The sharp decline in crude oil prices recently brings a cheer to the public sector companies in the oil and gas sector. It is likely to be a win-win situation for all players involved - the oil marketing companies (OMCs) such as Indian Oil Corporation
(IOC), Bharat Petroleum Corporation
(BPCL) and Hindustan Petroleum Corporation
(HPCL), the upstream companies (ONGC, OIL India and GAIL) as well as the Government of India. Thanks to the fall in crude oil prices (down 15 per cent since September 2012), the under-recovery burden for FY14 is estimated to halve, which will boost the profitability of OMCs, push up net realisations of the upstream companies and reduce the government's fiscal deficit for FY14. Additionally, gradual diesel price increases coupled with lower crude oil prices and a firm rupee are likely to erase diesel under-recoveries faster than anticipated, believe analysts.
While the exact estimate of under-recoveries and their impact on the earnings of the companies will differ with the rupee, crude oil price and actual subsidy sharing between the government and the oil companies, gains for OMCs are significant. Analysts estimate gross under-recoveries for FY14 to be anywhere between Rs 70,000 crore and Rs 1,20,000 crore as against Rs 1,60,000 crore in FY13.
Among the fuels, OMCs are expected to see near elimination of under-recovery in diesel, if oil prices remain benign at current levels. "The under-recovery on diesel (which accounted for 45 per cent of overall fuel consumption in 2012-13) was as high as Rs 11 a litre in February 2013 and is estimated to have fallen to meagre Rs 1-2 a litre on April 16," notes CRISIL.
Lower under-recoveries will improve the financial health of OMCs, as their working capital requirements would reduce. This will reflect in lower interest costs and consequently boost the earnings as well as cash flows of OMCs. "We expect OMCs' interest cost to decrease by Rs 2,500-3,000 crore in 2013-14, which is close to half of their net profit in 2011-12," rating agency CRISIL writes in a recent note. The rating agency expects Brent crude oil price to average $100-105 a barrel in 2013, driven by weak global demand and growing supply from Opec and non-Opec countries.
"Muted oil products demand reflected in lower GRMs, Brent at $90-100 a barrel and further increases in diesel prices to the extent of Rs 2.7 a litre (six price hikes) as expected by us, could wipe off diesel losses completely and bring de-control much earlier than expected as of now," says Amit Rustagi, oil and gas analyst at Antique Stock Broking. He expects diesel price rise of Rs 4 a litre over FY14 and Rs 3 a litre over FY15.
While lower under-recoveries is a positive, the key to earnings visibility will be clarity on subsidy sharing. Analysts believe, the government is likely to retain major part of gains from lower under-recoveries which means that the under-recovery share for upstream companies may remain unchanged at 40 per cent. However, the absolute amount will come down by Rs 25,000-30,000 crore in FY14. Also, as a result of diesel price increases, analysts expect net realisations of upstream companies to increase to $60 a barrel from $45-51 a barrel levels prevailing. This will boost upstream companies' profitability in FY14-FY15.
Operationally, OMCs continue to face the challenges of lower refining margins, likely lowering of product import duties, amongst others. Among the three OMCs, BPCL remains the top pick of most brokerages. Despite the recent rise in share prices, analysts believe, BPCL is attractively valued given that current prices do not adequately capture the exploratory upsides for the company.
Somshankar Sinha and Pooja Sinha, analysts at Barclays in their report last week, said, "We remain more constructive on BPCL (overweight, adjusted 0.3 times price/book value) than IOCL and HPCL (both underweight). While BPCL should benefit from policy tailwinds like its peers, it has also outperformed them on downstream performance for the past decade while its upstream assets are also undervalued, in our view".
While the environment is turning positive, for it to sustain it is necessary that crude oil prices remain benign at current levels, rupee stays firm and there is no adverse change in subsidy sharing.