Should investors buy upstream oil firms?

Falling crude oil, weak outlook on gas prices, subdued volumes eclipse inexpensive valuations

The shares of crude oil producers such as Oil and Natural Gas Corporation (ONGC), Oil India Ltd (OIL), and Cairn India (Cairn) have fallen about 40 per cent each in the past year and have under-performed the S&P BSE Sensex. Oil India hit its 52-week low of Rs 342 on Monday. A weak crude oil price is one reason; downward pressure in domestic gas prices is another. The weakness in Cairn stock can be attributed partly to company-specific issues such as flat production, and uncertainty on utilisation of cash. As a result, the stock has under-performed both ONGC and OIL in the past year. Though these stocks are trading at undemanding valuations, their prospects are unlikely to improve soon. At Monday's closing prices, ONGC trades at eight times FY17 estimated earnings, whereas OIL and Cairn trade at seven and nine times, respectively.

Crude oil prices recently touched two-month low of $44 a barrel on the back of higher inventories. This will hit realisations of Indian upstream firms such as ONGC, OIL, and Cairn. With excess global supply, slowing Chinese and other economies; and improving shale oil supplies in the US; crude oil prices are unlikely to witness any meaningful improvement in the near term, believe analysts. Downward pressure on domestic gas prices (in line with international trends) will add to the woes of these companies.

The falling subsidy burden in the domestic market offsets the impact of weak crude oil prices for ONGC's domestic business. However, as the subsidy burden is expected to be marginal in FY16 and FY17, this benefit could be limited. ONGC, thus, is a play on crude oil prices. ONGC's international business via subsidiary ONGC Videsh (OVL), though, will be hit by weak crude oil prices; analysts at Spark Capital believe it is unlikely to contribute to ONGC's FY17 earnings, even if crude oil price recovers to $60 a barrel. Assuming rupee at 66 to the dollar and crude oil price at $45 a barrel, OVL is likely to post negative earnings per share (EPS) of Rs 1.8 in FY17, eating a slice of ONGC's stand-alone EPS (earnings per share) of Rs 17.6, say analysts at HDFC Securities.

In case of OIL, a lack of global operating assets and negligible non-regulated business are key positives and should shield OIL's earnings in a low crude oil price environment to some extent. Weak production, though, remains a concern. The upstream companies are looking to shift the cess on crude production from a fixed Rs 4,500 a tonne to an ad-valorem rate on crude of eight to 10 per cent. Analysts say this change could add $4-5 a barrel to realisations.