Imperial is a long-term play for OVL

STATE-OWNED oil behemoth ONGC’s whollyowned subsidiary ONGC Videsh (OVL) has agreed to buy the UK-based Imperial Energy (IEC). If the deal goes through, OVL will gain access to rich oilfields in the Western Siberian region of Russia besides adding significantly to its reserve base.
IEM commenced commercial production of crude oil in November 2007. However, the company incurred an operating loss of $39 million in 2007 due to high exploration expenditure. To satisfy its investment needs over the next two years, the company has mopped up $191 million by way of a convertible bonds issue in December 2007 and $600 million through a rights issue in May 2008.
OVL has agreed to pay nearly GBP1.4 billion ($2.58 billion) for acquiring IEC’s 102.24 million equity shares of 2.5 cents each and outstanding convertible bonds. The deal values equity shares of the company, which holds petroleum exploring assets in Russia and Kazaksthan, at GBP12.50. The company holds a 75% stake through a joint venture in an exploration block in Kazakstan.
IEC – listed on the London Stock Exchange – was floated in 2004 and in a short time amassed over 920 million barrels of oil and oil equivalent gas (O&OEG) reserves primarily located in the Tomsk region in Russia.
IEC reached a production level of 10,000 barrels per day (bpd) by end-2007, but it slipped to around 7,000 bpd during the quarter ended March 2008 due to some technical snags. By the end of 2007, the company had 20 vertical and five horizontal wells drilled. Going forward, it plans to add another 69 vertical production wells in 2008 to take the number of wells to 89. It has also set a target of 25,000 bpd by the end of 2008 and 35,000 bpd by 2009-end.
Assuming that IEC is be able to achieve its production targets and crude oil prices average at the current levels, the company will be able to generate EBITDA of Rs 2,300 crore in 2009. However, there is no clarity on the quality of crude oil and the price it will command, and the government’s share in the production. Hence, it is difficult to judge the valuation offered by OVL for IEC’s acquisition.
During 2007, IEC produced nearly 833,000 barrels of crude oil and generated a sales revenue of $20 million. The company is currently investing heavily in ramping up its assets and carrying out exploration work. IEC has lined up capex of $350 million in 2008 and $250 million in 2009 and is not expected to generate operating cashflows till early 2010. The managements of both companies have agreed upon the acquisition terms, but the deal is not fully done yet. Particularly, OVL will have to secure the requisite approvals from the governments of Russia and Kazakstan, which could take time. Some licences held by IEC are only exploration licences, which means OVL will have to secure production licences in case of a hydrocarbon discovery later. All in all, the deal is likely to generate value for ONGC only in the long-term.

End Of Good Times

The slowing demand for petro products globally and a glut in upcoming refining capacity in the country do not bode well for the refinery sector

DOMESTIC petroleum refiners, who have been enjoying rising refining margins over the past couple of years, reported record high refining margins during the quarter ended June ’08. However, there are definite signs that the industry may have hit a peak and the way forward is just downwards. The growth in demand for petroleum products is slowing down and with a number of refinery projects coming onstream, supply of these petroleum products is set to go up substantially.
The International Energy Agency (IEA) — the energy policy advisor to 27 developed countries — has downgraded the estimated growth in petroleum products demand to just 0.86 million barrels per day (mbpd) in ’09. compared to an increment growth of 0.89 mbpd in ’08. According to the latest estimates, the global demand for oil is expected to inch up 1% to 87.7 mbpd in ’09, compared to 86.9 mbpd in ’08.
High energy prices and economic slowdown are weighing down on the consumption of petroleum products. Today, the slowdown in product demand is so severe that the margins available on production of petrol, naphtha and fuel oil for refineries have turned negative. It is only the high price of diesel, thanks to an unusual spurt in global demand, which is helping refiners post gains in their refining operations. But the demand growth for diesel owes itself to a number of extraordinary events, such as nuclear power outages in Japan, China’s stocking up prior to the Olympics, power outages in India and South Africa, and natural gas outage in Australia. The scenario can worsen for the global refining industry, once these extraordinary factors vanish.
While the demand for refined products is slowing, the supply is actually going up. In fact, a number of refinery projects are scheduled to commission between now and ’12 — the first and the foremost being Reliance Petroleum’s 0.58-mbpd refinery, which will single-handedly “represent almost 50% of the estimated global oil demand growth in ’09,” as informed by chairman Mukesh Ambani. And this is not the only refinery coming up this year.
IEA, in its latest medium-term oil market report, estimates that an additional 1.49 million bpd of refining capacity will come up in ’08, followed by another 1.83 million bpd in ’09 and so on. Thus, the increase in supply of refined products is likely to outpace the estimated growth in demand, creating a glut-like situation. A number of regions, which are currently net importers of petroleum products, are expected to turn net exporters during this period. IEA’s (July ’07) medium-term oil market report mentions, “Out of the 10.6 mbpd refining capacity expected to come up by ’12, the Middle East and Asia account for 6.7 mbpd, with refining capacity growth in these regions exceeding regional product demand.” Similarly, the Chinese refinery expansions are forecast to reduce Chinese distillate imports over the course of ’08 and restore China’s net exporter status by the end of ’09.
Besides the new refinery projects, a number of refineries are investing in capacity expansion or upgradation projects. These projects will improve their product slate, thereby minimising the production of heavy distillates, such as fuel oil, and increasing the production of petrol and diesel. This, too, will add to the supply of these transport fuels. At the same time, increasing supplies of bio-fuels will keep the incremental demand for petroleum products under check. “Global gasoline supply potential will increase significantly in ’09, thanks to the increase in refining capacity in Asia and North America, and increasing supplies of ethanol. Against this, weak global demand growth is forecast in the major consuming regions,” noted IEA in its latest monthly oil market report. In the current scenario, the availability of sweet and light crude oil is reducing globally, even as the availability of heavy crude oil (or that with high sulphur content) is increasing. At the same time, the environmental norms are getting tighter. For example, the European diesel markets will move to 10 ppm (particles per million) sulphur limits from January ’09 under the Euro-V standard, from 50 ppm currently. Anticipating these changes, the new refineries are being built to not only process the worst quality of crude oil, but also to produce cleaner fuels. This will eventually increase the demand for high-sulphur heavy crude oil, which is currently trading at a huge discount to light and sweet crude oil.
As a result, the current price differential between the worst and best crude oils will narrow down. Thus, the refining operations of these new refineries will not be as profitable as is being estimated currently.
All these trends are likely to affect the profitability of domestic refiners negatively. Going forward, domestic refiners will witness a pressure on their gross refining margins (GRMs), which represent the differential between the prices of products and the cost of crude required to produce them.
The refineries may also face pressure on capacity utilisation levels. In short, the capital appreciation in refinery sector scrips is likely to stagnate over the next one year.

Inventory gains perk up refining cos’ quarter show

PETROLEUM refiners posted record margins in the June 2008 quarter on inventory gains from rising crude oil prices. However, public sector oil marketing companies reeled under pressure from under-recoveries. The continuous rise in crude oil prices increases the value of inventories with refining companies. This, in turn, pushes up their gross refining margins (GRM).

During this quarter, the largest standalone player Reliance Industries posted a record high GRM of $15.7/barrel, which was below market expectations. Apparently, the company did not book any inventory gains. This eroded RIL’s operating margins. Although the company’s revenues rose 46%, the refining division posted only a 19% growth. Still, the company posted a 13% growth in profit for the quarter to Rs 4,110 crore. Essar Oil reported its two months of commercial operations in the quarter. The GRMs were impressive at $12.54 and the company went on to post a maiden profit of Rs 30 crore. The profits could have been higher, but for the Rs 320-crore write-off, thanks to the rupee depreciation. The state-owned standalone refiners MRPL and Chennai Petroleum (CPCL) also reported record high level of GRMs at $18.03 and $15.89, respectively. As a result, MRPL’s net profit zoomed 129% to Rs 845 crore, while CPCL’s net profit spurted 117% to Rs 703 crore. Indian Oil proved to be the only oil marketing company (OMC) that could post a net profit for the June quarter, with both BPCL and HPCL slipping deep into the red. Besides nearly doubling their refining margins, these OMCs enjoyed a strong support from upstream oil companies and the government. However, heavy under-recoveries ate into their profits. IOC’s GRMs stood at $16.81 per barrel against $9.02 in FY08. The discounts extended by upstream oil companies — ONGC, Oil India and Gail — jumped 156% to Rs 6,235 crore with the oil bonds at Rs 13,527 crore, over 70% of what it received for the entire FY08. Still the quarter’s net profits lost 72% on y-o-y basis to Rs 415 crore. The scenario was not much different for BPCL and HPCL. Their GRMs during the quarter were more than twice that of FY08.
The future doesn’t appear exciting for the refiners with the GRMs falling globally. With the crude oil prices coming off high levels, the benefit of inventory gains will not be there to boost the GRMs in the coming quarters. The demand for crude oil is also weakening in many countries while a number of new refineries will be coming on stream globally over next three years.

LIVING IN SLOW MOTION

India Inc’s June ’08 quarter results don’t seem to paint a rosy picture. But is the situation really as bleak as it appears? Ramkrishna Kashelkar and Santanu Mishra sift through the numbers to try and find a silver lining…

ANOTHER QUARTER is behind us and there seems to be no respite for India Inc. Incremental growth is hard to come by as companies try to beat rising raw material, energy and interest costs. The manufacturing sector has been badly hit on all these counts, while the services industry is faring much better. And this time round, India Inc has another reason to despair — the provisions to account for an increase in companies’ debt liabilities due to depreciation in the rupee against the dollar. In the June ’08 quarter, major companies were hit by mark-to-market (MTM) losses on their foreign exchange (forex) exposure.
The detailed 20-quarter analysis of 1,019 companies shows that Corporate India’s net profit growth is now in single digits — the lowest in the past 20 quarters. The ‘other income’ factor, which had lent support to the weak earnings in the past few quarters, has fallen drastically. However, the most worrying aspect of the results is that even operating margins are showing signs of weakness.
For the quarter ended June ’08, India Inc has reported a 25% jump in operating income to Rs 299,800 crore. The sample excludes banks (since their accounting standards are different), oil companies (which are incurring heavy losses due to under-recoveries) and those companies for which data for the past 20 quarters is not available. Net sales growth in the June quarter was higher than that in the March quarter, but this was mainly due to rising inflation.

FEELING THE PINCH:
Majority of the companies have tried to pass on the rise in their raw material costs unsuccessfully, which, as a proportion to net sales, have risen to their highest level in the past two years.
As a result, operating profit margins — which had started their downward journey in the March quarter itself — have stagnated to a 10-quarter low of 18.2%. As the prices of crude and coal soared to record high levels globally, energy costs have soared for India Inc as well.
India Inc has started feeling the heat of soaring inflation and interest rates. In the latest quarter, companies’ interest cost has jumped by 62%, accounting for nearly 3.3% of their sales — which is a four-year high figure.

MARK-TO-MARKET LOSSES:
The depreciation of the rupee has highlighted two types of losses. The first category is the MTM losses arising from the revaluation of derivatives contracts. The second category is the translation losses due to increase in the value of foreign currency loan in rupee terms. The first category of losses is mainly incurred by companies in the IT sector, which hedge their revenues. (The IT sector gets a major chunk of its revenues from abroad). These companies were booking gains till last year, when the rupee was appreciating. But now that the trend has suddenly reversed and the rupee has depreciated by around 7% quarter-on-quarter, these companies are reporting MTM losses. For instance, Tata Consultancy Services (TCS), which booked a gain of around Rs 60 crore in the June ’07 quarter, has reported a loss of Rs 76 crore for the June ’08 quarter. Here, it is important to understand that as long as companies have not closed any of these derivatives positions, the loss is notional and there will not be any cash outflow. The second category of loss is incurred by those companies which have taken foreign currency loans to fund their expansion plans. As the rupee depreciates, their liability increases in rupee terms. For instance, if the loan amount was $1 million last year, when the rupee-dollar exchange rate was at Rs 40/dollar, the rupee liability was Rs 4 crore. As the rupee depreciates to Rs 43/dollar, this liability will increase to Rs 4.3 crore. This extra Rs 30 lakh will hit the profit and loss statement of companies. The companies which have reported such losses are from different sectors and include Ranbaxy Laboratories (Rs 193 crore), Tata Steel (Rs 303 crore), Tata Motors (Rs 200 crore) and GE Shipping (Rs 138 crore), among others.

In Fits And Starts
MANY OTHERS, including Reliance Industries (RIL), have followed the Companies Act and accommodated MTM losses in their balance sheet. As per the accounting standards, this should have been reported in the companies’ profit and loss statement. Whatever be the situation, one thing is certain — the depreciating rupee has affected the profitability of companies in the June-ended quarter.

MANUFACTURING VS SERVICES SECTOR:
The combination of high inflation and interest rates has hit the manufacturing sector the most. The 766 companies in the manufacturing space have reported just 3.5% growth in net profit during the June ’08 quarter, despite a 25% jump in net sales. Their operating margins have fallen by 160 basis points (bps) to 16.5% in the June quarter. Meanwhile, the 253 companies from the services sector have posted a healthy y-o-y growth rate in net profit, compared to the previous quarter. The services sector has also witnessed a marginal growth in operating margin to 23.2%, over the March ’08 quarter. IT, non-banking finance, shipping, telecom, hospitality, entertainment and media are the main industries representing the services sector. IT and telecom sectors have reported encouraging numbers, with healthy growth in bottomlines, supported by an increase in operating margins on a sequential basis.
Non-banking financial companies (NBFCs) have had a tough quarter, with operating revenues as well as other income falling on a yo-y basis. But their net profit growth is almost flat, compared to the year-ago period. The entertainment and media sector has reported a 79% jump in its net profit, mainly because its largest constituent, Zee Entertainment, wrote back substantial tax provisions. Higher day rates due to buoyancy in trade have helped the shipping industry to post high revenue growth in the June ’08 quarter. However, high fuel costs, dry-docking expenditures, as well as forex losses have weighed heavily on operating margins, bringing down the aggregate net profit.
In the manufacturing segment, industries such as capital goods and consumer durables have put up a better performance in the June ’08 quarter, contrary to popular belief. The aggregate net profit of 24 consumer durables companies has grown 22.4% during the June ’08 quarter, against 14.5% in the June ’07 quarter. This is supported by a marginal improvement in operating margin, while the growth in other income is lower. Similarly, the capital goods industry has reported 17% profit growth, as its operating margins have expanded.
The chemicals industry has also outperformed the overall trend. Despite high energy prices, the surge in prices of commodity chemicals has helped the industry to expand its operating margins to 18.8% from 14.7% in the corresponding quarter of the previous year. The sales of 47 chemical companies have risen 41%, which is a combination of volume growth, as well as price increases. This has helped the industry to post a massive 86% jump in net profit, despite a fall in other income and rise in energy and interest costs. Fertilisers, plastic goods and steel are the other manufacturing industries which have performed better, compared to the corresponding previous quarter.
However, the pharmaceuticals and FMCG industries have posted dismal results, despite endorsement from several experts, which has led to a better performance on the bourses. The pharma industry’s aggregate net profit has fallen 18% y-o-y, mainly due to forex losses and spurt in interest costs. Its operating margins have remained healthy, and are only slightly weaker than the year-ago levels.
The FMCG industry’s profit has grown just 5%, much lower than the 17% seen a year ago. The industry’s operating margins have weakened, despite sales growing at 22% — the highest in the past five years.
Other high-profile industries which are going through tough times are auto & auto ancillaries, cement, power, hospitality, real estate and textiles, most of which have witnessed a fall in their aggregate net profits vis-à-vis the June ’07 quarter.

SUMMING IT UP:
Despite the overall grim picture, there are a few factors which can have a positive impact on India Inc in the long run. Growth in the capital goods industry indicates that Corporate India’s huge capital expenditure (capex) plan is mostly on track, despite the rising interest rate scenario.
Global crude and coal prices have come off their peaks and are likely to ease further over the next six months. This will ease inflationary pressures, as well as the energy costs of domestic companies.
Last year, we had seen India Inc accounting for forex gains to boost its profits, when the rupee was appreciating. With the rupee turning weak again in ’08, the notional losses reported by Corporate India are weighing heavily on profits. This implies that the extent of slowdown may actually be lower than what the numbers suggest. Similarly, a weak rupee will favour export-led industries.

Derivatives losses take the shine off Essar Oil profits

Essar Oil posted net profit of Rs 30 crore during the June 2008 quarter on net sales of Rs 8,950 crore as the gross refining margins (GRM) stood at $15.5 a barrel. Its 10.5-million tonne per annum (mtpa) refinery commenced commercial operations from May 1, 2008, and processed a little over 2 million tonnes of crude oil by the end of June 2008. Since the commercial production has started recently, the results are not comparable with previous periods.
Despite healthy GRM, the company’s profit got eroded due to Rs 217 crore write-off on account of derivative losses. The company also provided for Rs 102 crore for forex fluctuations. Beginning this quarter, the company started charging depreciation (Rs 115 crore) and interest costs (Rs 169 crore), which were capitalised earlier.
The oil major maximised production of diesel and aviation fuel to 48% of the total production. Nearly 70% of the company’s sales came from domestic market, where it has signed long-term agreements with BPCL and HPCL. The company has embarked upon an ambitious project to increase its refining capacity from current 10.5 mtpa to 34 mtpa by the end of 2010. Going forward, EOL’s refining margins are likely to decline from the current levels, in line with the industry trend. The refinery stands at 6 on Nelson’s complexity index, which indicates that its ability to handle dirty crude is limited and so is its ability to manipulate its product basket. This will restrict its refining margins to around $7-8 a barrel level for FY09, putting pressure on its operating profits compared to the current level.

RPL stock hit as refinery misses market target

JUST nine months ago, the outlook on Reliance Petroleum’s (RPL) new refinery was that it would become operational by March 2008, a time when the refining margins would be at its peak. This drove up its valuations to crazy levels. RPL’s market value soared past Rs 1,20,000 crore in early November 2007 — nearly 20% higher than all the public sector refiners put together — even before the company had started its business.
H o w e v e r, the excitement fizzled out when the project did not take off in March. Now, even July has passed and the refinery is yet to start commercial production. And all the investors are left with is an assurance that “the refinery is expected to be completed ahead of schedule”. Now, considering the original schedule of September 2008 for completion, it could at most be a month, if not just a couple of weeks, by which the project could be preponed.
This confusion has resulted in a downward revision in the valuations of RPL as well as its parent company Reliance Industries (RIL). In its latest report on RIL, DSP Merrill Lynch says: “Our earlier FY09E earnings forecast assumed RPL’s refinery operating for nine months (from July 2008) in FY09E. Now, we expect only three months of commercial operations for RPL in FY09E.” It has maintained a ‘buy’ on RIL, but downgraded its earning estimates.
In mid-2007, several broking houses, including Goldman Sachs and HSBC, were predicting the RPL refinery to commission six months ahead of schedule. Although they were off the mark on this count, the scrip has already crossed their price targets based on estimated FY10 earnings.
Despite such controversies over the before-time completion of the 5,80,000 barrels per day (bpd) RPL refinery, some experts appreciate the project execution capability of Reliance management. Vandana Hari, Asian oil news director at Platts said: “Capital goods market is tight globally. There is severe shortage of manpower as well as engineering services and a number of refinery projects are now facing inordinate delays and cost overruns all over the world. In this scenario, RPL refinery getting ready within 36 months as well as within budget is really commendable.”