In this edition of selecting stocks for the future, we will analyse and see whether the Oil and Gas sector can lead the Nifty in the future.
The fact that the oil and gas sector is driven by government policies makes the sector unattractive. India depends on imported oil, importing 70% of its total requirements of crude oil. Hence any upstream oil company such as ONGC, Cairn and to a certain extent Reliance is given higher valuations by the market. Downstream companies in the public sector is given absurdly low valuations while the largest downstream company in the private sector, Reliance is given higher valuations. Table 1. shows the weight of oil and gas companies in the Nifty index, the full market capitalization of the stocks and the sales to market capitalization ratio.
The Nifty index is dominated by Reliance, as its free float is much larger than that of ONGC. Reliance has a free float of over 55% while ONGC has a free float of 10% of total shares issued. The future outlook for Reliance is important for the Nifty given its weight in the index. However, further equity dilution by the government in ONGC (Government holds 90% of ONGC) will increase ONGC’s weight in the Nifty and as a consequence its importance to the Nifty.
Government ownership of oil and gas companies a huge negative
The government controls three of the five oil and gas companies in the Nifty index. The fact that GAIL and ONGC are monopolies in gas transportation and oil production respectively, the market valuation is on the higher side. On the other hand, BPCL, an oil refiner has been beaten down by the markets because the government forces the company to sell products below cost price. Even though the government compensates BPCL for its losses, the company is always on the back foot in terms of its fund requirements as government compensation comes with a lag. The result is that the company cannot expand and grow.
The government also uses GAIL and ONGC for oil subsidy purposes. GAIL and ONGC are expected to share the subsidy bill of the government if oil prices rise in the global market. The minority shareholders do not get the benefit of higher oil prices as the government uses its clout to make the companies pay for fuel subsidies.
The government owned oil and gas companies in the Nifty index, will always underperform the index if the government consistently runs up a subsidy bill. Unless the government frees up fuel pricing, investors should not be minority shareholders in Gail, ONGC and BPCL.
Private sector oil and gas companies
Cairn India and Reliance are the two private sector oil and gas companies in the Nifty index. Cairn is an upstream oil producer while Reliance is in both upstream and downstream business. Cairn’s market valuation is reflecting its future sales once production starts in full swings in its oil fields. Cairn’s potential is directly correlated to oil prices and if oil prices do move up, Cairn will reap the benefits and shareholders will gain in the process. Cairn however will not have pricing power, as the government will determine the price at which oil can be sold in the country.
Reliance is a much more complex stock. It has license to drill in many oil and gas blocks and some of the blocks have become operational. Reliance is also one of the largest refiners and petrochemical producers in the world. Reliance future depends on margins in refining, oil prices and petrochemical margins. Given Reliance’s upstream and downstream presence in a fuel starved country, Reliance stock should ideally lead the Nifty. It is not case as the government controls the pricing of gas and oil produced by Reliance and sold in the market. The government will not let one private sector oil and gas producer earn abnormal profits while public sector oil and gas producer shares the subsidy burden of the company.
Government control on the price of fuel sold to the end user affects Reliance as the company is forced to export its produce rather than sell at government determined prices, which is not economically viable sometimes.
Reliance shareholders are at the mercy of the government, which will keep Reliance share price from becoming an outperformer. Governments fuel pricing will the key to Reliance’s performance.
Government is the key to the oil and gas sector performance
The current government policies do not favour oil and gas stocks both in the public as well as private sector. Unless there is reform in fuel pricing policies of the government, it is unlikely that oil and gas stocks will lead the Nifty index forward. If there are reforms, the valuations of oil and gas stocks will surge.
Watch out for fuel pricing reforms.