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ONGC: Riding high on oil prices

May 12, 2004

The recent surge in crude oil prices has had a mixed impact on Indian oil companies. While the companies engaged in the upstream activities are benefiting from high prices, downstream oil marketing companies (OMCs) are witnessing immense pressure on the margins, as prices have been frozen to their existing levels since the new year begun. However, one company that has benefited from high prices is ONGC. To put things in perspective, the company adds Rs 9 bn to its topline with every US$ 1 increase in crude prices.The prices of crude have now touched thirteen-year highs and domestic oil marketing companies have taken a hit of nearly Rs 20 bn during the last quarter due their inability to increase prices. Government's subsidy sharing agreement had a rub-off effect on ONGC and GAIL along with the OMCs. The OMCs are already taking a hit of around Rs 106 per cylinder of liquefied petroleum gas (LPG) and Rs 3 per liter of superior kerosene oil (SKO) and with a further reduction in subsidies, the burden is likely to increase to Rs 130 per cylinder of LPG and Rs 4 per liter of kerosene.

From the above chart, it is clearly evident that although globally, oil marketing is a lucrative business, in India, prices are still much regulated. To that extent, if retail prices are not increased commensurately, downstream companies (involved in marketing of products) suffer. To put things in perspective, operating margins take a hit as compared to ONGC, which has been able to sell crude at globally competitive prices thereby improving on its margins. However, we feel the gap is likely to reduce once ONGC enters into the downstream segment along with its subsidiary MRPL.

Given the profiles of the companies along the straddle of the energy sector, ONGC is likely to be the major beneficiary in case of higher crude prices, given that it has now been allowed to sell crude freely since April 2004. Further, ONGC Videsh (OVL), ONGC's overseas subsidiary has been on the prowl for equity oil and oil field acquisition thereby geographically diversifying the company's business. ONGC is also planning its foray into the downstream activities of marketing and this, to a large extent, result in the consolidated margins lowering down.

Comparisons with global majors such as Exxon Mobil and Royal Dutch/Shell show that ONGC's operating margins of 53% are way too high as compared to Shell, which has an operating margin of around 15% (Exxon Mobil's margins are at around 13%). It should be remembered that these majors are present in the entire value chain of the energy business and as such, margins do get diluted. We believe, with ONGC's entry into power, petrochemicals and downstream segment of energy sector, margins shall witness some correction from the current high in the long term.

However, with ONGC becoming a fully integrated energy business, it commands a premium over other companies in the energy sector in the domestic scenario. ONGC is also planning a capital investment of nearly 35 bn for development and upgradation of its fields and another Rs 20 bn to increase the capacity of MRPL, its refining subsidiary.

Currently, the marketing companies such as HPCL and BPCL are trading at a price to cash flow of 7.5x and 8.1x FY03 earnings, while ONGC is trading at a price to cash flow of 8.0x FY03 earnings. Given the scope of business in which ONGC operates and India's dependence on crude oil, ONGC is likely to play a major role in the future in the energy sector.


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