OMCs: Rising demand, profitability in fuel retailing to drive earnings

Higher refining margins, rising demand, new capacities and improving profitability in fuel retailing to drive earnings

After lagging the leading indices in recent months, the shares of the three government-owned oil marketing companies or OMCs — Bharat Petroleum (BPC), Hindustan Petroleum (HPC) and Indian Oil (IOC) have started looking up. These rose by two to four per cent on Tuesday.
 
Abhijeet Bora, analyst at brokerage Sharekhan, says this is due to improvement in the earnings outlook for their marketing business, given strong petroleum consumption, stabilisation of marketing margins on automobile fuels and likely inventory gains, given higher oil/petro product prices in the March quarter.
 
Refinery and marketing margins had seen some softness from October. Gross refining margins (GRMs) are defined as the difference between the combined sale value of products sold by processing a barrel of crude oil. Marketing margin is the profit OMCs earn on retailing of automobile fuels such as petrol and diesel.
 

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After the extraordinary rise caused by supply disruption due to Cyclone Harvey in America during August-September last year, GRMs had normalised. The benchmark Singapore GRM per barrel at $7.3 in the December quarter was lower than the $8.3 in the September one. A bigger worry emerged on the marketing margin, with fuel price increases not in proportion to the rise in global crude oil prices, which analysts attributed to state elections.
 
That confidence is now improving. ICICI Securities data suggest that in the current quarter (till March 5), the net marketing margin in auto fuels is up seven per cent year-on-year, at Rs 1.03 a litre. Crude oil prices have fallen due to a rise in US oil output and rising inventories. Brent crude prices, which had surged from sub-$60 a barrel at the start of October to $71 by January-end, are now down to about $65.
 
On the positive side for the OMCs, oil demand is rising. Analysts at foreign brokerage Jefferies say that over recent months, India’s oil product demand has grown a strong 7.7 per cent year-on-year or by 304,000 barrels a day last month. Every one per cent change in volume impacts the OMCs' earnings by 0.8-1.3 per cent; HPC is the most leveraged and IOC the least.
 
Margins, an important earnings driver, have normalised to the second quarter (July-September) level, feel analysts at Jefferies. They forecast a 4.5 per cent compounded annual growth rate (CAGR) in average automobile fuel marketing margins during FY18-21 (a 7.5 per cent CAGR was seen during FY14-18). Every 10p a litre increase in these margins raises the earnings of OMCs by 1.7-3.5 per cent.
 
BPC will gain not only from the improving outlook but also due to the expanded capacity of its Kochi refinery, which has stabilised. This should aid its refining margins. Analysts maintain a strong positive view on BPC, with those at IIFL saying the stock price’s underperformance to the broader markets is set to end, as the visible effects of refinery expansion on output and GRMs are expected from the June 2018 quarter.
 

Source: BS Research Bureau

The firm outlook on GRMs, sustained volume growth, and gradual expansion in marketing margins will lead to sector-beating 17.4 per cent annual growth in consolidated earnings over FY18-20, says IIFL, which also believes the current valuations are inexpensive.
 
HPC, in the limelight due to Oil and Natural Gas Corporation acquiring majority stake in the company, should now see a focus shift to integration of operations. Analysts remain positive on its refining and marketing prospects. However, they also believe that since its Vizag expansion project requires a large amount of capital expenditure (capex), this could weigh on the company’s cash flow during FY18-20.
 
IOC, despite challenges in the December quarter, posted better marketing margins as compared to its peers (BPC stood out on volumes). IOC’s prospects in the refining business also remain good with its new Paradip refinery having stabilised. Analysts expect utilisation at this refinery to increase from 93 per cent in the December 2017 quarter to 110 per cent by FY20. Since there is no large capex in the pipeline, this should lead to generation of free cash flow of at least Rs 404 billion during FY18-20, say analysts at HDFC Securities. They are, they say, structurally positive on IOC, owing to its diversified business model, ramp-up of the Paradip refinery and healthy cash flow.
 
On the flip side, a sharp increase in crude oil prices has the potential to weigh on Street sentiment and the OMCs' financial numbers, should government policies turn unfavourable. Second, investors will need to watch the response of private companies such as Reliance Industries and Essar Oil (now owned by Russia’s Rosneft) on the marketing front, as aggression on their part to gain market share could hurt margins.