Oil & gas stocks are outperformers, but each for different reasons
Munira Dongre 15 December 2010

The BSE Oil & Gas Index has been one of the best performing indices of late. Upstream stocks have done particularly well, but marketing and downstream firms have not participated in this rally

The BSE Oil & Gas Index is up almost 2% over the past week against the 1% fall in the Sensex.  Stocks that have done very well within the index are RIL, Petronet LNG, ONGC and Cairn, all upstream companies. Oil marketing or downstream companies have not participated in the overall oil & gas rally.

Among the heavyweights in the oil & gas index is Reliance Industries (RIL), which has recovered about 10% from a low of Rs959. The thought process seems to be that the negatives from the lower gas ramp-up from the KG basin is priced in, polyester margins are rising due to a tightness in the cotton market, refining margins are seen improving (investors are equating the rising crude prices to rising demand), and finally, the market expects RIL to be able to hike the price of the incremental gas it will sell from KG. The pricing expectations are fueled by the government’s decision (earlier this month) to allow ONGC to hike gas prices by 10% to $5.25 per million British thermal units (mBtu) from $4.75 for non-priority customers. An overtly optimistic few are even looking at the distant shale gas revenues.

Based on RIL’s latest updates about a slower ramp-up of KG gas production, Citi Investment Research and Analysis toned down its gas production forecasts sharply to 57/64/80 million standard cubic metre per day (mmscmd) over FY11/12/13 (from the earlier 63/80/110mmscmd). However, its revisions to EPS estimates are not heavy—a cut by 3/2/5% over FY11/12/13. Citi also believes that cotton tightness is unlikely to ease until 2HFY11, lending support to polyester margins.

Citi estimates that gross refining margins (GRMs) will go up because of a recovery in global oil demand based on firm prices; near-term tightness in diesel supply; imports from China lending support; and widening of the differential between light and heavy crude, which benefits complex refiners such as RIL. Recently, the company was said to increase crude imports from Latin America, so that it can get better refining margins by processing heavier and cheaper grades of oil, a strategy that has worked for the company in the past.

Is it possible that RIL is deliberately holding back on gas production from KG until the government relents and lets it raise prices? Citi says in a recent report, “We recently met the RIL management, wherein they mentioned that the company was in dialogue with the government for higher gas prices, stating that they needed an assurance of higher gas prices before committing capex and going ahead with the development of the D-6 satellite fields, NEC-25, and the CBM blocks.”

It must be pointed out that while the Dollar Index did fall from a high of almost 89 on 7th June to a low of 75 on 3rd November (a 16% drop), it has climbed back up to almost 80 now. A rising dollar is generally not good for commodities.

Petronet LNG is going up simply because RIL is not ramping up like it said it would, forcing companies to buy expensive gas at spot rates from Petronet LNG. Besides, gas prices are holding up higher. Nymex gas prices have risen from a low of $3.2 per unit late October to $4.5 per unit currently—a huge 40% rise in less than two months. (Of course, one has to factor in that it is winter in the US when heating requirements shoot up.)

In a recent report, Motilal Oswal (MOSL) says, “Although India’s domestic gas supply is expected to post 16% CAGR over FY10-14 the country is still expected to be gas deficient. Globally, LNG prices are expected to be soft, as the emergence of shale gas in the US has rendered large LNG investments underutilised. India’s gas deficit and LNG availability at reasonable prices will help Petronet to post volumes of 12% CAGR to 12.5mmtpa (million metric tonne per annum) (50mmscmd) by FY14.” MOSL also goes on to say that they expect Petronet LNG to continue increasing regasification charges by 5% every year (a heavily debated issue) to ensure a 16% RoE (return on equity), and in fact it expects the company to achieve an RoE of 25% by 2012. A large section of the market believes that the government will soon clamp down heavily on Petronet LNG’s regasification charges, forcing it to earn RoE more in line with other utility companies (around 14%). MOSL is also betting on Petronet’s new 5mmtpa (20mmscmd) Kochi terminal, which is likely to be commissioned by the end of FY12, leading to a 50% increase in its capacity to 15mmtpa.

ONGC is rising ahead of its forthcoming follow-up public offer (FPO). A couple of days ago, RS Sharma, chairman and managing director of ONGC said in a television interview that he is hopeful of launching the FPO by mid-February. It is also considering a stock split and bonus. (FIIs have long complained about the low levels of liquidity in ONGC vis-a-vis other frontline stocks.)

Investors and analysts also believe that rising crude prices are good for ONGC’s net realisation despite the increasing subsidy burden. This, despite Mr Sharma saying that the best crude levels for the company are between $70 and $80. At current crude levels, upstream companies are going to have to shell out about Rs220 billion of subsidies, more than 80% of which will be borne by ONGC. The market is hoping that the forthcoming hike in diesel prices will mean a lower subsidy burden for ONGC. The company is also expected to get compensation in lieu of royalty for Cairn India’s Rajasthan assets.

ONGC shares have gone up from a low of Rs1,192 on 26th November to Rs1,332 levels currently, a gain of 12%. Cairn India shares too have risen on hopes of better realisations with a rise in crude oil prices. The stock is up 19% to Rs338 from a recent low of Rs285.

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