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UBS Investment Research
India Oil and Gas
D iesel price hike but no pricing freedom
We met with officials at the ministry, and govt-owned oil sector companies
In light of the high oil prices, we met with policy makers and stakeholders over the
past few weeks to discuss the potential government response to the increasing
subsidy burden.
Looking to investigate the extent of a diesel price hike
Our key objective was to get an industry view on: 1) how likely is deregulation of
diesel, LPG, and kerosene; 2) the possible extent of a diesel price hike; and 3) any
new reactions to the low budgeted numbers for oil products subsidy.
Full deregulation is unlikely in the medium term
Our interviewees corroborated our view that a hike of 8-10% in diesel prices is on
the anvil alongside LPG and kerosene price hikes. Further, citing political
compulsions and challenges in implementation, our interviewees did not believe
deregulation was a possibility in the medium term. There has been increased news
flow that the government will move to providing direct subsidy to the poor and will
deregulate petroleum products, but we got a strong sense that this is at least three to
five years away.
UBS top picks: ONGC/IOC in large caps; OIL in small caps
Upstream companies ONGC and OIL are our top picks as they benefit most from a
lower subsidy burden. IOC is our top pick among oil marketing companies
(OMCs) as it has support from other businesses. Additionally, we believe one price
hike will not be enough and expect a series of price hikes in the future. At current
oil prices, the government needs to increase diesel prices by Rs18/litre (48%) to
reduce the subsidy gap to zero. Even if crude falls to US$95/bbl, diesel prices will
have to rise by Rs8.5/litre (22%).
Meetings with sector participants
Given oil prices are the highest in two-and-a-half-years, we see keen investor
interest in whether the government will raise prices of the regulated petroleum
products namely diesel, kerosene, and LPG. The three OMCs namely IOC,
BPCL, and HPCL sell the products at government determined prices and are
compensated for the loss by the government and the upstream companies—
ONGC and OIL. GAIL, a pipeline operator, also contributes to the payment of
the subsidy.
To get an in-depth perspective of all the stakeholders we met with:
- An official in the ministry of petroleum and natural gas
- Officials at ONGC and IOC, the largest oil marketing company, and GAIL
Expect a hike in diesel prices; market
determined pricing looks unlikely
Our key takeaways from the meetings corroborated our views that we outlined
in our related notes: India Oil and Gas: Looking beyond deregulation, published
on 14 February 2011, and India Oil and Gas: Near term event—Watch diesel
price hike, published on 9 May 2011 (author: Prakash Joshi).
The perspectives of our interviewees matched with our view that an 8-10%
hike in diesel prices is on the anvil. Like us, they also believed that prices of
LPG and kerosene may also be hiked. We got a strong sense that pricing
freedom for these three products is still a distant possibility. There has been
increased news flow that as recommended by the Kirit Parekh committee, the
government will move to providing direct subsidy to the poor and will
deregulate petroleum products. Despite the logical arguments in favour of
deregulation, our interviewees felt that the nation’s leaders will continue in
this ‘who bells the cat situation’ and actual freeing of diesel, LPG and
kerosene prices will be a very slow process if it ever happens.
Subsidies constitute a large portion of the fiscal deficit of the country. The
industry believes it is going to be difficult for the government to meet its
FY12 budget numbers as the numbers imply crude prices of US$80/bbl.
Despite the pressure to not miss the budgeted numbers by a significant
margin, our interviewees believed that due to political compulsions and
challenges in implementation there is low likelihood of market driven pricing
in the medium term.
The government makes the OMCs whole for not only whatever losses they
make on selling diesel, LPG, and kerosene at controlled prices but also
includes a notional profit on the sale of these products. Hence, in effect, the
companies do not bear incremental losses if under-recoveries are higher. The
main financial impact of a bigger gap between the ideal retail prices (i.e.
leading to zero underecovery) and the regulated prices is the increased
working capital of the company as the government subsidy comes with a lag.
For instance IOC’s borrowings have increased to Rs620bn from Rs420bn as
at March end. In calculating the under-recoveries, the government includes a
normal profit for the OMCs.
ONGC’s realisations are range-bound as the upside from increase in
international crude prices is limited by the subsidy payout to OMCs. The
company was given most of its producing blocks on a nomination basis and
hence the company needs to contribute to the subsidy payout and that is
something neither we nor the company expects to change.
ONGC/IOC are our top picks in large caps; OIL
is mid-cap top pick
Upstream companies, ONGC and OIL are our top picks as they benefit most
from a lower subsidy burden. We like IOC as OMCs do not substantially suffer
by selling products at capped prices as the government eventually pays them
(though the delay in payment does lead to increased short-term borrowings and
negative sentiment). For instance as international crude prices increased IOC’s
borrowings increased to Rs620bn from Rs420bn as at March end.
UBS analysis of under recoveries
At current oil prices the government needs to increase diesel prices by Rs18/litre
(48%) to reduce the subsidy gap to zero.
Even if crude falls to US$95/bbl, diesel prices will have to rise by Rs8.5/litre
(22%).
Government needs to price diesel higher to cut
subsidies
We believe that the government will need to hike diesel prices as it eventually
pays for the retailers’ losses. Rising oil prices will start to impact the
government’s budget significantly if it does not move to contain at least diesel
losses.
We calculate the impact of government subsidies paid to the retailers as a % of
GDP and of fiscal deficit. We understand that the subsidies are off-balance sheet
i.e. not included in the fiscal deficit. However, the market does look at fiscal
deficit after including off-balance sheet items.
Parekh Committee report
A report on A Viable and Sustainable System of Pricing of Petroleum Products
from the Parikh Committee was released in February 2010. This report argued
for liberalisation of all petroleum product prices and put forth the following
recommendations:
Petrol prices to be market determined both at refinery gate and retail level
Diesel prices to be market determined both at refinery gate and retail level
An additional excise duty should be levied on diesel car owners
Introduction of smartcards to make transparent public distribution of
kerosene and domestic LPG.
Reduction in publically distributed kerosene across India by 20%
Publically distributed kerosene prices raised by Rs6/litre (to restore cost base
to 2002 levels) thereafter linked to agriculture sector growth
LPG prices hiked by at least Rs100/cylinder, thereafter linked to per capita
income growth
Calculation of OMC under-recoveries based on import parity pricing
Financing of OMCs under-recoveries of PDS kerosene and LPG by cash
subsidy from budget plus ONGC/OIL contributions
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
UBS Investment Research
India Oil and Gas
D iesel price hike but no pricing freedom
We met with officials at the ministry, and govt-owned oil sector companies
In light of the high oil prices, we met with policy makers and stakeholders over the
past few weeks to discuss the potential government response to the increasing
subsidy burden.
Looking to investigate the extent of a diesel price hike
Our key objective was to get an industry view on: 1) how likely is deregulation of
diesel, LPG, and kerosene; 2) the possible extent of a diesel price hike; and 3) any
new reactions to the low budgeted numbers for oil products subsidy.
Full deregulation is unlikely in the medium term
Our interviewees corroborated our view that a hike of 8-10% in diesel prices is on
the anvil alongside LPG and kerosene price hikes. Further, citing political
compulsions and challenges in implementation, our interviewees did not believe
deregulation was a possibility in the medium term. There has been increased news
flow that the government will move to providing direct subsidy to the poor and will
deregulate petroleum products, but we got a strong sense that this is at least three to
five years away.
UBS top picks: ONGC/IOC in large caps; OIL in small caps
Upstream companies ONGC and OIL are our top picks as they benefit most from a
lower subsidy burden. IOC is our top pick among oil marketing companies
(OMCs) as it has support from other businesses. Additionally, we believe one price
hike will not be enough and expect a series of price hikes in the future. At current
oil prices, the government needs to increase diesel prices by Rs18/litre (48%) to
reduce the subsidy gap to zero. Even if crude falls to US$95/bbl, diesel prices will
have to rise by Rs8.5/litre (22%).
Meetings with sector participants
Given oil prices are the highest in two-and-a-half-years, we see keen investor
interest in whether the government will raise prices of the regulated petroleum
products namely diesel, kerosene, and LPG. The three OMCs namely IOC,
BPCL, and HPCL sell the products at government determined prices and are
compensated for the loss by the government and the upstream companies—
ONGC and OIL. GAIL, a pipeline operator, also contributes to the payment of
the subsidy.
To get an in-depth perspective of all the stakeholders we met with:
- An official in the ministry of petroleum and natural gas
- Officials at ONGC and IOC, the largest oil marketing company, and GAIL
Expect a hike in diesel prices; market
determined pricing looks unlikely
Our key takeaways from the meetings corroborated our views that we outlined
in our related notes: India Oil and Gas: Looking beyond deregulation, published
on 14 February 2011, and India Oil and Gas: Near term event—Watch diesel
price hike, published on 9 May 2011 (author: Prakash Joshi).
The perspectives of our interviewees matched with our view that an 8-10%
hike in diesel prices is on the anvil. Like us, they also believed that prices of
LPG and kerosene may also be hiked. We got a strong sense that pricing
freedom for these three products is still a distant possibility. There has been
increased news flow that as recommended by the Kirit Parekh committee, the
government will move to providing direct subsidy to the poor and will
deregulate petroleum products. Despite the logical arguments in favour of
deregulation, our interviewees felt that the nation’s leaders will continue in
this ‘who bells the cat situation’ and actual freeing of diesel, LPG and
kerosene prices will be a very slow process if it ever happens.
Subsidies constitute a large portion of the fiscal deficit of the country. The
industry believes it is going to be difficult for the government to meet its
FY12 budget numbers as the numbers imply crude prices of US$80/bbl.
Despite the pressure to not miss the budgeted numbers by a significant
margin, our interviewees believed that due to political compulsions and
challenges in implementation there is low likelihood of market driven pricing
in the medium term.
The government makes the OMCs whole for not only whatever losses they
make on selling diesel, LPG, and kerosene at controlled prices but also
includes a notional profit on the sale of these products. Hence, in effect, the
companies do not bear incremental losses if under-recoveries are higher. The
main financial impact of a bigger gap between the ideal retail prices (i.e.
leading to zero underecovery) and the regulated prices is the increased
working capital of the company as the government subsidy comes with a lag.
For instance IOC’s borrowings have increased to Rs620bn from Rs420bn as
at March end. In calculating the under-recoveries, the government includes a
normal profit for the OMCs.
ONGC’s realisations are range-bound as the upside from increase in
international crude prices is limited by the subsidy payout to OMCs. The
company was given most of its producing blocks on a nomination basis and
hence the company needs to contribute to the subsidy payout and that is
something neither we nor the company expects to change.
ONGC/IOC are our top picks in large caps; OIL
is mid-cap top pick
Upstream companies, ONGC and OIL are our top picks as they benefit most
from a lower subsidy burden. We like IOC as OMCs do not substantially suffer
by selling products at capped prices as the government eventually pays them
(though the delay in payment does lead to increased short-term borrowings and
negative sentiment). For instance as international crude prices increased IOC’s
borrowings increased to Rs620bn from Rs420bn as at March end.
UBS analysis of under recoveries
At current oil prices the government needs to increase diesel prices by Rs18/litre
(48%) to reduce the subsidy gap to zero.
Even if crude falls to US$95/bbl, diesel prices will have to rise by Rs8.5/litre
(22%).
Government needs to price diesel higher to cut
subsidies
We believe that the government will need to hike diesel prices as it eventually
pays for the retailers’ losses. Rising oil prices will start to impact the
government’s budget significantly if it does not move to contain at least diesel
losses.
We calculate the impact of government subsidies paid to the retailers as a % of
GDP and of fiscal deficit. We understand that the subsidies are off-balance sheet
i.e. not included in the fiscal deficit. However, the market does look at fiscal
deficit after including off-balance sheet items.
Parekh Committee report
A report on A Viable and Sustainable System of Pricing of Petroleum Products
from the Parikh Committee was released in February 2010. This report argued
for liberalisation of all petroleum product prices and put forth the following
recommendations:
Petrol prices to be market determined both at refinery gate and retail level
Diesel prices to be market determined both at refinery gate and retail level
An additional excise duty should be levied on diesel car owners
Introduction of smartcards to make transparent public distribution of
kerosene and domestic LPG.
Reduction in publically distributed kerosene across India by 20%
Publically distributed kerosene prices raised by Rs6/litre (to restore cost base
to 2002 levels) thereafter linked to agriculture sector growth
LPG prices hiked by at least Rs100/cylinder, thereafter linked to per capita
income growth
Calculation of OMC under-recoveries based on import parity pricing
Financing of OMCs under-recoveries of PDS kerosene and LPG by cash
subsidy from budget plus ONGC/OIL contributions
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