Paradip refinery to turn around IOC's prospects
New Delhi   21-Jan-2016

Inexpensive valuations, improving business outlook could trigger re-rating of the stock

Indian Oil Corporation (IOC) has lagged peers Bharat Petroleum Corporation (BPCL) and Hindustan Petroleum Corporation (HPCL) on gross refining margins (GRMs) and on as stock performance in recent times. The company’s GRMs stood at $0.3 a barrel in FY15, while that of BPCL stood at $3.2 a barrel (Kochi refinery) and $4 a barrel (Mumbai refinery). HPCL’s consolidated GRMs were $2.3 a barrel in FY15. This is largely on account of higher fuel and as inventory losses for IOC, which has higher dependence on inland refineries vis-à-vis peers.

Things are set to change for the better for IOC. Although most analysts expect its GRMs to increase to $4-5 a barrel this financial year, the real shot in the arm to this metric will come after commissioning of its Paradip refinery in February. Its high complexity will enable IOC to process low-cost and heavier types of crude oil. Second, its proximity to the Paradip port will reduce fuel losses for the company. This refinery is also equipped to produce low-emission BS-IV-compliant motor fuel enabling IOC to benefit from earlier adoption of this standard in the country.

Once commissioned, the refinery with a capacity of 15 million tonnes per annum (mtpa) will account for a fourth of IOC’s 60-mtpa refining capacity. Typically, high complexity refineries of Reliance Industries and Essar Oil have turned in GRMs of around $10 a barrel. Although IOC’s current capacity is spread over 10 plants (Paradip being the 11 one) where GRMs are way lower, the huge scale and higher profitability of Paradip plant would still perk up the company’s blended GRMs and boost earnings.

IOC's management believes its blended/consolidated GRMs would improve by $2-3 a barrel after commissioning of the Paradip refinery. Analysts at Bank of America Merrill Lynch estimate that a $0.75 a barrel increase in GRM could boost IOC’s earnings per share (EPS) by 13 per cent. The actual earnings, though, will be a function of factors such as crude oil price and currency movement, among others.

Notably, IOC’s stock has underperformed that of its peers in the past year primarily due to weaker profitability, overhang of stake sale and delay in commissioning of the Paradip refinery. The stock now trades at a steep discount of 43 per cent and 20 per cent to BPCL and HPCL, respectively, on a price-to-book basis. IOC trades at 1.2 times the FY17 estimated book value, while BPCL and HPCL trade at 2.1 times and 1.5 times respectively. Going forward, most analysts believe the risk reward appears favourable for the stock and this discount could narrow down.

“Based on our expectation of stabilisation in IOC’s return on equity (RoE) to 13-14 per cent over FY16-FY17, or 300 basis points above the historical RoEs, we expect the IOC stock to re-rate”, says Ritesh Gupta, analyst at Ambit Capital. He has a target price of Rs 526 or 26 per cent higher than Monday’s closing price.

Analysts at Spark Capital second this view and believe the IOC scrip could outperform its peers going forward. Continued traction in its petrochemicals (about half of earnings before interest, taxes, interest, depreciation and amortisation) as well as pipeline businesses are key positives. With large part of the capex behind it and lower working capital needs, analysts believe the company’s return ratios should pick up from here on. IOC’s future planned capex of about Rs 39,000 crore should be funded by healthy cash generation of Rs 51,500 crore over the next two years, adds Gupta. Diesel price deregulation will aid marketing margins of the company and reduce interest cost burden.

But, there are potential downside risks as well. Delay in boosting capacity at Paradip refinery (expected to break even in FY18), high volatility in crude oil prices and currency are key risks for the stock. IOC has been asked to declare its 20 pipelines as a common carrier. If implemented, this will also impact its profitability going forward, believe analysts. So, keep an eye out for these, too.