CRISIL OpinionJune 2014

Road ahead clears up for Oil PSUs

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Last updated: May, 2013

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CRISIL Opinion

1

Oil PSUs poised for structural improvement in profitability

Under-recoveries to halve with ongoing price revisions and softer crude prices

Under-recoveries on petroleum products are expected to decline by over 50 per cent from 2013-14 levels

over the next 2 years due to ongoing efforts to move towards market-linked diesel prices and the expected

decline in crude oil prices. This will have a significant positive impact on both upstream and downstream

PSU oil companies. PAT of downstream companies will increase by Rs 33-36 billion y-o-y in 2014-15 and by

another 7-10 billion in 2015-16 because their interest cost will decline and they won’t have an under-recovery

burden. On the other hand, upstream companies, which typically share 40-50 per cent of the total under-

recovery burden on petroleum products, will see a sharper improvement of Rs 105-120 billion y-o-y in profit

after tax (PAT) in 2014-15 and a further improvement of Rs 70-75 billion in 2015-16. This is because the

impact of reduced burden of under-recoveries will more than offset the impact of decline in realisations due

to lower crude prices. If we include the benefit from the potential hike in gas price to US$8.4 per mmbtu, PAT

of upstream companies will further increase by Rs 70-75 billion in 2014-15, resulting in an overall increase of

Rs 215-230 billion.

High under-recoveries hurt profitability of both upstream and downstream oil companies

In the past few years, high under-recoveries on sales of petroleum products have left deep holes in the

financials of oil companies (both upstream and downstream). This is because, in India, petroleum products

such as diesel, LPG, and kerosene are sold by downstream public sector oil marketing companies (OMCs)

at regulated prices, well below the cost (petrol prices were de-regulated in June 2010). The resultant loss,

termed as under-recovery, is generally shared by three parties – the government, upstream oil companies

(ONGC, OIL India and GAIL) and oil marketing companies (IOCL, BPCL and HPCL) – in a proportion

determined by the government every year.

Trend in under-recoveries and its share absorbed by government, upstream and downstream

companies

Source: PPAC, CRISIL Research

0

200

400

600

800

1000

1200

1400

1600

1800

20

08-0

9

20

09-1

0

20

10-1

1

20

11-1

2

20

12-1

3

20

13-1

4

20

14-1

5P

20

15-1

6P

Petrol Diesel Domestic LPG PDS Kerosene

461

782

1,3861,610 1,400

900-1,000

600 - 700

1,033

Rs billion

46%

68%56% 52%

60%51% 50% 50%

33%

32%

31% 39%39%

48% 50% 50%

21%

0%12% 9%

1% 1% 0% 0%

0%

20%

40%

60%

80%

100%

120%

200

8-0

9

200

9-1

0

201

0-1

1

201

1-1

2

201

2-1

3

201

3-1

4

201

4-1

5P

201

5-1

6P

Government Upstream Downstream

2

CRISIL Opinion

The sharp increase in overall under-recoveries and, thereby, the government’s contribution towards under-

recoveries over the last few years has led to a surge in the interest cost of OMCs The interest cost has gone

up owing to a significant rise in working capital requirement, which is the outcome of delay in payments from

the government. Average delay in payments by the government has been to the tune of 3-6 months over the

last few years. Consequently, interest cost for OMCs more than tripled from Rs 30 billion in 2007-08 to Rs

104 billion in 2012-13 after declining to Rs 78 billion in 2013-14 (due to dollarization of rupee loans as well as

decline in under-recovery burden). Total debt also doubled to Rs 1,325 billion in 2013-14 from Rs 673 billion

in 2007-08. Also, short-term debt as a percentage of total debt has remained, on an average, around 75 per

cent since 2007-08 in line with rising working capital requirement. Due to conversion of rupee denominated

working capital loans to foreign long term loans (external commercial borrowings of minimum 3 year tenure),

share of short term debt declined in FY14.

Increase in gearing largely to cater to short term requirements of OMCs

Source: PPAC, MoPNG, Company financials

As seen in the chart below, subsidy receivables by OMCs at the end of each year almost tripled from Rs 150

billion in 2007-08 to Rs 427 billion in 2012-13 resulting in an increase in their borrowings. More pertinently,

oil companies have used the debt to meet their working capital requirements rather than spend it on

expansions or acquisition of upstream assets.

355

702

258 407

832 970

714

1.1 1.4

1.2 1.2

1.5 1.5

1.3

-

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

-

200

400

600

800

1,000

1,200

FY08 FY09 FY10 FY11 FY12 FY13 FY14

TimesRs billion

Government share of under recovery

Debt/Equity of OMCs (RHS)

537 679 597

712

1,029 985

735

136

210 283 255

253 359

590

-

200

400

600

800

1,000

1,200

1,400

1,600

FY08 FY09 FY10 FY11 FY12 FY13 FY14

Rs billion

Total short term debt Total Long term debt

889 880967

1,2821,384 1,325

3

Trend in government subsidy receivables of OMCs

Source: Annual Reports, CRISIL Research

The sharing of under-recoveries between government, public sector upstream and downstream companies is

done on an ad-hoc basis depending on the financial position of both upstream as well as downstream

companies as well as government finances. Over the last few years, with under-recoveries soaring to Rs

1,400 billion in 2013-14 from Rs 771 billion in 2007-08, the contribution (in absolute terms) of upstream

companies towards under-recovery sharing has increased significantly to Rs 670 billion in 2013-14 from Rs

257 billion in 2007-08. Consequently, they have not benefitted from the combined effect of high crude oil

prices and the weak rupee.

Between 2008-09 and 2013-14, crude oil prices rose at a CAGR of 5 per cent to $108 per barrel. During the

same period, the rupee depreciated from INR 46/$ to INR 61/$ (6 per cent CAGR). However, upstream

public sector companies could not benefit from rising oil prices and weak currency as their net realisation

declined to $41 per barrel in 2013-14 from $48 per barrel in 2008-09 due to increased share in under-

recoveries.

150

83119

183

353

427

0

100

200

300

400

500

2007-08 2008-09 2009-10 2010-11 2011-12 2012-13

(Rs billion)

Amount recoverable from the government at the end of every year

4

CRISIL Opinion

Upstream companies not getting significant upside from high crude oil prices and rupee

depreciation

Note: Figures on top of the bar indicates gross realisation

Source: Annual Reports

As the above chart shows, while average crude oil prices increased by 16 per cent CAGR between 2009-10

and 2012-13, ONGC’s net realisation (after removing discount offered to OMCs) declined by 5 per cent. In

rupee terms, ONGC’s gross realisations increased at 21 per cent CAGR as against a 1 per cent decline in

net realisations. Even in 2013-14 when gross realisation declined by ~$5 per barrel, discounts actually

increased by $3 per barrel. Consequently, profit after tax (PAT) margins of upstream companies remained

more or less stable around 28 per cent as their contribution towards under-recoveries almost doubled to Rs

670 billion in 2013-14 from Rs 341 billion in 2008-09.

Increasing contribution towards under-recoveries for upstream PSUs restricting PAT margins

Note: Figures on top of the bar indicates PAT margins if no under-recovery was paid

Source: Annual Reports, CRISIL Research

48 56 54 55 48 41

38 16 36

63 63

66

-

20

40

60

80

100

120

140

FY09 FY10 FY11 FY12 FY13 FY14

USD/ barrel

Net realisation - ONGC discount given to OMCs

8672

89

117112 107

3,965

3,399

4,074

5,627 6,025

6,457

2,195 2,654 2,450 2,622 2,604 2,479

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

FY09 FY10 FY11 FY12 FY13 FY14

Rs/barrel

Gross realisation (Rs terms) Net Realisation

26% 28% 28%33%

26% 27%

10.4% 6%10%

13%

15% 17%

0%

10%

20%

30%

40%

50%

FY09 FY10 FY11 FY12 FY13 FY14

Actual PAT margin Increase in PAT margins if no U/R was paid

34%38% 39%

46%

42% 43%

341

148

246

541

604

670

-

100

200

300

400

500

600

700

800

FY09 FY10 FY11 FY12 FY13 FY14

Rs billion

Share of upstream companies in overall under-recovery burden

5

Govt undertaking steps to ease under-recovery burden

To reduce the burden of under-recoveries the government has, in the recent past, taken quite a few

measures such as a calibrated increase in diesel prices, deregulation of bulk diesel prices, cancellation of

multiple LPG connections and a cap on the supply of subsidised LPG cylinders.

In 2013-14, with an increase of 50 paise every month, retail diesel prices have risen by Rs 6.90 per litre.

Around 10-12 million duplicate LPG connections, which account for 7-8 per cent of overall connections in the

country, have been cancelled over the last 18 months. Due to these measures, in spite of high crude oil

prices (~$108 per barrel) and a sharp 11 per cent depreciation of the rupee against the dollar, under-

recoveries in 2013-14 have declined by 13 per cent y-o-y. The new government has also continued with

diesel price hike of 50 paise. CRISIL Research expects market alignment of diesel prices to continue as a

result of which diesel (like petrol) will also be eventually de-regulated.

Under-recoveries on petroleum products to halve over next 2 years

After declining in 2013-14, under-recoveries are expected to decline further by 30-35 per cent y-o-y to Rs

900-1,000 billion in 2014-15 and 25-30 per cent y-o-y to Rs 600-700 billion in 2015-16 on account of the

following factors:

a) A 8-10 per cent y-o-y decline in international petroleum product prices over the next 2 years

Over the next 2 years, global crude oil supply will outpace demand with growth in the latter continuing to

remain sluggish. Global demand growth is expected to be impacted by weak crude oil demand in North

America and Europe on account of increase in efficiencies and a shift towards natural gas as well as

relatively slower demand from developing countries such as China and India led by declining subsidies.

With relatively higher supply due to increase in output from Iraq, Iran and North America, crude oil prices are

expected to decline from $107.6 per barrel in 2013 to less than $100 per barrel in 2015 barring any major

geo-political event. Currently it is largely the unrest in Ukraine which is supporting prices despite weak

demand.

b) Gradual alignment of domestic diesel prices with international prices; slower growth in diesel

consumption

Under-recovery on diesel, which accounted for about 45 per cent of the total burden in 2013-14, is likely to

be eliminated by the end of 2014-15. This is due to the government’s decision to increase diesel prices by 50

paise every month till domestic prices get aligned to international prices.

While the 50 paise price hike did not take place in April 2014 due to ongoing general elections, diesel prices

were increased by Rs 1.09 per litre on May 13, 2014, after the polls ended. Further, after the formation of the

new government diesel prices have been increased by 50 paise already.

6

CRISIL Opinion

Trend in under-recoveries on diesel

Note: Under-recoveries are average for the month; number for June 2014 is as on 1s t

June

Source: PPAC, Press Information Bureau (PIB)

The increase in retail diesel prices narrowed the gap between diesel and petrol prices and reversed the shift

that was being seen towards diesel cars. The price hike along with slowdown in transportation segment due

to economic slowdown has helped rationalise diesel demand, which was growing at 7-8 per cent till 2012-13.

Post price increases, diesel demand is estimated to decline marginally by 1 per cent in 2013-14 and grow at

a relatively slower pace of 2-3 per cent over the next 2 years.

c) Marginal increase in LPG and kerosene retail prices coupled with cancellations of multiple LPG

connections and cancellation of PDS kerosene allocations

We also expect marginal increases in prices of LPG and kerosene over the next 2 years in line with the

increases in the past. Although the government has not increased prices of LPG and kerosene in 2012-13

and 2013-14, CRISIL Research estimates that retail LPG cylinder and kerosene prices will go up by Rs 40-

50 per cylinder and Rs 1-2 per litre, respectively per annum, over the next 2 years as was the case prior to

2012-13. This, along with cancellation of multiple LPG connections and cancellation of public distribution

system (PDS) kerosene allocations, will help to contain under-recoveries in future.

Outlook on under-recoveries on various petroleum products

Year\Product Diesel (Rs billion) LPG (Rs billion) Kerosene (Rs

billion)

Overall

Under-recoveries

(Rs billion)

2012-13 921 396 294 1,610

2013-14 628 465 306 1,399

2014-15P 210 513 277 1,000

2015-16P - 388 229 617

Source: PPAC, MOPNG, CRISIL Research

11.4

9.6

15.5

9.7

6.5

3.8

5.6

13.3

10.4

9.1

5.7

2.8

0.0

4.0

8.0

12.0

16.0

20.0

Ju

n-1

2

Ju

l-12

Aug

-12

Sep

-12

Oc

t-12

No

v-1

2

De

c-1

2

Ja

n-1

3

Feb

-13

Ma

r-1

3

Ap

r-13

Ma

y-1

3

Ju

n-1

3

Ju

l-13

Aug

-13

Sep

-13

Oc

t-13

No

v-1

3

De

c-1

3

Ja

n-1

4

Feb

-14

Ma

r-1

4

Ap

r-14

Ma

y-1

4

Ju

n-1

4

Rs/litre Diesel under-recoveries

Sharp rupee depreciation raised U/R on diesel

Continued hike in diesel prices once again brought down U/R

Decline in U/R due to price increases and fall in crude oil prices

7

Lower under-recoveries to add Rs 175-190 billion to PAT of upstream companies by

2015-16

With the expected reduction in under-recoveries over the next 2 years, and assuming that upstream PSUs

share 50 per cent of the burden in line with the past, the discount to OMCs by upstream PSUs will reduce

from Rs 670 billion in 2013-14 to Rs 450 billion in 2014-15 and Rs 300 billion in 2015-16.

Due to the decline in under-recoveries, net addition in profit after tax (after adjusting for royalty payment and

taxes) of upstream companies will be Rs 105-120 billion y-o-y in 2014-15. PAT will increase further by Rs 70-

75 billion in 2015-16 due to the fall in under-recoveries.

Gas price hike to add to profitability

PAT of upstream companies will also get a boost due to an increase in gas prices during 2014-15. Although

the revision in domestic gas prices was expected from April 1, 2014, the Election Commission deferred the

decision and left it to the new government to take a decision.The new government is deliberating the same.

The extent of revision is awaited.

The potential increase (as per the Rangarajan committee formula) of the natural gas price to US$8.4 per

mmbtu from $4.2 per mmbtu will increase the PAT of upstream companies (ONGC, Oil India) by Rs 110-115

billion in 2014-15. The combined effect of lower under-recoveries and the gas price hike is expected to lift

PAT of upstream companies by about Rs 215-230 billion in 2014-15.

For upstream PSUs, the increase in PAT has been calculated on the assumption that they will not be asked

to share the subsidy burden of the government in other sectors such as fertiliser and power or significant

change in proportion of subsidy shared which is potential downside to our assumptions.

Profitability of OMCs to also get a boost with decline in interest burden

After rising to Rs 250 billion in 2010-11, capital expenditure by OMCs declined sharply to below Rs 100

billion in the subsequent 2 years due to a significant increase in interest costs. Higher interest costs were

due to an increase in working capital requirement caused by delayed subsidy payments. Subsidy receivables

from the government increased almost three-fold over the 5 years ending 2012-13. The lack of growth in net

profit has also impacted the ability of these companies to undertake capital expenditure.

8

CRISIL Opinion

High under-recoveries restricting capital expenditure plans of OMCs

Source: Company financials

Other things remaining the same, the decline in under-recoveries in 2014-15 and 2015-16 will improve

OMCs’ PAT by 26-28 per cent to Rs 161-164 billion in 2014-15 and by another 4-6 per cent to Rs 168-171

billion in 2015-16. Although OMCs shared Rs 21 billion under-recoveries in 2013-14, we have assumed they

will not share any under-recovery burden in 2014-15 and 2015-16 due to significant decline in overall under

recovery burden going forward. Over the next 2 years, as gross refining margins (GRMs) of OMCs are

expected to remain similar to 2013-14 levels of $3-4 per barrel, the improvement in profitability will largely be

on account of the decline in under-recoveries

If the above-mentioned initiatives pan out as expected, and oil prices stay soft, the entire sector will receive a

much-needed shot in the arm and encourage investments.

Impact of lower under-recoveries and gas price hike on PAT of upstream and downstream

companies

Improvement in PAT (y-o-y) 2014-15 2015-16P Total benefit

Upstream companies (excluding gas price hike) Rs 105-120 billion Rs 70-75 billion Rs 175-190 billion

Upstream companies (Including gas price hike) Rs 215-230 billion Rs 70-75 billion Rs 285-290 billion

Downstream companies Rs 33-36 billion Rs 7-10 billion Rs 40-43 billion

39

131

105

62

86

108

0

20

40

60

80

100

120

140

FY09 FY10 FY11 FY12 FY13 FY14

Rs billion PAT

58

144

250

98 91

-

50

100

150

200

250

300

FY09 FY10 FY11 FY12 FY13

Rs billion Capex

9

Analytical Contacts:

Rahul Prithiani Kelvin Shah

Director, CRISIL Research Associate Director, CRISIL Research

Media Contacts:

Tanuja Abhinandan Jyoti Parmar

Associate Director Assistant Manager

Communications and Brand Management Communications and Brand Management

Email: tanuja.abhinandan@crisil.com Email: jyoti.parmar@crisil.com

Phone: +91 22 3342 1818 Phone: +91 22 334 21835

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