Oil firms are looking at healthy margins after the deregulation of petrol prices, but a clear picture on how much they gain will emerge only after the government finalises its subsidy sharing formula.

Last month, the government initi­ated the new petroleum produc­ts pricing regime. On an immediate basis, petrol price has increased by Rs 3.73 per litre. Diesel prices have been also inc­reased by Rs 2 per litre and are to be der­egulated in due course. In the cooking fuel segment, liquefied pet­roleum gas (LPG) prices have been inc­reased by Rs 35 per domestic cylinder, and kerosene price by Rs 3 per litre. How­ever, cooking fuels will continue to be subsidised.

Key beneficiaries

Downstream companies — Indian Oil (IOC), Bharat Petrol­eum (BPCL) and Hindustan Petroleum (HPCL) — are likely to be key beneficiaries of the deregulation. On the other hand, upstream companies — Oil and Natural Gas Corporation (ONGC), Oil India (OIL) and flagship gas transmission and marketing company, Gail (India), will also get some relief bec­ause the fuel subsidy borne by them is likely to come down.

“The sector was suffering due to underrecoveries. There were problems of liquidity that lead to a lot of borrowing. Decontrol of petrol price will lead to a competitive market and improve the financial health of state-owned oil marketing companies (OMCs),” said B M Bansal, chairman and director of business development of IOC.

Impact level

However, the degree of the impact cannot be determined until two key decisio­ns are announced — first, a mechanism for determining and revising petrol pri­ces; and second, a policy for subsidy sh­aring between the government and the companies for the present financial year.

“The actual impact on individual companies would only be clear once the government finalises its subsidy sharing formula,” Amit Mishra and Gagan Dixit, analysts at ICICI Securities, said in their June 28 report. “Even though OMCs and upstream companies (to a lesser extent) have already posted impressive gains in line with the government decision, further upside to these stocks is likely as the market incrementally prices in the positive im­pact from these changes,” Mishra and Di­xit said.

Deepak Pareek and Amit Vora, analysts at Angel Broking said in their report that the absence of definite free pricing bands acts as an overhang over the dere­gulation process. “We expect governme­nt to provide further details over the free pricing mechanism of petrol,” they said.

At present, IOC is incurring a loss of Rs 3.14 on every litre of diesel. While kerosene is sold at a loss of Rs 15.60 per litre, the company is losing Rs 201 on an LPG cylinder. The total underrecovery in the complete financial year on kerosene is expected to be Rs 16,500 crore, while on diesel and cooking gas, it is likely to be around Rs 15,000 crore and Rs 21,000 crore, respectively.

“Since underrecoveries will remain hi­­gh even after these steps are initiated, th­­ere is a need for creating an institutio­nalised mechanism to share the burden in a timely manner,” said Pawan Agraw­al, director at Crisil Ratings.

BPCL is likely to be least impacted by this growing competition. “HPCL and IOC, which have maximum coverage on the highways, will be affected the most, while BPCL would be impacted the least because most of its outlets are within the city. BPCL’s impressive exploration and production (E&P) portfolio would offer further upside to investors and we believe long-term investors are better off investing in BPCL at present,” said Mishra and Dixit.

Health of PSU OMCs

The health of state-run OMCs depends highly on government’s moves. “Despite the public sector oil companies’ underrecoveries, Crisil’s ratings on them have always reflected the belief that these co­mpanies will remain strategically important to the government and continue to play a key role in implementing the government’s socio-economic policies, and the government will continue to support them by absorbing substantial portions of their underrecoveries,” said Amod Khanorkar, head of Crisil Ratings.

This is because the public policy role performed by these OMCs makes it morally binding on government to support them, he said. “Now, with the deregulation in petrol prices, the government has underscored the importance it attaches to the sector, and to its continued commercial viability,” Khanorkar said.

The upstream players — ONGC and OIL — will be benefited once the subsidy-sharing mechanism is decided. On the other hand, Gail (India) has asked government to spare it from sharing subsidies, but no decision has been taken as of yet.

“We expect ONGC to report net realisation of around $60 per barrel (in FY2011E and FY2012E) because the large part of the benefit on account of reduction in underrecoveries is retained by the government and OMCs. However, in case of ONGC, on the back of reduction in overall under recoveries, the risk associated with variability in earnings estimates of ONGC has reduced to an extent,” Pareek and Vora said.

Despite assuming 50 per cent subsidy sharing for upstream companies (vis-à-vis past five years’ average of 35 per cent), where ONGC shared nearly 80 per cent of the underrecovery, according to ICICI Securities, its target price is still Rs 1,340 per share, which implies 6 per cent upside from the present levels.

“If the government reduces the ups­tream burden to 33 per cent, ONGC’s FY11E and FY12E earnings per share (EPS) would go up further 12-13 per cent from our revised FY11E and FY12E EPS, while ONGC’s target price would increase to Rs 1,489 per share. This wo­u­ld imply an impressive 18 per cent up­side from the present levels,” Mishra and Dixit said.

Mishra and Dixit have also raised OIL’s end-FY11E target price to Rs 1,435 per share from Rs 1,409. “However, if the government reduces the upstream bu­rden to 33 per cent from the expected 50 per cent, OIL’s FY11E and FY12E EPS would go up further 13-16 per cent from our revised FY11E and FY12E EPS, while its target price would inc­rease to Rs 1,543 per share, implying 13 per cent upside possibility from the present levels,” Mishra and Dixit added.

Another key decision — whether Gail should be asked to share the subsidy burden or not is yet to be decided. The Kirit Parikh Committee, based on which reforms have taken place, also recommended that there should not be any subsidy burden on Gail. The committee perceived Gail to be a distribution company rather than an upstream company.

“We were also pinning hopes on the announcement of the subsidy-sharing formula. However, the absence of the sa­me has left us a bit disappointed because it makes it difficult to judge the beneficiaries of the move. At present, we continue to build subsidy-sharing by Gail in our estimates,” Pareek and Vora said. “However, the Kirit Parikh Committee recommendation, if accepted, would be significantly positive for Gail. We maintain our estimates and recommend a ‘buy’ on Gail with a target price of Rs 580,” they added.

Stock performance

Shares of IOC, HPCL and BPCL have zoomed 30.93 per cent, 21.69 per cent, and 5.28 per cent, respectively, year-to-date. More than 10 per cent of jump in the shares of OMCs was witnessed on the day when the petroleum ministry announced de-regulation of petrol and diesel prices. Gail and ONGC, which used to share the subsidy burden, rose 11.64 per cent and 10.83 per cent. The BSE Sensex has inched down 0.02 per cent during the same period.

“Shares of OMCs are likely to stay positive. The rise in petrol and diesel prices will help the downstream and upstream companies improve margins. The deregulation of petrol and diesel prices has removed uncertainties over the sector. The subsidy burden borne by upstream companies will come down. We expect further upsides for OMCs, when the diesel prices will get fully deregulated,” said Varatharajan Sivasankaran, oil and gas analyst at Indiabulls Institutional Equities.

The BSE Oil & Gas index inched up 2.35 per cent during the same period.

Crisil believes these steps will positively impact the financial risk profiles of OMCs, and gradually pave the way for the economic pricing of cooking fuels.

(With inputs from Amit Mudgill)

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Deregulation in diesel will be the new trigger

Ajay Parmar

Head of Institutional equities,

Emkay Global Financial Services

We feel the oil sector, especially oil marketing companies, will continue to perform well after the deregulation. The hike in petrol and diesel prices will help OMCs improve their margins. But even after the hike, the OMCs will see a loss of Rs 1.3 a litre on diesel. Although the government has announced that it will deregulate diesel prices as well, we are clueless how much time it will take. It may take long to see similar moves on kerosene and LPG prices as the government owns the responsibility of safeguarding the poor. It is very likely that upstream companies will continue to bear the burden of subsidies on kerosene and LPG. We feel the trigger is almost over. The investors may seek new triggers. However, the commencement of deregulation of diesel may open some fresh buying interest on the oil counter. Oil stocks carry 17 per cent weightage on Nifty. Any such move will help the broader market.