Oil India: Buy

A likely cap on the upstream subsidy-sharing burden, ambitious expansion plans and strong metrics are reasons to invest.

The stock of public sector upstream major, Oil India, has fallen almost 15 per cent since mid-September 2010, significantly underperforming the broader market (Sensex down 5 per cent in this period) and its larger peer ONGC (down 13 per cent). This has primarily been on account of fears of an increase in the company's subsidy-sharing burden following the run-up in crude oil prices (Brent currently around $110 a barrel).

However, we think the concerns may be overdone. Notwithstanding some ground regained in the last few months, at the current price levels (Rs 1,380), the stock presents a good buying opportunity for those with a long-term perspective. Oil India now trades at a trailing 12-month price-to-earnings ratio of around 12 times, marginally lower than ONGC's multiple of around 13 times.

A likely cap on the upstream subsidy-sharing burden, an improvement in net realisation, ambitious expansion plans, and strong operating and financial metrics underpin our recommendation.

Burden capped

On several occasions, the government has stated that the share of upstream companies (ONGC and Oil India) and GAIL in the subsidy-sharing mechanism (provided through product discounts to refiners) will be restricted to one-third (around 33 per cent).

Of this, Oil India's share has been around 11 per cent for the past couple of years. We do not expect these equations to change, particularly in the light of the impending follow-on public offer by ONGC, which the government would be averse to jeopardise.

The last fiscal saw PSU upstream companies, including Oil India, benefit substantially from policy measures. This included the more than doubling in the price of gas under the administered pricing mechanism and market-linked prices for additional gas from nominated blocks. Besides, the first steps towards fuel price deregulation undertaken last June had raised hopes of an unshackling of the oil industry (including upstream players) from the subsidy overhang.

Unfortunately, price deregulation has not played out as expected (due to a combination of economic and political factors), and the rally in crude oil has affected the financials of the oil marketing companies.

Yet, upstream players, including Oil India, are hedged to a fair extent, since their crude oil output also commands a better price (linked to global oil prices), though not to the optimum level. As a result, their net realisations (price realised per barrel after providing discounts) tend to improve at best, or are range-bound (floor capped) at worst.

This is seen in the net realisation of Oil India, which improved from $58.78 a barrel in Q3 2010 to $67.14 in Q4 2011, despite a 19 per cent increase in subsidy provided. For the nine-month period ending December 2010, the net realisation was $60.57 a barrel compared with $58.78 in the previous period.

While any increase in the share of upstream companies (beyond 33 per cent) could see their net realisations dip, the government is unlikely to resort to such value-destructive moves.

Also, with major state elections now winding up, the Government has the political window to hike fuel prices, at least to some extent. There is a high possibility of a price hike in petrol, diesel, and LPG, which should aid the cause of not only the oil marketing companies, but also upstream players.

Growth on horizon

From being a predominantly north-eastern player, Oil India has been taking steps over the years to expand its footprint to other high potential regions in the country (including the Krishna-Godavari basin) and abroad.

The company has interests in around 65 exploration and production blocks domestically, including 30 acquired in NELP auctions. Some of the NELP blocks are estimated to be high potential, with discoveries made and appraisal plans approved.

The company so far mainly an onshore player, has also made its entry in some offshore and deep water blocks in an operator's role. Additionally, it has won 10 blocks in the latest NELP IX auction.

Large acreages, both within (127,879 sq km) and outside (41,656 sq km) the country provide Oil India good growth prospects, if it is able to convert the opportunity.

The company's high reserve replacement ratio (1.65) and low cost of production are other positives.

Oil India's international foray (interests in 9 countries) has not yet yielded great results (with the company relinquishing blocks in some countries such as Libya). However, some of the blocks (including that in Venezuela which is expected to commence production by FY 2013) appear to have high potential and are expected to provide good production upsides.

The company has lined up significant capex plans (around Rs 3,200 crore in FY 12) to boost production. It has planned a significant increase in seismic surveys, exploratory drilling and development drilling in 2012. In the current fiscal, Oil India expects to increase crude oil production to 3.76 mmt from around 3.70 mmt in 2011, and natural gas production to 2,633 mmscm from 2405 mmscm in 2011.

The first nine months of the last fiscal saw a dip in production of both oil and gas, mainly due to the shutdown in the Numaligarh refinery in the first quarter.

However, output has now again been ramped up. Also, the commissioning of the Duliajan-Numaligarh pipeline in March 2011 and the Brahmaputra Cracker and Polymer Ltd (BCPL) expected to be commissioned in 2013 (Oil India has stakes in both projects) is expected to give a boost to the company's gas production.

Oil India has also tied up with GAIL to explore shale gas opportunities in the US, and is evaluating shale gas potential in the Assam-Arakan basin.

Strong financials

A solid financial position buttresses the company's position. Despite a dip in output in the first nine months of the last fiscal (full year results not declared yet), Oil India managed an improvement in financial performance, thanks mainly to improvement in product prices. Sales improved 3 per cent to Rs 6,284 crore, while profits increased 7 per cent to Rs 2,325 crore.

Margins are also quite healthy at both the operating (around 50 per cent) and net levels (around 35 per cent).

A strong cash position (around Rs 8,500 crore as of March 2010) and negligible debt-to-equity provide sufficient cushion for funding expansion.

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