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Energy
India
Some relief, more on the anvil. We hope the recent hike of `2.5/liter in gasoline
prices will allay some concerns on the credibility of gasoline deregulation at high levels
of crude prices. We believe that the street is overly cautious on earnings uncertainty of
downstream companies given (1) high level of crude oil prices and (2) lack of clarity on
subsidy-sharing mechanism. We highlight that the government is mulling a reduction in
custom and excise duties for diesel and gasoline which could result in savings of `334
bn in FY2012E. We maintain our BUY rating on BPCL, HPCL and IOCL given 45-63%
potential upside from current levels
Gasoline prices hiked by `2.53-2.54/liter
We see the recently announced gasoline price hike as lending credibility to the gasoline
deregulation process. We highlight that gasoline prices have been hiked by `10.4/liter since the
announcement of deregulation on June 25, 2010 (see Exhibit 1). The frequency and quantum of
price hikes should allay concerns on the credibility of deregulation process at high levels of crude
prices. We compute under-recovery of `1.8/liter for gasoline post the announced hike in domestic
retail selling prices. We use international oil prices for the week-ended January 14, 2011 for our
calculations of marketing margins.
A likely change in duty structure will result in lower under-recoveries
We highlight that the government is mulling changes in duty structure to reduce the burden on
downstream companies. The changes under consideration include—(1) reduction in excise duty on
diesel and gasoline and (2) reduction in the custom duty on diesel and gasoline. We compute
annual saving of `195 bn for OMCs if the government reduces excise duty on diesel and gasoline
by `2/liter (see Exhibit 2). We compute saving of `139 bn for OMCs from reduction in import duty
on diesel and gasoline to 2.6% from 7.7% currently (see Exhibit 3). We would highlight that the
government can achieve the same objective through a direct compensation to the downstream
companies as opposed to changes in the duty structure for petroleum products. We compute
marketing margin of `1.4/liter for gasoline and under-recovery of `2.7 for diesel if these duty cuts
are implemented (see Exhibit 4).
Concerns on earnings uncertainty overdone
We believe that the street is overly cautious on earnings uncertainty of downstream companies in
the current environment of (1) high crude oil prices and (2) lack of clarity on subsidy-sharing
mechanism for FY2011E. We do not see high crude oil prices as a critical variable for earnings of
downstream companies so long as the government provides sufficient compensation to the
downstream companies. We expect the government to finalize the subsidy-sharing scheme for
FY2011E only at the time of announcement of 4QFY11E results on determination of actual gross
under-recoveries in the system.
Valuations compelling as stock prices seem to be discounting extreme pessimism
We believe that the best time to invest in downstream companies is when they are saddled with
extreme pessimism on earnings uncertainty; the current valuations reflect a similar scenario. We
highlight that the valuations of downstream companies are compelling with the stocks trading at
0.9-1.5X P/B ratio. We maintain our BUY rating on the stocks given significant potential upside to
our 12-month fair valuation for the three stocks—`860 for BPCL, `585 for HPCL and `500 for
IOCL.
Diesel deregulation has been delayed, but net under-recoveries is the critical
variable
We currently assume that diesel deregulation will be implemented from 3QFY12E. We
acknowledge concerns on the delay in implementation of diesel deregulation but would
highlight that a delay in implementation may not result in lower earnings for downstream
companies. A delay in diesel deregulation would result in higher gross under-recoveries but
the earnings of downstream companies will depend on compensation from the government.
We work on the philosophy that the government would provide sufficient compensation to
the downstream companies to protect their earnings. We assume net under-recoveries of
`63 bn each for FY2011E and FY2012E which is higher that `56 bn borne in FY2010 levels
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