Is it a good time to bet on OMC and downstream companies, as crude oil & gas prices rally?

Crude oil prices are on a roll amid supply concerns as parts of the world sees demand pick up with the easing of pandemic conditions. Brent crude was trading at $79.23 a barrel, having risen a third consecutive week through Friday. U.S. Oil added $1.11 or 1.5% to $75.09, its highest since July. India’s oil imports hit a three-month peak in August, rebounding from nearly one-year lows reached in July, as refiners in the country stocked up in anticipation of higher demand.

“Global energy markets are undergoing major shifts on the supply side as energy transition accelerates. Policy changes in India’s energy sector over the past decade are amplifying this trend, inflecting earnings quality and improving capital allocation – all a recipe for re-rating multiples,” said Morgan Stanley in a report.

Global gas shortages

Global gas supply shortages and low inventories, global gas benchmarks like Henry Hub, Canadian gas, Henry Hub – all of which determine India’s producer gas ASP – have doubled. While some of this is driven by weather and supply-side shocks, we see prices remaining at decade highs near US$4/mmbtu from F23. Investments in global LNG (Liquified Natural Gas) projects and shale have significantly declined, and demand is likely to rise as more renewable capacity enters global electricity generation, China’s dependence on coal diminishes with supply-side reforms making gas play an important balancing force for grid stability.

“Capacity adds in downstream energy, like in the past two years, continue to get pushed out and older capacity permanently closed. China’s “Two Highs” policy will elongate the cycle. Inflation in the global cost curve is underappreciated by investors, and this should allay fears of oversupply across the energy value chain. All the above leads us to move refiners to the top of our preference order,” the report added.

Morgan Stanley sees significant tailwinds for ONGC, which would see its domestic gas business turning profitable for the first time in two decades even in a US$60/barrel long-term oil price environment. Also, with news flow around investments in Russia oil & gas well flagged.

Tailwinds for refiners

Diesel, which accounts for nearly 50-55% of India refinery sales, is seeing margins break the US$5/bbl levels and glide towards normalised pre-Covid for the first time since the pandemic started. OSP cuts by OPEC producers also remove a significant headwind Indian refiners have faced for the past five years of OPEC lowering production.

According to the global brokerage firm the stars are aligned for the first time in more than a decade for India’s upstream energy producers as the commodity up-cycle and policy support come together. Global gas markets are tightening much faster than expected, and weather patterns have added to the tightness. Global fuel demand is recovering quickly, inventories are now at five-year lows, and refining margins are picking up despite jet fuel demand only in the early recovery cycle.

Stock play

Morgan Stanley is overweight on ONGC, Indian Oil, BPCL, HPCL.

ONGC | Rating: Overweight | Price target: Rs 154

Domestic gas prices to sustain at higher levels after the global gas glut of the past five years kept domestic gas prices low. Gas accounts for 40% of ONGC’s domestic hydrocarbon production and 52% of consolidated production. ONGC is slowly raising domestic gas production which should restore its earnings back to 2018 levels after multiple years of consistent decline and negate some of the volume growth challenges that it has faced for the past decade.

BPCL | Rating: Overweight | Price target: Rs 500

BPCL’s Propylene Derivative Petrochemical Project at Kochi Refinery and FCC unit in Mumbai Refinery should aid refining margins by the end of F22. Second largest fuel retailer, with a robust outlook on overall marketing margins. Valuations are still attractive, with a dividend yield of 3.5% seen for F22e.

Morgan Stanley applies a one-year forward average EV/EBITDA (Enterprise Value to Earnings Before Interest Tax Depreciation & Amortization) multiple of 7x to its refining business, in line with global comps for refining peers. Similarly, it assumes 10.0x for its fuel marketing business, which in our view is more robust and less volatile and deserves a higher multiple than refining. And the brokerage firm has valued the company’s listed investments at a 25% discount to the current market price, to reflect risks associated with market volatility.

Hindustan Petroleum | Rating: Overweight | Price target: Rs 364

Permanent refinery closures and recovery in oil product demand drive refining margins higher. HPCL is also investing in green and brownfield refinery capacity additions/expansions. Stable marketing margins despite elevated oil prices. One-year forward EV/EBITDA is below historical averages despite visible triggers – margin expansion and volume growth.

Indian Oil | Rating: Overweight | Price target: Rs 159

IOCL is India’s largest fuel marketing company by size. Every dollar change in the marketing margin affects F23 earnings by 20%. Refinery hardware upgrades, diversifying crude mix, and the startup of the petrochemical complex should improve cashflows. One-year forward P/E (Price to Earnings) is currently at 6.5x, 23% below the historical average.

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