Covid did not have a huge impact in terms of fundamental agronomic demand. Overall acreage under crops was largely unchanged, water availability was better than last year, most importantly major crops such wheat, rice, cotton, potatoes had better economics.
‘GIDC decision does not serve the national interest’
Nadir Salar Qureshi is the Chief Executive Officer of Engro Fertilizers since December 2018. He joined Engro Corporation Limited in March 2017 as Chief Strategy Officer.
He completed his MBA from Harvard Business School, and his Bachelor’s and Master’s degrees in Nuclear Engineering from MIT. He brings with him expertise in multiple sectors across GCC, Turkey, Australia, India, ASEAN, and EU. He is also experienced in consulting, private equity and finance.
Nadir began his career with Engro Chemical Pakistan Limited as a Business Analyst and then moved on to organizations such as Hub Power Company, Bain & Company, Carrier Corporation and Abraaj Capital, leading up to his most recent role as Chief Investment Officer at Makara Capital in Singapore.
Nadir is a Director on the Boards of Engro Fertilizers Limited, Engro Energy Limited, Engro Polymer Limited, and Engro Vopak Terminal Limited.
BR Research recently spoke with Nadir on the burning issues surrounding the fertilizer industry of Pakistan, such as the court’s decision on GIDC, sales tax regime for fertilizer dealers, potential impact of locust attack, among others. Below is an edited excerpt of the conversation.
BR Research: Let us start with this situation around the urea industry. The urea offtake was considerably lower despite reduced prices. Could you walk us through the reasons?
Nadir Salar Qureshi: Let me give you some context. The year started at the back of a bumper December, which meant we entered 2020 with significant channel inventory.
It led to a slow start and then the GIDC removal happened, as the government took down GIDC by almost Rs400 per bag. Originally, the impact on us was around Rs160/bag, because around 60 percent of our gas is fixed and inclusive of all taxes, duties, levies, fees, and charges.
We were the first company to reduce the prices by Rs160/bag and then the industry followed us. But then Covid hit the country, and we anticipated the impact it was going to have on the economy, and we proactively decided to reduce the prices by another Rs240/bag. This was of course in the interest of our company as well, as our sales had suffered due to the large delta in prices, with the competitors.
Prior to that, dealers were selling the product at our market price while buying it from others. At the end of the day, Pakistan is a balanced urea market.
If we had just waited, we would have sold our produce eventually. But we decided it was going to be a tough year for the economy and took this decision with the potential of a Rs7 billion hit to our P&L. But the benefit passed on to the industry was Rs28 billion, because the prices came down across the entire industry’s sales.
BRR: How much of an impact has Covid had and is having on the agriculture sector, in terms of the crop results and the farm economy?
NSQ: Thankfully, Covid did not have a huge impact in terms of fundamental agronomic demand. Overall acreage under crops was largely unchanged, water availability was better than last year, most importantly major crops such wheat, rice, cotton, potatoes had better economics.
As the sales had started to pick up and the government announced the massive subsidy program for agriculture. The sentiment in the market changed and the buyers started to demand products at subsidized rates, which was not there in the market. The market slowed down tremendously in April and May.
By that time, the government finally decided in the third week of June to have a targeted subsidy program. That scheme had earlier been phenomenally successful in Punjab.
All provinces were not ready for this and there was great uncertainty around it. Finally, the government decided to delay the program for the next crop season and that too only offer subsidy on phosphate fertilizers.
That is where clarity came in the market, but urea sales were still down by 8 percent year-on-year in June 2020. July brought in even better numbers and the industry was down only by 3 percent year-to-date.
The situation stabilized by the end of June, and we have the highest ever June sales in the history of the company. From an agronomic and inventory perspective the industry is now in a good place, and I expect the calendar year agronomic demand will end close to the 5-year average volumes.
BRR: What are the most significant headwinds you see facing the industry in general, and Engro Fertilizers in particular?
NSQ: The government in the meanwhile felt the need to restart the LNG plants for urea fertilizer production. The rationale for the decision is best known to the government. The government is now going to provide subsidy on LNG to the tune of Rs2 billion.
It is the government’s choice, but we believe the market was adequately supplied from indigenous based production. Secondly, there was nobody complaining of fertilizer prices having become unaffordable, instead due to oversupply urea was being sold at a discount till July end.
Urea prices ended last year at around Rs2,040 per bag last year, and this year it was selling at Rs1,550/bag. Imagine the prices have come down by over Rs500/bag of urea.
Indigenous gas production is adequate to meet demand and we started the year with near all-time high safety stock, yet the government felt somehow urea affordability and / or stocks are an issue. Their decision appears to be a solution looking for a problem.
BRR: How big of a headache could the locusts be?
NSQ: The locusts that are already in the sub-continent have been very well-managed and have hardly impacted 2-3 percent of domestic agricultural output. The real fear is a mega swarm, which is potentially four to five times bigger than the current size, currently in the horn of Africa.
The swarm is expected to make its way into Pakistan anywhere between 30 to 60 days from now (August 13, 2020). That could coincide with cotton and rice crops being in full bloom.
God forbid, if the damage is anywhere near the potential of a swarm that size carries, we could end up losing 25 percent of our standing crop, which is a catastrophic number for the country. And our agriculture cycle works in a way that the farmer usually uses the sale proceeds of one crop to plant the other. And if one goes bad, then the agriculture engine of the nation stutters.
What gives us confidence is that the National Disaster Management Authority (NDMA) has a very profound and deep understanding of the issue. They have mobilized the armed forces who working with provincial resources are taking a number of measures to manage the situation.
We have lent our support as well to this initiative. We are cautiously optimistic that the locust situation will be reasonably well looked after. You must remember Pakistan has not had a major locust attack in 27 years, and it will be a new challenge for us.
BRR: What is your best guess of the extent of crop losses in case a major locust attack happens?
NSQ: We really do not have precedence of the scale of potential attack we are talking about. What we do now is when Pakistan has had disasters such as flood in the past, we have seen agronomic demand fall by about 5 percent. But those are somewhat geographically limited. However, a locust attack, if it happens, will be across Sindh and Punjab, and it difficult putting a number on potential losses.
BRR: You have been very vocal on the government’s decision to have the dealers register for sales tax. What is your ground of criticism?
NSQ: To start with, there is a fundamental mismatch between input and output sales tax. Most of our dealers are registered for income tax but not for sales tax and to make things worse the government has disallowed input sales tax adjustment for sale to un-registered dealers. We have a remarkably simple value chain where most of our dealers operate at thin margins of 2 to 3 percent.
Registration would lead to a much higher withholding tax of 4.5 percent on them that leads them to losses. That is why they simply refuse to register even though we have repeatedly tried to convince them.
This is an anomaly that applies to the fertilizer sector only. The cement sector and others do not have this structure, and we have pled this case in Islamabad as well.
BRR: On the sales tax issue, the government’s intent looks around strengthening and documenting the chain. What is your response to that notion?
NSQ: We, have always supported documentation of economy and have raised these practical challenges in implementation with the FBR, and other ministries, that the tax structure for fertilizer today is not the same as other industries.
Please remember, we already deduct 1.4 percent from unregistered dealers which is twice of 0.7 percent deducted from registered dealers. Now the government wants to tax the other end of the chain.
We do not challenge the sovereign’s authority to impose tax, but it should be done in a thoughtful manner. Eventually, this will have to be passed on to the consumers, which will lead to higher product prices, and will have a detrimental impact on farmers’ affordability.
BRR: Why hasn’t the demand of urea grown over the years, as it has been stagnated around 5.8 million tons? And what role is Engro playing in promoting the use of balanced fertilizer application and towards the agriculture productivity challenge?
NSQ: People think of us as a urea-only company, as that drives almost 90 percent of our profitability, but this is a problem that we keep thinking about and is remarkably close to our heart.
In actual fact, we are the only company in the entire fertilizer sector that provides Seed-to-Harvest solutions where we provide key inputs across the entire agri-value chain including quality seeds, crop protection, specialty fertilizers along with urea and phosphatics, and even mechanization solutions.
In Pakistan we are very well supplied on the nitrogen nutrient as we have been educating farmers since 1968. Three generations of farmers have now understood that urea is a great product for agriculture productivity. Urea’s impact on yield is very well understood in Pakistan.
It is the impact of phosphatic (P) and potash (K) fertilizers that is not understood well. If the incremental rupee is spent on phosphatic fertilizer, it will lead to greater yield improvement.
DAP and Potash based fertilizers are largely imported and are expensive fertilizers, in comparison to urea, but the yield improvement is worth it. Our farmers are not yet educated to that extent.
We recently ran a program in Punjab where we asked farmers to provide plots and we provided all inputs.
The urea consumption was dramatically reduced, as we put in P, K, and other micronutrients. The average yield improvement was 15 percent, which is a staggering number in staple crops. Of course, the results will vary, but would directionally be the same if you do it on a larger scale.
The biggest improvement in yield will come from P and K. There is no reason to subsidize N in the country. The subsidy should be directed towards P and K instead.
Another area that will go a long way in addressing the agriculture productivity challenge is the seed quality. Today, Engro Fertilizers is the only fertilizer company that provides seed solution. And we are taking several steps to ensure farmers in Pakistan have better access to high quality seeds.
The application of urea is driven by acreage under crop, and if the acreage is flat, why would you apply more. However, we are massively behind P and K application in terms of global averages.
BRR: Could increasing the spending on P and K be possible done without reducing the spending on N?
NSQ: If you compare the agriculture spend of the Pakistani farmers with farmers in the emerging markets, we spend less.
Urea prices in Pakistan are 20-25 percent lower than any other country at most times. But in terms of application, our nitrogen application is adequately on average. But we are definitely not adequate on phosphatic application.
This is not a zero-sum game. If a farmer invests more in DAP, it will yield him more and that is the point. The size of the pie will increase, and he will have room to invest in DAP and other fertilizers. There has been enough empirical evidence that yields went up when the government ran programs for DAP subsidy.
Today we may be the biggest beneficiary of more nitrogen fertilizer use, but we still advocate higher spend on phosphate in the national interest, as the yields will go up. With better farm economics our farmers will have the income to invest more in higher quality seeds and specialty fertilizer to improve yields even further.
BRR: Is there a consideration of exporting urea at some point in the future?
NSQ: If you recall, in 2015, when LNG plants were allowed to operate and Pakistan produced in excess of demand, we were allowed to export. Even now, if the government allows, we will find room to export.
Afghanistan imports nearly 0.4 million tons of urea fertilizers annually, that is imported from various countries, unloads at Gwadar Port and reaches Afghanistan via transit trade.
Our production capacity at around 7 million tons far exceeds our demand of 5.8 million tons. There is a place for Pakistan to become an exporter in markets where we are competitively positioned.
Due to regulatory reasons, the industry is not permitted to export, as there is somehow this notion that Pakistan will be short of urea, which would appear to be why the LNG plants have been restarted.
Currently Urea produced on RLNG and Petroleum Policy Gases may provide significant relief to the fiscal and trade deficit of the country. Urea has the potential to become one of the leading exports of Pakistan.
BRR: Do you think the fertilizer industry has been significantly subsidized?
NSQ: There is this idea somehow that the fertilizer industry is a great beneficiary of subsidies. Pakistan has been a net importer of urea in the previous decade. The Fertilizer Policy 2001 was aimed at encouraging investment in the sector to make Pakistan self – sufficient. There were two basic foundations of that Policy.
One was to supply gas at comparable prices to the countries we imported fertilizers from. The other was to encourage investment in the fertilizer sector, and that is where the 70 cents gas came into play.
We spent a billion dollars setting up the single largest urea complex in Pakistan, and Fatima followed. It was an investment incentive and should not be confused with subsidy. And it worked the objective of the policy was fulfilled and Pakistan became self-sufficient in urea.
BRR: We understand the concept around concessionary gas, but that incentive will soon be gone for both you and Fatima.
NSQ: We had a distressed period due to non-availability of gas to our new plant before alternative gases were found. But the 2-year period we suffered was without any gas.
We feel that the contracts had time bound but had volume and heating value commitments as clarified by the ECC. While technically, the 10-year period expires earlier, but if you go by volume of supply, we should have another three years.
Let me tell you what has happened as a result of the Fertilizer Policy. Rs600 billion of value has been created for the farmers over a decade if you look at the delta between domestic and international fertilizer prices. The Policy worked brilliantly, as it created massive value for the farmers, solved the domestic production problem, and grew the tax base of the government of Pakistan.
Somehow, there is this mindset that the fertilizer players make excess profit on the backs of poor farmers. When instead there is a value transfer of more than 3 times to the farmers in terms of the gas price delta under the Fertilizer Policy and the lower prices farmers in Pakistan enjoy vs internationally traded urea
BRR: Now let us talk about the elephant in the room that is the Gas Infrastructure Development Cess (GIDC). How do you see the Supreme court judgment and the impact it is going to have on the industry players and the product prices?
NSQ: The Supreme Court is the apex court, and I am not a lawyer, so I am not qualified to comment on views around the technical legal issues. But if you ask me, this decision does not serve the national interest.
They are citing points of law, while I am talking from the national strategic interest. I am really struggling with the decision, because it was only a few months ago that the Supreme Court had come up with an absolutely brilliant solution, where they had opined that GIDC was a tax and the government had to demonstrate that the money collected thus far has actually been spent on gas infrastructure.
The industry at the times was being told that you do not have to pay until the government has spent the sums collected thus far on gas infrastructure.
The amount collected by the Government was around Rs 295 billion. By the time it would have happened, the companies would have had a chance to make arrangements for any further dues. But under the recent ruling GIDC is applicable on all gases, and we have 24 months to pay.
We, as Engro Fertilizers, have a situation, where we get a significant portion of our gases at rates stipulated under the Fertilizer Policy that is already inclusive of all taxes, duties, levies, fees and charges whatsoever, whether local, federal or provincial and hence the decision should have no additional implications on that.
On non-concessionary gases, we have been providing and so have the others. Under the SC decision, Rs19 billion must be paid in the next 24 months which has adequately been provided for.
But if concessionary gas also falls under the ambit, then that is an additional Rs39 billion. If suddenly, we have to pay Rs39 billion over the next two years that has never been provided for, you can imagine what that does to our dividend payout. We will have to borrow to pay taxes if the decision does indeed include these gases as well.
We were looking potentially at a billion-dollar project pipeline at Engro Fertilizers alone, seeing the growth opportunities.
You can well imagine what a hit of this magnitude will do our capability and appetite to make new investments. I am not sure how the Board and shareholders will react to this. And this will impact others in the industry as well.
BRR: How are you likely to respond to this decision. Could there be an industrywide reciprocal increase in product prices? Also, as you touched earlier, the judgement does indeed refrain the government from collecting any further in lieu of GIDC until the amount collected in expended on infrastructure projects.
NSQ: I will speak for ourselves. On non-concessionary gases, we have been providing. We will pay that as required under the law.
The problem comes if it applies on concessionary gas as well, because if it does, we will obviously seek a review. Because we see that situation as a violation of our contractual rights, as we have an agreement with the government of Pakistan as clearly stated in the Government’s Fertilizer Policy of 2001.
But beyond that, how we react to that is literally too early to say. The cash flow impact is massive, and it mops up liquidity. I would like to see the mechanism how the government will or has spent Rs295 billion on gas infrastructure. It will take years to even come close to spending that amount.
What is for sure is this decision reduces investable surplus available with large industrial business groups of this country, and that will dampen investment appetite. Furthermore, if indeed we are required to pay amounts that we have never been provided for that could potentially lead to a significant increase in prices to help fund such a shortfall.
Originally published at Business recorder