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Energy
India
Earnings may not be in trouble despite crude bubble. We do not see downside risk
to earnings of downstream companies from high gross under-recoveries resulting from
high crude oil prices as long as the government provides adequate compensation. We
already assume that downstream companies will bear higher net under-recoveries in
FY2011-12E versus the amount borne by them in FY2010. We have revised our
earnings for BPCL/HPCL/IOCL to reflect (1) higher crude price assumption, (2) higher
gross under-recoveries and (3) delays in diesel deregulation. We maintain our BUY
rating on these companies given potential upside of 32-49% from current levels
Net under-recoveries of downstream companies—the pertinent metric
We see limited downside risk to earnings of downstream companies from the recent spurt in crude
oil prices as the absolute amount of net under-recoveries to be borne by downstream companies is
the critical variable as opposed to the gross under-recoveries in the system. We compute earnings
estimates for downstream companies assuming that downstream companies will bear ~`63 bn in
FY2011E and FY2012E (compared to `56 bn in FY2010). Thus, we would not be overly perturbed
by the recent surge in crude oil prices or lack of government action on deregulation of diesel as
long as the government provides sufficient compensation to downstream companies. We do not
see any reason to believe that it would not do so; the petroleum secretary stated so recently.
Do not overlook government’s stance historically; government has protected earnings
We note that the government has historically given downstream companies adequate
compensation to ensure a decent level of profitability for these companies (see Exhibit 1). The
downstream companies did not bear any subsidy burden in FY2009 when it had ballooned to `1.1
tn. Thus, there is no reason to believe that the government would unduly increase the burden on
the downstream companies. The government’s philosophy is supported by the petroleum
secretary’s statement that the under-recovery of the downstream companies will be decided after
reviewing the operational performance of these companies.
Subsidy-sharing arrangement will be finalized only at the time of 4QFY11E results
We believe that the subsidy-sharing details will likely be finalized by the time of 4QFY11 results
(May 2011). Thus, we would not be perturbed by speculation on the likely subsidy-sharing
mechanism until then. On the contrary, we would take comfort in the recent statement of the oil
secretary’s recent statements on the subsidy-sharing arrangement highlighting that (1) upstream
companies will bear 33.3% of the gross under-recoveries and (2) government will not restrict
compensation to 33.3% of the gross under-recoveries and will provide sufficient compensation to
protect the earnings of downstream companies. We work on the same philosophy in estimating
the earnings of upstream and downstream companies.
Gross under-recoveries at `721 bn for FY2011E
We compute under-recoveries at `721 bn for FY2011E assuming crude oil price at US$82/bbl. We
assume that crude prices will remain at US$90/bbl for the remainder of the year and there will no
change in domestic retail prices for the three regulated products (diesel, kerosene and LPG). We
estimate under-recoveries at `656 bn for FY2012E assuming (1) crude oil price of US$85/bbl and
(2) deregulation of diesel from mid-FY2012E.
Valuations attractive; retain BUY given potential upside of 32-49%
We see the recent correction in stock prices of downstream companies (BPCL, HPCL and
IOCL) as a good opportunity to buy these stocks given the decent potential upside from
current levels. 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 price assumption. We have revised our crude price assumption to US$82/bbl for
FY2011E and US$85/bbl for FY2012E versus US$79/bbl and US$81/bbl previously. We
maintain our long-term crude price assumption of US$85/bbl.
` Gross and net under-recoveries. We compute gross under-recoveries at `721 bn for
FY2011E and `656 bn for FY2012E. We work on the philosophy that the government will
provide sufficient compensation to the downstream companies to protect their earnings.
We assume that downstream companies will bear higher net under-recoveries at `63 bn
in FY2011E and FY2012E versus `56 bn in FY2010.
` Diesel deregulation. We now assume diesel deregulation to be implemented from
3QFY12E versus our earlier assumption of 1QFY12E.
` Exchange rate assumption. We have revised our exchange rate assumption for FY2011-
13E to `45.6/US$, `45.5/US$ and `44/US$ from `45.5/US$, `44.5/US$ and `44.5/US$.
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