Indian Oil Sector
Too Much Priced In; Further Re-rating of R&M Sector Depends on
Lower Oil PX
Strong government is a plus, but… — Indian oil stocks have strongly rallied during
the past week on talks of fuel price reforms after the favorable election outcome.
We think partial price de-regulation on auto fuels is possible but expect the
government to fall short of freeing cooking fuels (LPG/SKO). In our base case, we
therefore expect annual losses of Rs270-320bn at US$55-60 crude and ONGC to
continue sharing 1/3rd of the burden. We maintain Sell on ONGC, HPCL, and
BPCL, and downgrade IOC to Sell.
Competition and crude price will limit over-recoveries on petrol/diesel — Like in
FY04, there is possibility of over-recoveries on petrol/diesel being used to offset
losses on LPG/SKO. If crude dips <US$55, assuming R&M cos retain 50% of the
profits, LPG/SKO losses (net of over-recoveries) decline to Rs100-130bn only at
US$47-48 and get completely recovered at US$40. This rules out extinction of
upstream sharing above US$50. Meanwhile, excessive auto fuel margins could
attract eager private players (RIL), which would cap the level of over-recoveries
from petrol/diesel. We assume peak over-recovery of Rs1.5/l (over and above
normative margin) for MS/HSD, implying healthy margins of Rs3.0/l ($10/bbl).
ONGC - What is factored in? — ONGC is trading at PER of 13x base case 10E
earnings (US$55, with subsidy), 10x (w/o subsidy sharing) and 9x (w/o sharing +
gas price at US$4.2). Given its historical trading range of 7-11x, we think the
stock is factoring in a near blue-sky scenario (Fig 9). Maintain Sell with TP Rs820.
Lower oil px is key for full-fledged reforms — US$40-45 oil px could allow
downstream R&M to partially recover LPG/SKO losses and/or enable more
constructive de-regulation. These will be the key upside risks to our view on BPCL,
HPCL and IOC.

Meaningful reforms depends on crude levels too 3
Optimism built into valuations; crude at sub-US$50 required to turn
constructive 3
Free market pricing? Maybe for petrol/diesel, but what about
LPG/SKO? 6
Upstream subsidy share to continue unless crude declines to
US$50 7
Valuation analysis 8
Retain Sell on ONGC 8
Maintain Sell on HPCL and BPCL; Downgrade IOC to Sell 9
Oil & Natural Gas (ONGC.BO) 14
Bharat Petroleum (BPCL.BO) 17
Hindustan Petroleum (HPCL.BO) 20
Indian Oil (IOC.BO) 23
Appendix A-1 26
Analyst Certification 26