With the INR’s recent appreciation and marginal fall in crude prices, we anticipate a reduction in fuel under-recovery run rate to INR1.3tn. Prior to recent measures initiated by the government—hike in diesel prices and cap on LPG cylinders—the under-recovery run rate was INR1.9tn due to weak INR, high crude prices and high diesel cracks. This sharp reduction in under-recovery could turn into a virtuous cycle as a result of lower fiscal burden leading to further INR appreciation and a further fall in under-recoveries to as low as INR814bn (crude at USD100/bbl and USD-INR at 50). While this fall in under-recoveries benefits all OMCs via better cash flows and lower interest expenses, BPCL remains our top pick, given its ongoing drilling programme in Brazil/Mozambique, which should lend greater clarity to oil reserves.
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Under-recovery run rate down to INR1.3tn
Government reforms over the past few weeks, starting with the hike in fuel prices, have resulted in a turnaround in the Indian macro scenario. Prior to the hike on September 14, fuel under-recovery run rate had ballooned to INR1.9tn, driven by a combination of weak INR, high crude prices and high diesel cracks. Since then, the Brent has plunged 4%, the INR has appreciated 6%, leading to a ~10% fall in crude prices in INR terms. Diesel cracks, while still high, have dipped marginally as refineries in US and Venezuela return from temporary shutdowns. As a result, we estimate fuel under-recovery run rates to dip dramatically from INR1.9tn pre-fuel price hike to INR1.3tn at current crude and INR levels. Our sensitivity analysis (detailed in table on following page) highlights that while 1% INR appreciation leads to a fall in under-recovery by INR40bn, 1% fall in crude price leads to a INR30bn dip in under-recovery.
OMCs to benefit; BPCL top pick due to E&P triggers on horizon
Post the fuel price hike, diesel prices are pegged at Brent crude of USD87/bbl with USD-INR at 50. With low likelihood of a further increase in fuel prices in the near term, the key driver of oil marketing companies will be INR appreciation or a fall in crude prices. Fall in diesel cracks to more normal levels can also trim under-recoveries. We also see a possibility of a virtuous cycle in under-recovery reduction as a result of lower fiscal burden leading to a further appreciation in INR. In an optimistic scenario, FY14E under-recoveries can fall to as low as INR814bn with USD-INR at 50 and crude at USD100/bbl.
High under-recoveries have led to OMCs’ aggregate short-term borrowings ballooning 42% and interest cost catapulting 104% in FY12. Thus, lower under-recovery should improve their cash flows. OMCs should also see the benefit of improvement in GRMs in Q2FY13 coupled with gains on inventory and forex. Among the three OMCs, BPCL (BUY/Sector Outperformer) is our preferred pick due to several triggers in its E&P business in the near term in both Mozambique and Brazil.
Regards,
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