Muted earnings growth ahead for OMCs as refining margins under pressure

Soft refining margins, higher working capital, subsidy sharing and capex are key risks

The stocks of oil marketing companies (OMCs) BPCL, HPCL and IOC have rebounded sharply by up to 22 per cent from their lows in May. 

With the overhang of any price cuts out of the way after the general elections and a stable government expected to continue reforms in the sector, market sentiment had turned favourable. 

Moreover, OMCs also posted steady March quarter numbers while crude oil prices saw some correction. Valuations, too, have remained attractive.  

However after the recent gains, analysts have turned cautious as refining margins continue to remain under pressure. Despite good marketing margins and inventory gains, refining margins were soft in the March quarter. The refining margins outlook remains subdued with recovery seen only with implementation of the International Maritime Organization (IMO) regulations in 2020. This can drive demand for diesel cracks and, in turn, boost refining margins.

Crude oil prices continue to remain volatile. With sanctions on Venezuela and Iran as well as OPEC production cuts, they (oil prices) are most likely to remain in the higher band, say analysts. However, higher crude prices also mean higher working capital requirement.

“OMC’s have had to take 22 per cent more short-term debt last fiscal because of inadequate payments from the government, and also to service under-recoveries of the recent past,” said Prasad Koparkar, senior director, CRISIL Research. Koparkar believes net profit margins would come under pressure because of higher interest costs.

OMCs have a high capex requirement, given the undergoing refinery expansion which can keep near-term earnings growth under check.

Analysts at IIFL have cut earnings estimate of OMCs for FY20-21 by 4-12 per cent on the back of lower refining margin assumptions. 

They maintain that assumptions on product sales growth, normalised marketing margins and earnings growth will remain muted at 1-4 per cent per annum.

The risk of OMCs being asked to absorb subsidies, too, remains high. Analysts say that with geo-political tensions rising in the Middle East, the risk of rising crude oil prices and chances of subsidy burden on OMCs continue to loom.  

Rahul Prithiani, director, CRISIL Research, said, “The government can increase subsidy allocation in the Union Budget for this fiscal. But given the financial constraints, it is unlikely to foot the whole bill. In such a scenario, the likely way out would be asking downstream public sector oil producers and OMCs to bear a part of the under-recovery.”

While HPCL has the highest share of marketing margins in overall earnings, it has also gained the maximum.

Meanwhile, HPCL may see its Barmer refinery start by 2022 and IOC’s quality of earnings may improve with the commissioning of its plant at Paradip and ramp-up of the Ennore LNG terminal.