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OMCs | Attractive bets led by strong marketing and refining margins

…SG GRM at US6.1/bbl in 2HFY22_YTD

* Due to global refinery closures, conversion to Logistics terminals/bio-fuels, and delays in upcoming capacities due to the COVID-19 outbreak, the global refinery utilization rate is expected to rise by CY30. SG GRM has already risen to USD6.1/bbl in 2HFY22 YTD.

* Oil Marketing Companies (OMCs) have used the cut in excise/VAT, to raise their marketing margins on Auto fuels to INR3.5-6.1/lit in 2HFY22_YTD despite surge in oil prices.

* The sharp underperformance of OMCs since the outbreak of COVID-19 has been due to concerns on marketing margins, amid rising oil prices, uncertainty on throughput/sales and suppressed refining margins. As the world moves away from lockdowns for handling the pandemic, we see sustained GRM of USD6.1/bbl in 2HFY22 YTD, despite rising COVID-19 cases. We reiterate our Buy rating on IOCL and BPCL, while remaining Neutral on HPCL due to its rising debt, interest cost, reducing leverage to marketing as well as project execution risks.

Marketing margins remain strong

* Gross marketing margins on Auto fuels stand at INR3.5-6.1/liter in 2HFY22 YTD compared with INR5.8-6.2/liter in FY21 and INR3.2-4.9/liter in FY20. Despite OMCs guiding for a reversal to mean of ~INR3/liter of gross marketing margins, sustained high gross marketing margins make a case for extrapolation.

* Our forecast of INR3.3/liter is still aligned with the management’s guidance. An INR1/liter change in the gross marketing margins of Auto fuels alters the FY23E EPS of IOCL/BPCL/HPCL by 28%/28%/39%.

* On a blended basis across all products, gross marketing margins, including inventory, has risen to INR5.8-6.6/liter in 1HFY22 from INR6.3-6.9/liter in FY21 and INR3.9-4.6/liter in FY15.

Refining margins remain strong

* As a result of consolidation in the US, operable refining capacity has shrunk to 18.1mnbopd in CY21 from 19mnbopd in CY20 (refer Exhibit 2).

* Due to further consolidation, global refinery utilization rates are expected to tighten by CY30, as per IEA (refer Exhibit 3).

* Despite a surge in COVID-19 cases, the world doesn’t appear to be heading for a complete lockdown once again. As a result of which, GRMs have averaged USD6.1/bbl in 2HFY22 YTD. This bodes well for Indian refiners. We build in FY23E/FY24E GRMs of USD5-5.5/bbl for OMCs. A USD1/bbl change in GRM alters the FY23E EPS of IOCL/BPCL/HPCL by 19%/13%/14%.

Mouth-watering valuations

* Since the deregulation of diesel in 2010, OMCs have traded at average one-year forward P/BV of 1.1x/1.9x/1.2x for IOCL/BPCL/HPCL. Compared with that, IOCL/BPCL/HPCL are currently trading at 0.8x/1.6x/1x. Part of the de-rating is also due to the expectation of electric vehicles (EVs) taking away share of Auto fuels in transportation. In our earlier report, we had highlighted how EVs would threaten the market share of traditional players like CGDs and OMCs.

* Transportation fuels are witnessing an ever-changing landscape. It increasingly appears that EVs would transition towards hydrogen fuel. As hydrogen is similar to the current fossil fuels in terms of transportation and dispensing, it would require investments and infrastructure like retail outlets, which only players like OMCs can afford.

* While OMCs may lose market share to EVs in the interim, the future remains bright if they continue to invest in the hydrogen ecosystem.

* We reiterate our Buy rating on IOCL, valuing the stock at 1.1x Dec’23E BV. We expect a FY23E/FY24E FCFF yield of 8.2%/9.5%. We reiterate our Buy rating on BPCL, valuing the stock at 1.8x Dec’23E BV. We expect a FY23E/FY24E FCFF yield of 7.3%/7.5%. Stabilization of the polyols complex at Kochi and widening of LtHv differential is expected to add to Kochi refinery GRM.

* We have a contrarian call on HPCL as highlighted in detail in our earlier report. Valuing it at 1x Dec’23E BV, we reiterate our Neutral rating on the stock.

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