Oil, Gas & Cons Fuels – Oil price touches new high:: RBS

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Oil, Gas & Cons Fuels – Oil price touches new high

Brent touching US$90/bbl is bad news for the Indian oil marketing companies (OMCs) as rising
under-recoveries will make it difficult for Indian government (GOI) to deregulate diesel prices and
provide clarity on cash compensation. Rising uncertainty could also impact sentiment for
upstream subsidy players.


Global oil prices have touched a two-year high, with Brent now at US$90.05/bbl. Our
estimates assume under-recoveries for the combined OMCs at Rs626bn in FY11 (Brent
averaging US$79.5/bbl in 2H) and Rs632bn in FY12 (Brent US$84/bbl). In terms of sensitivity,

every US$1/bbl increase in the global oil price would lead to the industry under-recovery
rising Rs32.6bn pa.

Yesterday's Business Line newspaper reported the Petroleum Minister, Murli Deora
estimating FY11 under-recoveries at Rs650bn (compared to their earlier estimate of
Rs520bn). He estimated the under-recovery on diesel at Rs4.11/litre, on LPG at
Rs272/cylinder and on kerosene at Rs16.88/litre. We believe this would be based on average
international prices prevailing in second half of November 2010 (Brent US$84.5/bbl). At
current international diesel oil price (US$96.8/bbl) for example, domestic diesel underrecovery would rise by a further Rs1/litre to Rs5.1/litre.

Domestic petrol prices, though apparently deregulated, have not kept pace with the sharp rise
in international prices. At current international petrol price of US$97.15/bbl, we estimate
domestic under-recovery at Rs5.1/litre. Note that with petrol being "deregulated", any underrecovery on this product will not be eligible for compensation under the subsidy sharing
mechanism.

Despite domestic auto fuel prices remaining below international levels, the absolute prices
(diesel Rs42.06/litre, petrol Rs57.35/litre in Mumbai) are at all-time highs. It may be too early
to present a cause-effect relationship, but volume growth in auto fuels has come off in the last
few months. Diesel yoy volume growth during Aug-Oct 2010 was 2.8% compared to 9.5%
during Apr-Jul 2010.

Stock prices of the OMCs - BPCL, HPCL and IOC - moved up after 26 June 2010, following
the price hikes in regulated products and announcement of petrol deregulation. The market
had expectations of diesel deregulation and clarity on subsidy sharing mechanism. This
optimism was also based on GOI plans to divest its stake in ONGC and IOC.

However, our negative view on the OMCs is driven by our forecasts of rising crude prices
which we believe would make it difficult for GOI to meet market expectations on deregulation
and subsidy sharing-for details please see OMCs - Challenges to overcome, dated 8 October
2010. Developments over last two months have been negative for the OMCs. Global oil prices
have touched new highs (well above even our expectations) and GOI subsidy support for
1HFY11 has been just 41% of total under-recovery, well below even its initial guidance of
50%.

We retain our Sell rating on BPCL (TP Rs560), HPCL (TP Rs370) and Hold rating on IOC (TP
Rs410). These ratings are based on expectations that status quo will be maintained, ie some
price hikes, no deregulation, under-recoveries continue and GOI compensation to be pegged
at levels ensuring 11-12% ROE for HPCL (with proportionate sharing for BPCL and IOC).

The higher oil price should not have negative implications for the GOI-owned upstream
subsidy contributors (ONGC, OIL, GAIL) if the current mechanism of one-third subsidy from
upstream is maintained. However, historically, even upstream players have under-performed
in the event of a sharp rise in global oil prices, given that the entire subsidy sharing
mechanism is viewed as opaque and subject to change.