Stock Fundamentals

Oil marketing companies: Value in the pipeline

Anand Kalyanaraman | Updated on October 14, 2018 Published on October 14, 2018

The companies are against the ropes now, but could spring back

The stocks of the public sector oil-marketing companies (OMCs) — Indian Oil, BPCL and HPCL — were hammered down 25-35 per cent in just two trading sessions on October 4 and 5. This sucker punch was the market’s strong show of disapproval to the Centre’s move to force these companies to take price cuts of ₹1 per litre on petrol and diesel as part of the price relief package for customers.

On its part, the Centre cut excise duty on these fuels by ₹1.5 per litre, and the Finance Minister urged States to reduce sales/value-added tax (VAT) by ₹2.5 a litre to bring the total relief to ₹5 a litre.

Rapidly rising global crude-oil prices, the rupee’s rout, and high excise duty and VAT, combined together, were propelling petrol and diesel prices to all-time highs on a daily basis. With customers getting increasing restive, the Centre, under pressure, finally cut excise duties after holding out for a long time. In the process, it also made the oil companies sacrifice.

End of an era?

While customers were somewhat relieved, the market voted with its feet at the forced co-option of the OMCs in the cost cuts. There is a strong fear that this move signals the end of fuel-price deregulation — the key reform that was instrumental in improving the fortunes of the OMCs over the past few years. Petrol pricing was decontrolled in 2010, and that of diesel in 2014. While the Finance Minister has stated that pricing of the fuels remains deregulated and that the OMCs could continue to adjust prices with market movements, the market seems unconvinced.

That’s because a pattern has emerged of the OMCs capitulating to the diktats of the government — their major shareholder — and losing their pricing freedom on petrol and diesel in the poll season — the companies go slow or temporarily freeze price hikes altogether.

This happened during the run-up to the Gujarat elections last Decemberm and repeated itself prior to the Karnataka elections in May. As a result, the marketing margins of the OMCs took a sharp knock. But when the poll season was behind them, the oil firms made up the lost ground by hiking prices; marketing margins went up again.

The market has been worried whether this recoup-after-elections phenomenon will be possible in the coming months, with an intense election cycle on the cards.

Elections in Rajasthan, Madhya Pradesh, Telangana, Mizoram and Chhattisgarh are lined up for the end of the year and the Lok Sabha elections is likely to be held sometime in April. Even before the latest rout, the OMC stocks had been big losers — losing 30-50 per cent over a year.

The latest arm-twisting of the OMCs by the Centre only adds to the apprehensions of the market. There is continued uncertainty about the trajectory of both oil and the rupee, and the Centre’s financial position is tight. There are worries that in the event oil prices again rise sharply or the rupee’s rout continues, the OMCs will be again told to cut fuel prices. The stocks’ recent crash has more to do with seriously soured sentiments than the financial impact of the ₹1-per-litre cut. In all, after a strong run from 2013-end until last year, the OMC stocks have shed about 40-55 per cent or more over the past year or so.

Valuations are also down sharply. The Indian Oil stock now trades at about fives times trailing 12-month earnings, compared with the three-year average of 10 times. Similarly, the stocks of HPCL and BPCL are trading at about four times and 5.5 times, much lower than their three-year averages of about 8.5 times and 12 times. The stocks seem to have been de-rated on the concerns about the lack of pricing freedom.

Does this sharp fall present a buying opportunity? Maybe, but only if you have a stomach for high risks and a long-term horizon. There is danger — in the short-term, at least — that the OMCs may again be made patsy to keep petrol and diesel prices under check. But on the other hand, there are certain factors that make for an investment case now.

One, heavy value-destruction in the OMC stocks harms their major shareholder — the Centre — too, and could sharply reduce the latter’s inflows in the future when it may seek to divest stakes in these companies.

A better way out

The Centre will hopefully take lessons from the recent carnage and become more creative in the future when it comes to price cuts. It could direct the OMCs — arguably, still in good financial health — to pay higher dividends, and cut excise duties from these proceeds, instead of asking the OMCs to cut prices on their own. If this were done, the monetary implications for the Centre will largely be the same, but the market sentiment for the OMC stocks could improve.

Next, coming to dividends, the OMC stocks are likely to continue paying healthy dividends, come rain or shine. Over the past three fiscal years, the dividend per share has been ₹14-35. The combination of high dividends and stock price decline translates into high dividend yields. After the recent crash, the dividend yield is 7-8 per cent for these three stocks.

Finally, despite the pulls and pressures, earnings growth has remained healthy for the OMCs, aided by expansions and inventory gains. While the price freezes and cuts will have some impact, earnings should continue growing at a good pace over the long run, with the companies expanding and upgrading their capacities. Besides, it is unlikely that the government will completely roll back the pricing reforms that had ushered in huge positive change over the past few years. It is likely that, in less than a year, when the election dust settles, true pricing freedom will be restored to the OMCs.

Published on October 14, 2018

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