FREE

Sector update: Oil & Gas - OMCs; Recent headwinds obscure structural resilience

Oil marketing companies (OMCs) IOCL, BPCL and HPCL have underperformed the broader index by 15%, 17% and 24%, respectively, over last 6 months. Earnings and multiples of OMCs have expanded steadily over FY15-17, owing to a favourable regulatory and operating environment. However, concerns on petrol and diesel marketing margins on the back of Gujarat state elections in Nov-Dec 2017 and higher crude prices have led to apprehension that the favourable environment could reverse. We believe OMCs offer an attractive opportunity to get back in at the current price. This is because the OMCs are still present in a large sustained growth market for petroleum products and refining environment still looks fairly bullish from a 3-year perspective. The three companies trade at a sharp discount (OMCs at 9-13x FY19E EPS) to Nifty multiples of 18.5x FY19E and 16x FY20E, despite RoEs of 15-20% (FY20E) versus IDFC coverage universe RoE of only 14.5%. We believe the risk reward for OMCs is favourable, with material upside from the current level. Reiterate Outperformer on HPCL, IOCL and BPCL - our pecking order for the three stocks.

Volume growth to remain strong; Margins on recovery path: We expect OMCs to witness robust 4-5% growth in marketing volumes and GRMs to play catch up with benchmark GRMs over the next 2-3 years, notwithstanding higher crude prices and lower retail fuel marketing margins. Additionally, marketing margins have recovered by Rs1.4/ltr for petrol and Rs1.5/ltr for diesel until 23 Jan 2018, over the lows seen in Dec 2017. While election-led moderation in margins due to a temporary freeze in price changes was a policy setback and a disappointment, we would look at longer term average margin trends before turning structurally bearish on them for OMCs.

Refining environment looks optimistic: Global refining demand and supply balance remains tight, based on industry analysis of global refining supply additions, which implies surplus demand growth over the next two years (despite recent cut backs in demand growth estimates). This growth, coupled with gradual improvement in overall refinery configuration/complexity of OMCs either via expansion or debottlenecking should result in GRMs growing steadily to US$7-7.5/bbl over FY19-20E versus average reported GRMs of US$3.7-5.0/bbl over FY13-17 for OMCs. In addition, steady growth in refinery thruput due to higher capacity should result in refining earnings increasing steadily over 2-3 years.

Valuations attractive relative to the broader index: Our bullish stance on OMCs stems from their current multiples of 8-10x consolidated FY20E EPS (adjusted for dividend income) versus market multiples of 16x, despite consistent RoE in excess of 15% over last several years. We have moved to an EV/EBITDA-based valuation for IOCL/BPCL/HPCL, valuing OMC’s refining business at 6x, marketing at 8x and pipelines at 8x FY20E EBITDA. Our target price of Rs480/565/515 per share implies 23/17/30% upside from CMP for IOCL/BPCL/HPCL, respectively. Reiterate Outperformer.