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Energy Sources: Free markets

Oct 12, 2002

The petroleum industry, as compared to non-commoditised businesses is not as dynamic. And compared to other commodity businesses, the threat of competing products is significantly lower. Until a commercially exploitable alternative source of energy is discovered, demand for petroleum products is certain. Although India ranks as the eleventh largest consumer of oil, the per capita consumption numbers exhibit emerging market characteristics. Demand is likely to be driven by shift from labour intensive methodologies to technology intensive practices within industry. And with a growing middle class, rising demand for automobiles is expected to increase consumption of vehicular fuels.

Per-Captia Consumption
Calendar year (2000) India U.S China World
Consumption (m kgs) 97,600 897,400 226,900 3,503,600
Population 1,033 285 1,273 6,137
Per-capita 94 3,149 178 571
Source: The Economist Handbook 2000

The current fiscal, FY03, has been a watershed year for the domestic petroleum industry. The ongoing Industry deregulation, which has been in fits & starts over a decade starting with decannalisation of base oil in FY92, is nearing completion. Theoretically, only market prices of liquefied petroleum gas (LPG) and kerosene are under administration. As second generation reforms gain momentum, subsidies on these products are expected to be eliminated over the next two years. Under the new industry pricing mechanism, petroleum-marketing companies have been revising product price fortnightly. Price elasticity of demand for petroleum products is low, offering inherent pricing power to marketing companies in a free market environment. With flexibility in market pricing, incumbent refining & marketing (R&M) companies are better positioned to cushion adverse movements in refining margins.

Also, with dismantling of administered pricing (APM), the oil pool account has been dissolved and subsidies on LPG and kerosene are to be met by the central budget. With lesser Government intervention in product pricing and the new subsidy management mechanism likely to reduce blockage time of funds, we reckon the industry could benefit from improved working capital cycle. Having said that, the new subsidy management mechanism is primarily in theory; operational details are yet to be determined. Consequently, we reckon, the industry has not seen any improvement vis--vis the old system.

In FY02, the Government decannalised import of crude oil for public sector refineries and RBI has permitted refineries to hedge crude oil and petroleum product prices in international markets. Consequently, refineries are likely to adopt more scientific methodologies for procuring raw material for better synchronization with their production schedule. Under cannalisation, large spot orders from Indian Oil Corporation (IOC) did tend to firm-up oil markets. Therefore, the industry could experience a salutary effect on raw material prices.

Having said all that, the Government has issued directives for introduction of green fuels in the country based on the recommendations of the Mashelkar committee. As per the stipulation, fuels compliant with Euro - II specifications are to be introduced in key cities by 2003 and across the country by 2005. Fuels complaint with Euro - III norms should be introduced in key metros by 2005 and the entire country by 2010. As per reports, over two phases, the project is expected to cost the industry Rs 350 bn. The environment friendly fuels are likely to be priced higher but we reckon the return on investment is likely to be low.

Further, in 2002, year-to-date crude, oil prices have risen by 44% to $28.5/ barrel (Brent blend). Prices have been on an ascent since early part of the year, triggered by twin effects of the Organisation of Petroleum Exporting Countries (OPEC) taking out 5 m barrel/ day (mbd) from oil markets since 2001 and the U.S economy registering first quarter GDP growth of above 5%. Despite global slowdown in the second quarter, oil markets remain firm. With the Israeli-Palestine conflict followed by threat of U.S military action against Iraq, oil markets continue to factor in war-risk premium. Any adverse developments in the region could lead to a sharp spurt in oil prices. We estimate average crude oil prices for FY03 at $24.5/ barrel.

With the petroleum industry moving towards freer markets -- enjoying greater freedom in business decisions -- equity markets should view the development positively. Public sector R&M companies, historically, have traded in a band of 4x-7x earnings, while international peers attract valuations of 8x-12x earnings. Going forward, we reckon discount in valuations as compared to international peers is likely to narrow.

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