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ONGC: Hold Gail: Hold Reliance: Hold

IT WAS always a low-profile industry from the stock market standpoint. With just a couple of listed companies to count, and public sector ones at that, the upstream oil sector or the exploration and production (E&P) segment, as it is generally known, did not really offer too many investment opportunities for the stock market.

However, today, the two big names from this sector, Oil and Natural Gas Corporation (ONGC) and Gail India, are much-sought-after stocks along with Reliance Industries, which is an integrated company with interests from oil and gas production to refining, petrochemicals, power and textiles.

Indeed, ONGC is the most valuable company on the bourses today with a market capitalisation of close to Rs 70,000 crore. Thatthere are now three E&P companies, including ONGC, among the top 12 in terms of market capitalisation would give an idea of the following that the sector commands.

The market interest is traceable to four major reasons. First, the dismantling of the administered price mechanism and the reimbursement of market prices to oil producers for the crude that they sell. This has resulted in pricing freedom for ONGC, which has negotiated market-price-linked contracts with buyers such as Indian Oil and Bharat Petroleum.

Second, the dismantling coincided with a period of rising global oil prices that brought in a windfall for ONGC in terms of revenue and earnings in 2002-03, the first year of free prices. ONGC saw its revenues rise 47 per cent to Rs 34,277 crore and earnings by a whopping 70 per cent to Rs 10,529 crore.

Third, the privatisation programme of the Government has also had a hand in keeping sentiment in PSU stocks such as ONGC buoyant.

This is despite the Government's categorical statement that ONGC will not be put on the block.

Finally, the discovery of gas by Reliance in the Krishna-Godavari basin has raised expectations across the board from the market. Now, are these good enough reasons for these stocks to remain buoyant? The crucial point is that freedom to price at the market level does not necessarily translate into windfall revenues or earnings.

It has been to the sector's and ONGC's good fortune that the freedom coincided with rising oil prices enabling ONGC to reap the benefits. Assuming that the period had been one of falling prices, ONGC would have seen a drop in its earnings and revenues.

The point is that henceforth the revenues of E&P companies such as ONGC will be volatile and this will be directly in proportion to the volatility in global oil prices. There is really nothing that an E&P company can do about it except integrate itself across the value stream and hope to ride out the price cycles. And this is exactly what ONGC is trying to do; it has forayed into refining by acquiring majority equity in Mangalore Refinery and Petrochemicals (MRPL) and it is only a question of time before ONGC buys out the complete equity and merges MRPL with itself.

Reliance Industries is well placed in this respect as its interests span across the oil chain. The advantage is that at a time of low oil prices, the company can maintain its cash flows through its petrochemical and textile businesses. This exactly is what multinationals such as Royal Dutch/Shell, ExxonMobil and ChevronTexaco do, given that their business interests range from E&P to refining, transportation, petrochemicals and power.

Gail India, though part of the same sector, is a different play altogether. The company derives a major part of its revenues and earnings from the transportation of gas with the balance coming from its petrochemicals foray. Gas prices are administered still and the government determines Gail's transportation tariff. They are presently capped at levels determined by the ability of the user industries — fertiliser and power — to pay. Recently, the Government did revise tariffs but the benefit for Gail may be marginal given the minor revision.

What is important for Gail though is to secure access to gas reserves, which it does not have at the moment. The company is at various stages of investment in gas fields abroad — in Myanmar, for instance — but these are still a few years away from production. Gail will gain access to a major quantum of gas when the Petronet LNG project begins functioning later this year. But ironically, going by current indications, it may find itself burdened with high-cost gas that may not have many takers.

Price negotiations for the gas from Petronet's project are at a critical stage now, with major buyers unwilling to pay a delivered price of more than $3.5 per MBTU (million British thermal unit), including taxes. Gail may not be able to meet this price unless it takes a major cut on its revenues.

Investors need to factor in this while investing in the Gail stock. There are no such concerns in the case of ONGC though. Oil prices are once again moving up; they have been at the upper end of the $22-$28 per barrel price band in the past three months and appear set to continue that way. ONGC will stand to gain in this environment, but those considering an investment in the stock will have to be prepared for quick entry/exit strategies as the stock swings in tune with international oil price movements.

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