Oil and refinery stocks have been rising like there is no tomorrow. In just two months, they have posted collective gains in market capitalisation of 60 per cent.

IBP topped the table with a gain of, hold your breath, 179 per cent, with its share price shooting up from Rs 210 on May 2 to Rs 586 on June 26.

Even the worst performer, Hindustan Petroleum Corporation Ltd, managed to post worthwhile gains of 22 per cent.

Will oil slip from this lofty perch? An answer to this question is important to the whole market since the current rally has been spearheaded primarily by two sectors -- oil and banks.

If one were to look at the market as a whole, oil fuelled 44 per cent of the nearly Rs 100,000 crore gain in market capitalisation between June-end last year and now. And while banks appear to be peaking, oil continues to be on the boil.

Market analysts discount the possibility of any major meltdown. Says Satyam Agarwal, analyst with research brokerage Motilal Oswal Securities: "The recent run-up in oil stock prices is the result of a re-rating of the sector because of the structural changes that have taken place in the industry."

Translated, it means the rally has some staying power. This flies in the face of the conventional assumption that oil is good primarily because of the proposed divestment plans of the government. But trends in stock prices show why this is not so.

If the rally had been triggered merely by soaring divestment hopes, HPCL should be the leader. It is the one company the government has formally committed itself to privatising by roping in a strategic partner. But in terms of price spikes, it is a laggard.

Analysts say the re-rating of the sector is the result of a whole host of factors, and two in particular. One, with technology stocks failing to live up to their promise, big investors needed a sector large enough for them to invest in.

And you don't get them bigger than oil. Large institutional investors have piled into oil, raising the market cap of the sector to around 19 per cent of the overall market.

Add Reliance Industries, which is substantially an oil company now, and the market cap figure moves closer to a quarter of the country's total.

The second, more fundamental, reason for the price rise is the structural shift that has taken place after the dismantling of the administered pricing regime last year.

Oil companies now have the power to price their products even though it is widely believed that the government continues to exercise a behind-the-scenes restraining hand.

But there is little doubt that prices are more flexible than before, and the oil marketing companies have been able to improve their marketing margins in the last fiscal.

Not surprisingly, the immediate trigger for the oil spiral has come from exceptionally good fourth quarter numbers.

In Q4 of fiscal 2003 (ended March), Indian Oil's net profits were up 70 per cent from Rs 1,297 crore (Rs 12.97 billion) in the last quarter of fiscal 2002 to Rs 2,199 crore (Rs 21.99 billion).

For the year as a whole, the profits rose 112 per cent to Rs 6,115 crore (Rs 61.15 billion). HPCL's full-year profits rose by 95 per cent to Rs 1,537 crore (Rs 15.37 billion).

Much of these gains came on the back of solid inventory gains as companies stocked up crude ahead of the US-Iraq war.

For instance, BPCL recorded an inventory gain of Rs 550 crore (Rs 5.50 billion) in the fourth quarter. But for these gains, the company may have actually ended up with a loss during the quarter.

Similarly, HPCL witnessed inventory gains to the tune of Rs 650 crore (Rs 6.5 billion). Not only that, refining margins were way above the average for the first three quarters or the same quarter in the previous year.

In fact, for the entire Asian region, refining margins were strong for several reasons. The severe winter in the northern hemisphere and inflated natural gas prices led to a sharp rise in demand for liquid fuel.

Much of Asia's liquid fuel found its way to North America. Singapore refining margins jumped in the January-March 2003 quarter to $4.27 per barrel compared to $0.83 in the same period of the previous year.

In the second quarter, margins have eased off to $2.42 a barrel.

Consequently, even smaller refining companies like Bongaigaon Refineries (a 74 per cent subsidiary of IOC), Chennai Petroleum (a 54 per cent subsidiary of IOC) and Kochi Refineries (a 55 per cent subsidiary of BPCL) were strong performers in the fourth quarter.

Chennai Petroleum's net profit was up from Rs 79 crore in the last quarter of fiscal 2002 to Rs 225 crore in last quarter of fiscal 2003.

Kochi saw its net profit jump to Rs 290 crore (Rs 2.9 billion) in the fourth quarter from Rs 26 crore (Rs 260 million) in the same quarter last year.

Obviously, this is getting reflected in the share price performance of parent companies which show up the consolidated numbers.

A caveat

But analysts say it wouldn't be wise to extrapolate the fourth quarter numbers into the future.

A recent report by Kotak Securities elucidates this point with an example: in the case of Chennai Petroleum, for example, refining margins for the fourth quarter were as high as $7 per barrel while the average for the first three quarters was $2.9.

The increased contribution from higher refining margins to EBITDA (earnings before interest, depreciation and tax) thus works out to Rs 280 crore (Rs 2.8 billion).

The bulk of the EBITDA increase came in the fourth quarter (Rs 400 crore Vs an average run rate in the first three quarters of Rs 90 crore.)

In the case of Kochi Refineries, the gross refining margins during the year were higher at $4.2 per barrel compared to $2.4 during the previous year.

Similarly, BPCL saw its refining margins shoot up from $3 in the first three quarters to $5.3 in the fourth. The higher contribution to EBITDA on account of higher refining margins is estimated at Rs 210 crore (Rs 2.10 billion).

For fiscal 2003, refining margins were up by $ 1.3 per barrel, leading to an additional contribution of Rs 380 crore (Rs 3.8 billion).

It's obvious that the high refining margins are unlikely to be sustained. And it is unreasonable to expect a repeat of this splendid performance in the forthcoming quarter.

So the risk really arises from the irrational exuberance surrounding oil stocks after the fourth quarter results.

Once the first quarter results for FY 2004 come in next month, share prices should come down to earth, especially if some companies end up with inventory losses with international prices declining.

Though analysts are not ready with their estimates for the first quarter ending June 30, inventory losses are believed to be in the range of Rs 200 crore (Rs 2 billion) each for HPCL and BPCL.

But it is tough to find too many pessimists. Says Satyam Aggarwal of Motilal Oswal Securities: "Refining companies should show about 20-25 per cent bottomline growth on a year-on-year basis next quarter even if there are inventory losess. And that should keep the markets happy."

The next big risk to prices could emanate from government action -- or rather inaction. If the government backtracks on disinvestment, it can cause a sentiment shift and be a party pooper.

July should see a Supreme Court decision on a petition which calls for Parliamentary approval for the privatisation of BPCL and HPCL. If the court finds in favour of this argument, the privatisation process could get delayed, if not derailed.

As the majority owner of five big oil companies, the government has the power to influence business decisions.

Even though most of them have been managed well and have been efficient users of capital, imprudent business decisions by government (especially in cash-rich companies) is a permanent threat for state-owned companies, says an analyst.

The govenment, moreover, is yet to fully compensate the marketing companies for LPG and kerosene subsidies. If this does not happen soon, it could adversely impact earnings.

The plus point, however, is that the government's own need for cash has translated into higher dividend payouts, which works in favour of all shareholders.

HPCL, for example, has announced a 180 per cent dividend and ONGC, whose new profits topped Rs 10,000 in FY03, a whopping 300 per cent.

Competitive threats

Another possible cause for worry is impending competition. The entry of new players into oil retailing brings new threats to existing public sector giants.

Reliance Industries, Essar Oil, ONGC and Numaligarh Refinery have been given the right to market MS (petrol), HSD (diesel), kerosene and LPG. Reliance is planning to set up about 1,500 retail outlets by March 2004. ONGC also plans to roll out about 1,100 retail outlets in three to five years.

However, analyst do not see this as a threat to existing players for the next two years.

"Any sizeable network to pose a threat to existing marketing companies is 18-24 months away. During the gestation period, the profitability of existing companies is not likely to be threatened by competitive pressures," says Anish Desai, analyst, HDFC Securities.

Despite the risks, no one doubts the ability of oil companies to keep growing. Over the last five years, petrol and LPG consumption has grown at an annualised rate of 7.2 per cent and 11.8 per cent respectively.

During the same period, the economy grew at an average 5.4 per cent. "While participating in any upside, we believe that petroleum marketing offers a reasonable refuge from a downturn in the economy," says Desai of HDFC Securities.

For fiscal 2004, analysts predict refining margins to be lower by 20 per cent. But the real boost to the bottomline will come from marketing margins. Some analysts expect marketing margins to even double during the fiscal.

"The growth in marketing margins should be more than enough to compensate for the lower refining margins as well as loss on kerosene and LPG," says Desai.

The downside, however, could be any unexpected spurt in oil prices and the inability of companies to pass on the hike to consumers. Currently, crude oil prices are ruling around $27 per barrel, and look stable.

For ONGC, the country's largest upstream oil company, the last fiscal was extraordinary with net profits jumping 123 per cent, thanks to deregulation of prices.

Bonny Light oil, a proxy for ONGC crude, averaged $27.7 per barrel in FY03 compared to the ceiling price of $16 earned in FY02. The company's foray into retail marketing is seen a positive in the long-term, though this will not mean any immediate benefits.

More importantly, the much awaited deregulation of gas prices could play the trick.

However, analysts have already reconciled themselves to delays in deregualtion due to the political factor. State elections are due later this year and general elections next year. Weaker than expected crude prices could also be a potential downside.

In terms of overall valuations, Indian companies are rated on a par with their Asian peers on the basis of price-earnings multiples.

Even US-based refining companies like Ashland, Frontier Oil, Sonoco and Valero attract P/Es of around 7 to 9 - which is roughly where Indian P/Es are currently. This means the potential for a further uprating may be limited.

Though global oil majors like BP Amoco, Exxon Mobil, Royal Dutch Shell and Totalfina Elf command superior valuations - P/Es of more than 10 -- Indian companies may not command the same because of their relatively smaller sizes and non-integrated nature of operations. Most of them are either refiners or oil producers, not both.

But looked at from another angle, Indian valuations may even seem attractive: dividend yields for oil stocks still average more than five per cent.

A further upside for oil stocks could come from progress on divestment. If the HPCL divestment gather steams, there could be another round of buying at oil counters.

Overall analysts are particularly bullish on HPCL as it has been a laggard in the recent rally.

On the other hand, if the government goes ahead with the an offer for sale of shares in BPCL, analysts see a liquidity overhang casting a shadow on the stock. Prospects for IBP look very bright, given that it is a pure marketing play. But the stock price has more than doubled in the past two months leaving little scope for further appreciation.

ONGC, with its projection of another year of Rs 10,000 crore (Rs 100 billion) plus profits in FY04, continues to remain a buy with most analysts.

Oil's well that ends up well.

Risks & rewards

HPCL

• Looks cheap compared to BPCL and IOC, based on current valuations.
• Privatisation could be biggest trigger; even by conservative estimates analysts predict a bid price of Rs 450.
• FY04 first quarter results could be disappointing with inventory losses to the tune of Rs 200 crore (Rs 2 billion).

BPCL

• Fairly priced at current levels. But for any surprises, the stock should perform in line with the market.
• Subsidiary company Kochi Refineries' performance can drag or boost bottomline.
• If the government decides to offload its stake to the public, the stock could suffer from a liquidity over-hang.

IBP

• Pure marketing company, and marketing margins are likely to get substantially better going forward.
• Recent run-up in stock prices limits scope for further appreciation in the near term.

IOC

• Favourable refining-marketing mix can mean better gains than HPCL or BPCL.
• Subsidiaries' performance will impact bottomline depending on their performance.
• Stock is fairly priced and may not see much upside from current levels.

ONGC

• Gas deregulation can be the biggest trigger, but delays may not impact sentiments very much.
• Bottomline is likely to be flat this fiscal, and hence not much scope for appreciation.
• Negative news on disinvestment will dampen sentiment in all oil stock.