Lost money investing in OMCs? You can make some by betting on oil producers

OMC shares tanked over rising crude as there is little scope to hike fuel prices in an election scenario; Producers like ONGC and Vedanta, however, are likely to gain

Investors worried over losses in their investments in oil marketing companies (OMCs) can save some of the pain by investing in oil producers instead. Worries that rising oil prices will hurt the profitability and financials of OMCs have led to their share prices falling by 15-26 per cent in the past three months, versus a 2.5 per cent rise in the S&P BSE Sensex. 

Past performance shows that oil marketing companies tend to underperform on the bourses during times of rising oil prices. While there are arguments that this time could be different for OMCs, as pricing of retail fuels has been freed, increasing prices during elections doesn't come easily or at least the quantum is smaller. With many state elections and the general election due in the next 12 months, there could be periods when the price hikes are delayed even as crude oil prices rise. Analysts suggest that the profitability of OMCs will get impacted in FY19 before rebounding in the next fiscal. 

In an April 19 note, Crisil had said, that any further rise in crude prices could force the government to ring-fence consumers by restraining OMCs from passing on the increases fully, especially given the political cycle. The government is not expected to reduce excise duties to influence prices, as they have to maintain their tax revenue targets for the year. Since April 19, Brent crude oil has risen from $73.78 to $77.08 now, as per oilprice.com.

Although the domestic research agency believes that the impact on marketing margins, which have risen sharply after daily pricing of fuels, will be lower as compared to historically, there is a possibility of higher subsidy burden on sale of LPG and kerosene.

Prasad Koparkar, Senior Director, Crisil Research, says, “Consequently, including under-recoveries, the Ebitda margins of OMCs are expected to decline 13-15 per cent this fiscal. However, some inventory gain ($1-1.5 per barrel) in the coming quarters would provide a modicum of offset. Net-net, therefore, Ebitda margins are seen declining 8-10 per cent.”

There are reasons, which suggest that crude oil prices are more likely to remain elevated.

For one, if global growth picks up pushing up demand for oil, prices are also likely to rise even as new supplies, including from shale assets, increase. The OPEC and Russia, too, are inclined to maintain discipline to keep oil prices higher, which some believe are more likely to rise towards $80 a barrel.

Moreover, if Saudi Arabia's Aramco is moving towards an IPO, the world's largest oil producer would also desire to extract higher valuations. And for that, it will want oil prices to remain high.

While there is a shift towards renewables, it is more likely to be a gradual shift.

Global tensions such as US-Iran deal, South-North Korea, etc will also keep oil on the boil, say experts.

In a research note on Wednesday explaining four implications of a likely return of Iran sanctions, Taimur Baig, Chief Economist at DBS Bank said, "Given the prevailing tight supply-demand dynamic in the oil markets, the return of sanctions will cause substantial upside risk to the spot price of oil."

Given the backdrop, oil producers are likely to benefit. Vedanta, which now owns Cairn India, will be one of them. However, movement in base metal prices would have a larger influence on the natural resources major.

Public sector oil producers such as ONGC and Oil India would also benefit. But, the gains could get capped should the government decide to put some of the burden of higher oil prices on these companies, as seen in the past, by asking them to share the subsidy the government may want to give consumers. Such worries have kept a tab on their share prices, which are down, albeit marginally, by 2.5 - 5.9 per cent during the past three months. For now, they are expected to benefit in the form of higher profits.

"This fiscal, EBIDTA margins of upstream oil companies are seen rising 23-25 per cent on account of higher realisations driven by increase in crude oil prices. Those numbers could rise another 1,000 basis points to 33-35 per cent if these companies aren’t forced to share under-recoveries equally with downstream players," CRISIL said.

It further says that the Union Budget for FY19 has assumed the average price of the Indian crude basket (weighted average of Dubai and Oman crude, and Brent) to be $57.50 per barrel, and estimated the petroleum subsidy for the year at Rs 249 billion. But, with crude oil at over $70 now, the subsidy bill could rise by Rs 100 billion.