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Tuesday, November 24, 2020

Explained: Here’s why inventory gains are helping oil companies

We examine what causes inventory gains and how they impact the financial performance of oil marketing companies.

Written by Karunjit Singh , Edited by Explained Desk | New Delhi | Updated: November 6, 2020 12:57:27 pm
Indian Oil Corp. tanker trucks sit parked at one of the company's gas stations near the Delhi city boundary in Faridabad, Haryana. (Photographer: Prashanth Vishwanathan/Bloomberg)

Both Indian Oil Corporation Ltd. (IOCL) and Bharat Petroleum Corporation Ltd. (BPCL) have reported strong financial results in the second quarter of this fiscal despite lower operating revenues. The key item driving profits for both companies in the quarter were “inventory gains”. We examine what causes inventory gains and how they impact the financial performance of oil marketing companies. HPCL, the third major state owned oil refiner, has not yet reported financial results for the second quarter.

What are inventory gains?

Inventory gains are registered from an appreciation in the value of inventory held by a company. In the case of oil marketing companies, inventory gains can be caused by an appreciation in the price of crude classified as refining inventory gains or an appreciation in the price of products such as petrol and diesel classified as marketing inventory gains. Refining inventory gains are a result of an appreciation in the price of crude oil in the company’s inventory. OMCs purchased crude oil in April when the price of Brent crude hit a low of $19.33 per barrel. The price of Brent crude oil recovered to around $40- 45 $ per barrel in mid-June though a recent fall has pushed it to $38 per barrel in late October.

OMC, can also get inventory gains from an upward change in the price of end products including petrol and diesel that they have in stock. The price of petrol and diesel are calculated based on benchmark prices of petrol and diesel in the international market. Notably, OMCs were likely insulated from some possible declines in the international price of petrol and diesel as they stopped revising prices on a daily basis from March 16 to June 6 when international prices of petrol and diesel fell sharply as a result of low international crude prices.

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A gas attendant stands waiting at a Bharat Petroleum Corporation Ltd. gas station in Mumbai (Photographer: Abhijit Bhatlekar/Bloomberg News)

How did these changes in inventory value affect the performance of OMCs?

The rise in prices of brent crude allowed IOC to register a gain of Rs 5,829 crore on crude alone and a total inventory gain of Rs 7,400 crore including marketing inventory gain on end products such as petrol and diesel when net profit for the quarter was Rs 6,227 crore. BPCL similarly saw a refining inventory gain of Rs 1,303 crore and and marketing inventory gain of Rs 1,200 crore in the quarter ending September 30.

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Notably, All three state-owned OMCs registered major inventory losses in the previous financial year due to a sharp fall in the international price of crude oil. Indian oil corporation recorded a Rs 11,305 crore reduction in the value of its crude oil inventories as an exceptional item while BPCL recorded a reduction of Rs 1,081 crore leading to both companies posting large losses. Indian Oil posted a loss of Rs 7,783 crore in the Q4FY20 while BPCL posted a loss of Rs 1,361 crore. Hindustan Petroleum Corporation also suffered an inventory loss of Rs 4,113 crore in the January-March quarter.

What quantifies operational performance of OMCs when inventory gains and losses play such a major role in earnings?

While analysts do take into account the ability of a company to claw back inventory losses incurred, they asess operational performance by comparing gross profits with EBITDA or operating profit to assess the underlying operating performance of the company.

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