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Rising crude prices and its downstream effects

Monday, December 20, 2010
By Manik K. Malakar

Buy refiners and short OMCs say analysts

Crude oil is often referred to as Black Gold and in conjunction with its yellow coloured counterpart the prices of this liquid too seems set to rise. And this may have some startling effects on companies and the economy.

 “Everything is going good for crude here; there is a demand uptick and prices are continuously going up,” says Alok Deshpande. Oil prices had been in the price range of 75 to 85 dollars in the June to October period and now prices are expected to shoot up as the demand for energy continues to increase.

So what is the price that crude is expected to trade at? “Going forward, we think that crude is going to trade in 85-95 dollars range,” said Deshpande. “Crude is expected to remain sideways in the next quarter. The expected range is 80 to 90 dollars per barrel,” said Avinash Gupta, Vice President Research Equity, Bonanza Portfolio Limited. However “Since we are at present close to the upper end of the price band there could be some weakness in the short run,”  says Gupta .

The possible hike in prices of crude and downstream products like petrol and diesel will have some macro-economic effects on the Indian economy. In an earlier note on India’s November inflation rate, Devendra Kumar Pant, Director, Fitch Ratings said, “Crude oil prices are touching $90/barrel and if it translates into retail price hike, it will increase inflation rate directly and indirectly through manufactured goods prices.”

However, some sources feel that the possible decontrol of diesel prices would be beneficial as people would be more efficient in fuel usage. “It would reduce the subsidy burden on the government. However in the short run it could add to inflationary pressures,” noted Gupta about possible diesel decontrol.

The increasing prices of crude will have a beneficial side effect in that technological-related issues will receive a boost. Cheaper and renewable energy sources will increase. “Biofuels, and hybrid options would be increasingly in focus, but the political will to force massive changes in automobile technology or incentivise such fuels have been sporadic and feeble,” says Anand James the Chief Analyst at Geojit Comtrade.

And yes, rising crude will affect the prices of sugar. Sugar? While governments bat for ethanol blending, possible sugar shortages will put pressure on the government on using this as a resource base. “The global shortage for sugar that was visible in the last few years was a direct fall out of such diversion, even though inclement weather was the main reason for India's shortage,” James continued.

At the level of the individual company’s the march of crude prices will now bring some interesting factors into play.

“With crude prices rising, the age-old trade of long E&P/refiners and short OMCs (Oil Marketing Companies) again comes into play,” said Deshpande. This is thanks to the regulated nature of the petroleum sector in India. Analysts note that when crude sustains a price range of above 70 dollars per barrel for a reasonable amount of time, Refiners and E&P players benefit and hence show a positive correlation to crude; while it is vice-versa for oil retailers.      

So according to inputs from Elara, the price of RIL has been good on the back of good GRMs (Gross Refining margins) ONGC despite subsidy sharing does receive partial benefit for rising crude prices. Cairn would benefit since they have a good correlation with crude, on the back of their crude based reserves.

So, despite the recent (partial) de-regulation since June 2010, OMC’s will suffer when crude breaches higher dollar price ranges. “Again, with crude expected to remain at the current high levels, OMCs should under-perform in the short term,” said Deshpande. Thus, he is bullish on RIL, ONGC and Cairn. HPCL, BPCL and IOCL are scrips on which he has a sell recommendation on.

Geojit’s James too is positive on refiners’ vis-à-vis OMCs. “Usually the best way to play the rising oil price would be exit OMCs and buy refiners. With global prices of sweet crude oil in the 90 dollars vicinity, we are at such a situation,” he said.

However some other factors need to be considered according to Geojit inputs. With the Oil decontrol that has been in place since June 2010, one or two OMCs may emerge successful, and would be worth investing. Refiners could take a bit longer to achieve economies of scale, and start enjoying the refinery margins, especially as the Indian refiners process a thicker crude oil.
 

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