The Hindu Business Line : More pain in the near term — How cos are tackling the price spike

WHAT does the near term hold for the refining and marketing companies and what is their strategy to tide over the difficult period ahead? Mr Sarthak Behuria, Chairman and Managing Director, Indian Oil, assured shareholders at its annual general meeting last Thursday that the company will manage to post a profit in the second quarter and that it will continue with its investment plans. Ordinarily, that should have lent confidence but it fails to now, given the prevailing environment.

First, there are strong prospects of global oil prices remaining high in the near to medium term. World over, analysts are fast veering around to the opinion that the price rise of the last year is due more to genuine demand growth rather than because of a supply shock caused by artificial factors.

This would mean that the price rise is well founded and unless new supply sources come on stream, prices will remain high driven by genuine demand.

A recent article in The Economist states that the equilibrium price of oil has risen decisively and quotes analysts from Goldman Sachs as saying that oil prices would average $68 a barrel next year and $60 a barrel for the next five years.

When you add the other occasional price drivers, such as Hurricane Rita now and the role of speculative money in the oil market, the chances of such predictions coming true appear higher. In the immediate period, yet another factor driving prices would be the demand for heating oil in the northern hemisphere with winter approaching.

This should set the alarm bells ringing for oil companies in India. The last round of price increase combined with the oil bonds and discounts from private and standalone refineries will be of limited help if oil prices continue at current levels or, worse, rise further.

With elections due in Bihar and given the general political opposition to any price increases in petroleum products, it is unlikely that the oil companies will be allowed to raise retail prices in the near term. This will mean that they will continue to bear the burden, at least for the next quarter, if not the one after that as well.

The oil companies have devised their own methods to cut down on losses. For instance, they are going slow on sale of cooking gas, where they lose more than Rs 100 per cylinder now.

The waiting period for cylinder refills is increasing slowly but surely as the oil companies cut down on LPG sales to reduce their losses.

Second, we may well see a number of major refineries going in for maintenance shutdowns in the near future. Reliance Industries has announced that its refinery will be shut for eight weeks in the third quarter for maintenance.

This is yet another way of cutting down on losses. Though fixed costs will still be incurred during this period, they may well be lower than what the refinery has to shell out by way of discounts on LPG and kerosene.

While such tactics may offer some relief, the fact is that the oil companies are staring at a very tough period ahead in the next quarter or two.

What should investors in these companies do now? At current price levels, the stocks of Indian Oil, BPCL and HPCL are trading close to levels that can be termed attractive for investment with a medium to long-term perspective.

A fall of 10-15 per cent from current levels would make them attractive buys. A word of caution, though: Global oil price trends and government policy should be watched closely, both before committing investment and after as well. Shareholders can stay invested through the rough patch.

The standalone refining companies — Kochi Refineries and Bongaigaon Refinery — and IBP are well into the process of merging with their respective parents.

Given the divergent experience with the share exchange ratios fixed for Kochi Refineries' merger with BPCL and that of IBP with Indian Oil, it may be safer to await the announcement of the merger ratio before committing investment in Bongaigaon Refinery.

The merger ratio for Kochi Refineries was seen to be unfavourable to its shareholders while in the case of IBP it was the reverse.

Mangalore Refinery appears a good investment bet at current price levels from a long-term holding period perspective while Chennai Petroleum can be watched for a 10-15 per cent decline from current levels for acquisition.

The ONGC stock has been riding the crest of high oil prices that have boosted revenues and earnings. The only restraint on the stock is the impact of the government directive asking it to share a huge burden of the subsidy on cooking gas and kerosene.

A formal announcement of a new gas find in the KG Basin is expected soon from the company, which, along with the expected commercial production of gas from a deepwater field in the same area by next April, could set off a positive trend in the stock.

On the fall side, an ever-rising subsidy burden may well neutralise the favourable impact of any further rise in global oil prices.

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