All pumped up?

In keeping with the maxim that what falls the most should also rise the most, oil and gas stocks have been among the big gainers in the market rally since last September. The BSE Oil and Gas index has risen more than 30 per cent. The gain would have been higher but for the latest conflict in Iraq which has led to a spike in oil prices, resulting in oil and gas scrips crashing last week. Escalation of hostilities in Iraq could threaten the good run in some of these hydrocarbon stocks.

Oil marketers HPCL and BPCL have nearly doubled or more on the bourses since September; so has refiner MRPL. Explorer ONGC is up 49 per cent, while city gas distributor Gujarat Gas has gained more than 80 per cent. Other stocks in the pack have also registered gains in the range of 14-80 per cent.

What drove the rally? Hopes of an economic revival have seen investors shifting in droves from defensive to cyclical sectors; this helped oil and gas stocks too. But more importantly, reforms already undertaken and >the expectation of more to come have been the primary drivers .

Riding on reforms and hope In January 2013, the biggest game-changer in the Indian oil and gas sector in more than a decade took shape when the UPA Government decided to raise the price of diesel in a calibrated way, by 50 paise a month.

While the deregulation of petrol prices since June 2010 was a good move, it did not make much of a difference to under-recoveries incurred by the public sector oil marketing companies (OMCs) — Indian Oil, HPCL and BPCL — due to selling fuels below cost. This was because diesel was the largest contributor (nearly 60 per cent) to the total under-recoveries.

With the regular price hikes over the last year, diesel under-recoveries fell 32 per cent and the total under-recoveries of the OMCs reduced to about ₹1,40,000 crore in 2013-14 from ₹1,61,000 crore in 2012-13. This was despite the rupee tumbling during the year and actually adding to the import costs.

The price hikes, which were on hold during the election, have restarted and the new Government has continued with them. This has resulted in under-recovery on diesel falling to below ₹3 a litre currently from more than ₹13 a litre last August.

If the hikes continue, diesel under-recoveries could be neutralised in six months. This could provide a boost to hydrocarbon companies across the board.

The OMCs incur under-recoveries in the first place, face long delays in receiving compensation from the Government and have to borrow heavily. They will benefit from reduction in debt levels and lower interest outgo. A healthier financial position will help them accelerate refinery upgrade plans and move towards integrated operations, including petrochemicals production, to boost gross refining margins (GRMs).

Over the last four years, the total debt burden of the OMCs has increased to ₹1,32,500 crore from ₹88,000 crore. The GRM of these companies is in the low-to-mid single-digits in contrast to fully integrated refiners such as Reliance Industries (RIL) and Essar Oil whose GRMs hover in the range of $9-10 a barrel. Also, PSU hydrocarbon explorers ONGC and Oil India and gas transmitter GAIL (India), which together bear up to 50 per cent of the under-recovery burden through product discounts, will benefit from an improvement in realisations. ONGC and Oil India currently realise just around $50 a barrel, despite crude oil ruling at nearly $110 a barrel.

A market-linked diesel price could also encourage private players such as Reliance Industries and Essar Oil to start retailing diesel.

Not just diesel, there is talk of putting a leash on under-recoveries on subsidised LPG cylinders too. Unlike diesel, under-recoveries on LPG cylinders increased more than 17 per cent last year. Even the supply of subsidised kerosene may be streamlined.

Boost to financials All this, if implemented, could give a fillip to the financial performance of public sector oil companies. Crisil Research estimates that lower under-recoveries will add about ₹10,500-12,000 crore to the total profits of ONGC, Oil India and GAIL in 2014-15.

For the OMCs, lower under-recoveries will boost profits by about ₹3,300-3,600 crore in 2014-15, says Crisil Research. Not surprisingly, these stocks have gained big time.

Then, there is high expectation that the hike in domestic gas price, which was to come into effect from April, could soon be given the go-ahead.

The near doubling of gas prices from the current levels of $4.2 a unit will primarily benefit ONGC and Oil India which account for almost 80 per cent of the domestic gas production.

It is estimated that the gas price hike could add ₹8,000 crore to ONGC’s annual profit and ₹1,000 crore to Oil India’s bottom line — that’s about 30 per cent of the companies’ consolidated profits in 2013-14.

RIL, which has seen output at the KG-D6 field plummet sharply over the last few years, will also gain. But there is a caveat — it will have to forfeit its bank guarantee (for incremental revenue from gas price hike) if found guilty of deliberately suppressing output at the KG-D6 field. The bank guarantee of about ₹510 crore for the April-June 2014 quarter given by RIL was returned by the Oil Ministry since the new rate had not yet been announced.

The market seems optimistic about the final outcome and has given a thumbs-up to the long-languishing RIL stock. This has also been aided by the company’s improving fortunes in its international shale gas ventures, and the retail business and expansion plans in petrochemicals and refining.

The domestic gas price hike, when it happens, will also benefit Cairn India which has started gas production at its Rajasthan block and Essar Oil, which produces coal bed methane gas in the eastern part of the country.

The Cairn stock, though, with 14 per cent gains since September, has not been on a tear like its peers. Despite healthy oil output growth in its mainstay Rajasthan field in 2013-14, a muted production forecast for 2014-15 has held back the stock.

Essar Oil, on the other hand, has shot up more than 80 per cent since September, despite its still high debt levels. This is thanks to the company’s improved operating performance, an upshot of its refinery’s higher capacity and complexity.

Positive chain reaction A rise in gas prices can help halt the decline in domestic gas output and make it viable for production blocks earlier considered uneconomical due to low realisations.

This, in turn, will aid the utilisation of the pipeline network in the country, which is currently under-utilised due to low gas supplies.

For many quarters, gas transmitters GAIL and GSPL have seen their sales volumes take a hit. Along with falling domestic gas output, higher price of spot imported gas which resulted in lower offtake by price-sensitive customers has taken a toll.

GAIL has also been impacted by the Tamil Nadu Government not allowing pipelines to pass through farmland — this has impacted the completion of the Kochi-Bangalore pipeline and added to the company’s costs.

It has also resulted in very low capacity utilisation at gas importer and regasifier Petronet LNG’s 5 mtpa terminal in Kochi. But there is hope that with the expected price hike, the worst should be over for domestic gas production in the country and that output should rise.

This, along with a recent moderation in spot imported gas prices, has helped the GAIL, Petronet and GSPL stocks rally strongly from their lows.

More gas availability will also benefit city gas distributors Indraprastha Gas and Gujarat Gas. The former has done well on the bourses, thanks in part to the Government mandating cheaper domestic supplies for CNG vehicles and households using piped natural gas.

But this mandate is negative for Gujarat Gas since its major customer base — the industrial segment — may face pro rata cuts on cheaper domestic gas.

However, the Gujarat Gas stock, despite weak operational performance, has got a strong boost from expected synergies from the proposed merger with group companies such as Gujarat Distribution Network and GSPC Gas.

MRPL has been among the largest gainers, thanks to the completion of its Phase III refinery expansion programme which has added significantly to both capacity and complexity of the refinery.

This should help the company post better GRMs and profits in the coming years. Peer standalone refiner CPCL has also rallied sharply since September, but this appears more of a sympathetic rise in line with other refiners — the company’s core performance remains weak and upgradation and expansion initiatives may take a long time to show results.

The rally in the BSE Oil and Gas index since September has been on firm feet, the prime drivers being reforms and an improvement in fundamentals. FIIs have been active buyers — between September and March, they increased their stake in all the above stocks except Oil India, Indraprastha Gas and CPCL.

What should you do now? Despite the rally, there are still good picks in the oil and gas space. Cairn India, for instance, continues to trade at an attractive valuation of 5.6 times its trailing earnings. Higher oil prices due to the Iraq crisis are also a positive.

While the company’s output growth in the near-term may be muted, its long-term prospects appear quite promising making it a good bet for patient investors. Similarly, RIL, despite an increase in its valuation to about 14 times trailing earnings from 12 times in September, still has room for upside.

This is considering its multiple growth triggers from different businesses (domestic exploration, shale gas, retail, petchem and refining) in the next two to three years.

Indraprastha Gas, thanks to its monopoly position in the city gas distribution business in the Delhi region and competitive price advantage of natural gas over fuels such as diesel, petrol and LPG, should do well, despite the expected increase in gas sourcing cost.

Its valuation has also not run up too sharply. Investors can buy this stock.

All the three OMCs have run up sharply. That said, BPCL’s core performance (GRM) has been consistently better than that of Indian Oil and HPCL. It has also been very successful in its international exploration forays in Mozambique and Brazil; this can significantly add to earnings in the next three-four years. Investors can buy the BPCL stock, while pruning their holdings in HPCL and Indian Oil which may not fare as well on the margin front. Also, the Iraq crisis which can cause an unexpected rise in under-recoveries warrants holding on only to the strongest.

MRPL holds the potential to be a strong turnaround story, thanks to its revamped refinery. Investors with a high-risk perspective can consider buying or continue holding this scrip.

Likewise, despite the rise in valuations, investors can hold on to explorers ONGC and Oil India. Expected increase in production growth, gas price hike benefit, and improved realisations due to lower subsidy burden are positives.

These companies may, however, have to bear a part of the compensation to power and fertiliser companies which will be impacted by higher gas prices. Besides, the risk of higher under-recoveries due to the Iraq crisis warrants caution.

Gujarat Gas, GSPL and CPCL have run up quite sharply. These companies continue to face challenges; Gujarat Gas and GSPL on the volumes front and CPCL due to low margins. This seems a good time to book profits in these stocks.

Also, it may take two to three years for GAIL and Petronet to improve capacity utilisation. Book profits in these scrips too.

Essar Oil will benefit from its upgraded refinery but its heavy debt burden remains a concern. Investors may be better off exiting the stock.

Also read: >Keep the reforms flowing

(Have something to say about Portfolio? Write to us at >blportfolio@thehindu.co.in )

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