Opportunity in refinery stocks

Refineries have been standout performers during Q3, 2019-20 (October-December 2019). This is because international crude and gas prices have remained low during this period. This is one of the few positives of a slow-growth global economy.


On average, the Indian crude basket cost $62.6 per barrel between October-December 2019. The average price for the fiscal (April-December 2019) was $64. It would have been even lower but for tense Iran-US relations. This was substantially less than the $69.9 per barrel average of 2018-19 and also less than the $67.75 of October-December 2018.


Five refiners/marketers (including Reliance Industries or RIL) have reported Q3 results so far. They registered an aggregate 50 per cent improvement in year-on-year profitability and a jump in aggregate operating margin of about 2.5 per cent.


If we exclude RIL (due to the company’s other divisions), the results remain impressive. Indian Oil (IOCL) and HPCL have seen profits climbing by 378 per cent and 402 per cent respectively, while Chennai Petroleum Corporation has moved from loss to profits and Mangalore Refinery and Petrochemicals (MRPL) has very substantially reduced losses. 


The slowdown in India’s economy is apparent from the fact that crude imports have reduced marginally during 2019-20, compared to the year before. This is yet another data-point, which is hard to reconcile with an economy that is growing, albeit at a reduced pace.


One effect of the newly named Covid 2019 has been a dip in global energy demand. Crude and gas prices have adjusted downwards as a result. February has seen the Indian basket running at well below $60. Given downgrades to global growth projections, energy prices are very likely to remain low for the rest of the year. The major caveat while making this prediction is geopolitics — further escalation in the Iran-US situation, or some other event that impacts supply — could lead to a panic spike in energy prices.


Assuming such a situation doesn’t occur, there’s a good chance that refineries could continue to register decent profitability gains. This would be useful for the disinvestment agenda, apart from taking pressure off the Trade Account and reducing the government’s subsidy burden.  So the sector is likely to receive a lot of trader attention.


Fertilisers could be another sector for the bullish trader to focus upon. Profitability increases for fertiliser companies whenever crude and gas prices fall. In addition, the government appears to be pushing an agenda of trying to boost rural consumption, and that should be good for fertiliser companies. The complexity of subsidies enters the picture, of course, but if you believe energy prices will stay down, and you believe that there will be some sort of boost to rural consumption, fertiliser companies should do better. Lower fuel prices should also translate into a bounce for aviation, and maybe, reduce the expenditure burden for telecom.


There are few signs of recovery in other sectors. Banks have registered a spike in profitability in the last quarter due to the Essar Steel Resolution. Everything else indicates consumption demand is down, and so is investment, precisely because consumption demand is down. The auto sector, for example, is operating at below capacity and that affects activity up and down the chain—in steel demand, auto ancillaries, advertising, financing, etc.


Valuation of listed PSUs in the refining/oil marketing sector will also be driven by government policy and guesses about movements on the disinvestment front. If the market believes that there will be a genuine strategic sale that leads to more efficient performance by BPCL, that will be factored in as a positive. However, the track record in terms of cross-holdings doesn’t inspire too much confidence.


Reliance is an interesting outlier for the sector. The company has been cash-flow negative for years. It has poured huge sums into telecom and retail. There was at least one downgrade by a prominent brokerage after RIL declared Q3 results. While retail and telecom have grown quickly, RIL is still very dependent on the core division for its cash-flows. Good quarters for the core business cannot hurt!


Energy prices are usually excluded when calculating “core inflation”. That’s because they can change suddenly and sharply. Even though the best guess is that crude and gas prices will stay low, anybody investing in refining, as opposed to trading these stocks, has to be aware of that.

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