OMC stocks come under pressure over muted demand, weak refining margins

Rising Covid-19 cases in India and talks of a second wave of the pandemic globally are adding to concerns on demand for petroleum products moving forward

Stocks of domestic oil marketing companies (OMCs) have come under pressure since late July over concerns on demand, inventory losses led by soft crude prices, and weak refining margins.

Bharat Petroleum (BPCL), Hindustan Petroleum (HPCL) and Indian Oil (IOC) have corrected up to 22 per cent since their highs of July, while the Sensex has risen over five per cent in this period.

Rising Covid-19 cases in India and talks of a second wave of the pandemic globally are adding to concerns on demand for petroleum products. The adverse news flow is keeping the Street nervous on demand for auto, aviation fuels and the prospects of OMCs.

Consider this: The International Energy Agency (IEA) recently cut its oil demand growth forecast for calendar year 2020, the first downgrade in several months. According to IEA, global oil demand is expected to be 91.9 million barrels per day in CY2020, down 8.1 million barrels per day on a year-on-year basis.

With expectations of weakness in demand, crude oil prices have softened from over $45 a barrel (after surging from April trough of $19 a barrel) to around $42 a barrel now, and further decline is anticipated. For OMCs, falling prices would mean potential inventory losses (as they carry inventory at higher price). The Street, generally, was factoring inventory gains for OMCs during the September quarter. However, the fall in prices could lead to the inventory gains of the early part of the quarter getting wiped out feel analysts such as Yogesh Patil at Reliance Securities.

Strong auto fuel margins and low operating expenditure, which drove earnings in the June quarter, would also normalise going ahead, feel analysts. The Street will, thus, be looking out for volume and demand recovery, which could provide triggers.

The fall in crude prices would also mean lower prices for allied petroleum products. This might not be good news for petrochemical prices, and other commodity prices, which will reflect negatively on earnings of oil refiners and sellers.

The picture for global gross refining margins (GRMs) is not encouraging either and Asian GRMs are likely to remain under pressure for longer. “The bulk of post-lockdown oil demand recovery is largely behind us, and the recovery momentum will likely be stalled as we head into winter,” say analysts at Credit Suisse. Referring to the latest mobility data, they say activity levels are still 20 per cent below pre-Covid levels on average, and with the lingering threat of a second wave, there will be limited upside.

Further, there will be about 3 million barrels per day of newly commissioned refining capacities in 2020-21, say analysts, and if demand continues to falter, GRMs will feel more heat with higher supplies. Not surprisingly, Credit Suisse estimates Asia GRMs to be significantly below mid-cycle levels through to 2021, and believes spreads will not recover to pre-Covid levels until 2022.

Though analysts did not expect much of an uptick in GRMs in the near term, prolonged weakness might impact forward earnings, too, they feel.

The only positive is the strong marketing margins, which are priced in valuations.

For BPCL, the progress on stake sale is being watched keenly as it is likely to unlock value for investors. But, with limited clarity on bidders, the Street is slightly nervous, say analysts. BPCL remains the top pick of analysts at Emkay Research with disinvestment being the key trigger.

HPCL, which trades at a cheap valuation (6.7 times trailing 12 months earnings, versus 22.7 times for BPCL), has also seen a strong Q1. The Q1 profits were over 50 per cent of earnings estimated for FY21, say analyst. 

This may cushion downside for HPCL, which has more exposure to retail fuel sales in its portfolio and, hence, will reap higher benefits of strong marketing margins. Comparatively, IOC has higher exposure to refining and petrochemicals, and is thereby more vulnerable, say analysts.