Indian oil producers and refiners bear brunt of falling crude prices

Crude oil prices, falling for the last eight months, rallied briefly in the fourth week of March after Saudi Arabia bombed neighbouring Yemen, leading to fears of supplies being disrupted. But it was a brief respite. Within days, all gains had been lost and prices were sliding further with the prospect of oil from Iran - sanctions against which are likely to be lifted - creating a bigger glut. On March 31, crude spot prices at the benchmark West Texas Intermediate (WTI) and Brent closed at $47.72 and $53.69 per barrel, respectively.

It has been a long way down for crude from an average Brent price of $108.1 per barrel in the January-March quarter of 2014 to $53.9 per barrel in the corresponding quarter this year. The WTI averages for the same quarters were $98.7 a barrel last year, and $48.5 a barrel this time. The reasons are well known - Saudi Arabia refusing to reduce production despite the glut, Russia's refineries increasing exports and high shale oil production in the US, reducing its dependence on imports. The decline has been welcomed by many in India as it is helping to reduce inflation, the fiscal deficit and the import bill. But the oil companies, be they in refining or exploration, or both, are suffering.

Reliance Industries Ltd's (RIL) profit after tax, for instance, dropped 7.7 per cent year-on-year in the third quarter of 2013/14, to Rs 5,085 crore, while net sales declined 22.5 per cent in the same period to Rs 80,196 crore. Total income fell from Rs 1,05,826 crore to Rs 82,598 crore. Essar Oil's profit stayed flat at Rs 52 crore, but total income decreased 19.24 per cent to Rs 20,295 crore. Cairn India's income and profit fell by 25.38 per cent and 62.3 per cent, respectively. Among public sector companies, Oil and Natural Gas Commission (ONGC) suffered the most, with its profit almost halved to Rs 3,571.20 crore in the third quarter of 2014/15 from Rs 7,125.97 crore in the same quarter a year ago and income down to Rs 20,302.02 crore from Rs 23,514.57 crore. (See Taking the Rap.)

Results in the new financial year are expected to be worse, since the base will be the financials of the first few months of 2014/15, when oil prices were still reasonably high. While refining companies can make some adjustments, purely exploration and production (E&P) ones like Cairn India will be hit hardest. "In the upstream business, the cost of production remains the same," says a Cairn official. "When the price falls, it directly cuts margins and profitability." Cairn India sells its crude at around 10 per cent discount to the Brent price. Around 75 per cent of the production from its largest oilfield in Barmer, Rajasthan, is bought and refined by RIL and Essar. Its public sector counterparts, like ONGC, will be affected less. "The government anyway takes away the surplus value above ONGC's net realisation of around $45 a barrel to subsidise the fuel," says analyst S.P. Tulsian. "Crude volatility will not make much difference to ONGC."

To offset losses, Cairn India will pursue a two-pronged approach. "First, we will only undertake projects that are economically viable at current oil prices," says the Cairn official. "Second, we will re-engineer and renegotiate existing contracts." (These are the contracts with suppliers of oilfield services and equipment.) Cairn's recent capital expenditure of over $4 billion in its Barmer oilfields will stand it in good stead. "The investment has put the company ahead of the cost curve and will allow it to be more selective about projects going forward," the official adds. He also hopes the government will lift the ban on exporting crude. "We can get a better price in some overseas markets, but are forced to sell in India," he says. Cairn produces around 28 per cent of India's oil, around 11 million tonne per annum (MTPA) against ONGC's 26 MTPA.

RIL remains a relatively small player in crude E&P, producing around 0.65 MTPA, but it is a giant in refining, which contributes about 78 per cent of its revenues and 55 per cent of its profits. Its gross refining margin (GRM) has already taken a hit, going down to $7.30 a barrel in the third quarter of 2014/15, against $8.30 a barrel in the second quarter. Apart from crude procurement efficiency and refinery efficiency, GRM depends mainly on the "crack" - the price difference between the crude bought and the petroleum product. The purchase price is difficult to estimate in a price-fluctuating market.

"Globally, GRM also tends to take a hit when crude prices go down," says Dilip Khanna, Partner, Transaction Advisory Services, Ernst & Young (EY). "But loss on crude inventory is short term." RIL officials, too, maintain they are not overly worried. "Our GRM did fall in the third quarter, but it was still higher than the benchmark Singapore GRM," says an RIL executive. "Revenue may fall due to the crude price decline, but profitability will be less affected."

RIL is also likely to gain from its new petroleum coke gasification plant at the Jamnagar refinery, its new refinery off-gas cracker, the expansion of its polyester/aromatics capacity and its import of cracker feedstock from the US. "RIL is executing four key downstream projects in its core refining and petrochemical business with estimated capex of around $15.5 billion? We estimate these projects will add around $3.2 billion in incremental EBITDA in the first full year of operations even in a low $70 per barrel oil environment," says Morgan Stanley Research's Asia Insight report. Even if the price falls to $40 per barrel, the reports estimate an additional EBITDA of $2.2 billion; if it rises, the added EBITDA could be as high as $4.9 billion.

The weak oil price, however, will affect RIL's hitherto rising shale oil venture, whose US revenue in 2013/14 was $893 million, up 45 per cent over the previous year, with EBITDA at $659 million, up 37 per cent. Exploration activities, too, remain mired in arbitration with the government, while gas production in the Krishna Godavari basin, KG D6 block, down to 11 million standard cubic metre per day.

Essar maintains its refining "crack" stable despite crude price volatility. It is setting up one more hydrogen manufacturing unit and converting vacuum gas oil in its effort to increase GRM by about a dollar a barrel.

What of the future? Many experts expect it to be just as bleak. Economist Frank A. Wolak of Stanford University, for example, claims oil prices could remain low for the next decade or two. Wolak's report cites reasons such as growing shale oil production in North America, the declining role of the once-powerful Organisation of Petroleum Exporting Countries (OPEC), the standarisation of oil well drilling technology and the lower price of natural gas as compared to oil. Indeed, oil inventories in the US are the highest in at least 80 years.