ONGC Stock Doubles In A Year. Should You Buy In?

ONGC Stock Doubles In A Year. Should You Buy In?ONGC.
Snapshot
  • Globally, energy prices have been on a roll, as demand for the fuels has risen at a quick pace and has outstripped supply.

    Several countries are facing an energy crisis as fuel prices continue their upward march.

After several years of underperformance, oil stocks have risen at a rapid pace. Oil and Natural gas Corporation of India (ONGC) and Oil India Limited (OIL) have more than doubled with ONGC giving a 130 per cent return and OIL giving a 170 per cent return within the past year.

The increase in stock prices is a reflection of the fact that crude oil prices are at a three-year high. Brent crude trades at around $ 84 a barrel, whereas the US West Texas Intermediate (WTI) crude rose to $ 81.

Globally, energy prices have been on a roll, as demand for the fuels has risen at a quick pace and has outstripped supply. Coal, which is used to run thermal plants, is at a decadal high.

Several countries are facing an energy crisis as fuel prices continue their upward march.

Reversion to the Mean

Just a year back, US crude had slipped into negative territory, meaning that the seller paid the buyer extra money for buying crude. WTI Crude had fallen as low as minus $ 38 a barrel, meaning the buyer received $ 38 along with a barrel of crude.

The price was a result of a large production surplus and the lack of demand due to the lockdowns. Further, storing the crude would be a risky endeavour with the uncertainty surrounding the future demand for crude.

As storage capacity filled up, storing crude would become more expensive, hardening the traders resolve to sell.

In August 2020, Exxon Mobil, the world’s largest publicly traded energy company, was removed from Dow Jones after a 92-year run, and was replaced by a software company.

Many experts were quick to declare that oil will never come back.

Yet, oil did come back. Now we see articles justifying the high prices, and expecting them to remain at these levels for the foreseeable future.

But that is unlikely.

Extrapolation

Traders, as always, have extrapolated the increasing demand and price rise, just like they had extrapolated decline in demand and the low prices. The markets have swung from one extreme to the other within a period of a few months.

The markets for all commodities are highly cyclical with periods of shortages and gluts.

Nassim Nicholas Taleb said “I’ve seen gluts not followed by shortages, but I’ve never seen shortages not followed by gluts”.

Similarly, it is very likely that the high energy prices will incentivise a larger number of enterprises to work on exploration, resulting in moderate prices at some point in the future.

Therefore, an extrapolation of the current scenario is probably not justified.

Operational Troubles

The two largest companies in the space — ONGC and OIL — have seen their oil production decline continually for several years. ONGC alone accounts for more than 50 per cent of the country’s oil production, yet the contribution has been steadily declining each year.

According to a report, ONGC’s contribution to India’s oil output fell from 76 per cent to 59 per cent from 2008 to 2015. According to the annual report, its oil output has more or less remained stagnant in the past few years.

The reason behind the decline is ageing oil-wells that are not as productive as they were earlier. In addition, ONGC has been unable to strike a substantial oil discovery, in the past decade.

Unless it can find some way to grow its production, the stock could suffer. From the country’s perspective, lower domestic production would mean higher dependence on imports from other countries, putting India’s energy security scenario in a tight spot.

In a scenario reminiscent of the red queen effect, the large part of the company’s capital expenditure is spent for just staying in the same place. It has been spending more than 60 per cent of the Rs 25,000 to 30,000 crore in annual capital expenditure to keep its ageing oil wells active.

If it doesn’t do so, it risks an accelerated production decline as the company still derives more than 90 per cent of its production from mature and ageing oilfields. Yet, surprisingly, its reserve replacement ratio has continued to remain above one for more than a decade. A ratio above one implies that it has been adding more reserves than it has been depleting.

The heavy capital expenditure required in converting a reserve into a production block, combined with the uncertainty regarding the crude price and long gestation periods has kept ONGC from expanding aggressively.

In addition, the governmental pressure to pay out dividends and buy out HPCL, has affected its finances adversely.

Despite these issues, ONGC’s Vision 2040 highlights its ambitions to triple its revenues, quadruple its profits, and quintuple its market capitalisation.

Investors should be Cautious

Nevertheless, the entire episode holds an important lesson for investors — all sectors are cyclical and therefore, narratives that extrapolate the current scenario over the long term should not be relied on.

The best time to invest in the energy sector was when the mainstream narrative was extremely negative. Despite having more than doubled, ONGC trades at an earnings ratio of 9 and a dividend yield of 2.2 per cent which is cheaper than the market.

At this point in time, investors are rushing into energy stocks as the mainstream narrative turns positive.

Analysts continue to favour the stock as fuel prices continue rising. However, investors should not throw caution to the wind.

Timing the commodity markets is a difficult task and no one knows when the cycle could turn.

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