We believe Street's renewed rhetoric on the potential increase in marketing margins may take time to play out for OMCs given rising competition from private players over the next few years amid slower volume growth; a daily change in fuel prices, if implemented, will moderate earnings volatility to begin with. We expect OMCs to benefit from a robust refining cycle instead, driven by continued improvement in global utilization amid firm demand and slower capacity addition. IOCL remains our top pick and preferred over BPCL and HPCL given comfort on earnings and valuation.
Rising competition amid slower demand growth may prevent material expansion in margins
We see limited merit in the Street's argument of imminent expansion in marketing margins on auto fuels for OMCs by juxtaposing benchmarks of global peers given presumable differences in the operating environment and competitive dynamics. It is worth noting that marketing margins on auto fuels have remained steady, at best, over the past two years post deregulation despite a marginal presence of the private players in retail network and a strong growth in fuel demand. With reversal expected in both, it is unlikely that marketing margins will expand materially over the next few years until private players gain their fair share in the market. Private refiners, Essar Oil and RIL, have gained a modest ~5% share in auto fuels retail volumes as compared to their 8.5% share in retail outlets and 27% share in domestic petroleum refining business.
Marketing margins may not be determined by frequency of change in fuel prices
A daily change in fuel prices instead of current fortnightly revision, if implemented, will (1) enhance OMCs' ability to make gradual changes in prices avoiding any intermittent interventions, (2) reduce volatility in earnings from sharp fluctuation in global petroleum prices during fortnights and (3) eliminate irregularities due to inventory management by dealers on expectations of upward/downward revision in fuel price. However, none of these have impacted recurring profitability of OMCs as much and may not necessarily translate into a material increase in marketing margins on auto fuels, in our view. On the contrary, daily changes in prices could improve comfort around sustainability of deregulation in higher crude price environment as well and accelerate participation from private players such as RIL.
Refining segment to benefit from a robust cycle driven by improvement in operating rates
We expect downstream companies to benefit from a robust refining environment driven by a continued increase in operating rates, reflecting (1) strong growth in global petroleum demand and (2) slower refining capacity additions. IEA's forecasts of 3.9 mn b/d of growth in petroleum demand over CY2017-19E is well ahead of our bottom-up calculation of 3.3 mn b/d of net refining capacity additions during the same period and 0.3 mn b/d of incremental NGLs supply; actual addition to refining throughput will likely be slower and lower as the new capacities will take some time to ramp up utilization post commissioning. We expect overall refining utilization to remain above 90% over the next few years with OECD refining utilization already near 88%.
Fine-tune estimates and TPs; retain BUY on IOCL and REDUCE/SELL on HPCL/BPCL
We fine-tune our estimates for OMCs factoring in (1) modest changes in refining and marketing assumptions and (2) revised exchange rate forecasts by our economics team. We reiterate our BUY on IOCL with a revised TP of Rs470 (Rs440 previously) rolling over to March 2019E, while maintaining REDUCE and SELL on HPCL and BPCL with revised TPs of Rs550 (Rs480 previously) and Rs675 (Rs640 previously) respectively. We expect IOCL to benefit from ramp-up in utilization across all units at Paradip refinery over the next few quarters and likely slower capex in the medium term. On the other hand, we see risks to cash flows of BPCL and HPCL in the medium term from their proposed investments in upstream business and Rajasthan refinery, respectively.