Visit http://indiaer.blogspot.com/ for complete details Gasoline-powered deregulation. We expect the `0.70-0.72/liter gasoline price hike
by BPCL and IOCL to provide further credibility to the deregulation process. The second
price hike after the June 25 deregulation announcement should allay investor concerns
about the ability of OMCs to increase retail prices at high crude oil prices. We expect
the subsidy-sharing to be finalized by end-FY2011E and would ignore media
speculation in the interim period. We maintain our positive view on the downstream
companies. We upgrade BPCL to BUY, maintain BUY on HPCL and ADD on IOCL.
Deregulation is here to stay
We expect the `0.70-72/liter gasoline price hike by BPCL and IOCL to further enhance investor
confidence in the deregulation process. The recent price increase will likely allay investor concerns
about the credibility of the deregulation process at high crude prices. We note that gasoline prices
have been increased by `4.5/liter since the announcement of deregulation on June 25, 2010. We
note that the under-recovery on gasoline (pre-increase) is `2.1/liter at current level of crude prices
(US$83.5/bbl Dated Brent for the week ended October 15, 2010). We have assumed that gasoline
prices will be market-linked from 3QFY11E in our earnings model.
Don’t be swayed by speculation on subsidy-sharing mechanism
We caution investors against media speculation on the potential subsidy-sharing mechanisms for
FY2011E. We would not be surprised if the government does not provide any compensation to the
downstream companies in 2QFY11E and would not extrapolate the amount, if any, to assess
compensation for FY2011E. We believe that it is too early for the government to finalize the
subsidy-sharing for FY2011E given the sharp volatility in several key variables—(1) crude oil prices,
(2) global product prices and (3) exchange rates. We also note the government’s plans to divest
stakes in IOCL and ONGC by March 2011 and expect the government to create the right
investment environment before their divestment. We work on the philosophy that the government
would provide sufficient compensation to the downstream companies to ensure that their
FY2011E and FY2012E net under-recoveries are similar to FY2010 levels (`56 bn).
Recent correction in stock prices provides opportunity to buy
We would recommend that investors take advantage of the recent correction in stock prices of
downstream companies driven by (1) sharp increase in crude oil prices and (2) media speculation
about an unfavorable subsidy-sharing arrangement. We view the announcement of a hike in
gasoline prices as positive for the sector as it will (1) reduce the under-recoveries in the system and
(2) show that the policy-makers and downstream companies are serious about deregulation of
auto fuel prices. We upgrade BPCL to BUY and see significant potential upside to our 12-month
fair valuation for the three stocks—`855 for BPCL, `625 for HPCL and `480 for IOCL. Finally, our
blue-sky scenario of full deregulation (government compensates entire subsidy loss on cooking
fuels) shows 39-72% potential upside from current levels.
Diesel deregulation in practice will likely follow soon
Diesel prices have been left unchanged but we expect the same to be deregulated in 4QFY11E on
a likely easing of inflationary concerns. We compute under-recovery of `1.5/liter on diesel at crude
oil price of US$83.5 in the week ended October 15, 2010. We believe diesel deregulation is critical
to address the subsidy issue given that it is the largest product by volumes (60% of total sales of
regulated products). We see the pragmatic approach towards deregulation of gasoline providing
greater confidence in timely implementation of diesel deregulation.
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