>Oil & Gas & Petrochemicals (ICICI Securities)

Take some money off the table

Strong outperformance in the O&G space despite continued weak fundamentals – end-product demand remains weak and significant dip in refining margins in March ’09 – has necessitated revisiting our estimates and recommendations for companies under I-Sec O&G coverage. Though the market continues to be buoyant, we believe there is little upside to O&G stocks – most stocks under I-Sec coverage that rose 17-41% over the past three months are trading at a premium to fair value. We believe long-term investors should book profits at current valuations. We downgrade Oil & Natural Gas Corporation (ONGC), GAIL and Reliance Industries (RIL) to HOLD from Buy. We maintain BUY on Cairn India (Cairn), which is our top pick in the sector. Also maintain HOLD on Hindustan Petroleum Corporation (HPCL) and reinitiate Bharat Petroleum Corporation (BPCL) with HOLD recommendation.

■ BPCL, HPCL – Attractive defensive BUYs in overpriced market. Though oil marketing companies (OMCs) are at risk from possible diesel price cuts and reintroduction of customs duty post elections, they would be attractive defensive bets in a falling market. OMC stocks may outperform if market sentiment turns negative.

■ Cairn – Maintain as top pick in sector. Earlier-than-expected commencement of production from Rajasthan’s southern fields would enable Cairn to quickly resolve issues with the Government regarding the benchmark for crude sales and applicable cess. This would be a key trigger for the stock. Cairn’s bear-case valuation of Rs167/share would offer an excellent entry point for long-term investors.

■ GAIL – Gas abounds, but risks aplenty; downgrade to HOLD. Though management is confident of maintaining tariffs for the HVJ pipeline, we remain uncertain on the PNGRB allowing current tariffs to continue for the pipeline as we believe that the policy is prospective and may ignore any retrospective returns that GAIL might have made historically. Given that LPG/SKO would comprise most of the under-recoveries in the next two years, historical evidence suggests GAIL’s share of upstream burden at ~7.5% versus I-Sec & market estimates at 5.5%. This is a concern for GAIL’s FY10 and FY11 earnings.

■ ONGC – Our call vindicated, but what next? Downgrade to HOLD. We had upgraded ONGC to our top pick in the O&G PSU space on February 12, ’09. Since then, the stock has been the top performer in the space, rising 21% overall and outperforming the O&G PSU space 17.5% over the past two months. However, the stock now trades at a marginal 2.5% discount to our fair value and, we believe, investors should book profits at current prices.

■ RIL – Valuations, the only blemish; downgrade to HOLD. RIL’s fundamentals look strong despite weakness in the extant refining and petchem businesses due to significant cashflow generation from the Reliance Petroleum (RPL) refinery and KG D6 projects. Exploration at the company’s E&P blocks would result in further reserve accretion and improved valuations. However, our valuations already include significant reserve accretion from the company’s attractive E&P portfolio. RIL is likely to see improvement in debt-to-equity on positive free cashflow generation and register earnings CAGR of 34% over FY09E-11E. We value the stock at Rs1,536/share and downgrade it to HOLD despite strong fundamentals due to stretched valuations. While bear-case valuations stand at Rs1,122/share, bull-case valuations are at Rs1,981/share.

To see full report: OIL & GAS & PETROCHEMICALS