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Spark Capital: Oil Sector Update - Current rerating to be followed by upgrade cycle; OMCs pricing in the best case




Spark Capital Advisors(India) Private Limited


21 Jan 2013





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Current rerating to be followed by upgrade cycle; OMCs pricing in the best case Finally, MoPNG after consulting with Finmin, gave OMCs the nod to take small price hikes in Diesel “from time to time” and also increased the cap for subsidized cylinders from 6 to 9 per annum. Consequently, OMCs raised Diesel price by Rs. 0.45/litre and expect to increase it further on a monthly basis. Also, OMCs are allowed to sell Bulk Diesel (18% of volumes) at market rate. The Bulk Diesel deregulation would generate savings of ~Rs. 140bn on an annual basis. Including the first hike the savings would be ~Rs. 150bn. At this rate it will take ~20months to eliminate the extant Diesel UR of Rs. 9.6/litre. While GOI denied to deregulate Diesel immediately, the blanket nod to hike prices from time to time has removed lots of bottlenecks. We expect OMCs to increase Diesel prices monthly for atleast 10-12months leaving a window of 4-5months before General elections in 2014. We see this as a beginning of the much awaited reform process. While it would take 15-20months for under recoveries to fall significantly, market has already started looking beyond this period which is evident in current re-rating of Oil stocks. We believe the next leg of upside would come from the upgrade cycle and ONGC/OIL would be the biggest beneficiaries. OMCs would only benefit out of reduce interest costs but subdued GRMs and forex/adventitious swings would constrain RoEs. Given the current rally, we recommend to book profits in OMCs and play further reforms through ONGC/OIL as gas price hike play is yet to pan out. Downgrade OMCs to Sell; Retain Buy on ONGC and OIL; and downgrade GAIL to ADD Diesel price hikes can reduce Under Recoveries by Rs. 400bn in FY14 and Rs. 250bn in FY15 We expect OMCs to increase Diesel prices by Rs. 5/litre over the period Jan’13- Oct’13. This coupled with savings from deregulation of bulk Diesel can drive a decline of ~Rs. 400bn in under recoveries in FY14. Assuming a $5 correction in crude, we see under recovery to decline from Rs. 1.6tn in FY13 to Rs. 1tn in FY14 and Rs. 0.8tn in FY15. Even assuming a conservative share of 50%, it entails a 11%/12% FY14 EPS upgrade in ONGC/OIL. Lower interest cost would drive 6%/5%/11% upgrade in FY14 EPS of IOC/BPCL/HPCL Some pointers: Too early for private sector refiners (RIL/Essar) to get excited as free retail market is still >2years away. Deregulation of bulk segment would bring them in some action OMCs RoEs (FY14 HP/BP 11%-12%; IOC 13%) would not rise to levels enough to justify further rerating; Bina/Bhatinda continues to drag consolidated earnings; Pricing in best case of nil under recoveries ONGC/OIL trading at reasonable valuations; Further upside from FY14 earnings upgrade and FY15 Gas price hike GAIL would not be big beneficiary as it shares only cooking fuel subsidy Valuation and outlook: Oil stocks are witnessing rerating on the hope of sustained monthly price hike in Diesel. OMCs got rerated from 0.6-0.7x core book to 1-1.3x FY14 book. Overall, we do not expect further re-rating in OMCs and weak GRMs and forex/adventitious factors would continue to constrain returns. ONGC/OIL would be the direct beneficiary if GOI succeeds in raising prices for 10-12months. Despite the current rally, ONGC/OIL are trading at attractive multiples of 8.5x/7.3x FY14E EPS. Buy ONGC/OIL to play earnings upgrades and gas price hike

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