They Are Back!

The government’s move to deregulate oil prices may give a sigh of relief to the debtburdened industry. Investors of oil companies are also likely to benefit from this as they will be rewarded with good dividends in future. ETIG’s Ramkrishna Kashelkar takes a closer look

THE government’s decision to finally bite the bullet and raise retail fuel prices is indeed path-breaking. Petrol prices have been deregulated and diesel prices are set to go the same way, with minor increases in kerosene and LPG prices. Although these steps still fall short of what was required, a precedent has been set. And the principle to gradually move towards market driven prices has been recognised. It may be a matter of time — may be a few months — before the retail prices of transport fuels are fully decontrolled. For the three oil marketing companies (OMCs) — and also their battered investors — which had dropped in an abyss of losses for the past five years, there’s finally a light at the end of the tunnel. While OMCs can hope to get control over their profitability back, investors can hope for better days ahead. And if the mandarins in New Delhi take the next steps, investors’ gains could be really dramatic, given the size of the Indian oil economy.
Nothing is small, when it comes to the oil business. When the three oil majors lose money, it’s in hundreds of crores a day. When they will turn around, it could very well be likewise. The government’s decision on Friday is an effort to set the direction for this industry, while managing its public face and inflationary concerns. The decision to protect consumers, despite rising oil prices over the past eight years, came at a great cost for the government. It added over Rs 150,000 crore to the country’s debt burden and public sector upstream companies lost over Rs 120,000 crore. Still a huge chunk of the burden had to be borne by the trio. In the entire process, all these PSUs not only failed in creating wealth for their investors — the government being their single largest shareholder — but also had to curtail dividends. The three OMCs together recorded a turnover of Rs 530,000 crore in FY10 with net profit of just Rs 13,800 crore. However, they needed an assistance of Rs 26,000 crore from the government and discounts of Rs 14,500 crore from upstream companies, such as ONGC. Still they lost nearly Rs 5,500 crore by way of under-recoveries. Based on the figures of the last financial year, the industry’s current net profit margin works out to be just 2.6%. In pre-controlled days when companies had pricing freedom, the industry profit margin used to be around 5%. The gap indicates the upside potential available, if they are granted full control over their product prices. Considering the losses incurred by the companies in the first three months of the current fiscal and the continuing losses on kerosene and LPG, the industry’s gross under-recoveries for FY11 are expected to be higher than that in FY10. It’s therefore, unlikely that the upstream companies ONGC, Gail and Oil India would offer lower discounts this year. Similarly, unless further price increases are allowed, the government too will have to shell out substantially higher than Rs 26,000 crore it offered to OMCs in FY10.

The key benefits that the marketing companies get from the partial implementation of Kirit Parikh Committee recommendation is that their cash flow will improve and thus reduce their borrowing. This, in turn, will greatly reduce their interest burden and improve net profit. In FY09, for instance, the combined interest burden of the three OMCs amounted to Rs 8,724 crore, up by nearly nine times in five years. In FY04, these OMCs had spent just around Rs 900 crore in servicing their debt. In FY10, the industry interest burden subsequently declined to Rs 3,783 crore primarily due to a fall in international crude prices. The freeing of petrol pricing and rise in diesel prices will further reduce their funding requirement and help them save on interest cost.

It was way back in April 2002 that the government had discontinued the earlier administered pricing mechanism to link retail prices to market forces. This had fuelled a huge rally in the stock prices of all the three OMCs. Between March 2001 and March 2004, the combined market capitalisation of Indian Oil, BPCL and HPCL expanded at a compounded annual growth rate (CAGR) of 55%. The profits as well as dividends distributed by these biggies grew at a CAGR of over 40% in this period.

Since then their dependence on the government’s aid increased progressively as their selling prices stagnated despite rising international crude oil prices. Still the companies continued to diversify to generate profits that can augment the deteriorating bottom lines.

Investing inthe petroleum exploration business — a backward integration — or setting up petrochemical plant — a forward integration — have been their obvious choices. The players also invested in alternate energy sources, including bio-fuels, while also moving into natural gas value chain. However, compared to their traditional business of fuel retailing, these new initiatives still remain insignificant.

All these companies are also progressing well with their expansion plans, thanks to the understanding that the government will finally bail them out. BPCL’s sixmillion tonne refinery at Bina in Central India is nearing completion, which is likely to come out with an IPO soon. HPCL is also setting up a 9 mt refinery in Bhatinda in a joint venture with Mittal Energy to commence operations by the end of FY11. Similarly, Indian Oil is developing a 15 mt refinery at Paradip in Orissa that will be commissioned in 2012.

Although the players have been managing themselves somehow, they never really prospered all these years. All of them consistently underperformed the markets for the past five years. With their dividends also coming down, retail investors suffered both ways.

Set To Fire Up
IT WILL, therefore, be good to see them unshackled and able to compete freely. On the combined turnover of Rs 530,000 crore, if they are able to generate even 5% net profit, all three companies could figure in India’s top 10 profit making companies. This will not just boost their share prices, but will also benefit retail investors by way of attractive dividends. The oil industry’s deregulation is also essential to maintain the fiscal health of the country, which has a deficit target of 5.5% of GDP for FY11. India’s gross debt, as a proportion of GDP, is one of the highest among emerging markets. The sovereign debt crisis in Southern Europe shows that continued deterioration of public finances could easily snowball into rising interest rates and a period of painful economic adjustment. Though India’s debt burden hasn’t reached the Greek levels, given the size of India’s oil economy, it could be just a matter of time. In the short term, concerns on inflationary pressures caused by the fuel price hikes could be deterring. However, it is a necessary evil. It remains a fact that despite the hikes retail fuel prices in India continue to remain lower than those in most European and South Asian countries. The government has taken the first step after much dithering. We wish it the best luck for mustering enough courage to take the big plunge before it becomes too late.