The pain and gain from the fall in crude prices

Softer crude brings cheer to PSUs, pain for private oil producers

The fall in Brent crude oil prices is definitely a boon for India, which depends largely on imported crude for its needs. More specifically, it spells good news for public sector undertakings some of whom continue to share the subsidy burden due to under recoveries (difference between the selling price and cost price of fuels sold at a subsidised rate).

While downstream oil and gas companies who sell the fuel through retail outlets as Hindustan Petroleum (HPCL), Bharat Petroleum (BPCL) and Indian Oil (IOC) stand to gain the most, the impact on upstream companies as ONGC though mixed is also positive. On the other hand, while oil production business of the upstream companies will be impacted due to lower crude realisations, their subsidy burden will also fall substantially. Since they share a large part of under-recoveries, the net impact is positive.

Sensitivity analysis- Brent prices v/s Subsidy burden

Analysts at Ambit observe that every $1 a barrel decline in crude price reduces FY15 under-recovery by about Rs 4,600 crore or 5.3% of the total estimated burden of Rs 87,000 crore (initial estimates for FY15 assuming crude at $108 a barrel and exchange rate of Rs 60 to a dollar).
 

With Brent crude price declining by 28% to $83/barrel in October'14, after touching a peak of $115/barrel in mid-June, driven by weakening demand and rising supply, the under-recovery estimates stood lowered at Rs 65,000 crore. Looking at further decline in prices, the net under-recovery estimates for FY15 and FY16 are likely to be further reduced.

Analysts at Nomura say that at crude price assumption of $90/barrel, the annual subsidy for FY16 would be at Rs 63,000 crore, and this would reduce to Rs 52,000 crore when crude declines to $80/barrel and Rs 46500 crore at $75/barrel. Effectively, each $5/barrel decline in crude price cuts the under-recovery bill by Rs 5,500 crore, as per their estimates.

Impact on individual companies

For oil and gas producer ONGC, since its subsidiaries ONGC Videsh (OVL) and MRPL contribute about 25% at the PBIT level, lower crude prices does not bode well for the oil production business (OVL). However, the impact will be partly offset by lower subsidy burden which in turn will lead to better net realisations in domestic business. Add to this, the higher APM gas prices and decontrol of diesel, it will boost overall profitability for ONGC.

Analysts at Nomura say that for ONGC, while immediate reaction will be negative, the bottom line impact may not be large, given that they would likely eventually get relief from subsidies. "We would recommend any potentially sharp price decline in ONGC as an opportunity to accumulate," they add.

On downstream companies, the sharp fall in oil price is positive for oil marketers namely, BPCL, HPCL and IOC as subsidy concerns reduce further. Most analysts have a buy rating on the three stocks. The only near-term concern is that due to sharp decline in oil price, these companies will again have a weak December 2014 quarter due to likely inventory losses and some impact on gross refining margins (GRMs).

For private sector oil and gas producers as Cairn India, their profitability depends on crude oil prices. Cairn India, whose net realisations are typically about 9-14% lower (discount) than Brent due to the wax content in the oil it extracts from Rajasthan block, lower prices don't bode well. However, the pessimism on oil prices has led the stock dip to its three-year low of Rs 255 levels on Monday.

Analysts at Nomura say that Cairn is likely to see the worst impact as it is a pure play, however looking at the share price correction they have Neutral rating on the stock. Cairn's stock is trading at 0.7x book value which is at a discount to its historical average of 1.1x book value. While the stock is likely to remain under pressure in the near-term, analysts say these levels can be used for accumulating it for the medium to long term given the company's significant hydrocarbons reserves, potential of further additions to these reserves and lastly, production ramp up plans.

Reliance Industries (RIL), among top global refining and petrochemicals companies, has its business of refining skewed towards GRMs. The refining business accounts for about half of RIL's segment profits. The decline in benchmark Singapore GRM's indicates towards weakness in refining business in the near future.

Nevertheless, Reliance has again shown its ability to report higher than benchmark GRMs in September'14 quarter, which is positive and likely to sustain. The lower crude prices, on the other hand, can mean that the company gets feedstock for petchem business at lower prices benefitting the segment's margins despite existing excess capacity concerns in China and Middle East exerting pressure over industry's profitability.

However, analysts say that as Reliance also has domestic E&P and US shale production operations, it will see some negative impact on those counts. In this backdrop, they maintain their bullish ratings on the stock.