Sunil Jain: Penny-wise, pound-foolish

RATIONAL EXPECTATIONS

Though oil prices are lower than the near-$100 a few weeks ago, with the government unlikely to hike prices, it is time to take stock of just what the government's actions mean. The oil subsidy in 2006-07 was around Rs 50,000 crore, of which a little less than half was borne by the government through the oil bonds, and the rest by the oil companies. What's important "" apart from the fact that the oil subsidy the PSU oil firms bore was greater than their profits "" is what this has done to the government's revenues and wealth.

Calculating the wealth impact is simple. If the government had, for instance, paid the full subsidy itself, the oil companies would have had Rs 27,000 crore worth of additional profits, less the Rs 9,000 crore of tax they'd have to pay on this. Given the average price-earnings (P-E) ratio for the oil PSUs was around 14.5 in 2006-07 (calculated by adding the weighted P-E of each firm, with the relative market capitalisation of each firm serving as the weight), this would have meant their market capitalisation would have risen by around Rs 260,000 crore "" the additional market capitalisation in the table is a smaller amount of Rs 225,000 crore as this does not include the subsidies paid by IBP and standalone refineries. Given that the government holds around 70 per cent of the stock of these PSUs, that's a wealth loss of around Rs 160,000 crore! 
 

HOW TO KILL A PSU (gains in market capitalisation if government funded subsidies)
in Rs crore	RIL	ONGC	IOC	HPCL	BPCL	GAIL
Sales	111,699	56,636	216,447	89,725	96,557	16,037
Net Profit	11,943	15,643	7,499	1,571	1,805	2,387
UnderRecovery	---	17,060	2,190	770	770	1,488
Market Cap	417,859	255,039	71,517	10,416	15,284	40,452
PE Dec 2007	34.99	16.3	9.54	6.63	8.47	16.95
PE Apr 2002	10.8	6.3	5.4	12.5	11.6	5.39
Gain A*		185,428	13,923	3,403	4,346	16,813
Gain B*		296,332	85,214	Na	Na	18,543
* Increase in market cap if no under-recovery and using current PE ratios of the oil PSUs ** Increase in market cap if no under-recovery and PSU's PE ratio-to-RIL in 2002 maintained

This, however, is a huge understatement since it assumes the current P-E levels are the correct ones. But this is hardly true since, one of the reasons for the low P-Es is that the market does not believe the PSUs will ever be free to charge the correct price "" that is, they'll never be able to capture the huge upside of the rising prices. A recent report by Kotak Institutional Equities Research estimates, for instance, that BPCL and HPCL are trading at 0.88 and 0.69 times even their respective book values and at around half their replacement values.

One way to try and estimate the "correct" P-E is to see what the relative PEs were in April 2002, the time when petroleum prices in the country were supposed to have been fully freed. Firms such as BPCL and HPCL had PE levels higher than those of Reliance Industries while IOC was lower (presumably, the market valued HPCL/BPCL more as it felt they'd soon be privatised). So, one way could be to use the relative PEs of 2002, apply them to Reliance's current PE, and then calculate the possible market capitalisation of the PSUs.

Based on this, the additional market capitalisation is a huge Rs 550,000 crore "" but, given HPCL/BPCL are vastly less profitable than Reliance, this doesn't work for them. For the likes of ONGC and IOC, however, this may work since their new assumed PEs are roughly in keeping with those of different parts of Reliance's businesses that they compete with today "" ONGC on exploration and IOC on refining. These two alone add up to around Rs 380,000 crore of market capitalisation.

Experts will get different results depending upon the assumptions used, but the broad numbers are what matter. In which case, the next time Petroleum Minister Murli Deora goes to meet the finance minister to make a case for sparing the oil companies from the subsidy burden, he may wish to take this article with him!