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This is a complex industry with some of the largest public companies in india. It would be difficult to cover the entire industry in detail in a single post. I would however try to cover the critical components of the industry and try to explore one of the subsets of the industry in this post

The industry can be roughly be split into 3-4 groups

Refining companies – This would include standalone refining companies like RPL, MRPL.chennai petroleum etc and other vertically integrated companies like IOC, HPCL and BPCL which have their own refineries. Refineries are capital intensive businesses with high economies of scale, low differentiation in the product and competitive advantage being mainly with the low cost producer. In addition refineries are cyclical in nature with their margins driven by the price of crude

Marketing companies – There are no stand-alone marketing companies in india. Most of the companies like IOC, BPCL HPCL and now reliance are a combination of marketing companies (through retail outlets) and refineries supplying the marketing companies.

Marketing companies have more pricing power, some level of branding and less cyclical in nature. However in india as the retail price is controlled by the government, companies having the marketing division (HPCL, BPCL, IOC) etc do not have control on their pricing and typically have to bear losses which at best is mitigated through oil bonds.

Gas – These include companies like GAIL, Gujarat gas, Indraprastha gas etc. This is one the fastest growing sub-sectors in the oil and gas industry. With India trying to reduce its reliance on oil, there is a lot of focus on switching to the gas fuel.

In addition pricing for gas is not tightly controlled by the government. As a result most of the companies have fair amount of pricing power. As the industry is characteristed by entry barriers in the form of pipelines and licenses in specific markets. At the national level the market has been controlled by GAIL. However the government has opened the sector to compeitition and the common access guidelines provide access to the national gas pipelines controlled by GAIL.

The sector is however growing rapidly with a lot growth coming from industrial consumers and some cities switiching to CNG for vehicles.

Lubricants – These are some standalone lube companies like castrol. However for most of the companies this is an additional product which is produced and supplied through the same supply chain (Petrol pumps) or through retail outlets.

This sector is characterised by high competition with the industry growth dependent on the growth of the automotive sector. The last 2-3 years have been better in terms of the growth. However the sector characterised by poor pricing.

In the rest of the post I would cover the refining sector. I will cover the other sectors in future posts.

Porter’s 5 factor Industry analysis for refining companies

Entry barriers

The industry has moderate barriers characterised by economies of scale. Larger refineries with latest technologies which can process varying types of crude tend to have higher GRM (gross refining margins). For ex: the new RPL refinery is to have the latest technology with the capability to process heavy and sour crude oil(HSCO) and as a result could have margins as high as 10 $ per barrel.

Rivalry Determinant

The rivalry in the industry has been low till now as the industry was tighlty regulated by the government. The level competition would increase in the future, with reliance and other MNC becoming more aggressive

Supplier power

Supplier power is high as the net margins are strongly dependent on the price of the crude. Due to crude price volatility and supply risks, a lot of the indian companies are integrating backwards into E&P activities

Buyer power

Not too critical for most companies as refining operations are a part of the complete supply chain, with the refining operations supplying the product to the marketing company. However in case of standalone companies (which may no longer apply) long term contracts have to be signed with the marketing companies. The margins in such cases are dependent on such long term contracts.

Substititute product

Although gas , solar power etc exist as substitiutes , none of them are big enough to impact the demand of the petroleum products.


Company details

The key companies in this sector are MRPL, Kochi refineries, RPL (IPO), Chennai petroleum and Bongaigaon Refinery. Most these companies have benifitted with the high crude prices and are currently operating a high capacity utilisations. A few thoughts on these companies are below

RPL – the major points are coevered in this article. In addition, the pricing of the IPO at 60 would be on the higher side and as suggested in the article would account for the positives of the project being priced in. As an aside, considering the good deal which reliance is getting , I would like to look at RIL (it seems after all the demergers, the cross holding creation has started again in the new companies).

In addition, chevron has picked a stake too.

MRPL – The company has been turned around in the last 2 years and has now become profitable. It is now running at high capacity utilisation 119% (10 mmt capacity) . The financial numbers are much better now (see here) and the company has turned around after receiving capital from the parent (ONGC). The company is now valued at a PE of 9. Considering that the petroleum prices are at a high and any further expansion of earnings would come with further increase in refinery capacity, I think the company is fairly valued ( most of refinery companies are experiencing a cyclical high in terms of earnings).

Bongaigaon Refinery – This is a small refinery (2.1 MMT) with majority holder being IOC. It is running at fairly high capacity utilisation (100% +). The company is valued at a normalised PE of around 10 (based on average of last 5 years of earnings). Again the last year’s earnings seem to be at a cyclical high (GRM – gross refining margins were almost at 10 dollars last) and this year there has been a 50% drop in profits. Also further expansion will come only through capacity expansion, so the earnings / Free cash flows could be subdued for some time. However among all the refinery companies, this one is worth further analysis.

There are industries with stable pricing power like FMCG companies (to a certain extent), cylical pricing power like cement, steel and other commodity companies which depends on the demand and supply conditions and then there are companies which have a business model where the price is always dropping. A few industries, which come to mind are the computer industry (Dell, HP etc), semiconductor industry, memory (moser baer) and even electronics.

These industries are not even like airlines where there is a certain cyclicality of pricing. In the above industries, there is a relentless race to the bottom. Its almost a given. A PC now is around half the price of a PC in 2000 (maybe lesser), but it is 5 times or more powerful. So you have a scenario where the product keeps getting better and the price keeps falling.

So even when the revenue is increasing, the margins and profits may be shrinking. So what does it mean for an investor?

1. To be competitive all participants in the industry must constantly spend huge sums on new technologoies, equipments and other cost reduction options. So effectively the earnings are overstated for these companies, as depreciation is way to lower than the obsolence in the industry.
2. Due to poor pricing power, any drop in the demand has a severe impact in margins (see samsung results here). Companies like Intel which have a monopoly in the processor business have also taken huge hits when the demand has dropped.
3. Sudden shifts in technology can destory the exisiting product lines and put the company at risk. Even small shifts can hurt these companies badly (nokia got hurt and lost market share when the preference moved to clamshell phones in 2004/2005.)

In the end I would value these companies at low multiples if I can forsee the future of the company and figure out that the company would do well for quite some time.

As an example, look at Moser baer. This company has grown a lot, but at the same time operates in a falling price environment and needs constant investment into capital equipment. As result the company has had to add capital to the business. I am not sure if this business would really have any free cash flow.