Indian energy sector is vulnerable to international oil prices (read crude), as the country is dependent on imports to the extent of 70% of domestic refining requirements.

Although the world has witnessed many oil shocks earlier, most of them were supply-scarcity driven (i.e. wars), while the current one is largely a demand-pull activity. We believe, this high demand is likely to continue in the foreseeable future.

Let us look at the impact the high crude prices have on the various segments of the Indian oil sector across the value chain (upstream and downstream).

	Upstream	Downstream
Parameters	E & P *	Integrated	Refineries
High crude prices	A big positive, as companies sell crude at import parity prices. To put things in perspective, every US$ 1 increase in international crude prices lead to a Rs 9 bn addition to ONGC's revenues.	Mixed impact. Although APM has been dismantled, government continues to control pricing resulting in the lack of ability to pass on high input prices to the consumers. However, the refining margins compensate for the squeeze in marketing margins.	On the face of it, negative, as raw material costs increase. However, the resultant increase in product prices lead to better margins.
Duties	Negative, as it forms a major portion of the cost, as part of drilling, surveys and royalties. As compared to global competitors, ONGC's payment of duties is one of the highest.	Negative. Since the government subsidises LPG and kerosene, high duties are levied on petrol and diesel. To put things in perspective, at current international prices, cost of petrol per litre is nearly Rs 13, while it is sold at Rs 42 per litre in Mumbai.	A big positive. Since India is product surplus, customs duties are levied so as to bring the product prices to international levels, thereby resulting in higher profits to refineries and a protection against imports.
Pricing	Although in line with international prices, the government has roped in these upstream majors like ONGC and GAIL to share a part of the burden of subsidies on LPG and kerosene. Therefore, negative.	Limited autonomy (within a 10% band). However, as on date, the 10% band has already been breached.	Positive, as prices at the refinery gate are in line with the international prices. As such, high demand has pushed product prices higher resulting in robust profits for refineries.

Upstream -- ONGC, GAIL and Oil India
Currently, crude oil (Indian mix) prices are at record levels (nearly US$ 41 per barrel), which should lead to robust performance by the upstream major, ONGC, which accounts for nearly 90% of Indian crude production. However, subsidies to the tune of nearly US$ 3 per barrel on account of LPG and kerosene subdues overall profitability.

Integrated players -- BPCL, HPCL, IOC
Oil refining and marketing companies have been on a refinery expansion spree, although the country is currently faced with surplus refining capacity (i.e. production higher than demand).

The expansion is likely to give these companies better control over their produce and at the same time, enable them to ride on the high refining margins. Further, it is always good to reduce external dependence (mostly companies like BPCL and HPCL, purchase from other refineries in select markets due to the lack of capacity and logistics benefits).

Just for instance, post the contract with Reliance's Jamnagar refinery, oil marketing PSUs have nearly halved their product offtake from the private player on account of higher refining capacity.

Standalone players -- Kochi Refineries, Chennai Petroleum, MRPL, Bongaigaon
Standalone refineries are currently witnessing a dream-run with international product prices ruling at record high levels ($6 to $7 per barrel as against $3 per barrel in FY04).

This is a demand driven hike in prices and is expected to continue over the foreseeable future. We therefore believe that petroleum product prices at the refinery gate are likely to witness a further boost.

Overall sector view
As per the government's recent announcement of the 10% price band, it was also decided upon to maintain a flexible duty regime, whereby, in case of a breach in the ceiling of the band, the customs duties on products would be cut.

Although India does not import petroleum products like petrol and diesel (except LPG), customs duties are levied on these products to bring the prices at par with international levels, resulting in higher profits for the refineries.

This is likely to have a negative impact on the refineries' profitability and would help maintain marketing margins for the marketing companies. Given this backdrop, we would advise investors to exercise caution till further clarity emerges on custom duty cuts.

However, over the long-term, energy stocks are looking attractive due to the fact that demand remains inelastic at the margin, regardless of prices.

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