Truth of western media's OPEC vs Shell hype

I wonder if western media's recent hype about crude oil price falls (OPEC vs Shell gas) have any truth in it. Why am I saying this?

Well for starters, no one else made the connection other than them, that the recent fall in crude prices and OPEC's decision not to cut production is to send shell gas producers out of business. What I think is its just hypothetical. If hypothesis is the news then I hypothesise  that the OPEC's decision is influenced by USA.

Rational? What about US to bring Russia on its knees? The only fallout of the recent fall in crude prices has been Russia! US succeeded in getting Russia on back foot without anyone asking questions. The whole world has bought OPEC vs Shell, no one even thought about it as old Cold War tactics of US. Remember what happened in 89? US oil  producers were just collateral damage!

Just like that time this time too the real war is US vs Russia.

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].

Factors:
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.

Refining

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.

Freight
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.

Annual Monetary Policy 2008-09

Highlights
- Bank rate, reverse repo rate and repo rate kept unchanged
- Following a CRR hike by 50 bps on April 17, the ratio hiked by further 25 bps to 8.25%, with effect from the fortnight beginning May 24. This cumulative hike of 75 bps is expected to suck out liquidity worth Rs 277.5 billion
- Survey on GDP growth for 2008-09 in the range of 8.0-8.5%
- Inflation target raised from 5 to 5.5%, with a medium-term objective of 3.0%
- M3 growth to be contained within the range of 16.5-17.0%
- Deposits projected to increase by around 17%
- Growth of non-food credit to be contained around 20%
- The limit of bank loans for housing enhanced from Rs 20 lakhs to Rs 30 lakhs for applicability of reduced risk weights at 50%
- Indian companies allowed to invest overseas in energy and natural resources sectors such as oil, gas and coal in excess of the current limits

RBI Governor Yaga Venugopal Reddy is known to often surprise the market and the annual policy review this time around showed him being true to form again with his decision to raise the cash reserve ratio for the third time without touching key policy rates.

The Monetary Policy of 2008-2009 comes in the backdrop of a slowing economy facing a sudden and a sharp surge in inflation. The WPI-based inflation touched 7.41% in March way above the virtual roof (RBI’s comfort zone of 5 per cent). The growth moderating effects of tight monetary policy over the last two years are still coming through and a moderating global economy is reducing the external stimulus to growth. Also, the inflationary surge is largely because of higher food, metal and energy prices. This is creating strong supply side (cost-push) inflationary pressure on the economy with significant threats to growth.

As monetary tightening is more effective in controlling demand-driven inflation, the central bank faces a difficult choice of balancing downside risks to growth along with upside risks to inflation. In our April 2 note (“Inflation: through the roof – way forward?”) we forecasted the inflation number to hover in the range of 7-7.5% and for last four weeks it has. We expect inflation figure to slow down due to the fiscal measures taken on supply side along with further tightening of money supply in the range of 6-6.5% for next few weeks, and to be in the range of 5.5-6% until June’08.

Money is the ultimate commodity because all prices have only money in common. And it is the only thing that a central bank directly controls. With increase in CRR by 75bps in three fortnights, would force banks to reduce their short-term deposit rates to contain their borrowing cost and to protect their margins. Such action would also impact the deposit growth contain M3. As of the aggregate deposits mustered banks are required to park 25% of their net demand and time liabilities in SLR securities and 8.25% of as CRR balances with the RBI. Only the balance 66.75% of total deposits along with the borrowings, are available for deployment towards advances. If lending rates and the yield on investments remain constant, SCBs as a whole have had to take a hit of 7 bps (annualised) on their spreads and net profitability margin solely due to CRR increases.

The move enhancing the limit of housing loans from Rs 2 million to Rs 3 million is a positive one and may partly help in addressing the current slowdown in housing loan disbursements. The enhancement of loan limit will, positively impact the capital adequacy of banks, with a 25% savings in capital charge. This measure might indirectly create a cushion of margin money in the event of a likely fall in property prices.

Policy document says, “It is critical at this juncture to demonstrate on a continuing basis a determination to act decisively, effectively and swiftly to curb any signs of adverse developments in regard to inflation expectations”.

Though most of the inflationary pressure is imported and not necessarily due to supply shortage. Mostly due to soaring commodity prices in global market due to weakening dollar, as most of the commodities are denominated in dollar. Such impact is clearly visible in crude oil prices, world oil demand grew by just 1% annually over the past two years while crude oil prices had shot up by over 90% in dollar terms, hitting $120 a barrel. Over 70% of the price rise in just few months, oil was at $70 in late August.

According to Wall Street Journal, since 2003 the dollar price of oil has climbed far more rapidly than has the euro price – 273% in dollars, compared to 146% in euros. Had the dollar merely retained the same purchasing power as the euro, today's price of oil would be below $70 a barrel.