Heydays are back for India’s largest public sector oil marketing companies namely Indian Oil (IOC), Bharat Petroleum (BPCL) and Hindustan Petroleum (HPCL). While falling global crude oil prices had led to a sharp fall in under-recoveries on retail fuels like diesel and LPG - petrol price was decontrolled in June 2010, and diesel in 2014 - margins in the fuel marketing business are expected to rise, providing a boost to EBITDA of these oil marketing companies (OMCs).
“An imminent expansion in diesel marketing margin is a key trigger for OMCs, in our view. It was capped at Rs 1.4 per litre (versus Rs 2+ per litre for petrol) for over five years. Marketing segment contributes 50-85% of EBITDA for OMCs and diesel is about 50% of volumes,” said HDFC Securities analysts in recent note.
Bhaskar Chakraborty, Oil & Gas sector analysts at IIFL echoes a similar view. “The three OMCs are on a very good wicket because private players RIL and Essar have not entered fuel retailing in a big way. Now that diesel price is fully decontrolled, there is a good scope of diesel marketing margins rising by 50 basis points from Rs 1.4/litre to Rs 1.9/litre over the next one year. The positive impact of higher margins on EBITDA will be Rs 1,000 crore for BPCL, Rs 800 crore for HPCL and Rs 2,100 crore for IOC.”
But, even if Reliance and Essar turn aggressive, it is unlikely to have a major dent on the profitability of the public sector OMCs given the increased break-even level for private players.
“Our IRR (internal rate of return) model indicates that to earn reasonable RoI (return on investment), new entrants require minimum diesel retail margin of Rs 1.6/litre versus Rs 0.7/litre prevalent prior to deregulation,” say Edelweiss analysts Jal Irani and Yusufi Kapadia in a report last month.
What’s more, over these years, the public sector OMCs have significantly upgraded their infrastructure that today has modern automated machines, leading to high brand recall and loyal customers. Importantly, for any other player to set up such a vast distribution network it would cost far higher than the cost these OMCs have incurred.
The Edelweiss analysts believe that new entrants — Reliance and Essar are likely to target customer loyalty and highway outlets to gain market share, but may in fact drive up margins, a trend seen during the earlier free pricing era (2002-04).
Bhaskar though believes that private players will enter only when they are convinced that diesel will not be brought back into the subsidy mechanism if crude price goes back to three figures.
Meanwhile, the gains from lower crude oil prices leading to a sharp fall in under recoveries will also fully reflect in FY16. Under recoveries reflects the loss incurred on selling fuel at below cost price. Although majority of the loss was compensated by the government and upstream players like ONGC and Oil India by way of subsidy and cash compensation, the compensation came with a lag of as much as six months. As a result, OMCs bore the brunt of increased deployment of cash leading to stress on working capital and higher interest costs. But, with crude oil prices down sharply, the under recoveries are seen falling by 70-75% leading to a sharp fall in working capital as well as interest costs. Analysts peg the under recoveries at about Rs 70,000 crore for FY15, down from Rs 140,000 crore in FY14. For FY16, the same is projected to fall to Rs 30,000-35,000 crore.
“As a result, total debt of OMCs will reduce from Rs 133,000 crore to Rs 75,000 crore while interest costs will reduce from Rs 7,800 crore to Rs 4,300-4,500 crore,” said an analyst.
Notably, after some volatility in the recent past, crude oil prices seem to be stabilising. The US deal with Iran will further add to the supplies, leading to a tab on oil prices. Broadly, crude oil prices are likely to remain soft for the next few quarters.
The decline in prices, however, had led to a huge inventory loss of over Rs 14,000 crore for OMCs in the December quarter, which in turn impacted absolute profit figures. Average per barrel price of Brent crude for December 2014 quarter fell to $76.11 from $109.78 in September 2014 quarter and $109.39 in the year ago period. The same averaged at $53.89 in March 2015 quarter, and are seen stabilising at these levels currently. With prices stable, inventory losses will also come down sharply going ahead.
Positively, though oil prices are down, gross refining margins (GRMs) are up sharply in the March 2015 quarter. For the OMCs, which have presence in refining segment, there could be further gains.
However, one will need to watch the trends going forward as there is little medium-term visibility on the same. Higher planned refinery outages across the globe in the month of March and May this year has led to higher product prices, thereby boosting GRMs. While the high Singapore-benchmark GRMs of about $9-10 per barrel may not sustain such high levels post May this year, the trend is likely to remain healthy.
Chakraborty at IIFL, though, says, “With regards the GRMs, there is no clear trend. Demand remains weak and hence margin trajectory remains difficult to predict.”
Nevertheless, the refining business contributes less than a fourth to profits of these companies, hence, unless the trend reverses sharply, the impact on overall profits should not be meaningful.
In this backdrop, earnings of public sector OMCs are estimated to increase sharply over the next 1-2 years. While Edelweiss analysts forecast HPCL’s EPS to grow at a CAGR of 85% during FY15-17, BPCL’s is expected to grow by 29% and IOC’s by 24%. HDFC Securities’ analyst Satish Mishra, too, expects earnings of OMCs to grow at a fast clip. In fact, earnings of the OMCs are expected to more than double (close to double for HPCL) during FY15-17.
Bhaskar says there are other triggers as well. “If the government increases the price of LPG or keeps affluent section out, it would prove to be another positive trigger.”
On the negative side, there is no clear roadmap on subsidy sharing. Hypothetically, if the government asks these OMCs to share more of the subsidy burden (which so far is Rs 2,000 crore), then the stocks will react negatively, he adds. The street has been awaiting a clear roadmap or subsidy sharing mechanism, which is essential to enhance earnings predictability, and to some extent will prevent a re-rating of these stocks.
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