OIL RALLY TO FUEL ONGC, OIL INDIA EARNINGS

A weak rupee will increase realisations for these firms

Rising demand and geopolitical tensions have led to a rally in crude oil prices, which touched their two-year highs on Tuesday. With Brent crude oil at $59- 60 a barrel, the prospects of upstream public sector oil producers such as ONGC and Oil India have got a boost.

Analysts had already increased their earnings estimates about a month back, but with oil prices gaining further and the rupee sliding, there is more upside for earnings. A weak rupee will increase realisations for the companies.

Street sentiment for oilproducing companies was impacted when Brent oil prices declined to lows of about $44 a barrel in June 2017, a significant fall from $58 a barrel levels in January 2017. The share price of both ONGC and Oil India had seen their one-year lows in June-July this year. However, as the Brent started gaining thereafter, Oil India has seen a rebound of almost 37 per cent, while ONGC has gained 9-10 per cent from their respective lows. The lower gain for ONGC can be attributed to some concerns regarding its acquisition of Hindustan Petroleum (HPCL), its funding and potential equity dilution. But, these should ease going forward as clarity emerges, as the acquisition is expected to be earnings accretive for ONGC.

The news is also positive for Cairn India, which is now a subsidiary of Vedanta. The dynamics for Vedanta, the natural resources major, however, are different as it has been benefitting from rising base metal prices too. Nevertheless, with rising crude prices, Cairn India’s contribution to revenues and operating profits of Vedanta at 12 and 6 per cent, respectively, during the June quarter can rise further. The share price gain could, however, be restricted as the share-swap ratio for merger of Cairn with Vedanta has already been fixed.

The impact, though, will be more profound for the two PSU oil and gas majors. While ONGC and Oil India remain in a sweet spot with government reforms on fuel pricing leading to reduced subsidy burden, rising oil prices will drive earnings further. For ONGC, the outlook has been improving with expected rise in oil and gas production too. Though standalone domestic output from its own fields during FY17 was flat, the positive news is that ONGC has reversed the declining crude oil production trend. Gas production, on the other hand, had increased 4.3 per cent to 22.09 BCM ( billion cubic metre) during FY17, its first increase in past four years. Analysts now expect a 10-15 per cent per annum increase in gas production moving forward. The June quarter has already seen gas output rise 10.6 per cent year-on-year for ONGC.

Improving prospects have led analysts to upgrade their earnings estimate for the companies. Credit Suisse, for instance, had revised upwards ONGC’s FY18/19 earnings by four and three per cent, respectively, on September 7, on the back of higher volumes. The brokerage said it stayed positive on ONGC due to robust volume momentum, continued subsidy reduction, and about 30 per cent increase in gas prices. With crude prices having moved up since then, Jefferies on Wednesday assumed coverage on ONGC with a ‘buy’ rating. The brokerage expects a 14 per cent compounded annual growth in the oil major’s earnings during FY18-21 as Brent rises to $65 a barrel. The HPCL acquisition, likely EPS-accretive, is an overhang, but with dilution to ONGC’s fair value being modest and in any case, with the stock 20-50 per cent cheaper than peers, there is adequate cushion, it add. Jefferies has a target price of ~200 for the stock trading at ~170 levels now.

For Oil India, the trigger of improving oil prices is crucial, considering that it had been seeing earnings cuts earlier due to prospects of flattish production. Analysts at Sharekhan had cut their FY18 and FY19 earnings estimate for Oil India by 15 per cent in July looking at the oil price declines. Hence, the rebound in crude prices bodes well for Oil India.

Jefferies has also assumed coverage on Oil India, with a target price of ~465 for the stock that closed at ~349 on Wednesday. The brokerage says that Oil India (enterprise value to Ebitda of 3.6x FY19) is 15 per cent cheaper than ONGC.

The only risk, apart from fall in oil prices, is if the government tinkers with oil pricing mechanism and reforms in an unfavourable manner.