While complete pricing freedom looks unlikely, the move to de-regulate auto fuel prices will be welcomed.

The country’s public sector oil and gas stocks have seen an increase in activity in the recent past. The reason: the market believes that the recently elected government will infuse a new lease of life into the oil marketing companies (OMCs) by de-controlling fuel prices, if not fully at least partially. Reports quoting government officials that the proposal to de-regulate the pricing of retail fuels is pending with cabinet for approval, has fuelled this optimism. Thus, post elections, the three OMCs (Indian Oil, Hindustan Petroleum and Bharat Petroleum) and ONGC were seen outperforming the broader indices.

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Subsidy-led pains
In the past and in a regulated environment, domestic fuel prices did not mirror the global crude oil prices, especially on their way up, much to the despair of the OMCs. The companies had to sell their products at lower rates as compared to the costs. The losses that OMCs suffered on this count were however, to a large extent (about 80 per cent) borne together by ONGC (discount to OMCs) and the government (by issue of oil bonds).

In 2008-09, at the peak crude oil price of $145 per barrel, the subsidy burden was estimated to reach catastrophic levels of Rs 245,000 crore or 4-5 per cent of GDP. However, subsequent to the price correction, the actual subsidy outgo was a little over Rs 100,000 crore, but even then, it was still the highest ever. While the government and ONGC took the full burden, the OMCs did not go unscathed as financials were impacted by way of higher borrowings.

For 2009-10, Amit Shah, VP - Oil & Gas, BNP Paribas Securities India, says “In view of a global slowdown, we expect crude oil prices to hover around $59.8, much lower than 2008-09 prices.” At $60 a barrel, gross under-recoveries are expected to be around Rs 35,000-45,000 crore, but significantly higher atRs 60,000-65,000 crore if prices average at $70. And this, says Kumar Manish, associate director, KPMG, “Although the gross under-recovery number is expected to be significantly lower this fiscal, the government may still continue with tri-partite sharing mechanism involving upstream companies, central government and OMCs.” In that case, there is no good news for the OMCs.

The options
Among the most obvious ways to eliminate the subsidy burden is to de-regulate prices, which would reduce government’s intervention and allow companies to mark their produce in line with global crude prices. With crude oil prices lower, many feel that it is an opportune time to effect deregulation in fuel prices. However, a complete de-regulation would leave consumers to bear the direct consequence of higher crude prices. Besides, the government will also be mindful of any overshoot of a fuel-price backed inflation.

So, while the possibility of implementing full de-regulation of fuel prices looks difficult at this point of time, Amit Rustagi, analyst from Antique points out that “introduction of de-regulation of auto fuels can be a possibility.”

The thought of partial de-regulation is not without reason and is gaining ground. Crude oil prices have doubled in the last six months to over $70 a barrel and some state elections are also due. Partial de-regulation of auto fuel prices will help keep a status quo on PDS-kerosene and domestic LPG prices. Also, it would help relieve some pressure on the fiscal deficit, which stands over 6 per cent. Lastly, inflation is also under control, which is why some experts feel that it is a right time to hit the reform path.

But, analysts also believe that the government might give pricing freedom to OMCs (for auto fuels) only up to a certain level of crude oil prices, say $75 per barrel, beyond which it may have to put in place some mechanism (like subsidy sharing, higher taxes for domestic oil producers) to offset the pressure on consumers. These expectations are based on one of the many recommendations made by the B K Chaturvedi committee last year.

The impact on OMCs
Should the government allow OMCs to fix prices as per market rates, experts believe that it could lead to a re-rating of their stocks. Under a free fuel-pricing regime, OMCs could price market fuels (at a profit) ensuring sustainable profitability at every crude oil price level. Deregulation could positively impact several companies – either directly or indirectly, by creating a level playing field for public as well as private oil companies.

Even a partial de-regulation could add to profitability. In that case, analysts expect the earnings per share (EPS) of OMCs to rise by 25-40 per cent in 2009-10 and 2010-11. However, the exact benefits would depend on nitty-gritty of the de-regulation package. In a recent note, Harshad Borawake, analyst at Motilal Oswal Securities, says “Even if auto fuel prices are deregulated, the implications on OMCs' profitability would still be dependent on the sharing of LPG and Kerosene under-recoveries, which will have to be borne either by the government through oil bonds, or by upstream players through discounts, or by the OMCs.”

Assuming that a reasonably decent formula is arrived at, a partial deregulation would help ease the pressure on the financials of OMCs, which have been under strain for quite some time. To give an indication, in 2008-09, the OMCs faced pressure owing to inventory losses (as crude oil prices slipped), lower refining margins and high interest costs. A delay in receipt of oil bonds and higher working capital requirements meant an increase in borrowings, resulting in their combined interest costs shooting up by 163 per cent to Rs 8,719 crore in 2008-09.
 

Secondly, in terms of product-wise subsidies, given that the share of auto-fuels has increased from nil (a few years ago) to 56 per cent in 2008-09, the partial de-regulation should have visible implications for OMCs.

For now, although things are relatively better in the current fiscal year, the recent rise in crude oil price is likely to take a toll on the profitability of OMCs. Echoing concerns, says SK Joshi, Director (Finance), BPCL, “We are losing around Rs 3 on petrol per litre, Rs 12 on kerosene, experiencing marginally negative margins on diesel and Rs 72 per LPG cylinder at the present prices.” And, these under-recoveries are based on fortnightly prices as on June 01, 2009 when average crude oil price stood at $60 per barrel.

So, even if there is a partial de-regulation, along with some macro improvements it would help the companies deliver better results in the current year. This will be helped by the stabilising refining margins which are seen stabilising, and softer interest rates. Also, as crude oil prices are relatively lower, it will result in lower working capital needs. Additionally, if the companies choose to encash some of their oil bond holdings, it could help lower their overall debt and interest burden.

What’s equally important is that any reasonable move should clear off the uncertainties haunting the sector in terms of subsidy sharing, revenue and earnings visibility and, hopefully lead to a transparent pricing mechanism.

Within OMCs, analysts prefer HPCL. The stock is trading at less than one time its 2009-10 book-value and is considered to be better placed to take advantage of any auto-fuel price de-regulation, due to its product mix.

...on ONGC
It’s not only the OMCs, but upstream (exploration) companies have also footed the subsidy bill and in a big way. In the last three years, they doled out Rs 79,300 crore in terms discount on the market price of fuels, which effectively works out to about a third of total subsidies. ONGC contributed around three-fourth of upstream subsidy burden and hence, would stand to benefit from de-regulation of product pricing. But, since its realisations are likely to be capped beyond a certain level, the gains may not be significant for the company. The B K Chaturvedi Committee has recommended a ceiling price of $75 per barrel for upstream companies. On the other hand, its overseas arm (OVL) should gain from sale of crude oil at higher prices in the international markets.

The expected de-regulation in administered gas prices are also expected to shore up the company’s profitability. ONGC currently sells about 45-50 mmscmd of gas at administered price of Rs 3,200 per mscm, which is less than half the current domestic market price. However, if there are any moves to increase gas prices, says Borawake, “we believe that the most likely scenario would be steady increase in gas price over the next few years to bring it at par with the market price.” Borawake estimates that a 20 per cent hike in gas price will improve ONGC’s EPS four per cent (or Rs 4 per share), whereas a 100 per cent hike will lead to a 22 per cent (Rs 19) rise in earnings. These moves will be positive say analysts, who expect an upward revision in the company’s earnings--by around Rs 5-10 and Rs 30-40 in 2009-10 and 2010-11, respectively.

...and on private players
Denial of market forces to determine fuel prices discouraged private sector to expand aggressively in the country. In fact, they were forced to close shop (retail outlets). Any moves to adopt free market pricing would rejuvenate private players like Reliance Industries and Essar Oil, as it will create a level playing field. But, this could also mean increasing competition to OMCs as it happened during 2006-07, when the OMCs lost market share.

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