We all know that sentiment and government responses to the Covid-19 virus have hit the market. Much newsprint, internet traffic, airwaves and broadcast time have been dedicated to this subject.
Since February 21, the NZX has dropped by a significant 22 per cent from its previous highs (at the time of writing).
Over a similar period, fuel retailer Z Energy has moved slightly more (down 29 per cent). For a business whose self-stated ambition is to be a "world class Kiwi company", this is a sharp fall from grace. The fall is even more pronounced from July 2018 — around a 60 per cent reduction from its $7.60 share price.
It might surprise readers to learn that Z has been operating in a growing industry. Fuel volumes have grown by 18 per cent since 2014, after nearly a decade of zero growth before that. That correlates with a strong GDP performance across New Zealand, including increasing population, freight and air traffic.
Digging into the numbers should assuage some of our guilt (well, a little). Most of the growth has been in "mid-distillate" volumes (diesel and aviation fuel) that support commercial transport operators and airlines.
A benign environment then? Hardly. Z has been feeling discomfort over the past couple of years, culminating in the Government's recent Covid-19 response announcement.
Scrutiny over industry margins and regional price differentiation, significant margin pressure from new entrants and efficiency challenges when compared with its legacy competitors (BP and Mobil) form a systemic backdrop to Z's new challenges created by Covid-19.
In December, the Commerce Commission's Retail Fuels Market Study recommended the introduction of a spot price regime based at fuel storage terminals across the country. More on that later.
In its 2019 annual report, Z itself estimated that unmanned sites now made up 15 per cent of retail fuel demand (some of which it supplies), contributing to a reduced margin and Ebitda guidance (to $350m-$380m) in December. The company estimates a $90m impact on margins. On top of that, refining margins are also poor, as global demand begins to slump.
Efficiency challenges, as compared with its legacy competitors, are perhaps more arguable. Nonetheless, Companies Office financial returns for BP and Mobil show a trend of significantly higher returns on total assets compared with Z. Meaning that Z either has too many assets, or not enough net profit to compete effectively when times get tough. And it's now official — times are tough.
The emerging volcano: Covid-19
Even without Covid-19, Z's net profit for the 2020 financial year is likely to be below $100m, its lowest level since its Caltex acquisition in 2016. The 2021 year isn't shaping up to be any better.
Aviation fuel makes up a hefty portion of industry volumes — around 23 per cent of total fuel demand last year.
The Government's response to Covid-19 will exacerbate the more systemic issues facing Z in its battle with its competitors, small and large.
Assuming that Z holds a 40 per cent-ish share of the jet fuel market and a demand drop of around 50 per cent, that could be a further hit of between $15m-$25m to Z's already strained Ebitda for the next financial year.
And there's that Commerce Commission-led study. It estimated that consumers would be better off by $400m each year if a viable wholesale market could be established. Z's share of that is an eye-watering $180m, although their announcement of a $90m loss of retail margin (about 4c a litre) during this financial year probably accounts for half of that.
Still, if the Commerce Commission is to be believed, a further $90m margin reduction, coupled with loss in aviation volume, would result in a post-tax loss for Z in 2021.
The newer breed of fuel competitors (including Gull) have the least to lose in this brave new world. Recession means their core retail demand may not grow much, at least without investment to steal market share off others, but at least they will continue to return positive cashflow.
The big legacy competitors (BP, Mobil), like Z, will take a big hit. But given their higher underlying asset returns, they are likely to remain profitable. In a period of sustained, slow or no growth, that underlying efficiency becomes a strong advantage — one that Z will have to address head-on in its own cost and asset base.
And sea monsters?
There is also the matter of a collapsing oil price and its impact on Z.
Reduced demand and a spat between Saudi Arabia and Russia resulted in a huge slump in global oil prices this month, with barrel prices roughly half what they were a fortnight ago. This is unlikely to have any long-term impact on Z from a fundamental profitability perspective.
But it's the speed and timing of this oil price shock that may cause an issue. The industry prices oil (and fuel) on "replacement cost" rather than the actual historic cost value of the stock in its tanks — which is why retail pump prices in New Zealand rise and fall relatively quickly in response to global oil market movements.
Z reports in both "historic cost" (as it is required to do under accounting standards) and "replacement cost". The large drop in oil prices could create a further "historic cost" negative impact this year, as stock bought at a high price a few weeks ago is now being sold at a lower "replacement cost" basis.
That same impact could also flow into next year's accounts, as crude oil purchases made in February are unlikely to have been shipped to New Zealand, refined, distributed and sold in service stations before the end of the financial year in March.
From a historic cost perspective, the company is essentially selling product for less than it paid for it (although in the "replacement cost" accounts, there is minimal impact).
Whatever you might think of the different accounting treatments, cash is king right now.
For Z, there is likely to be a one-off negative impact. It depends on Z's payment terms as to whether it hits this financial year or next and relies on assumptions as to the timing of Z's crude oil and refined product purchases. Z's hedging policy may also influence the impact.
A rule of thumb analysis shows a one-off negative cash hit of around $20m-$30m (unhedged).
Of course, if oil prices suddenly rise again, that could disappear very quickly.
World markets might have a Covid-19 hangover right now. Even without that, however, it's difficult to see how Z can chart a safe passage home for its shareholders without creating options for change within its business.
Shareholders will be looking forward to how Z can challenge itself to be the "new disruptor" in the industry in the coming year and set a new competitive baseline for sustainable performance.
Z is due to announce its 2020 financial year results on May 7th.