Rally in OMCs to continue; BPCL top pick: Macquarie Group

With Brent crude below USD 90 a barrel, the spotlight has zoned in on the oil and gas space, mainly oil marketing companies (OMCs). According to Jal Irani, managing director of oil & gas research at Macquarie Group, the rally in this space is likely to continue as crude prices continue to fall.

“We have seen that the oil marketing stocks have pretty much begun to run at the moment, but the rally in my opinion has just started,” he said in an interview to CNBC-TV18. India is one of the biggest beneficiaries of the crash in crude oil prices. Firstly, it reduces India’s import bill, as crude is the largest item on the list, but secondly, it also reduces the government’s oil subsidy. “This inevitably leads to the earnings of OMCs increasing,” said Irani. He adds that this could also lead to reforms in the space. “Reforms to cap the oil subsidy, especially the diesel subsidy, and link diesel to some form of oil prices will come in, which will kickstart the second leg of the rally,” he said. Companies benefitting from the crash in crude oil prices are refiners such as BPCL, HPCL, IOC etc. Out of these names, Irani’s top pick is BPCL. “Bharat Petroleum is our top pick in the entire sector because not only is it counter cyclical to oil prices falling, but it has also got very significant additional businesses that it is growing within the energy space,” he explained. On the flip side however, pure play companies like Cairn India will take a hit on earnings due to this fall. Irani says that Cairn India’s earnings will by impacted by 13% per USD 10 per barrel swing in crude prices. Below is an edited transcript of his interview with Udayan Mukherjee and Mitali Mukherjee. Also watch the accompanying videos. Q: OMCs have done well, but would you still buy your favourite Hindustan Petroleum Corporation Ltd (HPCL) for more gains? A: What we saw during the 2008 fall in oil prices was that during the one year period which followed, these oil marketing stocks doubled. So we have seen that the oil marketing stocks have pretty much begun to run at the moment, but the rally in my opinion has just started. So we have got a long way to go before these stocks doubled. By far HPCL is the best leveraged essentially as a counter cyclical to oil prices because it is more of a pure play. But having said that, Bharat Petroleum Corporation Ltd (BPCL) is our top pick in the entire sector because not only is it counter cyclical to oil prices falling, but it has also got very significant additional businesses that it is growing within the energy space. Q: How much of this upside that you are expecting to see is directly because of the crude price correction? Also, does anything in terms of policy changes on diesel pricing figure into the scheme of things? A: Inevitably I think the issues are linked because first what you see is purely crude falling that gives a feel good factor and generally the subsidy burden would decrease for these companies so earnings will increase. If you look at last year, the profits of these companies were extremely low because crude was high. So initially it’s just a factor of crude decreasing and profits increasing as a result. But as crude falls further, and mind you it’s still USD 90 per barrel which is still at reasonable levels, the country’s subsidy burden decreases then there is expectation of sector reforms coming in. I understand from press reports that Mr. Kaushik Basu, the Economic Advisor to the finance ministry, is shortly going to be coming out with a report suggesting reforms across various sectors. His primary focus is reforms in the oil sector, and it seems that one of things he has proposed is to cap the oil subsidy, especially the diesel subsidy, and link diesel to some form of oil prices. So the second leg of the rally or the second leg of expectations is essentially just kicking in. Q: Where does that leave a stock like Cairn? A: In sharp contrast, Cairn is a deep cyclical. Essentially, Cairn is perhaps the only pure play among the majors in Asia to crude prices. Our forecast is that essentially USD 10 per barrel swing in crude prices will impact earnings by 13%. It is a very high quality company and some of the recent finds, especially in KG onshore, have found a fair bit of oil. The resources estimates there seem to suggest that this could be in excess of 500 million barrels, which by any major is a pretty sizeable sum. But that would be exploited in the distant future, and in the meanwhile it by far remains a deep cyclical expose to oil. So its earnings would indeed get impacted very significantly. Q: What about Reliance? The stock has been grinding around Rs 700, the management has bought back some stock, but do you see any triggers which could unleash any kind of rerating in the near-term in the stock? A: I think the one key thing that the market is looking for is value accretive growth and how it is going to deploy its cash in a value accretive manner. We did see the chairman spell out growth plans during the AGM, but these are going to have fairly significant growth only in the distant future. So I am afraid that the growth trigger is absent in the near term, so it’s a long-term story and not an immediate story. Q: You track some midcaps like Petronet LNG as well. Would you be bullish on that name on execution and delivery or do you think post IGL regulatory hangover might cap valuations? A: Petronet has done extremely well in a two player industry to capture significant volume growth. It has got further LNG terminals coming up and also the industry back-drop has been very favorable, so with domestic gas production actually declining, they are actually very favorably placed. Now as you mentioned, while there doesn’t seem to be any issue on Petronet’s immediate margins, nevertheless the risk that the market perceives is if Petronet could potentially get into the same sort of trouble as IGL. It’s one of the few oil link stocks in the Indian space which has been significantly owned by investors, the weightage of investors is pretty significant, so I think what investors are progressively doing is gradually shaving off their stakes as the stock price rises. With a price to book value of essentially three times plus, one is really factoring in extremely rich valuations. You need return on equity to sustain above 30% per annum to perpetuity; that is a very tall task. Either potential regulation over the next few years is going to cut that, or sharp fall in oil will diminish the attractiveness of imported LNG, because remember it tracks oil and is actually a fairly expensive commodity. So consumers may decide to consume more NAFTA for example than consume high price LNG, so we think that that stock is at material risk. Q: Given the point that you are making about crude prices, how much of a salutary effect do you think it is going to have for ONGC and would you significantly change around price targets for that as well? A: I think there are two elements to ONGC. Firstly, similar to oil marketing companies, it is a counter cyclical. But what we have seen is that it is a counter cyclical till a point at which oil prices decline and then it becomes a gentle cyclical. That is the strange way in which subsidies have been shared in the past; there is of course no clear cut formula so one can never say that with a high degree of confidence. But we think that till some threshold level of maybe USD 75-85 per barrel, that sort of a range till which it tends to be a counter cyclical, after which it will become a cyclical. The more fundamental angle is that we think ONGC is structurally poised to turn around. Its volumes have been declining very mildly, and in my opinion we can see a reversal, a mild increase in volumes. Essentially, its reserve replacement ratio has exceeded 100% now for five years, which means that as developed stores reserves are found, its production is going to increase. Also, its gigantic blocks such as Mumbai high recovery factor is barely 28-30%, which is very low by global standards. It is in the process of completing enhanced oil recovery projects in two of its largest regions in Mumbai offshore, which should start reviving volumes, so I think fundamentally it is poised to do well. Notably the imperial energy investment that it had made a few years back, which was very costly acquisition of USD 2.1 billion, will also see some turnaround. The Russian government seems to have given some concession by way of reduced export taxes from 65% to 60% and also has removed mineral extraction tax, so we believe that there could be a NPV value addition of about a billion dollars on that account. So the element of it being very a counter cyclical at the moment and there is more fundamental element, I think ONGC should do alright.