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Cairns IPO: Our view - Views on News from Equitymaster

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Cairns IPO: Our view

Dec 12, 2006

Cairns India, Indian biggest private sector E&P company has come out with an IPO for the issue of 328.8 m shares (excluding the green shoe option of 49.32 m shares). The issue is on for subscription till December 15, 2006. The minimum subscription level for retail investors is 35 shares. The company plans to raise Rs 62.5 bn to Rs 52.6 bn (at the lower and higher price level respectively) from this issue and the shares will be listed on the NSE and BSE.

Cairns India Limited (CIL) is one of the largest private sector E&P companies in India with proved and probable reserves (2P) of 472 million barrel of oil equivalent (mmboe). Cairns Energy PLC, an LSE listed crude oil and natural gas Exploration and Production company is the promoter of CIL. Cairn India is currently in the reorganization phase and will acquire 100% of Cairn India Holdings Ltd.

CIL has a large resource base with 2P reserves of 472 mmboe and gross contingent reserves of 413 mmboe.

Major operating blocks of the company are as follows

  • Rajasthan Block: CIL, with 70% working interest in the bock is the operator in the block, while ONGC holds remaining 30% interest. The block forms a major chunk of CIL’s resource base and has three main fields – Mangala, Bhagyam and Aishwariya (MBA fields). These fields together hold 1.9 bn boe gross in-place reserves and have a recovery factor of 32.5%. However, management has indicated to enhance the recovery factor to 40%. CIL is planning to apply EOR (Enhance Oil Recovery) and other techniques at the MBA fields via which the recovery rate is expected to increase by 5%-10%. Amongst the MBA fields, production in the Mangala is expected to begin from 2009, with initial production of 50,000 barrels of oil per day and a peak production of 100,000 barrels of oil per day. The Bhagyam and Aishwariya fields are expected to commence operations within 6 months and 18 months of the start of production at the Mangala field. The production from the Bhagyam and Aishwariya fields is likely to touch 25,200 barrels of oil per day and 17,050 barrels of oil per day respectively. As per PSC, post break-even point (cost recovery), government share of the profit petroleum will increase to 50%. CIL will not have to bear any royalty however uncertainty over the cess rates prevails. Crude oil from the block is expected to trade at a discount of 5%-10% to Brent crude. However, evacuation of the crude oil still needs to be resolved.

  • Ravva Block: CIL has operating interests in Ravva block, situated in the KG basin. Ravva is a producing field with current gross production of 62,700 barrels of oil equivalent. CIL has 22.5% working interest in the block.

  • Cambay Block: CIL holds 40% interest in Cambay basins block CB/PS-2, comprising of Lakshmi, Gauri and Ambe fields. CIL does not have to pay royalty for the fields. These fields primarily produce gas.

Reasons to apply

World-class resource base: Cairns India holds working interests in licensees covering a significant portfolio of exploration and appraisal acreage in 10 blocks in eastern, western and northern India. Its discovery in the MBA fields is one of the biggest discoveries made in the Indian oil and gas space during the last 20 years. Amongst its 2P reserves of 472 mmboe, a significant portion, i.e. 93% is in the Rajasthan block.

Experienced management: Cairns Energy PLC, with post issue stake of 69.5% in the company continues to be its promoter. Cairns Energy PLC has substantial experience in the Indian oil and gas space. It also has highly experienced and skilled board backed by strong development team.

Exploration expertise in India: CIL has a long and a proven exploration expertise in India, having made 30 hydrocarbon discoveries since 1994, including three of the seven landmark discoveries made in India between 2000 and 2005. CIL has made additional discoveries after the first discovery of Mangala in the Rajasthan Block and continues to undertake appraisal work, which may lead to future discoveries. CIL has continued to add to its exploration portfolio and, in addition to accessing new opportunities through asset purchases and farm-ins, has been an active and successful participant in NELP licensing rounds.

Strong development and reservoir management skill: Cairns has a proven track record in not only exploration but also in the development of hydrocarbons in India. It has shown good reservoir management skills in the past, in the Ravva fields in particular. Cairns is the operator in two of its operating fields – Cambay basin blocks and Ravva fields. As the operator of the Lakshmi field in the Cambay Basin, Cairns India commenced natural gas production in less than 30 months following the discovery. In Ravva field, Cairns increased the production from 3,700 barrels per day to 35,000 barrels per day in 26 months. Cairns India has also established itself as a low cost producer in the country.

Reason not to apply

Sensitivity to crude oil prices: Like any other upstream player, the fortune of CIL is dependent on the international crude oil prices. Decrease in the international crude oil prices could materially affect the financials of the company. Also, the financial feasibility of the some of the resource base might change.

High cost of production: As per our understanding, the lifting cost for the crude oil from the Rajasthan blocks is going to be on the higher side, as the field is a low energy reservoir. This is due to the wax like nature of the crude oil produced, which will require costly techniques as heated water injection to prevent solidification.

Pricing issues: We foresee certain concerns over the pricing of the crude oil produced from the Rajasthan basin. Crude oil produced by the basin will be priced at a discount of 5% to 10% vis-à-vis Brent crude. However, issues on the midstream segment regarding transportation of crude oil could adversely affect realisation. MRPL has asked for a discount of US$ 2-3 per barrel over and above the discount over Brent Crude on the grounds of recovery of transportation cost. Also, the quality of crude oil from MBA fields is such that it can be processed in refineries having delayed cokers. Only IOC, Reliance and Essar have delayed cokers, which can be used to enhance the production of the higher value products. Government wants to allocate Rajasthan crude to PSU refineries; the possible candidate for the purchase of it is IOC (with its two inland refineries at Mathura and Panipat). However, if MRPL continues to be the nominee for the crude oil, the discounts will be offered to him as a compensation for laying down pipeline facility. This is likely to further depress realisations for the company.

Uncertainty over pipeline: Cairns has said that transportation and distribution of crude oil is the responsibility of the Government or its nominee (MRPL). After the plans of pithead refinery being scrapped by ONGC, crude oil from Rajasthan fields will require laying of a 500 km pipeline thereby transporting it to MRPL’s refinery. The pipeline is expected to cost around US$ 500mn and would take 2 years to build. Management has iterated that the issue of laying pipeline will be resolved upto mid next year. Till date there is no clarity on who will build the pipeline. Any delay in building the pipeline will impact crude oil evacuation and hence its realization. However, if Cairns itself plants its foot forward and builds the pipeline, it would increase project investment and thus will impact overall returns.

Uncertainty over Cess: ONGC will be bearing royalty on MBA crude oil but till date there is no clarity on the crude oil cess. The dispute is regarding cess on the MBA fields. Cairns has maintained the view that as per PSC, it is not obliged to pay any cess, and if at all the cess has to be charged, then it has to be at a rate prevailing at the time of signing of PSC. Currently, the cess on crude oil is Rs 2550/ton and was around Rs 900/ton at the time when the production sharing contact (PSC) was signed for the Rajasthan block. If Cairns is made to pay higher cess, it will negatively impact the profitability to an extent.

Relative valuations…
CIL’s profitability picture is expected to change post 2009, with the commencement of production from the Mangala fields. While we do not doubt the technological and managerial strengths of the company, it seems to be steeply priced compared to its domestic peer ONGC. We have used the EV/ 2P reserve metric for the valuation of the company. Valuation such as P/E and discounted cash flow approach are inappropriate for valuing the company given the fact that company is still to start operations from the Rajasthan block. Also, the long gestation period coupled with number of assumption made under the discounted cash flow approach limits its applicability. Thus, we have relied only on the EV/reserve method.

Compared to its domestic peer, ONGC, which is priced at EV/Reserve of US$ 6.4 mmboe, CIL is valued at EV of US$ 13.3 per mmboe at the lower end of the price band, while at the upper end, it is priced at an EV of US$ 15.8 per mmboe, translating into a premium of 108% at the lower end of the price band. Such a premium seems to be unjustified, even after considering the discounted valuation of ONGC on account of its subsidy burden. Also, the quality of the crude produced by ONGC is much better than the MBA crude, even if Cairns has to end up paying lower cess on its produce. Further, as mentioned in the contract, Cairns’ share of profit oil is expected to decline to 50% in a gradual manner once Cairns recovers its costs. ONGC, on the other hand, does not have such profit sharing agreement with the government. Thus, the premium embedded in CIL’s valuation seems to be unjustified.

As compared to its international peers, the company seems to be valued in line, but at the lower end of the price band. However, considering the fact that company is still to produce from the Rajasthan blocks and uncertainty over the cess issue, we believe there is little left on the table for the investors to take. Higher gestation period also acts as a dampener. However, as mentioned before, we are enthused by the technological expertise and managerial ability of the company.

We advise investors to ‘AVOID’ the issue, as the risk-return outlook over the next few years is in favour of risks.

Comparative valuations…
Company EV Reserve EV/Reserve
(US$ m) (mmboe) US$
Apache Corp. 23,940 2,117 11.3
Anadarko Petroleum 48,580 2,449 19.8
Devon Energy 37,940 2,112 18.0
Occidental Petroleum 43,100 2,707 15.9
Noble Energy 9,710 806 12.0
Pioneer Natural Resources 5,580 987 5.7
Petrobras 116,440 11,820 9.9
CNOOC 36,250 2,361 15.4
Petro China 228,910 19,557 11.7
Global Average     13.3

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