MRPL & Essar Oil - " Play the Refining Theme":: LKP

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A combination of high crude prices and sustained product demand is resulting in strong product spreads which has positioned pure refiners in a sweet spot. This is best manifested through a cursory glance at the benchmark Singapore GRM which is going strong at $ 8.8/bbl during the quarter-to-date. To put things in perspective, the Singapore GRM during Q1FY11 was just $ 4.1/bbl, which represents more than doubling of refining margins y-o-y. Refining margins have also risen sequentially from $ 7.5/bbl in Q4FY11 to $ 8.8/bbl during the quarter-to-date. Currently, Singapore GRM is ranging between $ 8-8.5/bbl, which is expected to result in very favorable economics for pure refiners.

Sector Dynamics

A sweeping glance through the oil sector reveals a host of issues that are dogging the sector as a whole and some company-specific issues which are acting as a drag on the respective stocks. The over-arching issue of the adhoc subsidy sharing mechanism is taking its toll on the PSU space. Crude prices of $ 110+/bbl threaten to complicate the scenario considerably. The recent move to arbitrarily increase the subsidy burden on the upstream sector to ~39% has severely impacted the stocks. With the finances of the PSU OMCs held hostage to grants by the Govt., it has become very difficult to estimate future performance.

On the other hand, falling output from the KG D6 block threatens to overturn the capacity utilization calculations of various gas pipeline operators which may result in adverse near term performance. The Cairn-Vedanta deal, which was announced 10 months ago, is proving to be a case of indecisiveness in policy-making at the highest levels with opposing pulls & pressures from all sides. The interim CAG audit report on KG D6, Rajasthan & PMT fields couldn’t have come at a worse time for a sector that is already battling a multitude of headwinds.

MRPL & Essar Oil best positioned

We believe that the refining space within the oil sector is best positioned for a take-off, aided by strong fundamentals and availability of companies which are expanding their capacities at the most opportune time to capitalize on the refining cycle. With the sword of under recoveries not hanging over them, we believe MRPL & Essar Oil offer the best bets to play the refining theme.

Valuation

We value MRPL using EV/EBITDA multiple of 6.25x on FY13E EBITDA and arrive at our price target of  Rs.115, which translates to a hefty upside of 58.7%. MRPL is our top pick to play the strong refining cycle.

We value Essar Oil using SOTP valuation. We value the refinery using 6.25x FY13E EV/EBITDA and the Mehsana and Raniganj blocks using DCF. We value the Ratna/R-series & Nigerian blocks using EV/boe multiple. We upgrade our rating on the stock to BUY with a target price of Rs.187, which translates into an upside of 59.3%.