Oil trade: Buy upstream companies, but avoid downstream stocks

Publish Date: September 28, 2018

The Indian government on Wednesday hiked the import duty on 19 items including jet fuel. So, on Thursday, the shares of oil marketing companies (OMCs) like IOC were under some pressure. With crude oil prices and the US dollar on the rise, are OMCs a good bet or a bad one?

We believe that upstream oil companies like ONGC and GAIL will be beneficiaries of the oil-on-the-boil and weak rupee trends. With fuel prices creeping up, valuations of OMCs have also increased, even though the pressure on refining and marketing margins may rise. Read on to know more.

Industry and oil view

The fuel industry has three major component sectors: upstream, midstream, and downstream.

The upstream industry finds and produces crude oil and natural gas. It consists of exploration and production firms like ONGC and GAIL.

On the other extreme are the downstream companies. They are involved in refining petroleum crude oil and processing and purifying raw natural gas. They also carry out marketing and distribution for products derived from crude oil and natural gas.

We see a near-term upside to crude prices. This position is due to three main reasons, and the price outlook is linked to our view on upstream and downstream stocks.

First, a visible tightening of the global oil market is taking place. This is due to an expected reduction in oil exports from Iran due to the US sanctions. According to the data available, Iran crude exports have dropped by nearly 0.5 million barrels per day from the peak of 2.4 million barrels a day achieved in April–May 2018. As the US sanctions on crude imports become effective from 4 November, this could fall further.

Also read: How high crude oil prices and Iran dilemma will impact India

Second, oil prices are firming up due to a persisting decline in Venezuelan production. Venezuela crude production has declined to 1.2 million barrels per day, down from 1.9 million barrels per day a year ago. The number is anticipated to drop to one million by 2018-end given the continued turmoil.

Third, crude prices are also being affected by a slowdown of growth in the US liquids production. At normal times, this helps keep crude oil prices in check. The logistical challenges in the US Permian Basin are unlikely to be fixed before the middle of 2019.

Also read: 6 effects of rising crude oil prices on the Indian economy

Upstream and downstream stocks

Given the oil price situation, we have a positive stance on GAIL and ONGC. Both the stocks are beneficiaries of elevated crude prices and a weaker rupee.

The ONGC stock is placed well. We feel the stock is discounting net realisation below $45/barrel, which indicates that the government may put the entire incremental subsidy burden beyond the budget provision on upstream companies. Since the ONGC stock is already pricing in a negative scenario, this makes the risk–reward scenario better, in our view.

Also read: Searching for value? Keep an eye on consumer product stocks as they correct

As regards OMC stocks, we think it is safer to avoid the likes of BPCL, HPCL, and IOC in the near term. Over the last three months, many OMCs have seen a correction, thereby making valuations appear optically cheaper. For instance, BPCL shares decreased 10% in the last three months. CPCL and IOC are down by over 8% each. HPCL has declined 16%.

We think that even as the valuations of OMCs have become somewhat reasonable, the risk of a further downside cannot be ruled out. Any spike in crude oil prices may put pressure on refining as well as on marketing margins. Also, there is increasing uncertainty about the subsidy-sharing mechanism, which could mean OMCs may be forced to bear a portion of the incremental subsidy burden.

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Also read

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