>OIL MARKETING COMPANIES (IDFC SSKI)

With a stable and pro-reforms Congress-led government back in power, expectations of speedy and aggressive policy reforms in the areas of oil product pricing and strategic disinvestment have stoked a handsome rally in OMC stocks. Significantly outperforming the Sensex (14% rise) post the election results, IOCL, BPCL and HPCL have gained 23%, 20% and 24% respectively in just five trading sessions. At current prices, IOCL, BPCL and HPCL trade at 6.6x, 6.7x and 8.5x FY10E EV/ EBITDA respectively, and ~1x BV. At these levels, we believe the potential upside from product price deregulation in FY10 is already built into the stock prices. Also, we are skeptical of any concrete measures being effected on the strategic disinvestment front in the near term. We
also note that free pricing of petrol and diesel is feasible only till crude prices below US$65 /bbl, beyond which product price increases would become difficult to implement. We maintain our Neutral stance on the sector.

■ New government expected to be committed to reforms
Initial statements made by Congress party office bearers indicate that the incoming government will have firm focus on the reforms process. This implies that there may be some definitive action at last on the refining and marketing sector reforms that have been on ice for a long time. We see several economic and political reasons supporting the reform process currently:

• The relatively low crude prices would result in small increases in domestic fuel prices even after deregulation, making it politically convenient to implement the measure, while having little impact on inflation.
• The government will see a steep drop in its under-recovery burden, which would improve its stretched fiscal position. We see a reduction of Rs50bn from government’s oil bond contribution.
• Disinvestment of government stake in the OMCs will unlock value for the government, while a larger free float for the companies will result in better price discovery.

■ Lower crude price offers a window for change
Crude prices have cooled down substantially to USD55-60/bbl levels, and global demand continues to be subdued. In this backdrop, we see crude prices trading in a narrow range over the next 12 months, despite the current upturn seen in commodities (tracking the global equity markets). This provides the Indian government a good opportunity to push through a free market pricing regime. At the prevailing crude price levels, this would imply a small increase in
petrol prices and a marginal decrease in diesel prices.

■ Current prices close to international break-even levels
At a crude price of $55/bbl, the subsidy on petrol and diesel combined is estimated at Rs100bn, 84% lower than FY09 levels. We estimate that at a crude price of US$50/bbl, the under-recovery on petrol and diesel tends to be zero. Even at the prevailing crude price of US$60/bbl, removal of price controls will not result in any substantial increase in prices of petrol and diesel. Some reports indicate that at these levels, diesel prices will in fact be lower by ~Rs0.3/ltr,
resulting in substantial benefits to the economy.

To see full report: OIL MARKETING COMPANIES