Margin Call
Oil Marketing Companies are slowlyemerging from a regulated structure across businesses. And, thought the realbenefits of deregulation in the form of auto fuel margin expansion have startedflowing through only over the last two years, it is set to rise further, writesAparajita Sharma.  
Covid hit FY21 petrol demand by 6.8 per cent Y-o-Y and diesel demandby 12 per cent. Barring bitumen and LPG, all other products’ demand declinedduring the year. Overall, oil product demand was down 9.1 per cent Y-o-Y.
Year-to-Date (Apr and May) demand for petrol is up 59.6 per cent Y-o-Y,while diesel is up 39.7 per cent given the low base last year. However, YTDdemand is down 15.8 per cent and 19.2 per cent for petrol and diesel respectively,from FY20 levels, mainly impacted by the second wave. Despite the weak demand YTD,analysts expect petrol demand to recover by 10 per cent and diesel demand by 14per cent as most parts of the country begin to unlock. Industry experts expectFY23 demand to remain robust with 10 per cent and 5.0 per cent growth in petroland diesel demand respectively.
Globally, vaccine-drivenrecovery in oil demand and permanent closure of refineries is estimated toboost global refinery utilisation to 77.8 per cent in CY21E from 37-year low of72.5 per cent in CY20E. Industry experts estimate global refinery utilisationto gradually rise from 79.1 per cent in CY22E to 80 per cent in CY26E. IEAestimates permanent closure of 3.6m b/d of refining capacity, but believes 6.0mb/d is required to ensure global refinery utilisation is sustainably above 80per cent.
In CY07- CY18,16.5m b/d of refining capacity was added globally, but 8.0mb/d was shutimplying net capacity addition of just 8.5m b/d. More refinery shutdowns arerequired – and are likely too – in the medium and long term to preventoversupply. BP Plc estimates 10m b/d of refinery closures would be needed byCY40 to prevent refined products oversupply.
IEA estimatesrecovery to pre-Covid levels for global diesel demand in CY22E and jet fueldemand in CY24E, but believes global petrol demand already peaked in CY19. Thus,long-term outlook for diesel cracks appears better than petrol though currentlypetrol cracks are far stronger. Diesel cracks recovery would be positive forIndian refiners as at 40-50 per cent, it is the largest product in theirproduct slate.
Back to normal
Auto fuel gross marketing margins are almost back at FY21 averagelevels, the highest annual average margins ever. The recovery is being drivenby continuous retail price revision, making new highs every time. Given the rallyin global crude/product prices, it appears that this trend is here to stayunless the Government decides to cut excise.
While diesel is almost back at FY21 average levels, petrol lags atalmost 1/3rd of that level. However, the sharp increase in petrolretail prices has made ethanol blending very profitable, with ethanol addingover `0.95/ltr to petrol’s overall margins currently, though petrol continuesto lag even after this huge contribution.
Analysts are ofthe opinion that despite the steady increase in costs, the current net margins improvementis just short of what gross margins would indicate given that incentives fordigital payments were a drag on net margins till FY20 when they werediscontinued and, despite the historic high retail prices, the estimatedincrease in transportation cost, transaction cost, and working capital cost arejust slightly higher than the incentive outgo at the peak.
While FY21 witnessed historic high auto fuel margins, analystsbelieve it is likely to rise further over the next few years driven by thecontinuous investments by OMCs in marketing. They expect margins to rise by `0.2/ltrevery year over the next three years.
Despite the scepticism, marketing margins have recorded steady growthpost deregulation. Though OMCs have been perceived to be not entirely marketdriven most of the time, they have managed to keep retail prices moving andhave delivered robust margin improvement.
Elections have held back retail prices and margins multiple times inthe past, but have always recovered to normal levels. Margins have improvedsharply over the last two years, with FY21 recording the highest ever annualaverage. Analysts believe disinvestment of BPCL is likely to rid of anyresidual influence the Government is likely to have on OMCs, which would be a significantpositive.
Auto fuel marginsrecovering on the back of retail price revisions
Recently, auto fuel gross marketing margins fell sharply duringelections in the month of April, due to lack of retail price revision even asglobal crude and product prices were rising continuously. Diesel drifted below `2.0/ltrlevel while petrol was in negative territory. However, as in the past, retailprice revisions resumed post elections and margins are back close to FY21 levels,which was the highest annual average gross margin ever.
Retail price revisions continue despite hitting historic highs everytime. Given the recent rally in crude and product prices, as well as the nearterm bullish outlook for crude and product prices, this trend of new historichigh retail pricing is likely to continue, unless Government decides to cushionit with excise duty cuts.
Ethanol boost forpetrol margins
While diesel margin at `5.3/ltr is evenhigher than FY21 levels, petrol continues to lag significantly at about 1/3rdof last year levels – at about `1.5/ltr. However,given the historic high petrol prices and fixed ethanol prices (reviewed andrevised every season by the Government starting in the month of November),ethanol blending has become a very profitable activity since the spread ofpetrol ex-depot price over ethanol is a whopping `11.5/ltr adjustedfor additional transportation cost and levies on ethanol.
With ethanol blending proportion steadily rising over the last sixmonths reaching 8.2 per cent in the last week, the latest contribution ofethanol to overall petrol margins is over `0.95/ltr. However,petrol gross margins continue to lag diesel despite the ethanol boost. Industryexperts expect it to catch up in the near term.
Sharp retail pricerevision has not squeezed net margins
Despite the increase in some of the cost elements over the years, theimprovement in net margins is largely similar to improvement in gross margins,due to:
A) Incentives between FY17-20 keeping net margins low, and
B) Some cost elements, like marketing cost and working capital,staying largely flat.
While gross margins have improved from `2.9/ltr in FY15 to`4.6/ltr in FY21, and currently `4.1/ltr, net marginsare up from `1.3/ltr in FY15 to `2.7/ltr inFY21, and `2.5/ltr currently.
Post demonetization, the Government decided to encourage digital paymentsby providing an incentive of 0.75 per cent of retail price. This ended up beinga significant cost for OMCs as digital payments increased sharply to over 30per cent of sales. Industry experts estimate a cost of `0.15/ltr based on30 per cent (industry sources indicate varying proportions ranging between 25-40per cent).
With the penetration plateauing, the incentive was reduced to 0.25per cent from 0.75 per cent from August 2018, bringing the cost downsignificantly to an estimated `0.05/ltr. The incentivesystem was withdrawn in October 2019.
Cause for concern?
So, why should such small costs be of any concern? While the absolutecost is small, the incentives hit net margins by 20 per cent, say industryexperts. Calculationsindicate that the increase in auto fuel retail prices over the years has drivensome costs up:
1) Transportation cost,
2) Transaction cost, and
3) Marketing costs involving: a) working capital, b) employee andestablishment cost, and c) evaporation losses.
Transportationcosts – Up
Over the years, it has been observed that transportation cost asreflected in P&L of OMCs have increased by CAGR of 6.1 per cent. Adjustedfor volume growth, transport cost has increased at a CAGR of less than 3.0 percent. This cost already builds in the benefit of OMCs expanding their pipeline network.
The price build up for regulated petrol and diesel was building in afreight cost of `1.0/ltr, which is now estimated at `1.25/ltr. (Ofcourse, there was a difference between the cost charged in petrol, diesel, andLPG price build-up before deregulation vs actual cost charged in P&L beforederegulation due to the notional freight system.).
This cost does not build in the over `6.0/ltr or 7.75per cent increase in diesel prices over the last 40 plus days. However, it islikely to settle marginally above the 3.0 per cent volume adjusted CAGR thathas been built in given the proportion of pipeline volumes (just short of 50per cent of total volumes), which is at fixed rate, and the ability oftransporters to pass on the increase (fuel normally constitutes about 50 percent of the freight rate!).
Transaction costs– Flat: Post demonetisation, Government's push for digital payment for fuel, introducedtransaction costs for oil companies in the form of payment to credit card/otherdigital wallets. Though normally these costs are a percentage of transaction sum,given the large quantity of transactions, OMCs entered into bilateral agreementswith a significant portion of fixed payments. Hence, industry experts believethat the outgo for OMCs is negligible in the overall cost build-up and there isno linear relationship of these costs to the fuel pricing as well.
Marketing costs –Largely Flat: Calculations by analyst indicate that the per litre cost of `0.3/ltr isunlikely to have increased given the volume CAGR growth of over 3.0 per cent(petrol, diesel and LPG) as well as the overall lack of growth in employeecosts commensurate with scaling up of operations, both refining and marketing.
Working capital costs– Up: OMCsmaintain about 20 days of product inventory. With the rise in prices (mainly onaccount of excise increase), working capital costs have increased. However,fall in interest rates have cushioned the increase to some extent.
Evaporation losses– Up, and in line with retail prices: Given the multiple handling points(refinery storage, terminal and, finally, depot), evaporation loss issignificant. Pre-deregulation prices used to build losses of over 0.5 per centfor petrol and over 0.2 per cent for diesel.
Industry experts believe that with more volumes being moved bypipeline and use of better practices in terms of sealing of trucks, losseswould have come down significantly. However, it is not possible toindependently verify this.
Marketing marginsset to rise further
OMCs have continued to invest in marketing network to cater to theincreasing demand, sprucing up the capacity of terminals and depots. OMCs haveinvested over `700-bn over the last five years and therun rate is likely to continue over the next three years, given the plannednetwork expansion, though investment is LPG is likely to reduce, havingachieved 99 per cent penetration.
Looking at the situation, industry experts expect marketing marginsto rise further over the next three years, driven by the continued investment. Investmentwas the basis for marketing margin expansion under regulated regime in thefirst place, and it is believed that it would continue to be used as a basis.
A back of the envelope calculation indicates a margin increase ofRs0.15/ltr. on petrol and diesel for a double digit IRR on the annualinvestment by the three OMCs in the marketing business, assuming flat volumesand about 70 per cent of marketing investment for petrol and diesel infrastructure.
Key risks
Refining margins: If global demandrecovery were to disappoint or get delayed, GRMs can potentially remain belowcash costs for a longer period of time. However, the current expectation ofover 4mbpd of oil product demand growth in 2HCY21 appears quite safe, unless a3rd or 4th wave of Covid were to hit the key economies. Vaccination progress inUS and Europe is very good with coverage of well over 50 per cent and withChina almost back to normal, demand recovery risk appears minimal at thispoint.
Sharp rally incrude leading to lag in marketing margins: If global demand were to recover asexpected, OPEC+ will be required to pitch in with significant additional productionquotas (possibly about 3.0mn bpd, assuming Iran sanctions are not withdrawn). OPEC+,in its recent meeting, did not give any indication of its plan of action.
If OPEC+ decides to hold back production even by 0.5mn bpd, leadingto inventory destocking, Brent can rally above US$80/bbl, with some forecastingeven a US$100/bbl. In such a scenario, petrol/diesel retail prices may lagleading to squeeze in margins.
Also, a very sharprally could bring back inflation concerns, though experts believe in such a circumstance,excise duty cut would be inevitable. Hence, OMCs may not suffer significantmargin squeeze. A sharp crude price rally would also derail any prospect of LPGdere
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