Wednesday, February 17, 2010

>THE WORLD IN 2050 - Beyond the BRIC's: a broader look at emerging market growth prospects

To read the report: WORLD IN 2050

>A Viable and Sustainable System of Pricing of Petroleum Products

1.1 India‟s imports of oil are increasing. Our import dependence has reached 80 per cent and is likely to keep growing. At the same time 2008 saw an unprecedented rise in oil price on the world market. Oil price volatility has also increased. Though future oil prices are difficult to predict, they are generally expected to rise. Given our increasing dependence on imports, domestic prices of petroleum products have to reflect the international prices.

1.2 When the average monthly price of Indian basket of crude oil on the world market increased from US$ 36 / barrel in May 2004 to US$132.5 / barrel in July 2008, the government did not permit Public Sector Oil Marketing Companies (OMCs) to pass the full cost of imports on to domestic consumers of major oil products, i.e., petrol, diesel, domestic LPG (i.e., LPG used by the households) and PDS kerosene (i.e., Kerosene sold through Public Distribution System of the Government). The consumers of these products thus received large subsidies. As a consequence, OMCs had large under-recoveries1, which were financed partly by Government through issuing bonds, and partly by upstream public sector companies ONGC and OIL, and GAIL through price discounts. The OMCs also absorbed a part of the under-recoveries themselves. A detailed analysis on these issues is provided in Note 1, Appendix to the report.

1.3 These policies had a number of consequences. They put stress on government‟s finances. They reduced the cash surplus of upstream public sector oil companies restricting their ability for exploration of domestic fields and acquisitions overseas. As the oil bonds were not issued to OMCs on time, they created cash flow problems for OMCs who had to borrow from the market, which increased interest payments and reduced their surplus. Since only the OMCs were provided financial support, the private sector companies withdrew from oil marketing. This not only made infructuous the large investments they had made in setting up retail outlets, it also reduced competition in oil marketing. Subsidizing domestic consumers also did not incentivize them to economize on use of petroleum products. Rather, as prices remained low, and personal incomes rose, the demand for petroleum products such as petrol and diesel recorded double digit growth – higher than the GDP growth. Continuation of the present policies is not viable, particularly once oil prices rise again.

1.4 Over the years, Government has followed a variety of policies for pricing of petroleum products, all of which have been found to have some deficiency or the other. An overview of these policies is provided in Note 2, Appendix to the report.

1.5 Countries across the world have followed different strategies to deal with oil price volatility in the recent years. These are summarized in Note 3, Appendix to the Report.

1.6 A viable long-term strategy for pricing major petroleum products is required. A viable policy has to be workable over a wide range of international oil prices and has to meet the various objectives of the government. It should limit the fiscal burden on government and keep the domestic oil industry financially healthy and competitive.


2.1 The very first question is: Should the government intervene at all in the market and set prices?

2.2 The first reason for intervention is to protect poor consumers so that they may afford kerosene for lighting, which is a necessity for those who do not have access to electricity.

2.3 Another objective may be to provide merit goods to consumers such as clean cooking fuels like natural gas, LPG and kerosene to replace use of biomass-based fuels such as firewood and dung. These biomass based fuels create indoor air pollution that causes respiratory diseases, eye infections and result in many premature deaths, particularly of women and children. Also, use of firewood encourages deforestation and dung is better used as a fertilizer. Moreover, the task of gathering these fuels keeps girls away from schools. Thus, use of clean cooking fuels has many social and environmental externalities, and as merit goods the government may promote them through subsidies.

2.4 Another frequently reported reason for Government's intervention is to insulate the domestic economy from the volatility of petroleum prices on the world market. It is feared that complete pass-through of increase in world oil prices may cause inflation which may persist even when oil price comes down. There is no clear evidence that in an increasingly open and competitive economy, price movements triggered by changes in the prices of oil products would persist over the medium-run. In addition, attempts to insulate the domestic economy against volatility requires discriminating between a secular price rise due to demand-supply forces and a price rise due to transient causes such as speculation in the world market. This is difficult to do.

2.5 To the extent the level of self-sufficiency in domestic oil production increases, the impact of international oil prices on domestic economy would be reduced. Thus, keeping domestic oil firms viable and in good financial health and providing an environment in which they can grow are also important policy objectives. It is equally important to keep domestic private sector firms viable as it is to keep public sector firms viable. A level playing field between public and private sector firms as well as among public sector firms is desirable to promote competition.

2.6 A major objective of policy is to have an efficient and competitive oil economy that promotes efficient use by consumers, appropriate choice of fuels among substitutes and a proper choice of technique. This is best ensured by a competitive energy sector.

2.7 Intervention through price control necessitates that someone bears the financial costs. The issue therefore is to assess the costs and incidence of the burden of alternative mechanisms on different groups in the society. On whom the burden falls depends on the policy and the instruments used. If the costs are financed by a general increase in taxes, or by increasing fiscal deficit or by cutting other government expenditure, all these affect certain sections of the people adversely.

2.8 Price control means setting prices. If it is done on a cost-plus basis, it creates incentives for gold plating and creative accounting. Also, price calculations involve rigid specifications of items to be considered and their costs. This discourages innovation. For example, storage of LPG in large underground caverns facilitates imports by larger ships and reduces unloading time compared to storage in over-ground tanks. But, it may involve increase in operating costs. If the cost formula has set item-wise limits on operating costs, the project may be discouraged even if its total cost is much less.

2.9 If prices are to be fixed by the Government, that has to be based on some principle. Prices can be fixed based on pre-determined formula, which is derived from principles like import parity (IPP), trade parity (TPP), or export parity (EPP). This approach is also fraught with major deficiencies. The formula often involves elements of cost-plus. In an industry, which is continuously changing, a prescriptive and biased cost-plus pricing formula requires continuous monitoring and periodic adjustments in certain components of the formula. For instance, there is no single or unique formula for import parity which is applied globally (Note 3, Appendix). The Rangarajan Committee (February 2006) suggested a pragmatic approach of TPP for pricing of petrol and diesel which was accepted by the Government. It has, since then, been applied to petrol and diesel.

2.10 Price control, subsidies and taxes can introduce distortions which may not be desirable. Apart from inefficient use, it also leads to erroneous choice of technique. For example, if diesel is cheap, it may encourage freight movement by trucks rather than by train. When the price difference between petrol and diesel is high, diesel driven vehicles may be preferred. If there is a large difference between the prices of diesel and kerosene, kerosene may be used to adulterate diesel. In 2008, we have even seen diesel being used in place of furnace oil. Intervention in pricing must be carefully thought out for its possible consequences.

To read the full report: PETROLEUM PRODUCTS

>Oil Marketing Companies (JM FINANCIAL)

Kirit Parikh Committee – Logical recommendations but implementation difficult.

Logical recommendations: The Kirit Parikh Committee report has recommended a series of measures to make fuel prices in India sustainable and viable. These recommendations include increasing Kerosene prices by Rs6/lit (c.65% increase), increasing LPG price by Rs100/cylinder (c.30% increase) and totally eliminating the subsidy on Auto fuels – Petrol (or Motor Spirit) and Diesel. The Committee has also recommended that the under-recovery on LPG and Kerosene could be shared by the upstream companies like ONGC and OIL in a graded method based on the prevailing crude price.

but implementation unlikely to be easy: These recommendations make economic sense and we would be happy to see them implemented. We believe that increasing Petrol price is the easiest option as the increase required to bring Petrol price to International parity price is just c. 8% or Rs4/litre. In diesel, the increase required to eliminate under-recovery is just about 6% or c. Rs2/litre. However, given the concerns on inflation (particularly food articles inflation), we believe that it may not be easy to implement even a small increase in diesel price. We also believe that it will be impossible to implement a 65% increase in Kerosene price and a 30% increase in LPG price and the only solution is to increase the product prices in a phased manner (if international prices do not increase in the meantime).

Unless implemented fully, impact on under-recoveries minimal: We estimate FY10E total under-recoveries to be c. Rs451bn with LPG and Kerosene contributing c. Rs313bn and Rs138bn under-recovery due to Petrol and Diesel. These estimates are based on current crude and product price and current forex. LPG and Kerosene subsidies make c.69% of the total under-recoveries and if the prices of these products are not raised, this will be just another committee with one more report.

Impact on companies: The Oil Marketing Companies – Indian Oil, Bharat Petroleum and Hindustan Petroleum are likely to benefit primarily by way of improved cash flow. ONGC and OIL India would benefit as there would be a clear and transparent method of calculating the under-recovery. The biggest beneficiary of the recommendation is likely to be GAIL, which has not been mentioned and is therefore likely to be excluded from the under-recovery process. In FY10E, GAIL has already borne under-recovery of Rs9.9bn in 9MFY10 and therefore on an annualized basis, EPS of GAIL would improve by c. Rs6.7/share.

To read the full report: OIL MARKETING COMPANIES


Building a steadier tomorrow for itself: The cover page of HUL’s 2002 annual report read: “We do not inherit the world from our ancestors. We borrow it from our children”. We are keen to believe that HUL’s laundry price adjustments (c.12% cut in Surf, c.25% in Rin) and all other initiatives to offer ‘better consumer value’ reflect steps towards building a steadier future for itself. 4-5%-pts market share losses in laundry/soaps over past 12 months coupled with prolonged period of sub-peers growth rate highlighted that HUL’s stance of aggressive price hikes and margin-consciousness (we suspect some of this was even at the cost of product quality) weren’t really the most optimum strategies in a fiercely competitive market place. Given its distribution muscle, a right price-cum-quality value mix is perhaps a good first-step to help HUL address the issues. In our end-Dec’09 management meeting, HUL’s CFO had indicated that the company remains committed to participating in the huge growth opportunity in the Indian
market, even if (hypothetically) it brings with it the need to lower its operating margin-profile from the current level. Refer our report “CFO meeting notes: portfolio, premiumisation & profitability” dated 23 Dec 09 for details

8-10% earnings and TP cut; will there be light?
Near-term earning weakness imminent; cutting FY11-12E EPS by 8-10%: While HUL’s aggressive ‘competitive growth’ strategy appears to be the right step, near-term earning weakness is imminent. As per our workings, the pricecuts are likely to result in 5-6% cumulative drop in laundry realization over FY10- 11E and a 225-250bps compression in soaps & detergents segment gross margin. We estimate Surf and Rin’s share in HUL’s laundry revenue to be 30-35% and 15-20% respectively. Note that the cumulative drop in laundry realization over 2003-04 (P&G price war) was c.6%. We have, however, cushioned some margin impact by building in moderation in A&P growth going forward as: (a) HUL has already hiked spends aggressively in FY10, (b) Lower prices may gradually replace A&P. We are also assuming that HUL’s cost savings plan will continue to yield results.

Reducing target price to Rs253; continue to prefer ITC for a premium growth profile: We have lowered our FY11-12E EPS by 8-10% based on the effected price adjustments (P&G yet to react but is quite likely to), ‘equalization’ of prices of other Surf and Rin SKUs and building in slight cut in Wheel as well. Our revised EPS estimates for FY10-12E are Rs10.0, Rs10.6 and Rs12.2. We continue to prefer ITC on account of its premium growth profile. Refer our note on ITC “Portfolio power: multiple drivers of growth” dated 25 Jan 10 for details.

To read the full report: HUL


ACC’s 4QCY09 result was considerably below our expectation. Standalone sales increased 2% YoY to Rs19.2bn, against our estimate of Rs19.4bn. PAT declined 7% YoY to Rs2.8bn against our estimate of Rs3.7bn. The negative surprise was primarily due to an unexpectedly steep fall in realisations, coupled with an increase in other expenses. Realisation dropped on account of a sharp fall in prices in the key central and south regions. Prices have recovered sharply in the central region, which accounts for ~25% of ACC’s total cement volumes. We expect the positive news flow from the central region to boost the performance of ACC’s stock in the short term. That said, the valuation is not cheap; we continue to prefer Ambuja Cement, which has a better regional mix and reasonable valuations, in our view. We have tweaked down our estimates, and retain REDUCE on ACC.

Sharply below expectation

Muted volume growth: ACC's cement volumes declined 2% YoY on account of poor demand in the south and capacity constraints in other regions. A major part of ACC's expansion in Bargarh, Orissa, was completed in 3QCY09. The 3mtpa expansion in Wadi, Karnataka is likely to start by mid-2010 (about six months later than the original schedule). The delay in expansion in Wadi is likely to lead to moderate volume growth in CY10.

QoQ realisation fall steeper than expected: ACC's cement realisation increased 4% YoY but declined 9% QoQ. Prices in the central region have rebounded sharply. However, with likely depressed prices in the south and moderate price declines in other regions, we expect the overall realisation to remain under pressure in CY10 as well.

To read the full report: ACC