In August 2005, former petroleum secretary S C Tripathi wrote to Cabinet secretary B K Chaturvedi that IBP, a subsidiary of Indian Oil Corporation [Get Quote], would be the first oil company to turn sick by September 2005, followed by Bharat Petroleum Corporation [Get Quote] Limited, which will take just 13 months to go to the BIFR, while Hindustan Petroleum Corporation [Get Quote] Limited would be sick in 20 months.

Despite such a strongly worded letter, the government did not take the corrective measure of hiking domestic petroleum prices in tandem with the global crude spike.

The reason: a belligerent Left was against burdening the common man with more fuel price hikes. Consequently, oil stocks have lagged behind on the bourses despite the sensational three-year long rally. But the stock market has got a reason for the shrug.

"There is no way of evaluating a company where basic principles of economics do not apply, where business decisions are not taken rationally," says Ramdeo Agrawal, managing director, Motilal Oswal.

Oil and Natural Gas Corp, IOC, HPCL and BPCL, which currently have a combined market capitalisation of Rs 2,65,000 crore (Rs 2,650 billion), have delivered an average return of 10.23 per cent during the past couple of years, while the Sensex doubled in the same period.

Because of its majority ownership, it is also the government which has turned out to be the biggest loser, but that is hardly any solace for other investors holding the stock.

Priyadarshi Srivastava, director, India Broking, says, "No fundamental research can be done on the sector, as the external environment remains unpredictable and the managements can do little to change their own destiny."

Till a few weeks ago, analysts were sharply negative on the sector as hopes of policy changes in the Budget last month were shattered as the finance minister refrained from taking any steps to put these companies on a firm ground.

Oil marketing companies have been seeing their profits erode in the wake of rising crude, as they have been unable to hike the prices of auto and cooking fuel to cover their costs because of government controls.

But as extreme pessimism grips the sector, is it a good time to go bottom-fishing? After all, these are companies, which have substantial physical assets - manufacturing capacities, marketing infrastructure across the country and valuable real estate.

Sure, but investors need to be patient as "stocks may not perform unless their earnings improve. And that would not happen unless the government policy changes," says Agrawal.

However, in a bold move, a leading foreign broking house last week put out a report with a buy on the sector suggesting that policy changes could be round the corner and that could reverse the situation sooner than later.

According to the report, if the Rangarajan committee recommendations were implemented, the three marketing companies could see an earnings upside of 48-135 per cent.

The Rangarajan committee, which had made its recommendations before the Budget, had suggested dual pricing to ensure zero losses on cooking fuels and trade parity pricing on auto fuels, apart from certain changes in the duty structure and the prevailing retail prices, none of which has been ratified yet.

Oil companies can be ideally contrarian picks at this point. But this is under the assumption that more pain in the system would only force the government to rescue the situation and accelerate reforms.

Especially after the state elections are over in May 2006, the government may be in a better position to effect these changes. Even as disinvestment now seems altogether ruled out, the government's commitment to ensuring the oil firms' financial health poses a big question. If the government decides not to free up product pricing soon enough, the downsides could be severe.

Competition is going to be keen in times to come with the Mukesh Ambani-controlled Reliance Industries [Get Quote] entering the oil retailing space. The company has already put up about 1,000 retail outlets and plans to further expand its network.

"Private players have already entered this sector. So, to make it a level-playing field, the sector should be decontrolled soon," says Srivastava.

In countries such as Europe and the US, 35 per cent of the total revenue for oil companies comes from non-oil sales. In India, it is only 2 per cent. "So, oil marketing companies should try to increase their non-oil revenues to make good the losses," Srivastava adds.

But when a core business is bleeding, the management can ill-afford to focus its precious resources on non-core activities.

Already on the refining side, Reliance enjoys better margins because its refinery can process sour crude, which is cheaper. With strong cash flows from its refining operations and other downstream businesses, Reliance has the resources to absorb marketing losses in the initial years to capture market share.

Even if the company is able to capture a 30 per cent share in the retailing pie over the next couple of years, especially with its modern retailing outlet which can deliver better throughput, it could make the going pretty tough for public sector players.

Analysts feel that now is the time for state-owned oil companies to up their ante, invest in modernisation, and strengthen their marketing infrastructure besides taking pre-emptive steps to counter competition.

Currently, PSUs are in a position of strength as far as retail reach goes. IOC along with its refining subsidiaries Chennai Petroleum, Bongaigaon Refinery and marketing subsidiary IBP has a combined refining capacity of 54.20 million metric tonnes per annum and has a 56 per cent per cent markets-share in petroleum products among the public sector companies.

IOC owns and operates the largest network of cross-country crude oil and product pipelines spanning nearly 9,000 kilometres, with a combined capacity of 60.42 mmtpa. Rival HPCL and BPCL alas have around 7000 and 6500-odd retail outlets respectively across the country.

By not allowing free pricing and allowing oil companies to bleed, the government is indirectly allowing competition to thrive and asking state-owned companies to fight with tied fists.

Over the past two years, crude prices have risen 78 per cent from $34 to about $61 currently. Consequently, the burden of subsidy on cooking fuel - kerosene and domestic LPG - ballooned to unprecedented levels.

Besides, as the government restrained from passing through the higher international prices to domestic consumers by not hiking rates to cover the costs, oil companies have suffered serious losses on marketing auto fuel.

The combined profits of marketing companies, which were healthy at Rs 10,818 crores (Rs 108.18 billion) in 2003-04 declined to Rs 7,193 crore (Rs 71.93 billion) in 2004-05 and got totally eroded during the current year with losses of Rs 2,898 crore (Rs 28.98 billion) in the first nine months of the fiscal. This is after assistance of Rs 9,750 crore (Rs 97.5 billion) from upstream companies and a budgetary support of Rs 2,000 crore (Rs 20 billion) during the period.

Now sample this: even as Brent crude prices have averaged $58/bbl in this fiscal compared with $42.2/bbl in fiscal 2005, IOC made a profit of only $1.1/bbl, same as last year. Rivals BPCL and HPCL earned a minuscule 0.3 dollar/bbl as against $0.9 for last fiscal as their product mix was unfavourable compared with IOC.

Dissecting it further product-wise, for every kiloliter of petrol sold, marketing companies make a loss of Rs 770 in this year compared with a profit of Rs 1175 last fiscal.

Similarly, on every kiloliter of diesel sold, they lose Rs 1495 compared with a profit of Rs 741 in the previous year. Much worse, since prices of cooking fuel such as LPG and Kerosene are subsidised, marketing companies incur a loss of Rs 148 on every cylinder sold and about Rs 11.3 per litre of kerosene sold.

Adding it all, the total loss on account of selling fuel at less than market prices during the current fiscal is estimated at Rs 38,600 crore (Rs 386 billion), up from Rs 20,100 crore (Rs 201 billion) last year.

Of this, the three upstream companies namely ONGC [Get Quote], Gail and OIL are to share Rs 12,800 crore (Rs 128 billion), the three downstream companies have to dish out Rs 11,700 crore (Rs 117 billion). The government has given its share in the form of oil bonds worth Rs 11,500 crore (Rs 115 billion). Pure refining companies are to pay a relatively small sum of Rs 270 crore (Rs 2.7 billion).

Ironically, rising crude prices is not only eating into the profits of marketing companies but also oil explorations companies such as ONGC should ideally gain from rising oil prices. But, since upstream companies have to share a third of the subsidy bill, ONGC has to shell out nearly Rs 12,000 crore (Rs 120 billion) out of its profits.

Since this money is being doled out in the form of discounts on sales to marketing companies, realisations have suffered. For instance, compared with international average price of $60 a barrel, ONGC realised only $42 in the last quarter. Despite crude oil prices increasing by 32 per cent y-o-y during the quarter, net sales increased by only 3 per cent.

One blessing in disguise is that owing to stress on the system, and thanks to a buoyant market too, the government has finally given a nod for unwinding of crossholdings in state-owned companies. The estimate value of the stake IOC holds in ONGC and Gail amounts to Rs 148 per share.

So how to play oil stocks? Oil prices are expected to remain high as it is not just demand-supply dynamics but high levels of taxes imposed by governments across the world which will keep prices high. When there is absolutely no visibility on earnings, the best way to value a company is based on its assets. Based on replacement cost, analysts peg the value of IOC at around Rs 85,000 crore (Rs 850 billion).

Similarly, for BPCL and HPCL the equity valuation based on replacement cost is pegged at Rs 21,000 crore (Rs 210 billion) and 19,000 crore (Rs 190 billion), respectively. "Stocks should be at least 30-40 per cent from current levels if one were to value them based on replacement cost," says Susanta Mazumdar, director reserach, UBS.

It may be tough to take a long-term call on the stock because the survival of these companies in the long run would depend on their ability to compete, especially with private sector entering the game now.

In the medium-term, like we said in the beginning, it is purely a call on the government, not fundamental analysis.

Over the short-term, some upside is possible with more analysts taking a positive view on the reform process, which can bring in some takers for a sector whose stocks are grossly under-owned.

Among the three oil marketing companies, IOC looks the best bet because of its diversified earnings profile and cash value in its investment holdings. After the impending merger with Kochi, BPCL should also have more stable earnings.

HPCL though is most vulnerable to policy risk and for the same reason would provide maximum gains in case the Rangarajan Committe recommendations are accepted. ONGC trading currently at 8.85 times fiscal 07 earnings still offers deep value with a attractive dividend yield of nearly 4 per cent.

With inputs from Rupa Dattani.

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