May 24, 2008

Change of mind - HPCL

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).


Ninad Kunder said...

Hi Rohit

"There are only two things that are infinite, the universe and human stupidity, and I am not sure about the former".

This is a quote by Einstein and aptly summaries the levels of stupidity our politicians are sometimes capable off.



Rohit Chauhan said...

Hi ninad

I used to think on the same lines earlier regarding politicians. I find them equally replusive now too. However i have changed my opninion on their actions as bein stupid

after reading munger's lecture on pyschology of misjudgement, it quite possible to see why politicians will follow these horrible policies as it benefits them to get votes and win elections. It also helps them to profit from the corruption


Shunya said...

I am not sure if abandoning HPCL is such a good idea right now. You can buy good stocks at bargain only during distressed times. First crude prices will definitely go down. its just a temporary blip and secondly government cannot afford to shut down these PSU oil companies. Definitely PSU oil companies are not a long term bet for me..but for the short term ..i guess there is an excellent opportunity as of now. I know i can be wrong.

Anonymous said...


If we go strictly by value investing principals ,then I dont think HPCL is a bad bet for 2-3 year holding period.

- Current market cap is 6576 Cr. Your earlier valuation was Rs 25000 Cr +
- Price much below book value
- It is an uncertain environment not RISKY. (if we go by Mohnish Parbai, this is the best investment situation)

- Oil seems to have peaked or near its peak. As per an expert who predicted high oil prices, oil will drop to 60 USD per barrel in a year or two.
In any case ,value should not depend on short term price movements. Is market assuming permanent high prices in valuing HPCL?
- There is no way govt will allow HPCL or any other refiner go bankrupt as oil distribution would stop.

I think market is factoring a worst case scenario in case of HPCL. There would be positive triggers only in next 2 years(price drop, govt change of policy,merger etc)

I am betting on a 100% return on HPCL over 2-3 years horizon although there could be some downside in short run.

May sound optimistic,but just that it is a stock no "sane" person would look at should make it a shortlisted candidate to a value investor.

Comments are welcome.


Rohit Chauhan said...

Hi alok
the value is still there ..but i am not so confident if as investor we will realise it till oil prices drop.
it is politically impossible for the goverment to raise prices as high as required

on the oil price front, there are as many predicitions as the number of experts. so although the crude price has a very important impact, i am not position personally to make a judgement.

the crude prices may drop, but in the interim the oil companies will continue to bleed. ofcourse the goverment will not allow them to die, but that may not benefit me as a shareholder.

frankly i see better opportunities out there and hence moved out of hpcl. the co. may give a good return, but i am not comfortable with risk reward situation.

to give buffett's analogy - why jump 7 footers when 1 footers are available ?