From inventory losses to higher interest costs, analysts cautious on OMCs

Shares of oil marketing companies (OMCs) such as Hindustan Petroleum Corporation (HPCL), Bharat Petroleum Corporation (BPCL) and Indian Oil Corporation (IOC) have gained 15-45 per cent from their October lows, beating the S&P BSE Sensex by a good margin. These gains have accrued as concerns eased over the marketing margins of the public-sector OMCs.

Earlier in October 2018, as crude oil prices hit a nearly four-year-high, the government asked OMCs to bear a subsidy of Rs 1 per litre on auto fuels, leading to worries of a return to the subsidy-sharing mechanism. However, as oil prices have corrected 27 per cent since October highs of $84 a barrel, analysts now see a sharp expansion in marketing margins. Some even believe that daily marketing margins on auto fuels (such as petrol and diesel) have improved to around Rs 8 per litre from a low of about Rs 1 per litre three months earlier. Analysts at Edelweiss estimate auto fuel margins to have improved by 

46 per cent sequentially in the December quarter to Rs 3.3 per litre.

In the backdrop of improved marketing margins, stock valuations appear favourable even as share prices have risen. Yet, investors need to exercise caution looking at the sharp fall in gross refining margins (GRMs), likely inventory losses on lower crude oil prices, expected rise in interest and depreciation costs on capital expenditure (capex) and the upcoming general election that may impact pricing power of OMCs, warn analysts. 

Threat to profits

While lower crude oil prices may have led to an expansion in marketing margins, GRMs of the OMCs are estimated to be weak in the December 2018 quarter (Q3) following the fall in Singapore benchmark refining margins. Singapore GRMs have declined to $4.3 per barrel in Q3 from $6 per barrel in the September quarter and $7.2 barrel in December 2017 quarter, the lowest since Q3 of FY14.

Moreover, the OMCs will have to bear significant losses on their crude oil inventory. The OMCs, which have been posting strong earnings growth for the past few quarters as rising oil prices resulted in inventory gains, are estimated to post weak earnings in Q3, say analysts. The decline in average crude oil price by $4.6 per barrel would lead to inventory losses, worsening the impact on GRMs, say analysts at Nirmal Bang Securities, who expect a 40.3 per cent, 93.9 per cent and 92.2 per cent sequential decline in Q3FY19 earnings of IOC, HPCL and BPCL, respectively.

The earnings disappointment for OMCs will be primarily driven by lower GRMs, rising interest costs as well as depreciation, and inventory losses on account of the decline in average oil price (Dubai-Fateh) from $74.0 per barrel to $69.4 per barrel.

Analysts also feel that high margins in auto fuels may not sustain for long. Kotak Institutional Equities says: “We are certain that the margins are a lot higher than the normalised levels of Rs 2.5-Rs 3 per litre and in our view, the OMCs may be targeting to recover large inventory losses on the recent sharp fall in crude prices, while perhaps creating an adequate buffer for a plausible increase in excise duties in the near term and/or headroom to prevent material price hikes in the run-up to central elections on any potential recovery in global crude prices.” The recent weakness in refining margins is also concerning and may pose a downside risk to our FY2020 estimates for OMCs, they add.

External worries

Crude prices, after the sharp decline, are also seen rebound­­­ing with the cut in output by oil producing companies and due to US sanctions on Iran. In such an event and given the looming elections, OMCs may not be able to raise auto fuel prices in tandem with crude prices. 

Analysts at Motilal Oswal Securities say that although auto fuel prices have declined, there is always a risk of populist measures hitting the OMCs during the election period. Among stocks, IOC remains their preferred pick due to strong free cash flows, high dividend yield and inexpensive valuation. However, since IOC and BPCL are at the beginning of their capex cycle and therefore, depreciation and interest costs are seen rising, analysts at Kotak Institutional Equities feel that this may negatively impact their earnings.