 "Further re-rating on the cards for oil marketing companies")
After a prolonged period of decline (except in the case of Bharat Petroleum Corporation or BPCL), the stocks of public sector oil marketing companies (OMCs) have recorded strong gains in the last three months. Compared to the BSE Sensex’s 5.4 per cent rise, BPCL, Hindustan Petroleum Corporation (HPCL) and Indian Oil Corporation (IOC) are up 33-35 per cent since mid-December 2013.
The key factors driving this re-rating are the small but consistent diesel price increases. That OMCs will not be restrained from raising fuel prices during the elections, too, has added to the Street’s confidence. Largely, global crude oil prices have remained stable, while the rupee has been firm against the dollar, suggesting if diesel prices are raised 40-50 paise/litre a month, underrecoveries on the fuel will be done away with in about a year (currently, petrol prices are market-linked; it is estimated diesel will account for 47 per cent of the industry’s total under-recoveries in FY14).
Positive change for OMCs
For some time, OMCs’ profitability has been dependent on the contribution of the government and upstream companies towards the losses on selling fuel at subsidised rates, resulting in volatile earnings. If diesel prices are fully de-regulated in spirit, as the Street hopes, OMCs’ interest costs and debt levels, especially high-cost working capital loans, will be reduced.
Since January 2013, OMCs have raised diesel prices by a total of Rs 7.8/litre; these are expected to wipe out diesel underrecoveries, currently about Rs 7.4/litre (through Rs 0.5/litre price rises every month by May 2015). Analysts believe OMCs will save Rs 800 crore and Rs 1,500 crore on incremental interest costs in FY14 and FY15, respectively, as diesel prices are raised. The improved working capital cycle, zero-subsidy burden and bottoming out of gross refining margins (GRMs) will rub off positively on OMCs’ profitability and return ratios.
“Despite assuming Brent at $105/barrel and the rupee at 62/dollar, gross underrecoveries are estimated to decline 45 per cent during FY14-16 to Rs 1,05,000/76,500 crore in FY15/16 from an estimated Rs 1,38,700 crore in FY14. We estimate OMCs’ earnings to bottom-out in FY14. OMCs’ earnings are highly sensitive to GRMs, which are at cyclical lows,” says Amit Rustagi, oil & gas analyst at Antique Stock Broking. He adds an improvement of $1/barrel in GRMs could provide a 23-35 per cent upside to OMCs’ earnings and vice versa.
Rahul Singh of Standard Chartered Equity Research says, “We expect the re-rating of OMCs to continue, given the improving RoE (return on equity) predictability at the margin. Assuming full compensation for OMCs to continue in FY14/15, the potential improvement is unappreciated, given the still-attractive valuation of an estimated adjusted price/book value of 0.5-0.7 times for FY14.”
Moreover, a potentially favourable electoral outcome can be a game-changer, says Singh, who prefers HPCL and BPCL and has downgraded IOC to ‘in-line’, given the company’s recent out-performance compared to its peers.
BPCL
In the last two-three years, the BPCL stock has significantly outperformed its peers, largely due to the growth potential in its E&P business. The estimated reserves of its Mozambique block have been upgraded from three-four trillion cubic feet (tcf) in 2010 to about 45-70 tcf (this was raised 15 per cent earlier this month). BPCL has stakes in 10 Brazilian blocks that are undergoing exploration and appraisal. Any announcement of reserve estimates across these blocks will act as a trigger for the stock.
“We have revised BPCL’s target price to Rs 486/share (from Rs 464 earlier), following the reserve upgrade for the Mozambique block. We maintain BPCL as the top pick among OMCs due to its relatively strong balance sheet, operational upsides through capacity additions and complexity improvement (in refining business) and the E&P upside potential,” says Harshad Borawake of Motilal Oswal Securities. Every Rs 0.5 a litre rise in diesel prices adds Rs 8-9 to BPCL’s earnings per share.
HPCL
HPCL is expected to gain the most from the fuel price reforms. It could see a significant improvement in return ratios, analysts say. In addition to the lower subsidy, HPCL’s debt is unlikely to increase substantially, as a large part of its refinery-upgrade capital expenditure is completed and its Bathinda refinery is expected to see an increase in profitability. This is likely to provide support to the company at a time when it is seeking to expand its standalone refining capacity to 23.8 million tonnes per annum (mtpa) by setting up a nine mtpa refinery in Barmer in three-four years. Currently, the HPCL stock is being traded at 0.71 times the FY15 estimated book value, 29 per cent lower than its historical average of about one.
IOC
After the announcement of the sale of 10 per cent stake in IOC to Oil and Natural Gas Corporation and Oil India Ltd, a key overhang on the stock was removed. Analysts believe the company’s GRMs might improve after the commercialisation of its Paradip refinery, the most complex public sector undertaking-owned refinery in India. This, along with diesel price de-regulation, will be the key earnings driver for IOC. At 0.90 times the FY15 estimated book, the IOC stock is currently being traded at a 25 per cent discount to its historical average one-year forward price/book value ratio of 1.2. The weak polyester intermediate margin is a key pressure point.
The key factors driving this re-rating are the small but consistent diesel price increases. That OMCs will not be restrained from raising fuel prices during the elections, too, has added to the Street’s confidence. Largely, global crude oil prices have remained stable, while the rupee has been firm against the dollar, suggesting if diesel prices are raised 40-50 paise/litre a month, underrecoveries on the fuel will be done away with in about a year (currently, petrol prices are market-linked; it is estimated diesel will account for 47 per cent of the industry’s total under-recoveries in FY14).
Positive change for OMCs
For some time, OMCs’ profitability has been dependent on the contribution of the government and upstream companies towards the losses on selling fuel at subsidised rates, resulting in volatile earnings. If diesel prices are fully de-regulated in spirit, as the Street hopes, OMCs’ interest costs and debt levels, especially high-cost working capital loans, will be reduced.
Since January 2013, OMCs have raised diesel prices by a total of Rs 7.8/litre; these are expected to wipe out diesel underrecoveries, currently about Rs 7.4/litre (through Rs 0.5/litre price rises every month by May 2015). Analysts believe OMCs will save Rs 800 crore and Rs 1,500 crore on incremental interest costs in FY14 and FY15, respectively, as diesel prices are raised. The improved working capital cycle, zero-subsidy burden and bottoming out of gross refining margins (GRMs) will rub off positively on OMCs’ profitability and return ratios.
“Despite assuming Brent at $105/barrel and the rupee at 62/dollar, gross underrecoveries are estimated to decline 45 per cent during FY14-16 to Rs 1,05,000/76,500 crore in FY15/16 from an estimated Rs 1,38,700 crore in FY14. We estimate OMCs’ earnings to bottom-out in FY14. OMCs’ earnings are highly sensitive to GRMs, which are at cyclical lows,” says Amit Rustagi, oil & gas analyst at Antique Stock Broking. He adds an improvement of $1/barrel in GRMs could provide a 23-35 per cent upside to OMCs’ earnings and vice versa.
Rahul Singh of Standard Chartered Equity Research says, “We expect the re-rating of OMCs to continue, given the improving RoE (return on equity) predictability at the margin. Assuming full compensation for OMCs to continue in FY14/15, the potential improvement is unappreciated, given the still-attractive valuation of an estimated adjusted price/book value of 0.5-0.7 times for FY14.”
Moreover, a potentially favourable electoral outcome can be a game-changer, says Singh, who prefers HPCL and BPCL and has downgraded IOC to ‘in-line’, given the company’s recent out-performance compared to its peers.
BPCL
In the last two-three years, the BPCL stock has significantly outperformed its peers, largely due to the growth potential in its E&P business. The estimated reserves of its Mozambique block have been upgraded from three-four trillion cubic feet (tcf) in 2010 to about 45-70 tcf (this was raised 15 per cent earlier this month). BPCL has stakes in 10 Brazilian blocks that are undergoing exploration and appraisal. Any announcement of reserve estimates across these blocks will act as a trigger for the stock.
“We have revised BPCL’s target price to Rs 486/share (from Rs 464 earlier), following the reserve upgrade for the Mozambique block. We maintain BPCL as the top pick among OMCs due to its relatively strong balance sheet, operational upsides through capacity additions and complexity improvement (in refining business) and the E&P upside potential,” says Harshad Borawake of Motilal Oswal Securities. Every Rs 0.5 a litre rise in diesel prices adds Rs 8-9 to BPCL’s earnings per share.
HPCL
HPCL is expected to gain the most from the fuel price reforms. It could see a significant improvement in return ratios, analysts say. In addition to the lower subsidy, HPCL’s debt is unlikely to increase substantially, as a large part of its refinery-upgrade capital expenditure is completed and its Bathinda refinery is expected to see an increase in profitability. This is likely to provide support to the company at a time when it is seeking to expand its standalone refining capacity to 23.8 million tonnes per annum (mtpa) by setting up a nine mtpa refinery in Barmer in three-four years. Currently, the HPCL stock is being traded at 0.71 times the FY15 estimated book value, 29 per cent lower than its historical average of about one.
IOC
After the announcement of the sale of 10 per cent stake in IOC to Oil and Natural Gas Corporation and Oil India Ltd, a key overhang on the stock was removed. Analysts believe the company’s GRMs might improve after the commercialisation of its Paradip refinery, the most complex public sector undertaking-owned refinery in India. This, along with diesel price de-regulation, will be the key earnings driver for IOC. At 0.90 times the FY15 estimated book, the IOC stock is currently being traded at a 25 per cent discount to its historical average one-year forward price/book value ratio of 1.2. The weak polyester intermediate margin is a key pressure point.