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ONGC: Applying the margin of safety
Sep 29, 2008

We have updated our estimates for ONGC based on its recently published annual report for FY08. Following are the key observations from the exercise. Valuation drivers
We try to estimate ONGC’s 2P reserves balance (proved + probable) and the realisations (revenue) from them. Since realisations are denominated in US dollars, the rupee dollar exchange rate is used to convert them into rupees. We then estimate the earnings from the total rupee realisations. Finally, we project the present value of the earnings.

ONGC’s reserves balance, realisations and the movement of the rupee in FY08 were more or less in line with our estimates. However, earnings margins deteriorated on the back of higher costs for the company in terms of rig costs, finding costs and lifting costs. The present value factor also deteriorated to accommodate the receding production timelines.

Estimate vs. actual for FY08

Driver FY08 estimates Actual Impact on ONGC
Balance oil reserves (2P) 464 mtoe 453 mtoe Marginally negative
Balance gas reserves (2P) 447 mtoe 440 mtoe Marginally negative
Realisation from crude oil US$ 55.3 / barrel $52.9 Marginally negative
Realisation from crude oil US$ 2.5 / mbtu $2 Marginally negative
$/ Re exchange rate Strong rupee Strong rupee Neutral
Margins 34% 31% Negative
Present value factor 48% 44% Negative

Applying the ‘margin of safety’ to valuation drivers
“Introduce a margin of safety into calculations - somewhat as an engineer does in his specifications for a structure.” – Benjamin Graham.

It is clear from the above description that we estimate many factors to arrive at ONGC’s valuations. Since future estimates are bound to be uncertain, actual figures often deviate from the values originally taken. To safeguard against this, we take conservative figures while projecting the valuation drivers. They provide the cushion that negative movements in a few valuation drivers will be offset by positive trends in others.

It is also vital to include a margin of safety while projecting the future performance of a business like upstream oil & gas, which involves great operational risk. Conservative estimates also build in a margin of safety against the vagaries of the stock markets of the kind we have witnessed over the past year.

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