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Rising oil prices a boon for producers, others to feel the pinch

Crude oil had a near death experience in 2016, but you won’t know it if you saw current price levels. Earlier this year, prices dropped to lows that were not seen in more than a decade. On 20 January, Brent crude oil touched a low of $27.88 a barrel. 11 months down the lane, prices are hovering around $55 a barrel levels.

It was in late 2014 that the Organization of the Petroleum Exporting Countries (Opec) shifted its production strategy to defend market share rather than price. For a while now, oil producers have been producing more than demand. At the beginning of 2016 too, Opec and non-Opec producers kept producing at high levels amid tepid global demand. Concerns of slowing Chinese demand added to the woes.

After a while, oil prices found support from supply disruptions, stronger than expected demand and anticipation that the market will rebalance sooner than later in 2016, following forecasts of a deep fall in high-cost non-Opec output. The main turning point came at end-September when Opec decided to cut oil production, the first reduction since 2008, taking the markets by surprise. More details emerged in a November meeting, when Opec decided production levels for member-nations. This month, key non-Opec producers also agreed to cut output. These initiatives have given a new lease of life to crude prices and are expected to bring demand-supply balance in global crude oil markets.

Of course, implementation remains a key risk. Three major producers (Iran, Libya and Nigeria) in Opec with reasonable spare capacity have been kept out of the new production limits, analysts from Kotak Institutional Equities noted in a report on 16 December. Secondly, non-Opec countries are first-time participants in Opec’s crude supply management. Thirdly, US shale oil production could rise sharply on the back of higher crude oil prices. Kotak has forecast the global crude oil price at $50 a barrel for FY2017 and $55 a barrel for FY2018.

How do higher oil prices affect Indian companies? The table above shows the earnings sensitivity of Indian upstream oil companies to crude oil prices. Earnings per share of these companies increase as oil prices rise. In fact, strengthening crude prices is one factor that has helped these stocks outperform the benchmark Sensex in recent months. In keeping with the expectations of firmer oil prices, price realisations for Oil and Natural Gas Corp. Ltd (ONGC), Oil India Ltd (OIL) and Cairn India Ltd are expected to improve in financial year 2018. Also, realisations of Gail (India) Ltd’s liquefied petroleum gas (LPG) and petrochemicals business benefit from higher crude prices. So far in 2016, ONGC, OIL, Cairn India and Gail stocks have increased about 20%, 15.4%, 76%, and 15%, respectively.

But for the state-run oil marketing companies—Bharat Petroleum Corp. Ltd (BPCL), Hindustan Petroleum Corp. Ltd (HPCL) and Indian Oil Corp. Ltd (IOC)—higher crude prices lead to an increase in the “fuel and loss” component, say analysts. Fuel and loss refers to the cost that refiners incur due to the fuel consumed to run their plants and the fuel lost in the system while processing crude oil into petroleum products. Moreover, working capital requirements may also increase.

Currently these stocks trade in the range of 9-11 times estimated earnings for this financial year.

Lubricant makers—Castrol India Ltd and Gulf Oil Lubricants India Ltd—too are expected to be adversely affected. Their key raw material—base oil—is a crude oil derivative. Higher crude prices will lead to higher base oil prices. The impact of higher crude prices will show after a few months considering inventory levels and the lag effect in base oil prices. Also, to what extent these companies will pass on the burden to consumers will be worth watching in order to gauge the impact on profit margins. Rising fuel prices will also pinch consumers’ pockets. Higher oil prices are likely to cause some grief to consumers and companies that use it as an input, but should bring benefits to its producers.
Source: LiveMint

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