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The pot of gold at the end of privatisation...

Apr 22, 2000

While the stock market continues to remains enamoured with technology stocks, no one is willing to invest in old economy stocks believing that they would fall even further. Among the old economy stocks, the most palpable effect of this theory seems to affect the refining and marketing companies - Bharat Petroleum (BPCL), Hindustan Petroleum (HPCL) and Indian Oil (IOC).

A glance at the stock prices of these companies will show them at close to, or touching their 52-week lows. Apart from the overall bearish sentiment, the market seems to have discounted issues such as risks from the regulatory uncertainty, the fear of overcapacity in the refining sector and arguably, the non-sustainable nature of the earnings growth into the prices of these companies. Let us take a look at each issue and see its effect on the overall picture of the refining industry.

The regulatory uncertainty stems from the fact that the prices of four products petrol, diesel, kerosene and LPG which account for almost 70 percent of the volume of the refinery products sales' are still fixed by the government. The risk stems from the fact that as international crude oil prices rise, the cost to the refineries increases. They however may not be able to raise the prices of the fixed products immediately. The government of the day takes a decision based on the political ramifications of the price increase.

Next is the fear of a potential overcapacity in the sector. With Reliance Petroleum and Mangalore Refineries adding almost 35 million tonnes to the refining capacity over the last year, the refining capacity has gone up over 50 percent to 110 million tonnes. An overcapacity scenario is expected in certain commodities like petrol, which could force domestic refiners to export petrol at a discount to the domestic price. Related to this is the factor that even when products such as petrol are deregulated, competition would force refineries to drop the price of deregulated products.

All these fears cannot detract from the fact that refining assets, the transport infrastructure and the marketing assets are far more valuable than the stock markets have made them to be. For instance the Nagarjuna group has recently proposed the setting up of a six million tonne refinery by relocating a plant from West Germany. The capital cost works out to Rs 5,800 per tonne.

Applying the replacement cost theory at Rs 5,000 per tonne of capacity, BPCL's 8.5 million tonne refinery and HPCL's 10 million tonne capacity are worth almost Rs 42.5 billion and Rs 50 billion respectively. And that's only the cost of their refineries! Add to that the cost of setting up a marketing network, a distribution pipeline, a dealer network, establishing a brand and the value of these companies increases exponentially.

  Selling for a song?
Refining capacity (million tonnes) 8.5 10.0 31.7
Product pipelines (kms) 250.0 517.0 6,268.0
Petrol Pumps 4,376.0 4,327.0 6,779.0
LPG dealers 1,147.0 1,463.0 2,902.0
Kerosene dealers - 1,622.0 3,423.0
Aviation fuel stations - 9.0 94.0
Market cap (Rs bn) 30.9 24.7 65.2
Market cap / tonne (Rs bn) 3.6 2.5 2.1

Incidentally, refining capacities in the West have exchanged hands at only 20 percent of their replacement costs. But it is the other tangibles and intangibles outlined above that make these companies that much more valuable. For example, BP-Amoco took over Castrol at a premium of 74 percent of its price on the FTSE. One can safely say that a major portion of that premium was towards the brand value of Castrol which would have been difficult for BP-Amoco to replicate otherwise.

An interesting stipulation in recent policy paper Hydrocarbon Vision 2025 that allows only those companies investing Rs 20 billion in either refining or oil exploration and production to set up marketing networks itself underscores the importance of the retail marketing setup of the refining companies.

Admittedly, these assets will become valuable only when deregulation and privatisation of these companies will get underway. Privatisation in this sector may not be imminent but the upside for investors could be large, as and when it does happen.

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