Indian Downstream Stocks Pricing in Diesel Dereg; Time to Shed Some Complacency: Citi

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Indian Downstream
Stocks Pricing in Diesel Dereg; Time to Shed Some Complacency

 Gov’t: intent good but more action needed — We upgraded OMCs last year on
the back of growing confidence in the government’s intent to compensate
OMCs for the under-recoveries incurred by them. While the gov't has
subsequently taken significant steps in the right direction – deregulating petrol,
increasing diesel/LPG/kero prices and announcing the intent to deregulate
diesel – we believe further stock re-rating would be contingent on the
government addressing some of the issues it has fallen short on – clarity on its
own contribution, transparency in the subsidy sharing mechanism, and
implementation of diesel deregulation – all of which we remain uncertain of.

 Downgrading OMCs — We downgrade BPCL from Buy to Hold, HPCL from Buy
to Sell, and retain Hold on IOC. The stocks have been significant performers in
the last year, up 27-35% and outperforming the broader market by 11-19%.
However, with the stocks leaving limited upside even to our increased TPs and
considerable risks to earnings we see stemming from: (i) diesel deregulation
timelines remaining uncertain, (ii) uncertainty on gov’t policy and intent to fully
compensate the OMCs, and (iii) upside risks to crude, which is trading above
the US$70-80 range, that have so far kept both the gov’t and the market
relatively complacent, we believe it is time to shed some of this complacency,
esp. given the protracted delay by the gov’t in following up intent with action.

 Stocks already pricing in diesel deregulation — We value OMCs by evaluating
their inherent earnings potential along with suitable risk-weightages, and base
our TPs on sum of: (i) 6x FY12E EV/E in the base-case (1/3rd upstream share,
50% gov't share, diesel dereg.), and (ii) 25% probability to incremental
earnings in an upside scenario (OMCs fully compensated, i.e., nil net losses).
We have lowered our upside probability from 50% earlier following the FY10
disappointment. Our new TPs rise to Rs746 for BP (Rs713), Rs511 for HP
(Rs493), Rs427 for IOC (Rs355), but still imply just 3-5% upsides. Our base
case (i.e., ex. upsides) yields ~Rs60bn net losses, in line with FY10, and TPs
1-8% below current levels, implying stocks already appear to be pricing in
diesel dereg and healthy compensation. Rising crude increases overall losses
by ~Rs30bn for every US$1, besides reducing the probability of diesel dereg.

 Upside/downside scenarios — In a best case, a move to fully compensate OMCs
for losses could lead to 37/50/27% upsides for BP/HP/IOC, though the mkt will
likely hesitate in pricing this in (hence, our probability adjustment). On the
other hand, a delay in diesel deregulation combined with the gov’t capping its
share at 50% could lead to downsides of 23/33/10% for BP/HP/IOC