Oil is on the boil – how can investors benefit? (A guest post)

Oil price is once again making headlines as it inches up towards the $100 mark. Food inflation shows no signs of cooling off, making another round of interest rate hikes by RBI almost inevitable. Rising price of oil will be an additional headache that will lead to rising import costs, worsening India’s trade deficit. Another rise in petrol and diesel prices – unless the government becomes proactive by reducing taxes – will further stoke the fire of inflation.

Is it all darkness and doom? In his guest post this month, Nishit looks at the silver lining. He discusses two stocks that are likely to benefit from higher oil price. Before we get to Nishit’s post, here is an announcement from Nishit’s friend Anuraag about an interesting Panel Discussion that readers in Mumbai may want to attend:

With the purpose of spreading awareness among Market Participants, in association with Eco Ashram, we are organising a Panel Discussion on the topic “Stock Markets or Rigged Casinos?” on 21st of January 2011 at "Y. B. Chavan Centre, Mumbai" from 5:00 P.M. to 7:00 P.M. The event is called "NATIONAL ECONOMIC DEBATE".

The Panelists are Dr. Ajit Ranade (Chief Economist, Aditya Birla Group), Shri. G. Anantharaman (Former Whole-Time Member, SEBI) & Dr. R. Vaidyanathan (Professor, Finance & Control – IIM, Bangalore).

The discussion will be followed by release of the book, “Sense, Sensex and Sentiments – The Failure of India’s Financial Sentinels” written by Shri. M.R. Venkatesh, Chartered Accountant.

For more details, contact:

Anuraag Gupta
Profound Consulting Pvt. Ltd.
502, A-Wing, Delphi, Hiranandani Business Park, Powai, Mumbai - 400076
Telefax: 022 25704357
Cell: +919892832789; anuraag@nedindia.com

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Crude prices have risen to 92 dollars a barrel. Now, the question is how do we benefit from this? One way is buying crude as a commodity on the MCX Exchange, which is beyond the reach of most retail investors. My sincere advice to retail investors is to stay away from Commodity Trading. So, how do we play it on the stock markets?

We could buy companies dealing in crude. The downstream players are HPCL, BPCL and IOC. Now these companies mainly refine crude and sell the products. They have to bear a subsidy burden on Diesel and Kerosene. The government has come with a formula of 1/3^rd burden by refiners, 1/3^rd by government and 1/3^rd by the upstream companies like ONGC, Gail and Oil India. Now, crude prices can go over the roof and the government has no defined mechanism to handle it.

Keeping that in mind the downstream companies are strictly off the buy list. Coming to ONGC, the price which ONGC gets is strictly capped due to the subsidy burden. ONGC is supposed to come out with a FPO in mid-March 2011. The stock is getting split along with a bonus issue for which the record date is yet to be announced. So at the closing price of Rs 1205 (Jan 7 ’11), you would be getting 4 shares for every 1 share you buy now.

Arguments in favor of buying ONGC:

1. Government Company - so a very safe buy
2. EPS of 74 and P/E of 16 - so not very expensive. Safe play on crude oil. A multi-bagger over past 10 years. Can buy and hold
3. If the Government wants the FPO to go through, they will clear the air on subsidy burden, thus making it an attractive offering

Argument against ONGC:

1. The subsidy sword keeps dangling over ONGC. Until clarity comes nothing can be done to enhance profitability
2. FPO in March ’11. Experience over past 1 year is stock prices of government companies which come for FPO are usually kept depressed before the FPO, so folks get a good rate

Cairn India is a good company, which I like and had written about in a post in August ‘10. Here is the link:

http://investmentsfordummieslikeme.blogspot.com/2010/08/cairn-india-oil-story-worth-betting-on.html

To update the story, Vedanta has to get approvals from the government, which are expected in the middle of February ‘11. If this goes through, the Open offer will be at Rs 355 for a 20% stake. The promoters of Cairn have been paid Rs 50 as non-compete fee. There is speculation that the open offer could well be at Rs 405.

Now taking crude oil prices to be around 96 dollars, the fair value of Cairn is already around Rs 350. Vedanta has the muscle to pump in funds to make acquisitions and companies taken over by Vedanta in the past have sizzled post acquisition. Sesa Goa and Hindustan Zinc are prime examples.

Government approvals should be in place, ONGC will negotiate to get rid of their royalty burden on joint oilfields with Cairn in return for giving a NOC.

How do we play all this?

In Cairn, the downside looks limited, so should be bought now. One can buy ONGC during the FPO. The reason for this is FPOs are always at a discount to market price, plus the retail fraternity gets additional 5% discount to the offer price. By buying Cairn now, we are getting a crude oil exposure. Crude going up means the fair value of Gold is 1380 dollars. Normally 1 ounce of Gold should buy 15 barrels of Crude Oil. Time to add Gold along with the Crude.

Cairn India’s market cap is 1/4^th of ONGC’s. ONGC is the old giant whereas Cairn India is the new kid on the block.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)