I had written the post below on 20-May. Since then the government has started thinking of raising the fuel prices. Note the word – thinking. The decision to raise prices is easier said than done. Even if the prices are raised, the haemorrhaging of the oil companies will reduce only partly.

I had written about HPCL earlier see here and here

The key elements of the investment thesis was as follows

1. The company is currently engaged in diversifying its revenue streams via various initiatives and reduce the impact of the pig headed policies of the government. These initiatives are lube marketing, Gas distribution and retail initiatives and oil trading and risk management. The market is currently not valuing any of these real options.
2. The GRM and net refining margins are at their lowest. Going forward the worst case sceanrio is that they would remain at the same level. If that is the case, the bottom line should still improve as the various company intiatives take effect (see page 53 of Annual report)
3. The 9 MMT refinery and expansion of Vizag refinery to 15 MMT and export of the petro-products and E&P activities should help the company improve its margins going forward.

The key unsaid assumption was that oil would not spike sharply. Oil prices are now at 130 usd a barrel (double the levels at the time of the analysis) and show no signs of coming down. In addition , I also read the following report – oil firms weeks away from bankruptcy. Now I do not believe the oil firms will go bankrupt – technically speaking. It is in the interest of the government to keep these companies alive. However the future looks bleak for these companies for the following reasons

1. Oil prices are unlikely to come down anytime soon. So the only way the government can sustain these companies is by issuing oil bonds. To raise cash, these companies will have to sell the oil bonds at some discount , incurring losses.
2. The government is unlikely to compensate these companies fully, wanting to keep the deficeit under control. As a result expect these company to incur losses for the forseeable future. In such a scenario, I am not sure how much these companies can invest in profitable growth and other assets.
3. These companies will increasingly look like the State SEB and other power companies in the long run – forever subsidsing the consumer due government pressure and unable to grow the business or invest in it.

Key learnings

1. I was clearly wrong about point 2 in the thesis. I never expected the oil prices to spike to 120+ (if i knew, oil futures would have been a great investment) . I never expected this government to remove the subsidy (and the next government wont do that either – it is not in their self interest). However the price spike in crude will be devastating to the oil companies.
2. Ignoring key pyschological principle – self interest combined with a crude price shock. Individuals and goverments take actions which are in their personal interest. Which political party is ever going to increase fuel prices and risk losing elections. I expected the government to behave in the way it is now. However self interest combined with high crude price will hurt the companies big time. As long as the prices were 100 usd or lower, the situation was bad, but now it is dire for these companies.

The loan waiver was still a one time event (hopefully). However the above subsidy is ongoing and will hurt the oil companies in the long run (in the short run they will be compensated via oil bonds and other mechanism). The above thesis was reasonable for moderately high crude prices. However the current price shock could drive the networth to zero.

Disclosure – I am exiting my position at a small gain. HPCL has not been a big position for me. The risk reward situation was good initially. However with the oil prices shooting up, I think the risk is not commensurate with the return.

Added note : In life there is no free lunch. Till date the government has subsidized fuel by gouging the oil companies. That well is now dry. Eventually all this subsidy will have to be paid by someone. It will likely come through taxes and higher inflation (most likely a combination of both).

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