Sector Update - Oil & Gas - Elara Capital

Crude, Cairn and PSUs – Heady Cocktail

Neutral/negative outlook, no sharp spike likely in crude

Political uncertainties across the MENA region have driven up crude prices by 47% during the last six months. Conflicting forces are at play in crude; the recent Libyan oil supply shock has easily overshadowed the Japanese demand dilemma. In our view, the aftereffects in Japan are not only in terms of a lower direct demand, but also the supply chain disruption in Chinese trade linkages. While China sends 8% of its overall exports to Japan, it imports a higher 13% (from Japan), comprising mainly of critical equipment required for its industrial activity. But as we move to H2CY11, these opposing forces are likely to reverse their roles; supply concerns would ease while the Japanese reconstruction effort would perk up the demand. However, as seen currently, with the supply issue being of a much higher magnitude, crude is likely to cool off in H2CY11 with easing of supply concerns.

The possibility of a super spike in crude prices is now reasonably low, in our view. A super spike would require a significant disruption in physical oil supply of big nations such as Saudi Arabia. The kingdom currently supplies 9.7mnbpd of oil, contributing 12% to the global supplies. Importantly, Saudi holds a spare capacity of 3.2mnbpd, which along with other OPEC spare capacity would be largely sufficient to compensate for any loss of oil supply. Given the political dynamics and the importance of oil for Saudi, we are tempted to rule out a significant political turmoil in the Arabian nation in the short to medium term. Thus, we expect crude to stabilize at USD110-115/bbl in Q2CY11.

Downgrade Cairn to Reduce on unfavorable risk-reward

The Union Cabinet's decision to refer the Cairn-Vedanta deal to a ministerial panel comes as another dampener which might extend the overhang on the stock. We had upgraded Cairn in Feb'11 to Accumulate driven by a favorable risk reward as an upside potential existed in either of the approval outcomes. With the stock rallying to the current levels, we believe that the risk-reward for investors has reversed and thus, we downgrade Cairn to Reduce with a potential under-performance in store. We reiterate that the stock may still gain 3-5% from these levels on newsflows. However, with the deal price at INR355/share and crude poised to stabilize and cool off, especially in H2CY11, Cairn may see some under-performance vis-à-vis the market.

Maintain Accumulate on PSU upstreams

We continue to back the Indian oil PSUs after the recent crude price driven correction. We maintain our Accumulate ratings for ONGC and Oil India with potential upsides of 6-9%, despite the recent investor interest in these stocks. In our view, at these levels, oil PSUs are factoring in FY12 under-recoveries of INR950-1,000bn. We maintain our TP of INR325/share for ONGC and INR1,430/share for Oil India, derived by assigning at an EV/EBITDA of 5.5x.

Source : Equity Bulls

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