oil 2.0 the rise of india’s middle...

OIL 2.0 THE RISE OF INDIA’S MIDDLE CLASS

DUCK CAPITAL MANAGEMENT

Atlanta Hedge Fund Challenge 2012-2013

TABLE OF CONTENTS

Contents

To Our Potential Investors _______________________________________________________________________________ 1

Macroeconomic Market Overview ______________________________________________________________________ 2

Crude Oil around the World _____________________________________________________________________________ 7

India’s Current Oil Situation _____________________________________________________________________________ 9

Energy Subsidy and Price Control within India ______________________________________________________ 12

Indian Fiscal Budget 2013 – 2014_____________________________________________________________________ 15

Investment Thesis ______________________________________________________________________________________ 16

Overview: Alpha Generation _____________________________________________________________________________________ 16

Cairn India_________________________________________________________________________________________________________ 18

Oil and Natural Gas Corporation _________________________________________________________________________________ 21

Essar Oil ___________________________________________________________________________________________________________ 23

Oil E&P Company Comparisons _________________________________________________________________________________ 26

Essar Shipping ____________________________________________________________________________________________________ 27

Great Eastern Shipping ___________________________________________________________________________________________ 30

Risk Analysis – Oil Prices ______________________________________________________________________________ 34

Expectations ______________________________________________________________________________________________________ 34

Back Testing _______________________________________________________________________________________________________ 35

Risk Simulation ___________________________________________________________________________________________________ 36

Risk Analysis – Foreign Exchange _____________________________________________________________________ 38

Expectations ______________________________________________________________________________________________________ 38

Back Testing _______________________________________________________________________________________________________ 39

Risk Simulation ___________________________________________________________________________________________________ 40

Trade Structure _________________________________________________________________________________________ 42

Exit/Entry Strategy and Repeatability ________________________________________________________________ 44

Entry Strategy _____________________________________________________________________________________________________ 44

Exit Strategy _______________________________________________________________________________________________________ 44

Repeatability ______________________________________________________________________________________________________ 44

OIL 2.0: THE RISE OF INDIA’S MIDDLE CLASS

Page 1

To Our Potential Investors

In today’s tremulous world economy, it is quite a challenge to find an investment opportunity

that is original, repeatable and “un-Google-able”. We live in a world where every second is

accounted for and every news story breaks as it happens. This presents quite a unique task in

terms of analyzing data and making tough calls as to what can and will turn a sizeable profit.

When everyone is talking about everything, we must tune out the noise and capture the

harmony.

Duck Capital Management would like to task you with what we call Oil 2.0: The Rise of

India’s Middle Class. Before we proceed with our investment idea, we would like to notify

readers that we are well aware that the oil sector is one of the most talked about commodities

and has been covered by various institutions. However, we challenge you to rethink the oil

strategy, from the view point we have taken, and ultimately realize that from such a saturated

market, comes an idea that leverages this same problem to its advantage. In the same light, it is

not possible to open a reputed newspaper today that is not talking about emerging markets,

India in particular. Using all of this information, the “Google-able” data, we have found an

investment strategy that uses fundamental knowledge, economic analysis, micro/macro

worldviews and a study into what it means to be a part of a rapidly growing economy.

Duck Capital Management

March 7, 2013


Page 2

Macroeconomic Market Overview

India, with its 1.2 billion plus people, has been propelled onto the world stage with expectations

soaring and its economy booming. With 48% of the population between 0 and 24 years, this

young demographic has aspirations and dreams that are being realized through advancements in

infrastructure, education and awareness. These advancements, tied to a hunger for success,

have increased the middle class median income. In August 2010, a report published by the

National Council for Applied Economic Research (NCAER) proved that there was a rise of the

Indian middle class, or households with an annual income of at least $4,000, during the last

decade. In 2001-2002 13.8 million households had incomes in excess of $4,000 per year, by

2009-2010, the number – at constant prices – rose to 46.7 million, representing a population of

about 200 million individuals. During the same period, the proportion of very low income

households – those earning less than $1,000 per annum – has fallen sharply from 65.2 million

in 2001-2002 to 41 million by 2009-2010.

Figure 1: Increase in annual household income within India


Page 3

While the Indian economy grew at stellar figures in the last decade, it is currently cooling down

and finding its place within the turbulent world market. According to the Advanced Estimates

released by the Central Statistical Organization (CSO), the growth in GDP (Gross Domestic

Product) is expected to be between 6.1% and 6.7%. These values are lower than the GDP

growth rate for the last few years (averaged at around 8%). However, the government is on

track to meet its fiscal deficit target of 5.3% of GDP this fiscal year, and to narrow it down to

4.8% of GDP next year.

This rise in the overall income of Indian citizens has changed their consumption baskets. A

research paper titled “What is middle class about the middle class” by Ester Duflo and Abhijit

Banerjee, two professors from the Economics Department at MIT, shows that people who start

earning more also start spending more on luxury products that they could not afford before. The

main fact that makes the middle class what they are is that they have steady, well-paying jobs.

This provides the opportunity to obtain high energy consuming products such as televisions and

personal motor vehicles. India is a free market economy, with barriers of entry within the

consumables sector being very low. This particular characteristic drives prices lower and makes

luxury products more affordable. The preferred vehicle of choice for the middle class Indian is

a two wheeler (economically feasible and easy to ride in dense traffic). Figure 3 shows the

increase in motor vehicle sales between 2002 and 2012. It can be seen that two wheeler

(motorcycle) sales have grown much faster than any other vehicle; this is attributed to a large

increase in the number of people who can afford these products.

Figure 2: Growth rate of GDP (1993-2011)


Page 4

From Ester Duflo and Abhijit Banerjee’s research paper, middle class Indians tend to purchase

products that consume high amounts of energy (petrol, diesel, electricity, etc.) With a large

number of people entering the middle class population, India’s current energy profile will need

to change.

The graph above clearly shows that Oil and Coal are the two largest sources for energy within

the country. We chose to look at the Oil market in particular since the Coal Industry in India is

on a serious decline due to environmental regulation and government pressure to reduce the

countries dependence on the commodity. However, in terms of Oil, the country is as dependent

as every on the commodity, and this dependence is steadily rising.

Figure 3: Demand for motor vehicles in India (2002-2012)

Figure 4: Total Energy Consumption in India by type (2009)


Page 5

As Figure 5 shows, India has a large deficit in domestic oil production. For the last decade, the

rate of production has remained constant, while consumption has been increasing rapidly.

Currently, domestic oil is primarily extracted from the Mumbai High (west coast of India).

Recent oil discoveries on-shore has moved some of the domestic production towards the

mainland. India is the 4th largest consumer of oil products, but it is the 24th largest producer.

The task of reducing this large gap falls into the hands of the Indian government.

The government has two options in regards to filling in this gap between oil consumption and

production: increased domestic production or increased oil imports. The two cases are

discussed below.

Increased Domestic Production

India currently has 5.62 billion barrels of oil reserves as per EIA (U.S Energy Information

Administration) estimates for 2009. The oil reserves in the Mumbai High meet 25% of the

country’s demand. There are considerable underdeveloped resources located in the offshore

Bay of Bengal and in the state of Rajasthan. In 2010, India produced an average of about 33.69

million metric tons of crude oil as on April 2010 or 877 thousand barrels per day as per EIA

estimate of 2009.

India’s oil sector is dominated by state-owned enterprises, although the government has taken

steps in past recent years to deregulate the hydrocarbons industry and support greater foreign

involvement. India’s state-owned Oil and Natural Gas Corporation is the largest oil company.

ONGC is the leading player in India’s upstream sector, accounting for roughly 75% of the

country’s oil output during 2006, as per Indian government estimates.

As a net importer of all oil, the Indian government has introduced policies aimed at growing

domestic oil production and oil exploration activities. As part of the effort, the Ministry of

Figure 5: India's Oil Production and Consumption (1990-2009)


Page 6

Petroleum and Natural Gas crafted the New Exploration License Policy (NELP) in 2000, which

permits foreign companies to hold 100% equity possession in oil and natural gas projects.

However, to date, only a handful of oil fields are controlled by foreign firms. India’s

downstream sector is also dominated by state-owned entities, though private companies have

enlarged their market share in past recent years.

Increased Oil Imports

With the Indian government striving to reduce the fiscal deficit, there is a lot of pressure to

reduce the import of oil into the country. However, the demand for energy has put enough

pressure upon the government to increase its imports of crude oil (since domestic production

cannot meet the demand), particularly from OPEC (Organization of the Petroleum Exporting

Countries) nations. Figure 6 shows India’s oil import distribution. Notice the constant rise in

total oil imported.

A more detailed analysis into the type of oil India imports is presented in later sections.

Figure 6: India's Oil Imports from 2001 - 2010


Page 7

Crude Oil around the World

Crude Oil is classified into four broad categories: light, heavy, sweet and sour. The definitions

are as follows:

Table 1: Light vs. Heavy Crude Oil

Light Crude Heavy crude

Low Density Higher density than light crude

Flows freely at room temperature Does not flow as easy as light crude at room temperature

Low viscosity High viscosity

Low specific gravity Higher specific gravity than light crude

High API* gravity due to presence

of a high proportion of light

hydrocarbon fractions

Any liquid petroleum with an API gravity less than 20°

Extra heavy oil is defined with an API gravity below 10°

Low wax content Higher wax content

Higher price Lower price

Used to produce gasoline Used to produce diesel

*API gravity – American Petroleum Institute gravity (standard measure) – it is a measure of

how heavy or light a petroleum liquid is compared to water. If its API gravity is greater than 10,

it is lighter and floats of water; if less than 10, it is heavier and sinks)

Sweet oil is considered “sweet” if it contains less than 0.50% sulfur. In comparison, Sour oil

contains small amounts of hydrogen sulfide and carbon dioxide and it is commonly used for

processing into gasoline, kerosene and high-quality diesel. Before sour crude can be refined

into gasoline, impurities need to be removed, therefore increasing the cost of processing. This

results in a higher-priced gasoline than that made from sweet crude oil. Therefore, sour crude is

usually processed into heavy oil such as diesel and fuel oil rather than gasoline to reduce

processing costs.

The three major oil baskets are as follows:

- West Texas Intermediate (WTI):

o Extremely high quality crude oil which is greatly valued for the fact that it is of

such premium quality, more and better gasoline can be refined from a single

barrel than from most other types of oil available on the market

o With an API gravity of 39.6° and only 0.25% sulfur makes it a “light”, “sweet”

crude oil


Page 8

o Primarily refined in the United States

- Brent Blend:

o Combination of different oils from 15 fields throughout the Scottish Brent and

Ninian systems located in the North Sea

o With an API gravity of 38.3° and sulfur content of 0.37%, it is a “light”, “sweet”

crude oil, however not as “sweet” as WTI crude

o Mostly refined in Northwest Europe

- OPEC Basket

o It is a collective of 7 different crude oils from Algeria, Saudi Arabia, Indonesia,

Nigeria, Dubai, Venezuela and the Mexican Isthmus

o OPEC: “Organization of Petroleum Exporting Countries”

o Much higher percentage of sulfur within its natural make-up, it is not nearly as

“sweet” as WTI or even Brent Blend. It is not naturally “light” as well

o OPEC oil is consistently lower than either Brent Blend or WTI. However,

OPEC’s willingness or ability to quickly increase production when necessary

makes them a consistent “major player” in the oil industry


Page 9

India’s Current Oil Situation

India domestically produces a “light” and “sweet” crude oil. This oil is better than the OPEC

basket, on par with Brent, but not as good as WTI. Domestic oil only accounts for 17% of the

total oil that is refined in India.

India imports the OPEC basket (high sulfur content). This basket is cheaper than Brent oil (and

the oil produced within India) by around $1 - $2 per barrel, and much cheaper than WTI

(around $3 - $4 per barrel). Refineries in India would rather import OPEC oil since the margins

on this basket are the highest (barring overhead technological costs to refine high sulfur content

oil). Nearly 90% of imports are sour crude. The 20% that is sweet comes from Africa.

India's limited resource base will cause production to remain relatively flat. In the International

Energy Outlook (IEO2011), EIA projects that Indian oil production will grow at an average

annual rate of less than 1% through 2035.

India is a diesel based economy (as opposed to a gasoline based economy like the United

States). In economic terms, diesel demand in India is regarded as inelastic with respect to price

in the short term. This means that its demand does not necessarily decrease with an increase in

price. This is because more than 90% of the diesel in the country is used for intermediate

purposes like transport, which results in the production of further goods and services. Only

about 5% is being used for meeting the ultimate demand of consumers in power generation.

The government is looking to deregulate diesel prices but this most likely will not happen in the

short term. Diesel is best produced from heavy oils (most of which are sour). Since India’s

domestic oil is sweet and light (producing gasoline), the government is left with no choice but

to import heavy crude oil (from OPEC and African nations) to provide the refineries with the

right inputs.

India currently does not import WTI oil, even though it is cheaper to refine. Results from a

study of Oil Refineries showed that the cost to transport WTI oil offsets the gains from cheaper

refining.

Oil within India is indexed using the “Indian Crude Basket”. This index is made up of the

following: 38.60% BFO (North Sea Benchmark), 30.70% DUB-1M (Dubai Benchmark) and

30.70% OMA-1M-A (Oman Benchmark). The government uses this Indian Crude Basket to

price oil products. Figure 7 and 8 show the Indian Crude Basket price compared to WTI, Brent

and OPEC prices. It can be seen that the Indian Crude Basket is consistently cheaper than the

Brent Basket, slightly more expensive (recently) than the OPEC basket and consistently more


Page 10

expensive than WTI. These are spot market prices, the transportation costs of the crudes must

be taken into consideration before assigning a final value. OPEC oil is the easiest to transport

and costs the least, Brent Oil is more expensive to transport than OPEC, but cheaper than WTI.

Due to the great distance between North America and India, WTI costs the most to transport

and this cost makes it unfeasible for use within the Indian bus continent.

Figure 7: Indian Crude Basket compared to WTI, Brent and OPEC prices

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137

May-99 Oct-00 Feb-02 Jun-03 Nov-04 Mar-06 Aug-07 Dec-08 May-10 Sep-11 Jan-13

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Indian Crude Basket

Brent Crude

WTI Crude

OPEC Basket


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Figure 8: Indian Crude Basket Price compared to WTI, Brent and OPEC prices (2009-2012)

India currently produces a higher grade oil than what it imports. Domestic oil produced within

India is not exported. However, the basket of Indian Crude Oil trades at a premium compared to

WTI and at a very slight discount compared to Brent.

Diesel and petrol prices in India are linked to international gas oil and gasoline prices

respectively, but with a ride: the ex-refinery price is to be calculated on a trade parity bases.

The weights given are 80% to import parity (including customs duty, freight, insurance) and

20% to export parity (ex: Singapore free-on-board basis). This was introduced as an incentive

to private refiners who helped the country gain self-sufficiency in refining and stopping petrol

and diesel imports from Singapore

The other two controlled products, LPG and kerosene, do not attract customs duty and are

priced solely on export parity, which is calculated at the first of each month. The other oil

products are freely priced.

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Sep-08 Mar-09 Oct-09 May-10 Nov-10 Jun-11 Dec-11 Jul-12 Jan-13

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Indian Crude Basket

Brent Crude

WTI Crude

OPEC Basket


Page 12

Energy Subsidy and Price Control within India

Data from: ‘A Citizens guide to Energy Subsidies in India’ http://www.iisd.org/gsi/sites/default/files/ffs_india_czguide.pdf

Petrol was deregulated in 2010. However, the prices of diesel, kerosene and LPG continue to be

regulated. In the case of petrol, Oil Manufacturing Companies (OMC’s) can only change the

prices every fortnight, and only after taking permission from the government. Diesel, LPG and

Kerosene are sold at a lower price than the world price. Diesel is priced at around $0.88 per

liter; this puts India within the cheapest 20% of countries for Diesel. The Diesel price in the US

is currently $1.03 per liter. The subsidies provided cover only part of the difference between the

cost price (including marketing cost) and the selling price, there by resulting in “under-

recoveries” for the OMC’s. Under-recoveries are calculated as the difference between the cost

price and the regulated price at which petroleum products are finally sold by the OMC’s to the

retailers after accounting for the subsidy paid by the government.

Figure 9: How under-recoveries are generated

A large part of these under-recoveries are compensated for by additional cash assistance from

the government (over and above the fiscal subsidy), while another portion is covered by

financial assistance from upstream NOC’s (National Oil Companies). The remaining portion

remains uncompensated for OMC’s. The Table below shows these values for the year 2010-

2011.


Page 13

Figure 10: Fiscal Subsidy and Under-recoveries for Kerosene and LPG

The cash assistance to OMC’s are made on an ad hoc basis, i.e., after the under-recoveries have

been incurred. The payments are made at the end of each quarter. Therefore, OMC’s often face

a shortage of investible funds in the short term. In case of these shortages, companies have to

take additional loans to finance their investments.

Figure 11: Compensation for under-recoveries by government and upstream companies from 2008 - 2011


Page 14

Figure 12: Subsidized Diesel pricing


Page 15

Indian Fiscal Budget 2013 – 2014

Budget 2013 released on 28th February 2013 by Finance Minister P. Chidambaram offers a

“realistic” plan to meet India’s fiscal deficit target. The main highlights of the budget that affect

our investment thesis are as follows:

- Shipbuilding is being exempted from excise duty, with resultant removal of

countervailing duties on import of ships: this is a positive for the Indian shipping

industry

- The proposed support for various infrastructure industries such as power etc. will be a

positive for the Shipping industry, given the growing need for import of coal

- The focus on Policy formulation in the oil & gas sector, together with the emphasis on

NELP (New Exploration Licensing Policy) blocks development, will be a positive for

the oilfields services business

- The increase in surcharge on corporate tax from 5% to 10% will have an adverse impact

- There will be a decrease in fuel prices in the fuel subsidy bill

- Only China and Indonesia will grow faster than India

- Strong emphasis on FDI

- Main worry is the current account deficit as exports slow down. Oil, coal and the

passion for gold weigh on imports, resulting in a higher current account deficit.


Page 16

Investment Thesis

OVERVIEW: ALPHA GENERATION

We expect the demand for oil in India to increase more than expected. Currently, various

organizations estimate oil demand increase by looking at the rising middle class. However,

many organizations fail to realize that a rising middle class also pushes the upper-middle class

and upper class to consume higher baskets. With renewable source of energy still being largely

unavailable within India, the upper-middle and upper class Indians will purchase high energy

consumption products (such as SUV’s). We believe that this demand will be catered to through

an increase in domestic oil production as well as an increase in the import of crude oil.

India imports heavy crude oil since it is a diesel based economy. The crude oil produced

domestically is light and sweet. Light and sweet oils are refined to primarily produce gasoline

and other useful by-products. Since India’s economy is so heavily dependent on diesel fuel, the

domestic production (light and sweet) is not as important as the heavy oil imports. Heavy oils

are refined to obtain diesel. While the transportation industry is a major consumer of diesel

fuel, there are various other entities that are dependent on this heavy oil product; Shopping

malls, offices, housing complexes, mobile towers and farmers who use diesel pumps for

irrigation are major consumers of the fuel.

We forecast that India’s onshore refining capabilities will continue to be the largest in the world

and may eventually cater to an increase in exporting refined oil products. India currently has

the largest refining capacity (per day) in the world. The largest refinery in the world is also

based in India. With the country heavily dependent on heavy crude oil imports, the refineries

themselves are technologically advanced enough to handle the more rigorous refining process

for heavy crude oil. Considering all of this, we expect India to become an exporter of refined

oil products in the near future.

The main thread that ties in all or our investment ideas is the Indian shipping industry. We

expect a steady growth within the shipping industry in terms of energy imports and exports.

With our forecast of oil imports increasing, and India moving towards becoming a refined oil

product exporter, we believe that the shipping industry will grow to meet the demand.


Page 17

Country specific factors to consider:

- A typical financial year extends from March 31st to March 31st, implying that Q1

begins on April 1st and ends on June 31st

- Current Exchange rate (March 6th, 2013): Rs.54.78 = $1

- Risk Free Rate:

Figure 13: Risk Free Rate

Considering all the above points, our portfolio will be comprised of the following companies.


Page 18

CAIRN INDIA

NSE: CAIRN | Market Cap: $10.19B

Our team recommends a long position in Cairn India. The company is India’s leading

Exploration and Production player and has established a strong presence in the field over the

last 15 years. It was founded as a subsidiary of Cairn Energy PLC, a UK based Energy

Company that has since sold substantial stake to Vedanta Resources PLC (UK).

The company owns majority stake in The Rajasthan Oil Block, which contains India’s largest

proven onshore oil reserve. The Block currently produces 175,000 Barrels per day (BPD) worth

of oil; however the company expects this production to ramp up to 300,000 in the near future.

At current rates, that will equal to 40% of India’s total domestic production. The following

graph shows how significant the company’s impact has been to the industry.

Figure 14: Cairn India's effect on the Indian Oil Market

We see that there is strong divergence in the graph in the year 2010: the year the company

ramped up production in the Rajasthan oil fields. This upward trend is bound to escalate before

stabilizing since the oil fields have potential for more exploration. The demand will increase in

absolute numbers and the Government will prefer domestic exploration given the impact it has

on savings, leading us to believe that company is on the crossroads of increased profits.


Page 19

Table 2: Cairn India Financial Highlights

Cairn India (Million USD) 2013 (Expected) 2012 2011

Revenue $3,198.51 $2,165.14 $1,876.22

EBITDA $2,368.85 $1,597.69 $1,312.57

Net Income $2,286.33 $1,449.02 $1,156.33

In the year 2013, the company expects to invest close to $1 billion in capital in the Rajasthan

oil fields, in addition to the $2.4 billion it has already spent. We feel that a strong cash position

(Net $1.54 billion) and a clean balance sheet put the company in a great position to pursue

development strategies.

Figure 15: Financial and Asset Highlights

The company has been aggressively expanding its footprint, holding minor stakes in other large

oil projects summarized in Table 3 (next page).


Page 20

Table 3: Aggressively expanding footprint

Oil Block Cairn

Stake

Oil Production (Million bpd) Gas Production (Million

Standard Cubic Feet)

Rajasthan Oil Block 70% 175,000 Expected in 2013

Ravva 22.50% 27,165 55

CB/OS-2 40% 5,204 18

Sri Lanka Oil Field 100% Phase 2 Exploration

South Africa Gas Block 60% Phase 1 Exploration

This data shows that the company’s most significant asset is the Rajasthan oil block but it has

been aggressively expanding its portfolio while steadily increasing the output from all oil

blocks. Another prominent asset the company is developing is the Mangala pipeline that has a

domestic refinery penetration of 75% giving the country’s infrastructure a much needed boost.

Correlation to oil and currency movement

Table 4: Correlations

Risk Correlation (12 month)

Oil Price 0.505

USD/INR Exchange Rate 0.477


Page 21

OIL AND NATURAL GAS CORPORATION

NSE: ONGC | Market Cap: $50B

Our team recommends a long position in ONGC. With a market capitalization of $50 billion, it

is one of India’s largest Energy Company. It is a Public Sector Undertaking (PSU), which

means that the Government has a majority stake in the company giving it strong political

backing. This backing goes a long way in protecting foreign oil interests that the government

intends to procure to secure the country’s long term energy demand. The company currently

supplies greater than 70% of the country’s crude oil and 80% of the natural gas.

Below is an abridged financial summary of the company:

Table 5: Consolidated Financial Summary

ONGC (Million USD) 2013 E 2012 2011

Revenue $ 14,821.10 $ 14,035.62 $ 12,531.73

EBITDA $ 7,588.54 $ 7,490.45 $ 6,447.28

Net Income $ 4,304.31 $ 4,586.14 $ 3,454.55

There is a steady increase in revenue expected in the year 2013. However, the net income is

expected to decline since the company received a one-time royalty fee (amounting to

approximately $300M) from Cairn India in 2012 that was added to the books. Removing

exceptional items, there are strong and growing top and bottom lines. The company added

242.5 million tons oil equivalent (MTOE) in oil and gas reserves during the 2012 financial year.

This includes 84.13 (MTOE) in in-place reserves. This gives the company a reserve

replacement ratio of 1.79, making 2012 the 7th consecutive year with the ratio being above 1.

The organizational structure of the company is shown in the following figure.


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Figure 16: Organizational Structure

ONGC’s International Subsidiary, ONGC Videsh Limited owns assets of approximately $12

billion, with E&P activities in Sudan, South Sudan, Syria, Venezuela, Brazil, Nigeria-Sao

Tome, Columbia, West Siberia and Myanmar. Its domestic refinery operations are mainly joint

ventures with different domestic and foreign companies. It also owns a 30% stake in the Cairn

operated Rajasthan Oil Block.

Therefore, this oil monolith has been aggressively expanding its global and domestic oil

footprint. It has a stake in most domestic production projects and has played a part in the

development of many international projects as well.The company has able management, good

political backing and a good executable strategy for the future that will play a large role in the

satisfying the country’s demand.




Oil Price -0.084

USD/INR Exchange Rate 0.237


Page 23

ESSAR OIL

NSE: ESSAROIL | Market Cap: $ 2.1B

Our team recommends a long position in Essar Oil. It is a uniquely positioned company when

compared to other competitors since its portfolio encompasses both the Upstream and

Downstream sectors.

The figure below shows the operations breakdown of the company:

Figure 17: Essar Oil Structure

The company has a refining capacity of 750,000 barrels per day, which it has been expanding

aggressively over the last three years. This aligns well with the Government of India’s vision to

make India a global refining hub, filtering crude oil for other resource constrained countries.

The company’s oil marketing operations have created a large land bank for it. It expects a

relaxation of retail gasoline price regulation and a more “level playing field” for private

Essar Oil

Exploration

8 Oil and Gas blocks with 100% Ownership

1.7 Billion Barrels of Oil Equivalient

2700 sq. Km of land in India

Refining

Total Capacity: 750,000 BPD

Stakes in three refineries: Vadinar

(India), Stanlow (UK) and KPR (Kenya)

10% of India's total refining capabilities

Marketing

1400+ retail outlets providing Non-Fuel

Retail

Agreements with Public Sector Oil

Marketing Companies


Page 24

competitors. In the meantime, it has started to focus on Non-Fuel Retail, building a better

customer service experience on the road network.

Financial highlights of the company are summarized in the following figures.

Figure 18: Financial Highlights

Table 7: Summary of Income Statement (in million $)

Essar Oil (Million USD) 2013

(Expected)

2012 2011

Revenue $1,641.00 $1,065.00 $859.00

EBITDA $53.00 $38.00 $51.00

Net Income $(23.00) $(23.00) $(5.00)

The figures above show the operation of the company from the 2010 financial year to the first

half of the 2013 financial year. We can see that the top line has been steadily increasing. The

reduction in EBITDA is due to planned downtime for expansion of refinery operations and

increase in oil prices. The average margin per barrel (CP GRM) fell from $4.53 to in 2011 to

$4.23 in 2012. The company has stated that this margin will increase as the cost efficiency of

the refinery increases. This increase can already be seen from the CP GRM graph. This goes to


Page 25

show that lower oil prices are beneficial for the company. However, higher oil prices justify

increase in capital expenditure in Exploration and Production, a sector where the company has

been steadily acquiring assets. The company is also expected to pay higher sales tax as an

exceptional item in the 2013 FY, greatly impacting its profits in the short term.

The expansion phase the company has been through has placed a large debt burden ($2.27

billion) on it. However, with assets in place, the annual report states that “the focus will now

move to ensuring that all assets operate in line with the expectations, and we start to deliver the

promised cash flows and profitability which will be utilized to de-leverage our balance sheet

and maximize the shareholder’s value.”

The company’s future operations look bright, considering that its integrated operations, good

management and large asset base place it on the brink of profitability.




Oil Price -0.209

USD/INR Exchange Rate -0.299


Page 26

OIL E&P COMPANY COMPARISONS

This is a good break point to compare the Oil E&P companies of the world to our portfolio’s

picks. The figure below shows the Price to Book and Price to Earnings valuations comparison

for the top oil E&P companies of the world.

Figure 19: P/B and P/E ratio comparisons

The above graph shows that our companies are fairly valued in comparison to their major

international counterparts. Cairn India, ONGC and Essar Oil have trailing P/E’s that are lower

than the industry average. Reliance, one of India’s biggest companies trades at the industry

average. Chevron and Exxon, two large international oil E&P companies, trade at valuations

similar to their Indian counterparts.

This analysis give provides confidence into the current valuation of our portfolio picks.


Page 27

ESSAR SHIPPING

NSE: ESSARSHPNG | Market Cap: $90M

Our team recommends a long position in Essar Shipping. Essar Shipping is an integrated

logistics solutions provider with investments in logistics services, sea transportation and oilfield

drilling services.

Figure 20: Company Overview

Essar Shipping is a subsidiary of a stable and diversified conglomerate: Essar Group.

Key Operational Highlights

- Awarded the first runner-up at Gujarat Star Awards in the category “Shipping Line of

the Year – Coastal Operator”

- Successful induction of four STX mini-capes for Essar Group Cargo

- Successful execution of SAIL (Steel Authority of India Ltd.) & Baosteel CoA (Contract

of Affreightment) under current difficult market conditions


Page 28

- Sale of 1983 built ships MV Govind Prasad and MV Mahavir Prasad during the

previous quarter (ending 20th September 2012) thereby reducing the average age of the

fleet to 13.5 years

- Efficient completion of planned Dry Docking of MV Kiran, MV Chandi Prasad & MV

Tuhina within budgets

- The semi-submersible rig Essar Wildcat continues to perform well with ConocoPhillips

in Indonesia. The rig flared two wells during the previous quarter (ending 20th

September 2012)

- Successfully completed 3 years of LTI (Lost Time Injury) free operations on the Essar

Wildcat rig

Risks

Spot markets continue to be volatile, VLCC day rates have started picking up. Essar Shipping is

hedged against spot markets volatility through time charters and CoAs (Contract of

Affreightment).

Financial Performance

Figure 21: Financial Performance in INR (‘Crore)


Page 29

Trailing P/E of 12.06 comparative to an Industry P/E of 11.77.

Essar Shipping demerged from the Essar Group in November 2011. Since then Essar Shipping

has operated independently and was listed on the National Stock Exchange of India.




Oil Price 0.143


Due to long term contracts, there only slight correlation between the stock price performance

and market movements.


Page 30

GREAT EASTERN SHIPPING

NSE: GESHIP | Market Cap: $650M

Our team recommends a long position in Great Easting Shipping. GE Shipping is India’s

largest private sector shipping company. The company has two main businesses: shipping and

offshore E&P. The shipping business is involved in transportation of crude oil, petroleum

products, gas and dry bulk commodities. The offshore business services oil companies in

carrying out offshore exploration and production activities, through its subsidiary Greatship

(India) Limited.

The shipping business operates under two main businesses: dry bulk carriers and tankers. A

sizable part of the tankers enjoy approvals from oil giants like Shell, BP, ExxonMobil, Chevron

Texaco and Totalfina.

Figure 22: GE Shipping Fleet

Key Operational Highlights

- GE Shipping has a committed Capital Expenditure (Offshore Business) of around

$210M. In 2013, GE Shipping will acquire 1 ROV Support Vessel and 1 Jackup Rig.

- The shipping fleet has grown 12.5% from 2012 till date


Page 31

- Recognized that demand is shifting towards modern vessels, especially as safety

becomes a major concern for oil companies: Company has adopted technologically

advanced upgrades to meet this new demand

Risks

Slowdown of demand for Oil Tankers in the United States: GE Ship plans on mitigating this

risk by securing long term contracts in India and China as those markets continue to grow.

Similar to Essar Shipping, GE Shipping partakes in long term contracts to mitigate the risk of

spot market volatility. The company maintains low levels of leverage and adequate liquidity at

all points in time. The company also actively hedges the net open FX exposure along with

interest rate liability.

Financial Performance

Figure 23: Income statement highlights in INR (‘Crore)

880.95

441.51

191.84

773.06

292.65

81.2

836.44

336.15

87.46

736.6

323.73

27.31

Revenue EBITDA Net Profit

Q3 FY'13 Q2 FY'13 Q3 FY'12 Q2 FY'12


Page 32

Figure 24: Balance sheet highlights in INR ('Crore)

Figure 25: Cash flow statement highlights in INR (‘Crore)

14407.43

13782.23

14007.55

13455.3

Total Assets

Q3 FY'13 Q2 FY'13 Q3 FY'12 Q2 FY'12

188.36

63.53120.26

372.15

598.08

-62.23

-318.41

217.44

263.4

-41.79

-251.25

-29.64

320.97

-192.8 -137.08

-8.91

From operatingactivities

From investingactivities

From financingactivities

Net cashinflow/(outflow)

Q3 FY'13 Q2 FY'13 Q3 FY'12 Q2 FY'12


Page 33

Figure 26: Key financial figures

Trailing P/E of 11.23 compared to Industry P/E of 11.77. Earnings per share increased from

5.33 INR in Q2 FY’13 to 12.6 in Q3 FY’13.




Oil Price -0.535


Due to long term contracts, there only slight correlation between the stock price performance

and market movements.

12.1

1.03

5.21

1.01

5.81

1.111.77

1.04

Return on Equity (%) Gross debt/Equity Ratio (x)

Q3 FY'13 Q2 FY'13 Q3 FY'12 Q2 FY'12


Page 34

Risk Analysis – Oil Prices

Given a portfolio consisting of assets with heavy connections to the oil industry, it is important

to consider the risks of oil price movements and its effects on the overall return of the portfolio.

EXPECTATIONS

The United States Energy Information Association expects oil prices to decline slowly over the

next three years due to increases in alternative energy and shale oil drilling. The EIA forecasts a

2013 average price of Brent Oil of $109 per barrel and a 2014 average price of $101 per barrel.

At the time of this writing, Brent Oil trades around $113 per barrel.

Figure 27: Crude oil implied volatility

Figure 27 shows the implied volatility of front month oil contracts. Given the high volatility

associated with oil, we want to ensure that our portfolio is hedged and robust to short and long

term oil price movements.

We estimate that oil prices will drop between 2% and 5% per year. Our portfolio is hedged

against changes in oil prices by shorting USO, an ETF that tracks WTI oil prices in the United

States, by 18.75% of the portfolio value. We chose this amount to minimize correlation of our

portfolio over the past six months to oil price movements.


Page 35

BACK TESTING

Figure 28 Figure 29

Historical back test – Figure 28 and Figure 29 show portfolio performance against the last six

and twelve month oil prices.

Figure 30 Figure 31

Lagged back test – Figure 30 and Figure 31 show portfolio performance using oil prices for the

period from Feb 24th 2011 to Feb 23rd 2012, with all other prices remaining at their 2012-2013

levels.


Page 36

Figure 32 Figure 33

Lagged back test – Figure 32 and Figure 33 show portfolio performance using oil prices for the

period from Feb 2010 to Feb 2011, with all other prices remaining at their 2012-2013 levels.

RISK SIMULATION

As mentioned above, our portfolio allocations and oil hedge were chosen to minimize exposure

to the oil price movements. Our current portfolio has a negative 2.6% correlation to USO over

the last six months and a negative 15.7% correlation over the last twelve months.

Figure 34 Figure 35


Page 37

Figure 34 and Figure 35 depict a situation in which the oil prices increase 35% in one day in

September of 2012. Prices for our companies were recalculated and forecasted based on their

correlations to the oil price movements over the last twelve months.

Figure 36 Figure 37

Figure 36 and Figure 37 show the reciprocal case where oil prices drop by 35% in a single day.

As above, prices for our companies were recalculated and forecasted based on their individual

correlations to oil price movements over the last twelve months.

In summary, our portfolio is hedged well against oil prices in order to be robust against the high

volatility present in the spot market for oil.


Page 38

Risk Analysis – Foreign Exchange

Given an international basket of securities, it is imperative to consider the risks of currency

exchange and the effects on the overall return of the portfolio.

EXPECTATIONS

Two common metrics for currency forecasts are inflation estimates and Federal Budget deficit

estimates. Typical inflation in the United States is between 3% and 5%. Inflation in India is

usually much higher at around 7% to 10% annually. The differences in inflation suggest that the

Rupee will devalue about 5% to 6% relative to the US Dollar.

The Federal Deficit as a percent of GDP in the United States in 2012 was 7.3% while in India it

was 5.1%. A currency estimation based on this information would predict the Rupee to gain

value relative to the Dollar.

The three-year implied volatility of the Rupee is 7.70% annually.

We estimate that the Rupee will devalue against the dollar between 0% and 3% per year. Our

portfolio is hedged against changes in the Rupee by shorting Rupee futures using 25% of the

portfolio. We chose this amount to minimize correlation of our Portfolio over the past six

months to the Rupee.


Page 39

BACK TESTING

Figure 38 Figure 39

Historic back test – Figure 38 and Figure 39 show portfolio performance against the last 6 and

12 months Rupee exchange rate.

Figure 40 Figure 41

Lagged back test – Figure 40 and Figure 41 show portfolio performance using the Rupee

exchange rate for the period from Feb 2011 to Feb 2012, with all other prices remaining at their

2012-2013 levels.


Page 40

Figure 42 Figure 43

Lagged back test – Figure 42 and Figure 43 show portfolio performance using the Rupee

exchange rate for the period from Feb 2010 to Feb 2011, with all other prices remaining at their

2012-2013 levels.

RISK SIMULATION

As mentioned above, our portfolio allocations and Rupee hedge were chosen to minimize

exposure to the Rupee. Our current portfolio has a negative 1.6% correlation to the USD/INR

over the last six months and a negative 8.8% correlation over the last twelve months.

Figure 44 Figure 45


Page 41

Figure 44 and Figure 45 depict a situation in which the Rupee devalues 35% relative to the

Dollar in one day in September of 2012. Prices for our companies were recalculated and

forecasted based on their correlations to the Rupee over the last twelve months.

Figure 46 Figure 47

Figure 46 and Figure 47 show the reciprocal case where the Rupee gains 35% relative to the

Dollar in a single day. As above, prices for our companies were recalculated and forecasted

based on their individual correlations to Rupee movements over the last twelve months.

In summary, our portfolio is hedged well against the Rupee in order to be robust against

currency movements that may erode other gains in the portfolio.


Page 42

Trade Structure

Our target portfolio was chosen to minimize correlation to the Rupee and to Oil over the last six

months of trading. Furthermore, we want diverse exposure to the full range of the oil industry

in India including E&P, Refining, and Shipping. We are targeting a portfolio valued between

$100,000 and $200,000.

Table 11: Asset Allocation

Asset Allocation

Essar Shipping 16.25 %

Great Eastern Shipping 22.5 %

Essar Oil 40 %

Cairn India 40 %

ONGC 25 %

Rupee Futures - 22.5 %

USO - 18.75 %

Margin Requirements 2.5 %

Total 100 %

Table 11 Notes:

- A negative allocation indicates our plan to short an asset.

- USO is the United States Oil Fund, an ETF that tracks US oil prices.

- Margin Requirements are based on a 5.750 % margin requirement.

Table 12: Portfolio statistics

Long Exposure 143.75%

Short Exposure 41.25%

Gross Exposure 185%

Average historic monthly volatility (portfolio) 5.58%

Average historic monthly volatility (SPY) 3.7%

Largest drawdown (last 12 months) 8.42%


Page 43

Given these results, we predict with 95% confidence that the maximum monthly drawdown for

the next year is 9.15%.

Our portfolio has a six-month correlation to Oil of negative 2.6% and a six-month correlation to

the Rupee of negative 1.6%.

Table 13: Liquidity – Average trading volumes

Equity Daily Average Trading Amount

Cairn India 925M INR ($1.68M)

ONGC 954M INR ($1.74M)

Essar Oil 55M INR ($1M)

GE Shipping 7M INR ($127,000)

Essar Shipping 1.18M INR ($21,500)

Figure 48: Portfolio return over last 12 months (*NSEI – National Stock Exchange of India Index)

-35%

-25%

-15%

-5%

5%

15%

25%

35%

Re

turn

Portfolio

Oil

USDINR

NSEI


Page 44

Exit/Entry Strategy and Repeatability

ENTRY STRATEGY

Analyzing our lagged back tests, we see that the best point to initiate our portfolio would be at

the beginning of the year (around January or February). This can be attributed to the fact that

India’s Fiscal Year runs from April – March: due to this, budgets are generally announced at the

end of February. Analyzing our historic data, we see that our portfolio always stagnates around

January and/or February, before the budget is announced.

With the Government of India trying to reduce the fiscal deficit, increase FDI, implement

forward thinking policies, and expand the energy sector, our portfolio consistently performs

well in the June onward period.

Alternatively, our strategy can be utilized when oil prices are expected to drop due to

macroeconomic effects (example: our current situation). With strong macroeconomic affects

pushing oil prices lower, initiating a position using our portfolio would allow for maximum

gains.

EXIT STRATEGY

As mentioned above, after the fiscal budget is announced, it generally takes a few months for

our portfolio to feel the effects. Selling, or reevaluating our positions around September would

give us maximum gains. We recommend holding this portfolio 12 to 24 months.

REPEATABILITY

Our portfolio performs very well when oil prices are low, and is very robust (does not move

much) when oil prices rise. Considering this with the Government of India’s yearly budget

announcement at the end of February, our entry exit strategy mentioned above can be

implemented to realize gains over a time period.


Page 45

Contact Information

MANAV BHATIA TANVEER CHANDOK RAYMOND DECUIR

Tel 847 337 3066

Email [email protected]

Tel 404 731 7776


Tel 225 287 5360


154 5th Street NW, Atlanta, GA 30313

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