Good Time To Pick OMCs?

OMC stocks have seen good upmove in the last week or so due to correction in crude oil prices, but these stocks are still trading way below their alltime highs. Tanay Loya finds out if it is the right time to add OMCs to your portfolio. 

The stock price of oil marketing companies (OMCs) are on the rise amid a fresh fall in global crude oil prices on concerns of a glut in supply. The global crude oil prices corrected almost 10 per cent in the last few days from the highs of $80 per barrel in the recent past. However, Nifty Energy and Gas index gained 16.56 per cent as compared to Nifty 50, which advanced 6.29 per cent in the last one month (as on August 08). The volatility is a clear indication of how quickly sentiments change in the market with changing geopolitical dynamics. 

Indian Oil Corporation Ltd (IOCL), Bharat Petroleum Corporation Ltd (BPCL) and Hindustan Petroleum Corporation Ltd (HPCL) have corrected significantly in the last six months as they faced headwinds resulting from rising crude prices. It is our conviction that OMCs are a good bet from a long term perspective and should not be discarded without deeper analysis. Here are a few points to ponder. 

Propitious business model 

It is generally perceived by the investors that there exists an inverse relationship between crude oil prices and the fortunes of OMCs. However, a closer look at the business model of these companies reveals that the perception is not entirely true. The primary function of the OMCs is to buy, refine and market oil, for which they earn a gross margin of about `2 to 3 per litre, regardless of the price of crude, given the deregulation of petrol and diesel prices. 

The price deregulation initiative taken during the UPA government regime has been followed well by the NDA government with the deregulation of diesel prices and elimination of subsidies. This landmark reform makes OMCs somewhat similar to the traditional retail companies. In the present scenario, the retail stocks trade at a price-to-earnings ratio of over 40, while OMCs trade in multiples of single digit. 

Further, the margins on the sale of petrol and diesel account for only a third of the revenue of these companies. These companies also have a portfolio of other products like LPG, bitumen, ATF, pet coke etc which account for a fair share of profits. 

Benefit from inventory gains 

The marketing margins, which the OMCs earn on the sale of every litre of petrol, fell to its lowest in about three years due to higher crude prices, depreciation in rupee and the freeze in price ahead of the Karnataka elections. In the quarter ended June 2018, on an average, the retailers’ margins have fallen by over 40 per cent as compared with the previous three months 

Brent crude, which is the Asian benchmark for crude oil, averaged around $75 per barrel in the quarter ended June 2019. This is over 11 per cent higher compared to the previous quarter. If the price of crude falls in the global market, refiners that bought oil at higher prices end up selling at lower rates through retail outlets, and vice-versa. As the average crude prices are higher in this quarter, the refiners are expected to earn more as they have purchased oil at a lower rate, thus clocking inventory gains for the third month in a row. Hence, inventory gains due to higher crude oil prices could offset the negative impact of falling marketing margins and gross refining margins of IOCL, HPCL and BPCL in the first quarter of FY19 

It is important to note that capex will further increase the quality of earnings. Currently, OMCs generate close to 20 per cent of their market capitalisation as cash flow. Hence, it is unlikely that there will be a significant increase in debt-to-equity due to a capex over the next 3 to 5 years. 

Robust growth drivers 

We believe OMCs are well-placed to benefit from India's demographic dividend. OMCs continue to invest in capacity addition on the back of strong consumer and industrial demand for petroleum products. According to a study by the Society of Indian Automotive Manufacturers (SIAM), for instance, the auto sales have grown by 12 per cent in FY18 and the sector is likely to continue this momentum in FY19. The sales of aviation turbine fuel has also grown at 8 per cent and these levels are expected to be maintained. 

The government’s ambitious ‘Pradhan Mantri Ujjwala Yojana’ which aims to provide 5 crore LPG connections to households is another growth driver for these companies. With plans to add about 25,000 new fuel retail outlets over the next 3 to 5 years, the trio of IOCL, HPCL and BPCL are well-placed to grow. 

Imminent GST reform 

There is a possibility that petroleum products would be brought under the ambit of Goods and Services Tax (GST) in the future. This suggests that the high taxes on petrol and diesel will begin to decline and will further improve consumer demand. 

Concerns 

Retail prices of diesel and petrol in India have been deregulated and now move in tandem with global trends. However, this was not the case in the quarter gone by. The prices were not hiked for 19 days from April 24 in a pre-Karnataka election freeze by the retailers. A similar situation was witnessed in the quarter ended December 2017 during the Gujarat polls. Hence,there are genuine concerns over sustainability of marketing margins with assembly polls planned in Mizoram, Rajasthan, Chhattisgarh and Madhya Pradesh before the Lok Sabha elections next year. 

Another concern among investors is the increasing capex. However, it is important to note that capex will further increase the quality of earnings. Currently, OMCs generate close to 20 per cent of their market capitalisation as cash flow. Hence, it is unlikely that there will be a significant increase in debt-toequitycapex over the next 3 to 5 years

"OMCs are in win-win situation with facility to pass on oil price hike on daily basis"

What is your outlook on OMC stocks? 

We had sharp fluctuations in crude prices in the range of US$70-80/bbl. In addition, depreciation of the rupee has also been a concern. The consequent high petrol and diesel prices resulting in uncertainty over oil marketing companies’ (OMCs) ability to pass on the same to customers have weighed on the stock price performance. OMCs will always have a constrained profitability. If crude prices stay at the current levels or above, we don't expect GRM to cross $6/bbl. Going forward, any restrictions on the same due to an election year will dent marketing margins and profitability as they won't have much of a chance to improve "crack spreads" If crude goes to high, then they had option for shared subsidy. 

BPCL's Kochi unit saw 100 per cent utilisation. The higher GRM and volume from Kochi would offset negative impact. Due to lower GRM under yet to stabilise mode to USD 5.6 per bbl from USD 5.9 per bbl earlier, it couldn't tap potential completely. If crude prices have topped out or go declining in the second-half of FY19 , we can see BPCL doing better than its peers with 10 per cent volume increase. 

HPCL: Though there is volume growth of 2-3per cent and GRM maintainance had been strong so far owing to refining volumes which were 4.63 mmt in Q4 and HPCL-Mittal Energy Ltd (HMEL) is helping sustain the price rise. View on stock is positive if crude cools off. 

How are the fortunes of OMC stocks linked to the crude oil prices? 

On the whole, the relation between crude oil prices and OMCs has always been reverse where crude price rise gives negative views on OMCs as they have to pay higher production cost for the oil imports, In case of downtrend in crude prices, then it benefits the OMCs as they have the benefit of lower cost of production. In times of stable crude prices, it gives a positive scenario as cost is passed on to consumers with marginal rises. 

But when the crude oil prices are very volatile, OMCs face trouble as they have to bear the cost of crude prices rise for the stipulated volatile times and cannot pass on to end-consumers. But with the domestic market now having the daily price change facility, OMCs have been in a win-win situation as we think they can pass the hike on a daily basis to end-users. 

Only during election times when the government intervenes so that OMCs do not pass the higher cost of production to consumers that the OMCs face the toughest of challenges. Hence, to conclude, in the near term with some major state elections and later Lok Sabha elections in 2019, we have a view of Hold on the OMCs, but the long term outlook still looks bright for the OMCs as profit margins may improve post the Lok Sabha elections.

Jateen Trivedi, Research Analyst, Bonanza Portfolio and
Pritam Deuskar, Fund Manager, Bonanza Portfolio 

Conclusion 

Oil forms the backbone of our economy. We expect an upside for investors in OMCs, given the high dependency on oil by virtually every industry, ranging from agriculture and mining to consumer goods manufacturing companies. Further, this dependency is here to stay for a long time, as about 80 per cent of our freight moves on the roads. Among the ambit of oil marketing companies, HPCL, with a price to earnings ratio of 6.7x, is available at cheapest valuations. We believe OMCs have largely corrected and offer significant untapped value for investors. Value investors should grab these stocks from long term perspective