Rising Carbon Prices Will Erode Refinery Margins

Key Takeaways

• Rising global energy transition and tougher climate regulations will erode demand, inflate costs, and restrict profitability for S-Oil's fossil-fuel-centric operations.
  
• Continued reliance on traditional refining and limited diversification expose S-Oil to supply chain risks, stiffer competition, and diminishing investor interest for future growth.
  
• Tightening global supply, surging Asian demand, project execution, and favorable Chinese policy position S-Oil for higher margins, increased market share, and long-term profitability.

Catalysts

S-Oil Corporation manufacture and sell oil refining, lube, and petrochemical products in South Korea.

• The global energy transition is expected to accelerate, with increasing adoption of renewables and electric vehicles worldwide, which will steadily erode long-term demand for refined petroleum products and petrochemicals, ultimately leading to declining revenues and lower refinery utilization rates for S-Oil.
  
• Tougher international climate regulations and escalating carbon pricing mechanisms are likely to drive up operational and compliance costs for fossil fuel refiners, squeezing S-Oil's net margins and reducing overall profitability over the coming decade.
  
• S-Oil's continued heavy reliance on its Ulsan refinery and predominantly downstream-focused operations make it vulnerable to supply chain disruptions and prevent significant diversification into higher-margin growth sectors such as renewables or specialty petrochemicals, limiting future earnings growth.
  
• As global peers in China and India add more efficient and integrated refinery-petrochemical capacity and compete more aggressively on exports, S-Oil faces the prospect of worsening price competition and prolonged margin pressure, reducing its ability to improve net margins or grow earnings sustainably.
  
• Secular declines in institutional capital flows and investor appetite for oil-centric companies, driven by ESG mandates and sustainability concerns, threaten S-Oil's access to low-cost financing, possibly forcing higher borrowing costs and constraining investment needed for future growth, ultimately undermining long-term shareholder value.

S-Oil Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on S-Oil compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming S-Oil's revenue will decrease by 6.3% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from -1.3% today to 0.5% in 3 years time.
• The bearish analysts expect earnings to reach ₩129.9 billion (and earnings per share of ₩nan) by about August 2028, up from ₩-449.2 billion today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 61.9x on those 2028 earnings, up from -15.9x today. This future PE is greater than the current PE for the KR Oil and Gas industry at 10.7x.
• Analysts expect the number of shares outstanding to remain consistent over the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 8.47%, as per the Simply Wall St company report.

S-Oil Future Earnings Per Share Growth

Risks

• Refining capacity closures in the United States, Europe, and Japan, combined with limited new capacity additions in those markets, are expected to create a tighter global supply environment, which could support higher refining margins and stabilize or increase S-Oil's revenue and profitability over the long term.
  
• Robust demand growth for transportation fuels in Asia, especially Southeast Asia, is outpacing earlier forecasts even amidst global economic headwinds, suggesting stronger-than-expected future sales and bolstering overall revenue.
  
• The Shaheen Project is progressing on schedule and is expected to deliver world-class energy efficiency and cost competitiveness through integration and internal sourcing of feedstocks, which could lift net margins and enhance long-term earnings once it becomes operational in 2027.
  
• Chinese policy increasingly favors shutting down smaller, less efficient teapot refineries and consolidating around larger players, reducing regional oversupply risks and providing an opportunity for S-Oil to capture greater market share, which would likely increase both sales volume and gross profit.
  
• Major unplanned maintenance and delayed ramp-up at new large-scale refineries outside of Asia (such as in Nigeria and Mexico), along with steady restructuring in China, are likely to limit global product oversupply and support continued export demand from S-Oil, positively impacting revenue growth and market share.

Valuation

• The assumed bearish price target for S-Oil is ₩54345.33, which represents two standard deviations below the consensus price target of ₩73631.82. This valuation is based on what can be assumed as the expectations of S-Oil's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of ₩90000.0, and the most bearish reporting a price target of just ₩52000.0.
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be ₩28632.9 billion, earnings will come to ₩129.9 billion, and it would be trading on a PE ratio of 61.9x, assuming you use a discount rate of 8.5%.
• Given the current share price of ₩61200.0, the bearish analyst price target of ₩54345.33 is 12.6% lower.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.