Valuations of oil stocks are likely to greatly improve in the long run. And then oil will truly smell sweet.
Is it the right time to invest in oil stocks? Let us examine a few facts. India, as a market, has a humungous appetite for oil. However, only 30 per cent of its requirement of nearly 110 million metric tonnes per annum is met by domestic producers. The downstream companies that refine and market crude, thus, have to import a major portion of their requirements. This is hugely expensive, as global crude prices have been ruling at $50-plus (Rs 2,200-plus) for some months now. They then process this crude and sell it at government-determined low prices. Who makes up the deficit? No one. It's a straight hit to their bottom lines. Will the government raise prices? Probably. But it is unlikely to raise them enough to make good the entire loss anytime soon.
Sounds bad? Yes. Does it still make sense to invest in these companies? Yes. Here's why: the current situation cannot go on for ever. Something has got to give. Either global prices will come down (which appears unlikely at present), or the government will have to raise prices. Once the oil companies (particularly the refining and marketing companies) are allowed to sell their products-especially kerosene and LPG-at market-determined prices (or at rates close to them), their bottom lines are likely to improve substantially. The profits of exploration and production major ONGC (Oil and Natural Gas Corporation) will shoot up too as it will not have to share a part of the implied subsidy burden with the refining and marketing companies. Then again, the stocks of most of these companies (with the possible exception of ONGC) are hugely undervalued, and any change in the scenario is likely to improve their valuations considerably. Here's a more detailed look at the oil sector from an investment perspective.
Exploration And Production
All over the world, increases in crude prices bring joy to oil exploration and production companies. The scenario is different in India, though. India's biggest exploration and production company, ONGC-also India's most valuable company, with a market cap of over Rs 1,25,000 crore-has not really been able to benefit from the global surge in crude prices due to domestic political compulsions. Bowing to the demands of the refining companies and unable to take the burden on itself, the Union government in 2004 decided that ONGC and GAIL (India) Ltd. would have to share the subsidy burden on LPG and kerosene with the refining and marketing companies. Today, that translates to an outgo equal to one-third of the total subsidy component on LPG and kerosene for ONGC. This is adversely affecting its bottom line. For instance, in 2004-05, ONGC had to fork out Rs 3,114 crore to IOC, HPCL and BPCL as subsidies for LPG and kerosene.
Is ONGC still a good bet? Sanjiv Prasad, analyst at Kotak Securities, reckons it is probably a better bet than the refining companies. On a turnover of Rs 35,450.75 crore (for the first nine months of 2004-05), it raked in profits of Rs 9,075.94 crore. This is after shelling out the subsidy to the refining companies. Moreover, increased investments in infrastructure, new gas discoveries, improving import facilities and continuing high prices are seen as positives for the company. Analysts expect the deregulation of the gas sector to add Rs 1,500 crore to ONGC's bottom line every year. Further, it now has permission to set up around 1,100 retail outlets (it set up its first outlet in Mangalore recently), which is likely to add to its overall growth in the near future. So, if you have stocks of ONGC, just hold on to them for dear life.
Refining And Marketing
The subsidy burden takes its highest toll on the public sector integrated downstream companies (which refine and market petroleum products) such as IOC (Indian Oil Corp.), BPCL (Bharat Petroleum Corp.) and HPCL (Hindustan Petroleum Corp.). These companies buy their crude either from ONGC (which bears one-third of the subsidy burden) or from global markets at prevailing international prices. However, they are unable to sell their products at market prices and, thus, have to bear huge losses. The total under-recoveries borne by the PSUs have gone up from Rs 9,370 crore in 2003-04 to Rs 19,900 crore in 2004-05. According to the Ministry of Petroleum, this is expected to touch Rs 37,000 crore this fiscal, while the oil companies put the figure at Rs 50,000 crore. And while they do benefit from higher refining margins of $12.15 (Rs 534.60) per barrel, they lose out because they are unable to sell their final products-kerosene, diesel and LPG-at market prices, thus, directly affecting their bottom lines.
So, what should your approach as an investor be? Should you buy, sell, or hold these stocks? Opinions differ, but analysts of all hues agree that over the long term, oil stocks are a veritable gold mine. Says Gul Tekchandani, Chief Investment Officer, Sun F&C: "Valuations are extremely attractive because going forward, there will be substantial returns for equity holders. The subsidy issue, too, should get sorted out soon." Tekchandani's logic: these stocks have hit rock-bottom prices, and you're unlikely to get them at such low values later. The outlook for the future is positive as well: India is an energy-deficient country, and demand for oil will certainly increase. Besides, all these companies have strong fundamentals.
Others are cautiously optimistic. Ramdeo Agarwal, Managing Director, Motilal Oswal Securities, says: "There is no significant upside in the short run unless the government revises oil prices," but admits in the same breath that it could well be a good time for the retail investor to get his feet wet because these stocks have already bottomed out.
So, if you don't have stocks of oil refining and marketing companies, the time to get in is now. And if you already own them, the right strategy will be to hold on to them, despite the negative sentiments currently surrounding the sector. Among the refiners, analysts are most bullish on IOC, simply because it owns and operates the country's largest crude oil and product pipeline network of nearly 80,000 km. Marketing companies using this network have to pay IOC access and transit fees, thus, giving it another revenue stream.
Then, there's Reliance. India's biggest private sector refiner, with 27 million tonnes per annum of refining capacity at Jamnagar, does not have to bear the burden of subsidies. Says Jigar Shah, Head of Research at K.R. Choksey Shares and Securities: "The infighting within the Ambani family has pushed its valuation down. This makes it even more attractive."
Whichever way you look at it, the energy sector in India looks good for the future. And if you've managed to stand your ground on slippery turf, the flavour of oil will be one to savour, and rememberBusiness Today