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What $50 means for oil stocks

N Mahalakshmi in Mumbai | October 11, 2004

It's crude reality. International prices of black gold have decisively surged past $50 per barrel. After flirting with the psychological barrier for more than two weeks, US light crude futures touched a new record of $53 a barrel last Thursday.

Since the dawn of 2004, oil prices are up more than 60 per cent. Worries about lean US inventory and supply disruptions in Iraq, Russia, Gulf of Mexico and now Nigeria, and the unquenchable demand from China, have combined to help keep prices levitated.

For oil companies, this should ideally be a moment to rejoice, as high prices usually translate into higher sales and earnings. But in India, oil prices are still not driven by market forces; thus marketers cannot hope to hike prices even if international prices head higher.

Over the last one month, oil stocks have marginally outperformed the index, but this is not quite the same as saying that the Indian bourses are rewarding oil stocks. While the S&P CNX 500 gave a return of 9 per cent, oil stocks returned 11 per cent on an average.

But what is interesting is the divergence in performance of companies operating in the different segments.

While the prices of pure refiners like Bongaigaon Refinery and Chennai Petro and upstream Oil and Natural Gas Corporation have seen a fairly strong upmove, that of refining and marketing firms like Indian Oil Corporation, Hindustan Petroleum and Bharat Petroleum have remained placid.

Refining and petrochemical major Reliance has also seen its price move 15 per cent in the past one month:

Uneven gains
(Share price in Rs)

Oct 7, 04

Sep 7, 04

% Change

Bongaigaon Refinery86.0067.2027.98
Chennai Petro200.65159.6525.68
Essar Oil22.1018.8916.99
Reliance Ind558.45484.7515.20
Kochi Refineries190.90173.709.90
Indian Oil Corp437.60405.607.89

Clearly, the performance of companies operating in different segments in the oil chain is becoming stark with the government trying to marry multiple - and often contradictory - objectives which include containing oil price inflation, retaining subsidies on kerosene and LPG,  at the same time trying to optimise revenues from the oil industry.

The net result is that a part of the burden of subsidising some petroleum products for the domestic sector falls unevenly on  oil companies, affecting their  profits.

Essentially, there are four legs to the Indian oil story. The first  is the change in crude oil prices, which is a function of global demand-supply forces.

The second leg is refining margins which are, again, a function of demand for petro-products and refining capacities.

The third is the marketing margin, which is the difference between the cost of producing petro-products and the sale price to the end-customer.

The fourth is the subsidy on kerosene and LPG which is shared by the oil firms and the government. Intertwined in these is also the levies, including the import tariffs and excise duty on crude as well petro-products, which impacts the profitability of oil companies.

Fortunately, regional refining margins have been very strong. Product prices across Asia have been firm on account of robust demand from China apart from some supply constraints. In the second week of September, Singapore complex refining margins touched an all-time high of $10.22 per barrel (based on Dubai oil prices).

Though analysts see this as temporary, tight demand-supply conditions should ensure strong margins for a quarter or two. According to Merrill Lynch, any slowdown in consumption could be another 12-18 months away.

"Asian gross refining margins (GRMs) should ease to around $6-7 per barrel over the next two quarters which itself is fairly strong," says Susanta Mazumdar, head of research, UBS Warburg.

For the Indian refining majors, analysts expect refining margins to be in the range of $4-5 per barrel for fiscal 2005, but a difference of $1 could swing profits 25 per cent either way.

On slippery ground?

Even though the earnings of R&M firms are highly sensitive to refining margins, these companies could see their profits plunge because of the higher subsidy losses on account of LPG and kerosene and weaker marketing margins on petrol and diesel.

Subsidy losses for downstream companies will be considerably higher this year compared to FY04. Year to date, crude prices have risen nearly 65 per cent, but prices of petrol and diesel at the pump have been raised by only 11 per cent and 9 per cent respectively.

The government, however, altered the excise and customs duty structure to share the burden. Since June 2004, it has cut excise duty on auto fuels twice - duties on petrol, diesel, kerosene and LPG have been lowered by 700 bps, 600 bps, 800 bps and 400 bps respectively.

In August, it  also reduced the import duty by 500 bps on the four retail consumption products while keeping tariffs on crude unchanged, thus, reducing the effective protection for refiners from 6.5 per cent to 3.8 per cent.

While these measures impact  refining margins adversely by  around 20 per cent, marketing margins of R&M firms  are likely to be around 30 per cent lower than FY04 levels despite the excise duty cuts. If regional refining margins remain steady, however, pure refininers may see earnings growth.

For R&M firms, the burgeoning subsidy on account of LPG and kerosene is also a bane. Based on year-to-date prices, the LPG/kerosene subsidy bill is likely to be 16,600 crore (Rs 166 billion), of which, the government will have to cough up Rs 2,500 crore (Rs 25 billion), upstream companies Rs 4,800 crore (Rs 48 billion) and three R&M firms Rs 9,300 crore (Rs 93 billion).

In FY04, R&M firms incurred a subsidy loss of Rs 4,300 crore (Rs 43 billion):

Partners in subsidy losses
FY2004 (Rs billion)





Subsidy on LPG/kerosene





Payment from government11112547
Payment from upstream571930
Subsidy losses12102143
Subsidy on LPG/kerosene373891166
Payment from government661325
Payment from upstream5113248
Subsidy losses26214693
Based on year-to-date prices
Source: Kotak Securities

Higher crude oil prices will only increase under-recoveries, if the prices of kerosene/LPG are not raised. Assuming crude prices at $42 and international price of LPG at $464 per tonne, under-recoveries could be marginally over Rs 20,000 crore (Rs 200 billion).

Accordingly, the share of oil companies' losses will also go up. One positive is that these firms will see tangible inventory gains due to the run-up in crude prices.

Last quarter, HPCL and BPCL recorded  inventory gains to the tune of Rs 170 crore (Rs 1.70 billion) each and IOC saw gains of Rs 300 crore (Rs 3 billion).

This quarter, too, there could be similar gains. Overall, analysts expect consolidated earning of all three R&M companies - IOC, HP and BP - to fall in fiscal 2005.

Among the three, IOC is better off because it derives the least contribution from marketing which is under more serious threat. IOC's earnings are expected to fall by 7 per cent this fiscal, while that of BP and HP are likely to fall by 27 and 28 per cent, respectively.

Earnings estimates for FY05
(In Rs)FY04FY05CMP
(Oct 7)
Trailing P/E (x) Forward P/E (x)
Bharat Petroleum


Hindustan Petroleum55.0739.45324.25.898.22
Indian Oil65.0060.00437.606.737.29
Oil & Natural Gas65.8483.06805.4512.239.70
Gas Authority22.1022.30199.309.008.99
Kochi Refineries32.0046.50190.905.974.11
Chennai Petroleum26.9035.65200.657.465.63
Reliance Industries37.0048.00558.4515.0911.63
Source: Based on consensus estimates by Motilal Oswal, Morgan Stanley, I-Sec, Kotak Securities and Enam. Not all broking houses have estimates for all companies.

While R&M companies will be clear losers in a rising crude price environment, upstream companies like ONGC and Gail may emerge winners. However, upstream companies' profits growth, too, will be moderate since they have to foot a third of the subsidy bill.

In the first quarter of fiscal 2005, ONGC, Gail and OIL contributed Rs 1,190 crore (Rs 11.90 billion) towards the subsidy burden of R&M in the ratio 68 per cent, 19 per cent and 13 per cent, respectively.

Based on the prevailing prices, ONGC's subsidy burden could be higher by over 50 per cent. Yet, rising crude prices will by and large be favourable for ONGC.

The arithmetic is simple: the amount of crude sold by ONGC roughly equals the total consumption of LPG and kerosene in India, so, ONGC will always stand to benefit in a rising crude price environment, assuming that it will bear only a portion (albeit a substantial portion) of the apportioned one-third losses for upstream firms.

However, analysts argue that Gail may end up a loser. In Q1FY05, Gail's subsidy losses were Rs 226 crore (Rs billion), 30 per cent of pre-subsidy pre-tax profits. Gail is not thus not making any profit from its LPG production, if subsidy losses are included.

Not all analysts, however, are bullish on ONGC. "We have raised our earnings forecast to factor in rising international  prices.

However, deteriorating fundamentals remain a cause  for concern - ONGC's high strike rate and finding costs have worsened. It's potential is limited given Reliance's aggressive pricing of KG gas and a high probability of additional levies following eventual deregulation," says Jal Irani, oil analyst, ICICI Securities, in his latest report re-iterating a 'sell' on the stock at Rs 747.

He projects an EPS of Rs 97 for FY05. Reliance  will see profits soaring on the back of strong refining margins. In fact, Reliance has the most complex refinery in India and, hence, can leverage the widening gap between sweet and sour crude. Traditionally, Reliance' refining margins have been better than its peers.

Besides, the petrochemical cycle is also on an upswing. Currently, cracker margins are hovering close to 60 per cent higher than the average margins in fiscal 2004, while refining margins are up over 30 per cent.

"Both the petrochemical and refining businesses are firing in tandem for the first time. We expect the upswing to sustain for the next 18-24 months," says S Varatharajan, analyst, Motilal Oswal Securities.

Reliance derives 90 per cent of its operating profits from its petrochemicals and refining business. Most analysts have a buy on Reliance with a price target of Rs 625-675.

Something to hold

Despite the heightened uncertainty surrounding oil stocks, hope floats. One of the triggers for oil stocks could be consolidation. The government seems to be more serious about consolidation in the sector than ever before.

Analysts say mergers which help create integrated players will be value accretive. They will see enhanced profitability through reduced costs and productivity gains apart from lower earnings volatility, resulting in better valuations. Worldwide, fully integrated oil firms trade at a 50 per cent premium to R&M firms.

That apart, analysts expect operational performance to remain strong across the sector. ONGC and Gail are strongly focused on volumes growth, while HPCL and BPCL are expanding and upgrading capacities to produce to meet Euro III compliance standards.

Again, domestic demand for petro-products is strong, thanks to steady growth in GDP and increase in the automobile population.

Demand Vs supply

The strong upsurge in oil prices has been a result of a combination of factors. Firstly, demand has been buoyant on the back of robust recovery in America, expansion in the Chinese and Indian economies as also some other Asian economies. About 30 per cent of the increased demand this year has been from China while 8-10 per cent has been from India.

Supply, on the contrary, has been uneven. The latest jolt came from the political uncertainty in Nigeria, one of Africa's leading oil producers and the world's seventh-largest exporter of oil. Elsewhere, in the Gulf of Mexico, disruptions to production, shipping and refining due to Hurricane Ivan had led to shrinkages in inventories.

Attacks on Iraqi oil pipelines and warnings by Russian oil giant Yukos on output disruptions have also worsened the situation. US inventories are already at a 30-year low. And there are also worries that the impending winter will aggravate the situation.

The big picture isn't pretty either. The fact is the world oil supply buffer, according to some estimates, is just about 1 per cent of daily global demand of 82 million barrels, leaving little scope for prices to remain stable in the event of demand-supply mismatches.

But it is not as though prices are rising on account of a demand-supply imbalance alone. The speculative element in oil prices now is far higher than normal, believe analysts and industry observers.

"About a third of the current oil price build-up is due to speculation," says Subir Raha, managing director, ONGC. When the flow of negative news stops, prices could drop to more realistic levels, reflecting fundamentals. "Irrational behaviour can't persist for ever, but when it will happen is anybody's guess," says Susanta Mazumdar, head of research, UBS Warburg.

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