Sector Analysis – Oil & Gas Industry, 2017

Investment Fund, IIMB

Contents
Introduction: ................................................................................................................................................................................ 3
Recent trends:.............................................................................................................................................................................. 3
Production vs. Consumption:................................................................................................................................................... 3
Price trends: ............................................................................................................................................................................. 4
Crude oil:.............................................................................................................................................................................. 4
Outlook: ............................................................................................................................................................................... 6
Gas prices: ............................................................................................................................................................................ 6
INDIAN SCENARIO: ....................................................................................................................................................................... 7
Facts : ....................................................................................................................................................................................... 8
Oil Mergers: ............................................................................................................................................................................. 8
Impact/Analysis of Oil mergers:........................................................................................................................................... 8
Major Players: .......................................................................................................................................................................... 9
Prospects: .............................................................................................................................................................................. 10
Structure of the Industry:
The petroleum industry, also known as the oil industry or the oil patch, includes exploration, extraction,
transportation and refining of petroleum products. Crude oil is the raw material for many products like plastics,
pharmaceuticals, fertilizers etc. The industry is divided into three:
1) Upstream:
Refers to the exploration, development and production side of the business. The companies in the
upstream sector, bid for oil and gas blocks from governments worldwide and control the rights to
production from these blocks for a fixed period. The governments in return receive a fixed royalty per
barrel of production.
2) Midstream:
The midstream sector involves the transportation and wholesale marketing of petroleum products.
3) Downstream:
The downstream sector is the refining of crude oil and processing and purification of natural gas. The
companies in the downstream sector also engage in retailing of products (i.e., fuels sales to customers,
LPG gas cylinders). Such companies are also known as Oil Marketing Companies (OMC).

Recent trends:
Production vs. Consumption:
Currently the global consumption of crude oil is 98.26 million barrels per day with demand projected to rise in
the future due to decreased prices. The chart below shows the production vs. consumption of liquid fuels.

Of the total world oil production, OPEC nations produce 39.3 million bpd. The OPEC block also holds the largest proven
reserves of oil in the world, with 81.5 percent of the world’s proven reserves, currently in OPEC nations.
The tables below show the largest producers and consumer of Oil and Natural gas worldwide:

Production Consumption
Rank Producer Consumer
(MMbbl) (MMbbl)
1 Russia 11.13 United States 19.60
2 Saudi Arabia 9.996 China 11.30
3 United States 9.62 India 4.159

Production Consumption
Rank Producer Consumer
(bcm) (bcm)
1 United States 750 United States 778
2 Russia 628 Russia 391.5
3 Iran 190 Iran 191.2

MMbbl = Million barrels per day; bcm=Billion cubic meters

Price trends:

Crude oil:
Crude oil prices are determined based on various factors like: place of production, sulphur content etc. The
three most common benchmarks for worldwide trade are:

Brent Blend – Roughly two-thirds of all crude contracts around the world reference Brent Blend, making it the
most widely used marker of all. These days, “Brent” actually refers to oil from four different fields in the North
Sea: Brent, Forties, Oseberg and Ekofisk. Crude from this region is light and sweet, making them ideal for the
refining of diesel fuel, gasoline and other high-demand products.
West Texas Intermediate (WTI) – WTI refers to oil extracted from wells in the U.S. and sent via pipeline to
Cushing, Oklahoma. The fact that supplies are land-locked is one of the drawbacks to West Texas crude – it’s
relatively expensive to ship to certain parts of the globe. The product itself is very light and very sweet, making
it ideal for gasoline refining, in particular. WTI continues to be the main benchmark for oil consumed in the
United States.

Dubai/Oman – This Middle Eastern crude is a useful reference for oil of a slightly lower grade than WTI or Brent.
A “basket” product consisting of crude from Dubai, Oman or Abu Dhabi, it’s somewhat heavier and has higher
sulphur content, putting it in the “sour” category. Dubai/Oman is the main reference for Persian Gulf oil
delivered to the Asian market.

The graph below shows the price trends for Brent crude over the last 10 years:

The graph clearly shows two dips. The first dip in the global prices was due to the global economic recession. The
second dip that started in 2014 was due to an over-production of crude oil. The reasons for the dip in 2014 are
analysed below:

Improved Technology:

Conventionally, Oil is extracted by drilling oil wells deep into earth (onshore and offshore) and then recovering
the oil, from where oil is trapped in large amount beneath a layer of non-permeable rocks. This method is in
use from the times when oil was first extracted. Sometimes, the oil is trapped into rock formations which are
generally not porous and hence, oil is trapped in small pockets which are disconnected along a vast area. Shale
Fracking is used to extract oil from these disconnected pores of shale rocks. The process involves high-pressure
injection of 'fracking fluid' (primarily water, containing sand or other proppants suspended with the aid of
thickening agents) into a wellbore to create cracks in the deep-rock formations through which natural gas,
petroleum, and brine will flow more freely. When the hydraulic pressure is removed from the well, small grains
of hydraulic fracturing proppants (either sand or aluminium oxide) hold the fractures open leading to smoother
flow of oil and gas.

With advancement technologies, shale fracking and extraction of oil by unconventional means (shale oil
through pyrolysis, hydrogenation and thermal dissolution) became economically viable in early 2000’s. For
example, In Saudi Arabia, oil extracted through conventional means break even at $ 10/bbl Brent price whereas
Shale Fracking evens around $ 60/bbl Brent price. High Brent crude oil trading price of around 100$ in June
2014, led to increase in oil extracted through shale and unconventional means and hence, resulted in
oversupply of Oil and gas in the market forcing the crash of crude oil prices in 2015.
Fight for market share:

OPEC countries historically used their production flexibility to keep prices under control. However, the block
decided to go on the offensive to protect their market share. They used their spare capacity to flood the world
market with oil resulting in a severe drop in oil prices. OPEC continues to hold significant spare production
capacity (which can be used to control prices and influence shale production) as seen from the table below:

Outlook:
Sustained low oil prices are not financially viable for many oil dependant governments worldwide. Thus, OPEC
and its allies agreed to cut production in steps to maintain crude prices. This has been quite successful as seen
from the sharp rally in prices in the second half of the year. This has also been aided by the geo-political
scenario. The key events to watch out for are:
1) The political situation in Saudi Arabia where, the government has arrested multiple influential people
under the guise of an anti-corruption drive.
2) The war in Yemen which has been worsening with spill-over effects in Saudi Arabia. Two missiles
launched by Iran backed rebels and targeting the Saudi capital were successfully intercepted.
3) The political isolation of Qatar by a Saudi led group of countries is threatening to upset the balance in
the world gas market with Qatar deciding to expand production by 30%. This could lead to more
countries in the OPEC block breaking away from production commitments.
4) The recent defeat of ISIS allows for more stable oil production from Iraq and Syria.

Gas prices:
Natural Gas prices continue to be under pressure due to a supply glut in the world market. This is likely to
increase due to a large amount of supply coming online this year. The outlook also does not paint a bright
picture primarily because of large discoveries in the recent past. A good of example of this is the Zohr Gas Field,
off the coast of Egypt. This is one of the world’s largest discovered gas fields ( USD 30 trillion cubic feet of
reserves ) and production is expected to commence by the end of this year.
The table below shows the variation in gas prices:

INDIAN SCENARIO:
Oil and gas sector (Energy) is one of the six core sectors of Indian economy. India consumes around 4.15
MMbbl/day and produces around 0.85 MMbbl/day, importing the rest (mainly from Saudi Arabia). Among the
key petroleum products, diesel and petrol are deregulated. Kerosene and LPG still operate under regulated
pricing regime.

Demand: Demand for petroleum products is line with economic growth. In current market scenario, oil is
oversupplied while demand is relatively muted due to slowdown in global economy.

Supply: Upstream: Indian domestic players cater 20-25% of total domestic demand for crude oil. Domestic gas
supplies are on decline and imports of gas are increasing. Downstream: Refining and petroleum product sector is
witnessing significant capacity addition.

Barriers to entry: Govt. permission is required to start operations in upstream sector. Exploration, development
and production cost of oil fields are significant. Requirement of highly skill workforce and poor success of
exploration (10% commercially viable) leads to higher entry barriers.

Bargaining power (suppliers): Crude prices are globally determined and are highly susceptible to geopolitical
events, economic growth, policies and demand factors. Since, the domestic players cater to only about 20%-25%
of the requirement, India can be considered as a price taker. India has surplus capacity in the petroleum product
segment and hence, the bargaining power is low.

Bargaining power (customers): Even though oil prices has crashed, price of petroleum products in India have not
declined by the same extent due to govt.’s interference in controlling the price through in excise duties etc.
Bargaining power of customers is not very strong as PSU’s control most of the market. This scenario might
change as private players start to gain a higher share in the market.
Competition: Upstream: GOI has enacted various policies (new exploration licensing policy [NELP], coal bed
policy methane [CBM]) to encourage investments and competition across the industry's value chain. However,
in the current scenario, companies may hesitate in making fresh investments in exploration. Downstream:
Companies are upgrading refineries and adding capacities which is likely to lead to more competition. With new
reforms announced in energy and power sector, more players are likely to enter oil and gas sector. Hence,
increase in competition is expected.

Facts :
 Total Oil and gas production stood at 68 million tonnes of oil equivalent for FY2061 -2017. ( 20% drop
when compared to the previous year)
 Domestic refinery capacity as on April 2017 stood at 230 MMT.

Oil Mergers:
In Budget for 2017-18, Finance Minister, Mr. Arun Jaitley talked about creating an integrated oil behemoth that
can compete with global markets.

HPCL and ONGC merger approved:

The board of state-owned Oil and Natural Gas Corp (ONGC) gave 'in-principle' approval to acquire government's
51.11 per cent stake in Hindustan Petroleum Corp Ltd (HPCL) on 21st August, 2017. Prior to the merger, HPCL is
likely to take over Mangalore Refinery and Petrochemicals Ltd (MRPL) to bring all the refining assets of ONGC
under one unit. ONGC currently owns 71.63 per cent of MRPL while HPCL has 16.96 per cent stake in it. HPCL will
become a subsidiary of ONGC and will remain a listed company post the acquisition, the source said adding the
board of the refining and marketing company will continue to remain in place. HPCL which is a downstream oil
refining and fuel marketing company, will become a subsidiary of ONGC and will remain a listed company post
the acquisition, the source said adding the board of the refining and marketing company will continue to remain
in place. The government has also constituted a committee -- headed by Finance Minister Arun Jaitley and
comprising oil minister Dharmendra Pradhan and road minister Nitin Gadkari to work out the modalities of the
sale. HPCL will add 23.8 million tonnes of annual oil refining capacity to ONGC's portfolio, making it the third-
largest refiner in the country after IOC and Reliance Industries.

Caution:
Moody’s has cautioned that the ratings for ONGC will be reviewed post the merger because of the increased
debt on its Balance Sheet.

Status of the other mergers:

The merger between Indian Oil Corporation and Oil India Ltd. Is currently on hold to allow ONGC to dis-invest its
stake in IOCL and allow the Government to offload 3% of its holding in IOCL to achieve its dis-investment target.
Hence, the M&A is expected to proceed only when the ONGC-HPCL merger is complete.

Impact/Analysis of PSU mergers:

Below are the main reasons why the deal is important for the country:

1. Mergers and consolidation of state-owned companies are the only way to create an oil giant. HPCL-ONGC deal
is the first step towards that goal. It will pave way for further consolidation. The government might ask IOCL to
acquire the smaller Oil India.

2. State-run oil PSUs consolidated into a single major company will create economies of scale and have higher
capacity to bear risks, improved margin and more efficiency
3. Consolidation in oil sector is a globally acknowledged practice. International oil giants such as ExxonMobil and
Royal Dutch Shell too have consolidated exploration, refining and retail operations. HPCL is a refining company
while ONGC is an oil explorer. Consolidation of different operations will give ONGC control over value chain
leading to strengthening of balance sheets.

4. A bigger Indian oil company will be able to better withstand the volatility in the global oil market.

5. The domestic companies are increasingly scouting for overseas assets in a bid to protect themselves from
volatility in crude prices. A bigger company will have better bargaining power.

6. The HPCL-ONGC deal will help the government meet more than a third of its divestment target for the current
financial year without losing control over the company. The disinvestment target is of Rs 72,500 crore and the
deal is valued at nearly Rs 28,000 crore.

Private Sector M&A:

Cairn India Ltd. was merged with its parent company Vedanta in April,2017. This deal was expected to give debt
laden Vedanta access to INR 23,300 crore cash reserves of Cairn India.

Russian oil giant Rosneft acquired Essar Oil Limited for USD 13 billion. This deal is the largest FDI inflow in India
and is expected to reduce a substantial portion of the debts of the Essar group.

Major Players:

ONGC: (Upstream): It is an Indian multinational oil and gas company headquartered in Dehradun, Uttarakhand,
India. ONGC was founded on 14 August 1956 by Government of India, which currently holds a 68.94% equity
stake. It is a Public Sector Undertaking (PSU) of the Government of India, under the administrative control of the
Ministry of Petroleum and Natural Gas. It is India's largest oil and gas exploration and production company. It
produces around 77% of India's crude oil (equivalent to around 30% of the country's total demand) and around
62% of its natural gas. ONGC videsh operates in 17 countries worldwide.

The current focus area for ONGC is gas production and the company is heavily invested in the development of
KG basin block of the coast of Andhra Pradesh with a proposed investment plan of INR 78000 crores. Though the
oil prices are low the company has managed to continue exploration by renegotiating contacts with vendors.
Because of this renegotiation, the company expects a 40% dip in the drilling price.

BPCL: (Downstream): Bharat Petroleum Corporation Limited is an Indian state-controlled oil and gas company
(55% stake) headquartered in Mumbai, Maharashtra. The Corporation operates two large refineries of the
country located at Mumbai and Kochi. It has capacity of refining 31.5 million metric tonnes per year.

HPCL: (Downstream): Hindustan Petroleum Corporation Ltd. is an Indian state-owned oil and natural gas
company with its headquarters at Mumbai, Maharashtra. It has about 25% marketing share in India among PSUs
and a strong marketing infrastructure. The Government of India owns 51.11% shares in HPCL. HPCL operates
two major refineries producing a wide variety of petroleum fuels & specialties, one in Mumbai (West Coast) of
6.5 Million Metric Tonnes Per Annum (MMTPA) capacity and the other in Visakhapatnam, (East Coast) with a
capacity of 8.3 MMTPA.

IOC: (Downstream): Indian Oil Corporation is India’s flagship national oil company and is the leading Indian
Corporate in Fortune’s prestigious ‘Global 500’ listing of world’s largest corporates at 161st position for the year
2016. Indian Oil accounts for nearly half of India's petroleum products market share, 35% national refining
capacity and 71% downstream sector pipelines through capacity. The Indian Oil Group owns and operates 11 of
India's 23 refineries with a combined refining capacity of 80.7 MMTPA.
Reliance Industries: Reliance Industries Limited (RIL) is an Indian conglomerate holding company headquartered
in Mumbai. Reliance owns businesses across India engaged in energy, petrochemicals, textiles, natural
resources, retail and telecommunications. Reliance is the second most profitable company in India, the second-
largest publicly traded company in India by market capitalization and the second largest company in India as
measured by revenue after the government-controlled Indian Oil Corporation. In oil and gas business, they have
upstream components like gas fields in KG-D6 (Krishna Godavari basins) and shale holdings in the US. Concerning
downstream, they own the largest refinery by throughput in the world in Jamnagar, Gujrat which can process 0.6
million bbl in a day, the total throughput of BPCL or HPCL!

In terms of profitability and revenues, the company has one of the highest GRMs (Gross Refining Margins) in the
world. The latest GRM for RIL is USD 11.5 / barrel.

Cairn India (currently merged with Vedanta): Cairn India is an oil and gas exploration and production company,
headquartered in Gurgaon, India. It is a subsidiary of Vedanta Resources and is one of the largest independent
oil and gas exploration and production companies in India. Cairn and its JV partners’ account for more than a
fifth of India’s domestic crude oil production. It has been operating in India for more than fifteen years. Cairn
India’s producing assets are in Rajasthan, Cambay and Ravva. Cairn India has a portfolio of nine blocks, that it
operates, which are in four strategically focused areas: one in Rajasthan; two on the west coast of India; five on
the east coast of India (including one in offshore Sri Lanka) and one in offshore South Africa.

Key financials for FY ending Mar 2017 (standalone results):

As of Mar, 2017 ONGC IOCL HPCL BPCL RIL

Revenue (in Cr.) 77907 438709 213488 241047 265041
Profit Margin 23.03% 5.30% 3.31% 3.92% 12.98%
GRM (USD/bbl) N/A 7.77 6.20 5.3 11.5

Prospects:
 After being a victim of regressive policies such as regulated price regime for Petroleum products, the oil
and gas sector has seen some relief on this front with moves such as deregulation of diesel, direct
benefit transfer, etc.
 Decline in the crude oil price has helped in reducing the import bill and under recoveries. As such,
subsidy burden of upstream companies has come down. More importantly, the working capital situation
has improved for oil marketing companies leading to lower debt.
 The sector is quite vulnerable to global threats like slowdown in the US/ Europe/China, tensions
between Iran and US region, Removal of exports restriction on Iran etc. Going forward, higher domestic
production, regulatory reforms across the value chain and pipeline, refining and gas infrastructure will
be the driving factors for the sector.
 Bharat Stage 6 emission norms is expected to have great impacts on the revenue of oil and gas
companies as refining companies need to upgrade their infrastructure by 2020 to be compliant with the
norms
 India has one of the largest gas hydrate reserves in the world. Exploration in this area is currently held
up due to lack of technology. Development if this resource will aid in reducing India’s import depedance.