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Event update: Oil & Gas - Government combines excise relief and price intervention; material negative for OMCs

EVENT – retail excise duties cut by Rs1.5/ltr but Rs1/ltr absorption by OMCs an unwelcome move

The Finance Minister (FM) has announced two measures, highlighting the pressure on retail fuel prices, given the sharp rise in crude prices These measure are i) cut of Rs1.5/ltr in excise duties for petrol/diesel, which effectively neutralises US$2.5/bbl of product price increase, ii) an additional Rs1/ltr of price cuts in petrol/diesel to be absorbed by OMCs, which effectively resumes the unwelcome era of ad-hoc price intervention by the Government.

IMPACT – Reversal of a 3-4 year policy direction a material negative

Sharp cut in OMC’s FY19-20E earnings: The Rs1/ltr hit on OMC’s retail margins effectively implies that FY19E gross margins for petrol/diesel will barely breakeven at the EBITDA level, while H2FY19E margins will actually be lower than overheads for the two fuels. We have accordingly cut our EPS estimates sharply for IOC, HPCL and BPCL by 15-25% (Exhibit 1).

Additionally, the return of unpredictability of marketing earnings for the OMCs has led us to slash our target EV/EBITDA multiples for the segment as well, driving a sharp 25-35% reduction in price targets for the three companies (Exhibit 2)

Read through for ONGC also bearish: In the backdrop of the policy direction (the above development) and government’s strained fiscal situation, we envisage a strong likelihood of Rs150-200bn of subsidy burden on ONGC + OIL. This is because, gross subsidy on LPG/Kero is likely to aggregate Rs450bn, even with crude at US$75/bbl for FY19E versus a provision of just Rs220bn for the year as announced in Feb 2018 budget.

We submit that even at that level of subsidy share, ONGC’s net realisations are unlikely to dip below US$60/bbl as even Rs150-160bn implies subsidy of US$15-16/bbl (implying a consolidated EPS of Rs27/sh). The bigger concern, however, is that such unpredictability on earnings until the end of FY19E implies that investors will be wary of building positions in ONGC till Q4FY19 results, irrespective of how attractive valuations look at this time.

View: OMCs downgraded to Neutral; positive stance on ONGC maintained

The cut in our earnings estimates sharply factors in the lower marketing margins due to this price cut; we have also slashed our target EV/EBITDA multiples across segments to factor in the heightened uncertainty around earnings over FY19-20E. While our revised target prices of Rs175/Rs360/Rs260 for IOCL/BPCL/HPCL, respectively, still implies healthy upsides from current levels, we believe prospects over the next 9-12 months will be driven by lack of visibility/clarity on earnings. As a result, multiples could see further de-rating, if margins come under further pressure closer to the election season. We have downgraded the 3 OMCs under over coverage to Neutral. However, we reiterate our positive stance on ONGC, as valuations already factor in policy negatives in the form of subsidy, albeit a provision of >Rs150-160bn will drive downgrades to our estimates in ONGC as well.