Whalesbook
Brokerage Nomura has expressed a preference for Indian Oil Corporation (IOC) over peers BPCL and HPCL, citing better refining profitability. The firm also highlighted potential in city gas distributors Mahanagar Gas and Gujarat Gas.
What Happened
Brokerage house Nomura has released a report outlining a strategic preference for Indian Oil Corporation (IOC) over other state-owned oil marketing companies, specifically Bharat Petroleum Corporation (BPCL) and Hindustan Petroleum Corporation (HPCL). The report suggests that IOC is better positioned to navigate current industry challenges, primarily due to its integrated business model which leans more heavily on refining operations.
Alongside this shift, the brokerage noted value in the City Gas Distribution (CGD) sector. It pointed to Mahanagar Gas and Gujarat Gas as preferred picks, citing improving sector dynamics and expectations that profit margins in this segment may have already hit their lowest point.
Refining Margins and The Business Model
To understand why the brokerage favors IOC, it is helpful to look at how these companies operate. Indian Oil Marketing Companies (OMCs) essentially have two main sources of profit: refining crude oil into fuel (the refining margin) and selling that fuel at retail outlets (the marketing margin).
When global refining margins—often measured by "crack spreads," which is the difference between the price of raw crude oil and the price of finished products like diesel—are high, companies with large refining capacities tend to benefit more. IOC, being a large refiner, acts as a hedge when these margins soar. In contrast, BPCL and HPCL rely more heavily on their retail marketing networks. When the government restricts retail price hikes despite rising global costs, these marketing-heavy companies often face more pressure on their earnings.
The Challenge of Under-Recoveries
Investors in this sector often track the concept of "marketing under-recoveries." This occurs when the government keeps the retail selling price of petrol, diesel, or LPG steady, even while the cost of importing crude oil rises. In such scenarios, the OMCs must absorb the difference, effectively selling the product at a loss.
State-owned OMCs, including IOC, BPCL, and HPCL, frequently deal with this balance. The brokerage's preference for IOC stems from its view that IOC’s higher integrated margins and refining capabilities provide a stronger buffer against these losses compared to its peers. Essentially, when refining is profitable, it helps offset the potential losses or lower margins from retail fuel sales.
The Outlook for City Gas Distributors
Beyond oil, the focus on city gas companies like Mahanagar Gas and Gujarat Gas is tied to the growing demand for natural gas in India. Natural gas is viewed as a cleaner alternative for both transport and industry.
Recent years have seen these companies face pressure due to global price volatility and changes in domestic gas allocation policies, which forced them to buy more expensive imported gas. However, the brokerage suggests that the worst of these margin pressures may be behind them. With demand for Compressed Natural Gas (CNG) remaining resilient because it is often cheaper than petrol and diesel, these companies could see more stable profit outlooks as supply and pricing dynamics improve.
Risks and Concerns
Investors should remain cautious of several factors that affect the energy sector. The most significant risk remains government policy. Because retail fuel prices are sensitive, government intervention to prevent price hikes can impact the profitability of all OMCs, regardless of their refining strength. Additionally, global crude oil prices are volatile and heavily influenced by geopolitical events in West Asia and other major production hubs. A sudden spike in crude prices, if not matched by retail price adjustments, can quickly erode profit margins.
For the gas sector, the primary risks involve the cost of imported Liquefied Natural Gas (LNG). If global gas prices rise again, it could force these companies to hike prices for consumers, which might eventually dampen demand. Furthermore, any changes in government-mandated gas allocation quotas can directly impact the cost structure of these companies.
What Investors Should Track
Moving forward, shareholders may want to monitor several key indicators:
- Global Crack Spreads: These indicate how profitable the refining of diesel and aviation fuel is. High spreads generally favor refiners like IOC.
- Retail Price Revisions: Any news regarding changes to petrol, diesel, or LPG prices is critical, as it directly impacts the marketing margins of OMCs.
- Crude Oil Prices: Movements in Brent crude directly influence the input costs for the entire energy value chain.
- Gas Allocation and Pricing: Updates from the government regarding domestic gas supply for CGD players will be a major monitorable for the stability of their profit margins.
- Government Compensation: Any announcements regarding subsidies or financial compensation for under-recoveries can significantly alter the financial health of the OMCs.