Identifying a refinery stock: Do's and Don'ts - Views on News from Equitymaster

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

  • MyStocks


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

Identifying a refinery stock: Do's and Don'ts

Aug 11, 2003

It is often said that the dynamics of the world economy are often altered due to the crude oil price movement. As a result, the dynamics of companies operating in this sector are very different. Here in this article, we deal with key factors that impact the performance of petroleum products companies. Profile
Petroleum products can be broadly classified as kerosene, diesel, petrol, naphtha, aviation fuel (ATF) and liquefied petroleum gas (LPG). As the name itself implies, crude is 'refined' into various usage based products or distillates. Without going into much complexity, the three broad classifications are heavy distillates (furnace oil and bitumen), middle distillates (diesel, kerosene, aviation fuel) and light distillates (LPG and petrol). This is how most of the companies in India classify products in their balance sheets. Margins are higher in middle and light distillates.

Globally as well as in Indian markets, government has a vital role to play in internal policies and external diplomatic relationships. This is because crude oil involves diplomatic relationships on the sourcing front and outgo of foreign exchange. On the other hand, the government also plays a key role in fixing excise duties on petroleum products. Moreover, it also deals with basic requirements of industries and public in general.

Revenues are a function of volumes and realisations. Lets look at the volumes side first.

Volumes in case of oil sector are linked to economic growth. Why? Economic growth, as you know, is linked to the performance of the agriculture, industrial and services sector. When growth gains momentum, demand for petroleum products tends to increase and vice versa, as it is a source of energy. This is not just restricted to the industrial side but also from the retail market (more units of cars and CVs sold, higher is the demand for fuel).

  • The industrial side
    Demand for petroleum products is relatively inelastic to change in prices. In case of industrial, the key user segments are fertilizer (naphtha or natural gas), utilities (naphtha or natural gas) and aviation (ATF). Any increase in power capacity, growth in tourism sector and better agricultural sector performance has a positive impact on petroleum companies. Hence, one should keep abreast of developments in these user segments. However, alternate sources of fuel like natural gas may adversely affect volumes growth.

  • The retail side
    On the retail sector, demand drivers are primarily linked to income levels at the hands of people. Higher income growth will lead to a rise in automobile demand as well as usage of LPG. On the auto sector front, diesel accounts for an estimated 40%-45% of total consumption. Kerosene and petrol account for 8% and 13% of consumption respectively.

One cannot however, ignore the realisation angle. Earlier before deregulation in 2002, the government fixed prices of petroleum products. Prices were cross-subsidised. While petrol prices were higher compared to the actual cost, kerosene, diesel and LPG were sold at lower rates. But with the dismantling of APM (administered price mechanism), prices of these products are now linked to international crude prices. What this means is that whenever crude prices go up, petrol and diesel prices will mirror the trend. Though LPG and kerosene continue to be subsidised, the government has decided to remove the subsidy in a phased manner.

As mentioned earlier, government has an active role to play in this sector. Hiking diesel and petrol prices is a politically sensitive issue, which could affect the vote bank of any ruling party. In this context, prices of LPG, diesel and kerosene are not based on reality. Government intervention and policies play a major role in determining the prices and hence one should be aware of these developments.

Since the prices of crude oil (major raw material) are linked to international prices, one must be aware of the prevailing prices internationally. Crude oil price is known to be very volatile (has moved from a low of US$ 10 per barrel to a high of US$ 147 per barrel) and is a function of demand and supply and also various geo-political situations. This apart, currency fluctuations alter the cost significantly.

Key parameters to look into...
Consider key things that one should look while analyzing the companies in the sector.

  • Refining capacity: To set up a 1 MT plant, an investment of Rs 10 bn is required. Of course, the cost goes down if one goes in for a higher MT plant. So, it is a very capital-intensive industry and therefore, barriers to entry are high. Besides, with environmental regulations expected to become stricter, watch out for the company's status on this front. Higher contribution from light and medium distillates is beneficial. Higher the refining capacity, higher the chances of altering product mix to derive more revenues. Though branding is possible, petroleum products are largely a commodity.

  • Integration benefits: Another key aspect is to note whether a company is integrated forward (distribution), backward (crude oil exploration) or a standalone player (only refining). Standalone players have less bargaining power, as products have to be sold to consumers through an external distribution network. Integrated players have an upper hand.

  • Distribution network: Petroleum products are usually sold through retail outlets that offer lot of leveraging opportunity for a company. Look out whether the company owns most of the outlets or it is franchise based. It costs Rs 20 m to set up a retail outlet and if a company owns a major part of the distribution, it can be valued accordingly. By leasing out part of its distribution, a marketing company can maximize revenues (like ATMs).

  • Valuations: Since it is a commodity sector, valuations should be in line with the economic growth in the long-term. But some companies get lower valuations due to the PSU status. But if a player in integrated, valuations tend to be on the higher side. Price to earnings and price to book value are useful tools.

And last but not the least, the management's past track record. Though the government owns some companies, watch out whether the management has been proactive in branding the product and new capacity expansions. But government intervention is still a reality and therefore to that extent, caution has to be exercised.

Click here to identify stocks from other sectors.

Related Links for Energy Sector: Quarterly Results NEW | Sector Analysis Report | Sector Quote | Over The Years

Equitymaster requests your view! Post a comment on "Identifying a refinery stock: Do's and Don'ts". Click here!


More Views on News

Sorry! There are no related views on news for this company/sector.

Most Popular

My Top Stock Recommendation for 2021 and Beyond (Profit Hunter)

Jan 5, 2021

My new guide will show you the huge potential in future proof businesses.

'Essential' Smallcap Stock Recommendations (Profit Hunter)

Jan 8, 2021

The smallcap rally has enough steam left in it. If you haven't joined yet, it is still not too late.

Is Nifty Forming a Top (Fast Profits Daily)

Jan 8, 2021

The charts are telling the bulls to be cautious.

Why Gold Hit Lower Circuit (Fast Profits Daily)

Jan 11, 2021

Were you shocked that bullion prices hit lower circuits on Friday on the MCX? Find out why it happened...

Five Wishes and a Will (The Honest Truth)

Jan 4, 2021

Ajit Dayal on the investing strategy for 2021 and beyond.


India's #1 Trader
Reveals His Secrets

Secret To Increasing Your Trading Profits Today
Get this Special Report,
The Secret to Increasing Your Trading Profits Today, Now!
We will never sell or rent your email id.
Please read our Terms


Jan 15, 2021 (Close)