Integrated oil firm positive for ONGC

Acquisition of a strong downstream business with stable cash flows should boost overall valuations

The news flow around a possible merger of Hindustan Petroleum (HPCL) with Oil and Natural Gas Corporation (ONGC) has recently got stronger, even as some believe that a merger with Bharat Petroleum Corporation (BPCL) will be more beneficial for ONGC. The Union Budget announcement over creation of an “integrated oil and gas company” has led investors and analysts to explore possible structures while making guesses on the companies that could be merged in the process. Whatever be the case, a merger of an oil marketing company (OMC) with ONGC will prove beneficial for the latter, though it may not necessarily be the case for the OMC. A key caveat here is the deal valuation.

Broadly, there are six major players in the public sector space, including upstream companies ONGC and Oil India, downstream companies BPCL, HPCL, Indian Oil (IOC) and gas distribution major, GAIL India. Others, such as MRPL, ONGC Videsh, etc. are subsidiaries of one of the above-mentioned companies. 

Of late, expectations have increased that the government may merge HPCL or BPCL with ONGC, while IOC and others will remain as independent entities. As the government aims to create a stronger exploration and production (E&P) major, analysts say the move will also help the government in selling its entire stake in either of the OMCs at one go to ONGC and meet its stake sale target. That’s assuming that any deal will be an all-cash deal and not a share-swap.

What are the options? ONGC, the oil and gas producing major, has seen success in E&P and has been consistently widening its portfolio. HPCL and BPCL are downstream oil and gas distribution companies, though BPCL has been pursuing E&P activities for long and its success is represented by the Mozambique and Brazil oil and gas discoveries. Thus, some analysts believe that for creating a stronger E&P entity, BPCL may get merged with ONGC.

Analysts at Motilal Oswal Securities had said that given the government’s aim is primarily to boost the E&P strength of the nation, they see greater probability of ONGC acquiring BPCL rather than HPCL. They add that they do not see HPCL as a candidate for merger with ONGC due to its large pending capex and there would be an outflow of about Rs 10,000 crore every year for next three-four years.

Also, the merger may not be a very good option for HPCL. It remains a strong cash-generating entity after fuel price reforms and was insulated to most crude oil price movements. Though HPCL has capex lined up, it also had strong cash generation to meet the same. ONGC, on the other hand, too has strong capex lined up in the K-G basin. Besides, ONGC may have to buy stakes in the Deen Dayal block from GSPL and OVL (ONGC’s arm) is in the process of completing its acquisitions too. Thus, in case of a merger, analysts say HPCL’s strong cash flows may get used up by ONGC for meeting its capex. 

On the other hand, BPCL’s capex is relatively lower. So, its merger with ONGC will not only expand ONGC’s global E&P portfolio, but will also help in terms of better cash flow. Like HPCL, BPCL is also generating stable cash flows and steady increase in earnings, after fuel reforms. In this backdrop, a merger with BPCL sounds more rational.

The ONGC stock at Rs 194.40 was down 0.61 per cent on Monday, while HPCL closed about two per cent lower at Rs 560-levels. The only issue with acquiring BPCL in an all-cash deal would be that ONGC will have to shell out Rs 51,000 crore (for 51 per cent stake) as compared to 29,128 crore in case of HPCL. 

Whether ONGC will have to make an open offer for another 26 per cent from other shareholders remains unclear given that both companies are government-owned. But, a share-swap deal for 51 per cent in HPCL or BPCL would make more sense for ONGC. That’s because, while it will increase ONGC’s equity by just 11.6 per cent or 20 per cent respectively, it will avoid any pressure on its balance sheet.