What will drive OMCs' next re-rating?

Improvement in marketing margins and momentum in demand for petroleum products augur well

Stocks of oil marketing companies (OMCs) Indian Oil Corporation (IOC), Bharat Petroleum Corporation (BPCL) and Hindustan Petroleum Corporation (HPCL) have run up in the past one year with gains of 45, 38 and 56 per cent, respectively. Even as weak crude oil prices aided domestic demand for petroleum products in the past one year, continued deregulation of fuel prices reduced interest burden and working capital requirements. Fuel price reforms led to virtual elimination of under-recoveries, which improved visibility and predictability on profitability. All these factors have fuelled outperformance of these stocks in past one year.

Even after this rally, most brokerages continue to be positive. But, what will drive the next leg of re-rating?

Expectations of high growth in consumption of automobile as well as industrial fuels is one. "We expect the demand for automotive fuels to increase at least 40 -50 per cent over 2016-20. Similarly, as we model for a 7.5 per cent annual growth in manufacturing gross domestic product, industrial fuel consumption is expected to increase 45-50 per cent in this period," says Nitin Tiwari of Antique Stock Broking.

Expansion in marketing margin is another trigger. Harshad Borawake of Motilal Oswal Securities expects IOC and BPCL's marketing margin to increase 24-25 per cent each in FY18 as compared to those in FY16. "A Rs 0.5/litre increase in petrol and diesel marketing margins increases HPCL’s FY18 earnings per share by 22 per cent. We model gross per litre diesel margin of Rs 1.6 and 2.3 in FY17 and FY18," he says. Improving marketing margins will compensate to some extent for the volatility in gross refining margins of OMCs. This is because the former contribute between 55 and 75 per cent to these companies' overall margins. Gradual deregulation of kerosene via monthly price hikes and direct benefits transfer is another positive.

Most analysts have BPCL as their top pick. HPCL stands to benefit from upgradation and expansion of its refineries at Mumbai and Vizag. IOC derives the lowest proportion (55 per cent) from marketing margins.

OMCs appear attractive, with IOC, BPCL and HPCL trading at 8, 10 and 9 times FY17 estimated earnings, respectively. These OMCs' June quarter results were boosted by inventory gains arising from higher prices of crude oil. Key downside risks include adverse regulations on pricing and competition.