The Hindu Business Line : ONGC: Hold

OIL and Natural Gas Corporation's (ONGC) performance in the second quarter ended September 30 is first evidence of the positive impact of deregulation of the oil sector on the company.

The upstream oil major has seen an impressive 36 per cent growth in sales and earnings during the second quarter. It is not as if ONGC's oil output has grown significantly or that it has suddenly turned super-efficient in its activities.

There is but just one change between the last year and the current one — deregulation of the oil sector from April 1.

This is responsible for the sudden burst of growth in ONGC's top and bottomline. Fortuitously for ONGC, deregulation coincided with a period of rising global oil prices.

Until fiscal 2001-02, ONGC was paid an artificially depressed price for its output under the administered pricing mechanism.

However, since April 1 this year, the company has been permitted to align its prices with prevailing global levels.

For the first half of this year, ONGC has assumed a price of $22 per barrel of crude for its supplies to the refining companies — lower than the average prevailing price of more than $25 per barrel.

ONGC is negotiating with the domestic refiners to price its supplies at a premium to global benchmark Brent prices since its Bombay High crude is of superior quality to Brent.

Similarly, in the case of natural gas, ONGC is still operating under an administered pricing mechanism where it is paid Rs 2,850 per million cubic metres when prevailing global prices are almost double that.

The government is considering freeing gas prices gradually over the next six months. ONGC's profits could surge higher when these two events happen. It could cut the other way too.

However, deregulation is a double-edged sword. It could cut the other way in a regime of dropping or soft global oil prices.

With its prices linked to prevailing international prices, ONGC could well see a corresponding drop in its turnover and profits when global prices fall to lower levels.

Suffice it to say that henceforth, ONGC's revenue and earnings would experience volatility unknown till now. The volatility would be directly proportional to that in the global oil market. Investors would do well to price this volatility into their calculations while making an investment decision on the stock.

On the oil production front, ONGC has been trying to get its act together, with some success, in the last one year.

In the first half of this fiscal, oil production was up by 7.4 per cent while gas output was higher by a smaller 2.2 per cent.

The significance of this growth, small as it is, is that it comes after a few years of stagnant output. ONGC now desperately needs new finds of oil and gas as the Bombay High output plateaus.

Actively acquiring oil equity abroad

ONGC has been striking out abroad acquiring oil equity in some producing fields while participating in other exploration ventures.

Recently, subsidiary, ONGC Videsh, acquired a 25 per cent stake in a Sudan field with proven reserves of about 150 million tonnes and current production of 12 million tonnes per annum at a cost of Rs 3,600 crore.

That would add about three million tonnes to ONGC's kitty right away.

Besides, it also has a 20 per cent stake in the Sakhalin I field in Russia which is projected to yield about five million tonnes of oil from 2005 and about 2.12 million tones of oil equivalent gas from 2008.

The investment in Vietnam offshore gas is expected to bring in another 1.21 million tonnes of oil equivalent gas from coming December.

Yet, ONGC needs a big find within the country to sustain future growth. It is investing big money for deep-water exploration in the hope of striking a big reserve.

The company has a very strong balance-sheet with a debt-equity ratio of just 0.02 — effectively a debt-free company.

It prepaid about Rs 2,500 crore of loans to the World Bank and ADB in the first quarter enabling a sharp 88 per cent fall in interest costs in the second.

Downstream foray

Meanwhile, ONGC is also acquiring an integrated character following its acquisition of the Birlas' stake in Mangalore Refinery and Petrochemicals (MRPL). Ironically, the accumulated loss of MRPL is attractive for ONGC as it can be used as a tax shield.

Of course, for this, MRPL has to be merged with ONGC, which is still a long way off. ONGC would have to buy out the other big partner, Hindustan Petroleum, which has an identical 37 per cent stake in MRPL. Merger or not, the downstream foray appears to be strategically a good move for ONGC.

The company already has permission to set up retail outlets and the refinery acquisition fits in well with its plans. Importantly, the marketing business could lend some stability to ONGC's revenue streams by evening out the volatility caused by the exposure to global oil price swings.

Oil prices are already showing signs of softening as they have dropped to $24 per barrel from $28-30 a barrel barely a couple of months ago. It is too early yet to say if they would fall further. The onset of winter and the possibility of a war in the Gulf could keep prices buoyant in the near term. ONGC is set to have a strong second half ; it could be stronger if the expected price revisions come through.

The stock has been very active since April following deregulation of the industry and had undergone a re-rating.

Shareholders can hold on to the stock but they would need to keep a close watch over global oil prices henceforth. It would be a sensible strategy to enter and exit the stock in tune with the prevailing global oil scenario as the stock is set to yo-yo a lot more in future than it has ever done in the past.

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