Energy sector: Should investors play the reform theme?

Wed, 24 Sep Pre-Open

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Indian energy sector is at a crucial turning point. After years of under recovery, state run oil firms are earning profits on diesel sales. Along with a phased hike in diesel price, the easing in crude oil prices has bought the smile back on faces of state run oil marketing companies. There is a speculation that easing oil prices will provide a perfect premise to deregulate diesel.

So for Indian energy sector to witness reforms, oil price will be a crucial parameter. Deregulating pricing in the energy sector at a time when crude price is high is likely to backfire in the form of high inflation and public outrage. However, if International Energy Agency estimates are anything to go by, the oil prices seem to favour decontrol. The renowned agency estimates that global oil demand has declined. Going by the laws of economics, low demand will keep the prices under pressure.

If that comes true and free pricing follows, it won't be just OMCs who will benefit. As suggested in an article in Business Standard, huge energy imports, especially crude oil bill that is a major reason for financial mess and twin deficits in the country, will decline. It will also lower the burden for firms like Oil and Natural Gas Corporation Ltd. (ONGC) whose potential remains unlocked as most of the potential revenues are sacrificed as subsidies.

However, before investors get excited about the diesel decontrol theme, here are a few facts and warnings. The first one is that the current valuations already capture most of the potential positive changes. Second, while diesel decontrol offers a lot of opportunities, it brings a new set of challenges for oil marketing companies. The biggest of which comes from the private sector. Complete deregulation of fuels will bring the private sector back into action. This will imply loss of market share and pressure on margins due to price wars.

In the past, even after full deregulation; oil companies had been selling petrol below the market prices and did not have complete freedom in pricing. And that was not even compensated later, being officially deregulated. One can not deny a similar situation for diesel if crude prices go up post decontrol. In short, while upside due to the expected reforms are already getting reflected in valuations of oil companies, investors must be aware of potential pitfalls while making investing decisions in the oil and gas space.