Oil& Gas: Subsidy sharing still a bigger issue, PLilladher

• Acting on ballooning under-recoveries estimates, government has finally bit the bullet by increasing diesel prices (Rs3.5/litre), excise duty on diesel (1.5/litre), resultant increase in diesel prices being Rs5/litre(52bps hike in inflation). Government has also capped the number of subsidy LPG cylinders to 6/household per annum. Capping of LNG cylinders is the structural reform undertaken which should aid in capping LPG under recoveries in the coming years, however we remain sceptical over benefits of the same in the near term. To act on the trend of ‘Dieselization’ of the economy, the government has reduced excise duty on petrol by Rs5.3/litre.
• Increase in prices by Rs3.5/litre is likely to result in saving of Rs240bn on full year basis. Notwithstanding implementation issues, LPG capping of cylinders to ~6 per annum should reduce LPG subsidies by ~Rs113bn (assuming nil leakages in the system). Thus, the cumulative impact of the move stands at Rs355bn. For the first fortnight of September losses on diesel had mounted to Rs 17/litre and consequent under recoveries in the system had mounted to Rs2020bn. Post this action on duty tinkering and price increase effected by the government, the scenario, although improving at the margin, remains grim considering the under recovery for FY13 at current prices is Rs1,809bn, an increase of ~34% on a YoY basis.
• We would like to highlight here that every dollar increase in the crude oil prices increases the under-recoveries by ~Rs44bn (FY14). Ad-hoc increase of Rs3.5/litre in diesel prices, coupled with capping of subsidised cylinder at six per household, could result in reduction in under-recoveries by ~Rs350bn (negated by appreciation of ~US$8/bbls in crude oil prices). Thus, there might be a scope of disappointment if the crude oil prices were to remain strong in Rupee terms in the absence of meaningful reforms. We maintain that the subsidy sharing mechanism is the key event to watch going ahead. While on the prima-facie GAIL stands to benefit on account of lower LPG under-recoveries, however we expect government to retain large part of benefit by change in subsidy sharing mechanism.

While crude oil prices continue to be the biggest variable impacting the overall subsidy estimates for a fiscal, the profitability of the downstream Oil marketing companies is no merely a factor of increasing or decreasing crude oil prices. We believe, government has been milking OMCs via alternative methods to lower its subsidy share and as well as to prevent passing of higher crude and product prices to end users. Following alternative mechanism has in fact led to decline in profitability to the tune of Rs80bn on consolidated basis for three OMCs combined over the last 3-4 years and has led to continuous de-rating in the OMCs stocks. We believe, building an investment case for OMCs will be a challenging task for the investors and OMCs at best continues to be a trading bet for the portfolio hedging in event of global economic slowdown. While the increase or decrease in crude oil as well as product prices does provide a favourable/adverse swing on count of these variables, we believe till a structural solution is evolved, building an investment case in OMCs will continue to lack.  

(a) Effective domestic protection to the refineries: There has been a constant decline in the effective protection to domestic refineries as the government has been cutting down the import duties on the petroleum products, which in turn adversely impacts the GRMs of OMCs, in turn adversely impacting the profitability. Effective protection to refineries has been reducing from 10% in FY2004 to 2.5% in FY2013E.

(b) Interest burden on the short term loans: One of the noticeable phenomenon’s for the OMCs is the mismatch between the announcement of the subsidy burden and actual disbursal of the same. Increasing under-recoveries leads to cash drain, which in turn leads to higher borrowing by these companies. To put the recent example in perspective, OMCs lost around Rs 48bn in FY12 on account of interest payout due to mismatch between the announcement and disbursal of the cash support to OMCs. 

(c) Lack of revision in marketing margins and costs embedded in subsidy calculation: Marketing margins and costs involved in subsidy calculation of the regulated products were fixed in 2004 and the same has not been reviewed over the period. Comprehensive marketing margin revision of LPG / kerosene and diesel has not been carried out for the last nine and five years respectively. In the interim, the cost increase has significantly outpaced volume growth, while the ad hoc margin adjustments significantly lag the actual cost increase in our view. 

(d) Categorization of petrol as deregulated petroleum product: In June 2010 government deregulated the prices of petrol, wherein OMCs were allowed to increase the prices in event of increased subsidy on the same. However, we are still witnessing clutches of regulation in terms of pricing from the government. Three OMCs combined lost around Rs48.9bn in FY2012 itself on account of lack of pricing freedom. Recognizing the fact that categorization of the petrol as deregulated petroleum product leads to OMCs effectively shouldering subsidy burden on the same, there has been a voices raised by BPCL , HPCL and IOC to treat Petrol as regulated product.

We continue to maintain our estimates and Target price for ONGC (Rs301/share), OINL (Rs508/share) and GAIL (Rs355/share) respectively pending clarity over the subsidy sharing mechanism.

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