly naphtha, which will grow in local currency terms as a result of lira depreciation. Higher feedstock prices, if not promptly passed on to customers (70% of products are sold in Turkey), can quickly erode profit margins and cash flow. The value of SOCAR's investment in Petkim has also been reduced by lira depreciation. SOCAR bought its 51% interest in Petkim in 2008 for over $2 billion. As of 13 August 2018, SOCAR’s stake in Petkim was worth $0.8 billion on the Istanbul stock exchange, with the valuation in US dollar terms largely suppressed by lira weakness.

Finally, from a longer-term perspective, 13% of STEAS belongs to Goldman Sachs International (GSI, A1 negative), which bought the stake in August 2015 for $1.3 billion. GSI simultaneously entered into a put option agreement with SOCAR, with the latter committing to buy back the shares held by GSI, at a specified price, if the planned IPO of STEAS in 2021 does not occur. If the geopolitical and economic woes in Turkey, exacerbated by lira depreciation, are sustained, SOCAR’s plans to conduct an IPO on attractive terms by 2021 may be put in jeopardy. This could lead to GSI exercising its put option, which would raise SOCAR’s leverage.