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OMCs: Risk/reward better as earnings outlook improves
Of the two main earnings drivers in oil marketing companies (OMCs), auto fuel net marketing margins have been super-normal in FY19 and FY20-TD. Gross refining margins (GRM) were weak in the last three quarters, but have recovered sharply in Q2FY20-TD. IMO-mandated change in sulphur content in marine fuel is likely to keep GRM strong until CY20. To factor these trends, we have raised OMCs’ FY20E-FY21E auto fuel marketing margin and GRM estimates. Risk/reward is better now as OMC share prices are down 19%-24% from levels in early-Jun’19 despite improved earnings outlook. We have upgraded BPCL to BUY and HPCL to ADD from Hold earlier. We reiterate ADD on IOC. BPCL, which is the best positioned OMC to gain from IMO-driven GRM strength, is our top pick.
Marketing margins super-normal in FY19-FY20-TD; raise FY20E estimate; further upside not ruled out:
Auto fuel net marketing margin is super-normal at Rs1.89/l in FY20-TD and Rs1.83/l in FY19 vs Rs0.97-1.07/l in FY15-FY18. The reelection of a strong government during whose previous tenure margins were strong also augurs well for auto fuel margin outlook. We have raised our net margin estimate for FY20E-FY21E to Rs1.25/l from Rs1/l earlier. Our revised forecast implies net margin of just Rs0.92/l in the rest of FY20. Further upside to our net margin estimate is not ruled out. HPCL would gain the most from higher margins.
IMO to keep GRM strong up to CY20:
Reuters’ Singapore GRM, which was weak at US$3.3/bbl in H1CY19, has surged to US$6.8/bbl in Q2FY20-TD boosted by permanent closure of a US east coast refinery. IMO mandated changes in marine fuel are estimated to boost global diesel demand by 0.2-0.9m b/d but reduce fuel oil demand by 0.3-1.6m b/d in CY19-CY20. We have raised our FY20E-FY21E GRM estimates for OMCs from US$4.5-6.0/bbl to US$5.8-6.8/bbl. Weaker than estimated demand growth and large refining capacity addition are risks to our GRM estimates.
BPCL our top pick:
Among OMCs, BPCL is our top pick as: 1) it stands to gain the most from IMO-boosted GRM as it has the most diesel and least fuel oil in its product slate; 2) its GRM would also benefit from projects that boost petrol and propylene yields and reduce naphtha yield in its product slate; 3) it would be the least impacted by Euro VI related refinery shutdowns in FY20; and 4) its large capex phase is already done. Capex as proportion of cash profit is estimated at 73%- 83% for BPCL, 180%-194% for HPCL and 103%-111% for IOC in FY20E-FY21E.
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