X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2019 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Refining: Understanding GRMs... - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

Refining: Understanding GRMs...

Sep 7, 2006

After touching historic lows in the late 1990s, Oil & gas sector has seen a significant increase in gross refining margins (GRMs) owing to two factors. One, hardening of crude prices and secondly, a favorable demand- supply equation in the global markets. As compared to GRMs in the range of US$ 1.0 to US$ 1.5 per barrel in late 1990s, GRMs crossed US$ 10 per barrel at one stage. Though margins have softened in the recent past, it is still substantially higher than the average of the last three years. Now, what is GRM? Simply put, GRMs are like the gross profit (and not EBDITA) for a steel company and it is always calculated per barrel (say, gross profit per MT for a steel company). Gross profit calculation excludes employee and administrative expenses. In this article, we analyse the composition of GRMs, how they are calculated, and how various regulatory policies in the form of protection affects the GRMs.

How are GRMs calculated?
Crude oil is the primary input cost for a refinery (90% to 95% of the total cost of refining). Refineries processes the crude oil purchased into various value-added products, which in turn are classified as light, middle and heavy distillates. A refinery tries to optimize its capacity to produce more remunerative distillates to boost margins (petrol and diesel).

GRMs (in US$ per barrel) can be defined as the difference between the costs of raw material (majorly crude) and weighted average prices of petroleum products. Given the fact that GRMs of the refining business depends on the weighted average prices of petroleum products, we need to understand the pricing mechanism of the petroleum products followed by the Indian refineries. Before deregulation, refining margins were 'administered' by the government on the basis of fixed return on capital employed (i.e. cost plus basis). However, following the dismantling of the administered pricing mechanism (APM), the refinery-gate-transfer-price (RGTP) of petroleum products was fixed on the basis of import-parity principle.

To simplify, here is a hypothetical example. Assume that a refinery processed 1 barrel of crude and derives output in the form of 28 gallon of diesel and 14 gallons of other products (say petrol and heating oil).Assuming the crude prices are US$ 65 and price of diesel (Refinery gate prices) are US$ 2.0/gallon, while the weighted average prices of other products are US$ 1.4/gallon.

Then the GRMs are = (28* 2.0 + 1.4*14) - 65

This translates into a GRM of US$ 10.6 per barrel.

How petroleum products are priced?

There are various ways to price petroleum products:

  • Import parity pricing
  • Export parity pricing
  • Trade parity pricing

Import parity pricing is based on the principal of opportunity cost, as this pricing mechanism the mark-up of freight, insurance, ocean losses, port dues and custom duties, to the benchmark (Singapore margins). However, given the fact that country has surplus refining capacity, the pricing mechanism seems to be flawed. Recently, the government shifted from import-parity to trade-parity pricing, which is a blend of import-parity and export parity pricing (currently 80:20). Thus, import parity pricing leads to higher revenues and profits for the refineries, due to the protection enjoyed by the domestic refineries in the form of custom duties.

Given fact that every refinery can be unique (in terms of its ability to produce products and process various crude forms), the production levels can be different. Thus determination of benchmark GRMs using the weighted average production of various refineries becomes a difficult task. The benchmark Singapore margins calculation assumes a product mix of approximately 32% of gasoline (petrol), 19% of jet fuel and kerosene, 16% of diesel/gasoil, 23% of fuel oil, 3% LPG and 7% MTBE/naphtha, and Dubai crude oil as input. The prices of various products are determined on the basis of demand-supply. Thus, a refinery, which can produce more high-value products or refine various forms of crude, can post GRMs above the benchmark GRMs.

Composition of GRMs:

GRMs can be further divided into two parts:

  • Core GRMs
  • GRMs due to tariff protection

Core GRMs are the GRMs, which a refiner would have earned in the absence of any custom duties. GRMs due to tariff protection are the incremental profits earned due to higher domestic refinery-gate-prices (due to inclusion of custom duties in prices). Example below explains the concept in a more lucid manner.

Calculation of GRMs due to protection effect...
Particulars Assumes prices in US $
Crude prices 40 50 60 70 80
Custom duty of crude 5% 5% 5% 5% 5%
Effective crude prices 42.0 52.5 63.0 73.5 84.0
Product prices 47 57 67 77 87
Custom duty on products 7.5% 7.5% 7.5% 7.5% 7.5%
Effective product prices 50.5 61.3 72.0 82.8 93.5
GRMs ( without protection) 7.0 7.0 7.0 7.0 7.0
GRMs ( with protection) 8.5 8.8 9.0 9.3 9.5
GRMs due to tariff protection 1.5 1.8 2.0 2.3 2.5

In the Indian scenario, recently, the government reduced the custom duty on petrol and diesel from 10% to 7.5% thereby reducing the protection available to the domestic refineries. Broadly speaking, if the custom duty on crude is lower than the custom duty on products, then the protection effect is positive.

The effect of entry tax on crude: Some states in India levy entry tax on crude (for example, in Maharashtra, it is at the rate of 3%). Entry tax on crude eats into refining margins and reduces the effective protection available to the refineries. Since both HPCL and BPCL have refineries in Mumbai, they enjoy lower margins as compared to that of IOC.

Effect of entry tax on the GRMs...
Particulars Assumes prices in US $
Crude prices 40 50 60 70 80
Entry tax 3% 3% 3% 3% 3%
Effective crude prices 41.2 51.5 61.8 72.1 82.4
Product prices 47 57 67 77 87
GRMs post- tax adjustment 5.8 5.5 5.2 4.9 4.6
GRMs pre-tax adjustment 7.0 7.0 7.0 7.0 7.0
Loss on a/c of entry tax 1.2 1.5 1.8 2.1 2.4

To conclude, it is pertinent to understand that if refining margins are higher in the global markets, it does not necessarily translate into higher profits for Indian refiners.The level of customs duty and state-level duties (not only on crude prices but also on end-product prices) does impact margins. Also, while investing in a refining company, it is always advisable to base one's investment decision on 'normalised' GRMs (long-term averages) as opposed to temporary blips.


Equitymaster requests your view! Post a comment on "Refining: Understanding GRMs...". Click here!

1 Responses to "Refining: Understanding GRMs..."

Kunal

Apr 29, 2011

Very useful and imformative article. Request you to provide something more on analysis on GRM for Indian refiners like RIL, IOCL, HPCL, BPCL....

Like (5)
  
Equitymaster requests your view! Post a comment on "Refining: Understanding GRMs...". Click here!

More Views on News

HPCL Announces Quarterly Results (4QFY19); Net Profit Up 69.9% (Quarterly Result Update)

May 24, 2019 | Updated on May 24, 2019

For the quarter ended March 2019, HPCL has posted a net profit of Rs 30 bn (up 69.9% YoY). Sales on the other hand came in at Rs 731 bn (up 10.2% YoY). Read on for a complete analysis of HPCL's quarterly results.

HPCL Announces Quarterly Results (3QFY19); Net Profit Down 87.3% (Quarterly Result Update)

Feb 13, 2019 | Updated on Feb 13, 2019

For the quarter ended December 2018, HPCL has posted a net profit of Rs 2 bn (down 87.3% YoY). Sales on the other hand came in at Rs 772 bn (up 22.8% YoY). Read on for a complete analysis of HPCL's quarterly results.

HPCL 2017-18 Annual Report Analysis (Annual Result Update)

Jan 1, 2019 | Updated on Jan 1, 2019

Here's an analysis of the annual report of HPCL for 2017-18. It includes a full income statement, balance sheet and cash flow analysis of HPCL. Also includes updates on the valuation of HPCL.

HPCL 2017-18 Annual Report Analysis (Annual Result Update)

Aug 14, 2018 | Updated on Aug 14, 2018

Here's an analysis of the annual report of HPCL for 2017-18. It includes a full income statement, balance sheet and cash flow analysis of HPCL. Also includes updates on the valuation of HPCL.

More Views on News

Most Popular

2 Stocks from Super Investor Sanjay Bakshi's Portfolio You Can Bet On... (The 5 Minute Wrapup)

Jul 12, 2019

Despite the current fear prevailing in the markets, both these stocks have the potential to deliver in 4-5 years.

The Electric Vehicle Disruption is Great News for this Smallcap Stock (Profit Hunter)

Jul 15, 2019

While big auto makers are finding the transition difficult and crying foul, this small cap company is already leading and benefitting from the electric vehicle disruption in the auto sector.

7 Stocks to Profit From an Irreversible Trend (The 5 Minute Wrapup)

Jul 18, 2019

Credit growth is likely to accelerate in India in the next decade. Here's how you can benefit from this megatrend.

Driverless Cars are Here. And This Tiny Company is in the Lead... (The 5 Minute Wrapup)

Jul 17, 2019

This future-ready company thrives on the pace of technological change.

Here's Why This Smallcap Will Beat the Big Autos in the EV Race (Profit Hunter)

Jul 16, 2019

As the conventional auto sector faces existential crisis, my latest smallcap recommendation is all set to ride the electric vehicle disruption and rise in new age vehicles.

More

Get the Indian Stock Market's
Most Profitable Ideas

How To Beat Sensex Guide 2019
Get our special report, How to Beat Sensex Nearly 3X Now!
We will never sell or rent your email id.
Please read our Terms

HPCL SHARE PRICE


Jul 23, 2019 (Close)

TRACK HPCL

COMPARE HPCL WITH

MARKET STATS