 "Optimism in oil and gas space may not last")
There has been some optimism visible across the oil and gas sector in the past couple of months. The share prices of primary producers such as Oil and Natural Gas Corporation Ltd, Cairn, Reliance Industries Ltd and Oil India Ltd have all gained. So have the share prices of refiners such as Bharat Petroleum Corporation (BPCL) and Hindustan Petroleum Corporation (HPCL) and Indian Oil Corporation (IOC).
This is an unusual situation. When crude and gas prices rise, refining margins fall and vice-versa, refining margins rise when primary crude and gas prices fall. Hence, the profitability of a pure refiner or a refiner-retail marketer is inversely correlated with the profitability of a primary producer.
Many energy company are integrated end-to-end across the value chain precisely for that reason. When primary prices are up, the integrated company's control of production helps make profits; when primary prices are down, refining margins improve.
In India there is the further complication of retail price controls. Retail prices of products are controlled and the government partially compensates retailers via direct payments. The government underpays its share of the subsidy and this means refiners-cum-marketers lose money on many products at the petrol pump.
Private sector refiners are very reluctant to sell refined products in India for this reason. They can find better markets abroad. Hence, the marketing segment is completely dominated by public sector units (PSUs). What is more, the government insists that PSUs in the upstream sector share the burden of losses forced by price controls. This means that upstream PSUs cannot maximise profits even when crude or gas prices are high.
The new gas pricing formula has been very controversial and it is possible that it will be modified. However, most investors and analysts believe that regardless of the exact outcome, gas prices will be aligned more closely to international levels in future. This would be logical since India is a major gas importer and linking domestic prices to international prices must be beneficial for every domestic gas production company.
The second positive perception is the hope that the gradual increase of diesel and petrol prices and the rationalisation of gas cylinder allotment will continue, reducing under-recoveries on liquefied petroleum gas (LPG). At some stage, kerosene price controls should also be rationalised.
Global crude prices were more or less steady through March and April and expected to remain low, given weak demand from China. However, tensions in the Ukraine has led to uncertainty and a hardening in crude and gas prices. At the same time, refining margins stayed firm and showed a small increase. The rupee has also strengthened which is good for crude and gas importers.
The underrecoveries on kerosene and LPG have declined a little. But diesel underrecoveries rose in the new financial year and so did underrecoveries on petrol. Elections meant no price rises in April or May. Everybody seems to expect this situation to be temporary and hence, the bullish fervour across energy counters.
In one scenario, the bulls will be caught flat-footed. An escalation of tensions in the Ukraine looks to be high probability. That would push up primary gas and crude prices suddenly. Hence, underrecoveries may go off the scale.
There is another scenario where domestic controversies lead to an outcome where hikes in gas prices are stalled for a while due to legal cases, etc. This would knock out one key assumption that Indian investors are betting on.
In any event, it is unlikely that non-integrated companies can all see price gains across the energy sector for an extended length of time. If primary producers gain, refiners/marketers should lose and vice versa. Right now, the hopes that the subsidy mechanism will be changed and/or price controls will be eliminated is driving prices up across the value chain. This is likely to be a pipe dream in which no government has ever displayed the political courage required to lift price controls and allow market forces to freely operate across the sector.
This is an unusual situation. When crude and gas prices rise, refining margins fall and vice-versa, refining margins rise when primary crude and gas prices fall. Hence, the profitability of a pure refiner or a refiner-retail marketer is inversely correlated with the profitability of a primary producer.
Many energy company are integrated end-to-end across the value chain precisely for that reason. When primary prices are up, the integrated company's control of production helps make profits; when primary prices are down, refining margins improve.
In India there is the further complication of retail price controls. Retail prices of products are controlled and the government partially compensates retailers via direct payments. The government underpays its share of the subsidy and this means refiners-cum-marketers lose money on many products at the petrol pump.
Private sector refiners are very reluctant to sell refined products in India for this reason. They can find better markets abroad. Hence, the marketing segment is completely dominated by public sector units (PSUs). What is more, the government insists that PSUs in the upstream sector share the burden of losses forced by price controls. This means that upstream PSUs cannot maximise profits even when crude or gas prices are high.
The new gas pricing formula has been very controversial and it is possible that it will be modified. However, most investors and analysts believe that regardless of the exact outcome, gas prices will be aligned more closely to international levels in future. This would be logical since India is a major gas importer and linking domestic prices to international prices must be beneficial for every domestic gas production company.
The second positive perception is the hope that the gradual increase of diesel and petrol prices and the rationalisation of gas cylinder allotment will continue, reducing under-recoveries on liquefied petroleum gas (LPG). At some stage, kerosene price controls should also be rationalised.
Global crude prices were more or less steady through March and April and expected to remain low, given weak demand from China. However, tensions in the Ukraine has led to uncertainty and a hardening in crude and gas prices. At the same time, refining margins stayed firm and showed a small increase. The rupee has also strengthened which is good for crude and gas importers.
The underrecoveries on kerosene and LPG have declined a little. But diesel underrecoveries rose in the new financial year and so did underrecoveries on petrol. Elections meant no price rises in April or May. Everybody seems to expect this situation to be temporary and hence, the bullish fervour across energy counters.
In one scenario, the bulls will be caught flat-footed. An escalation of tensions in the Ukraine looks to be high probability. That would push up primary gas and crude prices suddenly. Hence, underrecoveries may go off the scale.
There is another scenario where domestic controversies lead to an outcome where hikes in gas prices are stalled for a while due to legal cases, etc. This would knock out one key assumption that Indian investors are betting on.
In any event, it is unlikely that non-integrated companies can all see price gains across the energy sector for an extended length of time. If primary producers gain, refiners/marketers should lose and vice versa. Right now, the hopes that the subsidy mechanism will be changed and/or price controls will be eliminated is driving prices up across the value chain. This is likely to be a pipe dream in which no government has ever displayed the political courage required to lift price controls and allow market forces to freely operate across the sector.
The author is a equity and technical analyst