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High crude prices: How it pans out?

Oct 1, 2004

In the face of rising crude oil prices and the resultant international product prices, the government has again deferred the impending petrol and diesel price hikes for the current fortnight. To put things in perspective, crude prices touched US$ 50 per barrel early this week and the Indian crude mix is worth 50% more than the price paid by the refineries in FY04. What are the factors and how would they affect the players across the straddle? Let us now have a look at these factors:

Supply constraints:

  • OPEC production at the peak:  Currently, OPEC accounts for nearly 35% of the crude oil consumed globally. Members in the organization have been pumping crude oil at the highest capacities. The capacities cannot be stretched significantly in the short-term.

  • The supply side issues:  After the recent Venezuelan political turmoil, Nigeria, the fifth largest producer in the OPEC, is currently witnessing problems as militia and unions have threatened to interrupt production, thereby affecting the crude prices in the international markets. To add to this is the financial crisis being witnessed by the Russian oil giant, Yukos, which has cut exports to China, thereby adding to the scarcity premium of crude prices.

Demand constraints:

  • US oil inventories:  Major concerns over falling US oil inventories have driven crude prices in the recent months. The world’s biggest oil consumer’s inventory plays a major role in determining crude oil prices. To put things in perspective, the last three months have witnessed falling inventories in the US and it is during this period that crude prices soared by over US$ 10 per barrel. With the winter season in sight, demand for heating oil is likely to be strong.

  • Developing world gulping higher than ever before:  China has overtaken Japan to become the world’s second largest consumer of oil. On the other hand, India’s oil imports have increased by 16% during 1QFY05. Going forward, the consumption is likely to remain robust.

How would this affect the Indian companies?

  • Oil marketing companies:  The recent decision by the ministry not to hike product prices is likely to result in an acute squeeze in marketing margins although refining margins remain robust. We believe although the oil marketing companies have been witnessing high refining margins, subsidies on LPG and kerosene is likely to increase, as the product prices move in tandem with international prices. As per our calculations, oil-marketing companies currently face under-recoveries of Rs 96 per cylinder of LPG and over Rs 6 per litre of kerosene. As a result, subsidies are likely to create a further dent in the bottomline of these companies.

  • Refining companies:  Oil refining majors have had a dream run during the current fiscal as a result of firm product prices. Although the government reduced customs duties, product prices continue to remain firm, resulting in high margins. To put things in perspective, IOC is expected to witness refining margins of over US$ 8 per barrel for 2QFY05. As a result, integrated downstream majors such as IOC, HPCL and BPCL shall be compensated for the fall in marketing margins.

  • Upstream majors:  Upstream majors such as ONGC and OIL India are likely to witness a major jump in revenues during the current fiscal, riding on the back of high product prices. To put things in perspective, every US$ 1 per barrel adds Rs 9 bn to ONGC’s revenues resulting in higher margins as major costs are fixed. Also, crude prices are hovering at nearly US$ 43 to US$ 44 per barrel (in the Indian context) as against US$ 29 per barrel for FY04. We believe although the government’s decision to pass on additional subsidy burden on these majors would result in loss in profits, the bottomline is still likely to be significantly higher as compared to FY04.

All in all, we believe that the global crude prices are likely to soften from the current high of US$ 50 per barrel thereby giving some room for marketing margins to the oil companies. Add to this the fact that private competition is likely to help further de-regulation, thereby reducing government interference. At the current juncture, we believe investors should be selective in their stock pickings in this sector, as concerns over subsidies and crude prices loom large.

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