Oil India an E&P company (oil exploration and drilling) which came out with an IPO in 2009. The company is a category – I, miniratna which allows them operational flexibility from the government (atleast on paper). The company operates mainly in the north-east with additional fields in Rajasthan and a few JVs in the foreign markets such as Iran, Sudan and Venezuela.

The company has delivered fairly good results over the last few years. The company has been able to deliver an ROE in excess of 20% from 2003 onwards (the year from which the results are available). If one excludes extra cash on the balance sheet, then the return on capital is in excess of 50%. The company is debt free and has excess cash to the tune of 30% of its market cap.

The company has delivered a topline growth of around 15% per annum for the last 8 years and net profit growth of 24% per annum during the same period. The company had a topline of around 8859 Crs and profit of 2610 Crs in 2010. The company has been able to generate a net margin in excess of 25% and fixed asset turns in the range of 1.7-2. The company operates with low working capital requirement and has also operated with negative working capital for a couple of years.

The company has been able to invest the internally generated cash to acquire new assets (exploration blocks in India and abroad) and thus maintain and grow its oil reserves at a decent rate.

The company has a great balance sheet. It has almost 9000 Crs of excess cash on its balance sheet. This cash can be used by the company acquire oil assets and thus grow the business.

In the oil and gas business, the only way to grow the business is to continuously acquire rights to new oil fields and carry out exploration (read drilling) activities. The nature of the business is such that a few of the exploratory wells will be unsuccessful (no oil or gas), but the successful ones will more than cover for it and more. In addition new technologies such as 3D seismic surveys help the companies in finding attractive places to drill so that the chance of finding oil or gas is higher (and lower the chance of drilling a dry well which is literally a sunk cost).

The company has been able to grow its oil reserves from 33 MMKL to 38.3 MMKL and gas reserves from 29.1 MMKL-OE to 37.9 MMKL-OE in the last 5 years. Higher the oil reserves, higher the oil & gas which can extracted and hence higher the topline and profits.

In addition to the above positives, the company has been able to improve its return on capital by increasing the total asset turns from around 0.95 in 2003 to almost 1.7 in 2010. The company also pays almost 35% of its profits via dividends

So whats not to like in the company? On the face of it the company has great margins, high return on capital, great balance sheet and good growth prospects (India needs more oil and gas).

There is one word for the key risk – Government of India. Currently OIL India shares almost 33% of the fuel subsidy with the rest being borne by the downstream company. If you have been following the news lately, you must noticed that oil recently crossed 100 $ a barrel. The state owned oil companies as a whole are losing money at the rate of almost 1lac crore/ annum (no it’s not a typo).

The India government has two options – raise the price of fuel or pay for the subsidy through the budget. The government may raise fuel prices by a bit, but it is a politically difficult decision. The other option is to take the subsidy on the budget and blow a hole in the deficit. The third option can be a mix of these two options and to get the upstream oil companies to share the loss.

If the downstream companies such as IOC, HPCL are bleeding money, how likely is it that the government will allow the upstream companies like ONGC and OIL to make decent profits? What stops them from increasing the subsidy burden?

The last time oil prices crossed 100$/ barrel (2008), the company was able to maintain the margins and the subsidy burden did not hurt. So we have some level of comfort from the recent history, though the price spike was for a short period. We do not know how the government will react if the oil prices remain elevated for a long period of time.

I currently have no position in the stock. I am not able to evaluate the above risk. It may just be that I am over estimating the risk. At the same time one has to consider the possibility that oil could remain over 120 levels and the government may decide to increase the subsidy sharing, driving down the company’s profits.

If the above risk materializes and every other analyst is screaming a sell on the stock – it may be a good time to buy.

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