Silver Lining For OMCs: Low Crude Oil Prices Signal Structural Gains

Shares of state-owned oil marketing companies (OMCs) such as Hindustan Petroleum (HPCL), Bharat Petroleum (BPCL) and Indian Oil (IOC) are off 30-40 per cent from their 2020 highs led by the sell-off in broader markets. However, there is a silver lining too. Crude oil prices falling to 18-year lows has many long-term triggers for these companies. Shares of the OMCs, after hitting 52-week lows recently, have thus rebounded up to 15 per cent in last two trading sessions. And could gain more.

First the bad news. The recent fall in oil prices and demand collapse due to lockdown will lead to inventory loss (on crude oil and products) as well as profitability, and thus will hit OMCs' near-term earnings. Analysts at Centrum Broking foresee a 66-86 per cent fall in OMCs' operating and net profit in Q4 led by weak refining margins, inventory losses, decline in demand, etc.

The good news is that much of this bad news is priced in the share prices now. Despite the earnings cut, Centrum Broking has upgraded the three OMCs to Buy due to cheap valuations.

Importantly, the sustained softness in crude oil prices bode well for these companies, as it will lead to a rise in their marketing margins, decline in working capital requirements and zero risks of subsidy burden. Even the government will get an opportunity to roll out more reforms on kerosene and cooking gas pricing, which will be positive for the OMCs.

Thus, beyond the near term concerns, analysts say OMCs remain well placed for growth as they see demand rebounding fast once the lockdown is over. The outlook on marketing margins (on retailing fuels such as petrol and diesel) too remains strong. Yogesh Patil at Reliance Securities says that for every $1 per barrel fall in crude prices, net marketing margin of OMCs rises by Rs 0.45 per litre (45 paise). However, some of these gains may get offset if the government raises duties on retail fuels.

Analysts at Kotak Securities say their estimate of gross retail marketing margins (on per litre basis) on diesel and gasoline increased week-on-week to Rs 11.8 and Rs 13.3, as on March 27, 2020 from Rs 8.1 and Rs 7.1, respectively, a week ago. On the positive side, margins for key polymers also increased in the recent week led by a decline in naphtha and gas prices. The concerns had remained high on petrochemical margins too.

Edelweiss says that globally, there has been a sharp fall in GRMs and the trend in India is similar with modest refinery cutbacks ranging from 10-30 per cent. OMCs, however, have sharply increased retail fuel margins, partially offsetting lower volumes and weak gross refining margins (GRMs). They say: “We believe our recent 12-21 per cent cut in FY21 estimated EPS of OMCs is currently adequate. In fact, we believe Indian refineries will structurally gain in the long term as they enhance competitiveness.” Despite the cut, their FY21 estimates indicate a 20-75 per cent earnings growth for the OMCs.

Experts such as Yan Chong Yaw, Director of Oil Research & Forecast, Refinitiv (formerly Thomson Reuters Financials and Risks) say that the global oil demand for 2020 is set to contract for the first time in over a decade at 99.9 million barrels per day. This implies global crude oil prices are likely to remain soft and the expected benefits for OMCs are likely to sustain.

Analysts say, amongst the three, HPCL, having highest share of retail sales in overall revenues, remains best placed to gain from the better outlook for marketing margins. The stock is up more than 10 per cent in last two trading sessions compared to 3.4 per cent gains recorded by IOC. For IOC, concerns are more as compared to HPCL.

According to Emkay Global data, IOC is likely to see 20-30 per cent hit in its refining throughput compared to 10-20 per cent hit felt expected for HPCL and slightly more than 10 per cent for BPCL, given the lockdown. Thus, among the three, BPCL gained the most, up almost 11 per cent since Tuesday. Though there has some delay, with respect to the government's plan to sell its stake in BPCL, the stock is likely to see further upside. The three OMCs also offer strong dividend yield of more than six per cent which makes them attractive investment bets too.