The refining glut is expected to worsen in the longer term, led by capacity expansion, rising distillate yields, increasing mileage per gallon, and growing use of greener fuels.
The refining glut is expected to worsen in the longer term, led by capacity expansion, rising distillate yields, increasing mileage per gallon, and growing use of greener fuels. However, refining margins have been strong at $8.3/bbl since July 2017 due to high unplanned shutdown, globally; we expect this to continue for a while. After a bit of a slowdown in FY17, consumption of both petrol and diesel has grown strongly at 8.3% and 4.5%, respectively in FY18YTD. Further, with daily pricing since June 2017 and expansion of dynamic pricing, the profitability of oil marketing companies (OMCs – IOCL, BPCL and HPCL) appears set to increase. OMCs trade at an EV/Ebitda of 7.9x FY19e and a P/E of 10.9x FY19E with superior return ratios compared to global peers.
The OMCs remain in a sweet spot considering high consumption growth, potential marketing margin expansion, and low competitive intensity. Stock performance should mirror their efforts to effectively utilise the current dynamics to their benefit. OMCs catch up on refining marginsOver FY14-17, BPCL has increased its petrol and diesel yields by 5.7% and 4%, respectively. Similarly, HPCL has increased its petrol and diesel yields by 1% and 5.4%, respectively. This should support better refining performance for them. IOCL has increased its petrol and diesel yield by only 2.5% together, but addition of Paradip refinery should help improve its refining margin. Marketing margins appear to be strengthening. From mid-June 2017, the OMCs have been pricing retail petrol and diesel on a daily basis. This helps to better tackle issues of inventory volatility and competition. We expect marketing margins of petrol and diesel to increase by Rs 0.20-0.30/litre in each of the next two years.
Private players have been ramping up their operations. Their market share in retail auto fuels has increased to 5%. However, lack of logistics infrastructure remains the main bottleneck. We reckon that innovative business models, decreasing product placement costs and increasing lucrativeness of the domestic market with respect to exports could pose a risk in the medium-to-longer term. IOCL remains top pick
Both IOCL and BPCL are coming to an end of their capex cycles. We expect IOCL and BPCL to generate free cash flow of Rs 515 bn and Rs 75 bn, respectively during FY18-20.
We expect free cash flow for HPCL to remain negative for the forecast horizon. HPCL is the most leveraged to marketing. An increase of Rs 0.10/litre in retail auto fuel margins would increase its EPS by 4%. IOCL and BPCL, with lower leverage to marketing, would see EPS increasing by 2% and 3%, respectively. We value the OMCs using SOTP. We roll over partially to FY20 for arriving at September 2018 targets. We reiterate Buy on IOCL and HPCL, with targets of Rs 558 and Rs 583, respectively. We upgrade BPCL to Buy from Neutral, with a target of Rs 640. IOCL remains our top pick. HPCL is likely to be affected by how the strategic sale of government stake pans out.