Oil price deregulation opens new vistas for alpha generation
Mumbai   30-Aug-2010

Indian equity mutual funds have always allocated a large chunk of their assets under management to the oil and gas sector. However, the dynamics of the sector have now changed significantly. Reading these dynamics poses a new challenge for fund managers in stock selection, and opens new opportunities for alpha generation.

Petroleum products are universal intermediaries, entering into the cost of production of a number of goods and services. The impact of any price hike has a cascading effect on the prices of a range of commodities. The current year has been characterised by strong economic growth driven by rising consumption of petroleum products, low crude production and low reserve accretion, at the same time the government, burdened by a large subsidy bill, has been making attempts to phase out the subsidy on petroleum products.

The government set up the Parikh Committee, which proposed deregulation in the prices of petrol and diesel, prices of kerosene and LPG to be increased and subsidy on kerosene to be restricted to BPL families. However, on June 25, 2010, in the Empowered Group of Committee Meeting (EGCM), the government decision was not entirely in line of the said proposal. The only product which underwent a complete deregulation was the petrol price.

What may change?

Deregulation of petrol price poses the threat of increasing inflation. While the decision would have a cascading effect on the retail consumers, the oil marketing companies (OMCs) are expected to receive a respite from their current spate of losses. In India there are primarily three OMCs - IndianOil, Hindustan Petroleum Corporation and Bharat Petroleum Corporation - which have been suffering huge losses in the controlled price environment. These losses accumulated, as the companies import oil at higher prices and are forced to sell at the subsidised rates. In fact, post the deregulation decision, these three OMCs will be coordinating with one another to decide the petrol prices on a fortnightly basis. The revision in the pricing scenario is also expected to lead to the re-emergence of private players.

MFs cash in on the opportunity

The speculation over deregulation had been building for a long time and the concrete decision by the government has given rise to improved investment opportunities in the sector - particularly in the three oil marketing stocks. Thus prompting many fund managers to take calls in these stocks. A fund manager also pointed out that the deregulation will benefit both the upstream and downstream companies as it will remove the subsidy overhang.

The allocation to these three stocks gained momentum from May 2010 onwards when the number of schemes taking exposure under these stocks moved up from 90 at the end of April 2010 to 111 at the end of May 2010 and eventually to 116 at the end of June 2010.

However, within a short span of a month, after the deregulation was announced, many funds booked profits and exited these three scrips. End of July 2010, there were 101 equity diversified mutual funds which have invested in these companies but only a few have taken significant calls of more than 3% in these stocks over the past one year.

Allocation of assets in all the three stocks simultaneously will not provide any further diversification opportunity to the scheme as the three stocks are highly correlated to each other. However, stock selection is critical. BPCL and IOC have generated absolute returns in the range of 35% to 38% over a period of one year, while HPCL lagged with returns of 25% over the same time period. Nevertheless, it is quite common for funds to invest in all three scrips simultaneously. Also, of these three OMCs, HPCL has been consistently the most popular amongst fund managers since April 2010.

Fund manager Omprakash Kuckien has allocated more than 3% to HPCL under Reliance NRI Equity Fund. The allocation to the stock has been timed in tandem with the price movement of the stock. This has benefited the scheme significantly as the stock gained 20% approximately over the past three months. The fund manager has also taken the same call under Reliance RSF Equity Fund and thus benefited in a similar fashion, though the allocation to HPCL under this scheme was limited to a smaller 1.88%.

Similarly, HDFC Growth Fund entered BPCL in October 2008, with a paltry allocation of 1.38% of its assets. This allocation had reached a high of 6.34% in December 2009. The fund manager has held the stock steadily except for few instances of marginal selling to lock profits. From October 2008 to July 2010, the scheme delivered an absolute return of 95.45%, while the stock of BPCL alone gained by 123.46%.

IDFC Imperial Equity Fund had placed a strong bet in IOC when it entered the scrip with an allocation of more than 6% in September 2009 and eventually exited in March 2010. It is one of the schemes that re-entered the scrip following developments in the sector and again entered the scrip in May 2010.