>INDIA OIL & GAS (CLSA)

Deregulation vs crude prices

The state owned oil companies have rallied 26-42% since the election results on hopes of pricing deregulation. We view deregulation as a low crude- price outcome, however, and crude remains the dominant variable; earnings pressures will re-appear as crude rises. We recommend taking profits in IOC, BPCL and ONGC. Investors who do not concur with our views on (rising) crude prices or the policy direction could choose HPCL given its lower valuations (1x PB) and higher upside leverage.

Integrated R&Ms trading at 1.35x PB
■ The state owned oil stocks have rallied 26-42% since India’s election mandate.
■ While underpinned by expectations of deregulation, even pure refiners Chennai and MRPL have spiked indicating that the rebound also corrected for low valuations.
■ ONGC’s stock price is already pricing in auto fuel deregulation, in our view, but the
integrated R&Ms (which trade at 1.35x trailing PB) may still have room to rally.

Still no clarity on FY10 earnings, even deregulation may not help
■ This will require clarity on FY10 earnings; this depends on pricing policy, subsidy sharing and the trajectory of crude prices. Meanwhile, lower GRMs will hurt in FY10.
■ Our models build in Rs100bn in net under-recoveries for the R&Ms in aggregate. At our crude price ($64 Brent) and spread forecasts, this implies that the R&Ms share only 17% of the under-recoveries implying continued support via oil bonds.

We are skeptical on deregulation; policy canvas remain uncertain
■ While we do not expect changes in cooking fuel pricing, the impending proposal to allow the flexible pricing in petrol and diesel may lower auto fuel under-recoveries.
■ The government wants to cap prices at $75 crude, though. This will likely unravel the proposal; two similar bands were abandoned in 2004/5 as crude rallied.
■ Further, the implementation itself will test the political will of the government even as five states (including Maharashtra) go to their assembly polls over the next year.
■ Further, auto-fuel deregulation will likely also lead to a higher burden on the R&Ms for cooking fuel under-recoveries; these equations will be uncertain till end FY10.

R&Ms remain crude price plays; favour HPCL over IOC and BPCL
■ Crude prices remain the dominant variable, therefore – more so as it is only $10/bbl lower than the government’s proposed price ceiling of US$75/bbl.
■ In this context, we view the R&Ms as crude-price and not deregulation plays and see earnings risks returning as crude rises. We forecast US$80/bbl long term.
■ For example, every $10/bbl rise in crude increases gross under-recoveries by US$7.3bn – this is 1.25x the aggregate core FY10 Ebitda of the R&Ms (US$5.8bn).
■ We recommend taking profits in IOC, BPCL and ONGC. Investors who do not concur with our views on (rising) crude or the policy direction could choose HPCL given its lower valuations (1x PB) and higher upside in a low crude and deregulation scenario.

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