OREANDA-NEWS. Fitch Ratings has published India-based Hindustan Petroleum Corporation Limited's (HPCL) Long-Term Foreign-Currency Issuer Default Rating (IDR) of 'BBB-'. The Outlook is Stable.

KEY RATING DRIVERS
Strategic linkage with the state: HPCL's rating is equalised to that of the sovereign (which owns 51% of the company) as it remains strategically important to the state for meeting its socio-economic objectives in relation to the energy sector. Similar to Indian Oil Corporation Limited (BBB-/Stable) and Bharat Petroleum Corporation Limited (BBB-/Stable), HPCL follows government regulations on fuel pricing and incurs under-recoveries (i.e. difference between market price and selling price) on selling certain fuels below market price. While the government has deregulated prices for petrol and diesel - the biggest drivers of under-recoveries, LPG and kerosene prices are still regulated.

Benefit from subsidy reforms: The Indian government deregulated diesel prices in October 2014, allowing oil marketing companies (OMCs) such as HPCL to set rates for diesel based on market factors, thereby eliminating under-recoveries on its sale. Diesel contributed to over 50% of the total under-recoveries over FY11-14. The subsidy on LPG (cooking gas) will also be paid in cash to consumers from FY16, which should lower losses from leakages; India will use the three OMC's to channel this subsidy to eligible consumers. Supplementing the current low oil price environment, these reforms would significantly reduce the subsidy burden on the OMCs such as HPCL, and improve their cash flows.

Low oil price a positive: Apart from incurring lower under-recoveries, OMCs including HPCL have gained from significantly reduced working capital requirements in the current low price environment, also reducing its debt requirements to fund inventories. HPCL reported a 36% y-o-y decline in inventory in FY15, due to the sharp fall in oil price. The oil price fall also resulted in sharp inventory losses for HPCL in FY15, lowering profitability. This, however, was a one-off impact in Fitch's view.

HMEL a drag on leverage: HPCL-Mittal Energy Limited (HMEL), a refining company, which is 49% owned by HPCL, has generated negative EBITDA while it sorts out teething problems. This has impacted HPCL's EBITDA after proportional consolidation. On the other hand, HPCL's consolidated debt is boosted due to HMEL. As a result, HPCL's consolidated leverage as measured by net debt to EBITDA in FY14 of 7.6x, was much higher than the standalone level of 5.2x. Fitch expects HMEL's EBITDA generation to improve over time as issues are resolved, given the refinery's high Nelson complexity of 12.6.

Funding needs and its impact: We estimate that substantial capex (for refinery upgrade and expansion) would result in negative free cash flows over the medium-term. This implies that HPCL would need additional debt on a sustained basis and as such, a meaningful improvement in its credit metrics is not expected over the medium term.

KEY ASSUMPTIONS
Profitability: We expect improvement in HPCL's EBITDA (per unit of marketing volume) in FY16, factoring in lack of inventory losses, and assume limited gains thereafter.

Working capital requirements: Following a sharp fall in FY15, we assume working capital to rise from FY16 based on Fitch's oil price deck and in line with its historical working capital cycle.

Capex: We assume an average capex of INR80bn annually over FY16-18.

RATING SENSITIVITIES
HPCL's ratings are equalised with those of India.

Positive: Future developments that may, individually or collectively, lead to positive rating action include:

-An upgrade of the sovereign's rating, provided the rating linkages with the state remain intact.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

- A downgrade of the sovereign rating

- Weakening of linkages between HPCL and the state, which could arise due to a reduced policy role

For the sovereign rating of India, the following sensitivities were outlined by Fitch in its Rating Action Commentary of 9 April 2015.

The main factors that individually or collectively could lead to positive rating action are:

- Fiscal consolidation or fiscal reforms that would cause the general government debt burden to fall more rapidly than expected

- An improved business environment resulting from implemented reforms and structurally lower inflation levels, which would support higher investment and real GDP growth

The main factors that individually or collectively could lead to negative rating action are:

- Deviation from the fiscal consolidation path, leading to persistence of the high public debt burden, or greater-than-expected deterioration in the banking sector's asset quality that would prompt large-scale financial support from the sovereign

- Loose macroeconomic policy settings that cause a return of persistently high inflation levels and a widening current account deficit, which would increase the risk of external funding stress.