The recent deregulation in prices of petroleum products has once again put the companies in this sector on investors' radar screens. Earlier, on account of under-recoveries, players used to make massive losses. The situation is expected to improve, now that the prices of some of the products have been linked to the international price of crude. However, for the sector to become an outperformer, more reforms will be required.
Sector overview
Oil is the life blood of any economy. India is a net importer of oil, as it doesn't produce enough to satisfy its growing demand. To get a sense of its high dependence on imported oil, consider these numbers: in 2008-09 it imported 128.15 metric million tons (MMT) of crude while its total consumption was 133.4 MMT. In other words, India imported 96 per cent of its consumption demand. Its production during the same period was a paltry 25.36 MMT.
Due to insufficient domestic production and volatility in the international price of crude oil, until recently the government controlled the price of petroleum products sold in the domestic market. This was due to the fear that too large an upswing in prices could drag the economy into a recession. However, the large subsidy burden that this created has forced the government to undertake the recent reforms.
The industry
The oil sector is divided into upstream and downstream companies. The upstream companies are the oil exploration and production companies. “It is a high-risk, high-return investment that continues to capture the imagination of investors with a high risk appetite,” says Arvind Mahajan, executive director, advisory services, KPMG. In India there are three major companies in this segment: ONGC, OIL India and Cairn India.
The downstream segment is comprised of tasks such as refining, marketing and transportation of oil and natural gas. The total refining capacity in India is 177.97 metric million tonnes per annum (April 2009 figure). Reliance Industries and Indian Oil Corporation are the major players in this segment from the private and the public sector respectively.
The last group within this sector comprises the oil marketing companies (OMC). Even though Reliance, Essar and Shell have retail licences, they have stayed away from marketing of oil products because of government control over prices. Back in 2002-03, when the sector saw the first phase of reform, Reliance and Essar burned their fingers by entering the retail space.
Recent reforms and their impact
At the beginning of June, based on the Kirit Parekh report, the government decided to de-regulate the price of petrol completely. It also raised the price of diesel while keeping in place a constant subsidy of Rs.1.50 per litre. The committee had recommended full de-control.
Since petrol forms a very small percentage of the business of oil marketing companies (OMCs), players have decided not to compete with each other and will maintain a uniform price. Hereafter the price of petrol will be decided each month. This is the second time the government has attempted to reform petroleum prices. According to Mahajan, “The difference is that this time the prices of petrol and diesel have been decoupled. The deregulation indicates the government's intention to do away with distortions in the market in the medium to long term.”
According to an Edelweiss report, under-recoveries in the sector are expected to dip from Rs.68,200 crore to Rs.50,100 crore in FY11E. Mahajan is of the view that the key beneficiaries of this policy change will be the public sector OMCs, private players like Reliance and Essar, and the government. However, according to Deepak Pareek, research analyst at Angel Broking, “It is the government's subsidy burden that will come down.” Hence, he is of the view that the biggest beneficiary will be the government rather than the companies.
Moreover, complete clarity does not exist on the subsidy sharing formula. The government has said that it will bear 50 per cent of the subsidy burden and the upstream companies will bear 33 per cent. However, there is no clarity on who will bear the burden of the remaining 17 per cent. “If this burden falls on the downstream companies, then their profitability will be lower than what they reported last year. Then there isn't much positive about this new policy,” says Pareek. However, he concedes, “If there is further de-regulation or the government reimburses the OMCs, then their profitability will surely improve.”
Moreover, as Pareek points out, “De-regulation will not be complete without de-regulating diesel.” Since diesel is the life-blood of the Indian economy and is used in transport, agriculture, railways and defence, any increase in the price of diesel will be inflationary as it would increase the transportation cost of goods. Perhaps that's the reason why the government has left its de-control for a later date. However, the government can not postpone the decontrol of diesel prices for long. Says Mahajan: “In case the government doesn't correct diesel prices in line with the market at a later date also, it could lead to increase in diesel consumption. The under-recoveries attributable to diesel will then increase in future.”
What the future holds
World-class discoveries at KG Basin and in Rajasthan have improved the prospects of India's geological basins in the eyes of investors. With just 20 per cent of geological basins having been well explored, there is a lot of opportunity in the exploration space. Over 30 exploration blocks will be awarded in the sixth round of the new exploration licensing policy (NELP). So there is considerable room for improving production.
The government's intention of going ahead with the Open Acreage Licence Policy (OALP) in the future is a positive for the country's exploration and production (E&P) sector.
Midstream and downstream oil companies will continue to grow in line with the economy's growth. According to Mahajan, “Since India has surplus refining capacity investment in this space is going to be limited.” However, refining companies like Reliance have stated their intention to ramp up capacity.
In the retailing space, the biggest risk to companies, apart from fluctuations in the price of crude oil, arises from the threat of government intervention in their operations. As Mahajan points out, “If the government wants to intervene with subsidies, the benefit should be passed on to private players as well. All the players in the market should be treated equally.” The current reforms are a step in the right direction, but they need to be continued for private players to come into this segment.
Valuations
After finance, the oil and gas sector has the highest weightage in the Sensex. In the past seven months, its performance has been dismal. The BSE Oil and Gas index has lost 2.91 per cent value whereas the Sensex has gained 2.31 per cent. According to Edelweiss Securities, at today's prices, it is one of the most undervalued sectors. It is also one of the most under-bought sectors today.
After the news of de-regulation broke, the frontline stocks gained by an average 14.53 per cent in June 2010: their individual gains ranged from 4.42 per cent to 29.50 per cent. But as it became apparent that complete clarity does not exist on the subsidy-sharing formula, almost all the stocks fell in the very next month by an average of 3 per cent. Uncertainty about the subsidy-sharing formula is keeping potential investors at bay.
According to Pareek, “Investors should take into account not just the prospects of the business but also the stock's valuation. A couple of months ago, ONGC was quoting at Rs.1,000. All the triggers in the business were negative, but they were captured in the stock price.” He is of the view that investors should look at oil stocks only when prices correct from their current levels.
This article appeared in the August 2010 issue of Wealth Insight
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