## Saturday, October 20, 2007

### Gloomy perceptions about PSUs and their consequences

Business Standard has a very insightful editorial on the oil industry:

Global oil prices are nearly $90 per barrel; the Indian crude basket is more than$80/barrel. The Indian consumer scarcely knows this, though, since domestic oil product prices remain firmly fixed, and by the look of it will remain fixed till the next Parliamentary elections are over. Petroleum Minister Murli Deora has managed to deliver this state of nirvana by getting the Cabinet to approve the issue of Rs 23,458 crore worth of oil bonds and by forcing the state-owned oil enterprises to absorb the rest of the expected shortfall of Rs 54,935 crore during the financial year. Given the 14 per cent share of fuel, power, light and lubricants in the wholesale price index (its 5.5 percentage points for LPG, petrol, kerosene and diesel), it is obvious that Mr Deora's role in keeping prices down has been an important one, because what is called under-recoveries on petrol now total as much as a tenth of its retail price, while for diesel it is even higher at one-fifth. The under-recovery gets still worse for cooking gas (40 per cent), and for kerosene (65 per cent).

This is price distortion of the worst kind, and is not without costs even if these are not immediately obvious. Consider the non-consumer side of the picture. The private sector Reliance Industries, which had been grabbing market share from state-owned oil firms, has virtually given up trying to sell its refined products in the domestic market (it does not get the subsidy that the government gives the state-owned firms) and has become instead the country's biggest exporter of petroleum products -- the share of oil product exports in total exports has risen as a result from 8.4 per cent in 2004-05 to 14.7 per cent in 2006-07, and may have climbed further to 18 per cent this year.

The state-owned oil companies, for their part, do not have the luxury of escaping into export markets and must suffer the vagaries of government policy, which has affected their bottom line as well as their investment plans. To take the figures for the current year, the firms will jointly incur a loss of over Rs 30,000 crore a fact that is not lost on investors. The result is that Indian Oil's share price now commands a price-earning multiple of barely 6.5 (about a quarter of the average Sensex stock), while in the case of Bharat Petroleum and Hindustan Petroleum, the P:E ratios are about 4.5 and 4.8. On a combined market capitalisation for the three firms of Rs 75,000 crore, they are valued at less than what just one of them should be worth and also less than the value of Reliance Petroleum, which is a new refining company that is still to start business but which is already valued in excess of Rs 80,000 crore!

This is a pointer to how much punishment the government is taking on the stock market. And since companies finance fresh investments by floating new shares and thus capitalising on their share valuation, what the government has done is to make sure that the hopelessly under-priced state-owned oil firms will not be able to play this game. So the oil-refining business will increasingly have only private sector investors who being unable to sell in the domestic market will be busy exporting their product while domestic demand is met by imports through the state-owned companies.

This bizarre denouement is what Mr Deora has achieved. Meanwhile, even as Mr Chidambaram counts the extra tax revenue being delivered to him by a buoyant economy, he should consider whether as much and more has been lost on the stock market because of the oil-pricing policy. If the government had an annual balance sheet wherein it had to assess the value of its assets (and liabilities) each year, instead of the outdated financial system that it calls its Budget, the disastrous trade-off would be obvious to everyone. Indeed, in today's accounting system, even the oil bonds that are being issued do not show up in the definition of what is the fiscal deficit. It is no wonder that most people are completely unaware of the cost of today's oil-pricing policy.

A similar phenomenon is taking place in banking. In banking, given the way capital requirements are structured, equity capital through a combination of retained earnings and external share issuance is critical for enabling deposit growth. Let's focus on some of the bigger banks [full list]:

BankNet profitP/E
Jun-07 Quarter
(Rs. crore)
Bank of Baroda 331 10
Bank of India 315 11
Canara 241 8
Corporation Bank 202 9
Indian Bank 212 9
IOB 268 8
Oriental Bk. Commerce 200 8
Punjab National Bank 732 9
Syndicate 221 7
Union Bank 225 9

SBI 1426 20

Axis 175 38
HDFC Bank 321 41
ICICI Bank 775 36

(The net profits is for the June 2007 quarter since all the results aren't out for the September 2007 quarter. All banks with more than Rs.200 crore of profit in that quarter are in the table. The P/E is for September 2007.)

The same phenomenon that the BS edit describes, with oil companies, is visible here also. There's a striking pattern where `ordinary' PSU banks have a P/E of roughly 10; SBI is a PSU bank with a P/E of roughly 20; the three large private banks are at a P/E of 40.

1. The cost of destroying value of public sector oil companies is not just on the stock market. India is a large importer of oil and gas. The more the government forces its energy companies to subsidize consumers and reduce their own cashflows and earnings, the less money they have to explore for new energy and to invest in the production and marketing of it. Politicians and media commentators talk regularly of 'energy security' but fail to connect that problem with the short-sighted policies that handicap the biggest energy companies in India.

2. It is hardly fair to single out Murli Deora for the going-ons in the oil industry. Does one seriously think he calls the shots on oil prices and related matters?

In fact, his is a continuation of the policies of his predecessor Mani Shankar Iyer and even before him Ram Naik (of NDA) who started this practice of not letting prices rise as international crude prices started their upward journey 6-7 years ago.

And it is not only oil marketing companies, a E&P company like ONGC has seen its profits reduce and even a gas transmission company - GAIL - had to pitch in even though it doesn't sell diesel and petrol.

How ironical that is the Left parties who have resisted price increases (though they are not the only ones) and who shout the most about the neglect of PSUs have contributed to the weakening of the PSUs - think the law of unintended consequences.

As elections loom one can hardly hope that sense will return to oil pricing. The most charitable explanation is that the government never imagined prices rising so high (The EAC, last year, had forecast prices of crude in the \$ 50-60 range!!!) Had it not been for the appreciation of the rupee the situation would have been far worse.

Rather than let prices increase continually and in small increments (even if they have to be administered) the government waits a long time and then announces a big jump which inevitably causes a political backlash and a roll-back.

These distortions pervade the whole oil-gas-petroleum sector - fertilizer prices have not been raised for god knows how many years now, petrol is 50 % more expensive than diesel, custom duties on refined petroleum and petrochemical products are much more than on crude.

And rather than remove the distortions where they arise the government keeps adding new ones - oil bonds, sharing of under recoveries, maintaining/increasing the differentials between crude and various petroleum and petroleum derived products.

And while the media goes gaga over the role of Indians in this year's Nobel Peace Prize we should ponder what our pricing policies are doing to the immediate problems of air pollution and that of long-term ones like climate change. Is not increasing prices of fossil fuels a sensible policy? While renewables get tax breaks of arguably the most undeserving kind (accelerated depreciation, for example) prices of petroleum prices are left untouched - yet another distortion.

3. How does the argument extend to the banking sector , again? I can see the gross differences in the P/E of the private sector vs PSU banks but what is the causal factor here? I mean, are there parameters (akin to retail prices for petroleoum) that the Government artificially fixes by diktat specifically for PSU banks?

4. In the case of oil, the distortions are indeed more visible. But in both cases, there is one common issue: government ownership is inducing much lower valuations. The private sector is able to have firms with high P/E ratios and raise ample resources from the market. The PSUs are not.

5. Thanks Ajay, It will definitely be helpful to all of us to get a clear look of what changes are happening recently.
this is the nice information shared with us.

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