Monday, June 17, 2013

A Brighter Future for India's Upstream Energy Sector

From The Motley Fool. June 10, 2013
India’s leading oil and gas explorer Oil and Natural Gas Corp, or ONGC, has recently reported a steep decline in quarterly earnings as it sold its output at significant discounts. The company has been suffering from aging fields as the exploration-related write downs rose by one-third from the same quarter last year to $850 million while depreciation charges doubled to $423 million in the same period. Moreover, Brent crude prices also did not help, and averaged $112.64 during the quarter, showing a decline of 5% from last year.
On the other hand, Reliance Industries, the owner of the world’s largest refinery located in western India, has posted a 32% increase
in quarterly income to $990 million. However, unlike ONGC, Reliance is largely a refiner, which is a higher margin operation. In fact, like ONGC, Reliance has struggled with its oil and gas production business as the unit’s quarterly revenue dropped 39%. Its income from converting crude to refined products, however, rose 33% to $10.10/barrel. As a result, the business ended up with increasing profits despite recording a 1.2% overall drop in sales.
ONGC and Reliance Industries have significant representation in PowerShares India (NYSEMKT: PIN) and the WisdomTree India Earnings Fund (NYSEMKT: EPI), both exchange-traded funds (ETFs). The two firms are among the top-three holdings in both of these ETFs. The PowerShares India portfolio ETF is energy focused and devotes 25.6% of the funds to this sector while WisdomTree India Earnings Fund ETF is financials-focused with total sector weight of 25.4%. But the energy sector isn’t far behind with a weight of 19.8% of the funds.
ONGC’s strategy is to increase its domestic and international reserves and output. For this reason, it has increased its capital expenditure budget by 18.8% from last year’s $5.2 billion to the current $6.2 billion. The company also has a very ambitious target to spend $195 billion by 2030 on building reserves and increasing production. From this perspective, the drop in profits will put pressure on its cash reserves.
In the last fiscal year, ONGC’s total output was approximately 51.4 million tons of oil equivalents, which it expects to increase by 1.9% to 52.5 million tons. I believe that the target is modest but it is realistic. ONGC has recently announced two new discoveries of which the KG basin field will start production within three years.
India’s oil and gas sector has witnessed government reforms that have largely been received well. India, much like China, was keeping a lid on oil prices to tackle the rising inflation and as a result, ONGC was forced to sell crude at steep discounts to refiners.
However, the government has increased diesel prices while refiners are given more freedom to set their own price. I believe that this will reflect positively in the coming quarters as the current levels of subsidy that ONGC gives to refiners, which was approximately $2.2 billion in the previous quarters, will fall.
Investors should note that the India’s Oil Ministry is currently going through a report prepared by the head of the Prime Minister’s Economic Advisory Council which recommends a new pricing mechanism through which the country’s natural-gas prices will be closely linked with the international prices. If the plan is approved then I believe this could considerably change the fortunes of both Reliance Industries and ONGC as natural-gas prices will almost double.
Should you invest?
With the current softness in crude prices, analysts have identified that the sector looks undervalued at the moment. Due to reasons mentioned above and the ever- increasing energy demands of India, I am long-term bullish on the country’s energy-focused ETFs, particularly the PowerShares India, which allocates a quarter of its funds towards the energy sector.
I believe that WisdomTree India Earnings Fund is not as attractive as PowerShares India at the moment due to the former’s focus on the financial sector, particularly after the beating which the banking sector took during the current downfall at the Bombay Stock Exchange, or BSE.
Although on an year-to-date basis both ETFs have recorded a net outflow of $32.6 million (PowerShares India) and $156.6 million (WisdomTree India Earnings Fund), in the shorter time frame, i.e. the current quarter, PowerShares India has seen a net inflow of $8.2 million while WisdomTree India Earnings Fund continues to record a net outflow of $64.9 million.
However, if you are looking for exposure only toward the biggest Indian firms, then perhaps iShares S&P India Nifty 50 Index (NASDAQ: INDY) is a better option. This ETF focuses exclusively on the 50 largest Indian firms in terms of market cap. This fund is heavily weighted toward financial services and gives more than 22% to banks and 7% to other financial institutions but the energy sector isn't far behind. More than 11% of the funds go toward energy firms. Reliance ONGC and  are its fourth and 10th biggest holdings. Unlike PowerShares India or WisdomTree India Earnings Fund, iShares S&P India Nifty 50 has posted positive flows on both year-to-date and on a current quarterly basis. 
I believe that due to iShares S&P India Nifty 50 ETF's focus on giant cap stocks, it is a relatively safer investment which generates lower returns. This is also evident in its higher costs with a management fees of approximately 0.9%, which is more than what PowerShares India and WisdomTree India Earnings Fund charge. Nonetheless, iShares S&P India Nifty 50 can be a healthy low-risk-low-return addition to your portfolio. 
Bottom line
Recently, the BSE’s benchmark 30-share index Sensex closed to a record one-month low amid concerns over the falling levels of manufacturing activity. The PowerShares India Portfolio ETF certainly looks like a good investment option for those looking for exposure toward India’s energy sector but I believe the markets currently require some stability for this sector to become really attractive. This holds true for iShares S&P India Nifty 50 ETF as well. The fundamentals of the markets are strong and now it needs a catalyst -- which could come in the form of a new government (elections due next year) -- to really turn bullish. 
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own personal opinion. I have no business relationship with any company whose stock is mentioned in this article.