Energy: At the crossroads

With the 1QFY05 results season now over, let us now analyse as to how did the quarter pass by for the energy sector and the outlook going forward, all under the policy umbrella of the government, which plays a very important role in the fortunes of these companies.

Performance summary

The 1QFY05 was a mixed one for the energy sector i.e. for upstream (exploration) and downstream companies (refining and marketing of petroleum products). Despite crude prices rising sharply, the previous government did not increase petroleum product prices. As a result, the oil marketing companies (OMCs) suffered due to under-recoveries and a surge in the subsidy burden. At the same time, sharp spurt in international crude prices boosted revenues of the upstream majors and pure refining companies, which had a momentous quarter.

About the sector

The energy sector in India is at the mercy of political repercussions, as the decisions taken are as volatile as crude prices. Indian energy sector has been tracking the growth of the economy in the last five years (5.5% CAGR overall). Although the government dismantled the APM (administered pricing mechanism), lack of private competition has resulted in a virtual cartel, under which prices are fixed every 15 days in consultation with the ministry.

Global majors have reached enormous proportions in the business, while Indian companies sort out matters with the government over every growth proposal that comes their way.

(Rs m)	1QFY04	1QFY05	Change
Net sales	620,407	718,334	15.8%
Other income	6,639	5,634	-15.1%
Expenditure	542,358	623,882	15.0%
Operating profit (EBDITA)	78,049	94,452	21.0%
Operating profit margin (%)	12.6%	13.1%
Interest	2,037	2,101	3.1%
Depreciation	19,974	26,500	32.7%
Profit before tax	62,677	71,485	14.1%
Tax	23,342	26,347	12.9%
Profit after tax/(loss)	39,335	45,138	14.8%
Net profit margin (%)	6.3%	6.3%

What has driven performance in 1QFY05?

Growth despite constraints:  The aggregate topline of the sector grew by an impressive 16% YoY in 1QFY05

on the back of strong volumes. To put things in perspective, diesel witnessed double-digit growth (nearly 12% YoY) while petrol sales grew by 9% YoY during the 1QFY05. LPG (liquefied petroleum gas) sales continue to witness robust sales as more and more households switch to LPG from kerosene.

But for the under-recoveries and subsidy sharing arrangement by the government, topline growth would have been more impressive. The industry witnessed under-recoveries to the tune of nearly Rs 51 bn, of which the government's share stood at Rs 9 bn while 1/3rd was chipped in by upstream majors (ONGC, GAIL and OIL), 1/3rd was borne by the OMCs.

Overall margins look up:  Despite acute pressure on marketing margins (as retail prices failed to track input cost), energy companies were successful in recording a 50 basis points jump in operating margins on account of robust refining performance. Major oil marketing companies such as IOC, HPCL and BPCL have an integrated business model, having their own refining capacity. High product prices in the international markets led to robust refinery gate prices, as they track global trends.

To put things in perspective, IOC's refining margins more than doubled on a YoY basis (US$ 6.9 per barrel as compared to US$ 3.2 per barrel in 1QFY04). Such high margins helped companies with substantial refining capacity to boost the bottomline.

At the same time, high crude oil prices in the international markets helped upstream major ONGC to post decent numbers. ONGC realized nearly US$ 31 per barrel during the 1QFY05 (although the realizations could have been as high as nearly US$ 35 per barrel but for the subsidies).

It all filters down to the net level:  The sector witnessed a 15% jump in the bottomline led by a strong operating performance. To put things in perspective, IOC and HPCL witnessed more than 50% surge in the bottomline. This growth is despite a 15% dip in other income and a 33% jump in depreciation. However, strong refining margins and high crude prices led to such strong numbers.

What to expect?

The energy sector is largely driven by government policies and pricing structures. With the recent hike in prices announced by the government and also the fact that the government has allowed the oil companies to increase prices within a 10% band based on certain criteria augurs well for the sector. Another major positive is that these companies are planning to expand by way of vertical and horizontal integration, which would bring in economies of scale and synergies in business.

Another factor that raises the risk profile of energy stocks is the large-scale capital expenditure outlays. Though these may have long-term benefits (three to five years), in the medium-term, execution risk exists. The fact that interest rates in the domestic market may rise in FY05 could also add to the burden.

All in all, the prospects for the industry in the future are positive given the developing economy we are. However, given the history of rollbacks that have LEFT Indian energy stocks far behind their global competitors, concerns remain.

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