The strong increase in the value of oil marketing companies (OMCs) in the recent two months, driven by moderating crude oil prices and optimistic sentiment across all PSU stocks, has raised the danger of a correction.
In light of this, brokerage firm JM Financial Institutional Securities has downgraded many OMC stocks, noting that the risk-reward ratio has shifted unfavorably for OMCs due to the lack of valuation comfort following the recent run. According to the brokerage business, OMCs are selling at a 10-30% premium to historical P/B ratios.
JM Financial has downgraded HPCL from a buy to a sell with a revised target price of 370, Indian Oil Corporation (IOCL) from a hold to a sell with a revised target price of 110, and BPCL from a buy to a hold with a revised target price of 450.
"Stock prices of OMCs (HPCL, BPCL and IOCL) have rallied by 30-70 per cent in the last two months driven by (a) sharp jump in auto-fuel gross marketing margin (GMM) on account of moderation in crude price/product cracks, (b) near-term delay in auto-fuel price cuts, (c) end of rights issue-related overhang, and (d) bullishness across all PSU stocks," a report by JM Financial said.
JM Financial has increased OMCs' FY24 EBITDA estimates by 26-38 percent to account for high GRMs in the first nine months of the current fiscal year (9MFY24) and a recent substantial increase in marketing margins, aided by a drop in crude price and a delay in fuel price reduction. However, it emphasized that its FY25-26 EBITDA estimate sees only a 2-3% increase.
The brokerage firm said it has pushed its valuations to March 2025 and increased the EV/EBITDA multiple for the marketing business to 5.5 times from 5 times previously due to improved visibility on marketing segment earnings as crude prices fell from nearly $90 per barrel to $75-80 per barrel.
As a result, JM Financial has raised its target price for IOCL to 110 (from 85), HPCL to 370 (from 280), and BPCL to 450 (from 400).
JM Financial believes that the recent sharp increase in auto-fuel GMM to 7-8 per litre versus normalized 3.5 per liter is not sustainable because (a) the government is highly likely to cut auto-fuel prices ahead of the General Elections in Apr-May 2024 and/or hike auto-fuel excise duty, and (b) OPEC+ strong pricing power will support Brent crude near $80 per barrel.
The brokerage firm believes that OMCs' refining margins will normalize to $7-8 per barrel by FY25 (from $10-20 per barrel in FY23/FY24), driven by (a) the normalization of diesel cracks due to easing supply-side concerns and an increase in Chinese diesel exports, (b) the end of windfall tax benefits as a result of the normalization of diesel cracks, and (c) the narrowing of the Russian crude discount.
Furthermore, the brokerage business believes that several OMC projects fail to provide long-term value for shareholders.
"Historically, OMCs have seen significant cost- and time-overruns in the execution of large projects (for example, HPCL's Rajasthan refinery project cost jumped to nearly 73,000 crore versus the original 43,000 crore)." "The aggressive capex plans of OMCs accentuate our key structural concern, as many of the projects fail to create long-term value for shareholders, with several of them being undertaken from the perspective of the country's strategic energy security," JM Financial stated.
