Upstream oil stocks: Time to take a contrarian call

ONGC and Cairn currently hovering near multi-year lows; Oil India near two-year lows

Stocks of upstream companies, Oil and Natural Gas Corporation (ONGC), Oil India, and Cairn India (Cairn), have been under consistent pressure from falling crude oil prices. Upstream firms take the first steps to locate, test, and drill for oil and gas. Once reserves are proven, they extract oil and gas from the reserve.

ONGC and Cairn are near multi-year lows. Oil India is near a two-year low.

Brent crude oil prices fell below $40 a barrel on Monday and recovered to $44. This will hit upstream firms' net realisations. But, the impact on public sector firms (ONGC, Oil India) will be less compared to that on Cairn, as they share a part of oil marketing companies' (OMC) subsidy burden with the government. Net realisations, for many years, have been lower than market prices for ONGC and Oil India.

Subsidy is the discount given by OMCs to their consumers over the prevailing market prices of kerosene and liquefied petroleum gas. Lower crude oil prices mean lower subsidy burden which cushions net realisations. Cairn, though, is a direct play on crude oil prices and reflects this more closely.

But analysts say these stocks adequately capture negatives and offer attractive entry levels. "We repeat 'buy' on ONGC and Oil India, as we believe the stocks are now discounting a bear-case scenario of $50 a barrel crude realisations forever," says Tarun Lakhotia, oil and gas analyst at Kotak Institutional Equities. He says crude oil prices are likely to improve in the medium term. In Cairn, analysts do not see a significant downside. A ramp-up in output and utilisation of its huge cash kitty could be key. Most analysts have a neutral view on Cairn.

While ONGC's stand-alone business (domestic operations) is likely to see stable realisations, given the offsetting impact of lower subsidies, its consolidated revenues will be hit. That's because ONGC Videsh (OVL), its foreign subsidiary which accounts for about 12 per cent of its revenues, is a direct play (like Cairn) on crude oil prices. ONGC Videsh's production is likely to remain flattish and its realisations under pressure this financial year. Though net realisation estimates vary with crude oil price forecasts, analysts believe ONGC's net realisations per barrel could be $50 to $51 this financial year if crude oil prices stabilise at $55 per barrel versus $45 per barrel in FY15. Oil India should also see improvement in net realisation to $53 per barrel in FY16 versus $47 per barrel in FY15 due to lower subsidy burden. Steady production, high share of oil in its reserves, and attractive valuations are positives of Oil India.

Early clarity on subsidy sharing in FY16 is a key positive and has increased earnings visibility of ONGC and Oil, say analysts. But, if crude oil prices fall further or gas prices are cut, it could weigh on these stocks. A falling rupee could partially ease some of these risks.