May 17, 2004|
Oil PSUs: An impact analysis
Crude prices are trading higher than ever before and have broken the US$ 41 per barrel barrier. It is highly unlikely that the prices of crude oil are to sober down in the foreseeable future, given the strong underlying demand from countries like US, China and India. To put things in perspective, India imports nearly 70% of its oil requirements and as per an IEA report, uses 2.5 times the crude for a unit of GDP as compared to the OECD. Given this backdrop, we assess the impact of higher crude prices on the operating margin of oil companies.
In the face of high crude prices and also the new Government's intentions of not raising petroleum product prices, oil-marketing companies (OMCs) such as HPCL, BPCL, IOC and IBP shall take a major hit on their marketing margins, going forward. Currently, Indian crude mix averages US$ 32 per barrel (Source: BPCL) and firm prices in the international markets are a cause of concern. Further, the PSUs have to account for subsidies on LPG and kerosene, which as per today's mechanism, is an additional burden of Rs 13 bn (to be shared equally among the OMCs and GAIL and ONGC).
We have, hitherto kept the prices of petroleum products unchanged while adjusting for crude prices at US$ 32 per barrel and tried to work out the margins for HPCL, India's second largest OMC. As per the assumptions, the subsidies on LPG and kerosene shall continue to be in effect as in FY04 and petroleum product prices shall not be increased in the current fiscal.
From the aforementioned graph, it is clearly visible that HPCL shall witness a major dip in its operating margins to the tune of 300 basis points while the net profit margins have witnessed a fall of 200 basis points. This is largely due to the fact the HPCL not only sells products from its own refineries but also purchases products for resale. Strong global demand fuelling crude prices have resulted in high product prices at the refinery. Thus, HPCL shall have to pay up as per international prices at the refinery for the products it purchases for resale, mainly LPG and diesel. At the same time, under-recoveries on LPG and kerosene shall impact even further. We expect similar extent of impact on other oil marketing companies as well.
At Rs 331, the stock is trading at a price to cash flow of 5.3x FY05 earnings (assuming crude price at US$ 32 per barrel). However, if crude were to stabilize at US$ 29, post Chinese slowdown and peak season of US coming to an end by August and also that prices of LPG and kerosene are raised, the stock is trading at a price to cash flow of 4x FY05 earnings.
In the recent past, the stock has declined very sharply owing to two factors i.e. high crude prices and the disinvestment conundrum. While we believe that the former factor will impact profitability unless product prices are raised, the latter is more sentimental in nature. Whether disinvestment happens or not, HPCL and others have long-term plans (including venture into exploration and natural gas, capacity expansion of refineries and increasing the distribution reach). These initiatives, we believe, are unlikely to suffer. To that extent, the stock market has over-reacted to the disinvestment factor.
Fundamentally speaking, oil companies are asset-rich in nature and generate strong cash flows. Valuations are also cheaper compared to some global majors. Having said that, government intervention is a cause of concern and to that extent, the risk profile of the stock and the sector is higher. But investors have to ask whether there is anything 'new' in the same!
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