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From Kotak Securities

Refining Margins Crack-Negative for Reliance (owned Refinery Operations, attributed Investment Value in Reliance Petroleum and Closed Retail Oil Marketing Operations), Essar Oil, Chennai Petro and Bongaigaon Refineries.

Indifferent to: IOC, HPCL, BPCL

Refinery margins crack in the recent week led by a surging crude price and relatively stable product price
• Further rise in crude price and significant capacity addition from 2HCY08 will likely keep global refining margins under pressure
• Risks to earnings of RIL and RPET; PSU R&M will be neutral as lower marketing losses compensate for lower refining margins

Crude prices have risen by US$8/bbl (Dated Brent) while rise in product prices has been moderate (+US$1-3/bbl) resulting in sharp decline in refining margins. Although we expect refining margins to recover from the current low levels, we believe they will remain weak led by (1) product prices failing to keep pace with surging crude oil prices, which may also lead to demand weakness and (2) large refining capacity expected to start from 2HCY08.

A decline in refining margins will have a negative impact on the earnings of standalone refiners (including RIL's existing and RPET's upcoming refinery). PSU R&M companies will not be impacted much given the transfer of profits from the refining division to the marketing division.

Implications of decline in refining margins.

We note that RIL’s and RPET’s earnings are highly sensitive to refining margins and weaker-than-expected margins could significantly impact their earnings. We currently model very strong margins for RIL’s refinery at US$12.4/bbl for FY2009E and US$13.1/bbl for FY2010E and for RPET’s refinery at US$15.8/bbl for FY2010E and US$14.8/bbl for FY2011E.

We note that RIL’s FY2008 reported margin was US$15/bbl, which probably included US$3/bbl of adventitious gains; the sharp yoy decline reflects our assumption of adventitious gains in FY2009E and beyond. A US$1/bbl decline in refining margins impacts RIL’s FY2009E (standalone) EPS by 6% and RPET’s FY2010E EPS by 9%. Exhibits 3 and 4 show the sensitivity of RIL’s (standalone) and RPET’s EPS to changes in refining margins, respectively.

Although the current decline in refining margins may not be relevant for RPET since RPET’s refinery will likely start operations in 3QFY09, it will likely impact refining margins and earnings of RIL and sentiment for RPET’s earnings.

However, PSU R&M companies are not affected in the current situation as the decline in profitability of the refining segment due to the decline in refining margins will be matched by a decline in marketing losses; this will result in a transfer of profits from the refining division to the marketing division.

In any case, earnings of PSU oil marketing companies (BPCL, HPCL and IOCL) have lost meaning in the current environment given (1) likely high gross under-recoveries, (2) low possibility of favorable government action given fiscal and political compulsions and (3) uncertainty regarding the subsidy-sharing scheme.

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Imputed Value of Reliance Petroleum in the Reliance Industries stock consequently goes down. Expect Reliance to sink below Rs 2000 shortly.

New RPL supply to keep gasoline spreads weak; cut 09E-10E GRM; downgrade RPL, Formosa Petrochemical to Sell

RPL's new refinery to have impact on refining margins.We believe that Reliance Petroleum's (RPL) new 580Kpbd refinery, representing almost 50% of our estimate of global oil demand
growth in 2009, is likely to have ramifications for refining margins globally, particularly for gasoline spreads, when it comes on stream in 4Q2008E.

We estimate that RPL will produce almost 400 - 500 Kbpd of gasoline and diesel, which will be entirely exported out, in our view.

Divergence between weak gasoline spreads, stable diesel spreads.Incremental supply from RPL amid weak gasoline demand growth in the key US market and tighter ethanol blending norms are likely to keep gasoline spreads weak over medium term, in our view. However, we
believe middle distillate spreads are likely to remain robust, driven by strong demand from transportation and industrial growth in Asia and Middle East and steady demand from Europe, thereby absorbing RPL's diesel exports.

Fuel oil spreads are likely to remain weak, in our view.

Hence, we believe that US refiners with high gasoline exposure are likely to be more adversely impacted than most of the European and Asian refiners with high diesel yields. However, gasoline exports of some of the European refiners to the US may be displaced by RPL's gasoline. The simple refineries with high fuel oil yields are also likely to suffer across
geographies due to weak fuel oil spreads, in our opinion.

Reducing refinery margin and gasoline spread forecasts.We lower our Singapore complex refining margin forecasts for 2009E and 2010E by US$2.0/bbl and US$2.5/bbl, respectively, to US$8/bbl in each year and downgrade our Asian refining sector view to neutral from attractive.

This is in line with our outlook for the US refiners. We also cut simple margins for 2009E and 2010E to US$0.3/bbl in each year from US$2.0/bbl and US$2.5/bbl, respectively. As a
result, we lower 2009E EPS of refining stocks under coverage by 5%-35% and their
12-mo. target prices by 1%-22%.

Key risks:

1) rebound in gasoline spreads owing to strong US demand;
2) economic recession leading to negative oil demand; and
3) pricing reforms in India, China.