Diesel deregulation: Full benefit to OMCs by FY17

Gross underrecoveries expected to fall 75% by then; this and lower interest costs have already had a favourable effect on bottom line

The three oil marketing companies (OMCs), all government-owned -- Indian Oil Corporation (IOC), Bharat Petroleum Corporation (BPC) and Hindustan Petroleum Corporation (HPC) -- have already started reaping the benefits of diesel price deregulation.

In the December 2014 quarter, interest costs reduced between 26 per cent (IOC) to 61 per cent (BPC), year on year. Lower underrecoveries and full compensation by both the government and upstream companies towards subsidy (the loss on retailing of diesel below the cost price) also helped.

However, high inventory losses (due to a sharp fall in crude oil prices, totalling a combined Rs 17,000 crore,) along with foreign exchange losses, impacted profits of all the OMCs in the quarter. BPC was the only one of the three to report a net profit. HPC had a 81 per cent fall over a year before, to a net loss of Rs 325 crore. IOC's net loss was Rs 3,069 crore, up 123 per cent over the year-ago period.

The bad news is likely to end here. “Weak crude will give the OMCs an opportunity to expand their marketing margins. With low competition risk, OMCs’ profits could expand substantially,” believe analysts at Axis Capital. The full benefits of diesel price deregulation are likely to kick in over FY16 and FY17. Analysts at Deutsche Bank expect gross underrecoveries of the OMCs to fall by 72-75 per cent by FY17 as compared to FY14. Lower oil prices and underrecoveries will lead to a further decline in interest costs. In this backdrop, most analysts remain bullish on all three.

While overall profitability will improve for IOC as interest costs and underrecoveries come down, divestment will remain a key overhang on the stock. Analysts believe, the company’s gross refining margins are likely to improve after commercialisation of its Paradip refinery, the most complex one in the state sector. At 1.1 times the FY16 estimated book, the stock trades at a 12 per cent discount to its historical average one-year forward price/book value ratio of 1.2 times.

HPC is highly levered to expanding marketing margins. Notably, every 50p/litre expansion in petrol/diesel margins could add 50 per cent to earnings per share, as against 20-25 per cent in the case of IOC and BPC, estimate analysts. In addition to the lower subsidy burden, HPC's debt is likely to reduce further, as a large part of its refinery upgradation capex is over. The stock currently trades at 1.1 times the FY16 estimated book value, slightly higher than its historical average one-year forward price/book value ratio of about one.

Though BPC’s downstream business will benefit from oil reforms, the exploration and production (E&P) business could witness near-term softness, on the back of lower crude oil prices. However, an announcement around positive developments in the E&P business could act as a key catalyst for the stock. Analysts expect BPC’s return on equity to rise from 16.8 per cent in FY13 to 20 per cent in FY17, on the back of fuel price reforms. The stock, though, seems to have priced in most positives and is trading at 2.2 times the FY16 estimated book.