ONGC: On A Winning Spree

Rising global crude prices, healthy reserve accretion, rising production of OVL and benefits from ambitious investment plans are about to change the fortunes of ONGC

OIL & NATURAL Gas Corporation (ONGC), which produces 70% of India’s crude oil, is the country’s most profitable company in absolute terms. In the past few years, its profits have taken a hit due the discounts ONGC has to offer on the crude oil and natural gas it sells to oil marketing companies under the government’s directive. This made the company an underperformer on the bourses in the past two years. However, its fortunes are about to change.

The price of natural gas is likely to be increased by 12.5% in the near future. To top it, the proportion of crude oil, which it can sell at market price, is rising. ONGC has also drawn up an ambitious investment plan to boost the production of its existing wells and new discoveries. Considering high international prices of crude oil prices, ONGC is likely to be on outperformer in the next 12 months. BUSINESS: ONGC holds the largest acreage of oil and gas exploration blocks in India. The company has incorporated a wholly-owned subsidiary ONGC Videsh (OVL) to invest in overseas exploration and production (E&P) blocks. ONGC also owns a controlling stake in Mangalore Refinery and Petrochemicals (MRPL). MRPL has a refining capacity of 12.5 million tonnes per annum (mtpa), which is being expanded to 15 mtpa. MRPL is also expanding its petrochemical capacities in a joint venture (JV) with ONGC.

GROWING RESERVES: Last year, ONGC made 22 new hydrocarbon discoveries, nine of which were from virgin fields while the remaining were from established fields. It made nine more discoveries in the first half of FY08. These discoveries have resulted in a significant improvement in ONGC’s reservereplacement ratio (RRR), which is the ratio of incremental addition to reserves and current production.

In FY07, ONGC reported an RRR of 125%, indicating that it added more to its proven reserves than its annual production. This is the first time in ONGC’s recent history that its RRR is over 100%. The company added 76.10 million tonnes of oil equivalent (mtoe) to its proven reserves in FY07 compared to a production of 60.80 mtoe.

With new discoveries being added, ONGC is likely to maintain an RRR of over 100% in the next few years. The company is investing huge sums of money to increase the recovery factor in its existing fields, kick off production in marginal fields as well as new discoveries. It plans to invest over $30 billion in the next five years, 38% of which will go towards investments in overseas projects.

Some of its prestigious projects include KG basin gas fields off the eastern coast and Mumbai High redevelopment project. Scheduled to be commissioned in ’13, the KG basin project is estimated to generate 25 million cubic metres per day (mcmd) of natural gas annually, while the latter will raise the fields’ crude-oil production by 8% to 270,000 barrels per day. At current international oil prices, it translates into incremental revenues of Rs 2,300 crore annually over the next 20 years.

REVENUE DRIVERS: ONGC has to sell nearly 47 mcmd of its natural gas production at very low prices under the administered pricing mechanism (APM). The Tariff Commission has now recommended to the government to revise this price upwards by 12.5%, which will bring in an incremental operating profit of nearly Rs 2,000 crore every
year.

Over the past few quarters, ONGC’s subsidy burden is coming down sequentially and the government is under increasing pressure to come out with some long-term solution to the problem of high crude oil prices.

The current solution of offering consumption subsidy on an ad-hoc basis is not sustainable. ETIG believes that new measures will lessen the subsidy burden on ONGC and improve its finances dramatically.

The government is coming out with the seventh round of the New Exploration Licensing Policy (NELP) in the next few weeks for around 60 more blocks. Cumulatively, ONGC has been awarded 85 blocks or more than half of 162 blocks awarded so far in the six previous NELP rounds. ONGC hopes to maintain its winning streak this time around also. Besides its own production, ONGC also derives a small part of its production through its JVs. Although the proportion of such production is currently less than 10% of ONGC’s total production, it is rising steadily. As this production can be sold at market determined rates, its rising prominence is good for company’s future prospects.

ONGC’s another growth driver is its overseas arm OVL. The latter is operating in 15 countries with 26 projects and has produced around 8 million metric tonnes (mmt) of oil & oil equivalent gas last year, up 25% over the previous year. OVL has also formed a joint venture with Mittal Energy, which has obtained four overseas blocks so far. One of OVL’s most prestigious project is Sakhalin-1 in Russia in which it hold a 20% stake. The project reached peak production of over 250,000 barrels of crude oil per day in March this year. At this rate, OVL share is estimated to add around Rs 6,000 crore to ONGC’s consolidated revenues in FY08.

FINANCIALS: During the half-year ended September ’07, ONGC reported a 17% improvement in its standalone net profit at Rs 9,708 crore after its revenues inched up 2% to Rs ,29101.6 crore. This was despite discounts of Rs 7,448 crore extended to downstream refining players. On a consolidated basis, ONGC had registered a 16% growth in topline to Rs 82,253 crore and a 15% higher PAT at Rs 17,770 crore during FY07 despite a 42% jump in subsidy burden to Rs 17,024 crore.
VALUATIONS: In view of rising global crude oil prices, healthy reserve accretion, rising production of OVL and benefits from ambitious investment plans, the company has significant upside potential. ETIG estimates the forward EPS for FY08 on consolidated basis at Rs 105.

At the current price of Rs 1,350 per share, the stock is valued at just 12.9 times. This is low for a company with high revenue visibility in the next two to three years.

ONGC is also a high dividend-paying company. It paid Rs 31 per share as dividend during FY07, which works out as tax-free 2.3% dividend yield at the current market price. This is an ideal portfolio stock and investors can consider holding it for next four to five years.

RISKS: The government has not yet declared any policy on the subsidies issue. Its ad hoc decisions to impose higher subsidy burden on the company will have an adverse impact on its profitability. Similarly, the E&P projects are high-risk, capital-intensive and time-consuming business. The company is also facing high attrition in key areas, which could affect its future performance.
The salaries of employees of oil sector PSUs are pending revision with effect from January 1, ’07. Once finalised, they would increase the financial burden on company. Its realisations may also suffer in future if the rupee continues to appreciate against the dollar or if international crude oil prices come down substantially.