Falling crude, decontrolled diesel bring good times to OMCs

Falling global crude oil and decontrol of diesel prices have ushered in a phase of prosperity for public sector oil marketing companies (OMCs).

The changed conditions have led to a sharp fall in under-recoveries and boost to earnings before interest, tax, depreciation and amortisation (Ebitda) of the OMCs – Indian Oil (IOC), Bharat Petroleum (BPCL) and Hindustan Petroleum (HPCL) .

The falling crude oil prices have brought down the under-recoveries on retail fuels such as diesel and liquid petroleum gas (LPG). Petroleum prices were decontrolled in 2010. The recent decontrol of diesel prices are expected to lead to a rise in the margins, providing a boost to the Ebitda.

“An imminent expansion in diesel marketing margin is a key trigger for OMCs, in our view,” said HDFC Securities analysts in recent note. It added: “It was capped at Rs 1.4 per litre (versus Rs 2 or more per litre for petrol) for over five years. The marketing segment contributes 50-85 per cent of Ebitda for OMCs and the diesel is about 50 per cent of volumes.”

Bhaskar Chakraborty, oil and gas sector analysts at IIFL, echoed the HDFC analysts.

“The three OMCs are on a very good wicket because private players – Reliance Industries and Essar – have not entered fuel retailing in a big way. Now that the diesel price is fully decontrolled, there is a good scope of diesel marketing margins rising by 50 basis points from Rs 1.4 per litre to Rs 1.9 per litre over the next one year. The positive impact of higher margins on Ebidta will be Rs 1,000 crore for BPCL, Rs 800 crore for HPCL and Rs 2,100 crore for IOC.”

Even if Reliance and Essar turn aggressive, it is unlikely to have a major dent on the profitability of the 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 per litre versus Rs 0.7 per litre prevalent prior to deregulation,” claim Edelweiss analysts Jal Irani and Yusufi Kapadia, in their last month’s report.

Over these years, the public sector OMCs have significantly upgraded their infrastructure, leading to high brand recall and loyal customers. For private players, to set up such a vast modern distribution network would cost far higher.

Edelweiss analysts believe new entrants 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).

Chakraborty, though, believes private players will enter only when they are convinced that diesel will not be brought back into the subsidy mechanism if the crude price goes back to three figures.

Meanwhile, the gains from lower crude oil prices leading to a sharp fall in under-recoveries will be fully reflect in FY16. Under-recoveries reflect the loss incurred on selling fuel at below cost price. Although much of the loss is compensated by the government and upstream players (ONGC and Oil India) by way of cash compensation and subsidy, the compensation came with a lag of five to six months, leading to stress on OMCs’ working capital and higher interest costs.

But with under-recoveries seen falling from Rs 140,000 crore in FY14 to about Rs 70,000 crore for FY15, and further to Rs 30,000-35,000 crore in FY16, OMCs’ working capital and interest costs will also plummeting.

“Total debt of OMCs will reduce from Rs 133,000 crore to Rs 75,000 crore and interest costs from Rs 7,800 crore to Rs 4,300-4,500 crore,” said an analyst.

The decline in prices, which had led to a huge inventory loss of over Rs 14,000 crore for OMCs in the December quarter thereby impacting their profits, will also vanish. Average per barrel price of Brent crude, which fell to $ 76.11 in December 2014 quarter from $ 109.78 in September 2014 quarter and $ 109.39 in the year ago period, averaged at $ 53.89 in March 2015 quarter and is expected to stabilise at these levels for a few quarters. The US deal with Iran will only add to the supplies, and keep a tab on the prices.

But, even as oil prices are down, gross refining margins (GRMs) are up sharply and signal more gains for the OMCs.

However, one will need to watch the trend going forward as there is limited medium-term visibility. Higher planned refinery outages across the globe during March to May this year has led to higher product prices, thereby boosting GRMs. The Singapore-benchmark GRMs has risen to $ 9-10/barrel.

Chakraborty said: “With regard to the GRMs, there is no clear trend. Demand remains weak and hence margin trajectory remains difficult to predict.”

Nevertheless, the refining business contributes about a fourth to revenues of these companies (except IOC at about a third). Hence, unless the trend reverses sharply, the impact on overall profits should not be meaningful.

In this backdrop, earnings of OMCs are estimated to increase sharply over the next 1-2 years, though part of the surge can be attributed to the low-base effect given the earnings decline in FY15.

While Edelweiss analysts forecast HPCL’s EPS to grow at a CAGR of 85 per cent during FY15?17, BPCL’s is expected to grow by 29 per cent and IOC’s by 24 per cent. HDFC Securities’ analyst Satish Mishra, too, expects earnings of OMCs to grow at a fast clip. He expects their earnings to more than double (close to double for HPCL) during FY15-17.

Chakraborty added, “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, said Chakraborty. The street has been awaiting clarity on subsidy sharing mechanism which is essential to enhance earnings predictability, and the lack of it is preventing re-rating of these stocks. Given the outperformance in last three months, investors could consider the stocks on corrections.