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Energy
India
QE2 versus EUX and Indian oil companies. We would advise investors to ignore
news flow around deregulation and subsidy-sharing system for some time and invest
with a 6-9 months horizon. The downstream oil companies have given up most of their
gains post the June 25, 2010 deregulation announcement on concerns of policy
paralysis and high crude prices. We expect periodic bouts of mini-crises in EU and
forced slowdown by China through 1HCY11E to partially offset the impact of QE2 on
crude prices. Inflation in India will be less of a concern over the next few months.
Challenges to diesel deregulation exist although they are surmountable
We believe diesel deregulation can take place over the next few months led by (1) the small gap
between free-market and current domestic prices even at US$85/bbl crude oil price and (2) likely
decline in inflation in India over the next few months. We assume deregulation of prices from April
1, 2011 and would not be too perturbed by recent government inaction on pricing. Historical
experience suggests that deregulation process is highly erratic; periods of excess pessimism may be
the best times to invest in the downstream stocks.
Speculation on subsidy-sharing mechanism for FY2011E is pointless
The government’s decision to compensate the downstream oil companies about `130 bn out of
`314 bn of under-recoveries in 1HFY11 has raised concerns about a larger-than-expected share of
under-recoveries for the downstream oil companies in FY2011E. We believe that the subsidysharing
details will likely be finalized by the time of 4QFY11E results. We assume that the
government will provide adequate compensation to the downstream oil companies and restrict
their share of under-recoveries to about `63 bn, higher than `56 bn in FY2010.
Stocks back to pre-deregulation levels; little faith in deregulation
The government-owned R&M companies have largely retraced most of their gains following the
June 25, 2010 deregulation announcement. This would suggest that the market has little faith in
deregulation of diesel prices and/or the government’s willingness to provide adequate
compensation from the budget and protect the earnings of the companies. We note that the
stocks are trading at a steep discount to our 12-month fair valuations, which assumes higher net
under-recoveries in FY2012E versus FY2010.
Crude prices—QE2 versus EUX and fundamentals
The market has understandably got spooked by the US$10/bbl increase in global crude oil prices
following expectations of QE2 in late August, 2010. However, more recent concerns about the
depth, width and periodicity (hence, EUX) of sovereign debt crisis in the Euro Zone has cooled off
prices somewhat. In our view, this process will likely continue in 1HCY11E with periodic concerns
about sovereign debt in Europe partly offsetting the inflationary impact of the US Fed’s QE2
program. Also, crude fundamentals in CY2011E do not suggest crude prices sustaining above
US$90/bbl for an extended period of time.
Diesel deregulation can take place but patience may get tested
In our view, a combination of (1) ‘range-bound’ crude oil prices and (2) declining inflation in
India may allow the government to deregulate diesel prices over the next few months. We
note that the gap between required free-market prices and current domestic retail price for
diesel is not insurmountable. Exhibit 1 shows the marketing margins on diesel for the past
few months and weeks.
�� Crude oil prices—tension between QE2 on the one side and Euro Zone, China and
fundamentals on the other. Exhibit 2 shows the movement in crude oil prices over the
past few months (from June 1, 2010). Crude prices jumped up sharply from late August,
2010 when the market started factoring in the Fed’s QE2 program following the Fed
Chairman’s speech at the economic symposium at Jackson Hole, Wyoming. However,
they pulled back somewhat when concerns about sovereign debt in certain Euro Zone
countries (Ireland, Portugal and Spain) resurfaced in early November, 2010. The Chinese
government’s recent attempts to control inflation have also dampened crude prices
somewhat.
We expect this script to repeat in 1HCY11E as the street weighs (1) the impact of the
Fed’s QE2 program against (2) concerns about the sovereign debt positions in several
European countries and the pace of slowdown in China. We note that speculative
positions in crude futures have gone up to multi-year high levels, which in turn has pulled
up crude oil prices; this would suggest that crude oil prices have already discounted likely
weakness in the US Dollar as a result of the Fed’s QE2 program and its positive impact on
commodities and other asset classes.
We note that long-dated crude oil prices have moved less over this period (see Exhibit 3).
Finally, we believe that fundamentals are not strong enough to support crude oil prices
above US$90/bbl on a sustained basis. OPEC spare capacity is comfortable at around 6
mn b/d and we expect this figure to be unchanged through CY2011E. We note that
increase in non-OPEC supply at 0.7 mn b/d and NGLs at another 0.7 mn b/d will offset
likely global incremental demand of 1.2 mn b/d in CY2011E. Exhibit 4 shows our supplydemand
forecasts for crude oil, which are largely based on IEA’s forecasts. Finally, OECD
inventories are at multi-year highs.
Inflation in India—on the way down over the next few months. Our Economics
team projects a drop in inflation over the next few months as can be seen in Exhibit 6.
We note that price levels will largely hold up but the high base of last year will likely result
in yoy inflation (as measured by WPI inflation) coming off sharply. We expect inflation to
further soften in FY2012E barring unforeseen circumstances (weak monsoons, surge in
commodity prices). Finally, we note that inflation could still be on the lower side even if
the government/companies were to raise fuel prices (barring kerosene and LPG) to align
domestic prices with US$90/bbl crude price (average) in FY2012E
Stocks are discounting that diesel deregulation is largely off
Exhibit 8 shows that the stock prices of BPCL, HPCL and IOCL have largely retraced most of
the gains following the June 25, 2010 announcement of deregulation of diesel and gasoline
prices. The stocks had jumped up sharply initially but have come off over the past few weeks
on concerns about high crude oil prices and government inaction on diesel deregulation.
Our reverse-valuation exercise (see Exhibit 9) suggests that the market has largely given up
on deregulation of diesel price (and of kerosene and LPG prices) in perpetuity. In our exercise,
we subtract the value of investments from the current EV (based on end-FY2010 net debt)
to compute the implied EV of the companies and divide the resultant figures with our
FY2011E EBITDA estimate. The implied EV/EBITDA multiples are quite reasonable, in our
view. We note that we assume net under-recoveries for the R&M companies at `63 bn in
FY2011E compared to `56 bn in FY2010. We may be somewhat conservative in that we do
not ascribe any value to BPCL’s E&P assets or C-WIP in the case of all the three companies.
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