September 28, Sectoral movement

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1 September 28, 2017 Indian Markets CMP % chg 1d % chg 3m % chg 6m % chg ytd Nifty 9,736 (1.4) Sensex 31,160 (1.4) BSE Small Cap 15,797 (2.1) Midcap 15,192 (2.0) INR/USD (0.4) Developed/Emerging markets Dow Jones 22, S&P 500 2, Nasdaq 5, Nikkei 20, Hang Seng 27,510 (0.5) Bovespa 73,797 (0.7) DAX 12, FTSE 7, (1.0) (0.4) 2.4 SGX Nifty 9,730 (0.1) Top gainers Top losers Underlying Security CMP % chg Underlying security CMP % chg Shriram Trans. 1, Divis Lab 851 (11.4) Central Bk Siemens 1,219 (7.8) Infratel Relcapital 585 (5.8) Gruh Fin JSW Energy 69 (5.7) Alembic Ph Wockhardt 600 (5.6) Recent eco. data Actual Cons. Upcoming eco. data Cons. Previous Canada Wholesale Sales 1.5 (0.7) US Personal Spending India GDP UK Final GDP US Indus. Production (0.9) 0.1 US Chicago PMI Canada Retail Sales China Mfg PMI Canada CPI Japan Housing Starts 0.7 (2.3) FIIs & DIIs cash activity (Rs cr) Previous day MTD YTD FII Equity (856) (6,196) 40,648 DII Equity 1,858 11,113 79,281 FII Debt (631) 2, ,875 DII Debt , ,659 Turnaround Thursday! Markets may overcome fear The brave man is not he who does not feel afraid, but he who conquers that fear. Nelson Mandela Finally, the market may be in a mood to overcome its fears, albeit for a brief while. Reports of the Indian Army s retaliatory fire on insurgents at the IndoMyanmar international border left the domestic markets spooked in a week that was already consumed by volatility and selling pressure. Nifty rollovers into October were lower than the 3month average, while market wide rollovers were relatively higher as compared to the previous 3 months. F&O expiryrelated volatility in the market will add to swings towards the end. Both Asian and US markets welcomed the new tax reform unveiled by the US. The tax framework proposed bringing the corporate tax rate to 20 pc from 35 pc and reducing the highest individual income tax rate to 35 pc from 39.6 pc. The outlook is a positive start. Nifty intra-day movement 9,950 9,900 9,850 9,800 9,750 9,700 09:15 11:20 13:25 15:30 Sectoral movement 0 (2) (4) (6) (8) (10) Banknifty intra-day movement 24,400 24,200 24,000 23,800 23,600 09:15 11:20 13:25 15:30 % chg 1d % chg 5d IT Auto FMCG Energy Realty Media Pharma Fin Services Infra Bank

2 Corporate Snippets & Economy Updates Corporate News Economy News Reliance Industries won a bid to buy all the gas from its coalbed methane block till March 2021 Government plans to sell stake in ONGC oilfields to private firms Power Grid begins commercial operations of Pole II of the Champa Kurukshetra HVDC Terminal Air India ties up with Punjab National Bank, IndusInd Bank for Rs. 3,250cr loan APL Apollo Tubes entered into a JV with Singaporebased One to One Holdings PTE, for manufacturing of inline galvanized tubes Lakshmi Vilas Bank Board approves raising up to Rs. 800cr via rights issue Jain Irrigation says Mandala Rose Coinvestment acquired 3.62 crore shares (7.26%) in the company IDBI Bank sells 9 percent stake in SIDBI GE Power India won an order worth Rs. 328cr from Doosan Power India Ashiana signs pact to develop group housing project in Pune Fuel prices jump 8% since daily price revision introduced in midjune: ICRA India slips one place to rank 40th in Global Competitiveness Index GST mopup declines by 3.6% to Rs 90,669 crore in August Government constitutes high level forum to roll out 5G in India by 2020 Upcoming Events Sep 28: Sep 29: Germany GFK Consumer Climate, Germany Prelim CPI, US Final GDP, US Unemployment Claims, US Goods Trade Balance, US Prelim Wholesale Inventories. UK GFK Consumer Confidence, Japan Household Spending, Japan CPI, Japan Unemployment Rate, Japan Retail Sales, Japan Prelim Industrial Production, China Caixin Manufacturing PMI, Japan Housing Starts, Germany Retail Sales, France Consumer Spending, UK BOP, UK Final GDP, Canada GDP, US Personal Spending, US Chicago PMI.

3 SECTOR RESEARCH September 28, 2017 Oil Marketing Companies Macro risks abate optimism We have been extremely bullish on Oil Marketing Companies (OMCs) over the past three years during which HPCL, BPCL and IOCL delivered handsome returns of 307%, 127% and 133% respectively. Key drivers of this resounding rally include 1) Government s nod to marketbased pricing of fuels in line with global practices, 2) softening crude oil prices, 3) steady refining margins, 4) morethandoubled return ratios (from 810% to 20%+) and 5) improved balance sheets of the said players. While these factors would continue to boost OMC financials, other macro factors are posing a palpable threat to the sector. These include 1) imminent upward bias in crude oil prices in the wake of strong demand trend, growing geopolitical strife and reduced supply glut; 2) mounting competition from private players in the domestic fuel retailing space; and 3) aggressive vehicle electrification plans. Crude oil prices, following a downward spiral in the past couple of years (fall of 73% from 2014 to 2016), have followed a strong trend in recent past (up 20% in one year). The key driver is the strong OPEC adherence to production cuts announced in November 2016 that reduced the supply glut from the system. Meanwhile, global oil demand has looked up as reflected by the upgrade in IEA estimates. Furthermore, rising geopolitical tensions in Libya, Iran, Iraq and Venezuela can propel the rally in crude prices, putting the pricing freedom of OMCs at risk. In domestic fuel retailing market, private players have seen their market share increasing from nearly nil to about 7% in past few years. With improving marketing margins through daily and dynamic pricing, private players are likely to increase investments to widen their presence. However, this won t come easy considering the established OMC presence at strategic locations and zooming land prices in past few years. Analyst: Prayesh Jain For electrification of vehicles, India has far more aggressive plans visàvis the developed world. The government has set a target of selling only electric cars by With lithium ion battery prices heading south in the past few years and likely to see further declines as technology evolves, share of electric vehicles in would rise rapidly. Consequently, we believe, demand for petrol and diesel would witness constricted growth. Private competition will restrict volume growth besides triggering a pause in marketing margins surge for OMCs. Rising acceptance of gas and electricity would also hamper volume growth impacting marketing segment performance of OMCs. Refining segment performance, on the other hand, would see a marked improvement led by 1) increasing complexities of refineries, 2) better crude oil sourcing flexibility, 3) lower crude oil volatility that would entice OMCs to scale up hedging activities akin to private refiners and 4) higher incremental demand visàvis incremental refining capacity additions would translate into improved GRMs globally. Considering the macro risks, large capex plans ahead (causing higher borrowings) and expected lower dividend payouts, we are downgrading our view on OMCs from Overweight to Neutral. We cut our target prices on lowered target multiple for their standalone earnings. We downgrade HPCL from BUY to ACCUMULATE, and BPCL and IOCL from the erstwhile BUY to REDUCE. Figure 1: Recommendation summary HPCL IOCL BPCL Rating Accumulate Reduce Reduce CMP (Rs) Target (Rs) Upside (%) Source: IIFL Research

4 Oil Marketing Companies Crude oil prices upward bias in the offing Crude oil prices fell from a high of US$110/bbl in January 2014 to US$30/bbl in January 2016, and since then have rallied to the current US$55/bbl. We believe, in the near to medium term, there s an upward bias for crude oil prices based on 1) strong demand uptrend, 2) declining supply glut and 3) increasing geopolitical tensions. Strong demand uptrend: IEA recently upgraded its CY17 crude oil demand estimates from 1.4mbpd to 1.6mbpd on the back of a stronger than expected growth from OECD nations particularly US, Europe and China. In fact, in Q2 CY17, demand growth stood at 2.3mbpd. Over the medium term, India, China and US would continue to drive demand. Supply glut decreasing: Ever since OPEC production cuts were announced in November 2016, investors have been skeptical about adherence by member countries. While the group has not complied with the agreed cuts to the tee, the adherence is much better compared to that on prior occasions, as also current street expectations. During the collapse of crude oil prices, large oil producing countries had announced capex cuts, the impact of which is now being reflected in the form of lower production. Conversely, production from US shale continues to be strong. Overall, global oil inventories, while still above 5year average, have dropped from their peak levels. Growing geopolitical tensions: Libya, Venezuela, Iraq and Iran are grappling with geopolitical tensions. While Libya is seeing increased terrorism activities, Venezuela is going through a political turmoil. Iran s nuclear deal reconsideration by US could likely cause economic jitters again. Together, these countries produce 1112mbpd (1213% of global production) but export 78mbpd of their produce (1617% of global trade for crude oil). Such large quantum of global trade at risk can trigger a spike in crude oil prices. Figure 2: OECD oil inventories have started declining 3,200 mn barrels 3,100 3,085 3,000 2,985 2,900 2,800 2,700 2,640 2,600 2,500 Jan12 Apr12 Jul12 Oct12 Jan13 Apr13 Jul13 Oct13 Jan14 Apr14 Jul14 Oct14 Jan15 Apr15 Jul15 Oct15 Jan16 Apr16 Jul16 Oct16 Jan17 Apr17 Jul17 Source: Bloomberg, IIFL Research Figure 3: OPEC has raised its oil demand estimates mbpd Oct16 Nov16 Dec16 Jan17 Feb17 Mar17 Apr17 May17 Jun17 Jul17 Aug17 Sep17 Source: OPEC, IIFL Research

5 Oil Marketing Companies Figure 4: Libya, Venezuela and Iran production at risk Libya Venezuela Iran 8,000 7,000 '000 bpd 6,000 5,000 4,000 3,000 2,000 1,000 0 Source: Bloomberg, IIFL Research Figure 5: OPEC production declining Source: Bloomberg, IIFL Research Figure 6: US Oil production stagnating Source: Bloomberg, IIFL Research Figure 7: US rig count addition halted 0 Jan11 Jan12 Jan13 Jan14 Jan15 Jan16 Jan17 Source: Bloomberg, IIFL Research Jan11 May11 Sep11 Jan12 May12 Sep12 Jan13 May13 Sep13 Jan14 May14 Sep14 Jan15 May15 Sep15 Jan16 May16 Sep16 Jan17 May17 '000 bpd 35,000 34,000 33,000 32,000 31,000 30,000 29,000 28,000 27,000 26,000 25,000 34,140 32,710 12,000 '000 bpd 10,000 9,170 8,000 6,000 4,000 5,484 2,000 0 Jan11 May11 Sep11 Jan12 May12 Sep12 Jan13 May13 Sep13 Jan14 May14 Sep14 Jan15 May15 Sep15 Jan16 May16 Sep16 Jan17 May17 Jan11 May11 Sep11 Jan12 May12 Sep12 Jan13 May13 Sep13 Jan14 May14 Sep14 Jan15 May15 Sep15 Jan16 May16 Sep16 Jan17 May17 1,800 Nos 1,600 1,400 1,200 1,

6 Oil Marketing Companies Pricing freedom of OMCs at risk Given expected surge in crude oil prices, general elections slated 1.5 years from now, inflationary pressures from snowballing petrol and diesel prices and tight fiscal situation, the government may deny OMCs the pricing freedom granted currently. While the oil minister has categorically committed to zerointerference in day to day pricing by OMCs, a reconsideration cannot be ruled out if crude oil prices move sustainably beyond US$6065/bbl. Competition to rise at a brisk pace As per media reports, the government is keen on increasing private sector participation in India s fuel retailing market. Reliance Industries, through its tie up with BP, has evinced significant interest in expanding its limited presence in the sector. Rosneft, which recently acquired assets of Essar Oil, will have access to its 3,500 retail outlets making it the largest private retail operator. We expect Rosneft to significantly increase presence in this segment. Over the past couple of years, private players have doubled their market share, led by additional fuel stations and higher discounts, over FY17 to 5.3% (FY16: 3.5%) and 6% in diesel (FY16: 3.1%). While the OMC network, with about 55,000 stations, is still unmatched and cannot be replicated overnight, private players would gradually add new stations and gain market share. Both Reliance Industries and Essar Oil have been steadily adding outlets. Reliance added 281 outlets during FY17, taking the operational outlet count (out of 1,400 in place) to 1,221 (as of March), while Essar added 1,400 outlets, primarily in rural areas, to its existing base of 2,100 in FY16. Reliance can expand to 5,000 outlets and BP another 3,500, leading to a further increase in market share and competition for OMCs. Figure 8: Trend in retail outlets of OMC BPCL HPCL IOC 30,000 25,000 20,000 15,000 10,000 Nos 8,251 8,329 17,534 13,983 14,413 26,212 5,000 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 Source: PPAC, Petroleum ministry, IIFL Research Figure 9: Trend in retail outlets of other players 6,000 4,987 5,000 4,000 3,000 2,820 2,000 1,000 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 Source: PPAC, Petroleum ministry, IIFL Research

7 Oil Marketing Companies Figure 10: Amongst private retailers, Essar dominates in terms of reach but Reliance has a higher market share Shell, 85 Essar, 3499 RIL, 1400 MRPL, 4 Marketing margins to stay below global benchmarks According to industry reports, marketing margins in India are more than 50% lower than global benchmarks. Over the past few years, the discount has narrowed down albeit only marginally. Earlier, there were expectations that daily and dynamic pricing mechanisms would help narrow down this discount considerably. However, a reversal of these measures following the spike in crude oil prices can derail these expectations. In case these measures continue to exist, rising competition can exert some pressure on marketing margins. While one might construe that the current land prices and marketing margins may not be economically viable, we believe, private players have deep pockets and would be better placed to earn higher revenues and profitability from the nonfuel initiatives. Source: PPAC, Petroleum ministry, IIFL Research Figure 11: Private companies have seen improved market share 14.0% 13.0% 12.0% 10.0% 8.0% 7.0% 6.0% 4.0% 2.0% 0.5% 0.0% Source: Media reports, IIFL Research

8 Oil Marketing Companies Natural Gas Wider gas availability and underutilization of existing pipelines to drive demand Natural gas is considered a strong competitor to petroleum products owing to its environmentfriendly (relatively less polluting) properties. India is a gas starved nation, reflected by the fact that unmet demand continues to form a large share in the system. Nearly 50% of existing supplies come from imported gas. In the past, natural gas faced impediments like 1) Declining domestic production owing to ageing of fields, 2) India s limited LNG import capacities and 3) inadequate pipeline infrastructure in the country. As per the guidance provided by gas producers, (ONGC, Oil India and Reliance Industries) domestic gas production is set to rise at a brisk pace in the next few years as new conventional fields commence operations. Higher production from CBM fields would also boost supply growth. In terms of LNG capacities, many new terminals would become operational in the next few years, bringing in incremental supplies into the country. On pipeline infrastructure, while GAIL is investing to expand its capacities, utilization of its existing assets continues to be low. Figure 12: Domestic natural gas production has been declining bcm 31.5 FY08 FY09 FY10 Source: PPAC, IIFL Research FY11 Production FY12 FY13 Figure 13: Utilization of gas pipelines still abysmally low owing to lack of last mile connectivity yoy FY14 FY15 FY FY % 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 5.0% 10.0% 15.0% 20.0% New city gas licenses have been issued recently. With rising petrol and diesel prices amidst a flattish natural gas price scenario, we expect incremental conversions of private cars from petrol and diesel to compressed natural gas. Also, government plans to restrict the use of liquid fuels in industrial applications (banning of pet coke and fuel oil) to curb air pollution. This would translate into an incremental demand for natural gas from these industries. These factors can restrict petroleum product demand in the country. 42.0% 40.0% 38.0% 36.0% 34.0% 40.1% 40.1% 40.8% 32.0% 30.0% FY15 FY16 FY17 Source: PPAC, Petroleum ministry, IIFL Research

9 Oil Marketing Companies Electric vehicles to restrict petroleum product consumption growth in the longer term Off late, there s have been increasing talks of electrification of vehicles globally including India. In fact, the Indian Road Transport & Highways ministry is targeting that all cars sold in domestic market would be electric cars by This target is far more aggressive compared with developed countries such as UK, which have a target to sell only electric cars from In the shorter term, the electric car scale up has to lock horns with several headwinds. However, over the longer term, we reckon petroleum product consumption will face substantial threat from electric vehicles. Global outlook on electric vehicles According to British Petroleum, number of electric vehicles is likely to surge from 1.2mn in 2015 to around 100mn by As per OPEC, by 2040, around 266mn electric vehicles would ply on the roads. These are OPEC s revised estimates. (from 46mn a year ago) Other entities endorsing similar expectations: The International Energy Agency more than doubled its central forecast for EVs, raising its 2030 EV fleet size estimate from to 58mn from 23mn. Exxon Mobil boosted its 2040 estimate to about 100mn from 65mn. BP anticipates 100mn EVs on the road by 2035, a 40% increase in its outlook compared with a year ago. Statoil ASA, the Norwegian state oil company, says EVs will account for a 30% of new sales by 2030 stricter vehicle emission standards. This along with electrification can significantly dent oil demand. Figure 14: Short term impediments for electrification of vehicles in India Impediment Rationale Scale Policy Infrastructure Jobs Source: Media reports, IIFL Research As per the target, India would need to sell more than 10mn electric vehicles compared to 1.3mn vehicles on the road worldwide in In 2015, India had just 5,000 electric vehicles in 2015 while it sold more than 3mn passenger vehicles. Consistent and firm policies are needed to execute and achieve such large targets. In the past policies have been volatile. Hybrid cars policies have seen marked changes with initial favorable measures but abrupt increase in taxes now. Compared to more than 58,000 fuel outlets, India has just 206 car charging stations. Large infrastructure will need to be built if the targets must be met. This would be a major challenge as 24x7 electricity supply is still not available in many rural parts of the country A combustionengine car has 1,400 components to build the motor, exhaust system and transmission. An electric vehicle s battery and electric motor has only 200 components. The average combustion engine takes about 3.5 hours to be built, German auto industry association VDA claims a ban on combustionengine vehicles in 2030 would threaten more than 600,000 German industrial jobs, of which 436,000 pertain to car companies and suppliers. India too would suffer substantial job losses. In 2015, cars accounted for 19mbpd of the liquid fuel demand, a fifth of global demand. However, improvements in fuel efficiency will reduce this potential growth significantly (by 17mbpd) as manufacturers respond to

10 Oil Marketing Companies Figure 15: Battery prices for electric vehicles are likely to decrease significantly Figure 17: Demand estimates of electric vehicles by IEA Source: British Petroleum, IIFL Research Figure 16: OPEC has significantly increased its estimates for electric vehicle population Source: IEA, IIFL Research Figure 18: List of OEMs announcements on electric car ambitions, as of April 2017 OEM Announcement BMW 0.1mn electric car sales in 2017 and 1525% of the BMW group s sales by 2025 Chevrolet (GM) 30 thousand annual electric car sales by 2017 Chinese OEMs 4.52mn annual electric car sales by 2020 Daimler 0.1mn annual electric car sales by 2020 Ford 13 new EV models by 2020 Honda Twothirds of the 2030 sales to be electrified vehicles (including hybrids, PHEVs, BEVs and FCEVs) RenaultNissan 1.5mn cumulative sales of electric cars by 2020 Tesla 0.5mn annual electric car sales by 2018 and 1mn annual electric car sales by 2020 Volkswagen 23mn annual electric car sales by 2025 Volvo 1mn cumulative electric car sales by 2025 Source: IEA, IIFL Research Source: Bloomberg, IIFL Research

11 Oil Marketing Companies REFINING SEGMENT to act as a cushion Ramp up of refinery complexity Empirically, refineries of OMCs have been earning GRMs significantly below the domestic private players and regional benchmarks. The prime reason is the weak complexity of refineries. However, in recent times, the management of these companies, cognizant of this fact, are making investments to scale up the complexity index of their refineries. Adding secondary processing units to existing units and setting up of new complex refineries are the two ways out. HPCL has commenced operations at its Bhatinda refinery under its JV with Mittal Energy. IOC has recently commenced operations at its Paradip refinery, which is amongst the most complex refineries in the country. BPCL has scaled up capacities at its Kochi refinery along with increasing the complexity. Going forward too, the said companies would add secondary processing capabilities to their existing refineries to improve their product slate towards more valueadded products like petrol and diesel, resulting in better GRMs. Figure 19: Possible shift of production from low value products to high value products (5.0) US$/bbl (6.0) (10.0) Gasoline Diesel Jet Kero Naphtha Fuel Oil Source: ATMA, SIAM, IIFL Research Figure 20: Refinery complexity BPCL Bina 9.6 BPCL Kochi BPCL Mumbai CPCL Essar Oil Vadinar HPCL Bhatinda HPCL Mumbai HPCL Visakhapatnam Source: Media Reports, Company, IIFL Research IOC Barauni Figure 21: Current production profile of OMCs 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Source: Companies, Petroleum ministry, IIFL Research IOC Haldia IOC Koyali IOC Mathura IOC Panipat MS HSD LPG SKO ATF Naphtha Others 12.2 IOC Paradip 6.5 MRPL HPCL BPCL IOC 14.0 RIL Jamnagar RIL Jamnagar World Average

12 Oil Marketing Companies Better crude sourcing freedom In April 2016, the government empowered boards of OMCs and Mangalore Refineries and Petrochemicals Ltd (MRPL) to make quick spot purchases of crude oil on their own and take advantage of temporary market discounts, instead of issuing tenders like before. Spot purchases currently form 1530% of the overall crude procurement of OMCs. The government move was aimed at making staterefiners more competitive like their private peers. Officials at all three OMCs state that with boardlevel committees in place, spot crude purchases now happen in hours against days earlier, helping them avail of some discounts. The earlier tender method would take nearly a week, shutting them out of deals which had to be struck quickly. While the approvals are in place since more than a year, it s only recently that these companies are setting up trading offices in Singapore, the trading hub of Asia. Shortfall of adequately trained staff and fluid policies were the key hindrances. The Flexibility in sourcing of crude is reflected in the change in sourcing countries as well. Share of Iran has increased after the sanctions have been lifted, while IOC has added Russia to its list of suppliers. Refineries equipped with higher complexities as mentioned above have also provided these OMCs the muscle to bargain harder. Figure 22: Change in import source of crude oil Mexico S. & Cent. America Europe Russia Other CIS Middle East North Africa West Africa Other Asia Pacific 100% 80% 60% 40% 20% 0% CY14 CY15 CY16 Source: BP Statistical review, IIFL Research Figure 23: Volatility in crude oil prices has receded 25% 3m change in crude oil price Risk management will only improve from hereon OMCs have shied away from hedging crude oil prices, currency or crack spreads citing heavier costs, lack of expertise and huge volatility as prime reasons. Private refiners, in the past, have used hedging strategies to reduce the impact of gyrations in crude oil prices, exchange rates and crack spreads on their financial performance. Volatility in crude oil prices has reduced considerably in the recent past as it trades in a narrow band of US$4555/bbl. We expect this trend to sustain in the near term as supply side pressures created by production cuts by OPEC members is offset by higher production in US. Reduced volatility will lead to lower hedging costs for OMCs. Thus, we believe, OMCs will incrementally hedge their exposures. 20% 15% 10% 5% 0% Jan11 May11 Sep11 Jan12 May12 Sep12 Jan13 Source: Bloomberg, IIFL Research May13 Sep13 Jan14 May14 Sep14 Jan15 May15 Sep15 Jan16 May16 Sep16 Jan17 May17

13 Oil Marketing Companies Aggressive capex plans to hamper balance sheet strength Empirically, OMCs had high dependence on cash flows from government for compensation of under recoveries, which were sporadic. Consequently, companies had to borrow large quantum of funds. In fact, prior to FY10, the compensation was in the form of oil bonds that faced liquidity constraints. Hence, debt on the books had peaked to significantly higher levels. However, with deregulation of diesel and petrol prices, balance sheets have improved considerably. This coupled with lower interest rates in the economy has caused lower interest expenditure for companies. However, going forward, these companies are aggressively investing in expanding their capacities, and for diversification. All three companies have planned capacity expansion of their existing refineries and set up of new refineries. Together these companies are setting up 60mn ton refinery in Maharashtra. Also, these companies are expanding their marketing infrastructure to counter the rising competition from private players. In terms of diversification, investments are directed towards petrochemicals, pipelines and hydrocarbon exploration. Together these companies have lined up a capital expenditure of Rs3.7 to 4.0 trillion over the next five years. While cash flows would improve considering strong refining segment performance, we believe the companies would have to resort to borrowings to fund their projects. Figure 24: Large capital expenditure plans over the next 5 years 2,500 2,000 1,500 1, Rs bn 610 1,080 2,000 0 HPCL BPCL IOC Source: Media reports, IIFL Research Figure 25: Large capex plans will lead to higher leverage on balance sheet (D/E) x FY FY19E HPCL BPCL IOCL Source: Media reports, IIFL Research

14 Oil Marketing Companies High dividend payouts may not sustain Over the past couple years, strong growth in profitability for OMCs has led to high dividend payouts by them. Going ahead, we expect earnings growth to be muted. This coupled with large capex plans, will mean inadequate cash flows to sustain high dividend payouts. Valuations in line with global peers, we Downgrade our rating Oil marketing companies are expected to see a flattish earnings profile over the next couple of years. Higher capex would likely increase leverage on the balance sheet. Return ratios are forecasted to decline but would remain in top quartile. Valuations, however, are in line with global peers and hence present a case for a sector rating downgrade from Overweight to Neutral. Amongst stocks, we downgrade HPCL from BUY to ACCUMULATE, and BPCL and IOCL from BUY to REDUCE. Figure 26: Peer comparison Market cap (US$ mn) EV (US$ mn) P/E (x) EV/EBIDTA (x) RoE (%) Caltex 6,717 7, Showa Shell 4,362 5, SK Innovation 15,818 17, Thai Oil 5,731 6, Formosa 33,073 30, HPCL 9,677 12, BPCL 15,554 20, IOCL 29,653 38, Source: Company, Bloomberg, IIFL Research

15 COMPANY RESEARCH HPCL - Accumulate Undervalued visàvis peers Most leveraged to marketing weakness HPCL, with the highest marketing to refining volume ratio amongst OMCs, is the most leveraged to weakness in marketing margins with. Over the past decade, the company has seen a 73% jump in the number of retail outlets compared to 69% for BPCL and 49% for IOC. However, amidst rising competition from private players, HPCL has done well by ceding least amount of market share. Pressure on marketing margins could mean higher impact on HPCL s earnings visàvis BPCL or IOCL. Large capex plan ahead To improve its refining to marketing mix, HPCL is expanding its refining capacity. It s modernizing its Visakh refinery and expanding its Mumbai refinery capacity. In a joint venture with Rajasthan government, it s setting up a 9mn ton per annum refinery, which is likely to be completed in five years. Also, HPCL as part of consortium with IOC and BPCL, will set up a mega US$40bn refinery of capacity of 60mn tons on India s western coast. It would also invest in expanding and upgrading its retail network. Overall, HPCL would spend Rs600bn towards capex in the next five years. Additional borrowings would be needed to fund this large capex. Valuations hold the key to ONGC HPCL deal Government of India has decided to sell its 51% stake in HPCL to ONGC. The deal valuation will have a key bearing on the stock price movement. Recent media reports suggest ONGC may acquire the stake at market price rather than at third party valuation. Nothing changes materially for HPCL save for the change in promoter holding from one entity to another. Over the medium term, crude oil procurement costs could come down. On the flip side, HPCL s board would have to go through ONGC for major government approvals, which could invite delay. CMP (Rs) (As on Sep 20, 2017) 416 SECTOR: Oil & Gas 12mts Target (Rs) 470 Market cap (Rs mn) 635,510 Upside 13.0% Enterprise value (Rs mn) 804,510 Figure 1: Financial summary (Standalone) Y/e 31 Mar (Rs mn) FY16 FY17 FY18E FY19E Revenues 1,795,716 1,870,237 1,926,595 2,153,642 yoy growth (%) (13.1) OPM (%) Reported PAT 38,627 62,088 61,362 65,045 yoy growth (%) (1.2) 6.0 EPS (Rs) P/E (x) Price/Book (x) EV/EBITDA (x) Debt/Equity (x) RoE (%) RoCE (%) Source: Company, IIFL Research Still preferred over other two OMCs HPCL trades at FY19E P/E of 10x on its standalone earnings, which is in line with global peers. However, considering earnings contribution from its JV refinery and MRPL, valuations are at a discount to BPCL and IOCL. We believe, this discount will narrow down as the gap between performances on operational parameters reduces. We downgrade our rating from BUY to Accumulate with a revised 1year price target of Rs470.

16 HPCL Refinery complexity at all-time high In FY17, Bhatinda refinery (HMEL JV) and MRPL accounted for 18.4% and 7.2% of the consolidated profit respectively. Bhatinda refinery has a nelson complexity index of 12.6 compared to 8.1 and 7.7 for HPCL s erstwhile refineries in Mumbai and Visakhapatnam respectively. MRPL s complexity factor has moved up from 6.5 to 9.5 post expansion. The company is expanding operations at existing refineries and scaling up complexities through fresh investments. In a likely scenario of rising global GRMs and more freedom to OMCs for crude sourcing and risk management, we reckon improvement in profitability from refining assets would cushion the impact of weakness in marketing segment. Figure 2: SOTP Valuation for HPCL Component Value HPCL Standalone 363 HMEL 73 MRPL 31 Oil India holding 3 Total 470 CMP 416 Upside (%) 13.0 Source: IIFL Research Company rating grid Stock performance Low High HINDPETRO Sensex Earnings Growth Cash Flow B/S Strength Valuation appeal 60 Risk Sep-16 Jan-17 May-17 Sep-17 Sensex: 31, Week h/l (Rs) 493 / 269 6m Avg t/o (Rs mn): 1,736 FV (Rs): 10 Div yield (%): 4.8 Bloomberg code: HPCL IS BSE code: NSE code: HINDPETRO Figure 3: Trend in market sales mn tons Absolute return (%) 1M 3M 1Y (10.5) Shareholding pattern (%) Promoter 51.1 FII+DII 27.0 Others 21.9 MS HSD LPG SKO Others FY12 FY13 FY14 FY15 FY16 FY17 FY18E FY19E Source: Company, IIFL Research

17 HPCL Figure 4: Trend in refining throughput 18.5 mn tons FY12 FY13 FY14 FY15 FY16 FY17 FY18E FY19E Source: Company, IIFL Research Figure 6: Trend in GRMs 8.0 US$/bbl FY12 FY13 FY14 FY15 FY16 FY17 FY18E FY19E Source: Company, IIFL Research Figure 5: Trend in marketing to refining mix 2.5 x Figure 7: Trend in RoE and RoCE RoE (%) RoCE (%) 35.0 % FY12 FY13 FY14 FY15 FY16 FY17 FY18E FY19E Source: Company, IIFL Research FY12 FY13 FY14 FY15 FY16 FY17 FY18E FY19E Source: Company, IIFL Research

18 HPCL Financials (Standalone) Figure 8: Balance sheet Y/e 31 Mar (Rs m) FY16 FY17 FY18E FY19E Equity capital 3,390 10,163 15,244 15,244 Reserves 180, , , ,256 Net worth 183, , , ,500 Debt 239, , , ,865 Deferred tax liab (net) 48,105 58,956 58,956 58,956 Total liabilities 471, , , ,321 Fixed assets 353, , , ,670 Investments 109, , , ,756 Net working capital 8,021 50,669 48,761 55,473 Inventories 127, , , ,912 Sundry debtors 41,927 40,642 41,867 46,801 Other current assets 72,321 64,718 71,190 78,309 Sundry creditors (65,871) (126,581) (130,395) (145,762) Other current liabilities (167,447) (113,873) (125,260) (137,786) Cash ,374 2,423 Total assets 471, , , ,321 Figure 9: Income statement Y/e 31 Mar (Rs m) FY16 FY17 FY18E FY19E Revenue 1,795,716 1,870,237 1,926,595 2,153,642 Operating profit 79, , , ,012 Depreciation (26,668) (25,353) (27,035) (28,718) Interest expense (6,401) (5,357) (6,199) (7,041) Other income 11,381 15,147 15,451 17,251 Profit before tax 57,381 90,208 89,154 94,504 Taxes (18,753) (28,120) (27,792) (29,459) Adj. profit 38,627 62,088 61,362 65,045 Net profit 38,627 62,088 61,362 65,045 Figure 10: Cash flow statement Y/e 31 Mar (Rs m) FY16 FY17 FY18E FY19E Profit before tax 57,381 90,208 89,154 94,504 Depreciation 26,668 25,353 27,035 28,718 Tax paid (18,753) (28,120) (27,792) (29,459) Working capital 8,758 (42,648) 1,907 (6,712) Operating cashflow 74,053 44,793 90,305 87,051 Capital expenditure (54,523) (51,549) (80,000) (80,000) Free cash flow 19,531 (6,756) 10,305 7,051 Equity raised 2,238 (318) Investments 2,468 (3,809) (15,000) (15,000) Debt financing/disposal (13,754) 42,029 38,005 39,105 Dividends paid (17,525) (41,857) (30,273) (32,108) Other items 7,069 10,851 Net in cash ,037 (951)

19 HPCL Figure 11: Ratio analysis Y/e 31 Mar FY16 FY17 FY18E FY19E Growth matrix (%) Revenue growth (13.1) Op profit growth EBIT growth (0.2) 6.5 Net profit growth (1.2) 6.0 Profitability ratios (%) OPM EBIT margin Net profit margin RoCE RoNW RoA Per share ratios (Rs) EPS Dividend per share Cash EPS Book value per share Valuation ratios (x) P/E P/CEPS P/B EV/EBIDTA Payout (%) Dividend payout Tax payout Liquidity ratios Debtor days Inventory days Creditor days Leverage ratios Interest coverage Net debt / equity Net debt / op. profit Figure 12: Du-Pont analysis Y/e 31 Mar FY16 FY17 FY18E FY19E Tax burden (x) Interest burden (x) EBIT margin (x) Asset turnover (x) Financial leverage (x) RoE (%)

20 COMPANY RESEARCH IOC - Reduce Marketing pangs for largest marketer Marketing margins at risk IOC has 43% and 47% market share in domestic petrol and diesel sales. In terms of number of retail outlets, it commands a 44% market share. It has the widest reach on highways, enabling effective service to truck fleet operators. It also has an established presence in rural India through its commendable network of Kisan Sevak Kendras. Consequently, IOC could be at the receiving end if marketing margins fall due to competitive pressures. Diversification will provide some respite IOC is the most diversified player in terms of revenue contribution amongst OMCs. While 57% of the EBIDTA is derived from refining and marketing businesses, pipelines (crude and products) and petrochemicals contribute 17% and 21% respectively. In terms of pipelines, it s the largest player in crude and product pipelines. Profitability of the petrochemical segment is in the top quartile. The company has plans to expand operations in both segments. This reduces the cyclicality risk of refining and marketing divisions. Huge capex spends ahead Over the next five to seven years, IOC has lined up expansion of Rs2,000bn. In the oil exploration, it has earmarked almost Rs300bn whereas another Rs300bn is allocated for the petrochemical segment. For the refining segment, Rs520bn has been lined up for various expansion and upgradation projects. This excludes investment in the West Coast Refinery. Another Rs400bn would be spent on marketing facilities and around Rs220bn will be spent on expanding the pipeline network. These spends would be funded by incremental borrowings, which would reverse the decline in leverage ratios of the past few years. CMP (Rs) (As on Sep 20, 2017) 396 SECTOR: Oil & Gas 12mts Target (Rs) 413 Market cap (Rs mn) 1,921,239 Upside 4.3% Enterprise value (Rs mn) 2,494,590 Figure 1: Financial summary (Standalone) Y/e 31 Mar (Rs mn) FY16 FY17 FY18E FY19E Revenues 3,506,031 3,598,732 3,775,035 4,128,557 yoy growth (%) (19.9) OPM (%) Reported PAT 103, , , ,895 yoy growth (%) (2.0) 7.8 EPS (Rs) P/E (x) Price/Book (x) EV/EBITDA (x) Debt/Equity (x) RoE (%) RoCE (%) Source: Company, IIFL Research Fairly valued, stake sale by ONGC will be a key overhang IOCL trades at FY19E P/E of 9x on its standalone earnings, which is in line with global peers. Marketing margins being at risk would be a threat to earnings growth estimates. Furthermore, ONGC to fund acquisition of government s stake in HPCL may resort to selling of its stake in IOC. This will be a key overhang on the stock price movement as ONGC holds 13.8% stake in IOC. Considering this, we downgrade our rating on the stock from BUY to Reduce with a revised one year price target of Rs413.

21 IOCL Possible merger with Oil India Following the ONGC HPCL deal, as per media reports, government may consider selling its 66% stake in Oil India to IOC. At current price, the deal will require IOC to spend Rs163bn, which can be financed through incremental borrowings or through sale of oil bonds worth Rs100bn. The merger would be as a part of government s large scale initiative of creating integrated companies in the oil sector. IOC has stakes in 17 exploration blocks (8 domestic and 9 international). Oil India s expertise in the field will help IOC reap better value from those assets. Paradip refinery catapults refining complexity IOC recently commenced operations at its greenfield refinery in Paradip. The capacity of the refinery is 15mn tons with a nelson complexity index of It has capabilities to process 100% high sulphur crude oil, of which 40% can be heavier grades. Distillate yield of the refinery will be 81% as compared to 76% of its existing refineries. This will lead to significant improvement in overall refining basket for IOC. Also it has plans to expand capacities of existing refineries with increase in complexity. This will lead to higher production of value added products and translate into higher GRMs. Figure 2: SOTP Valuation for IOCL Component Value Standalone 362 Listed investments 41 Other investments 10 Total 413 CMP 399 Upside (%) 3.5 Source: IIFL Research Company rating grid Stock performance Low High IOC Sensex Earnings Growth Cash Flow B/S Strength Valuation appeal 60 Risk Sep-16 Jan-17 May-17 Sep-17 Sensex: 31, Week h/l (Rs) 463 / 282 6m Avg t/o (Rs mn): 2,040 FV (Rs): 10 Div yield (%): 4.8 Bloomberg code: IOCL IS BSE code: NSE code: IOC Figure 3: Trend in refining throughput mn tons 55.6 Absolute return (%) 1M 3M 1Y (7.6) Shareholding pattern (%) Promoter 57.3 FII+DII 17.4 Others FY12 FY13 FY14 FY15 FY16 FY17 FY18E FY19E Source: Company, IIFL Research

22 IOCL Figure 4: Trend in market sales mn tons FY12 FY13 FY14 FY15 FY16 FY17 FY18E FY19E Source: Company, IIFL Research Figure 5: Trend in marketing to refining volume ratio 1.4 x FY12 FY13 FY14 FY15 FY16 FY17 FY18E FY19E Source: Company, IIFL Research Figure 6: Trend in GRMs 9.0 US$/bbl FY12 FY13 FY14 FY15 FY16 FY17 FY18E FY19E Source: Company, IIFL Research Figure 7: Trend in pipelines throughput mn tons FY12 FY13 FY14 FY15 FY16 FY17 FY18E FY19E Source: Company, IIFL Research

23 IOCL Figure 8: Trend in EBIDTA/ton for pipeline division Figure 10: Trend in EBIDTA/ton for petrochemical division Rs/ton ,000 30,000 EBIDTA/ton 30, ,000 20,000 15,000 10,000 5,000 5,041 Source: Company, IIFL Research FY12 FY13 FY14 FY15 FY16 FY17 0 FY12 FY13 FY14 FY15 FY16 FY17 FY18E FY19E Source: Company, IIFL Research Figure 9: Trend in petrochemical volumes Figure 11: Trend in RoE and RoCE Mn tons % 20.2 RoE (%) RoCE (%) FY12 FY13 FY14 FY15 FY16 FY17 FY18E FY19E Source: Company, IIFL Research FY12 FY13 FY14 FY15 FY16 FY17 FY18E FY19E Source: Company, IIFL Research

24 IOCL Financials (Standalone) Figure 12: Balance sheet Y/e 31 Mar (Rs m) FY16 FY17 FY18E FY19E Equity capital 23,697 47,393 47,393 47,393 Preference capital Reserves 857, , ,974 1,028,691 Net worth 881, ,287 1,029,367 1,076,084 Minority interest Debt 606, , , ,483 Deferred tax liab (net) 68,590 67,592 67,592 67,592 Total liabilities 1,556,336 1,778,363 1,920,442 2,077,160 Fixed assets 1,123,721 1,186,173 1,316,769 1,440,192 Intangible assets Investments 371, , , ,046 Deferred tax asset (net) Net working capital 54, , , ,461 Inventories 387, , , ,882 Sundry debtors 74,586 85,024 89,189 97,541 Other current assets 241, , , ,058 Sundry creditors (223,318) (301,075) (315,825) (345,401) Other current liabilities (425,388) (512,695) (545,040) (580,619) Cash 6, ,024 20,461 Total assets 1,556,336 1,778,363 1,920,442 2,077,160 Figure 13: Income statement Y/e 31 Mar (Rs m) FY16 FY17 FY18E FY19E Revenue 3,506,031 3,598,732 3,775,035 4,128,557 Operating profit 200, , , ,995 Depreciation (48,528) (62,230) (69,404) (76,578) Interest expense (30,001) (34,454) (43,349) (51,117) Other income 22,463 42,086 52,035 52,035 Profit before tax 144, , , ,336 Taxes (54,405) (72,148) (92,231) (99,441) Minorities and other Adj. profit 90, , , ,895 Exceptional items 13,643 Net profit 103, , , ,895 Figure 14: Cash flow statement Y/e 31 Mar (Rs m) FY16 FY17 FY18E FY19E Profit before tax 144, , , ,336 Depreciation 48,528 62,230 69,404 76,578 Tax paid (54,405) (72,148) (92,231) (99,441) Working capital 65,740 (63,407) (3,425) (21,858) Other operating items Operating cashflow 204, , , ,615 Capital expenditure (147,487) (124,682) (200,000) (200,000) Free cash flow 57,129 65,205 53,237 56,615 Equity raised (59,495) 63,432 (0) (0) Investments 63,337 (101,232) Debt financing/disposal (47,102) 107, , ,000 Dividends paid (38,794) (138,552) (155,178) (155,178) Other items 29,799 (998) Net in cash 4,873 (5,064) 8,059 11,437

25 IOCL Figure 15: Ratio analysis Y/e 31 Mar FY16 FY17 FY18E FY19E Growth matrix (%) Revenue growth (19.9) Op profit growth EBIT growth Net profit growth (2.0) 7.8 Profitability ratios (%) OPM EBIT margin Net profit margin RoCE RoNW RoA Per share ratios (Rs) EPS Dividend per share Cash EPS Book value per share Valuation ratios (x) P/E P/CEPS P/B EV/EBIDTA Payout (%) Dividend payout Tax payout Liquidity ratios Debtor days Inventory days Creditor days Leverage ratios Interest coverage Net debt / equity Net debt / op. profit Figure 16: Du-Pont analysis Y/e 31 Mar FY16 FY17 FY18E FY19E Tax burden (x) Interest burden (x) EBIT margin (x) Asset turnover (x) Financial leverage (x) RoE (%)

26 COMPANY RESEARCH BPCL - Reduce Upstream concerns & marketing woes E&P project delays Bharat PetroResources (BPRL), a whollyowned BPCL subsidiary, has participating interest in 17 upstream exploration blocks seven in India, six in Brazil and one each in Mozambique, Indonesia, Australia and East Timor. Of these, Brazil and Mozambique are the biggest discoveries with large reserves of oil and gas respectively. However, the development of these blocks has seen significant delays in the past few years. Given soft crude oil price outlook and oversupply of gas globally, these assets may not create incremental value in near future. Highest throughput per outlet but marketing margins at risk While BPCL lags HPCL in terms of retail outlets added across India, its throughput per outlet is 14% higher than that of HPCL and 4% higher visàvis IOCL. The company now intends to increase nonfuel revenues through pioneering initiatives like rural marketplace, integrated fleet management programs, personal travel offerings and urban household solutions. With marketing margins likely to be flattish owing to rising competition, we believe, BPCL akin to other OMCs will feel the pain in its marketing segment. Higher borrowings needed to fund huge capex plan BPCL too is spending heavily on increasing its refining capacity as well as marketing and upstream activities. Total outlay over the next five years is estimated to be in excess of Rs1,000bn. Major projects include 1) raising capacity of Bina refinery to 320,000 bpd from 120,000 bpd., 2) further expansion of Kochi plant to 400,00bpd by 2022, and 3) raising Mumbai refinery capacity by 17% to 280,000bpd. Apart from this, the company would invest in marketing activities, E&P investments and setting up petrochemical plants. These projects will need to be funded via incremental debt. CMP (Rs) (As on Sep 20, 2017) 466 SECTOR: Oil & Gas 12mts Target (Rs) 483 Market cap (Rs mn) 1,010,004 Upside 3.6% Enterprise value (Rs mn) 1,311,371 Figure 1: Financial summary (Standalone) Y/e 31 Mar (Rs mn) FY16 FY17 FY18E FY19E Revenues 1,893,033 2,022,106 2,190,374 2,195,971 yoy growth (%) (20.5) OPM (%) Reported PAT 74,319 80,393 79,541 86,353 yoy growth (%) (1.1) 8.6 EPS (Rs) P/E (x) Price/Book (x) EV/EBITDA (x) Debt/Equity (x) RoE (%) RoCE (%) Source: Company, IIFL Research Upsides restricted by upstream assets BPCL trades at FY19E P/E of 10.7x on its standalone earnings. With risks to earnings growth from the marketing segment along with erosion in value of upstream assets through constant delays, we believe the valuations are fair at current levels. We downgrade our rating from BUY to Reduce with a revised 1year price target of Rs483.

27 BPCL Possible takeover of GAIL Under the government s strategy of creating integrated oil companies, a takeover of government s stake in GAIL by BPCL is under consideration. At CMP, BPCL may have to pay Rs180bn to buy out the government s stake for the planned merger. BPCL and GAIL already operate together through a few JVs in the city gas business including IGL, Central UP Gas, Maharashtra Natural Gas and Goa Natural Gas. This acquisition would support BPCL s aggressive plans to increase its gas sector presence. Kochi refinery expansion to drive up overall refining complexity BPCL recently completed its expansion project at its Kochi refinery, scaling up capacity from 9.5mtpa to 15.5mtpa and modernizing it to produce autofuels in line with EuroIV/EuroV specifications. Given that the project units have the flexibility to process high sulphur crudes, the complexity index of the refinery would likely rise from 6.4 to 10.2, enabling higher share of value added products through a lower cost crude diet (from heavier and sourer varieties of crude intake) leading to higher GRMs. The Bina refinery also has a high nelson complexity index of 9.1 enabling it to earn higher GRMs visàvis Mumbai refinery. Company rating grid Stock performance Low High BPCL Earnings Growth 120 Cash Flow B/S Strength Valuation appeal Risk Sensex: 31, Week h/l (Rs) 546 / 389 6m Avg t/o (Rs mn): 1,755 FV (Rs): 10 Div yield (%): 4.7 Bloomberg code: BPCL IS BSE code: NSE code: BPCL Figure 3: Trend in refining throughput Absolute return (%) Sensex 60 Sep16 Jan17 May17 Sep17 1M 3M 1Y (8.4) Shareholding pattern (%) Promoter 54.9 FII+DII 30.1 Others 15.0 Figure 2: SOTP Valuation for BPCL Component Value Standalone 373 E&P 50 Listed investments 60 Total 483 CMP 468 Upside (%) 3.2 Source: IIFL Research mn tons FY12 FY13 FY14 FY15 FY16 FY17 FY18E FY19E Source: Company, IIFL Research