'Curious case': Sell IOC, BPCL, HPCL, GAIL, Oil India, Petronet LNG shares, says Kotak. Here's why

Large and rising capex by oil & gas sector PSUs has been one of key reason why Kotak Institutional Equities has turned cautious on the sector's prospects. Calling it a 'curious case', Kotak noted that while oil PSUs upped capex by three times over FY2019-24 in comparison with FY2005-09, returns from those investments have fairly been weak. 

"Our near-term earnings estimates are optimistic and not much below consensus estimates, as we assume generous prices and margins. However, in the past, earnings have been volatile both on macro environment and government policies. Despite the strong run-up of PSUs, the Street seems to be giving high multiples, and, in our view, ignores large capex with likely weak returns," it said.

Kotak said it has a cautious view on oil & gas PSUs. It suggested 'Sell' ratings on IOC, BPCL, HPCL, GAIL, Petronet LNG and Oil India. It has a 'Reduce' rating on ONGC. 

In the case of upstream companies, despite large capex, oil & gas production and reserves are declining. In refining, there is surplus capacity and creation of new capacity is questionable, Kotak Institutional Equities said adding that while Petchem is a new focus area for PSUs, but their track-record has been dismal. 

"High capex has led to low free cash flow relative to PAT for PSUs. Recently, PSUs have benefited from higher realisations, yet FCF remains weak. The market seems to be giving generous multiples to near-term elevated earnings and ignoring large capex with likely weak returns. Maintain cautious view on oil PSUs," it said.

Kotak said conventional oil & gas sector is a sunset sector, and returns have been low. With pricing interventions and weak outlook, the private investment has slowed. However, PSUs’ capex continues to rise. 

"Compared with the average annual capex of Rs 34,000 crore over FY2005-09, top 10 O&G PSUs’ capex rose 2 times to Rs 70,000 crore in 2009-14, 2.7 times to Rs 93,000 crore over FY2014-19 and 3.2 times to Rs 1.1 lakh crore in FY2019-24. With plans aggressive in core areas, most are diversifying into petchem, renewable, and new energy, where returns will be weaker. Thus, capex will likely keep rising, while returns will likely get weaker for O&G PSUs," it said.

Kotak said most PSUs have benefitted recently with higher prices, realisations or margins.

In the case of upstream companies, net crude oil realisations (post wind-fall tax, royalty and cess) for FY2022-24 were 50 per cent higher versus FY2016-21 average. Similarly, APM gas prices were nearly 100 per cent higher versus FY2016-22 average.

In the case of OMCs namely as IOC, HPCL and BPCL, gross refining margins (GRMs) have been a puzzle and too good to believe, Kotak said.

"Reported GRMs have been at very high premium to benchmarks, or what their product slate suggests, accounting for Russian crude and better distillate cracks. While prices of petrol/diesel are frozen, the OMCs marketing margins have been elevated," it said.

In the case of GAIL, the upstream company is realising 15 per cent higher-than-approved tariffs for its integrated pipeline. In addition, due to elevated spreads on 50 per cent of HH linked US LNG, sold on oil-linked basis (primarily to fertilsers companies), earnings have been elevated.