On November 9, 2011, the then chairman of India’s largest oil refining and marketing company Indian Oil Corporation Ltd (IOC) R S Butola announced his firm may need to shut down some of its refineries since it was in dire need for cash to buy crude oil. The state-run firm had reported an unprecedented net loss of Rs 7,485 crore during July-September quarter of that year with its borrowings climbing to Rs 73,296 crore.
Government-controlled retail prices of petroleum products leading to losses (commonly known as under-recoveries for petrol, diesel, LPG and kerosene), and an opaque mechanism of subsidy, have been the bane of three oil marketing companies (OMCs) – IOC, BPCL and HPCL – for nearly a decade. Their earnings have been dependent on the government’s ad-hoc policies on pricing, subsidies and subsidy-sharing.
But, from being in dire straits three to four years ago, oil marketing companies have come a long way now. Thanks to de-regulation, first of petrol prices and subsequently those of diesel, and also due to tumbling crude oil prices—which have dropped all the way to $46.59/barrel on January 13, 2015 from $99.45/barrel a year ago—OMCs today are now on a much firmer footing financially. (For 2015, year-to-date Brent averaged at $59.2/barrel). And although kerosene and LPG continue to be subsidised, which means OMCs aren’t able to recover their costs on these, IOC, BPCL and HPCL are clearly in much better shape. Henceforth, earnings will be driven more by fundamentals – refining margins, crude oil prices, marketing margins and volumes – and their focus will now be on issues like efficiency and market share gains.
B Ashok, chairman, IOC, admits the firm’s cash flows have “certainly improved”, giving the company more room to plan investments for expanding the network of pipelines, LNG terminals and also for brownfield expansion of the refineries at Barauni, Panipat and Gujarat. “Our borrowings have come down to the level of Rs 53,000 crore from Rs 83,000 crore at the same time last year so we are likely to spend about Rs 15,000 crore as capital expenditure every year,” Ashok told FE.
S Varadarajan, chairman and managing director of India’s second-biggest state refiner BPCL, also revealed plans to invest Rs 3,500 crore for upgrading the capacity of the Bina refinery to 7.8 million tonnes a year from the current 6 million tonnes by 2018.
Indeed, after sustaining inventory losses last year which were 2.3 times the reported profits after tax, reasonably good refining margins and the lower cost of crude oil are expected to deliver sustainable earnings of a better quality.
The best is yet to come, believes brokerage house Nomura which wrote earlier this month that it expects a sharp increase in earnings of 53-134% as the full impact of reforms takes effect amidst a benign oil price environment. “Importantly, our confidence in earnings is far better than ever in the past 7-8 years. Market concerns on government’s interference in pricing/subsidies have now nearly vanished. OMC stocks should be driven more by fundamentals and the scope for further re-rating remains,” the brokerage observed.
What will make a big difference to the environment is the smaller under-recoveries (u/r), which have been the bane of oil PSUs for nearly a decade; they will fall meaningfully given diesel prices have been de-regulated since November , 2014 and the full impact will be felt this year. Moreover, with the direct benefit transfer (DBTL) scheme in place, LPG is now sold at market prices and while there will be subsides on LPG, these will be funded by the government from its budget. That leaves under-recoveries on kerosene; assuming oil prices at $60/bbl for FY16F, the under-recoveries are tipped to fall to Rs 16,000 crore, a drop of 78% year-on-year from Rs 72,300 crore in FY15, and only a tenth of the bill of Rs 1.6 lakh crore in FY13. Although petrol was de-regulated in June 2010, serious efforts to rein in subsidies started in September 2012 when there was a sharp hike in diesel price, an excise duty cut on petrol, and the limit on LPG refills was imposed by the United Progressive Alliance (UPA) government. With the introduction of monthly diesel hikes from January 2013, and with the gradual transfer of LPG subsidies to the DBTL mechanism), the reforms picked up pace. However, the process was derailed ahead of the general elections in 2014 and the UPA government rolled back some of the reform measures. The key difference between the earlier practice and DBTL is that in the first instance, OMCs needed to book losses if they didn’t receive the compensation for the under-recoveries in time.
The next big earnings kicker for OMCs could come from higher marketing margins on sales of diesel. The state-run firms could at least earn an additional marketing margin of Rs 0.5-1/litre even if private players pick up a market share of as high as 15% because, government-owned players will benefit on a net basis. Indeed, in the post de-regulation era it is now easier to earn higher than normal margins. Furthermore, with relatively benign oil prices, refiners are able to make higher marketing profits on other market-priced fuels such as lubes, naphtha, fuel oils and ATF.
In the near term, the OMCs should also benefit from discounts from Middle Eastern oil producers, as OPEC focuses on market share. Asian refineries, which are large consumers of West Asian oil, have enjoyed price discounts in recent months. On average, crude oil imports into Asia were at $5/barrel lower than for European countries in February, according to International Energy Agency (IEA). This was the largest discount since March 2011, in contrast with 2014’s average premium of $3-4/barrel. Meanwhile, the year-to-date average complex and simple refining margins are at $8.3/barrel and $3.5/barrel, respectively, significantly above 2014 levels of $5.8/barrel and $0.1/barrel each. Traders expect the Asian refineries to continue to enjoy Middle Eastern producers’ competitive pricing policy for a while. Since late 2014, Saudi Arabia lowered its official selling price (OSP) to Asia and has been selling at a discount to the Dubai benchmark reference, something not seen in four years. IEA states that other suppliers in Kuwait, Qatar, UAE and Iran also follow this strategy.
GAINS IN STORE
* FY16 will be a defining year for Indian oil PSUs
* The full benefits of reforms in oil marketing (diesel de-regulation, LPG direct benefit transfer, etc), and also the sharp decline in oil prices should be seen.
* Earnings growth of 53-134% for oil marketing companies and 35-66% for upstream oil PSUs expected.
* For the past seven-eight years, oil PSUs’ earnings have largely been dependent on the government’s ad-hoc policies on pricing, subsidies, and subsidy sharing. These market concerns have now significantly reduced.
* For OMCs, as several key reforms are in place, earnings should now be driven more by fundamentals (refining margins, oil price, marketing margins, volume growth, etc) and their focus will now be on issues like efficiency and market share gains.