Partial decontrol: Why investors should not be cheering oil stocks yet

The government will permit state-run oil marketing companies to set diesel prices, Oil Minister Veerappa Moily said today, in a surprise move that could help the government reduce its budget-busting subsidy bill.

The partial decontrol sent shares of oil market companies - HPCL, IOC and BPCL - soaring minister M Veerappa Moily announced . State-run refiners currently sell diesel at a loss of Rs. 9.28 per litre, which is the most consumed fuel in India.

HPCL shares were up 7 per cent at Rs. 348.50 while IOC jumped 5 per cent to Rs. 310.70 at 1.35 p.m. BPCL shares traded 4.5 per cent higher at Rs. 398.8.

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The decision is the biggest market-boosting announcement after Monday’s GAAR deferral decision and the Sensex surged over 100 points after the govt decided to partially deregulate diesel prices.

However the market enthusiasm maybe a little overstated since the government did not give a time-frame or quantity for such price increases.

[caption id=“attachment_583637” align=“alignleft” width=“380”]  Ever since the government started dropping hints of a fuel price increase, ONGC and Bharat Petroleum Corp have rallied. HPCL has risen 21 percent since 21 December. Reuters[/caption]

In the current subsidy sharing arrangement, state-run explorers ONGC and Oil India Ltd sell crude oil to Indian Oil Corp, Bharat Petroleum Corp and Hindustan Petroleum Corp at a discount in order to partly compensate for subsidised fuel sales. The government pays offthe remaining subsidy.

Ever since the government started dropping hints of a fuel price increase, ONGC and Bharat Petroleum Corp have rallied. HPCL has risen 21 percent since 21 December.

However, some analysts warn that investors may be over-estimating the benefits, while the action is expected to face stiff political opposition.

Goldman Sachs in a note said that a full deregulation is unlikely given high inflation and political considerations such as the upcoming State Assembly elections in some major states in 2013 and the 2014 general elections, which are likely to act as strong deterrents in its implementation.

“Partial hikes to reduce diesel under recoveries could lead to a sharp sell-off in OMC stocks such as HPCL and IOC as we believe they are currently pricing in much more than that.”

“While we believe that the de-regulation is far away, the partial price increases will have market participants factoring higher probability of de-regulation,” Edelweiss said in a note today.

Analysts have also said only upstream state-owned companies such as ONGC and Oil India would likely see significant gains from a diesel price hike as it would bring down their subsidy burden and allow them to earn more.

Downstream companies, such as refiners and oil marketers, would benefit far less given they are only partly compensated through cash subsidies as well as discounts from oil producers.

“Oil marketing companies would benefit on cash flows only, and they have cyclical risk as well. So direct fuel reforms should be played via upstream companies like ONGC and Oil India,” said Ashutosh Bhardwaj, a senior research analyst at Nirmal Bang Institutional Equities.