CRUDE: No Demand Dip Means Prices to Rule Firm

While global equity markets underwent major corrections, crude oil prices have refused to ease so far. Whatever weakness was seen earlier in the month has disappeared, with Brent crude prices moving up into three-digit territory at $112 per barrel. The reason is a visible tightness in oil’s demand-supply dynamics. Debt problems in the US and Europe and signs of slowing economic growth had softened oil prices earlier in August. The US GDP data was revised at the end of last month to reveal the country’s absolute GDP hadn’t grown since 2007 and that growth in the first half of 2011 now stands at an annualised rate of barely 1%.
While global trade is also declining steadily. Capgemini Consulting saidthat its Global Trade Flow Index that tracks import and export of goods and services for 23 top countries witnessed a sharp 8% fall in the first half of 2011. Since the global oil demand is closely linked to the economic growth and trade, this stagnancy has resulted in a downward revision in oil demand growth.
Opec’s decision to increase oil supply and International Energy Agency’s release of 60 million barrels of emergency petroleum reserves further added to the weakness. Still, these factors have clearly not been able to keep prices low for long. The demand forecasts, are still high and a number of geopolitical factors are creating supply tensions.
The quarters ending September and December typically see the year’s highest demand for oil. The oil demand in the second half of 2011 is expected to average 90.4 million barrels per day (mbpd) as per estimates of International Energy Agency. Adjusting for non-Opec supplies, the Opec will need to produce at an average 31 mbpd to meet this demand, which is higher than their current production rate of 30 mbpd. At the same time, the oil demand is not likely to go down in line with the slowdown in economic growth. The global growth is being led by developing countries such as India and China, where the fuel consumption is growing unabated.

CRUDE: No Demand Dip Means Prices to Rule Firm

While global equity markets underwent major corrections, crude oil prices have refused to ease so far. Whatever weakness was seen earlier in the month has disappeared, with Brent crude prices moving up into three-digit territory at $112 per barrel. The reason is a visible tightness in oil’s demand-supply dynamics. Debt problems in the US and Europe and signs of slowing economic growth had softened oil prices earlier in August. The US GDP data was revised at the end of last month to reveal the country’s absolute GDP hadn’t grown since 2007 and that growth in the first half of 2011 now stands at an annualised rate of barely 1%.
While global trade is also declining steadily. Capgemini Consulting saidthat its Global Trade Flow Index that tracks import and export of goods and services for 23 top countries witnessed a sharp 8% fall in the first half of 2011. Since the global oil demand is closely linked to the economic growth and trade, this stagnancy has resulted in a downward revision in oil demand growth.
Opec’s decision to increase oil supply and International Energy Agency’s release of 60 million barrels of emergency petroleum reserves further added to the weakness. Still, these factors have clearly not been able to keep prices low for long. The demand forecasts, are still high and a number of geopolitical factors are creating supply tensions.
The quarters ending September and December typically see the year’s highest demand for oil. The oil demand in the second half of 2011 is expected to average 90.4 million barrels per day (mbpd) as per estimates of International Energy Agency. Adjusting for non-Opec supplies, the Opec will need to produce at an average 31 mbpd to meet this demand, which is higher than their current production rate of 30 mbpd. At the same time, the oil demand is not likely to go down in line with the slowdown in economic growth. The global growth is being led by developing countries such as India and China, where the fuel consumption is growing unabated.

BPCL : A Good Stock to Have in Your Pipeline

BPCL appears to be a good bet for investors amid all the economic uncertainty. The company will gain if oil prices decline either as a result of recession or from a resolution of the Libyan crisis

Bharat Petroleum’s stock market performance of the last few weeks reflects its importance as a defensive stock, particularly, in the face of global economic challenges. The company is set to benefit from weakening global crude oil prices, while the government gradually takes steps to tackle the petroleum industry’s under-recovery problems. The recent commissioning of its Bina refinery and a portfolio of exploration blocks hold key to BPCL’s future success. Long-term investors should consider buying into the scrip.

BUSINESS
Bharat Petroleum (BPCL) is India’s second-largest petroleum retailer with annual sales of around 30 million tonne of fuels. It ended FY11 with a combined refining capacity of over 24 million tonne at its three refineries in Mumbai, Kochi and Numaligarh. The company’s profitability has stagnated over the last one decade due to government restrictions on retail sale prices of petrol, diesel, LPG and kerosene.

INVESTMENT ARGUMENT
At a time when the world is rife with fears of a double-dip recession, BPCL will be an excellent defensive bet as it stands to gain from falling oil prices. If fears of an economic recession come true, global oil prices are bound to fall from the current level due to lower demand. Even without a recession, an end to the Libyan crisis should bring down oil prices on hopes of an improvement in supplies.
Back home the government has been taking positive steps, albeit very slowly, towards addressing the under-recovery problem of the petroleum sector. Last year the government decontrolled natural gas prices followed by petrol prices. In the first quarter of FY12, the government slashed indirect taxes, before raising diesel, LPG and kerosene prices marginally. Still the industry is looking at under-recoveries of around 80,000 crore for FY12, which have to be curtailed if the government has to meet its budget deficit target.
The government is also mulling follow-on public offers (FPOs) of key petroleum sector companies ONGC and Indian Oil to meet its divestment targets for FY12. This will require further clarity on the subsidy mechanism, which will be a positive for the entire sector.
BPCL has recently commissioned its fourth refinery at Bina in Madhya Pradesh in partnership with the Oman Oil Company. The refinery has a capacity of 6 million tonne. Out of the 4,700 crore of equity, around 3,100 crore has been subscribed to by the two partners, while the rest is yet to be arranged. The company management is keen on an IPO to fund the gap. This new refinery is expected to improve the company’s overall margins thanks to its better configuration, besides higher volumes. An IPO in future will be a further positive for BPCL. BPCL holds stakes in 27 exploration blocks — 9 in India and 18 abroad — through its subsidiary Bharat PetroResources. Seven discoveries have been made in these blocks for which development is under way.
The company has entered other areas of the petroleum value chain through a series of joint ventures. It holds stakes in LNG importer Petronet LNG apart from city gas distribution companies such as Indraprastha Gas and Sabarmathi Gas. Its other JVs span businesses including operating fuel pipelines, renewable energy to bunkering for marine vessels and aeroplane refuelling at airports.

VALUATION & CONCERNS
BPCL has already outperformed its peers and is trading at a price-tobook value (P/BV) of 1.8, substantially above Indian Oil’s 1.4 and HPCL’s 1. BPCL’s dividend yield at 2% is the lowest among the three companies.
Any runaway spurt in global oil prices should be a trigger to dump BPCL shares, as the government’s reaction to mitigate impact of rising oil prices has always been delayed.

UREA FIRMS: Price Decontrol to Offset Costs, Boost Bottomline

The Group of Ministers (GoM) on fertilisers has proposed to bring urea under the nutrientbased subsidy scheme, wherein the manufacturers will be allowed to increase the urea price by up to 10%. While the move will benefit urea manufacturers, it will also bring down the government’s subsidy burden and encourage a balanced usage of fertilisers.
Last year, non-urea fertilisers such as potassic and phosphatic fertilisers were brought under the NBS after which, consumption of cheaper urea has increased. It stands at 27 mt per annum, which is more than half of the total fertilisers consumed in the country. Domestic urea output stands at 21 mt, necessitating imports of 6-7 mt every year.
Further, on the back of higher input cost, controlled price for urea companies is facing margin pressure. Urea production includes different forms of feedstock such as gas and naphtha and, hence, the cost varies from manufacturer to manufacturer. Under the draft policy, the government’s subsidy portion will be restricted at . 4,000 per tonne to gas-based urea plants but a higher subsidy will be given to naphtha-based players. These units will get three years to convert into gas-based producers. Further, the weighted average pooled gas price will be considered to arrive at a uniform subsidy amount.
Decontrol will help the companies offset their manufacturing cost and improve bottomline. National Fert, RCF, Nagarjuna Fert and Chambal Fert derive over half of annual revenues from urea. Among listed companies, PSU National Fert is the biggest urea producer with a capacity of 3.2 mt per annum. It derives over 95% of its revenues from urea. Its Q1 profits fell 66% due to a rise in raw material costs and interest burden. It has replaced naphtha with natural gas over the past few years, but still consumes substantial quantities of fuel oil that are not linked by natural gas pipelines. In FY10, almost 68.6% of RCF’s revenues came from urea and subsidy. The ratio stood at 73% for Nagarjuna and 51.3% for Chambal in FY11.
The partial price decontrol will ease liquidity positions for urea makers and help them realise their sale proceeds faster. Higher urea prices would also rationalise its consumption and bring down imports while encouraging more domestic production. Chambal has gained over 30% in the past six months already, which limits a further upside in the near term. However, analysts expect National Fert and Nagarjuna Fert to give positive returns.

GSPL to Gain from Cross-country Gas Pipeline Projects

The strong results for June ’11 quarter helped Gujarat State Petronet limit its fall as the market tumbled since the last week of July. The company’s results were better than expected as its volumes as well as tariffs grew and had the benefit of higher wind power capacity.
In spite of being a mid-cap company, GSPL’s shares have weathered the recent market storm fairly well. GSPL’s market value dropped 7.5% since the last week of July against a 13% fall in the BSE Sensex. The company has been consistently underperforming the benchmark index over the past one year due to concerns over its stagnating volumes.
In the June ’11 quarter, GSPL took its volumes up 1.4% YoY to 36.8 MMSCMD, which was its highest volume in any quarter. The tariffs for the quarter at . 0.81 per SCM was 6.6% higher against the year-ago period. The improvement in tariffs was a surprise, considering an expectation of the same easing towards . 0.75/ SCM level in the near future once the Petroleum and Natural Gas Regulatory Board (PNGRB) approved final tariffs. In fact, the tariff finalisation for the company may get delayed considering certain legal issues in PNGRB.
The company’s operating profit for the June ’11 quarter was up 10.1%. Depreciation dropped 34% and other income zoomed 163%, which helped it grow the pre-tax profits by 28% in spite of a 44% jump in interest costs. A 150-basis point drop in effective tax rate to 29.7% helped it end the quarter with 30.7% profit growth at . 137.4 crore. The company is moving out of Gujarat, where all its transmission activities are currently located to build three long-distance cross-country gas pipelines covering north, central and south-east India. This will bring the company long-term gains. GSPL is already the lowest valued company in the domestic listed natural gas companies. The company is trading at a P/E multiple of just 10 against 14-21 for its peers . This could be due to the fact that GSPL’s recent profit growth has come primarily from changes in its erstwhile aggressive depreciation policy in December ’10 quarter.

Gujarat Gas may Find it Tough to Maintain its High Margins

Stock may not gain much now as it had already climbed 10% in past month

The June ’11 quarter results of Gujarat Gas were surprisingly strong, as the company undertook price hikes in anticipation of an increase in LNG costs that didn’t happen. Still the company is facing challenges on volume growth and is unlikely to sustain current high margins going ahead. However, the scrip doesn’t appear to face any correction risks.
For a city gas distribution company, the 67% profit growth reported by Gujarat Gas for the June quarter exceeded expectations. The company posted a strong 41% revenue growth to . 576.6 crore and improved operating profit margin by 180 basis points to 23.9%. Most of the company’s revenue growth came from higher prices. It implemented an across-the-board price hike in April ’11, which took the average sales realisation 35.6% higher y-o-y to . 19.1 per standard cubic meter (scm). In comparison, the volume growth was a paltry 1.8% to 302 million cubic meters.
The key question is whether the company will be able to maintain such margins, going ahead. Despite the company’s monopoly status in its geography of operations, this appears tough. “Blended gross margins at . 5.9/scm increased by a sharp 46% y-o-y and 27% q-o-q (during the June quarter). With the company facing some consumer resistance, and volume growth suffering, we believe maintaining such high margins will be very difficult,” noted a research report by Nomura.
With domestic natural gas supplies limited, the company’s dependence on short-term LNG is increasing. It had reported a 37% jump in LNG volumes in the last quarter of 2010, against an average of 26% for the whole of 2010. This is set to go up further, making it susceptible to raw material price volatility.
The scrip has gained nearly 10% in the last one month, while the BSE Sensex lost over 10%. Still the company’s valuation doesn’t appear excessive at around 18.5 times its earnings for trailing 12 months, considering the fact that its peer Indraprastha Gas is trading at 20.6 times its earnings. Thus, Gujarat Gas’ scrip may not have any significant upside from here, but neither does it run any risk of a sharp correction.

OIL MARKETING COMPANIES: Fall in Crude Prices may Hit Growth

Under-recoveries, ad-hoc subsidies and a spurt in interest costs impacted the June 2011 quarter numbers of state-run oil marketing companies — Indian Oil, BPCL and HPCL. Although, the companies ended up in the red, stocks of these companies have remained buoyant thanks to falling oil prices and renewed hopes on clarity in policy. However, this may be just a case of irrational exuberance once again.
The three oil marketing companies have generated 1-4% returns since the last week of July 2011, despite the global stock market crash that led to a 13% fall in BSE Sensex. And that too, after the fall in the past couple of trading sessions following negative numbers for the June 2011 quarter.
A 20% fall in global crude oil prices was the key reason, while reports of follow-on public offer, or FPO, of ONGC and Indian Oil revived hopes regarding clarity on subsidy-sharing mechanism, which has remained ad-hoc so far.
These stocks could, however, be entering a correction phase. Oil prices have rebounded nearly 8% in the last couple of days as global equity markets recovered a bit. But clarity on subsidy-sharing remains elusive. “Any near-term decline in oil prices is positive for OMCs, but we continue to believe that for these companies to emerge as long-term investment ideas, clarity is needed on deregulation and (subsidy) sharing mechanism,” a research by Nomura said.
The losses of OMCs in the June 2011 quarter were despite the support from the government as well as upstream petroleum PSUs. However, the OMCs were forced to bear nearly a third of the quarter’s under-recovery, compared with less than 10% in FY11. The government’s decision to share a lower burden was possibly driven by the expected reduction in under-recoveries in the later half of FY12, following price hikes and tax cuts implemented in the past week of June 2011. A key failure of the three OMCs was their inability to generate healthy refining margins for the quarter, when their private sector peers did exceedingly well.
A10% fall in crude oil prices during the June 2011 quarter left these companies with inventory losses weighing heavily on refining profits. A sharp jump in interest burden and a fall in other income, too, were responsible for higher losses.
Overall, the June quarter numbers of the three OMCs hold little to support their strong market performance of late.

OIL INDIA : Strong on Pricing, but Headwinds Still Remain

Among the three upstream petroleum firms Oil India stood out with its outstanding results for the June 2011 quarter. The company’s improved profitability came not only from higher realisations, but also from a significant jump in production. This comes as a pleasant surprise at a time when the country’s biggest oil producer ONGC is struggling to maintain its output.
Oil India’s profits jumped 70% to . 849.6 crore during the June ’11 quarter. This was a significant feat considering the other two upstream petroleum PSUs — ONGC and Gail — could post profit growth of just 11-12%. A part of Oil India’s superior performance came from the higher oil price that it realised from sale of every barrel of oil compared to its bigger peer ONGC after accounting for the discounts they both had to extend towards the industry’s under-recoveries. ONGC could realise $48.76 per barrel after deducting $72.53 as discount, whereas Oil India’s net realisation stood higher at $59.55 per barrel after $56.77 as discount.
However, higher realisations were just one reason for the jump in profits. Oil India’s oil production shot up almost 20% to 0.96 million tonne and natural gas production up 16% to 642 million cubic meters during the quarter. The company benefited from the low base effect of last June quarter, when its key customer — the Numaligarh refinery — had remained shut down for an extended period.
For Oil India, the production growth in near future will depend on its ability to find newer customers. A large chunk of the increase in gas production during the June ’11 quarter was thanks to the completion of Duliajan-Numaligarh pipeline supplying 0.86 MMSCMD to the Numaligarh refinery. The Brahmaputra Cracker project, which is expected to be commissioned in July ’13, will enable the company to raise output by another 1.35 MMSCMD.
Oil India remains a top bet, with most of the broking firms due to its ability to improve production and earn a better price. However, with the government considering various alternatives to the method of calculating future subsidy burden, it could face headwinds. “Sharing of subsidy among upstream firms may no longer be based on profit but may be based on oil volumes. Any such changes may cut FY12E EPS growth of Oil India (OIL) to 6-9% from 24% in the base case,” mentioned a BoA Merrill Lynch report.

ONGC: Price Hikes, Royalty Cut to Drive Growth

ONGC’s June 2011 quarter profits were up 12% against the year-ago period. But, the company’s performance was lackluster. Production of oil and gas dipped lower, while net realisation stood at just $48 per barrel after its share of subsidy burden. An expected reduction in subsidy burden in rest of FY12 and a possibility of favourable resolution of royalty issue of Rajasthan fields weigh favourably for the company’s earnings growth. Following the petro-product price hikes and duty cuts by June-end 2011, the industry’s under-recoveries are set to fall considerably in the rest of the three quarters. This could enable ONGC to obtain a higher price for its crude oil. “If upstream companies have to bear only one-third of the subsidy burden as in June 2011 quarter, our estimated full-year net realisation of $53/bbl would have significant upside risk,” mentioned a Goldman Sachs report on ONGC.
The other key positive would be Cairn India’s acceptance to make royalty cost recoverable for the Rajasthan block. Since commencement of production in FY10, ONGC has paid nearly . 1,500 crore towards royalty share. A favourable verdict in this matter would not only reverse this, but would significantly reduce its future royalty payments, thereby boosting the bottomline. Cairn India will hold a postal ballot to seek shareholder approval for this change in treatment of royalty.
During the June 2011 quarter, ONGC’s operating profit margins were under pressure, but the profits got a fillip from a 79% jump in other income. However, its depreciation jumped 32% to . 4,122.5 crore mainly due to the . 1,879-crore dry well expenditure written off. This restricted net profit growth at 12% y-o-y. The company plans to drill 12 deepwater wells in FY12 in Andaman, KG and Mahanadi basins. Every such well costs . 200-400 crore, its depreciation costs are expected to stay high.
ONGC is being valued at around 11.8 times its earnings for the past 12 months.

SUPREME INFRA: Infra Player With a Strong Foundation

Mid-sized infrastructure EPC contractor Supreme Infrastructure appears substantially undervalued considering its better than industry performance in terms of margins, return on equity and working capital cycle. Its growing order book and entry into BOT road projects give strong visibility about future growth. Long-term investors should add this scrip to their portfolio.

GROWTH DRIVERS
The company currently has orders worth 3,117 crore which is 3.4 times its sales for FY11. Nearly 85% of these unexecuted orders are for buildings and roads, while the rest consist of bridges, irrigation and power etc.
In the roads segment, Supreme Infra is a fully backward integrated company. It produces all the key raw materials such as asphalt and RMC, and has in-house stone quarrying and crushing capacities. This enables it to earn one ofthe best margins in the industry.
The company moved into Build-Operate-Transfer (BOT) road projects only a few years back, and has six such projects in hand today. The company is awaiting financial closure for three of them. For these it can sell equity at the special purpose vehicle (SPV) level to some international financial investors.
To expand geographical presence, the company recently opened a regional office in Kolkata.
Supreme Infra is also ramping up its project execution capacities. It acquired a 51% stake in Aurangabad-based Rudranee Infra, which specialises in water pipelines and power distribution projects. Supreme has also taken up a hospital construction project in Mumbai, and an industrial construction project for a steel plant in Jalna.
It plans to enter new segments like ports, power plants and tunneling.

FINANCIALS
In the last six years, the company’s revenue has grown six-fold. In FY11, revenues grew 72% at 918.7 crore. EBIDTA for FY11 was up 65% at 156.5 crore. The bottom line grew 80% to 70.7 crore.
The company enjoys one of the highest margins, highest RoEs and the best working capital cycle among its peers.

VALUATION
The company is currently trading at 6.6 times its earnings for FY11. This is lower than its peers such as IRB Infra, Simplex Infra, Patel Engineering, IVRCL etc that trade at a P/E of between 7.8 and 13.8. In FY12, the company’s net sales are expected to hit 1,300 crore with a net profit of 95 crore. Given this, the company is trading at an attractive one-year forward P/E of 4.9.