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India: Energy
Equity Research
OMCs at US$100/bbl oil: Twin uncertainties cloud earnings outlook
OMC stocks have held up well at US$100/bbl oil vs. Mar-July 2008
While Brent has breached US$100/bbl, we find that the oil marketing
company (OMC) stocks are holding up quite well this time compared to the
last crude oil spike in March- July 2008, despite higher under-recovery on
diesel, possibly on expectations of a favourable policy action. However,
looking at the impact of oil prices on OMC earnings and limited options
with the government, we find the current risk-reward quite unfavorable.
High oil price = high under-recovery + high interest cost for OMCs
High oil prices not only dents the EBITDA of the OMCs owing to likely
higher net under-recovery, it also significantly increases working capital
loans on the OMC balance sheets leading to much higher interest costs,
which may or may not be subsidized. We have observed this in FY09, and
the OMC earnings were weak despite above-normal government grants.
Sticky inflation and upcoming elections keep price hike uncertain
This time around, we believe ongoing sticky inflation and a series of
upcoming provincial elections have added to the uncertainty on any further
fuel price hikes. While we expect headline inflation to peak 1QFY12E, it will
still remain uncomfortably high, in our view. Weaker INR/US$ exchange
rates add to the under-recoveries of the sector, in our view.
The govt appears to be in tighter spot now than in Mar-July 2008
We believe that the government is in a tighter spot now than in March-July
2008, from a policy action perspective, given slower M3 growth, weaker
balance of payment situation, higher inflation, higher fiscal deficit and a
more aggressive borrowing program. We believe this limits the
government’s leeway to provide a positive policy surprise to the OMCs.
The expected roll-back of customs duty on oil prices would reduce diesel
under-recoveries by about Rs1.75/lit only, vs. current loss of almost Rs8/lit.
Prefer upstream state-owned names to OMCs in this uncertainty
We prefer the state-owned upstream names – GAIL (Buy), OIL and ONGC (both
Neutral) over the OMCs, given their better visibility of cash flows. We retain
Sell on HPCL with 12-m EV/EBITDA-based TP of Rs350. We remain Neutral on
BPCL and IOC as we believe BPCL has potential to surprise in its E&P portfolio,
while IOC has more stable earnings mix from pipelines and rising exposure to
the petchem cycle. Risks: low oil price, strong INR/US$ exchange rate.
OMC stocks holding up well on reform expectation
While Brent has breached US$100/bbl, we find that the oil marketing company (OMC)
stocks are holding up quite well this time compared to the last crude oil spike in March-
July 2008, despite higher under-recovery on diesel, possibly on the expectation of
favourable policy action. However, looking at the impact of oil price on OMC earnings and
limited options with the government, we find the current risk-reward quite unfavorable.
High oil prices mean high under-recoveries; also high interest cost
High oil price not only dents the EBITDA of the OMCs owing to likely higher net underrecovery,
it also significantly increases working capital loans on the OMC balance sheets
leading to much higher interest costs, which may or may not be subsidized. We have
observed this in FY09, and the OMC earnings were weak despite above-normal
government grants.
Sticky inflation and upcoming elections keeps price hike uncertain
While further fuel pricing reforms have been delayed due to rising oil prices, we believe
that sticky inflation, weaker INR/USD exchange rates and political considerations for the
upcoming provincial elections in May, 2011 could further limit the possibility of a price hike.
The government seems to have limited choices for policy surprise
With the possibility of a price hike highly unlikely in the near term and the tight monetary
and fiscal position of the country now than in March-July 2008 the government is left with
limited choices to compensate OMCs. The widely expected roll-back of customs duty on
oil prices would reduce diesel under-recoveries by about Rs1.75/lit only compared to
the current loss of almost Rs8/lit.
In this environment of uncertainty, we prefer the state-owned upstream stocks, in
general, compared to the OMCs given the much better relative visibility of cash flows of
the former.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India: Energy
Equity Research
OMCs at US$100/bbl oil: Twin uncertainties cloud earnings outlook
OMC stocks have held up well at US$100/bbl oil vs. Mar-July 2008
While Brent has breached US$100/bbl, we find that the oil marketing
company (OMC) stocks are holding up quite well this time compared to the
last crude oil spike in March- July 2008, despite higher under-recovery on
diesel, possibly on expectations of a favourable policy action. However,
looking at the impact of oil prices on OMC earnings and limited options
with the government, we find the current risk-reward quite unfavorable.
High oil price = high under-recovery + high interest cost for OMCs
High oil prices not only dents the EBITDA of the OMCs owing to likely
higher net under-recovery, it also significantly increases working capital
loans on the OMC balance sheets leading to much higher interest costs,
which may or may not be subsidized. We have observed this in FY09, and
the OMC earnings were weak despite above-normal government grants.
Sticky inflation and upcoming elections keep price hike uncertain
This time around, we believe ongoing sticky inflation and a series of
upcoming provincial elections have added to the uncertainty on any further
fuel price hikes. While we expect headline inflation to peak 1QFY12E, it will
still remain uncomfortably high, in our view. Weaker INR/US$ exchange
rates add to the under-recoveries of the sector, in our view.
The govt appears to be in tighter spot now than in Mar-July 2008
We believe that the government is in a tighter spot now than in March-July
2008, from a policy action perspective, given slower M3 growth, weaker
balance of payment situation, higher inflation, higher fiscal deficit and a
more aggressive borrowing program. We believe this limits the
government’s leeway to provide a positive policy surprise to the OMCs.
The expected roll-back of customs duty on oil prices would reduce diesel
under-recoveries by about Rs1.75/lit only, vs. current loss of almost Rs8/lit.
Prefer upstream state-owned names to OMCs in this uncertainty
We prefer the state-owned upstream names – GAIL (Buy), OIL and ONGC (both
Neutral) over the OMCs, given their better visibility of cash flows. We retain
Sell on HPCL with 12-m EV/EBITDA-based TP of Rs350. We remain Neutral on
BPCL and IOC as we believe BPCL has potential to surprise in its E&P portfolio,
while IOC has more stable earnings mix from pipelines and rising exposure to
the petchem cycle. Risks: low oil price, strong INR/US$ exchange rate.
OMC stocks holding up well on reform expectation
While Brent has breached US$100/bbl, we find that the oil marketing company (OMC)
stocks are holding up quite well this time compared to the last crude oil spike in March-
July 2008, despite higher under-recovery on diesel, possibly on the expectation of
favourable policy action. However, looking at the impact of oil price on OMC earnings and
limited options with the government, we find the current risk-reward quite unfavorable.
High oil prices mean high under-recoveries; also high interest cost
High oil price not only dents the EBITDA of the OMCs owing to likely higher net underrecovery,
it also significantly increases working capital loans on the OMC balance sheets
leading to much higher interest costs, which may or may not be subsidized. We have
observed this in FY09, and the OMC earnings were weak despite above-normal
government grants.
Sticky inflation and upcoming elections keeps price hike uncertain
While further fuel pricing reforms have been delayed due to rising oil prices, we believe
that sticky inflation, weaker INR/USD exchange rates and political considerations for the
upcoming provincial elections in May, 2011 could further limit the possibility of a price hike.
The government seems to have limited choices for policy surprise
With the possibility of a price hike highly unlikely in the near term and the tight monetary
and fiscal position of the country now than in March-July 2008 the government is left with
limited choices to compensate OMCs. The widely expected roll-back of customs duty on
oil prices would reduce diesel under-recoveries by about Rs1.75/lit only compared to
the current loss of almost Rs8/lit.
In this environment of uncertainty, we prefer the state-owned upstream stocks, in
general, compared to the OMCs given the much better relative visibility of cash flows of
the former.
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