ongc is not a fair game

Exploration business

Brent crude is now at about $108 per barrel. In fact, it has remained higher than this level for much of the period. Oil exploration companies are treading good fortune, one might say. 

Despite that, 2013 annual report of ONGC says that its net realization on crude oil was $47.85, and it was $54.72 in 2012. For the first-half of 2014 it has been $42.56. This is not new, it has always been like that for ONGC. What is going on here? 

For any exploration business two biggest risks are explorable oil and oil price. The former depends upon several factors including technology and cost. As for the latter, the higher it goes the better it is. However, for ONGC it is not. Funny though, it is in a weird situation. 

The regulation

ONGC is forced to sell oil at discount to oil marketing companies, its customers. The discount is pretty large as we can already see. 

This is how it works: The government controls retail selling prices of high speed diesel, superior kerosene oil and liquefied petroleum gas. The reason appears to be simple; non-subsidized votes from the general public in exchange for subsidized petroleum products. Consequently, IOC, BPCL and HPCL sell for too low and incur losses (call it under-recoveries). The story gets interesting from now on. As mandated by the government more than 90% of these losses are to be borne by the government itself (about 55%), and upstream companies (ONGC, OIL and GAIL - about 35%). And more than 80% of the upstream share is charged to ONGC. The government does not reimburse in cash, it issues oil bonds to the oil marketing companies instead. ONGC and other upstream give discounts to them. 

Value destructive

Some thinking and analysis would tell us that this policy has had enormous impact on the business and shareholder value. The cornerstone of corporate finance has gone bonkers. In the last ten years, total subsidy borne by ONGC is about Rs.2,163 b; it's massive. That's the amount of revenue lost by the company. The bottom-line impact on ONGC is lower than this because it has to be pay VAT and statutory levies to the government. In 2013 the firm lost Rs.421 b and in 2012 it lost Rs.378 b on net basis; that is, cash loss after paying taxes. The minority public (including institutions) have lost about 30.77% (their stake) of this cash on account of poor regulation. 

Lack of substance

I just don't understand why the math had to be like this; it is ridiculous. If the public has to be supplied with cheaper products, why not just reimburse directly to the marketing companies? Just collect taxes, levies and dividends from the upstream, and give it to the marketing. Or better yet, stop this nonsense and go for market-driven policies where everyone gets what he or she deserves. Create employment, private partnership and growth, and make people work to afford goods and services, however expensive they might be in the market. If they cannot afford it, people should learn to live without it; a fair game.

The hapless minority

This is how I see it. The average return on equity (also return on capital) earned by the firm has been more than 26% over the last decade. If the subsidy cash was reinvested by ONGC in the business and earned say 25%, the current value of that cumulative reinvestment would have been staggering Rs.2,635 b; compare this to the current market value of equity of Rs.2,400 b. The government has destroyed the firm's equity value by about 50%. In other words, the minority would have been richer by 100% if only those policies were not adopted. Alas, it was not to be. 

The following shows how the minority has been taken on a ride by the majority shareholder (at March 2013).

This shows value lost by the firm at different levels of opportunity costs. Even the no-brainer 8% rate would have increased market value by Rs.1,534 b.

In fact, the government too could have done far better without regulation. Its share of value including all levies would be much higher. But then, politics is not business and finance.

The deregulation...the value creator

In 2013 both return on equity and capital reduced to less than 20% for the first time in the decade. No wonder the chairman is worried. The production levels (both oil and gas) have not moved much for a long time; fields have become old and mature.

For the firm to create value in future a few things have to take place: Increase reserves acreage; improve technology to reduce cost of production; hope for steady oil prices; and above all, pray for deregulation. The production targets require sustained reinvestment which would be impacted if the current policy continues.

We are informed that in June 2010 petrol prices were deregulated (I don't see it explicitly though) and diesel is on its way to be deregulated. All this is to bring down subsidies and fiscal deficit; the current hot topic.

When or whether it will happen is left only to guesswork. What we learn is that we don't learn. That should not stop us from guessing.