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Energy stocks: A peek at the valuations

Jul 5, 2004

The announcement of a price hike in case of petrol, diesel and LPG along with cuts in excise duties has resulted in a spurt in oil stock prices. At the same time, one is compelled to look at the valuations to arrive a conclusion. We have thus chosen two integrated oil companies (refining and marketing) and one refining company and shall try to put things in perspective as to why they deserve the valuations at which they trade.

FY05E BPCL HPCL KRL
EBDITA (%) 6.0% 5.5% 9.1%
NPM (%) 3.5% 3.0% 4.5%
EPS 59.0 47.8 32.0
P/E (x) 6.0 6.9 4.7
P/CF (x) 4.3 4.8 3.4

From the above table, it might look though that Kochi Refineries is cheaper as compared to the other two majors. However, one has to look at the business model. BPCL and HPCL are integrated oil marketing companies with refining capacities, while Kochi Refineries is a stand-alone refinery and does not, so far, have its own retail network. Lets' have a look at the individual companies to have a clear understanding of their businesses:

BPCL: BPCL is an integrated oil marketing company with its own refining capacity of 8.7 MMTPA (million metric tonnes per annum) and nearly 4,500 retail outlets. The company's business model is reasonably diversified as it has entered into the LNG business, which is likely to witness growth with new gas-based power capacities being added.

HPCL: The second largest oil marketing company has a refining capacity of nearly 13 MMTPA. It has nearly 5,100 retail outlets thereby giving the company flexibility to reach out through the length and breadth of the country. The refining margins adhere to international standards and therefore provide a cushion to the overall profitability of the company.

Kochi refineries: Kochi Refineries is a stand-alone refinery with a rated capacity of 7.5 MMTPA catering to the product needs of its parent BPCL in the southern markets. The company is now planning to venture into retail marketing of fuels so as to reduce its dependence on BPCL and diversify its revenue sources.

So, which stock would you like to be invested in?

The below mentioned table gives an indication with our views on the advantages/disadvantages of integrated companies and standalone refineries:

Parameter Integrated Standalone
Pricing Government controlled, quasi-deregulation Deregulated and conforms to international prices
Business flexibility Own marketing network. So, better bargaining power as compared to standalone refineries Since no marketing network, at the mercy of marketing companies.
Relative control on margins In a better position, as demand is relatively inelastic and pricing cartel among PSUs Government policies such as duty cuts and international prices softening can result in erosion of margins
Future prospects Expanding capacity and therefore, reducing dependence on standalone refineries Have to venture into marketing to diversify revenue base.
Competition Unlikely to be hit in the medium-term, as PSUs have created significant entry barrier. Long-term threats high. Controlled, as most of the stand-alone refineries are subsidiaries of the oil marketing PSUs and sell products to the parent.

From the above table, we believe it is a better option to stay invested in an integrated business model having better control over production and marketing of products as compared to a standalone refinery. The country is witnessing rapid expansion in refining capacity, and is likely to limit pricing power of standalone refineries in the future. The instance of Reliance Industries fits the above argument. Since the oil marketing companies are expanding capacities, offtake from Reliance has been lowered and as a result, Reliance Industries has offered nearly 33% discount of import parity differential on product prices. This signifies the fact that standalone refineries have little bargaining power against the marketing majors.

As the sector is de-controlled, like any global market, integrated players would be better placed to capitalize on the growth opportunity. Of course, integration is not only at the downstream level (i.e. marketing) but also at the upstream level (exploration). Until the players are given a free hand, the equation is not so favorably skewed towards integrated players.

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