HPCL

The stock of Hindustan Petroleum Corporation Limited (HPCL), the government-controlled downstream oil refining and marketing major, has run up sharply since the fuel pricing reform measures late last month.



This sprint on the back of euphoria that subsidy overhang on the oil marketing companies (OMCs) will be a thing of the past may, however, be overdone. Developments over the past week, which resulted in some price moderation, reinforce this opinion.

That said, investors with a long-term perspective and high-risk appetite can stay invested in the company, given the significant refining capacity in Bhatinda expected to come on-stream next year.

At its current price of Rs 448, the stock has gained around 28 per cent since the fuel price reforms and discounts the company's trailing 12-month earnings by 10 times. Though this is lower than BPCL's 14.6 times, the stock trades higher than its other peer Indian Oil (8.6 times).

Overboard on exuberance

Key, long-pending fuel pricing reforms announced in the last week of June raised hopes of an unshackling of the oil industry, and resulted in a sharp run-up in the stocks of public sector oil companies, including HPCL.

However, while the reform measures are a positive first step the problem is far from over and the markets seem to have gone overboard in their euphoria.

Under-recoveries for FY-11 at current crude oil price levels are still at a significant Rs 52,000 crore. Also, the indicative subsidy-sharing mechanism spelt out by the Oil Secretary last week may result in both upstream and downstream companies having to pull more weight in the current fiscal than in FY-10. Up to 17 per cent of the under-recovery may finally have to be borne by the downstream companies in FY-11.

In FY-10, HPCL had to bear under-recovery of Rs 1,226 crore, accounting for more than 80 per cent of its consolidated net profits for the year.

Going by recent announcements and assuming a similar share as in the last fiscal, HPCL may end up bearing in excess of Rs 1,900 crore in FY 11.

Also, despite announced intent, free diesel pricing may take quite some time to come. Besides, a clear time-frame has not been announced regarding disbursement of cash compensation for the government's portion of the under-recovery.

This may require downstream companies to continue to resort to borrowings, with the concomitant high interest costs. Net-net, variability in earnings and uncertainty in cash flows still continue for the downstream companies.

In addition, petrol pricing decontrol may be a double-edged sword. While it reduces under-recoveries, , it may also pave the way for the re-entry of formidable private sector competitors such as Reliance Industries, Essar Oil and Shell in fuel retailing.

The last time this happened in the first half of the decade, public sector incumbents lost significant market share. The scenario may repeat itself, though it remains to be seen if private players will take the plunge pending diesel pricing decontrol. Given the above uncertainties, we suggest keeping a close eye on the evolving dynamics.

Expansion on anvil

HPCL's planned 9 mmtpa refinery at Bhatinda, in a joint venture with Mittal Energy, is expected to be commissioned by June 2011.

This refinery, in which HPCL has 49 per cent stake, will add significantly to the company's existing refining capacities (the 6.5 mmtpa Mumbai refinery and 7.5 mmtpa Visakhapatnam refinery).

In addition to strengthening its presence in North India, the Bhatinda refinery, with its high Nelson complexity, is also expected to help HPCL improve its gross refining margins significantly from current low levels.

Also, the company has announced plans to set up a 15-16 mmtpa refinery on the Maharashtra coast, entailing an investment of Rs 30,000 crore, to overcome space constraints in its Mumbai refinery.

The new refinery, which may come up over the next five to seven years, may free significant space at the company's Chembur (Mumbai) facility for real estate development. HPCL also has plans to set up an integrated petroleum, chemical and petrochemicals region in Visakhapatnam.

HPCL has been plagued by subsidy overhang and uncertain cash flows for several years now. Also, sharp fluctuation in crude oil prices has led to high variability in financial performance over the years.

Performance metrics

The company's physical performance points to stagnating refining throughput since 2007, though market sales and pipeline throughput has grown steadily.

In FY-10, market sales stood at 26.27 mmt while crude throughput was 15.76 mmt. Higher marketing-to-refining ratio makes the company more vulnerable to under-recovery risks.

The commissioning of the Bhatinda refinery next year will help moderate the ratio. Gross refining margins (GRM) have also declined sharply from $6.54 per bbl in 2008 to $2.68 in 2010. Margins should improve when the Bhatinda refinery begins operation.

On a consolidated basis, HPCL's sales have grown at an annual average of around 5.9 per cent during 2007 – 2010 to Rs. 1,11,468 crore, while its profits declined from Rs 1,674 crore in 2007 to Rs 1,475 crore in 2010.

The last fiscal's net profit was, however, almost 95 per cent higher than in FY-2009, when heavy inventory losses undermined performance. Interest cost has been steadily increasing, though FY-10 outgo at Rs 932 crore was much lower than the Rs 2,112 crore incurred in 2009, an exceptional year.

Net margin in FY-10 was quite poor at less than 1.5 per cent, though return on equity was reasonable at around 12 per cent.

In FY 2009, HPCL's debt-to-equity was around 2 times. However, the company has improved its debt service coverage ratio from 1.6 in FY-09 to 2.5 times in FY-10.

Risks/Opportunities

Sharp spike in crude oil prices will increase under-recoveries and may result in increased subsidy burden for HPCL.

It may also force government intervention to cap petrol rates, rendering the recent deregulation ineffective.

Upsides could result from success in the company's exploration and production operations (more than 20 blocks), which are marginal currently.

via BL