Opportunities and options
By SHABBIR H. KAZMI
Aug 07 - Aug 13, 2000
The present government has plans to achieve higher GDP growth rate and to boost exports of cotton based products for the revival of the economy of Pakistan. To achieve the targets, efforts are being made to improve production and yield in the agriculture sector. Fertilizer is the backbone of agriculture. Pakistan has to add 2.5 million tonnes production capacity in next ten years to maintain self-sufficiency in indigenous production of urea. This can be achieved through debottlenecking of the existing plants and adding at least three new plants of 600 tonnes/annum between year 2004 and 2010. The factors governing the fresh investment are financial concessions, i.e. gas (feedstock) price, tariff on plant and machinery and level of corporate tax these factors determine the level of return on equity (ROE).
About 100,000 tonnes capacity must come on line during the year 2002 and the rest must follow a schedule. Therefore, the investors need a very clear cut policy within next couple of months. Establishment of a world class plant, 600,000 tonnes per annum, takes 5 to 8 years to commence commercial production. Mainly due to long drawn procedure for achieving financial close. To establish a plant of this size an estimated investment of US$ 300 to 400 million is required. However, the country enjoys a situation where capacity of 100,000 tonnes can be added by Engro and Fauji at an estimated investment of US$ 20 to 80 million within 3 to 4 years. Still, Engro and Fauji need a conducive policy, which can help in getting the desired ROE, to undertake such expansions. They need a clear cut policy regarding feedstock price and tariff on plant and machinery.
The surges in the international prices of Nitrogenous (urea) and Phosphate (DAP) demands that the country must maintain self-sufficiency in urea. Because the surges in international urea prices are more frequent and of higher intensity as compared to the surges observed in DAP prices. While the country enjoys a competitive edge in indigenous production of urea, manufacturing of DAP is not an economical proposal due to non-availability of quality phosphate rock in Pakistan. Therefore, a prudent option is to produce surplus urea for export to finance the import bill of DAP.
Deregulation of urea business in 1986 and DAP in 1993 coupled with duty free import of plant and machinery, tax holiday for a specified period and feedstock subsidy for 10 years have helped the country in doubling urea production capacity from 2.2 million tonnes to 4.3 million tonnes in the country. The GoP policy has helped in increasing indigenous supply of urea at a lower cost and also reducing dependence on imports. Since 1990 an investment of over one billion dollars has been made in the sector. Fauji, Engro, Dawood Hercules and FFC-Jordan are the major producers of urea. FFC-Jordan has the first ever DAP manufacturing unit in the country. The actual capacity utilization of urea plants has been above the designed capacity because 80 per cent of the installed machinery is less than 20 years old. The capacity utilization at Dawood has been slightly lower but it has been only because gas supply to the unit is curtailed during winter. However, with the discovery of new gas fields and expansion of gas transmission and distribution network in the country this problem will be overcome shortly.
According to industry sources Engro will be able to increase its urea production by 100,000 tonnes per annum through debottlenecking. The advantage of this addition is that the Company will not require any additional gas allocation. This capacity is expected to come online in the year 2002. Fauji will be adding another 100,000 capacity, through BMR, for which it requires additional gas allocation and the facility will be online in the year 2003. The country will need addition of another 250,000 tonnes in 2004 which can be achieved through BMR also. However, afterwards there will be a need to add plants of 600,000 tonnes each in 2005, 2008 and 2010. This calculation is based on a demand growth rate of 6 per cent.
Subsidy on feedstock
The pressure from multilateral lenders is increasing on Pakistan to abolish all types of subsidies and cross-subsidies. Is Pakistan the only country where subsidies are being paid? The reply is a very loud NO. Even the most developed countries, including the US, provide subsidy to farmers. However, one may argue about the mechanism and the level of subsidies paid in Pakistan. While the efforts are being made to ensure international prices for the produce to farmers, subsidies being paid on various inputs are also gradually been withdrawn. Fertilizer is an input on which the subsidy should continue for at least another decade. However, efforts should be made to reduce the level of subsidy on feedstock. This has become all the more necessary as the present government has expressed explicit intention to boost GDP growth rate by enhancing production and yield of agriculture sector. Since the area under cultivation is deficient in nutrient contents, the farmers have to apply larger quantity of fertilizer per acre to achieve higher yield in Pakistan. The per capita consumption of urea is still lower than the desired quantity.
Ever since the first fertilizer plant was established in the country, feedstock is being sold to the manufacturers at subsidized rate. The policy announced in mid eighties ensured availability of feedstock at subsidized rate as the GoP realized the need to increase indigenous production of both urea and DAP. At the same time the GoP also asked the urea manufacturers not to charge extra amount in case the landed cost of urea is higher than the cost of indigenously produced urea. So far the manufacturers have been withstanding their commitment despite the fact that international prices of urea have been higher. It was possible only because the quantity imported was low.
While the policy has helped the local manufacturers to earn higher profit, at times, the farmers were not asked to pay higher cost when international prices of urea touched the highest in 1995. Apparently the current resistance against subsidy is due to international prices of urea being lower than domestic prices which also forced the GoP to impose regulatory duty on imported urea. However, one should not forget that for nearly a decade international prices of urea were higher than domestic price. While the GoP was not paying the difference, as per policy, the burden was borned by local manufacturers. The sector experts say that while comparing the price of imported and indigenous urea the only basis is the cost at which the commodity is delivered to farmer not the FOB/C&F price.
In less than a decade the installed urea production capacity has been doubled at an estimated cost of over US$ one billion. Both Engro and Fauji have expanded the installed capacity and Fauji has also established FFC-Jordan to produce both urea and DAP. Whereas, Engro along with adding urea production capacity has diversified into jetty and tank terminal and PVC manufacturing plant. These are the joint ventures and foreign investment has come at a time when local investors were shy. Engro has undertaken another expansion programme. Such a colossal investment in fertilizer sector in the past was possible only because the profit margins were attractive.
The critics of GoP policy say that urea manufacturers in Pakistan have been reaping higher profit and hardly passing on the benefit to farmers. This may be partly right but partly wrong. It is evident that despite enjoying the incentive the companies did not distribute all the profit to shareholders. They also choose to reinvest their profit. The reason is that the ownership and management of these companies mostly belong to Pakistan which strongly believe that the increase in fertilizer production is a major contribution towards the growth of Pakistan's economy.
Therefore, at this juncture, it is necessary to ensure adequate supply of fertilizer, particularly urea, in the days to come. There is a need to increase installed capacity for urea production that too at the earliest to ensure adequate indigenous production. The current over supply is a temporary phenomena mainly due to lower offtake and marginal surplus. Keeping the annual growth of 6 per cent for urea demand, the additional capacity must come online strictly according to the plan. A factor which will determine the level of investment in the sector is feedstock price in the next decade upto the year 2010. Feedstock constitute nearly 70 per cent of the total cost of production of urea. Therefore, any investor would be keen to know about the GoP policy regarding gas allocation and its price up to the year 2010. Any attempt to make short-term policy can backfire.
It is necessary to understand the impact of increase in feedstock price at the profitability of fertilizer manufacturing companies. The GoP increased the gas price in the second half of 1999. The impact was 20 to 25 per cent reduction in the profit of urea manufacturing companies for the whole year. The recent 15 per cent increase in gas price, used for fuel, will further affect the profitability of these companies. The profitability will be affected for two reasons, higher cost of production and lower offtake.
However, some analysts say that historically urea manufacturers have always been successful in passing on any increase in cost of production to farmers. After the recent hike, they have already increased the price per bag by Rs 5 plus they will get the advantage of gains on inventory. Whereas others say that farmers have never been a looser. The GoP has been increasing the support price of various crops with regular intervals which enabled the farmers to pay higher price for agriculture inputs.
Global gas price
In the recent past Pakistan has experienced dumping of urea mainly from Middle Eastern manufacturers. To counter the influx of cheap urea the GoP imposed the regulatory duty. However, this is not a long-term solution and local manufacturers need to get gas at a cost whereby they can compete with other countries without the shield of regulatory duty. According to sector experts gas cost US$ 0.5 to 0.75 per MBTU to the fertilizer manufacturers located in Arabian Gulf. Whereas, Pakistani manufacturers get gas at US$ 1.4 to 1.7 per MBTU. It ranges from US$ 1.3 to 1.5 per MBTU for the Indonesian manufacturers.
Despite the fact that international price of urea was lower than the domestic prices, local manufacturers were able to export some quantity. Can this become a routine? Certainly export of urea can continue provided Pakistan is able to locate the right buyers. One such buyer is India. The Indian Punjab can become a big buyer due to its proximity to fertilizer plants in Pakistan. The mode of shipment can be rail or road. Since the commodity is voluminous freight becomes an important consideration. Similarly, Bangladesh and Sri Lankan markets can also be exploited. However, export orders can only be attained if Pakistan can offer attractive C&F prices dependent on FOB prices or cost of production. While upcountry units can export urea to India, shipments to Bangladesh and Sri Lanka can be made from FFC-Jordan with the least freight cost.
Since the basic raw material, high quality phosphate rock, is not available locally, the better option is to import DAP. FFC-Jordan has an installed capacity to produce 450,000 tonnes DAP per annum. There is no reason for Pakistan to establish more DAP manufacturing units. Import of phosphate rock is not economical as it contains two third clay which has to be removed. Even if phosphoric acid is imported it contain 50 per cent water. Therefore, the prudent approach is to enhance production of urea in the country, export the surplus quantity and use the proceeds to finance import of DAP.
The GoP faces a really tough situation. In the first instance it has to decide whether to continue subsidy on feedstock or not to continue it after the expiry of existing agreements. In case it decides not to continue the subsidy on feedstock, there will not be any increase in installed capacity, import of urea will further deteriorate the adverse balance of trade and above all farmers will be exposed to surges in international prices of urea.
The other alternative is to allow the local investors to form joint venture in Middle East for the production of urea and DAP and then import the commodities. This is not a prudent choice at all. Such a decision will cause massive outflow of capital from the country and adverse impact of import of finished commodities will always be there.
Some analysts suggest that the GoP may charge the feedstock at full price and pay a subsidy to the manufacturers as practiced in some other countries. However, some other analysts term this completely absurd idea. They say, why to ask for the payment of an amount which has to be refunded ultimately? The experience of following rebate and refund policy is not a very pleasant in Pakistan. Besides, this allows the government to follow 'arm twisting policy' which must be avoided.
Therefore, the most prudent approach is to announce the continued supply of feedstock at subsidized rate. It is true that feedstock price is around 40 per cent lower than the gas sold as fuel. However, this difference can be reduced by announcing annual increase at a fixed percentage. This will allow the manufacturers to optimize cost of production and the farmers to absorb price increase over a longer period of time.
A fact which must be kept in mind is that the gas will not be as low priced as it has been in the past. The raw gas price is now linked with international price of crude oil. On top of this, OPEC has already expressed its firm intention to maintain crude oil price between US$ 20 to 25 per barrel. Therefore, the GoP must take a long term perspective regarding feedstock price because the country needs expansion in urea production capacity.
The GoP and fertilizer manufacturers should also consider setting up NPK (composite type) fertilizer in the country. As the largest percentage of farmers is illiterate in Pakistan, they are often not able to apply proper dosage of various types of fertilizers. If composite fertilizer is bagged for application on specific crops it will help more in improving yield of various crops.
An interesting feature is that many West European fertilizer units are being closed because they have become uncompetitive. The reason being that the gas cost them US$ 2.5 to 3.1 MBTU which is too high as compared to other regions. Pakistan can relocate these plants. This will not be a new experience for the country. Engro has done the same in the past and the unit has been operating efficiently since 1994. Such relocations can help in bringing down the project cost ultimately reducing the cost of production. Therefore, it is imperative that the GoP should encourage import of these plants. The price of a new plant of similar capacity is around three times higher than the cost of a second hand plant. Import of such plants will also help the country in saving precious foreign exchange. The GoP must announce a comprehensive and conducive policy at the earliest to attract both local and foreign investment in the fertilizer sector.