K. Ravichandran, Senior Vice President and Group Head, Corporate Ratings, ICRA Limited
COVID-19 has had a devastating impact on the global economy and the fortunes of several industries. So much so that we are comparing COVID-19 with past cataclysmic events such as world wars, the Great Depression of the 1930s and the recent global financial crisis in 2008, in terms of the impact on the lives of ordinary people. While there are still several unknowns about COVID-19, what is clear is the impact it has already had on several businesses. Global oil and gas is one such deeply impacted industry. We have already witnessed negative oil prices in the US market. While West Texas Intermediate and Brent prices have recovered since April 2020, the prices are not yet in the comfort zone for exploration and production (E&P) companies and oil-dominated economies. Moreover, the oil market is awash with inventories, with producers and traders scrambling for space to store crude oil. In this backdrop, the Indian oil and gas industry too has been negatively impacted, as the business is global in nature. While all the segments of the oil and gas value chain have been impacted, the financial impact is somewhat different across segments. This article proposes to analyse these issues at length.
Before we do a deep dive, it is imperative to take a look at the likely trajectory of global oil prices. While oil prices traded in the commodity exchanges have recovered to around $30 per barrel (Brent) from the distress levels seen in April 2020, on the strength of production curtailment by the Organization of the Petroleum Exporting Countries plus (OPEC+) nations, the price increase by Saudi Aramco through its Official Selling Price (OSP) mechanism and resumption of economic activity in a few countries, they will remain volatile in the near term, within a range of $20 per barrel to $40 per barrel (Brent) with the ongoing COVID-19 pandemic. The bearish view is primarily due to the crude oil supply overhang, what with the record level of inventories in both inland and floating storages, even as demand has been curtailed by 25-30 per cent from the peak level of 100 million barrels per day in 2019. Until the oil market rebalances in terms of demand recovery and supply curtailment through voluntary and involuntary responses, crude oil prices will remain muted, and this will be a credit negative for E&P companies and oil exporting countries.
At the current level of crude prices, Indian national oil companies (NOCs) will either make a loss or generate meagre cash accruals, which will not leave them with sufficient surplus to reinvest in exploring and developing their fields. ICRA’s analysis indicates that on a full-cycle-cost basis, it is unviable to develop many of the discovered fields, given the current low realisation on oil. Moreover, domestic gas prices have also been slashed to abysmal levels, under which the NOCs will make losses on natural gas production from the nominated fields. Challenges are even more daunting for private oil and gas companies, with many of them expected to slash capex, which is a negative from an Indian self-sufficiency point of view. At the industry level, while a plethora of reforms were initiated by the government in the upstream space under the Hydrocarbon Exploration and Licensing Policy, the Open Acreage Licensing Policy and the Discovered Small Fields Policy, it may not be commercially viable for the industry to go ahead with its capex plans. While renegotiation of contracts by upstream companies for optimising their capex and opex is a possibility, actual savings this time around may not be material as many oil field service companies are already operating on thin margins. Given these headwinds, the anticipated improvement in domestic oil and gas supply may not materialise, resulting in a continued high dependence on imported liquified natural gas (LNG) and oil.
In this kind of challenging environment, the central government should seriously consider some relief to the industry, especially reducing fiscal levies (royalty, cess and profit petroleum) and effecting changes in the domestic gas pricing guidelines to provide for a floor price, for them to stay afloat and make investments. After all, the industry has contributed immensely to the national and state exchequers in the past several years, by way of various taxes (including income tax, dividend and dividend tax) when oil prices were high. Moreover, NOCs had sacrificed their net realisation on oil by sharing the subsidy burden when oil prices were elevated. Perhaps it is time to pay back the upstream industry, even though the government’s own fiscal position is expected to remain parlous, given the economic slowdown and lower tax collections.
With regard to the downstream sector, the oil price fall, demand destruction and depreciation of the rupee against the dollar have decimated profitability. The sharp fall in oil prices in March 2020 is expected to translate to an inventory loss of over Rs 330 billion for the industry in the fourth quarter of 2019-20, with inland refineries taking a bigger hit due to larger inventory holdings. Demand for petroleum products, especially transportation fuels such as motor spirit, high speed diesel (HSD) and aviation turbine fuel, has been hit anywhere from 60 per cent to 90 per cent from the peak levels, because of the pan-India lockdown. Further, the industry’s refining margins have also taken a hit due to the plunge in crack spreads as a result of a weakness in demand globally for these products. A sharp depreciation of the rupee within a short span of time has also added to the industry’s woes, translating to elevated mark-to-market losses. While the demand has been recovering more recently, with partial relaxation of lockdowns in many states and resumption of industrial activities, it will be at least four-six quarters before demand reaches normal levels. That apart, the government has also mopped up the gains accruing to oil marketing companies (OMCs) emanating from keeping a freeze on the pump prices, by an unprecedented additional excise duty and cess hike by Rs 10 per litre for petrol and Rs 13 per litre for HSD. While these additional levies will normalise OMCs’ marketing margins, they will not be left with any cushion to meet the shortfall arising from the negative growth in demand for products in the near term. The debt levels of OMCs have also risen sharply as of March 2020, due to high inventories and delays in payment by the government on account of subsidy and purchase of crude to fill strategic reserves. Nonetheless, Indian refiners enjoy a strong credit profile, which has allowed them to raise debt from the capital markets and banks under the long-term repo operations route at very competitive rates. Moreover, under a low oil price scenario, under-recoveries will be minuscule and power and fuel costs of refiners will reduce, and this should strengthen their profits going forward.
Regarding gas utilities, demand destruction across industries and price disparities between spot LNG and long-term LNG contracts have impacted industry dynamics. While the city gas distribution (CGD) segment is the most affected in terms of drying up of compressed natural gas and piped natural gas (industrial and commercial) demand, demand from the fertiliser and power sectors has kept the industry going during the lockdown period. While gas demand is expected to gradually limp back to normal for the CGD segment in the near term, marketing margins for marketers of “term LNG” will take a knock due to the price-related distortions between oil-linked and gas-linked contracts, and high unsold inventories. Due to the lockdown, several end consumers have invoked the force majeure clause as part of the gas supply agreement. This has reverberated across the gas value chain – gas aggregators, gas transmission pipeline sponsors, LNG regasification terminals and LNG exporters/domestic gas producers. Some of these force majeure invocations could end up in protracted litigations, which is a key credit concern.
COVID-19 has also impacted the roll-out of projects in the CGD and gas transmission pipeline segments, due to issues in labour availability and delays in getting approvals. With several CGD projects delayed, the industry will require some forbearance from the Petroleum and Natural Gas Regulatory Board for delays in achieving minimum works programme mandates. Having said that, well-established CGD companies are not expected to experience any stress in debt servicing due to low financial leverage and superior sponsor support. Nonetheless, there might be potential delays in financial closure of new CGD projects, as lenders have become risk-averse in the current challenging environment.
From the government’s perspective, resorting to aggressive purchase of crude oil to fill up strategic reserves and the sharp hike in duties on auto fuels are smart moves which should pay off in the long run. Nonetheless, it should swiftly come out with a set of relief measures for the industry, which is reeling under the recent black swan events, failing which, the credit profile of the industry could deteriorate in the near to medium term.