Oiling your investment wheels

While oil and gas companies are cash rich, focus on managements’ credibility and ability to run the business.

The dynamics of the oil and gas industry are quite different from other sectors. Besides being a highly capital-intensive industry, with a long gestation period, it is also intensively regulated by the government.

Given the requirement of huge capital expenditure, there are few players. And, there are company-specific dynamics. So, before making investments, it's important that investors understand the basics of the sector.

Operationally, the industry is divided into three major sectors: upstream (exploration & production), midstream (refining) and downstream (marketing). Generally, companies like to combine the midstream and downstream operations.

Companies in the upstream sector work on finding underground or underwater oil and gas fields. Those in the midstream segment process and store, market and transport crude oil or natural gas. The downstream sector companies distribute petroleum products via retail outlets. The latter also includes oil refineries and petrochemical plants and natural gas distribution companies.

Given the large scale of operations, the experience of the management and promoters matters a lot. Analysts say new players in the segment should be avoided, as a track record is important. Key pointers such as a company's ability to constantly plough more money into its operations make it attractive.

Analysts say going by plain numbers or annual reports could be a mistake. "One has to analyse more and seek details of the sector," says Vinay Nair, senior analyst, Khandwala Securities. Let us understand the finer points

Upstream: While investing in an upstream company, one has to look into crude oil prices, the potential reserves or prospective finds the company has, and its areas of investment.

For example, when you compare upstream companies like Oil and Natural Gas Corporation (ONGC) and Cairn India, the valuations would be different. While ONGC is regulated and its earnings are determined by government announcements regarding its subsidy sharing, Cairn's earnings are dependent on benchmark crude oil prices.

Midstream and downstream: The sector is dominated by state-run entities-Indian Oil Corporation (IOC), Bharat Petroleum Corporation (BPCL) and Hindustan Petroleum Corporation (HPCL) - all highly regulated. Product pricing is largely governed by the Ministry of Petroleum and Natural Gas (MoPNG) and mostly, not linked with movement of international crude oil prices. These companies heavily depend on issuance of oil bonds from the MoPNG, as they sell auto and cooking fuel at subsidised rates.

Due to this regulated nature, say analysts, an investor has to remember that returns can't go beyond a certain level. Though the sector has private players like Reliance Industries and Essar Oil, their presence is limited.

While there are mid-caps in the sector, they are completely overshadowed by the big companies. Besides, government presence is significant in all the big companies and there is support as well for them. Private sector players, more or less, have to stand on their own. Importantly, there is constant need for money.

Recent performance: The sector stocks have neither been under-performers nor significant out-performers. However, in recent days they have gained momentum, as investors are finding more visibility in their earnings.

Analysts suggest that for investors with a good risk appetite, upstream (private) companies are the best bet, as their valuations are completely determined by crude oil prices.

Risk is also higher in government entities, like ONGC, as a lot depends on subsidy sharing. Earnings are a concern, as returns are limited by the government's regulations. Analysts say one needs to find a rational subsidy policy, where ONGC's earnings become visible.

While ONGC has been delivering sustainable returns, Reliance Industries Ltd, an integrated oil and gas player, has been the best performer. Refining and marketing companies, which had been lagging for the past four months, have picked up recently.

Gas distribution: For investors who do not have a strong risk appetite, analysts suggest one could look at gas distribution companies like GAIL, Gujarat State Petronet (GSPL) and Indraprastha Gas (IGL). Though these companies are regulated as well, they have offered sustainable returns. The risks are lower in gas distribution; the returns are mediocre. Gas distribution companies are not able to command higher price-to-earning ratio due to the supply constraint, said a Mumbai-based analyst. The revenue model is akin to that of power companies.

Operating margins are the highest in the upstream sector, followed by refining and gas distribution.

While investing, the investor has to have a long-term perspective. Also, since the predictability of reserves in the sector is very difficult, the investor has to trust the company that it would be able to do what they have committed to over the long run.