Be ready for correction in Cairn India

CNBC-TV18s Executive Editor, Udayan Mukherjee

If one can tell me how much is too much for crude I’ll tell how much is too much for Cairn, it just becomes a simple proxy for crude. There are two ways that traders play crude now a days either they buy MCX in the metal market, the MCX crude in the commodity market or they simply buy Cairn in the stock market. So it’s become or at least perceived to be your pure play proxy.

ONGC is sadly missing out because of the government subsidy burden and it’s been a turdy in contrast over the last few days, the way Cairn has moved and the way ONGC has moved. ONGC keeps grinding down to Rs 900 and Cairn keeps flying and is now crossed Rs 325, so it’s been quite interesting and instructive the way these two stocks have moved.

I think Cairn is a kind of stock, where you will consistently be surprised and most of the sell side analyst have surprised quite a bit by the move in the Cairn and now they are behind the curve trying to up their price estimate. The one thing that is happening is that most investment banks and most experts are not calling crude right or have not called crude right. Ever since crude crossed USD 100/bbl I have seen so many analyst barring the odd Goldman Sachs, playing the contrarian trade - USD 110/bbl is the top, next move back to USD 65/bbl and USD 115/bbl that’s the top and next move back to USD 55/bbl. It is almost reminiscence of what was happening to the stock market in 2006-07 it kept going up and everybody said that it was overheated, will correct and will come down to the X level, which never happened.

So I think we are in a different kind of a zone, sure at some point the correction will happen it will be an ugly correction as well. But before that correction happens, it will clean out all the shorts of crude and people are doing this contrarian trades. But let’s see where crude goes to its USD 130/bbl could it start its correction at USD 140-150/bbl we don’t know. Is it likely that crude when it cools off eventually when the correction happens will go to USD 50/bbl, I suspect not that could be wrong it seems very unlikely that crude will go down to USD 50/bbl from USD 140-130/bbl.

So what do you play with for Cairn I terms of an average price of crude for the next few years? I think now it is a reasonable estimate that even if there is a sharp correction which is likely and should be expected at some point. You could probably work with something at least in the zone of USD 75-80/bbl in terms of crude for an average of the next 3 years. It could be more in which case you will get a bonus on Cairn and would say that I took a conservative estimate of USD 75-80/bbl and I got an average of USD 110/bbl, so big money in the bank.

But I think now people should start working with slightly higher average prices of crude over the next few years. Even if you take something like USD 80/bbl over the next 2-3 years while we are at USD 130/bbl now and are marking it down considerably. You still have a situation where Cairn will deliver may be an upwards of Rs 60-70 earnings in 2007. So Rs 325 from where Cairn comes from, looks a whole lot but if crude remains in a high kind of trajectory over the next few years, I’m not even assuming Rs 130 then you are probably trading at 5 times stocks in terms of pure P/E multiple in 2010. Is that expensive? No.

So the risk to Cairn is that crude cools down sharply and at some point, when that cool down happens you get a very sharp melt down in the stock because it will be moving with the underline crude price. There is a chance that you may get the stock cheaper or at some point you will have a big notional lose to deal with but I think if you look out 2-3 years, I suspect you could make a lot of money from Cairn because valuations given what crude expectation could be now are still not expensive. So I suspect the stock will still surprise but at some point there will be an ugly correction, which one should be prepared to ride.