We have been negative on the OMCs (oil and marketing companies) for some time. After the 28-47% stock fall YTD (year-to-date), we now take a more Neutral view of the space and upgrade Bharat Petroleum Corporation Ltd (BPCL) to Outperform.
*Dependent on overall losses. With the rise in rupee crude prices, under-recoveries are likely to remain high (R1,050-1,350 bn) in FY14/15 even if the government continues to deliver the promised diesel price increases and directed LPG payments. The government seems to have deferred the expected diesel price increase for now, but any efforts to reduce losses (which seems imperative) should be positive.
*Dependent on payment mechanism. Use of the export-parity pricing (EPP) mechanism is tantamount to under-funding of R130 bn (R113 bn ex-bulk diesel); in this case, OMC RoE (return on equity) could fall to 3-9%. Without EPP, the risk that the OMCs are not fully paid even at low levels of losses (like FY06/08) remains.
Hindustan Petroleum Corporation Ltd (HPCL) ó have underperformed the market by 36%, 28% and 47%, respectively, since their Jan-13 peaks. We estimate these now trade at 0.20-0.26x core book, which we believe imply RoE the OMCs are likely to deliver under export-parity pricing. Under-recoveries remain high, and the prospect of diesel price increases looks low in the near term. FY14 (and beyond) subsidy payment mechanisms remain unclear. Nonetheless, we believe current valuations should limit further downside.
Valuations reflect under-compensation/ EPP: Stripping out the valuation of investments, E&P and pipeline businesses and other holdings, we estimate the core refining and marketing businesses of IOC/BPCL/HPCL are trading at 0.20/0.23/0.26x (times) core book. If the cost of equity was 15%, their current valuations would imply core RoE of about 3.0%/3.4%/3.9%. We think these are not too different from the levels the OMC could deliver if export-parity pricing was implemented fully.
If the OMCs delivered RoE of 4%óas implied by their stock prices currentlyó IOC/BPCL/ HPCL would generate PAT+depreciation less dividends (as a rough measure of cash flow) of about R78/24/25 billion. This would be less than the capex these companies have incurred historically, and perhaps the amounts they need to sustain their businesses. It is possible that the governmentóthrough lower compensationóreduces