High on potential

Rising crude oil prices and promising hydrocarbon assets are positives.

Buoyancy in crude oil prices, limited downside to net realisations, potentially big-ticket hydrocarbon assets, improving refining margins and a correction in the stock price, position ONGC (India's largest hydrocarbon explorer and producer) as a good buying opportunity for investors with a long-term perspective of two-to-three years.

After a good run in calendar 2010 on the back of positive tidings (administered gas price hike, increased capex plans, corporate actions), the ONGC stock was beaten down quite a bit in the run-up to its proposed follow-on public offering in March (since postponed). This was in line with the pattern seen by most PSU stocks prior to their follow-on offers. Concerns about higher subsidy-sharing burden due to spiralling crude oil price also contributed to the weakness.

Though the stock has recouped some losses over the last month, we think that there is still reasonable upside from the current market price of Rs 288. Currently, ONGC trades at around 12 times its trailing 12-month earnings, marginally higher than its smaller and less diversified PSU hydrocarbon peer Oil India (11 times).

While the continuing subsidy overhang justifies some discount to global hydrocarbon explorers (average of around 20 times), concerns on this front may be overdone.

The government has been categorical that the share of upstream players in the subsidy burden will be restricted to around 33 per cent, in line with what was borne in earlier years. With the FPO of ONGC (which bears close to 80 per cent of the upstream burden) slated later this fiscal, the government would, perhaps, be averse to rock the boat and spook investor sentiment. In this context, buoyancy in the price of crude oil (Brent currently around $125 a barrel) provides a hedge to the company against a rising subsidy bill (in absolute terms).

In the recent December quarter results, the company improved its net realisation to $64.79 a barrel from $57.69 a year ago, despite a 21 per cent hike in subsidy burden. Possibility of the fuel price reform process being put back on track after the impending state elections, should also moderate subsidy burden for the sector as a whole.

Push to production

ONGC is investing aggressively (around Rs 26,000 crore) to develop its smaller domestic fields. It also plans significant investments to improve production at its existing fields, including the mainstay Mumbai High fields, which is in decline.

This should boost its domestic oil output which has been stagnant at around 25 million metric tonnes for some years now. Gas output currently is 60 million cubic metres a day. The company expects to improve oil output to 28 million metric tonnes by 2014, and gas production to 100 million cubic metres a day by 2016. ONGC has also been an active bidder in most of the NELP auctions, including the latest NELP-IX, in which it bid for the largest number of blocks.

ONGC is sitting on some potentially huge hydrocarbon assets, including the KG-DWN-98/2 block, which is next to the prolific KG-D6 block of Reliance Industries. The company expects to produce over 80 billion cubic metres of gas and 4.5 million tonnes of crude oil over the life of the field from the Northern Discovery Area in this block. It also plans to develop the ultra deepwater discovery in the Southern Discovery Area separately. Production is expected to commence from 2016-2017.

In addition, ONGC, through its subsidiary, ONGC Videsh Limited (OVL), is present in 32 projects across 13 countries. Despite setbacks such as the current output from the Imperial Energy fields in Russian being much lower than expected and losing out on many international bids to aggressive competition from China, OVL's acreages, especially those in Russia, Brazil and Venezuela, hold significant potential. Its production in 2011 touched 9.43 mmtoe, up from 8.87 mmtoe in 2010.

With its high complexity refineries, MRPL, ONGC's pure-play refining subsidiary is also well positioned to capitalise on the buoyancy in refining margins. ONGC's initial success in its pilot project for shale gas exploration in West Bengal should help, when the government finalises its shale gas policy.

We also expect a positive outcome for ONGC in the ongoing tussle regarding the Cairn Energy-Vedanta deal, whether or not the transaction finally goes through. With the government almost unanimous about the cost-recoverability of royalties paid by ONGC, the company is likely to assert its rights, either as part of a negotiated settlement or in arbitration/court of law.

Cost recoverability of royalty will help ONGC (30 per cent stake) realise the benefits of the expected increase in production (125,000 barrels a day currently) from the prolific Rajasthan fields.

Financial strength

A strong consolidated cash position (Rs 22,384 crore as on March 2010) and negligible debt-to-equity (0.23)position ONGC comfortably to fund its capex and expansion plans.

However, while consolidated sales have grown at 3 per cent annually during 2008 to 2010 to Rs 101,760 crore, profits have declined by 1 per cent to 19,403 crore. This is attributable mainly to the sharp volatility in crude oil prices during this period.

In the recent December quarter, the company more than doubled its profits (standalone) year-on-year to Rs 7,083 crore, while net sales grew at a relatively modest 21 per cent to Rs 18,586 crore.

The company benefitted from increase in crude oil prices, doubling in APM gas prices last calendar, and a one-time settlement from the gas pool account. Excluding the settlement, profits still grew by a healthy 70 per cent.

Net margins and return on equity at above 20 per cent are quite robust.

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