There are several reasons why the domestic government owned oil companies (especially the upstream companies) are analysed with a fair bit of scepticism – their reserves fluctuate with respect to the crude oil price, their asset block is hard to figure out, the management is appointed by the Government of India and they have been saddled historically with subsidies that the government provides to its citizens.
Although these oil subsidies are an integral part of the economics of an Oil Exploration & Production company, they are generally invisible in their financials since the subsidy is indirectly applied by the upstream companies when they sell the crude oil to downstream companies at a discount to the realizable price (this benefit flows to the final consumer). Historically, the subsidy burden was shared between the Government, the upstream oil companies and the downstream companies (oil refining and marketing companies) on the following lines –As can be seen from the chart above, the Government has shared the bulk of the expense followed by the upstream oil companies. It is also noteworthy that in the 3 of the last 12 years, the downstream companies were not subject to any subsidy sharing (2009, 2012 and 2013), due to their poor financial health.
The biggest possible change has come about in 2016 and 2017. Not only did the total subsidy decline from the peak of INR 1,610 bn in 2013 to 227 bn in 2017 (~85% decline), but the share of upstream companies burden has also come down significantly.
Reasons for Decline in Subsidy –
a. Decline in Crude Oil Prices
From the most recent top of 104 USD per barrel (USWTI prices) in May 2016, crude oil prices bottomed out at 26 USD per barrel in 2017 (a drawdown of 75%), resulting in India (a heavy importer) paying a much lower import bill and therefore applying a lower subsidy.
b. Decontrol of High Speed Diesel Prices
Historically, subsidies were provided by the Government on 4 end use commodities – Petrol, High Speed Diesel, Kerosene and LPG. With decontrol (removal of subsidy) of petrol prices in 2011(low impact), followed by de control of Diesel prices in 2015 (high impact), a large part of subsidy burden was removed as the prices of these commodities were now decided by the 3 competing OMCs and became market driven.It is pertinent to note here that the subsidy burden shared between the Government and the oil companies is not based on the composition of the subsidized sales in an oil company’s revenues. To illustrate – in case of India’s largest oil producer, for 2014, only 37% of revenue was under subsidy (LPG + Diesel + Kerosene), however, the subsidy share it was allocated was 68% of its revenue. Allocation of subsidy is based on total oil products consumed in India, irrespective of whether they are produced locally or imported.
Going further with the case study, subsidy burden has had a significant financial impact on this company, as can be seen from below –
|Subsidy per share||9||13||17||22||9||19||35||39||44||28||–||–|
|as a % of net Sales||23%||30%||35%||44%||19%||38%||58%||60%||68%||44%||–||–|
|Return on Equity||28%||28%||26%||21%||19%||20%||19%||16%||15%||10%||8%||9%|
While the upside of increase in crude oil price has been capped for this oil producing company, the downside has no protection as the declining realizations do not get any support from the government policies, post which the company’s financials have deteriorated in the last 2 years.
With decontrol of prices in petrol and diesel, fortunes of the downstream companies, viz. the refiners and the Oil Marketing companies (OMCs) improved significantly as their cost of inputs decreased while they were no longer under any price control and could thus raise prices at the retail level, as can be seen from below –
We have considered RoCE and not RoE here, since the financial leverage of the 3 companies above are not comparable.
With the financial trajectories of various companies in the crude oil value chain going askew with the commodity prices and government policies, we are at an investment crossroads, and the most important question to ask is –
Can the low subsidy environment sustain?
1.The petrol and diesel price at the retail level in New Delhi at the March of every year have been as follows –The decline in prices at the retail level do not mirror the decline in crude oil prices, because of significant increases in excise duty undertaken by the Central Government (especially in Diesel) as can be seen from below –2. As more and more households move to LPG for cooking with increased availability and geographic reach, the use of kerosene has been in a decline over the long term, as can be seen from below –
In early 2015, after diesel price was decontrolled and the subsidy was provided only on Kerosene and LPG, the government entered into a new subsidy sharing formula with upstream oil companies, which is as follows –
|Crude Oil Price||Amount of Subsidy shared by upstream companies|
|Below 60 USD per barrel||0%|
|60 – 100 USD per barrel||85% of incremental cost|
|Above 100 USD per barrel||90% of the incremental rate|
Downstream companies were kept out of the subsidy sharing ambit.
However, this formula was again tweaked in August 2015, with capping the kerosene subsidy provided by Government at INR 12 per litre and LPG subsidy at 18 per kg for a 14.2 kg cylinder. With this, the Government’s share of total subsidy was capped at 380,000 million INR, above which all of the subsidy burden would be borne by the upstream oil companies.
Today, with the crude oil trading above 70 USD per barrel, with Oil Marketing companies increasing fuel prices at the retail level, there are multiple scenarios that can be contemplated –
- The Central Government reduces the Excise Duty on petrol and diesel, thereby keeping the final prices unchanged while OMCs continue their price hike (limited decrease possible due to fiscal position).
- The OMCs are able to absorb the increase in international crude oil price (low probability given the legacy inefficiencies in the cost structures as well as wafer thin margins)
- The OMCs continue taking price increases that are absorbed by the final consumers (with the risk of a strong political backlash, again lower probability)
- The Government re-introduces subsidy on petrol and diesel.
It would be imprudent for us to invest our thought process into forecasting where the crude oil prices are headed or how the government intends to combat it with new subsidy rules, but what we think of as a probable outcome is that – if low crude oil price environment is not permanent, then the subsidies, in different forms, will inevitably follow. These subsidies not only counter the increase in crude oil prices, but a part of it also shrouds the inefficiencies inherent in the government run business.
More often than not, we have observed that government companies operating in sensitive industries have had a lacklustre record for good capital allocation or practicing shareholder stewardship because its priorities are very different than those of a private enterprise and for the stakeholders that motivate the operation of these entities, maximizing the shareholder wealth in the long term may not be the primary objective.
Thus, despite their utility nature and government patronage, we do not conceive of these businesses as good quality businesses.
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