“Our reverse valuation exercise suggests that the stock is already discounting dated Brent crude price recovering to about $50 per barrel, providing limited leverage to any improvement from current levels,” wrote analysts from Kotak Institutional Equities in a report on 23 August,2020. The analysts saw a sharp decline in oil prices which coincided with a dismal performance in the June Quarter for Oil India where it recorded a loss of Rs. 249 crores and proceeded to put two and two together. However this drop in sales in the latest quarter was to be expected given the government imposed lockdown in the whole world, specially in India. To put it simply if people stop commuting, revenues of oil companies will decline irrespective of oil prices.
Commodity companies in general are prisoners of the commodity price. The management can be extraordinarily competent and yet when the commodity price takes a fall the company is severely affected. Needless to say there are several ways to hedge against this but should you? If you are an investor in a commodity company, you are probably well aware of this risk. On the contrary you might want to invest because of it in order to diversify your other investments. Example: Rising oil prices might be bad for the economy overall but good for an oil company and vice versa. Hence, it doesn’t make sense for commodity companies to hedge against fluctuations in commodity prices. While all this is true for almost all commodity companies it isn’t true for Oil India. Before going into why that is let’s look at Oil India in detail.
Oil India: Company Overview
Oil India has six decades of presence in the oil and gas sector. The Government of India still owns more than 56% and it was awarded “Navratna” status in 2010. It has a strong domestic and global presence with 44 domestic blocks & 13 international blocks. According to its latest annual report, its 2P oil reserves stand at 116.73 million metric tonne and gas reserves stand at 134.49 billion cubic metres. In the last 11 years, revenues have grown at 7% CAGR & net profits have grown at 5.3% CAGR. The net profit margin has consistently stayed above 30% for the past decade and is currently 31.36%. The return on equity at 13.20% is still much more than the cost of equity. The debt to equity ratio is slightly high at 44% and is probably one of the many reasons why the company trades at a third of its book value. Its dividend payout ratio has never fallen below 30% and that should continue well into the future considering the Government of India will need all the cash it can generate in the future. Recently Oil India suffered production losses due to stoppages and blockades pot blowout in Bhagjan Oil Well on May 27, 2020. It was followed by a fire incident leading to loss of life and property. Floods in Assam also halted their preparations to cap the well. Cumulative production loss since May 27, 2020 due to bandhs and blockades stand at 22112 MT Crude oil and 52.53 MMSCM of natural gas. The loss sustained in the june quarter combined with the bearish view on oil prices, high debt to equity ratio and the recent production losses have resulted in the stock getting traded at just above its 11 year low.
Outlook for Oil Demand in India:
India is the world’s third largest energy consumer globally. While the current outlook is bleak considering the coronavirus pandemic and slow economic recovery, the long term outlook remains positive. In India, future oil and gas consumption will increase due to key factors such as a strong economy, population growth, and fuel economy. The dependence on oil and gas is further expected to increase as the country’s infrastructure continues to heavily rely on petroleum-based products. Now, let’s talk about the elephant in the room, Electric Vehicles.
EV sales in Europe account for less than 2% of the market share in large markets like Germany, France and the UK. However the market share is significantly better in some of the scandinavian countries. There are several problems with the charging infrastructure and most positive soundbites on the subject appear to be coming from the West and not the East which contributes to the bulk of car sales. With the breakeven for EVs still a few years away, OEMs will inevitably feel operating pressure and while wealthy governments can get behind it, it will be much more difficult for emerging markets. The infrastructure is especially bad in India, which imports more than 5 million barrels of oil per day. Safe to say oil demand isn’t going away any time soon.
Forget the Oil Price
As mentioned earlier, I am against the practice of hedging commodity prices but in the case of Oil India there seems to be a “natural hedge”. The government of India through subsidies and taxation seem to support upstream oil companies during periods of low oil prices and punish them when oil prices rise. But don’t take my word for it. I decided to graph the revenues of Oil India against Brent Crude Oil prices in the last eleven years. I took the average yearly oil price in US Dollars per barrel and converted it into Rs/litre using the average USD/INR exchange rate that year. I got the following result:
Next, I decided to plot a correlation between the oil price and revenues of Oil India. A correlation close to -1 or +1 indicates a strong relationship while a correlation close to 0 indicates no relationship. Needless to say there should be a strong positive relationship between price of oil and sales of an upstream oil company. When I computed the values I got a correlation of 0.07. In the last decade there has been no relationship between the price of oil and revenue figures of Oil India.
Let’s look at another multinational oil and gas company, Royal Dutch Shell. I repeated the same exercise for royal dutch and got the following result:
The correlation between the price of oil and revenue figures for royal dutch was 0.97. This is what would appear to be normal and is a stark contrast from Oil India. From the data it does look like the Government’s interference in the oil market has broken the relationship between oil price and performance of upstream oil companies.
Oil India: Valuation
In my valuation of Oil India, I didn’t treat it like a commodity company whose fate is decided by the fluctuations in oil prices. I treated it like a stable low growth company with a consistent dividend payout ratio of above 30%. As mentioned earlier all government companies payout dividends consistently often having a payout ratio of above 50% and Oil India is no different. The most recent dividend of INR 10.6 per share was pretty low considering the dividend payout ratio was only 30%. In my valuation I assume that this dividend of Rs. 10.6 per share will grow at 3% CAGR in the next ten years. This is a conservative estimate considering profits have grown at more than 5% in the past 11 years and the dividend payout ratio has been higher too. At the end of ten years I assume that I will be able to sell the share for close to its 11 year low at INR 75 which is 0.28 times current book value (book value will be much higher at the end of 10 years). This too is a very conservative estimate. I estimate my cost of equity at 11% considering the current ten year government bond yield is 6%.
The valuation sheet is as follows:
Conclusion: Value Oil India as a High Yield Bond
The above valuation sheet seems familiar because this is what we do for bonds. We take the future interest and principal payments and discount it to the present. In this case, the dividend yield is comparable to the interest payment and the eventual sale of shares after ten years is comparable to the principal payment. The discount rate of 11% is steep and hence comparable to a high yield bond. The duration of ten years was chosen because that is at least how long demand is expected to remain strong for oil and gas. The only difference however is that this is less risky than a high yield bond considering it is a public sector undertaking and has significantly higher upside if the stock price zooms upwards as it can in any equity market.