Is oil the new gold?

Oil is the new gold. Well it seems like it as most analysts agree that oil marketing companies are bound to outperform the markets!

After a bloody Friday, the market has suffered again from Monday blues, down 1.82 percent. But the oil marketing company (OMC) Indian Oil Corporation (IOC) is up 2.27 percent. HPCL and BPCL are up 2 percent and 1.8 percent, respectively over the past two trading sessions. ONGC is up 2.43 percent even today.

The immediate reason is evident with crude prices trading at $83.80 per barrel down from $86.88 on Friday. The total subsidy burden for oil is shared by the government (52 percent), upstream companies like ONGC, GAIL and Oil India (39 percent) and the OMCs (9 percent). So if crude prices fall, the subsidy burden goes down too. This means greater relief for the companies and improved cash flows.

Since September 2010, oil prices have gone up from $75 to $125 per barrel and the OMCs declined 50-60 percent. They were losing around Rs 500 crore per day, according to a report by Elara Securities, which came down to Rs 300 crore per day after the recent hike in prices. If price stay within $95-100, the OMCs were expected to lose around Rs 1,15,000 crore. With crude prices moderating, the losses might be much lower.

Ashutosh B of Nirmal Bang Institutional Securities says even if crude is around $5 below that price, subsidy burden would come down by around Rs 12,000 crore. With GDP growth slowing in many nations, he expects oil prices to hover around $105 in 2012 and at $100 in 2013.

Citigroup says, despite concerns about supply disruptions of crude, “a combination of higher OPEC production and lower possible demand growth could take crude to lower levels from here.” AK Hazarika, chairman and managing director of ONGC, also expects crude prices to be in the range of $95-100 per barrel though prices may not crash like it did in 2008.

The government of India is also working towards limiting oil subsidy as much as possible as they are trying to restrict number of cylinders and limit eligibility for subsidised LPG. Religare says, assuming a yearly allocation of 4-6 cylinders per household and a subsidy of Rs 300 per cylinder, LPG subsidies could shrink between US$ 0.6bn (Rs 2700 crore) and US$ 2.4bn (Rs 10,800 crore) which means almost 11-40 percent of total LPG subsidies.

The state oil companies will also strive to end discounts on diesel for railways, or sell fuel to airlines on credit. The total credit outstanding for airlines fuel is Rs 2400 crore for the industry. In case of diesel for railways, the discount hovers around 30 paise per barrel which BPCL has already discontinued and might be soon followed by the other public sectors OMCs.

No doubt then, that oil companies now feature in the wish list of analysts. Alok Deshpande of Elara Capital sees significant upside to oil marketing stocks while upstream companies like ONGC and Oil India might find it difficult to increase production substantially despite improvement in valuations due to government reforms. But OMCs will benefit both from growing business at 8-9 percent each year and the triggers in valuations that declining subsidy burden could bring.

Though people have a tendency to avoid these stocks due to their heavy dependency on government subsidy and volatility of crude prices, the OMCs have generated a return of 21.3 percent against a Sensex return of 9.9 percent over the past three years.

BPCL is the top pick for Elara with a target price of Rs 800 (current price: Rs 701). BPCL will be self-sufficient with the Bina refinery operations on one hand while on the other, its stakes in assets in Brazil seeing good execution traction, will bring higher profits. IOC is the top pick for IIFL as only 30 percent of its operating profits come from controlled products making it least exposed to government subsidies. They have a target price of Rs 400 which means s 17.6 percent return. Religare also maintains a positive stance on oil PSUs with preference for ONGC (Target price: Rs 35), IOCL (TP: Rs 455/sh) and HPCL (TP: Rs 470/sh).

Since price hike and tax cuts on 24 June, 2011, the government oil company stocks have gone up only 3-11 percent. This means the people have ignored the gains from such reforms, mainly because of high crude prices. Bank of America Merrill Lynch also suggested in a recent report that with reforms facilitated and crude prices falling, oil companies must do well. And we agree.