In India, retail fuel prices are regulated by Govt. If the crude oil prices are high, Oil Marketing Companies (OMCs) bear under recoveries on sale of fuel at lower prices. As per Govt., public upstream companies has to bear a part of subsidies losses of OMCs, whereas private companies like RIL, Cairn don?t have obligation from Govt. to share subsidy losses of downstream companies.

I find private upstream companies better, as they are not obliged to share under recoveries and can sell their crude oil at the same prices as public upstream companies (discount to Brent), domestically.

2. What is the subsidy sharing model between the following?

a- Upstream and downstream companies (quantify)

b- What will happen when the crude prices will go up and vice versa( Quantify)

a- As of now, there is no transparent subsidy sharing mechanism, proposed by Govt. But generally, the practice in the industry is as follows:

33% of total under recoveries to OMC:?? Shared by upstream companies (ONGC, GAIL, OIL in the ratio of 75:15:10)

33% of total under recoveries to OMC:?? Shared by Govt. (Cash subsidy/Oil bonds)

33% of total under recoveries to OMC:?? Shared by downstream companies itself (BPCL, HPCL, IOCL)

b- If crude oil prices goes up, that means, the raw material cost (i.e. crude oil) for downstream companies will go up. The OMCs has to sell the fuel at Govt. governed prices, irrespective of their cost. Thus, they bear loss.

On the other hand if crude oil prices get down, better for OMCs as their input cost also get lower.

3. What is proposed in Kritik Pareikh report for the upstream and downstream companies (Quantify)?

4. Peer comparison between the companies like Oil India, Cairn India, ONGC, HOEC related with the total reserves of oil and gas.

ONGC is the largest public upstream company on the basis of 2P reserve. At present, Cairn is not fully operational but commencement of Mangala field makes it attractive. If we look at the reserve and total assets, HOEC seems bit expansive to its peers.

OIL is better in terms of reserve and production growth in the past with a high success ratio of 70-80% of exploratory wells drilled as compared with 36% for ONGC and 34 % for global average, which is best in the world.

In terms of raising cost including taxes, OIL and Cairn enjoy benefit of being onshore players. They have total raising cost of around $11/barrel.

Rating: Positive

In 3Q 2010, our coverage universe reported positive growth in Net interest income (NII) with decent growth in advances except ICICI Bank. Net interest margins has grown up on back of falling cost of deposit as banks have bolstered their CASA base. We continue to have bullish view on sector since IIP (Index of Industrial production) can surprise on upside which will ignite private capital expenditure cycle. Banking credit growth stands at 13% YTD 2010 compared to 24% in 2005-09. We believe revival in private capital expenditure will fuel credit growth resulting in sector re rating. We expect our coverage universe to report credit growth of 19-23% over next two years.

Top pick: Axis bank remains our top pick with target price Rs 1241 (2.6 PBV times FY 11 BV of Rs 477).

IT Sector

Rating: Positive

We believe IT Software exports will grow by at least 10-12% in FY 2010-11(last estimated at 4% in Market Outlook dated Nov 2009) on the back of rise in discretionary IT Spending in US. In 3Q 2010 most of leading IT Players appears to be sanguine on US IT spending outlook as evidenced by rising geographical contribution by US (Infosys & Wipro have observed rising sequential revenues growth from US). We believe with restoration of macro environment global IT budget will be flat to marginally positive. IT vendors continues to report client addition suggesting decent revenue visibility on stable Re (we estimate INR/USD at Rs 44 for FY 2011). Our coverage universe reported rise in employee utilization which will be margin accretive in near future.

Top pick: TCS remains our top pick with target price of Rs 850 (22 times PER FY 11 EPS.

Engineering

Rating: Positive

The power T&D business in energy segment is witnessing increased competition from domestic players & Chinese/Korean imports resulting in pressure on margins for the engineering firms such as Larsen & Toubro and Siemens. On the other hand, there are still not clear signs of sustained recovery in corporate capex which affects the industry segment. The country has embarked on a confident growth path. The growth is likely to be fuelled by increased capacity creation to meet the huge shortage of power and need for building India’s infrastructure. The recovery and firming up of oil prices also makes us positive on the prospects for oil and gas business. Though the inflationary pressures in the economy may lead to tightening of liquidity in the system, Government’s resolve to target a 7-8% growth rate should present many exciting business opportunities.

Top pick: BHEL remains our top pick with target price of Rs 2850 (30 times PER FY 11 EPS of Rs 95).

Metals

Rating: Positive

During 3Q FY 2010, the ferrous metal results were in line with our expectations. The stellar profitability y-o-y growth reported during 3Q FY 2010 was due to the low base effect. Tata Steel (standalone), Steel Authority of India Limited, JSW Steel Limited and Sesa Goa Limited reported robust earnings growth. Amongst, non-ferrous metals, Sterlite Industries reported lower-than-expected profitability due to rising costs. In light of sharp run-up in stock prices and our analysis of 3Q FY 2010 results, we downgrade our sector view from positive to neutral. Nevertheless, we continue to remain bullish on Sesa Goa, while we have downgraded JSW Steel from to a HOLD after it achieved our target price.

Power

Rating: Positive

During 3Q 10 the result of the power companies were as per our expectations. The net realizations of the power unit have increased during the quarter due to merchant power sale. Some companies like Torrent power; CESC has shown robust growth visibility more than the big players like NTPC, Tata Power etc. In Power Transmission segment the market leader power grid has shown a good performance and we are bullish on it as we believe that it will remain be market leader in transmission segment in coming years. It is estimated that 47,488 MW of capacity addition will take place during the Eleventh plan. We believe that in order to maintain the current growth, the country will require faster capacity additions in the Eleventh plan. Further, additions to generation capacity will require high capacity additions in transmission and distribution (T&D) as well. A total investment of around Rs 3 trillion in the power sector in the eleventh plan is estimated. Of this, a major chunk of Rs 2.1 trillion is expected to be towards power generation and the rest towards T&D segment.

Top pick: Power grid remains our top pick-The Company has reported growth of 24% CAGR in revenue over FY06 to FY09. It is currently trading at 22 x FY10E EPS, 17 times FY11E of EPS. We believe that the company will continue to earn minimum RoE of 12% and an EPS growth rate of 34%. We re-rate the stock and recommend a “BUY” rating with a target price of Rs. 137 at 20 x FY11E EPS of Rs 6.9.

Media

Rating: Positive

We have upgraded advertising industry growth estimate from 2-4% to 10% over 2010-12. In 3Q 2010, broadcasters like SUNTV, Zee Entertainment reported positive revenues growth with improvement in margins. The regional GEC market would grow 20-25% compared to television advertising industry growth of 10% over next two years. Print advertising players have disappointed in terms of advertising growth with falling margins thanks to stable newsprint prices.

Top pick: SUNTV remains our top pick with target price of Rs 450 (25 times PER FY 11 EPS of 18).

Cement

Rating: Positive

As India’s GDP is expected to move on 8% plus path and consequently we believe that the cement consumption too would grow with multiplier co-efficient of 1.2 to 1.3 over GDP that is about 10%. During 3Q FY 2010, most of the cement companies have shown a growth in its revenues despite any demand from housing segment. Production between April-January 2009 has moved up 4.77% to 26 MT from 25 MT in the same period last year. Dispatches grew 4.74% to 26 MT (25 MT). The dispatches in December were the largest so far in the current financial year at 17.74 million tones. With this the industry has recorded the highest sequential growth rate at 12.78%, whereas on the year-on-year (y-o-y) basis, after a gap of three months since August last year, the growth was in double digits at 10%. Though fresh capacities will increase supply but we believe capacity utilization will remain stand at 80%

Top pick: Dalmia Cements remain our top pick with target price of Rs 301 on S.O.T.P basis where in standalone valuation stands at Rs 280 (i.e. 8 PER times FY 11 E EPS of Rs 35.1) and OCL is valued at Rs 21 per share on basis of its market capitalization.

Oil & Gas

Rating: Positive

Oil prices are hovering around $70-$75 a barrel. If we follow the pattern of the past 15 years, then Jan-Feb has typically been the months, in which, the seasonal oil price starts moving up again as markets prepare for the summer driving season.

We downgraded our rating on downstream companies to ?Sell? but the much awaited Mr. Kirit S. Parikh? panel report on retail fuel prices is out. This report supports market-determined pricing for petrol and diesel, Rs.100/cylinder hike in LPG and Rs. 6/liter hike in kerosene. Though the Oil ministry has to give its final words, as it has to ensure the consumer interest as well as the financial health of PSU fuel retailers, but still this report, focusing on minimizing under recoveries and subsidies, provides positive undertone to the earnings of OMCs. So, we remain Neutral to OMCs.

Considering the huge demand-supply gap, huge growth potential market, potential upside in transmission volumes on account of additional gas availability from RIL?s KG Basin gas, PLL?s RLNG and ONGC?s marginal fields in FY10-FY11, we are positive on gas transmission companies like GAIL (India) Ltd. and Indraprastha Gas Ltd.

Top pick:?? Indraprastha Gas Ltd. remains our top pick with target price of Rs 280, valued at 14x FY11E EPS of Rs. 20 with a target of one year.

Telecom

Rating: Neutral

In 3Q 2010, our coverage universe continues to report decline in its KPI like RPM, MOU & ARPU due to increase in competition plus greater share of rural areas in net incremental addition. In 3Q 2010, coverage universe observed steep fall in RPM which resulted in sequential degrowth in revenues along with falling margins. We believe telecom industry will indeed consolidate but that is still 12-18 months away as the new entrants would not be able to be profitable in long term and the prevailing price war will shake out the sector and eventually work the overcapacity out and probably only the incumbents will emerge as winners.

Infrastructure

Rating: Neutral

Our discussions with companies suggest that funding constraints could increase the near-term risk of execution on Andhra Pradesh irrigation projects. Payments to contractors are getting delayed, engineering and construction companies are going slowly on execution of these projects given lack of funding clarity, and future order inflows could also be at risk if the funding situation doesn’t improve.

Auto

Rating: Neutral

Auto sector continues to report robust volume growth on back of domestic consumption plus renewed exports orders. In 3Q 2010, two wheeler major Hero Honda?s volume registered 30% growth (YoY) whereas Maruti?s volume grew by 48% on YoY basis. Auto players continued to enhance their margin due to falling commodity prices like steel, aluminum & copper. But going forward excise rollback, monetary tightening & rising commodity prices will certainly limit earning growth. Auto stocks are trading at 20 PER times FY 11 EPS which are at premium to historical Price Earning Ratio (PER) band of 15 PER.

Top pick: M&M remain our top pick with target price of Rs 1450 on S.O.T.P basis where in standalone valuation stands at Rs 1050 (15 PER times FY11 EPS of 70) and subsidiaries are valued at Rs 400.

Downstream Co: Neutral

Gas Co: Positive

Q3 FY10 review: almost in line with our expectations

The Q3 FY10 results were broadly in line with our expectations. The upstream companies posted good profits during the quarter on account of higher average crude oil prices on YoY basis and higher GRMs. Commencement of Rajasthan field (Cairn India) and increased production in KG-D6 were the key contributors to the top line.

The downstream (OMCs) results were below our expectations, mainly due to the significant under-recoveries, not yet compensated by GoI. Government has committed an Rs 120 bn cash subsidy against the estimated under recovery of about Rs 300 bn for the current financial year.

The gas players did well on the back of higher gas transmission volume, except Petronet LNG.

Outlook

Oil prices are hovering around $70-$75 a barrel. If we follow the pattern of the past 15 years, then Jan-Feb has typically been the months, in which, the seasonal oil price starts moving up again as markets prepare for the summer driving season. Thus, this gives a Positive pitch to RIL and Cairn India.

We downgraded our rating on downstream companies to Sell but the much awaited Mr. Kirit S. Parikh? panel report on retail fuel prices is out. This report supports market-determined pricing for petrol and diesel, Rs.100/cylinder hike in LPG and Rs. 6/liter hike in kerosene. Though the Oil ministry has to give its final words, as it has to ensure the consumer interest as well as the financial health of PSU fuel retailers, but still this report, focusing on minimizing under recoveries and subsidies, provides positive undertone to the earnings of OMCs. So, we remain Neutral to OMCs.

Considering the huge demand-supply gap, huge growth potential market, potential upside in transmission volumes on account of additional gas availability from RIL?s KG Basin gas, PLL?s RLNG and ONGC?s marginal fields in FY10-FY11, we are positive on gas transmission companies like GAIL (India) Ltd. and Indraprastha Gas Ltd.

Considering the growing dependence on imports (80%) and a loss of Rs 180 crore per day on selling petrol, diesel, domestic LPG and kerosene below the imported cost by Indian Oil, BPCL and HPCL, this report supports market-determined pricing for petrol and diesel, Rs.100/cylinder hike in LPG and Rs. 6/liter hike in kerosene.

I have a 15 years’ crude oil seasonal price chart. This chart says that from January to September, crude oil prices increase substantially, mainly because of the summer vacation-driving season. Then, in September- October, it becomes sluggish and then in the month of November- December, demand for crude oil weakens because of the reduction in driving and more moderate temperatures between the summer cooling and winter heating seasons, thus, crude prices see correction.

During the last 15-year period, January has typically been the month, in which, the seasonal oil price starts moving up again as markets prepare for the summer driving season. It is interesting to note that, while crude oil prices are usually soft during December, energy stocks begin to strengthen in December, offering the investors an opportunity to capitalize the favorable seasonal demand.

The OPEC meeting just concluded in Angola. We found two take aways from the event: first was that Asian demand is strong, mainly from China and second take away was that $70 is the new floor in oil prices. i.e. oil between $70-$80 is perfect for OPEC. So, this implies that, anyhow, OPEC will attempt to keep the oil above $70. At present, crude oil is trading at $75. So, may be ?a new uptrend has begun.

So, if 2010 also, follows the pattern of the past 15 years, then we are approaching the start of a seasonal climb in the crude oil prices that could present a good investment opportunity in energy-related stocks.

Currently, the crude oil is trading near US$ 75 per barrel. Going forward, according to this chart, crude should move further up. This would result in higher realizations to upstream companies like RIL, ONGC, Cairn India. But at the same time, higher crude prices would also impact the profitability of downstream companies like HPCL, BPCL (Oil Marketing Companies) as retail oil prices are Govt. driven and OMCs cannot pass on the higher cost to the end users. It would also lead under recoveries.

Natural Gas

Currently, the natural gas is trading at $5.7 per mmbtu, below its average rate of US$ 8 per mmbtu. In the economic recovery, it would be preferred as cheap energy alternative. But there is huge surplus inventory buildup in natural gas; so, we expect that the upside is limited to US$ 8-8.5 per mmbtu. Given the vast demand-supply gap in natural gas, gas transmission companies like GAIL India, Indraprastha Gas and Gujarat State could be highly benefited in 2010.

Rupee

Another factor that can impact oil and gas industry is ?movement in Rupee?. We expect rupee is strong in the near term, on account of higher economic activities, FII inflows to India and the recent comment from FM that GDP growth in FY10 could reach 7.75%. This would be a positive factor for oil marketing companies like IOC, BPCL, HPCL etc. as it will reduce the oil procurement costs, thus reducing subsidy losses and it would also be good for Gujarat Gas as its procurement is dollar denominated and the selling price is rupee-based.

Whereas, rupee appreciation could be negative for stand-alone refineries like Chennai Petroleum as their GRMs are dollar denominated and for upstream companies – ONGC and OIL as crude realisation is US$ denominated but some negative impact is mitigated due to lower subsidies.

Overall, I remain constructive on energy stocks?supply and demand fundamentals for energy will tighten, given the improving economy and positive seasonal factors, heading into the New Year. So, the energy stocks will benefit in 2010.

Currently, the natural gas is trading below its average rate of US$ 5.5 per mmbtu. In the economic recovery, it would be preferred as cheap energy alternative. As there is huge inventory buildup in natural gas, we expect the upside is limited to US$ 6.5-7 per mmbtu. Given that the vast demand-supply gap in natural gas, gas transmission companies would be highly benefited.

Another factor that can impact oil and gas industry is ?movement in Rupee?. We expect rupee is strong in the near term, on account of higher economic activities and FII inflows to India. This would be a positive factor for OMCs like IOC, BPCL, HPCL etc. as it will reduce the oil procurement costs, thus reducing subsidy losses and it would also be good for Gujarat Gas as its procurement is dollar denominated and the selling price is rupee-based.

Whereas, rupee appreciation could be negative for stand-alone refineries like Chennai Petroleum as their GRMs are dollar denominated and for upstream companies – ONGC and OIL as crude realisation is US$ denominated but some negative impact is mitigated due to lower subsidies.

The very first reason is the OPEC’s success in taking a fair amount of oil off the market to balance the supply-demand picture. Since September 2008, OPEC has reduced production by around 4.2 million barrels a day to support the prices.

Second reason can be the speculation in the market, because normally, oil and gas prices reach to their highest level in April or May, as speculators in the energy markets bid up prices, in anticipation of higher oil demand because of the peak driving season during the summer, which increase the crude oil significantly.

Another possible reason can be the first signs of a turnaround in the world’s two biggest economies i.e. the US and China. In China, which is the world’s second-largest oil consumer, market sentiment has improved considerably after the encouraging data from China, which showed that the economy is on a revival path. The CLSA China purchasing managers’ index rose to a seasonally adjusted 50.1 in April 2009 from 44.8 in March for the second straight month. A reading above 50 indicates an expansion and it’s a positive sign for China that the gloomy surroundings have started to disappear. The rate of decline, in China’s oil product consumption is also slowing. In January, China’s oil product demand growth declined by 16.5%, in February it came down by 8.1% and in March by just 2.7%.

Same in case of the world’s biggest oil consumer US. A bunch of good numbers is fuelling positive sentiment. The latest labor department data showed that jobless claim applicants unexpectedly fell by 34,000 last week, while retailers posted better-than-expected sales numbers for the second straight month.

So, these are the possible reason why crude has reached at the level of $65.

One point I would like to mention here is that, OPEC has played a wonderful role in increasing the prices by cutting the supply, but actually there is no shortage of oil inventory above ground, much of it floating at sea. Yes! OPEC has stored the crude oil in the rented ship tankers. Currently, around 100 million barrels of crude oil and 25 million barrels of oil products are estimated to be floating at sea on giant tankers and OPEC is waiting for that day to come when the oil prices will reach far above their breakeven and then, they will clean up their inventory at higher prices. But, this can also lead to an increased supply, which can again throw the oil prices below $50. So, OPEC will have to play very carefully in releasing the supply.

Moreover, as we all know that the US crude inventories are at 18 year highs, which indicates that US is in position to control oil prices if they surge further because of the production cut from OPEC. But one thing is to be noted here that the US crude inventory is kind of “Strategic reserve” for US for meeting future demand. It will not affect the current demand supply in the market.

So, we saw in the past months that the crude oil prices have increased by more than 80% since hitting lows of $33 because of the one or another reason. Now, I present some “Green Shoots” of “Real oil shortage” in the world.

In Iraq, U.S. is handling over the security operations of the oil-exporting infrastructure to Iraq, putting them at increased risk. Moreover, terrorism is increasing on the ground as the Shiite government is abandoning the Sunni support. More recently the Kurds announced that they are planning to start exporting oil without the permission of Federal, which will not be accepted peacefully.

In Nigeria, there are new protests against the government for manipulating the last election and for widespread corruption.

In Venezuela, it is clear that the time has come when its already declining oil production of 8% on Y-o-Y basis is likely to decline much more rapidly. President Chavez is seizing hundreds of millions of dollars of foreign oil production equipment, belonging to contractors who have not been paid and who, therefore are withdrawing from their assignments in Venezuela.

So, Iraq, Nigeria, and Venezuela are three vital oil-exporting nations and nobody knows when oil exports from these countries will begin declining, due to these political disturbances. This decline can be a fundamental cause of decline in OPEC output, well beyond what is planned by OPEC. If so, the day of a fundamental reason for higher oil prices will come more quickly than it is otherwise expected.
 
Till now, crude oil prices are rising because of the scarcity of supply. The day is near when the global economic recovery will start and crude oil prices will rise because of the huge demand. So, in any case, outlook for crude oil is bright.

Where does all this leave India? If prices continue to move northward, an upward revision in retail prices would be the right thing to do to save oil companies. Crude oil in international markets is $60+ a barrel, the price from where oil-marketing companies start thinking about losses. The UPA will have to deregulate the administered price mechanism for all oil and gas products, if oil prices increases. Otherwise, we will return in the fiscal deficit, by once again subsidising the oil-marketing companies for their losses.