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How valuations of oil PSUs can rise

By Devangshu Datta
August 24, 2009 14:41 IST
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Removing the administered price mechanism for oil could see valuations of PSUs jump, writes Devangshu Datta.

One no-brainer through the recession has been a continued focus on infrastructure spending. This is one way to keep economic activity ticking over, while building assets that accelerate future growth.

Every infrastructure project faces major challenges. Viability often depends on the cost of real estate. Since this is politically sensitive, it can have many ramifications and leads to scams and political unrest.

In other cases, such as in the power sector and in oil and gas, the cost of fuel is critical and again, this cost is dependent on government policy, rather than on market forces.

Land is always liable to remain a thorny issue. Fuel pricing could become less of a problem if the government brings itself to ease controls and let market forces come into play. Market prices in oil and gas (and in coal as well) are volatile enough to make Exploration & Production (E&P) risky anywhere.

The administered pricing mechanism (APM) adds another arbitrary dimension to E&P risk in India. APM is not imposed on private players. However, they do have to price competitively versus the state-owned retail sector, which must sell at APM prices. When APM margins are negative due to high crude costs, private E&P players have problems as well.

Despite APM, the government hopes the latest edition of the New Exploration and Licensing Policy (NELP VIII) will see a decent response from global E&P players. NELP VIII offers 70 blocks for bidding. Major strikes by RIL, GSPL, Cairn, in previous NELP editions could help make this round a success.

British Petroleum's "Statistical Review of World Energy" has upgraded India's estimated reserves as a result of NELP finds. At end-2008, it estimated India's proven crude oil reserves at about 800 million tonnes (mt), an increase of over 10 per cent compared to 726 mt at end-2007.

Gas reserves were estimated to be around 1,090 billion cubic metres (bcm) against 1,055 bcm the previous year. Gas reserves have increased at a compounded annual growth rate (CAGR) of 4.25 per cent during 2003-2008.

India will remain dependent on imports for over 70 per cent of its oil needs though gas dependency will drop considerably due to earlier NELP finds. More crude finds (and the start of full production from Cairn's Rajasthan find as well as RIL's KG Basin crude find) could make a difference to import dependency. 

The export of refined products could also make a large difference to net energy import bills. Indian refineries have significant cost advantages, which are visible in higher refining margins. Private players like Reliance and Essar Oil have benefited from exports in the last two years.

India controls only about 3 per cent of global refining capacity, with a total capacity of around 170 million tonnes per annum. At the same time, APM has made retailing and refining a losing proposition for PSUs, which are restricted to the domestic market.

If India does develop excess refining capacity, and PSUs are allowed to export excess production, they could avail of the opportunity to earn hard-currency profits. In fact, most refiners are looking at capacity expansion. If all the plans materialise, there will be an additional 90 mtpa of capacity by 2011-12.

There are interesting signals in retail as well. Reliance and Essar shut down their retail petrol-pump operations (involving about 2,500 licensed outlets) during 2008-09. While crude was at record highs, APM forced PSUs to retail at huge losses. Private players couldn't compete against those retail prices. The total PSU 'under-recoveries' during the last fiscal probably comes to over Rs 100,000 crore (Rs 1 trillion).

It seems private players are considering a re-entry to retail. This is partly because crude prices have dropped to levels where APM could offer some positive returns. It is also rumoured that private players are angling for a slice of the subsidies PSUs receive, though the oil-bond subsidy mechanism is very clunky. 

Reliance has ended the export-oriented unit status of its older 33 mtpa refinery, while the newer 29mtpa facility commissioned in December 2008 is an EOU. This implies that Reliance will re-enter domestic retailing.

It would obviously be in every refiner's interest to see a removal or easing of the APM. Intense lobbying by the private players could help accelerate this process. That would represent a major investment opportunity since PSU valuations would instantly jump.

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Devangshu Datta
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