The Case for Cairn Energy

The Company:

Cairn Energy (CRNCY.PK), based in Scotland is an independent and frontier exploration company. It typically goes into countries and regions that Big Oil has overlooked. It is a pure play in terms of oil and gas exploration as it is not into owning or running gas stations or refineries.

Cairn Energy has two distinct subsidiaries:

1. Cairn India
2. Capricorn Energy

The Assets:

1. Near Term Trigger

The most significant asset that Cairn India has is the oilfields in Rajasthan India. The oilfields of Mangala, Aishwariya, Saraswati and Raageshwari in Rajasthan have an estimated 3.7 billion barrels of oil. Cairn owns 70% of these oil fields (ONGC, one of the Indian national petroleum companies owns the other 30% and not all the oil is extractable).

Cairn expects to start production at 30,000 barrels a day in the second half of this year and ramping it up to a peak production of 125,000 barrels a day by 2011. The 125,000 barrels per day is expected from the MBA fields (Mangala, Bhagyam and Aishwarya). These figures do not take into account any other oil finds that Cairn may find and exploit elsewhere in India.

2. Exploring outside of Rajasthan

1. Sri Lanka – In the Sri Lankan waters close to the Krishna Godavari basin (where India has discovered its biggest gas find ever), Cairn has rights to explore hydrocarbons in a 1,500 square km. Cairn India owns 100% of this field.
2. North India – The Ganga Valley sedimentary basin is one of the most under explored basins in India. Cairn India owns 50% of the rights to explore acreage in Uttar Pradesh and Bihar.
3. Eastern India – Cairn’s focus in the East is based on the Ravaa oilfield in the KG basin (Krishna Godavri basin). In partnership with 2 other companies, Cairn India is producing 50,000 barrels a day from this field and can process 70,000 barrels per day, 95 mmscfd of natural gas and 110,000 barrels per day of injection water.
4. Western India – In partnership with 2 other firms, Cairn has been producing gas from the Lakshmi gas fields in the Cambay basin.
5. Greenland – Cairn is exploring 3 different basins in Greenland that are suited to oil and gas deposits with a total of 72,000 sq km under license for exploration.
6. Mediterranean – Cairn is also bidding and exploring for oil in Tunisia, Spain & Albania.
7. Capricorn – All of the non Indian assets that Cairn Energy holds are owned via a subsidiary called Capricon Energy. Capricorn Energy Limited (“Capricorn”), a subsidiary of Cairn is the exploration focused arm. Capricorn now has assets in Bangladesh, Nepal, Northern India, Greenland, Tunisia, Peru, UK (West of Shetlands), Albania, Australia, and pending licence awards in Spain and Sicily.

Cairn Energy holds 90% of Capricorn, an unlisted subsidiary.

Risks:

1. Oil prices fall and stay there for a while

My perspective is that even if this happens, usage of petroleum in India will continue to remain strong. At the end of the day, we are talking about a commodity that is depleting and that we will eventually run out of. Sooner or later prices will go back up and stay there.

2. The state of Rajasthan goes back on its word and decides to tax Cairn heavily for the oil it draws out of the ground. The Chief Minister has already hinted at raising taxes on Cairn and others.

Again, if this does happen, Cairn has shown in the past that it is not afraid of going to court and fighting for its rights. The federal government in India understands that after many years, the oil majors are slowly looking to India for exploration. With a Congressional government both in Rajasthan and the Centre (federal level), I think it is unlikely that the Rajasthan government will tax Cairn to death.

3. Low quality Oil

When the GOI (Government of India) forced the state owned oil companies to firm up buying of the waxy crude that is produced by Cairn India, there was confusion about pricing the crude given its high viscosity.

However, those concerns have been laid to rest and Cairn has now signed deals that ensure that the crude will be sold and they have ready customers.

4. No additional oil is found

Usually where some oil is found, there are chances of finding some more oil. But investors should consider the possibility that despite promising seismic surveys and geology, Cairn may not find any major discoveries in its other explorations.

Valuation:

Here is how I have valued the MBA fields, Cairn India’s most promising asset.

At $ 40 a barrel, Cairn India has an enterprise value of $ 10.5 billion.

1. Reserves have been taken at a conservative 500 million recoverable barrels versus the company aiming for 685 million.
2. Average net margins have been taken at a conservative 15% compared to the 40% plus in the valuation done by IndiaBulls -
3. Assumed a conservative PE ratio of 5 for Cairn. Comparatives can be viewed here (9.1 PE for Independent Oil & Gas producers)
4. Current price on July 21, 2009 is Rs 245 or USD 5.05.

How to best play Cairn India?

Cairn Energy, the parent company trades in the UK markets and owns 69.5% of Cairn India.

Recommendation:

At a conservative $40 a barrel, Cairn India has an enterprise value of $ 10.5 billion. The market cap of the company on the Indian markets is at USD 9.3 billion and too far off from the $10.5 billion I have calculated/estimated.

Cairn Energy stock on the UK markets has a market cap of 3.32 billion sterling. At an exchange rate of 1 sterling being 1.64 USD, that translates into a market cap of USD 5.45 billion. Theoretically speaking the 69% of Cairn India should translate into USD 7.3 billion.

In light of the above, I would propose that at current prices Cairn Energy stock represents an opportunity to buy into the MBA fields at a discount and get exposure to all of the other exploration that Cairn Energy has lined up at zero cost.

If you wish to buy Cairn and wait till 2011/2012 (my suggested hold period), I would suggest buying it on the UK markets.

Comments

[Steven Ward:]

Good article and a fine example of US investors not paying enough attention to foreign oil stocks if they don't trade on an American Exchange.

One could easily add BG, Premier Oil, Tethys, Serica for a choice as well. These are the potential stocks that are a 10 bagger as Cairn once was and could be again.

Jul 22 10:52 PM

[manka khanna:]

The article provides a very clear picture of CAIRN at present. very complete

Jul 23 12:24 AM

[A Barrel Full:]

A great article, that neatly and succinctly sums up what the author likes about Cairn. I should have a closer look.

Jul 23 01:19 AM

[kaps:]

I am not sure about your calculation of Enterprise value. It seems you have multipled EBIT by PE ratio to arrive at Enterprise value..I think it is wrong... can you clarify?

Jul 24 01:57 AM

[karthick:]

You seem to be completely ignoring leverage and when you are not considering interest payments the enterpise value represents sum of Market cap and debt (not market cap alone ). I don't know about the tax structure of th company and you are assuming a tax rate of zero. If its not the case then PE ratio of 5 on pre tax earnings is really not a conservative assumption.

Jul 24 12:47 PM

[Harmit Kamboe:]

Dear Kaps & Karthick,

Many thanks for your feedback.

1. EBIT x PE ratio and Enterprise value - Instead of using the PE ratio to calculate the value of a single share, I have indeed multiplied it by the EBIT.

2. You are correct on the fact that Interest payments and texes have not been accounted for. Unfortunately, I was not able to find the information on these two aspects and I ended up using a lower net margin % number (see "B" under "Valuation").

Rest assured, I will endeavor to address or highlight these two points in my next pick/suggestion over the course of the next week.

Best

Jul 31 09:01 AM