The Hindu Business Line : Oil stocks are still slippery

Shares of oil companies have gained last week on the back of falling crude oil prices. But the optimism is premature as the current decline in crude is not enough to enable a turnaround in the fortunes of the domestic oil companies.

Raghuvir Srinivasan

The biggest factor spooking the stock market in recent times is just about beginning to fade away. Or, is it? Oil prices are in the retreat mode after peaking at slightly above $147 a barrel just a couple of weeks back. In a little over a week, the price of benchmark WTI crude has declined by 16 per cent to $123 a barrel now and there seems to be a definite downward bias, at least in the near term.

For most of us who have almost forgotten that oil prices can also move in a direction other than up, the downtrend in the last few days has come as a pleasant surprise.

That seems to be case with the stock market as well, going by its reaction to the falling oil prices. Stocks of oil refiners, which till the other day were untouchables, have begun to move up in the last few days.

Is this optimism for oil stocks warranted? Should retail investors now being to acquire stocks such as Indian Oil, BPCL, HPCL and ONGC? What should shareholders of these companies now do? Finally, the all-important question: are oil stocks about to turn the corner?

Crude gyaan

The retreat in global oil prices over the last few days appears linked to more than one factor. The biggest of them all is the threat of a recession in the US, which will impact demand growth.

At just over 20 million barrels per day, the US accounts for just under a quarter of global oil demand. A fall in oil consumption growth there will have a significant impact on global demand growth and, hence, on oil prices.

The second factor is the start of the Olympic Games in Beijing. China is reported to have stockpiled large reserves of petroleum products, especially diesel, in the run-up to the Olympics.

With the Games round the corner, China is said to be winding down its additional purchases in the oil market and in the process taking away an excuse for the oil market to push up prices.

The third factor is the perception, right or wrong, that the Federal Reserve could increase rates, albeit marginally, to combat the threat of inflation. This could halt the decline of the dollar and once again make it attractive as a speculative haven.

Though there are contradictory opinions on this, one theory for the rise in oil prices over the past year and more is the role of speculative money flowing out of the currency market and into commodities, specifically from the dollar to oil.

If this were true, then with the dollar possibly rebounding, such money has to flow back from oil into the currency market, causing a fall in oil prices in the process.

While the available signals point to a firm downtrend, it’s too early to celebrate for there are still a couple of factors that could send oil prices back up again quickly.

This is the hurricane season on the US Gulf coast; just one hurricane moving in the direction of the oil platforms in that area would be enough to reverse the downtrend. A similar effect can be caused by a renewal of tensions over Iran, though it appears unlikely now given that the election process has started in the US.

What does all this mean for us?

First things first, the decline in oil prices now, even if it extends to $110-115 a barrel, is unlikely to cause a turnaround in the fortunes of the country’s refining companies. Oil was trading at $123 a barrel when domestic fuel prices were increased on June 4.

Even after the increase, the upstream oil companies, ONGC and OIL were left with an estimated Rs 45,000-crore subsidy burden for this fiscal, while the marketing companies — Indian Oil, BPCL and HPCL — were to share Rs 20,000 crore amongst themselves as subsidy.

After these measures, including duty cuts on crude oil and products, there was still an unmet deficit of more than Rs 1,30,000 crore which the government promised to bridge by issuing bonds.

Such is the parlous state of the oil economy. So, if prices touch $123 a barrel we will only have moved from worse to bad! What is needed is for oil prices to retreat significantly to $100 or below that and stay there, for oil companies to begin to breathe a little easier.

The low prices have to be sustained for at least three quarters, if not more, for the finances of these companies to stabilise.

Remember, the marketing companies are probably going to declare losses for the first quarter of this fiscal, and big sums at that. Their cash-flows have almost dried up and they are big borrowers in the short-term market with consequent ill-effects in terms of rising interest costs.

Therefore, it would be naïve if investors and the market were to believe that the retreat in global oil prices in the last few days is going to get our oil companies back in the pink of health. It would take much more than a week of declining prices for that to happen.

Policy overhang

Funnily enough, lower oil prices may not actually spell good news for most of the domestic oil companies, given the quixotic government policy.

For the upstream companies — ONGC and OIL, which is all set for an IPO — the falling prices could lead to lower realisations for their crude output.

Of course, this is assuming that their subsidy burden correspondingly falls; there can be no guarantee that the government will proportionately reduce the burden on the upstream companies.

Given that ONGC and OIL have been riding on higher realisations rather than higher output, a fall in the former can impact the revenues and earnings significantly.

For the refining and marketing companies — Indian Oil, BPCL and HPCL — the story is different. The reduction in oil prices could lead to lower under-recoveries but this benefit could be negated by falling refining margins.

A saving factor for the refiners was the record high refining margins that prevailed over the last few quarters, thanks to rising product prices. This balanced their losses from the marketing business.

The high refining margins continued into the first quarter of this fiscal. For instance, Chennai Petroleum, a stand-alone refining company, reported refining margin of $15.89 a barrel for the first quarter, compared to $8.76 a barrel in the same period last year.

Little surprise then that the company’s post-tax earnings more than doubled to Rs 703 crore in the April-June 2008 quarter. But this could work the other way when prices fall.

Typically, in a down-cycle, refining margins fall as product prices drop at a rate higher than crude oil prices. Indeed, there is currently an over-supply in the international market of products such as petrol and diesel, leading to refiners such as Reliance Industries offering a discount on their exports. In the last three months,

Reliance is reported to have contracted exports of a little over half-a-million tonnes of petrol at discounts of up to $2.5 per barrel.

In fact, Reliance’s first quarter performance was rather tepid.

Despite the high oil prices that had helped other refiners such as Chennai Petroleum and MRPL to double their gross refining margins, Reliance could only increase it marginally from $15.4 a barrel in the same quarter last year to $15.7 a barrel now.

The refining and marketing companies will continue to find themselves in a tough spot unless the Government increases retail fuel prices, which appears next to unlikely; or if the crude price falls steeply to levels of around $80 a barrel and stays there for a few quarters.

Investors should exercise discretion while seeking to buy shares of refining and marketing companies. The market’s optimism for oil stocks now appears a transient phenomenon; no more than a happy reaction to oil prices falling.

Investors should watch the trend in crude oil prices for a few more weeks before deciding to buy these companies’ shares.

The prospect of a turnaround in the fortunes of these companies is still distant, even after the fall in oil prices now.

As for the upstream companies, we continue to hold the view that any sustained appreciation in their valuations will happen only if and when they discover new reserves of oil.

In the case of ONGC, a revaluation could be in order when it commences commercial production of the gas discovered in the KG-Basin, which could be only in the medium term.

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