In today’s Finshots, we explain why the shares of certain oil companies witnessed a massive rally in 2023 and how recent events might be a dampener.

The Story

You can split the Oil industry primarily into two parts.

First, you have what’s known as the Upstream companies. They’re the folks that do the hard work of exploring crude oil wells and setting up the rigs to drill the oil out from the deep seas or far underground. For instance, ONGC and Reliance Industries.

Then you have the Downstream companies. Their job is to take the crude oil and refine it into the finished products. They give us petroleum and diesel. And they’re the ones who market these products to us. You have ones such as Indian Oil, HPCL, and BPCL in this list. Let’s call them Oil marketing companies (OMCs) for the sake of this story.

And these OMCs have had a rollicking time of late. Between November 2023 and February 2024, these stocks zoomed by around 100%!

Yup, if you’d invested ₹1 lakh into these companies, your money would’ve ballooned to ₹2 lakhs in no time.

But it looks like the magic run has hit a hurdle. Investors are now worried because of government interference. Elections are near and the government wants to look good. So it has asked these OMCs to cut the price of petrol and diesel by ₹2!

Mind you, this is the first such pan-India price cut since May 2022.

But before we dive into how this price cut could hurt these OMCs, we need to understand what drove the rally in the first place.

See, OMCs don’t extract and use their own crude oil. They have to buy it from third parties before they can begin their refining process. They could buy it from ONGC and Reliance, but we know that India isn’t really sitting on massive reserves of oil. So the OMCs need to import crude oil primarily from the Middle East to meet our massive demand.

Naturally, when their raw material — crude oil — prices trend lower, OMCs have a good time. And when oil prices head higher, that puts pressure on the companies.

So, what happened in the past few years?

Well, you’ll probably remember that after the Covid lockdowns, business activity rebounded with a vengeance. People were commuting and travelling again. And the prices of Brent Crude Oil quickly hit an 8-year high of over $110 a barrel by May 2022.

But after hitting that peak, oil prices slid back down to $75 during 2023.

Maybe it was partly to do with high inflation striking all parts of the world. People were cutting back on expenses and maybe on fuel consumption too. Then there was a worry that the slowdown in the US and China would mean a further drop in demand.

Or maybe it was because Russian oil was also slapped with sanctions after the country invaded Ukraine in 2022. That meant Russia was willing to sell its crude at a lower price to those who wanted to buy it too. At one point, the discount on Russian oil was as high as $30 a barrel.

Either way, Indian OMCs weren’t complaining. They latched on to the opportunity.

As per a report by Yes Securities, Russian crude oil only accounted for 2% of our basket in FY22, but, it jumped to 22% of our basket in FY23.

How does this help, you ask?

Well, we just need to look at something called the Gross Refining Margins (GRM). Just think of it as the difference between the cost of crude oil an OMC consumes and the market value of the refined products it produces. In a sense, it’s a measure of profitability. So, if the cost of their oil imports drops thanks to the mix of Russian crude but the value of the refined products remains at the status quo even, then the GRMs will rise.

And in FY23, the GRMs were almost too good to be true. It jumped to a massive 20% for some OMCs after hovering around 4–6% in the previous decade.

And the OMCs didn’t pass along their windfall to customers like us. They kept the retail selling price (RSP) of petrol and diesel elevated. And that translated into higher gross marketing margins for the companies too.

Take, for example, HPCL. HDFC Securities highlighted that the company’s blended marketing margins doubled from a 5-year average of ₹3 per litre to ₹6 per litre during the first 9 months of FY24.

The times were good.

But cut to today and the rally seems to have run out of fuel. Because that tiny ₹2 price cut has a big implication.

As per JPMorgan’s analysis, it will reduce OMC revenue by a massive ₹30,000 crores. And if you also consider that Russian crude isn’t available at a massive discount anymore, India’s oil refiners will start to feel the pinch.

But wait…there is more.

Not only had the government asked the OMCs to cut the price of petrol and diesel by ₹2, but they’ve also initiated a price cut for LPG by ₹100 a cylinder.

And that double whammy is worrying the analysts at Kotak Institutional Equities a fair bit.

Because right now, they’re worried about further government interference in the run-up to the general elections. Especially because petrol, diesel, and LPG account for around 80% of the sales volumes of these companies. So the lack of pricing freedom will hurt the OMCs.

You can bet investors share similar concerns too.

Especially since these folks didn’t actually improve their efficiency to improve margins. It was just the global tailwinds that helped.

Also, if you tack on the fact that valuations don’t seem cheap yet, you’ll see more furrowed eyebrows.

For instance, HDFC Securities had said in February that Indian Oil trades at an EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation, and amortisation) of 6.1 times. That’s a whopping 35% higher than its previous 5-year average. And as of today, even HPCL continues to trade at a 31% premium to its 5-year average EV/EBIDTA.

So yeah, unless investors truly believe that global oil prices will remain steady over the next few months and that OMCs will be allowed to roll back these price cuts as soon as the election is over, they might think twice about throwing more money into the stocks of these companies.

Until then…

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