The Hindu Business Line : Staring down the barrel

There is unlikely to be a sea-change in the operating dynamics of refining and marketing companies and things can only get worse if oil prices move further up, as they are projected to.

The business of oil can be strange indeed. In the last week of July, ExxonMobil, the biggest of Big Oil, reported bumper profits of $10.36 billion for the April-June quarter, its second highest ever. The biggest oil company in the world had just added an entire ONGC to its profits, in just one quarter!

Around the same time, half way across the world, India's oil biggies were putting out miserable report cards showing record losses for the same period. And if you ask why, the reason for both is the same: The relentless rise in crude prices.

Bizarre? Should not higher oil prices translate into fatter profits for oil companies? Logically, the answer should be `yes' and it has proved to be so at least for one, Oil and Natural Gas Corporation (ONGC). But such logic gets turned on its head when it comes to the refining and marketing companies, for which every dollar increase in crude price translates into higher losses and thicker red ink on the balance-sheet.

Bond(ed) with losses

The April-June quarter should rank as the worst for the industry, excluding ONGC, till date. Though the three refining and marketing companies — Indian Oil, Bharat Petroleum and Hindustan Petroleum — made losses in the same period last fiscal as well, the quantum was far greater this year.

One reason for the heavy losses posted by these companies is that the Government failed to issue oil bonds, as per the package sanctioned in June. The Government had announced a package of measures while increasing the prices of petrol and diesel in June, whereby the oil companies were to receive bonds worth Rs 28,000 crore as part-compensation for the subsidy they shared on cooking gas and kerosene. The bonds were also meant to cover a part of the under-recoveries on petrol and diesel.

These bonds were to be issued in four equal instalments at the end of each quarter. However, the first instalment was not issued by the end of the first quarter; in fact, it has still not been issued now, almost half-way into the second quarter. These bonds are accounted as income by the oil companies and, had they been issued on time, the red ink now splashed across the oil companies' financial statements could have been avoided.

Healthy refining margins

While the marketing margins turned negative because of under-recoveries, the refining margins were quite healthy, at $8-9 a barrel for most refineries. This was despite the shift to trade parity from import parity pricing as part of the package devised by the Government, which had the effect of reducing prices of petrol and diesel at the refinery level.

Indian Oil managed to show a net profit, thanks to the one-time gain of Rs 3,225 crore from the sale of a part of its holding in ONGC. However, no such luxury was available to Hindustan Petroleum and Bharat Petroleum to make up their losses.

Apart from helping it to write the bottomline in black, the ONGC stake sale also seems to have helped Indian Oil reduce its borrowings significantly. The company repaid Rs 3,861 crore in the April-June period, bringing down its outstanding loans to Rs 22,539 crore by June 30. Interestingly, Indian Oil also had to dispose of a part of the bonds issued to it last fiscal by the Government to boost its troubled cash flows.

The pure refining companies — Chennai Petroleum, Kochi Refineries, Mangalore Refinery and Bongaigaon Refinery — had a relatively better time, given that the refining margins were strong and these companies have no exposure to marketing losses. However, the current quarter may prove to be different because refining margins have been sliding the last few weeks due to a fall in global product prices. This, along with the shift to trade parity pricing and the reduction in import duties on petrol and diesel effected in June, will likely lead to pressure on refinery margins in the second quarter.

Unlike their refining and marketing peers, the pure refining companies do not get the cover of oil bonds; on the contrary, they are required to offer "discounts" to the marketing companies to share their subsidies on kerosene and cooking gas. Therefore, the earnings of pure refining companies are likely to be subdued during the second quarter.

Bounty for ONGC

Even as the rising crude prices laid low the refining and marketing companies, ONGC reaped the full benefits of the same. Earnings at the pre-tax level would have been a record Rs 11,000 crore but for the Rs 4,676 crore that it had to share with the refining and marketing companies as its share of subsidy. The reported post-tax earnings of Rs 4,119 crore was still 24 per cent higher than in the same period the previous year.

With crude prices averaging $65-70 a barrel during the first quarter, ONGC benefited the most, with a realisation of $45 a barrel, after accounting for the subsidy given to the refining companies. But the interesting part is that the buoyancy in ONGC's revenues and earnings was because of higher realisations and not due to increased output, which was stagnant at 6.48 million tonnes over the quarter.

This is something that should bother the company and its long-term investors as it points to basic problems in the company's oil-fields, the majority of which are past their prime. While the devastating fire in the Bombay High North platform a year ago is one cause for the stagnant output now, this is only a continuation of the trend in recent years of either stagnant or falling output from the company.

Irrespective of this, ONGC will continue to report bountiful revenues and earnings in the near future as oil prices are unlikely to fall back significantly from current levels. The current quarter, and the current fiscal will continue to be excellent for ONGC as crude prices are likely to remain above $70 a barrel. The only uncertainty is how much more will its main shareholder, the government, dig into the company's kitty to fund its subsidy scheme; at present, the company shares a third of the subsidy burden. It parted with almost Rs 12,000 crore last fiscal and, going by present trends, this figure is like to cross Rs 20,000 crore this fiscal.

Outlook for oil stocks

Oil stocks, save for ONGC, are unlikely to be the stars of any bull run in the market. Even during the peak of the bull market, these stocks under-performed the Sensex. There is unlikely to be a sea-change in the operating dynamics of refining and marketing companies and things can only get worse if oil prices move further up, as they are projected to.

Given the Government's compulsions to hold retail prices of petroleum products, it is unrealistic to expect it to grant the marketing companies total freedom to manage prices. Unless this happens, the phenomenon of "under-recovery" is not going to go away and the earnings of the refining and marketing companies will remain subdued.

Given the host of imponderables, ranging from the West Asian conflicts to the shut-down of production from a major Alaskan oilfield and the inexorable rise in demand, particularly from China and India, oil prices are likely to harden further over the rest of this calendar year.

This only means more trouble for the refining and marketing companies, which will be called upon to bear an increasing subsidy burden. Oil bonds may perk up the financials of these companies in the second quarter, but if crude prices rise further from current levels of around $75 a barrel, these companies could be staring down another kind of barrel!

Price controls are not going to be relaxed in a hurry and the refining and marketing companies have to learn to live with this constraint in the medium term. The industry is only going to be stuck in a complex web of subsidies, under-recoveries, discounts and duty reductions as the Government grapples with the conflicting objectives of keeping retail prices of petroleum products under check while ensuring that the finances of the oil companies do not tip over the edge.

The refining and marketing companies are adopting different strategies to cope with this situation. Indian Oil, for instance, has declared its intention of foraying into the non-fuel retail business through a subsidiary company. Plans are at a preliminary stage yet and it remains to be seen how the Government reacts to this idea. The company's entry into the petrochemicals business is also a part of the strategy to increase non-fuel revenues and earnings.

Indian Oil, Bharat Petroleum and Hindustan Petroleum have also entered the exploration business by bidding for blocks offered by the government. But these are long-term strategies that may help these companies if they discover oil or gas. In the near to medium term, though, the prospects for these companies appear none too bright.

If you are an investor content with dividend yield and willing to wait for long-term returns, you could bet on these stocks. But if you are looking for big capital appreciation in the near to medium term, then these stocks are not for you.

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