Ind-Ra: Diesel Deregulation Positive for Both Downstream and Upstream Oil Sectors

The government's decision to deregulate diesel prices will significantly reduce gross under recoveries (GURs) for downstream oil marketing companies (OMCs) following the petrol trajectory, says India Ratings & Research (Ind-Ra). GURs will now be majorly incurred on kerosene and liquefied petroleum gas. The deregulation would lower the working capital and short-term debt requirements of OMCs. Upstream oil companies will also be benefitted as they share the government's subsidy burden.

Long-term Implementation Key: However, it has to be seen whether this mechanism would continue even in case of any sharp increase in crude prices and whether government would modulate/control diesel pricing again. In the current year, softened crude prices accompanied with staggered diesel price increases have already led to zero under recoveries on diesel.

Reduced GUR for OMCs: Diesel sales account for over 50% of the OMC's revenue basket namely Indian Oil Corporation ('IND AAA'/Stable), Hindustan Petroleum Corporation Limited ('IND AAA'/Stable) and Bharat Petroleum Corporation Limited. Out of INR139.9bn GUR of OMCs on a combined basis in FY14, diesel accounted for 45% of the total share. In 1Q15, the diesel share of GUR reduced to 31.5% while the GUR in absolute terms was also lower by 18% yoy on an annualised basis. In 2H15, the overall GUR should further reduce significantly because of a substantial reduction in crude oil prices. The GUR reduction would lower debt and finance cost and improve interest coverage accompanied with greater cash flow predictability.

Lower Subsidy Burden to Benefit Upstream Sector: The under recoveries arising out of regulated pricing are partly being borne by the upstream oil companies by way of a discount on crude/products and partly by the government through subsidy. The government should potentially pass on the benefit of a lower subsidy to upstream companies such as Oil and Natural Gas Corporation limited and Oil India Limited. Out of the total under recovery burden, the upstream oil companies shared 47.9% in FY14. Clarity on the government's subsidy sharing mechanism would emerge in the short term, which would have to be seen to analyse the benefit.

Triggers for Deregulation: The recent sustained decline in international crude oil prices and the relatively stable INR/USD rate have eliminated diesel under-recoveries, and led to an over recovery (profit margin) of INR3.5/litre in October 2014 for OMCs. The Indian crude basket declined 21.7% yoy to USD84.12/bbl in October 2014.

Private Sector Retail Foray: The deregulation will lead to market-linked pricing and encourage private oil refiners to foray into domestic oil marketing space. This could gradually lead to greater competitive intensity and private refiners eating into the market share of existing national oil companies over the long run, as also impacting revenue and profit margins.

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