Worst over for ONGC, GAIL; OMC profits to go up: Edelweiss

Below is the transcript of Jal Irani’s interview with Latha Venkatesh and Sonia Shenoy on CNBC-TV18.

Latha: It is a stellar run that we have seen for BPCL in particular and in addition HPCL as well. Do you think now that we have started to see this turnaround in crude prices BPCL and HPCL will stop giving these stellar returns?

A: Firstly what we need to understand is that there are very significant and structural changes which have taken place and is enhancing the earnings and valuations of these companies. In a similar situation, during the 2002-2004 period when we did have deregulation, these stocks had gone up between 400-800 percent and in fact structural reforms at this stage didn’t even stick.

What are these structural reforms? Essentially we have had petrol decontrol about two years back and more importantly diesel decontrol which despite oil prices going up, has remained.

In fact, we saw two significant hikes of Rs 3 a litre and there was absolutely no opposition. So, the market believes that this decontrol is here to stay. What is not significantly publicised as yet is that LPG reforms are going very strong. 90 percent of the people have moved over to the direct bank transfer and that potentially is going to save another Rs 10,000 crore of subsidies.

So, what this all means to the bottomline of these companies is that the profits are poised to double over the next three years. In fact the valuations even after running so strongly are not very expensive. They are single digit or barely double digit versus the market at 15 times. So, for all these reasons we think that while these stocks are already run hard, we feel that there is a significantly greater run yet to come.

Sonia: What is your estimate as far as gross refining margins (GRMs) are concerned for say a company like BPCL? Last quarter they did GRMs to the tune of around USD 8 per barrel or so, how much do you think it could rise to in say the next couple of quarters?

A: We are looking at a GRM scenario which is reasonably benign. We are not expecting major leaps and bounce there. The point here is that we are not taking a cyclical call on these companies; we are taking a very structural shift. So, this has nothing to do with GRMs; this has got to do with retail margins.

Retail margins on diesel essentially where Rs 0.70 a litre which now is Rs 1.20 a litre and all studies of global markets such as Korea and US suggest that retail margins in the longer term should be in excess of Rs 1.60 a litre and even in excess of Rs 2 a litre.

Now, retailing as a business, these companies are bigger in retailing than they are in refining. It is the retail margins that are going to drive profits up significantly.

Also, the sharp fall in subsidy burden by 80 percent, halves working capital requirements and reduces their interest burden by 30 percent. So, that has a multiple effect.

Latha: BPCL, HPCL and Indian Oil Corporation (IOC) have been also outperformers over the past one year, BPCL in particular. Getting pretty close to your target price – your BPCL target price is Rs 935, it is already at Rs 845. So, these stocks have seen a decent gain, what hasn’t seen too much of gains are the gas stocks, Oil and Natural Gas Corporation (ONGC) and Gas Authority of India (GAIL) on two sides of that sector. What is your view on ONGC?

A: A minor correction, BPCL our target price is Rs 1030. We perhaps have the highest on the street.

The gas stocks haven’t performed very well and especially GAIL we have recently upgraded from a underperformer to a hold recommendation. I think the worst is over for these stocks because these stocks are hugely leveraged to oil prices including GAIL because its input cost essentially in his largest business which is petrochemicals is fixed. So, that input cost doesn’t change dramatically.

While its product price which is petrochemicals is linked to international prices and as a result we think the worst is over for them, for GAIL in this case, but the upside also at the moment would be limited.

ONGC as well it would seem that below USD 60 per barrel oil price or roughly about USD 60 oil price it would seem that the subsidy burden, they may not have to bear any subsidy burden or very little if at all.

Now, that makes them very sensitive to oil prices and similarly we think that oil is not in the longer term going to go down dramatically. So, fundamentally we see very modest growth for both of them in terms of volumes but from an operational leverage perspective, the worst is over for these companies.

Sonia: When you say the worst is over for ONGC, the stock price has fallen almost about 27 percent or so in the last one year. From hereon where do you think the stock could go?

A: We have a hold recommendation so at the moment we don’t think that it is going to move within a 10 percent band in either direction. It is not going to move significantly.