Oil refiners on the margin amid rising crude prices, muted demand

Indian majors have to balance between rising crude prices, muted demand and heavy central and state levies on retail prices

When Saudi Arabia announced a crude oil production cut on January 5, it took the world of petroleum by surprise and created a degree of frustration for India. Starting February and then March, the Saudi Kingdom will cut production by one million barrels a day, though the overall production levels of OPEC+ (OPEC plus Russia) will be unchanged.

The West Asian producer is among the country’s top three crude oil suppliers. Over the years, as India sought to reduce its dependence on Iran for crude oil owing to geopolitical pressures, it was Saudi Arabia to which it turned to fill the gap. Last week, Union Petroleum Minister Dharmendra Pradhan openly criticised the OPEC+ decision at a conference where OPEC secretary general Mohammad Barkindo was also present, saying the policy “contradiction” is “creating confusion for consuming countries”.

OPEC’s second biggest oil producer, Iraq, for instance, has reduced its 2021 term supplies to several major Indian refiners by 10-20 per cent, according to a recent Reuters report, principally to make up for production beyond its OPEC quota in the past. With the Saudi cut, import-dependent India worries not about crude oil contracts not being fulfilled but the prospect of soaring prices. Pradhan cautioned that any price increase will push India towards alternative energy sources.

As the world’s third largest consumer of crude oil, India prefers higher production and the lower prices that come with it. But Barkindo offered the assurance that “consumers, in particular India, whatever decision we take, we have the interest of consuming countries in mind”.

At home, retail petrol and diesel prices have shot through the roof. The historic high makes it necessary for the government to cut duties on these products. Petrol, for instance, at Rs 85.74 a litre in Delhi comprises Rs 32.98 of central levies and Rs 19.32 of state VAT. This means tax is almost 61 per cent of the retail price. Similarly for diesel, the retail price of Rs 75.92 on Monday in Delhi includes Rs 31.83 as central excise duty and Rs 10.85 as the state VAT. This means taxes account for 56 per cent of the diesel price.

Though the petroleum minister may want these taxes to be cut, there is little headroom for Union Finance Minister Nirmala Sitharaman to do so, given the government’s tight fiscal position.

The OPEC+ grouping is expected to meet again in early February. Their meetings have become more frequent given that the Covid-19 pandemic and lockdowns associated with it have created demand and price uncertainty in the global oil market. “We all agree that the recovery is fragile,” Barkindo admitted.

According to Sweta Patodia, analyst, corporate finance, Moody’s Investors Service, production cuts by OPEC will help manage the supply-demand dynamics and bring down crude inventory levels, which are relatively high compared to historical averages. This, she feels, will provide support to oil prices.

The key risk for Indian refiners is on their margins. Last week, in its post-result analyst call, India’s largest private sector refiner Reliance Industries Ltd (RIL) indicated that the transportation fuel outlook remained challenging with excess supply and a second Covid-19 wave hurting demand from the European and US markets. RIL’s management, however, expected refining margins to gradually improve when demand recovers and inventories are drawn down.

The business margins are under pressure due to the overhang of product stocks and excess supply from China and resumption of lockdowns in the US and Europe. According to a report by Moody’s, RIL’s refining margins will improve from current levels but would “remain below midcycle levels” over the next 12-18 months.

Similarly, Patodia says earnings for the government-owned oil marketing companies (OMCs) — Indian Oil Corporation, Bharat Petroleum Corporation and Hindustan Petroleum Corporation — will improve over the next 12-18 months driven by a recovery in refinery throughput and refining margins. But she, too, predicts that “even though we expect refining margins to improve from less than $1 a barrel currently, it will still remain below pre-pandemic levels”.

A Motilal Oswal report notes that despite the optimism surrounding vaccines and changing macros globally, demand concerns remain the biggest constraint on the recovery in refining margins. “Refiners are facing the longest stretch of poor refining margins, and simple refiners are likely to bear the brunt of this.” According to the International Energy Agency, refining capacity of 1.7 million barrels per day is expected to be closed down permanently (combined) over 2020–21, with the maximum closures expected in the United States.

The Motilal Oswal report points out the Union government (through excise duty) and OMCs (through gross marketing margins) have been using margins on auto fuels as a key tool to manage their finances/profits. “To put this into perspective, OMCs increased their gross marketing margins to Rs 3–5 a litre over 2019–20 (from Rs 2.5-3 a litre in 2016-18) as Singapore gross refinery margins contracted to $3–5 a barrel from $6-7 during the period,” the report pointed out.

According to the report, the current curtailment in gross marketing margins comes at a time when the growth in demand for petroleum products in India has exceeded pre-Covid-19 levels — resulting in better absolute marketing segment numbers for the companies. “In our view, as crude oil prices stabilise, OMCs would raise their gross marketing margins on auto fuels. We reiterate our belief in the sustainability of marketing margins around the long-term average (if not higher) — while aiding poor refining margins in the short term as well as cushioning against possible inventory loss.”

Any upheaval in the global prices, however, limits companies’ capability to maintain their margins, especially if the government does not budge on excise rates. The ability to push the global increase in prices on to consumers would, nonetheless, be limited given that retail rates are already high.