Near its 3-year low, is Cairn's stock a steal?

Weak production outlook, low crude oil prices and regulatory issues could keep the scrip in check

The Cairn India (Cairn) stock has corrected 18 per cent in the past year and has continuously under-performed broader markets, as well as peers such as Oil and natural Gas Corporation (ONGC), since May this year. The stock, which fell to a three-year low of Rs 258.3 on November 14, is now at Rs 272.4. Weakening crude oil prices, Cairn's inability to ramp up production and concern on the deployment of its Rs 16,030-crore cash kitty have pulled down the stock. Recent media reports suggesting the government could renegotiate the fiscal terms for extension of the production-sharing contract (PSC) for Cairn's Rajasthan block (90 per cent of Cairn's output) is another overhang for the stock.

Reports suggest the government could raise its share of oil from the block above the current 50 per cent and/or increase the stake of ONGC in the block from the existing 30 per cent. Recently, Cairn had applied for extending its licence for exploring and producing oil from this block for another 10 years and is awaiting a response on this. The contract is set to expire in 2020. If either of the two outcomes is unfavourable, it could negatively impact Cairn's financials, albeit in the long term.

"Renegotiation of fiscal terms for extension of the PSC will act as another overhang on the Cairn stock. Lack of comfort on production growth and reserves-addition constrains our view, despite the recent sharp correction," says Tarun Lakhotia of Kotak Institutional Equities.

Notwithstanding the multiple pressures, most analysts believe the negative news is largely captured in Cairn's valuations; they remain optimistic on the company from a two-three-year perspective. They favour the stock due to expectations of a gradual pick-up in production and potential exploration upsides. Current valuations are reasonable, at 0.7 times the FY16 estimated book, against Cairn's average price/book ratio of 1.1, they say.

However, the probability of a rise in the stock from current levels will increase only if production growth improves and/or if crude oil prices rise; the latter looks unlikely, given that the global outlook is benign. In fact, some analysts also forecast crude oil prices slipping to $60-70 a barrel.

On Thursday, OPEC, a global association of oil producers, kept output unchanged. Prior to the meeting, some members showed desire to cut output to support prices. Post the meeting, global crude oil prices slipped by over $2 a barrel. Given that demand environment remains weak, prices are thus expected to remain soft going forward, which is not good news for oil producers like Cairn. In this light, increasing production is crucial for Cairn.

Through the past three-four quarters, production from Cairn's Rajasthan block has stood at 175,000-180,000 barrels a day. The company maintains it is targeting volume growth of 7-10 per cent from the block through the next three years. Some analysts, however, believe this metric might not see a significant surge. "Against the current production of 180,000 barrels a day from the Rajasthan block, Cairn's production guidance of 7-10 per cent looks challenging and we model a six per cent CAGR (compounded annual growth rate) in our estimates, with FY15 and FY16 estimates at 188,000 and 195,000 barrels a day, respectively," says Harshad Borawake of Motilal Oswal Securities.

But analysts are unanimous in terms of the company's exploratory potential. Cairn has made 11 discoveries in the current exploration phase and has tested about half the three billion barrels of oil equivalent resources; the other half will be tested through the next few quarters. Analysts remain optimistic on further reserve potential from Cairn's exploratory activities.

Currently, Cairn is implementing a capex plan worth $3 billion through three years, of which 40 per cent is set aside for FY15. The company plans to double gas production from the Raageshwari Deep gas (RDG) field through the existing pipeline by the end of FY15, by installing additional compressors. The RDG field is estimated to hold one-three trillion cubic ft of hydrocarbons.

Additionally, Cairn will need cash for development costs to monetise the success of the Rajasthan exploration campaign. It has a policy of paying 20 per cent of its net profit as dividend to shareholders, according to the company. As such, in time, while adding to revenues and profits, all these factors should help ease concern on utilisation of the company's cash kitty.