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It’s total confusion out there!

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In my previous blog, I wrote about the confusion in the subsidy burden to be borne by the downstream trio of IOCL, BPCL & HPCL and the Govt. Well, the Govt. has announced that its share of the subsidy burden for FY11 would be Rs 41,000 cr and the upstream sector would have to contribute Rs 25,750 cr towards the total FY11 under recoveries of Rs 77,750 cr. This leaves a net under recovery of Rs 11,000 cr to be borne by the downstream sector.

However, confusion continues to persist in the markets, taking its toll on the stocks in the upstream sector, with ONGC losing 6% whereas OIL India & GAIL were down by 4% on May 17. This plunge was triggered by unconfirmed media reports about a hike in the upstream sector’s share of the subsidy burden from the norm of 33% to 38.5%. Not only would this impact the financials of these companies negatively, it would also renew concerns on the ad-hoc nature of the subsidy sharing mechanism which would result in still lower valuation multiples for these stocks in the long term.

However, latest reports indicate that the Govt. is working on a new & transparent subsidy sharing mechanism for the sector. Amongst the various ideas being suggested, the crude price-linked subsidy mechanism, which was first proposed by ONGC and subsequently included in the Kirit Parikh Commission’s report on petroleum product pricing reform, is also being considered. A clear & transparent subsidy sharing mechanism is precisely the need of the hour as it will dispel uncertainty from the minds of the investors and also remove a part of the valuation discount that is currently embedded into the stock prices. In light of the above, we feel that reports about the upstream sector bearing 38.5% of the under recoveries are without any merit.

Moving to the Q4FY11 results, we feel that the combination of $ 100+ crude oil & $ 8+ Singapore GRMs during the quarter would be beneficial for upstream companies and pure refiners. Accordingly, we remain positive on the upstream sector going forward. If the Govt. comes out with an improved subsidy sharing mechanism, this will lead to a re-rating of the sector as a whole.

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Written by Fundamental Side

May 19, 2011 at 3:29 pm

Posted in Oil Market

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Suspense on under recovery sharing continues

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Q3FY11 witnessed the spectacle of the PSU OMCs (IOCL, BPCL, HPCL) postponing announcement of their quarterly results since the Govt. was taking its time in declaring its share of the gross under recovery burden for that quarter. As things stand now, our estimated gross under recovery for Q4FY11 is ~ Rs 31 bn, which is almost double the gross under recovery figure of ~ Rs 15.8 bn for Q3FY11. The sheer amount of the subsidy burden makes this quarter’s results particularly interesting!

The prevalent under recovery sharing pattern entails the upstream sector (ONGC, OIL India, GAIL) to bear 33% of the subsidy, the Govt. to bear 50% of the subsidy and the remaining 17% to be borne by the OMCs. However, due to the meteoric rise of crude during Jan – Mar 2011 and no revision in retail prices of petrol, diesel, kerosene & LPG, the under recoveries have ballooned to ~ Rs 31 bn.

There is a concern that the upstream sector, which benefits from rising crude prices, may be asked to bear a higher share of the subsidy. Such a move, if implemented, would be negative for the entire upstream sector. Moreover, it may result in very poor investor response to the upcoming FPO of ONGC. A higher subsidy burden would be particularly negative for GAIL as it is not an oil exploration company like ONGC & OIL India, and hence, doesn’t benefit from rising crude prices. Hence, while high crude prices and higher subsidy burden roughly balance each other out for ONGC and OIL India, it is not so for GAIL as it has no upside but only downside in such a scenario.

To assuage investor concerns on this front, the Petroleum Ministry has time and again insisted that it would not increase the burden on the upstream sector beyond 33% of the gross under recovery. Meanwhile, enough hints have been dropped about raising petrol and diesel prices after the state assembly elections conclude, as per our expectations. However, this will impact FY12 under recoveries, and not Q4FY11 under recoveries. We expect the Govt. to bear upto 55% of the subsidy burden so that the OMCs can report a minimum ROCE of 12%. This episode only serves to highlight the continued dependence of the OMCs on the Govt.

From the desk of Deepak Darisi

Written by Fundamental Side

April 29, 2011 at 2:16 pm

Posted in Fundamental Side

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“Crude” Shock

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Since my previous post about a month ago, petroleum and petroleum product prices have spiked, with Brent crude touching $ 110/bbl. WTI crude is set to go past the psychological $ 100/bbl mark, on the back of political unrest in Libya and Algeria, which are oil producing countries, unlike Egypt.

The political unrest in Libya has taken a definite turn for the worse with reports of upto 1,000 protestors being killed by the Libyan Government. Muammar Gaddafi, the despotic ruler of Libya, has threatened to sabotage the country’s oil facilities. This move is aimed at sending a message to protestors that the country would be plunged into chaos if he is forced to cede power. Already, Libyan oil production is down to 75% of its normal production levels. This “sabotaging of oil wells” has a historical parallel in the 1991 Gulf war when the retreating army of Saddam Hussein was ordered to set fire to 700 oil wells in Kuwait. It took the US forces 9 whole months to extinguish the fires!

Hence, India will continue to bear the brunt of high crude prices, with increasing under recoveries for the state owned OMCs (IOCL, BPCL, HPCL). Per unit under recovery for the previous fortnight stood at ` 10.74/lit for diesel, ` 20.56/lit for kerosene and ` 356/cylinder for LPG. These figures can be revised upwards when the OMCs re-calculate their under recoveries for the current fortnight. The higher total subsidy burden will burn a deeper hole into the government’s finances, making fiscal consolidation harder.

Historically, Cairn India was the one stock which moved in tandem with crude prices. However, the uncertainty over its pending acquisition by Vedanta Plc has resulted in the stock barely budging despite crude’s surge. Government owned ONGC and OIL India have to provide higher subsidies at higher crude prices, which results in lesser sensitivity of their shares to rising prices. OMCs will be negatively affected as their raw material prices go up, whereas the product prices (diesel, kerosene, LPG) are fixed. The Government is unwilling to deregulate diesel as inflation continues to be in double digits.

With ONGC’s FPO about to hit the markets, there are expectations that the Govt. will announce some positive measures in the Budget, for example, reducing customs duty on crude to 0% and that on petrol & diesel to 2.5% which will reduce the level of under-recoveries in the system. Let’s hope that the Govt. smoothens this “crude” shock to the Indian economy.

From the desk of Deepak Darisi

Written by Fundamental Side

February 24, 2011 at 1:22 pm

Why has the oil & gas sector underperformed?

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Crude oil prices, refining margins and petrochemical spreads have been rising throughout CY2010-11. In spite of this, the oil & gas sector has underperformed the broader index with the BSE Oil Index dropping by 2.7% as against a gain of 11.3% in the BSE 100 Index year-to-date.

The reasons for the above are not hard to find. Lack of clarity regarding the subsidy sharing mechanism hangs like an albatross around the necks of the upstream companies (ONGC, OIL India) as well as the refining & marketing companies (IOCL, BPCL, HPCL). The positive effect of petrol deregulation has been nullified by the relentless rise in crude prices (Brent crude touched $ 99/bbl couple of weeks ago). This has increased the projected under recovery for FY11 to Rs 73,000 cr, compared to the projection of Rs 53,000 cr made post petrol deregulation in Jun 2010. Hopes of diesel deregulation in FY11 have been nipped in the bud by the Government in the face of 8% plus inflation levels. The Government, which is expected to provide for half of the total under recoveries, will find it tough to rein in fiscal deficit as it has abolished the practice of issuing oil bonds.

Cairn India, whose stock price has a correlation of 95% with crude price, has not performed in line with crude prices, as it awaits Government approval of its take-over by Vedanta Plc. RIL has turned in a stellar Q3 performance on the refining & petrochemicals front, however, ramp up of gas output from the prolific KG D6 basin remains uncertain. This delay is also raising questions on optimum capacity utilization of the pipeline network that is being set up by GAIL (India) and GSPL in the near term. Petronet LNG will be the beneficiary of the developing gas shortage scenario in the country.

As a response to India’s over dependence on crude imports, the Government is considering a system of OALP (Open Acreage Licensing Policy) where oil firms can choose the blocks they want to explore without waiting for the Government to put them on offer. This will minimize the lead time between bidding & commencement of exploratory activities, which can be as long as 3 yrs. The Government also needs to apply its mind towards simplifying the maze of price controls, duties and taxes being charged on the regulated petroleum products so that investors gain clarity on the working of the oil & gas sector.

Written by Fundamental Side

January 24, 2011 at 3:02 pm