OMCs: Marketing margin gains to drive valuations

Analysts believe re-rating in three stocks could continue, led by benefits from rising fuel marketing margins and lower interest costs

The September 2015 quarter performance of public sector oil marketing companies (OMCs) - Indian Oil Corporation (IOC), Bharat Petroleum Corporation (BPCL) and Hindustan Petroleum Corporation (HPCL) -- might look mixed, but the underlying core numbers as well as their business outlook are strong.

While gross refining margins (GRMs) increased over the year-ago quarter, two of the three companies,  HPCL and IOC, reported a net loss, thanks to inventory losses in the quarter. Excluding the inventory losses, the GRM per barrel for IOC stood at about $7, while the same for HPCL was $2.7 and BPCL was $3.9. Even though interest costs continue to fall on a year-on-year basis, some analysts were concerned with sequential increase in the same for IOC and HPCL. However, the sequential increase is on account of working capital loans borrowed to compensate for delayed payment by the government for the LPG subsidy. Marketing margins too reduced in the quarter sequentially due to delay in petrol and diesel price hike in view of the Bihar elections. However, all that has changed for the better.

"After Bihar election, OMCs marketing margin has improved. Currently, diesel marketing margin stands at Rs 1.2 a litre, while petrol margin stands at Rs 2.9 a litre. We believe OMC’s will manage to earn normalised marketing margin from next price change," believe analysts at Emkay Global. Notably, earlier as well, OMCs have managed to pass on higher excise duties and increase their marketing margins.

Analysts at Goldman Sachs too echo this view. "We expect Street concern on weakness in marketing margins to ease as diesel margins have now normalised, while petrol margins continue to remain robust which would drive sequential improvement," they said in a recent note. The brokerage has a buy rating on all the three companies and expects them to deliver returns of 34 per cent to 44 per cent over the next year.

Timely compensation of under-recoveries (about Rs 3,240 crore for all OMCs combined; due to sale of LPG and kerosene at subsidised prices) from the government as well as upstream companies meant that the OMCs did not bear any under-recovery in the quarter. Historically, OMCs' earnings have fluctuated significantly due to uncertainty and delay in compensation from the government, impacting their fortunes. Analysts also expect that for the rest of FY16 as well as in FY17, OMCs are unlikely to bear any meaningful under-recoveries. And this will improve the earnings visibility and predictability for these companies.

“We believe, OMCs will perform from here on as we do not see any negatives which would lead to downgrades in the consensus number for FY16. GRMs are on recovery side on winter demand and in Q1CY16, it will further improve on account of maintenance shut down in major US and European refineries,” say Emkay’s analyst Dhaval Joshi.

In this backdrop, most analysts remain positive on the OMCs. The view that oil prices will remain benign for a long time to come also augurs well for these companies.

While BPCL's superior return ratios as well as potential gains from exploration and production activities are key positives, HPCL stands to gain the most from rising diesel marketing margins. Successful turnaround of its Bhatinda refinery (12 per cent to HPCL's sum-of-the-parts) though is crucial. Analysts expect it to turnaround in the next 18-24 months. IOC is through with a large part of its capital expenditure which could aid its cash-flows going forward. Healthy dividend yield of 4 per cent is another positive.