Edited Transcript of 096770.KS earnings conference call or presentation 6-May-20 1:00am GMT

Seoul May 18, 2020 (Thomson StreetEvents) — Edited Transcript of SK Innovation Co Ltd earnings conference call or presentation Wednesday, May 6, 2020 at 1:00:00am GMT

SK Innovation Co., Ltd. – Head of Corporate Planning

SK Innovation Co., Ltd. – Chief of 2nd Finance Office

SK Innovation Co., Ltd. – Head of Finance Division

Samsung Securities Co. Ltd., Research Division – Analyst

S&P Global Ratings Inc. – Credit Analyst

[Interpreted] Good afternoon. I am [Jae Hoon Lee], IRP at SK Innovation. Thank you for taking time to join SK Innovation’s First Quarter 2020 Earnings Call. Today’s presentation has yet to be reviewed by our external auditor, so the results are subject to change based on such review.

Now I will hand it over to the CFO, Mr. Myung-Young Lee, for the presentation.

Myung-Young Lee, SK Innovation Co., Ltd. – Head of Finance Division [2]

[Interpreted] Good afternoon. This is Myung-Young Lee, CFO of SK Innovation. I would like to thank our shareholders and investors for your continuous interest in the company.

Today, I will present our first quarter 2020 performance. After which, we will have a Q&A session. On the call with me today are executives from SK Innovation and its major subsidiaries to answer your questions.

First, let me go over the first quarter full company performance, including sales and operating profit. To talk about the top line, a decline in petroleum product prices triggered by the fall in fuel, crude and weaker sales volumes caused sales to decrease KRW 625.5 billion quarter-on-quarter to KRW 11.163 trillion. Weaker petroleum and petrochemical product margins and higher inventory-related losses took operating profit down by KRW 1,897.7 billion quarter-on-quarter, leading to an operating loss of KRW 1,775.2 billion. On the nonoperating side, FX-related losses of KRW 104.7 billion, net interest expenses of KRW 69 billion, asset impairment losses of KRW 65.6 billion, derivative-related gains of KRW 27.2 billion and equity method losses of KRW 44.2 billion added up to nonoperating losses of KRW 272 billion.

Next, let me go over the balance sheet. As of the end of the first quarter, total assets stood at KRW 38,519.5 billion, a decline of KRW 1.066 trillion versus the end of 2019. Tangible assets increased as capital expenditure increased, but the plunge in crude prices decreased the value of inventory assets. Total liabilities was KRW 22,166.5 billion, an increase of KRW 850 trillion — billion versus the last year as debt increased. The debt-to-equity ratio was 18.5% higher at 135.6%. In addition, gross debt stood at KRW 14,034.1 billion, up by KRW 2,903.1 billion versus the end of last year. And net debt grew KRW 2.179 trillion to KRW 8,737.9 billion during the same period.

Now let me move on to the market environment and first quarter performance of each business. Let me start with the refining market overview. To start with first quarter crude prices, the OPEC place failed to agree on additional production cuts while Saudi Arabia and Russia engaged in market share competition. The COVID-19 outbreak hurt demand for oil, offsetting the supply demand balance. All in all, resulting in the plunge in crude prices.

In the first quarter, refining margins weakened significantly quarter-on-quarter due to a drop in refinery and product demand following COVID-19 and the lagging effect of the oil price fallout. Gasoline crack rebounded temporarily as U.S. refiners had temporarily shut down, but depressed demand led crack levels to soften. In addition, if we look at diesel cracks, it also weakened because of less demand following the coronavirus. Kero crack, in addition, declined significantly due to the contraction in jet fuel demand.

Next, I will discuss the first quarter performance of the refinery business. On the first quarter operating profit, weaker refining margins following COVID-19 and significant inventory-related losses tied to crude resulted in operating profit decreasing KRW 1,747.4 billion quarter-on-quarter to end at a loss of KRW 1.636 trillion. The first quarter refining inventory-related losses, including the LCM, or lower of cost or market application, was KRW 941.8 billion. Second quarter refining margins are expected to remain weak as oversupply continues and demand remains depressed from COVID-19.

Now let me go over the petrochemical market. In the first quarter, olefin supply decreased because of TAs conducted by regional crackers and crude fell, leading to better olefin product spread quarter-on-quarter. On the aromatic side, low feedstock prices declined. Overall, polyester chain demand decreased and new regional PX capacity went online, boosting supply and driving prices lower. As a result, quarter-over-quarter, our metric spread only improved slightly.

Next, let me talk about the first quarter performance of the business on the next page. If we look at the first quarter, even as olefin spreads improved quarter-over-quarter, significant inventory-related losses were recognized in aromatics, driving the nosedive — driven by the nosedive in naphtha prices. The first quarter petrochemical operating profit decreased KRW 97.1 billion to record a loss of KRW 89.8 billion. In the second quarter, olefin capacity is expected to decrease because of regional cracker troubles and turnarounds, but COVID-19 is expected to dampen demand further, creating a weak market.

Looking at the PX market, which is the flagship of aromatics, the decrease in demand for clothing in North America and Europe has translated into an overall weakness in demand for the polyester chain.

Next, let me move to the lubricants business. Lubricant operating profit was KRW 28.9 billion, less by KRW 58 billion quarter-over-quarter caused by a decrease in sales volume from COVID-19 and inventory-related losses as feedstock prices fell. The market in the second quarter is expected to face sluggish demand since automobile OEMs have been shut down. In addition, lower crude prices will be reflected in base oil prices leading margins to narrow further.

Moving on, I will go over the E&P business. The E&P business generated operating profit of KRW 45.3 billion, an increase of KRW 4.1 billion quarter-over-quarter. Though sales volume decreased and complex selling prices declined, operating costs for Peru 88 and 56 blocks and depreciation on U.S. assets decreased more materially, resulting in an increase in operating profit.

Next, let me move on to the battery business. Operating losses for EV batteries totaled KRW 104.9 billion, KRW 7.5 billion better than the previous quarter. This improvement was driven by a decrease in SG&A, even though there were some initial upfront costs for new overseas factories. To meet customer demand, the company completed production facilities in China and Hungary at the end of last year and has started commercial production in the first half to sell to market. In addition, we are currently building a #2 plant in Hungary and our first facility in Georgia in the U.S. To fulfill orders from the U.S., we are planning to build a second production facility soon.

Next, let me move on to the I/E Materials business. Operating profit for I/E Materials posted KRW 27 billion, up KRW 3.6 billion versus the fourth quarter due to an increase in LiBS sales volumes for EV. The company continues to increase production capacity for LiBS. In the fourth quarter of 2019, 2 additional lines in Jeungpyeong started commercial production, taking total production capacity from 360 million to 530 million square meters. In addition, we are also on schedule with the construction of our global production hubs in China and Poland.

This is the end of our presentation, and we will now start the Q&A session. (Operator Instructions)

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Questions and Answers

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Operator [1]

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(foreign language) Now Q&A session will begin. (Operator Instructions) The first question will be presented by Young-chan Baek from KB Securities.

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Young-chan Baek, KB Securities Co., Ltd., Research Division – Analyst [2]

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[Interpreted] I would like to submit 2 questions. First question relates to the FX impact on your operating profit. The $1 cross FX rate had gone up, like to understand what impact that had on your operating profit line. And also on a pretax basis, you’ve mentioned there was impairment of around KRW 65.5 billion. Could you provide some more color on what that is made up of?

Second question has to do with your run rates for your plants and facilities. Can you provide what the utilization or the run rate is currently for your Ulsan and Incheon facilities and what your outlook is for the second half? And I understand that your VRDS facility went under commercial operation back in April. Could you also provide some more data as to what the current run rate is and what the outlook is?

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Jang-Woo Kim, SK Innovation Co., Ltd. – Chief of 2nd Finance Office [3]

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[Interpreted] I am Kim Jang-Woo, the Head of Finance Office. Responding to your first question on what the FX impact was on our operating profit, and I would also elaborate as to the one-off impact on the non-op side as well. In the first quarter, yes, there was an average of KRW 17 increase in the FX rate. And the FX-related impact on our refining operating profit was KRW 56.7 billion, whereas for the petrochemical P&L, the impact was very minimal.

On the nonoperating profit side, yes, there were one-off expenses that was incurred from our petrochemical business. With regards to #1 NCC and EPDM facility, we had accounted for asset impairment, which totaled KRW 65.6 billion. For the #1 NCC, it amounted to KRW 29.6 billion. For EPDM, KRW 36 billion.

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Dong-yeol Lee, SK Innovation Co., Ltd. – Head of Corporate Planning [4]

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[Interpreted] I am Lee Dong-yeol from SK Energy. Responding to your question about our run rate. If you look at our Ulsan CLX facility for the SK Energy, in light of the fact that due to the impact of corona and the decline in the demand for jet and gasoline and also the decline in the crack levels, basically, we have taken a very conservative stance in running our CDU facilities.

To elaborate a little more, we also have a scheduled turnaround for our #5 CDU plant. And so compared to the first quarter, we’re planning to cut about 150,000 barrels.

Now in terms of the VRDS plant, we were quite successful in early operation and commencement of the production. But due to the impact of COVID-19, the economic feasibility is slightly lower compared to our original projection. However, we have been quite optimal in utilizing our feedstock ratio. So at this point in time, we are producing at 40,000 barrels per day as per our previous plan.

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Operator [5]

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The next question is presented by Se Hyun Park from Nomura.

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Se Hyun Park, S&P Global Ratings Inc. – Credit Analyst [6]

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[Interpreted] I would like to post 2 questions. First has to do with the significant level of your inventory valuation-related losses. Previously, if you look at your chemical business, the inventory-related losses, the size of the loss, was not very significant. We’d like to understand the reason behind why, for this quarter, we see such a significant rise. Is it because of the naphtha-related aspect? Or is it because of the prices of your petrochem product?

Second question is on your battery business. Your previous guidance on revenue target was KRW 2 trillion. Does this guidance still stand? And what is your outlook for your operating profit or operating loss going forward? And I understand that you’re continuously building your facilities and plants in the U.S. But as you know, the judgment that was rendered by ITC in the U.S. was not favorable for your company. And also still, this case is pending at the Delaware Court of Law. So what happens if the eventual outcome of this whole litigation process works against you and what impact would that have on your building of the facilities in the U.S.?

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Jang-Woo Kim, SK Innovation Co., Ltd. – Chief of 2nd Finance Office [7]

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[Interpreted] I am Kim Jang-Woo, Head of Finance, responding to your question. You asked about the inventory-related losses included in our operating profit and why we see such a high loss arising from our petrochem business. As you know, in the first quarter, we’ve seen a significant plunge in the Dubai price — Dubai crude oil price of $30, and also petroleum product prices plunged as well.

As a result, in Q1, the inventory-related losses, that’s including the LCM application included in the operating profit line item, amounted to KRW 1,113.8 billion. Looking at this by different business lines. For our refinery business, it’s KRW 941.8 billion; petrochemical, KRW 139.3 billion; lubricant, KRW 32.7 billion.

And the reason why we see such a high-rise in inventory-related losses for our petrochemical business is, yes, there was an impact from petrochemical product portfolio, but also there was a significant decline in terms of the naphtha price, the feedstock.

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Unidentified Company Representative, [8]

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[Interpreted] Yes, I am [Yoon Hyeon-Joo], I’m from the battery business support team. Back in the fourth quarter of 2019, we communicated that our top line and profit guidance for year 2020, relating to our battery business, we’ve communicated that our top line revenue target will be KRW 2 trillion. But as you would understand, due to the impact of the COVID-19 outbreak, the volume is bound to be adjusted at our OEM side. So our position at this point is that we will be downgrading or we will be adjusting downwards our original guidance by around 10%.

So it’s inevitable that we had been pushed to revise our revenue target, but we are going to do our utmost in order to maintain our P&L target. We will do our best to be effective in managing our yield rate and also optimize our cost structure. So we were set for ourselves and stretch targets so that despite newly built capacities coming online, we will do our best to minimize — or we will do our best to minimize any impact on the P&L side on a year-over-year basis.

So before the full-blown fallout from the COVID-19, we’ve taken a preemptive approach and have managed our business with a high level of vigilance. We have set for ourselves multiple number of scenarios and strategies and have been very closely monitoring the developments in the overall market and the industry. So we live in a period where uncertainties are bound. However, we will be very nimble and fast and flexible in responding to the changing situation so that we can achieve our profit and P&L target.

Recently, within the company, we’ve made the decision to add a second plant in the United States. And as a result, we will have a plant that will have a production capacity of 20 giga on an annual basis.

You also asked about the potential impact from the litigation process, but please understand that it’s difficult for us to, at this point, share with you any more details on our position as it may impact the outcome of that judgment.

Having said that, we are very closely monitoring many different developments, and we’re making preparations accordingly. So we will respond appropriately when that situation arises.

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Operator [9]

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The next question will be presented by Woo Ho Noh from Meritz.

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Woo Ho Noh, Meritz Securities Co., Ltd., Research Division – Analyst [10]

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[Interpreted] Thank you for the opportunity to ask questions. There are a couple of questions that I would like to ask you. First, in recent news, I think that there was a mention that in the L.A. Times that one of SK Energy’s subsidiaries was subject to actions that were taken against litigations or actions that were taken because of collusion related to, overall, the gasoline. Could you please explain what the actual nature of that action would be? And in addition to that, if we look at the second quarter or the third quarter, what type of costs, if any, would you expect be related to that action that has been taken?

The second question that I would like to ask you is about your overall battery business. You had mentioned that you would be developing and building out your #2 factory. So taking that new capacity in addition, could you please go over your capacity outlook for the next couple of years up to 2023? So for each year, how do you see your capacity building out year-over-year?

In addition, for the battery business, there’s a lot of discussion about new types of battery technology or new forms of battery. For example, solid-state batteries are being mentioned and other new types are also being discussed. Does the company have any plans to engage within these new forms? Or do you believe — and what plans would you have in those areas?

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Jang-Woo Kim, SK Innovation Co., Ltd. – Chief of 2nd Finance Office [11]

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[Interpreted] So this is Kim Jang-Woo, and maybe I can discuss and address the first question that you had. With regards to the actual action, it has been taken against SK EA, which is our trading company in the U.S. and there were accusations of price collusion. So this was a news report that hit on May 4, and it was related to a situation that took place in 2015. At the time, ExxonMobil had experienced an overall blowup of one of its facilities. And as a result, there were some implications from that. So the overall acquisition that has been taken is that 8 companies, including SK EA and also Vitol, were in a position in which they took on just interest from the people of California.

So on behalf of the California public, the California state government has raised a civil litigation. And with regards to the details of the content and the situation going forward, we have not been conveyed with that information as of today. Going forward, as much as we get informed and as much as necessary, we will share any updates through disclosures.

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Unidentified Company Representative, [12]

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[Interpreted] So this is the head of the battery business support office. And maybe I can address your question about the battery business. For the battery business, as you have mentioned, we continue to expand our global capacity. So therefore, we have said that we are expanding in Europe, China and in the U.S. So for these capacity plans and expansion plans, if they go ahead according to schedule, then that would take our overall capacity in 2022 over 60 gigawatt hours. And in 2023, over 70 gigawatt hours.

And maybe to move on to your next question. In the case of our overall research on the battery side, including solid-state batteries, of course, we continue to conduct studies about the next-generation of EV batteries. And therefore, this is an exercise that we are engaging with various professionals around the world so that we can make sure that we have a lead within setting the standards and we have various development road maps that we have in place.

And in the case of the EV batteries, of course, we are focused right now in getting higher energy density versus the lithium-ion batteries that are out with market. So we are looking at the next generation from that standpoint. In addition, for this initial development, we want to ensure that we have the development take place in an efficient manner, and that we minimize the risk related to that. So we have opted for an open innovation type of standpoint that we are taking right now. So as a result of that, we have formed a global consortium, of which the first consortium was formed last year.

So including solid-state batteries, of course, various technologies will continue to be explored, and we want to make sure that we have the right footing within — with regards to this new technology. So therefore, there will continue to be other global consortiums that we will participate in. However, as of now, if we look at where the state of development currently stands, we do think that some more time will be required until we can reach the level in which that technology would actually be tied in with a business model.

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Operator [13]

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The next question will be presented by Jae Sung Yoon from Hana Financial Investment.

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Jae Sung Yoon, Hana Financial Investment Co., Ltd., Research Division – Research Analyst [14]

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[Interpreted] My first question relates to the recent trends where the jet fuel margin has been quite weak. I would like to understand how you are going to respond to this trend. Do you plan to convert more to gasoline or other types of products — or excuse me, diesel, diesel or other types of products?

And my — and in the Q1, your RFCC run rate was above 90%. But in light of the current margin trend, I would think that this level of run rate would have to be adjusted as we go into the second quarter and third quarter. So what is your projection for the utilization of your RFCC facilities?

Third question is with respect to your plan to make investment into battery plants in the United States, would you need to consider sale off of some of the assets that you hold? Or would it be ample in terms of the resources — yes, in terms of the resources, would your free cash flow and financial position at this point, ample without any sales of assets? Could you provide some color on that?

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Dong-yeol Lee, SK Innovation Co., Ltd. – Head of Corporate Planning [15]

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[Interpreted] I am Lee Dong-yeol from SK Energy. Yes, the jet fuel crack had been very significantly weak in recent days. And so once again, our production-related position is that in terms of the run rates, we have significantly adjusted them, and we’ve taken a very conservative stance. For the CDU facilities, we have adjusted production-related moves, and therefore, we’ve made some adjustments into diesel and also kero distillates. Basically, we could take the kero distillates and do — and blend it with LSF, low sulfur fuel. So there are different types of responses that we are taking.

In terms of sales of jet fuel, basically, if you look at the exports — that exports of jet fuels, 50% is based off of term-based contracts. So the decline in dampening in the demand is somewhat offsetted because we have term contracts in place.

And relating to our RFCC facilities, in light of the significant decline in the crack levels, we are planning to significantly higher the production run rate in second quarter compared to the first quarter.

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Myung-Young Lee, SK Innovation Co., Ltd. – Head of Finance Division [16]

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[Interpreted] So I am the CFO, the Head of Finance Division, Lee Myung-Young, we will respond to — I will respond to your third question. You asked about the funds that will be employed for making investments into our battery business. Every year, we’ve been making around KRW 2 trillion of investment into our battery business. And for the second plant in the United States, basically, the expenditure will actually take place starting next year and the year after.

Battery business, as you know, is a business that has a quite long gestation period when it comes to the required capital. So to a certain extent, we do need to depend on raising debt. So the company is very mindful of not undermining our financial position in any way. That’s why, last year, we’ve sold off part of our Peru block and the monetization. And so we’ve done monetization of that existing asset. And we expect the actual money to be remitted, and it will come under our finances within this year.

But going forward, we will look at different methods to make use of our existing assets of monetizing them or securitizing them. We will look at various different options to make sure that it does not impact negatively our financial position.

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Operator [17]

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The next question will be presented by Min-Seok Won from HI Investment & Securities.

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Min Seok Won, HI Investment & Securities Co., Ltd., Research Division – Research Analyst [18]

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[Interpreted] There are 3 different questions that I would like to ask you. First is about the turnarounds that you are planning for the rest of this year. What do you foresee for the year until the end?

And the second is with regards to capacity additions that would be taking place on the refinery side. On the global landscape, what new capacity do you see coming online?

And for number three, the third question, recently, OSP has been falling. And I would like to know how that has been bettering the overall profitability of the company and what has been the impact from that.

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Jang-Woo Kim, SK Innovation Co., Ltd. – Chief of 2nd Finance Office [19]

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[Interpreted] So if we talk about the overall plans for each of the quarters, it would be that in the second quarter, we have the #5 CDU, the #1 RFCC and the #1 VRDS that we would be looking at.

In addition, if we look at the net capacity additions on a global basis for this year, it would be about 1.1 million barrels per day.

And with regards to the overall impact from the Middle East OSP, it is true that recently the OSP levels have been declining. And if you look at the announcements, the announcements of prices have been made for volumes that would be depleted or be used up into June. So as of the current time, in addition to that, of course, the COVID-19 situation provides a weak market backdrop. So that has been leading to the discounts. All in all, we do believe that this will be positive to our margin levels.

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Operator [20]

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The next question will be presented by Hyunryul Cho from Samsung Securities.

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Hyunryul Cho, Samsung Securities Co. Ltd., Research Division – Analyst [21]

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[Interpreted] I would like to post 3 questions. First, when do you think gasoline and jet fuel trend to normalize since it’s been impacted by COVID-19 pandemic?

Second question, would you adjust your CapEx-related plans on the backup, the COVID-19 impact?

And thirdly, do you have a year-end target for your net debt level?

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Dong-yeol Lee, SK Innovation Co., Ltd. – Head of Corporate Planning [22]

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[Interpreted] I am Lee Dong-yeol from SK Energy. Responding to your first question. Most of the refinery products have seen a dampening of demand on the back of COVID-19, and that weakness and softness continues. So when it comes to jet fuel and gasoline, we think that the current very weak trend will deepen as we enter into the second quarter. But once the COVID-19 situation somewhat comes to a close, we think that after that point in time, after probably month of June, there will be a gradual recovery.

So our company at this point has multiple number of scenarios for the gasoline and jet fuels as we closely monitor the change in the market backdrop. And we have countermeasures, quite steady and robust countermeasures in place.

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Myung-Young Lee, SK Innovation Co., Ltd. – Head of Finance Division [23]

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[Interpreted] I’m the CFO, I will respond to your CapEx and net debt question. So our CapEx projection for this year on a year-over-year basis, basically, we’re looking at upper KRW 3 trillion or end of KRW 4 trillion range. This will be our per annum CapEx, 60% of which will be invested into our battery and LiBS business.

In light of the recent decline in our performance as well as a significant level of external uncertainties, we are internally very closely reviewing and looking at different aspects so that we can very actively reduce the level of CapEx and OpEx.

When it comes to the level of net debt at the end of the year, basically, this amount is closely linked to our business performance. So it’s very hard for me to give you a specific figure at this point. Now having said that, based on our CapEx plan, a lot of the spending of the CapEx is really focused around the second quarter. So at the end of the second quarter, there may be some rise in the net debt. However, we will closely monitor the market situation and to make sure that we could find opportunities to reduce spending in different areas. And also in the second half of the year, we have proceeds from the sale of the Peru asset sales coming in, in the amount of KRW 1 trillion. So we do not think that as of the end of the year, we will see any significant rise in the net debt level.

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Operator [24]

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The next question will be presented by Oscar Yee from Citigroup.

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Oscar Yee, Citigroup Inc, Research Division – Director & Head of Pan-Asia Materials Sector [25]

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First question is, could you give us some idea about your current inventory in terms of the number of days or barrels for both crude and oil products? And how does this compare with the sort of normal range?

Second question is, I saw some news that you have rented some storage from KNOC. Does it mean that you currently are rerunning an inventory storage space? And could you also give us some idea about how much sort of surplus storage? Is it still available in Korea overall?

And final question is, just now you mentioned about 50% of your jet is sold based on term-based contract. Could you also provide some rough idea about — for your gasoline and diesel portion of your export? How much is term? How much is the spot?

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Dong-yeol Lee, SK Innovation Co., Ltd. – Head of Corporate Planning [26]

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[Interpreted] So maybe I can answer your questions based on an SKE basis. So this is Lee Dong-yeol from the Head of Corporate Planning for SKE and I would like to address your questions. So first, to talk about our crude overall inventory versus the end of 2019. If we look at the crude inventory as of the end of the first quarter, in actuality, there will not be any significant differences. So versus the overall storage capacity that we have, we do believe that we are maintaining an appropriate level.

And I’ll move on to the second point, in terms of our strategic reserves and what we are taking and keeping. Right now for the crude levels, there is a high-level inventory. And right now, in light of the fact that the freight prices are — is expensive, we want to try to utilize the spot price benefit as much as possible. So as a result of that, we have been leasing some capacity in Seosan from KNOC.

And in addition, to talk about how much exports represent with regards to our overall refinery products. As of the end of the first quarter, if we look at our overall portfolio, around 55% is sold through exports. And across our products, which would be, of course, the gasoline, diesel and jet fuel, this ratio is approximately the same.

So with this, we would like to wrap up the Q&A session and also the earnings conference call for the first quarter of 2020. Thank you very much.

[Portions of this transcript that are marked Interpreted were spoken by an interpreter present on the live call.]