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Buy On Declines

The recent deregulation of prices of petroleum products will benefit ONGC in the long run…

I am interested in buying stocks of ONGC. Could you please tell me about the company’s fundamentals and whether I should buy the stock at current valuations?
- Priyamvada

Oil stocks, particularly those of upstream companies like ONGC, have historically been under the shadow owing to the government’s whimsical policy-making. With no set formula on sharing under-recoveries, ONGC has had to bear ad hoc subsidy burden — from oil bonds to fluctuating loss-sharing ratios — which inevitably resulted in poor shareholder enthusiasm and poor returns from the stock.
But the recent deregulation of prices of petroleum products will diminish that overhang to a certain extent. What has changed? Oil companies get a reprieve with under-recoveries expected to decline by as much as half of that seen in the last few years. What hasn’t changed? They still face ad hoc loss-sharing burden. ONGC bore 82 per cent of under-recovery charged from upstream companies. That, say industry trackers, is unlikely to change any time soon. More reforms are underway and are expected to bring under-recoveries down. The recent UID report seeks to limit the supply of subsidised LPG to five cylinders per family. There is also talk of de-regulating the price of diesel. Any of these measures will directly benefit ONGC.

ONGC also faces a big risk to earnings if crude does not decline significantly. Under-recoveries could balloon from Rs. 44,300 crore (assuming average price of crude stays at $95/bbl in FY12) to Rs. 54,400 crore (if it stays above $110/bbl).
Despite the negatives, ONGC has been able to beat a lot of PSUs at the returns game. Its RoAE during the last three years has been upwards of 20 per cent — a return that propels the company into the ranks of the top 10 global E&P companies (based on returns). That return is expected to hold in the current year as total subsidies are set to decline by half from peak gross under-recoveries of Rs. 1 trillion seen in FY09.
Currently ONGC trades at 11 times its FY11 earnings. Investors may buy ONGC on market declines provided they have an investment horizon of three years.

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