Wednesday, June 4, 2008

Under recovery vs. losses

Reported daily under recovery of oil marketing companies (OMCs) is Rs. 450 Cr, when India’s crude import basket is over $100/barrel (Rs. 26.42/Litre)[1]. As this rate, wouldn’t the combined net worth of the three OMCs (IOC, BPCL and HPCL) would be “ZERO” in just 6 months time? Fortunately, the answers is NO.

At gross under recovery level of Rs. 500 Cr/day, OMCs net under recovery is Rs. 120 Cr/day and net loss is estimated at Rs. 22 Cr/day or Rs. 8,000 Cr for FY09[2].

1) Under recovery sharing mechanism -
a. Government shares 42.7% of gross under recoveries (GUR) through issuance of Special Oil Bonds.
b. Upstream (E&O) companies share 33.33% of GUR
c. Only 24% of GUR is born by OMCs, also referred as net under recovery

2) Calculation of GUR is such that it computes notional loss (opportunity cost or lost profit) rather than the actual losses. GUR calculation includes -
a. Notional trade parity price of refined products
b. Marketing margin
c. Margin on retail pump outlet
d. Various other charges/margins, apart from costs

We estimate in-built profitability of more than Rs. 28,000 Cr. for three OMCs in the calculation of GUR, estimated GUR for 2007-08 at Rs. 77,303 Cr, and net under recovery at Rs. 18,553 Cr. It suggests OMCs actually made profit in their retail operations in FY08 of Rs. 9,500 Cr.

With the crude basket continuing above the $130/barrel (in April, the Indian basket averaged $105.77), projected GUR in fiscal 2008-09 is Rs. 180,000 Cr. If OMCs are to share 24% of GUR, their net under recovery would be Rs. 36,000 Cr. Even at this rate their combined net worth would not be ZERO until 2020. However, OMCs would certainly be out of cash for running the operations.

Let’s take a look at calculation of GUR for OMCs in order to estimate their survival period without any change in support mechanism by government. OMCs are present in both the refining and distribution of petroleum products. We look at both of these segments.


Gross Refinery Margins (GRMs)
Average Indian GRMs in 2007-08 stood at Rs. 2.65/Liter. CRISIL Research expects GRMs to average at a much higher level of Rs. 4.76/Liter. Product price rise is expected to surpass the crude prices rise, and change in the heavy-light crude mix for Indian basket, to 61.4% heavy and 38.6% light in 2007-08 from 59.8% heavy and 40.2% light in 2006-07, would further help in increasing the Indian GRMs.

On average Indian refineries operate at near 100% capacity. We conservatively estimate daily GRM (net of under recovery) of IOC - 36 Cr. (annualized 13,100 Cr.), HPCL - 13 Cr. (annualized 4,700 Cr.) and BPCL - 16 Cr. (annualized 5,800 Cr.) (See Annex-1 for details, estimated OMCs annual refinery margins is Rs. 24,000 Cr.). Apart from GRM, refineries also earn profits on their pipelines and inventories, which by no means are marginal.

Marketing and distribution

Now coming to the calculation of under recoveries for OMCs, gross under recoveries are notional loss of profit, rather than actual loss!! Broad heads under which cost is build up from refinery gate price (Trade Parity Price) to the consumer level consists of operational and functional costs of marketing companies and duties and levies. We present the notional price build up for Delhi for April’08 below:

Marketing Margin
Marketing margin represents return on net fixed assets employed in the marketing of various products by the oil companies. OMCs get 12% return on net fixed assets with grossing up the same for corporate tax at 30%, surcharge at 10% and education cess at 2% resulting in pre tax return rate at 18.09%. We estimate OMCs to earn marketing margin of Rs. 1,600 Cr.

Retail Pump Outlet Charges
The overall component of retail pump outlet cost including return is Rs 354 per KL. Margin on retail pump outlet of Rs. 263 per KL. The actual cost as per audited accounts for the year 2005-06 varied between Rs. 86 .18 per KL to Rs. 94.87 per KL exhibiting weighted average for all the four public Sector Oil companies at Rs. 90.99 per KL for 2005-06. We estimate OMCs to earn RPO margin of Rs. 1,700 Cr.

Terminalling Charges
Rs. 41 per KL as terminalling charges as compensation to refineries for providing facilities for marketing activities in price build up of petrol and diesel. OMCs buy their product requirement from their own refineries, we estimate OMCs benefit of Rs. 400 Cr. due to terminal charges for 2007-08 to be IOC – 227 Cr., BPCL – 100 Cr., and HPCL - 80 Cr.

Interest on Working Capital
Interest on working capital has been considered at 20 days’ cost of sales excluding depreciation at State Bank of India prime lending rate 12.25%. Most of the OMCs working capital loans are at way below BPLR!!

Marketing Costs
The actual cost claimed by OMC as per audited accounts for the year 2005-06 vary from Rs. 413 to Rs. 463 per KL and the weighted average cost of all the four companies (IOC, HPCL, BPCL and IBP) for the year 2005-06 is Rs. 428.34 per KL. The cost in the price build up is Rs. 425.43 per KL with escalation at the rate of 4% on a y-o-y basis from 2002-03. Marketing cost build up is Rs. 590 per KL in Apr’08.

Stock Loss
Stock loss at 0.5% of cost of sales for petrol and 0.125% of cost of sales in case of diesel in the price build up.

Delivery Charges
Rs 66 per KL to under recovery of delivery charges in case of the price build up.

Domestic Logistic Adjustment Factor
Depending upon the availability of product at the refineries and the markets attached to those refineries for the purpose of pricing. Such movements result in additional logistic cost to OMCs for which Rs. 100 per KL is provided in the price build up.

Demand Draft Charges paid to dealers (RPO surcharge)
Demand draft charges are additional element of cost for the purpose of build up of purchase price at Rs 35 per KL for MS and Rs 20 per KL on HSD.

Rs. 322.75 per KL in case of petrol and Rs. 406.73 per KL in case of diesel is included as weighted average equalized freight from the ports to various depots while determining ex-storage selling prices. However, over time most of OMC have shifted to pipelines for transportation of the fuel from refineries to depots, hence resulting in savings.

[1] 1 Barrel of Petroleum = 42 US gallons = 158.9873 litres = 0.1364 tonnes.
Exchange rate 1 US$ = 42 INR
[2] We estimated in-built profitability of Rs. 28,000 Cr, gross under recovery for FY09 at Rs. 180,000 Cr. and net under recovery of OMCs at Rs. 36,000 Cr. Resulting in loss of Rs. 8,000 Cr. [3] IOC reported GRM of $9.02/barrel for 2007-08. CPCL achieved GRM of $8.47/barrel for the year 2007-08, net of under recoveries.