Diesel deregulation is imminent given favourable macro-environment
We expect the government to deregulate diesel retail prices in the coming months as underrecovery declines to negligible levels. In our view, downstream oil companies may be allowed to revise prices to align with global-parity levels on a fortnightly basis, similar to other deregulated fuels and the government may intervene only on a sharp spike in global prices. As the chart shows diesel under-recovery on domestic retail sales has declined to a modest ~R0.3/liter currently led by (i) a sharp decline in global crude prices (dated Brent at $102/bbl), (ii) subdued regional diesel spreads at $16/bbl and (iii) steady rupee-dollar exchange rate at R61/$. Moderate ramp-up in crude oil production from Libya, easing concerns on Iraq and adequate global oil supplies have led to a sharp correction in crude prices over the past two months.
Cooking fuels subsidy can be curtailed in the medium term
In our view, the government may attempt to reduce subsidies on LPG and kerosene in the medium term by implementing a combination of measures(i) allowing OMCs (oil marketing compamies) to increase retail prices by a nominal amount on a monthly basis, (ii) reducing the cap of subsidised LPG cylinders to a more reasonable six per household per annum (versus 12 currently) and rationing quota of subsidised kerosene for PDS, and (iii) promoting substitution of kerosene by LPG and LPG by piped natural gas. Implementation of direct benefit transfer (DBT) to target the deserving section of population can further reduce subsidies in the long run.
We note that $5/bbl decline in global oil prices will result in R51 bn reduction in fuel subsidies for FY16.
Raise EPS estimates to factor in lower net under-recoveries
We have raised our EPS estimates for downstream oil companies to factor in lower net underrecoveries of R10-18 bn in FY15-17e versus our earlier assumption of R27-37 bn. We now see only a modest upside to our EPS estimates under a normalized scenario of nil under-recovery and no forex/inventory losses. We have already factored in reasonable marketing margins of R1.25-1.5/litre on diesel and R2/litre on gasoline and a gradual improvement in refining margins for FY16-17.
Prefer BPCL and IOCL over HPCL; raise target prices by 12-16%
We prefer BPCL and IOCL over HPCL given (i) favourable reward-risk balance and (ii) valuation support for BPCL from upstream segment and earnings growth for IOCL from commissioning of Paradip refinery. We accord a higher P/E (price-to-earnings) multiple of 9x to BPCL and IOCL as compared to 7x to HPCL, noting superior performance of the core business in recent years. We raise our target prices for BPCL to R750 (+12%) and IOCL to R430 (+16%) while retaining our Add R480 (+13%).
Kotak Institutional Equities