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We would advise investors to invest in downstream stocks as the current valuations suggest an overly
pessimistic assumption of (1) crude prices remaining high in perpetuity, (2) no
deregulation of diesel prices and (3) the possibility of higher-than-expected subsidy
burden on downstream companies. We see the hike of `3/liter on gasoline as allaying
investor concerns on credibility of deregulation process We expect diesel deregulation
over the next few months given a likely sharp dip in inflation. We maintain our BUY
rating on BPCL and HPCL and upgrade IOCL to BUY (ADD previously)
Excess pessimism around downstream companies provides good opportunity to invest
Corrections in the prices of downstream stocks over the past two months reflect (1) a sharp surge
in crude oil prices, (2) delay in implementation of diesel deregulation and (3) a lack of clarity on
subsidy-sharing mechanism. However, we believe the concerns are overdone and current stock
prices seem to reflecting a scenario of (1) no government action on diesel deregulation, (2) no
softening of crude oil prices and (3) a higher-than-expected burden on downstream oil companies.
We would advise investors to take advantage of the current pessimism to invest in these stocks.
We upgrade IOCL to BUY and see significant potential upside to our 12-month fair valuation for
the three stocks—`860 for BPCL, `600 for HPCL and `500 for IOCL.
Some relief in sight—EGoM meeting on December 22 to review diesel prices
An Empowered Group of Ministers (EGoM) is scheduled to meet on December 22, 2010 to decide
on potential hike in diesel prices. A likely hike in diesel prices will help bridging the gap between
free-market and current domestic prices to a large extent. We note that if retail diesel prices are
increased by `2/liter, the breakeven crude price for diesel would increase to ~US$84/bbl. This
would make diesel deregulation manageable. We assume a deregulation of prices from April 1,
2011 and would not be too perturbed by recent government inaction on pricing.
We do not assume benefit of diesel deregulation to accrue to downstream companies in any case
We highlight that net under-recoveries are the more critical variable for downstream companies as
compared to gross under-recoveries. We model net under-recovery of `63 bn in FY2012E for
downstream companies, which is similar to FY2011E. Thus, we do not see risk to our earnings
estimates from a delay in or non implementation of diesel deregulation. However, diesel
deregulation will improve sentiment and valuations for downstream oil companies.
Gasoline prices hiked by `3/liter
We expect the `3/liter gasoline price hike by BPCL (effective midnight December 14, 2010) to allay
investor concerns about the credibility of the deregulation process at high crude prices. The retail
gasoline prices have been increased by `7.8/liter since the announcement of deregulation on June
25, 2010. We note that the under-recovery on gasoline post the price hike will be `2.3/liter at the
current level of crude prices (US$90.6/bbl Dated Brent for the week ended December 10, 2010).
Subsidy-sharing mechanism will likely be finalized by end-FY2011E
We expect the subsidy-sharing mechanism to be finalized by end-FY2011E as 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 do not see any
merit in speculating on the subsidy-sharing mechanism at the current juncture. We do not see risks
to earnings of downstream companies from significantly higher-than-expected subsidy burden. We
assume that government will provide `330 bn as compensation in FY2011E on gross underrecoveries of `621 bn. This is significantly lower than the compensation provided by the
government in the past
Crude prices to soften as fundamentals override speculative activities
We expect crude prices to correct from recent high levels led by (1) likely regulatory tap on
current high speculative activities in the US (see Exhibit 2) and (2) Chinese government’s
monetary tightening attempts to control inflation. We believe crude fundamentals in
CY2011E do not suggest crude prices sustaining above US$90/bbl for an extended period of
time. We note that the increase in non-OPEC supply at 0.6 mn b/d and NGLs at another 0.6
mn b/d will offset likely global incremental demand of 1.3 mn b/d in CY2011E
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