Oily conundrum

In a market desperate for good news, even a smidgen is grabbed with both hands. After the hike in petrol prices, it was taken for granted that a much-pilloried government would increase diesel prices, too, as a show of decisiveness. This expectation naturally filtered into the stock prices of state-owned oil companies. Investor hope was particularly high on state-run monolith Oil & Natural Gas Corporation (ONGC) with the stock rallying 15% from its June low of Rs.248. Since then the elation has subsided, as the talk of a substantial hike in diesel prices has remained just that — talk. 

The only thing that can provide some respite for oil companies is lower crude prices. That may well happen but, can lower crude prices really be good news for an exploration company? Even though ONGC bears the burden of oil subsidies, it is a myth that it will benefit from lower crude price.   

Before we get to that, a little background on ONGC and how the government milks oil marketing companies for its own benefit. ONGC through its production meets 20% of the country’s demand for crude oil. It also refines crude oil into petrochemical products through its subsidiary Mangalore Refinery & Petrochemicals. Then, through its overseas subsidiary ONGC Videsh (OVL), it hunts for oil and gas fields it can develop.

As for the government, it gets high import duties from crude that fill its coffers. Then, while petrol is freely priced, diesel, LPG and kerosene prices are still controlled. The upstream companies produce only 20% of India’s domestic crude requirement. The rest is met by imports by public sector companies like Indian Oil Corporation, Bharat Petroleum and Hindustan Petroleum (oil marketing companies or OMCs), which refine and market petroleum products.

Since OMCs cannot sell at prices that cover their costs, there is under-recovery (the difference between the retail price of oil products and their landed global prices). This under-recovery is to be funded by two parties — the government, through supplemental grants, and the upstream companies in a ratio that changes every year under the ad hoc subsidy-sharing mechanism.

The damage incurred in the latest quarter is about Rs.50,000 crore and about a third will have to be coughed up by the likes of ONGC, Gail and Oil India. The OMCs currently don’t bear the subsidy owing to cash flow issues. Thus, falling crude prices ensure that the share of under-recoveries borne by upstream players like ONGC falls. Now for the myth-bursting. 

Truth be told

Myth 1:  The drop in crude price will allow ONGC a significant reduction in the subsidy-sharing burden, helping it boost profits. Fact: Whatever gains made by the reduction in crude price has been offset by the plummeting rupee. “Crude price going down is good for us but at the same time the rupee has also depreciated. That has totally offset the gains of the reduction in subsidy burden,” concurs Sudhir Vasudeva, chairman and managing director, ONGC. 

And the falling price of crude cuts both ways: ONGC, too, gets a lower realisation on its production. “Currently, ONGC has a net realisation of about $56 a barrel. If the net realisation falls below it, and the subsidy share borne by upstream companies were to go beyond the current 38%, upstream companies like ONGC will be in serious trouble,” points out Mehul Thanawala, vice-president, research, JM Financial.

On the face of it, the company’s financials seem promising. It closed FY12 with a near 25% jump in sales as well as net profit, and the good times were expected to continue in FY13. But dig a bit deeper and the picture is not quite so rosy.

There is really no end to ONGC’s subsidy-sharing problems, says Niraj Mansingka, associate director of research at Edelweiss Securities. “There is no clarity from the government on the subsidy sharing mechanism. Thus, there is no way the company can predict its own cash flow position.”

Myth 2: The reduction in subsidy sharing in Q4FY12 was significant and shored up ONGC’s bottomline. Fact: The decrease was paltry. Consider these facts.  The total value of under-recoveries for the oil and gas sector in FY12 was Rs.1.38 lakh crore.

Out of this, the share of the under-recovery burden for upstream companies was 39.7%, or Rs.54,786 crore. ONGC’s contribution to this was 80.8%, or a whopping Rs.44,266 crore. The provisional decline in subsidy sharing for ONGC in Q4FY12 was a paltry 3%, amounting to a mere Rs.1,238 crore.

What is expected in Q1FY13 is not encouraging either. “The reduction in subsidy burden in the first quarter is marginal and doesn’t benefit us significantly. Also, the subsidy burden borne by us in the first quarter doesn’t depict a true picture of our overall burden. The government takes a call on how much we need to bear in the third and fourth quarter,” says Vasudeva.

At the margin

In its downstream ventures too, ONGC has had bad luck. And this is not a symptom of its inefficiency, it’s caused by a broader malady. Since 2008, gross refining margins (GRMs, the difference between the price of crude and refined products) have taken a beating and never really recovered. ONGC is no exception. Its refining subsidiary, MRPL, currently has a negative GRM of $-4.15 per barrel as opposed to $3.72 in the past year.

Vasudeva adds that MRPL’s GRMs decline was on account of inventory loss of Rs.733 crore and foreign exchange loss of Rs.650 crore. “GRMs have been falling since FY09 and the chief culprit is weak demand for refined products as also high price of crude,” says Thanawala.

Another thorn in ONGC’s side has been the cess of Rs.4,500 per barrel imposed on crude. This is bound to affect the company’s profitability, notably its profit before tax, significantly. Vasudeva reveals that this has not only hurt ONGC’s earnings but also increased its cost of production.

“With the cess, our unit cost of production for crude has increased by $6 to $44 a barrel. Our net realisation is $56 a barrel and we have asked the oil ministry to increase it to $60 a barrel and reduce our subsidy burden.”

Discovery, what? 

ONGC has an ambitious target of doubling its capacity by 2030 and that of its subsidiary OVL six-fold during the same period. It hopes to achieve this through the KG4 basin and Daman offshore fields.

But given that it has not had a single major discovery after Bombay High and that OVL saw a 7% y-o-y production dip in FY12 on account of the ongoing strife in Sudan and poor reservoir performance in Russia, this looks highly unlikely. 

Mansingka, too, thinks the company’s targets are a stretch. “ONGC will find it tough to ramp up production capacity. It is already facing trouble meeting its existing production targets as its fields are ageing and there have been no new discoveries for a while.” Management being management, it is also hoping for complete deregulation of all oil products. But given the price sensitivity of these products as well as political compulsions, it is highly debatable whether the company’s hopes will be fulfilled.  

To compound matters for the state-owned enterprise, Thanawala thinks falling crude prices are here to stay, in the near term. “The demand for crude continues to be weak. The US has sufficient quantities of shale to meet its requirements, so it’s importing much less. Since EU demand is also low, the only other major demand drivers are the Asian countries and China, and these are experiencing slowing growth — and demand —  too.”

Then, it is not clear if the rupee has stabilised against the dollar. Thanawala says, “If the rupee continues to depreciate, downstream companies will have higher under-recoveries because they end up paying more for the same amount of crude purchased.” 

Despite his reservations, Mansingka has a ‘buy’ rating on the stock. He justifies, “The stock is trading at a PE of 8x forward earnings for FY13E, which is attractive.” Analysts like Mansingka still believe that diesel prices can go only one way — up — because of the government’s fiscal position. Even if that is the case, it’s hard to place faith on ONGC where there are so many imponderables — from crude prices and rupee to retail prices and subsidy share.