Rising crude prices could put OMC margins under pressure, hurt stock rally

While analysts expect excise duty cuts or price hikes to offset pressure on marketing margins, there is some uncertainty currently; Oil producers seen gaining

The S&P BSE Oil and Gas index (up 1.7 per cent) outperformed the S&P BSE Sensex (up 0.07 per cent) on Monday, despite Brent crude oil prices surpassing the $70 per barrel-mark.

From a low of $36.9 hit on October 30, 2020, Brent is up 92 per cent, and analysts see further upside. Over the short-term, analysts expect Brent crude to hit $80 as OPEC+ countries curtail production, and there is recovery in fuel demand amid gradual ‘unlock’ of economies across the globe.

“In the near-term, despite prices trading in an overbought zone, there is no reversal pattern on charts and therefore prices are expected to remain elevated,” says Bhavik Patel, senior technical analyst (Commodities) at Tradebulls Securities. Some foreign brokerages expect Brent to average at $75 in June quarter and $80 for the September quarter.

Kshitij Purohit, Lead analyst commodities and currency at CapitalVia Global Research, in fact, sees Brent at $77-80 in the short to medium-term and expects crude to hit Rs 5,000 on MCX, versus Rs 4,840 on Monday.

Given that high crude oil prices improve realisation from crude sales for oil exploration firms, ONGC and Oil India are the key beneficiaries of the current up move in oil prices as every $1 per barrel rise in crude price may result in 2-3 per cent rise in their shares’ valuations, analysts at JM Financials noted in a March 5 report. Shares of ONGC and Oil India rallied 3 per cent each on Monday to close at Rs 118.30 and Rs 130.95 on the BSE.

Analysts at the brokerage have ‘Buy’ rating on ONGC and Oil India with target price of Rs 130 and Rs 145, respectively.

Shaky road for OMCs

Theoretically, a rise in crude oil price dents marketing margin – the difference between the cost price and the rate at which they sell it to retailers – of oil marketing companies (OMCs) if the latter don't raise fuel prices.

Sustained strength of marketing margins and recovering demand for petroleum products so far has supported profitability of the three public sector OMCs against weak gross refining margins (GRMs), pushing up stock prices in the current scenario, analysts say. Shares of Bharat Petroleum Corporation (BPCL), Hindustan Petroleum Corporation (HPCL), and Indian Oil Corporation (IOCL) also gained up to 2 per cent on Monday.

In Q3'FY21, OMCs clocked a surge of up to 23 per cent year-on-year in sale of petroleum products. Besides, the recovery of domestic transportation fuel demand to near normal levels, barring aircraft fuel, and marketing margins on auto fuel at above pre-pandemic levels aided their performance.

That said, analysts caution that, OMCs need to improve their gross refining margins (GRMs) by either raising fuel prices – which may be difficult given five state elections in the next two months – or the government cutting excise duties.

Sudeep Anand, research analyst at IDBI Capital, says, so far the OMCs have increased the prices whenever crude prices have gone up so that their gross margins remains between Rs 3-4 per litre. “We expect the firms to pass on the increased cost to the consumer. If this doesn't happen, we will have to see how long will crude prices sustain at higher levels. Going by the recent price increase, OMCs should increase the fuel prices by around Rs 2 per litre to maintain their margins,” says Anand.

The real-test of the government’s resolve will be seen if crude oil prices exceed $80 per barrel levels. In that event, Vivekanand Subbaraman, research analyst at Ambit Capital rules out the repeat of October 2018 when OMCs were asked to take a Re 1 per litre hit on marketing margins as the government has repeatedly argued in parliament of its price decontrol agenda, keenness to privatise BPCL, and desire to let OMCs earn reasonable returns so as to enable them invest in future ready energy assets.

So, what's the advice for investors? Most experts believe that awaiting for clarity on fuel price hikes or excise duty cuts would be prudent.

Ajit Mishra, VP-Research at Religare Broking advises new investors to stay on the sidelines as he believes the traction in OMCs is due to BPCL’s privatisation and overall optimism in the PSU space. “Going forward, the rally may not sustain considering the government may not allow these OMCs to hike prices due to upcoming state elections. In such a scenario, it’s prudent for investors to bet on companies such as Reliance Industries and ONGC,” he says.

Others, too, see some headwinds for public-sector OMCs. AK Prabhakar, head of research at IDBI Capital, believes that while BPCL’s privatisation may re-rate valuation of HPCL and IOC, the hit on margins due to rising crude prices may dent sentiment going-forward.

To what extent rising oil prices boost inventory of OMCs, and therefore cushion the hit on margins, remains to be seen.