Invest aggressively in OMCs now; top pick BPCL: Macquarie

Rupee's freefall to new lows of 68.80/USD last week has been a key concern for oil marketing companies (OMCs) as this steep depreciation would hit their profit margins and escalate subsidy burden.

Jal Irani, MD of oil and gas research at Macquarie Capitals is positive on the oil and gas sector and advises investors to aggressively park funds now. He told CNBC-TV18 that the government may hike prices by Rs 3-4/ litre to relieve OMCs of subsidy burden and that it will have lesser than anticipated impact on their margins. Irani's top pick is Bharat Petroleum Corporation Limited (BPCL) as it has a good upstream value. He also sees potential in Oil and Natural Gas Corporation (ONGC) stock as the company's production is likely to surge. The gas price hike from next year will only add to the positives, he added. Also read: In rupee terms, under-recoveries may increase: ONGC Below is the edited transcript of his interview to CNBC-TV18. Q: You have a diesel under-recovery which is at almost Rs 12/liter. There is rupee depreciation and we have not seen any kind of move from the government. Crude prices are also surging. How do you see the overall situation right now? A: The oil and gas sector is very interestingly poised. It presents a very significant opportunity on several fronts. The public oil sectors stocks have been down as much as 40 percent. These stocks typically do fluctuate a lot and it is that time when one should be investing in them aggressively. Rupee’s fall has increased the diesel-oil subsidy burden from negative Rs 3/liter but it has gone back to only about Rs 13-14/liter, which was the case about a year back. The government has been already doing significantly over the last year; otherwise the situation would have been worse. We would have had actually twice as much as subsidy burden. Following the current parliamentary session closing on the September 6, the government is likely to increase prices by anywhere between Rs 3-5/liter which will significantly reduce the subsidy burden. Net-net last year subsidy burden was Rs 1.6 trillion. I cannot see under any circumstances that number being exceeded this year. I am firmly of the belief that the subsidy burden is going to be lower. It is worth noting that I think with the Food Security Bill being passed the government is going to ease pressure on the oil subsidy bill significantly. So actually the food subsidy bill gives subsidy to exactly the people who are meant to receive it, while the oil subsidies go to everybody. The diesel prices being cheap go to both the rich and the poor equally. The government is now giving the food subsidy to exactly who they intent giving it to. Q: If the government has to cut petroleum subsidy then who will share it more? Will it go to Oil and Natural Gas Corporation (ONGC) because that has been the risk and the management has also confirmed. Is there a significant risk of ONGC paying far more than what they did in FY13? A: There is indeed a significant risk that the government may have the upstream companies, especially ONGC and even Cairn India bear a higher burden. They have a significantly higher capacity to bear that higher burden. The 20 percent plus depreciation in the Indian rupee and crude prices increasing by USD 7-8 enhances their profitability significantly. So it is likely that the government will takeaway a fair portion of that. They are not going to be any worse off than they were earlier. While the stock prices have crashed reflecting that they are going to be worse off, so it is just a function of them benefitting significantly and a bulk of it being taken away, not the reverse. The profits are not going to actually decrease. More importantly, what the government may do is not only increase the subsidy burden, but they may actually increase cess. There is a cess of Rs 4,500/tonne which applies not only to ONGC and Oil India, but also Cairn India. This is a cess in rupee fix terms and this is a cess which was actually doubled two and half years back from Rs 2,500/tonne. In dollar terms, this cess is actually reduced. So the government is fairly likely to increase this cess significantly and this actually will then allow them to even tax Cairn India as much as it will increase taxes on ONGC and Oil India. So subsidy burden apart the cess may also well increase. _PAGEBREAK_ Q: How would you approach Oil and Natural Gas Corporation (ONGC) after the kind of price destruction? You have also said there is a risk of slightly higher absolute subsidy burden? A: ONGC barely trades at 7-8 times price-earnings ratio (PER), EV/EBITDA is about 4 times that is compelling valuations. Dividend yield of 4 percent and its production is poised to turnaround from a mildly declining production to actually an increasing one especially in terms of gas. Besides it also has had a gas price doubling starting next year. So, for all those very fundamental reasons, it is certainly worth looking at. In sharp contrast the stock has fallen more than 20 percent. So indeed there is a material opportunity in ONGC. Q: Fundamentally do you see value in some these names like Hindustan Petroleum Corporation (HPCL), Bharat Petroleum Corporation (BPCL) etc.? A: The Oil Marketing Companies (OMC) HPCL, BPCL and Indian Oil Corporation (IOC) are actually entirely sentiment driven. They just counter-cyclical with subsidies, but in reality the subsidy burden does not affect them at all. At the end of the day the government has to give them a certain minimum profits otherwise they will have serious cash flow problems and they potentially could go bankrupt as well. So actually the way the subsidy is decided it is a goal seek profit number that they allowed and if subsidy burden goes up they do not bear a higher subsidy burden in any case. After the very steep fall in the stock prices of 30-40 percent they are on ridiculously low valuations. These companies are quoting on bankruptcy valuations so the market is saying that they will go bankrupt. Is that possible? They control 99 percent of the gas stations and petrol pumps in the country. If you do not have any oil distribution network in the country there will be economic chaos which the government cannot afford. So the worst case scenario which the market is pricing is not going to happen. What we would suggest nevertheless among the three OMCs, BPCL actually presents the best opportunity, because BPCL also has got a USD 3 billion odd upstream value. The oil and gas assets it has got in Mozambique, so ONGC has bought Anadarko's Mozambique stake, the same stake as BPCL has got for USD 2.6 billion. The entire market cap of BPCL is USD 2.8 billion. The market is telling us that BPCL's underlying refining and retailing business is actually for free. Besides, the upstream business of BPCL is actually a dollar denominated value business. So the currency depreciating and oil prices going up BPCL turns out to be a net beneficiary and the market at the moment is just looking the other way. So I certainly think the OMCs as a whole present significant value, but most importantly BPCL presents even greater value then the other two.