OMCs: Caution, Highly Inflammable!

Brent crude oil recently climbed to its highest level in more than three years. Consequently, oil marketing companies (OMCs) in India have been under immense pressure. Tanay Loya tries to figure out what lies ahead for the investors from the OMCs 

Crude oil crossed the $70 per barrel mark in the global markets in a renewed rally. OPEC, Russia and other producers’ firm stance on production cut in 2018 has led to the recent surge in oil prices. According to a Bloomberg report, Saudi Arabia wants to get oil prices near $80/bbl to support the valuation of state energy giant Aramco before its initial public offering. 

This was supported by easing concerns over a prolonged trade war between the US and China after Chinese President Xi Jinping showed signs of promising to open up China’s economy and lower import tariffs on cars. However, the US is increasing export of crude oil with little signs of slowing down, which is balancing out the surge in price to some extent at the moment. With rising crude oil prices, the oil marketing companies (OMCs) in India are already showing signs of underperformance. Hindustan Petroleum Corporation (HPCL), Bharat Petroleum Corporation (BPCL) and Indian Oil Corporation (IOCL) have underperformed both BSE Sensex and BSE Oil & Gas index in the last one month. 

Oil Demand: Overview 

Rising income levels boosted oil demand in India due to the growth in the sales of scooters, cars and trucks. According to the Society of Indian Automobile Manufacturers, India’s car sales increased 8 per cent in the year ended March 2018, while that of trucks and buses rose about 25 per cent from a year ago period. Consequently, India’s oil demand grew 7.2 per cent in March from a year ago as the country emerged from the effects of demonetisation and the roll-out of GST. According to the oil ministry’s Petroleum Planning & Analysis Cell, the nation’s total oil consumption expanded to 18.6 million tonnes in the month from 17.4 million a year ago. Also, India’s oil demand rose for the seventh straight month in March.

Demand for diesel, which accounts for about 40 per cent of India’s oil consumption, increased 8 per cent to 7.35 million tonnes. India’s oil demand had shrunk for the third consecutive month in March last year following demonetisation move by the government in November 2016. Now, with the RBI raising its outlook for gross domestic product growth to 7.4 per cent for the financial year 2018-19 from 6.6 per cent in the previous year, we can safely say that India’s economic growth has picked up and the demand for oil can only go upwards.

PSUs' Declining Market Share In Auto Fuel Volumes 

It is interesting to note that growth in the domestic sales volumes of OMCs has fallen short of growth in domestic petroleum consumption in recent years. This can be attributed to continuous loss of market share in auto fuels to private players since the deregulation of diesel. Also, there has been a substantial increase in import of fuels such as pet-coke by consuming industries directly or through trade channels. In 9MFY18, OMCs’ auto fuels sales have grown by around 2 per cent slower than the growth in domestic consumption, indicating continued loss of market share to private players.

Uncertainty Over Hike In Fuel Price 

According to media reports, the government may ask state OMCs to absorb a hike of up to Re 1 per litre on retail prices of petrol and diesel due to the escalation of petroleum product prices globally. As a result, OMCs would have to bear a notable burden on their profitability. However, these reports could not be confirmed In case the hike in fuel prices is absorbed by the OMCs, it will impact the gross marketing margins for these companies. Such a move is expected to impact HPCL the most as its marketing segment is the highest contributor to its overall operating income (around 55 per cent). 

The marketing segment of all the three oil retailers had taken a hit in the December quarter. A Re 1 per litre cut will bring the margins close to the November 2017 levels. According to Kotak Securities, Re 0.5 per litre drop impacts oil marketers’ earnings per share by about 12 per cent to 21 per cent.

India seeking better bargain with global oil producers 

Over the years, India has been unable to bargain better rates from the Gulf-based oil producers, despite being the third largest crude oil importer with over 210 million tonnes of annual purchase. Instead of getting a discount for bulk purchase, West Asian producers, particularly Saudi Arabia, charges a mysterious ‘Asian Premium’ for its oil supplies to Asian countries such as India and Japan. 

However, the situation is slowly changing. Key producers from OPEC, threatened by the rising output from new and non-OPEC countries, are now trying to secure a foothold in India where refining capacity is set to surge to 8 million barrels per day (bpd) by 2030 from 5 million bpd. Some concessions are already coming. Iran has offered to increase a discount on freight prices to Indian state refiners to double its sales to the companies, which control about one-third of India's refining capacity. Also, Saudi Aramco raised the credit limit for some Indian refiners last year so that they could lift more crude without explicit financial guarantees. 

India last year began buying oil from the US to cut its dependence on the Middle East, whose share of overall imports fell to around 64 per cent in FY17 from about 80 per cent in FY08. The US, as an alternate source of oil supply, can give us better bargaining power with the Middle East. 

Moreover, the Indian government is joining hands with China to have a collective bargaining power against cartelisation of oil producers. If successful, the attempt will change the dynamics of international oil markets and India’s oil imports will be cheaper by at least $4-6 per barrel. Both the consumers and OMCs will be the beneficiaries as petrol and diesel prices would fall considerably in one stroke. 

Conclusion 

Given the firm outlook for crude oil prices, especially ahead of the state assembly elections scheduled throughout CY18 and the general election scheduled in 2019, we expect OMCs to remain under pressure for at least next few months. Given this backdrop, one cannot rule out the possibility of OMCs not passing on the rise in fuel prices to customers. The key aspect, as of now, is to watch if the crude oil prices persist above $70, since it could mean an overhang of subsidy sharing, which will keep the stock price under check. If the government pushes its oil companies into sharing the subsidy, these stocks could underperform further. However, if the global oil market corrects, investors can grab OMCs at a discounted price. For now, remain cautious on the OMCs.

Since January last year, Brent crude prices have risen by about 30 per cent. Higher crude oil prices benefit upstream companies, while negatively impacting downstream ones, unless they fully pass on the burden to the consumers. OMCs like HPCL, BPCL and IOCL were the worst hit in the recent past. Ever since media reports surfaced on April 11, 2018, stating that the government might ask the state-run OMCs to share the subsidy, the stocks have hugely corrected. HPCL was the worst hit with 12.25 per cent decline since April 11, 2018. 

The rising crude price will improve gross refining margins (GRMs) and lead to inventory gains for refiners like Chennai Petroleum Corporation and Mangalore Refinery & Petrochemicals. Reliance Industries derives more than 50 per cent of its profit from refining and hence benefits from rising crude price, which is expected to further improve its bottom line.

The rise in fuel prices will have a negative impact on operational margins of aviation stocks like Jet Airways, InterGlobe Aviation, etc. as fuel accounts for about 50 per cent of the operating costs of an airline in general. However, the overall growth trend in the sector is expected to even out such negatives. 

ONGC is likely to benefit from rising crude prices after having broken a long-term declining trend. 

Ritesh Ashar, Chief Strategy Officer (CSO), KIFS 

How Will Rising Crude Oil Prices Impact The OMCs? 

Rising crude oil prices have two implications, either pass on the burden to consumers or the losses will be absorbed by the OMCs from their margins. The government is focusing on the second alternative as the first one will lead to inflation issues and will directly affect banking policy in the near future. The companies have to shrink their marketing margins, which is the difference between prices at the refinery gate to fuel stations, and the other alternative can be adjustment of taxes, which may affect the revenue of the government via taxation, but OMCs and consumers will not be affected as a whole. The reason why we are expecting the losses to be absorbed by the OMCs is that passing on the burden to the consumers will create a sense of fear, Inflation and political instability, which will somehow affect the elections to come in 2019 and Karnataka elections too. The oil industry is divided into two parts: OMCs (oil marketing companies) and OPC (oil producing companies). When we say the oil price goes up, we mean the prices of crude oil goes up. As the crude oil is the final product of the exploration and production companies (such as ONGC) which will now be sold at higher prices, the E&P companies will make profit. On the other side, for the downstream companies (such as HPCL), crude oil is a raw material which they will now have to buy at a higher price and their final selling products are refined products such as petrol, diesel, etc. The prices of these refined products may not necessarily increase in the same proportion as the increase in the price of crude oil. As a result, the refining companies ( BPCL and HPCL) start losing money.