Light at the end of the tunnel for domestic oil marketing companies

Marketing margins to support earnings, while refining outlook can improve with vaccine launches driving global economic recovery

Even as concerns over the global spread of the pandemic remain, positive news flow on Covid-19 vaccine has raised hopes of global economic recovery next year and improved prospects for oil and gas demand. This, in turn, also improves the outlook for domestic oil marketing companies (OMCs) such as Bharat Petroleum (BPCL), Hindustan Petroleum (HPCL) and Indian Oil (IOC), which have seen worries on demand and weak refining margins impacting sentiments.

With the US elections also behind, brokerages are expecting the focus to shift to economic revival in the world's largest economy. OMCs are already in news with the divestment of BPCL in progress, which if successful, should lead to value unlocking opportunity for the company's investors. Adding to this is the encouraging September quarter (Q2) performance of the companies. Not surprising, the OMC stocks have rebounded 17-30 per cent from their September-October lows.

The Q2 performance of OMCs was driven by inventory gains and strong marketing margins even though refining margins remained subdued. All the three OMCs saw marketing margins range between Rs 5.9 - 6.6 a litre, versus the typical Rs 2 - 3 per litre. The reported gross refining margins (GRM; per barrel) ranged from $2.7 - $8.6, boosted by inventory gains of more than $3. So, the core GRM was flat to negative for the OMCs. For example, IOC's refining margins at $8.6 included inventory gains to the tune of $9.6, say analysts at Motilal Oswal Financial Services (MOFL) who say core GRM was negative $1 per barrel.

Indian OMCs have resilient marketing earnings to offset the refining weakness, say analysts at Morgan Stanley, who add that the companies are effectively fuel marketing companies which have backward integration into refining. It is this strength and cheap stock valuations that keeps analysts positive on the OMCs. Post Q2, the OMCs have also seen earning upgrades. Emkay Global has raised FY21 earnings for the three OMCs by 9-44 per cent.

Another key key takeaway from September quarter performance was the OMCs maintaining their expansion and capex guidance, which is an indication of their forward prospects, say analysts.

Meanwhile, the improvement in vehicular traffic bodes well for petrol and diesel demand while there is gradual improvement in air traffic too. Marketing margins for petrol and diesel currently remain steady, says Yogesh Patil of Reliance Securities.

The refining margins, too, can improve helped by global recovery with positive news flow on vaccine raising hopes. Oil demand growth forecast for CY21 (that is just around the corner) currently stands at 6.5 million bopd (barrels of oil per day) compared to an estimated loss of 9.5 million bopd in CY20, says MOFL. The brokerage also points out that one dollar per barrel rise in GRM would result in an Ebitda increase of 9–11 per cent for OMCs in FY22.

Among companies, rising fuel consumption and in turn higher marketing earnings accrue more benefits for HPCL, which has a higher share of fuel retail sales in its portfolio. Not surprising, HPCL saw maximum earning upgrades of 44 per cent and 25 per cent for FY21 and FY22 (Emkay estimates), and its stock a sharper rise in the last one month.

IOC, comparatively, is more diversified with substantial exposure to refining and petrochemicals businesses. Morgan Stanley feels that all state-owned companies are trading cheap. It says, IOC has size, scale, and with long-term business plans of increasing petrochemicals integration across its refineries, a more diversified earnings model and 9 per cent dividend yield remain a positive.

BPCL's outlook is also improving, but in the near-term, its stock price will track the progress on its divestment by the government. On fundamentals, Morgan Stanley has maintained overweight rating with target of Rs 525 for BPCL's stock trading at Rs 385 levels now.