Devangshu Datta: Oil & gas sector worth a short-term trade

Last Updated: Mon, Jan 07, 2013 04:38 hrs

Certain industries are cyclical by nature because supply and demand change drastically over a period of time. Cycles would be of varying lengths. Most commodity-based industries are inherently cyclical, as are shipping and automobiles.

The peak price of a cyclical stock would be four or five multiples the low price. This pattern tends to repeat, which means a well-timed investment into a cyclical stock reaps huge returns.

Another attraction is that every stock in a cyclical sector can multiply at the same time, making for an entire group of multibaggers. The flipside is that a mistimed investment will lose a lot.

A cyclical has to be bought and sold at the right times for the best results; it cannot be held "forever", unless the investor is prepared to live with huge fluctuations. Price movements rarely coincide with the fundamentals, though they overlap. Stock prices tend to bottom out before the business cycle hits its low, and stocks tend to peak before the business cycle peaks. This is because the smart money anticipates a change in trends. This lack of coincidence between price and fundamentals adds to the risk.

Smart policy action and good business practices can smooth out cycles somewhat. But if a business is inherently cyclical, it will always have ups and downs. On the other hand, poor policy action can make things a lot worse.

The Indian oil and gas sector has always been a victim of poor policy, as well as being cyclical in nature. Rigid price controls prevent energy businesses reaping bumper profits when times are good. They have to bear the brunt when times are bad. Most businesses in this area are public sector units, which also suffer from overt government interference with normal management practices.

The exploration and production stocks, Oil and Natural Gas Corporation and Oil India Limited, suffer because they are not allowed to charge international prices for oil and gas. They also explicitly subsidise some downstream losses apart from selling at discounts.

The refiners-cum-marketers such as BPCL, HPCL, IOC, have it worst. The refiners buy the bulk of their feedstock abroad, paying in forex, since India is energy-deficient. They are not allowed to charge market rates for their refined products domestically, nor can they export. While some losses are subsidised by the Centre and by upstream PSUs, some of their losses have to be met from reserves. Over time, this has damaged their balance sheets.

The pricing of refined products is arbitrary, with changes occurring at random times. This is driven by political considerations, rather than fluctuations in international prices, actual refining costs, or domestic supply-demand. The huge subsidy burden is a major contributor to the fiscal deficit. Since 2000, every government has made pious noises about removing the Administered Pricing Mechanism (APM) but nobody has actually possessed the courage to do this.

There are rumours that the APM will be rationalised to some degree, with a regular review of diesel prices and month-by-month hikes. The Rangarajan committee has suggested gas prices be rationalised according to a formula that could approximately double realisations for producers. This is not ideal. But it is a lot better than the current situation.

While producers would gain from this, refiners would gain even more. The PSU stocks in the sector (and Cairn and Reliance Industries) have jumped due to investor hopes that these changes will be implemented. It seems international crude prices have stabilised, which helps refiners even more.

I suspect the government will eventually dilute these measures because of political considerations. But the sector is worth a short-term trade, if you are prepared to watch the news flow and price movements carefully.

If the recommendations are accepted, there will be a genuine turnaround and these stocks could be multibaggers. If the measures are delayed, or diluted, share prices will drop again. At that point of time, the trader could go short by selling the futures of these stocks. It is a high-risk strategy but could yield exceptionally high returns.

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