While Private Sector Oil Climbs, PSU Companies Look Cheap

The commodity story refuses to die away. It is now the turn of oil, which is nearing an unprecedented $100 per barrel mark. With oil at that level, oil stocks globally are also at valuations which would have been unthinkable even a few months ago.

While much of the oil sector in India is hobbled by government controls, private sector stocks are participating in the global oil price boom. However, investor frenzy over private sector oil stocks seems to be creating rather massive pricing anomalies in stock prices. So much so that if you were a value investor with a long term outlook, PSU oil stocks would perhaps be representing a good percentage of your portfolio.

It would perhaps sound quite ridiculous to talk about PSU oil stocks these days. They have underperformed massively in this entire bull run since 2003. They have perhaps underperformed the last three bull runs as well. So why talk about them now? The reason is that PSU oil stocks – BPCL, HPCL and IOC – are undervalued at this time, at least in comparative terms, perhaps in absolute terms as well.

Check the valuations of Reliance Petroleum and Cairn India. RPL is currently quoting at a market cap of around $31bn. CIL is quoting at a market cap of $10bn.

RPL is setting up a refinery with a capacity of around 29 mn tons per annum [mpta]. The project is not yet ready. According to a project update of 16 October, 70% of the work has been done. The company appears to be planning to start commercial production from Dec’08. This means it is currently quoting at a valuation of a little over $1bn per mtpa. Now let’s do a back of the envelope calculation to see how much the refinery business of BPCL and HPCL should be valued at. BPCL has refining capacity of 20 mpta, and HPCL has a capacity of 16mpta. Reliance’s refineries tend to be far more profitable compared to PSU refineries. But even if we take a per mtpa valuation at a third of RPL, BPCL’s refining business could be worth $7bn, and HPCL’s refineries could be worth $5bn.

BPCL has further value from ventures and stakes outside the parent company. It owns a 3mtpa refining capacity through Numaligarh refinery. It is also building a 6 mpta refinery, which is about 30% complete. These two could perhaps be another $1.5bn, looking at above numbers. BPCL also has a 12.5% stake in Petronet LNG and a 22.5% stake in Indraprastha Gas, which amounts to over $300mn at current prices. It has stakes in some other city gas projects as well.

The non-marketing business of BPCL can thus be valued at around $10bn. HPCL’s non-marketing business could be valued at $5-6bn. This is 3 times current market capitalization of these companies.

The marketing business, where PSUs have no pricing control, is destroying a lot of value for these companies. General government interference could also be a reason for low valuations.

Now imagine if value unlocking through M&A was possible. If for example, BPCL and HPCL were allowed to sell the marketing business even at a token Rs 1, these stocks could triple. Value capture could also happen if BPCL and HPCL were allowed to be acquired. An acquirer would most likely be willing to pay a price far higher than current market price, keeping in mind the underlying value. These could be numerous private sector companies wanting to acquire these PSUs – from Reliance to the likes of LN Mittal, Essar, or even Vedanta Group, which has good experience with turning around PSUs.

Of course, a lot of this is wishful thinking since government is unlikely to let go of oil companies easily. But in the long term horizon, who knows? A long term investor may also better be wary of Cairn Energy, which is quoting at a market cap of $10bn. Its parent Cairn Energy Plc holds 69.5% stake in CIL. This means imputed value of the stake is $6.95bn. Cairn Energy Plc is listed in London, and its current market cap is only $3.1bn, or less than half of value of its stake in the Indian entity. The UK markets don’t seem to share the same enthusiasm about Cairn as the Indian investors. While rising oil price could one reason why Cairn’s price may have gone up, the other pure oil producer, ONGC has not seen its price go up in similar ratio.