Cairn India: Buy

Investors can consider buying the Cairn India stock at the current price of Rs 224 with a medium-term investment perspective. The stock has appreciated 40 per cent in the last one year from its IPO price of Rs 160, undergoing a re-rating in the process. Appreciation from hereon could be slower though, and the stock price will be driven as much by positive news flowing in from the execution of the Rajasthan project as by sustained high oil prices.

Investors can consider acquiring the stock in tranches to exploit any price weakness caused by broad market factors.

Our recommendation is subject to three main risks. First, softer oil prices, which could erode the value of the company’s reserves in the Rajasthan field.

Second, the issue of who should bear the cess payable to the government — Cairn or ONGC — and in what proportion, is yet to be resolved. And, finally, a sustained appreciation in the value of the rupee versus the dollar could impact revenues as pricing is denominated in dollars.
On track

Cairn’s project in Rajasthan is on track to meet the deadline of mid-2009 for the first oil to flow out. The government’s approval for a pipeline to transport the oil to the Gujarat coast removes a major uncertainty surrounding the project –– the stock acquired momentum on news of the approval.

But one more hurdle remains to be crossed on this count as the government will have to approve the additional cost of laying the pipeline, estimated at $800 million (Rs 3,200 crore) including the storage tanks and single point mooring for evacuation of oil by sea.

Cairn has meanwhile gone ahead with the front-end engineering and design for the project and has also placed orders for equipment with long lead times.

The route of the specialised heated pipeline to transport the viscous Rajasthan crude has been planned in a manner that will give it access to existing pipeline infrastructure in the western region and to the refineries located there. Mangalore Refinery and Petrochemicals will be a prime customer for the oil which will be shipped from coastal Gujarat to the refinery.
Appreciating reserves

The sharp run-up in oil prices means that Cairn’s reserves have turned more valuable. Though the oil from Rajasthan will be priced closer to the commissioning of the project, the broad expectation is that it will be sold at a discount of between $5 and $7 per barrel to prevailing Brent crude price.

At current prices, that would mean Cairn will earn around $80-82 per barrel; at the time of its IPO a year ago, it was assumed that it will earn around $50-55 based on the then prevailing prices. Importantly, Cairn will not be weighed down by subsidies such as ONGC.

Cairn has conservatively estimated output from the field at 1,50,000 barrels per day at peak level, but this could increase by about 10-15 per cent with the company employing enhanced oil recovery techniques. The higher output and expected strong oil prices could buoy revenues and earnings in the initial period following commissioning of the project.
Risks to note

The biggest threat to Cairn’s valuation will be a retreat in oil prices. Given the rapidly rising global consumption and tight supply, the chances for a retreat appear small. But the travails of the US economy and the threat of a slowdown or even a recession there could cause oil demand to fall exerting pressure on prices. Subject to this caveat, the medium-term prediction is for oil to trade in the $80-90 band, which is beneficial to Cairn.

Second, the issue of who should bear the cess on the oil is in all probability headed for arbitration. Cairn is on strong ground as it is not liable, going by the production sharing contract.

However, chances are that eventually the company will be called upon to bear a part of the cess, thus affecting realisations. Cess payable ranges from Rs 927 to Rs 2,575 per tonne of oil depending on the classification of the field. An adverse decision could affect the stock sentiment.

The appreciating trend in the rupee is another cause for concern as Cairn’s output will be priced in dollars. Since the company’s IPO a year ago, the rupee has appreciated by 11.5 per cent against the dollar. Further appreciation could blunt the benefit flowing from higher oil prices.

Finally, the enhanced oil recovery techniques that Cairn will adopt such as chemical and polymer flooding in the wells are established ones but have not been tried out on the scale that the company plans to now do.

Incremental output over and above the planned 1,50,000 barrels per day may not materialise on the scale expected if the techniques fail.