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Real companies, unreal pricing

October 08, 2007 11:45 IST

The IT industry dismisses a certain type of announcement as "vapourware". This is a product or application hyped as possessing huge potential. Only, it is due to be launched many months or years later.

Despite the apparently ludicrous nature of "vapourware", it can drive up valuations. Somebody somewhere will buy stock on the news. During the Internet era, many billions were generated and eventually lost through an endless stream of vapourware.

When a lot of people are buying vapourware, it is a signal the market is overheated. During such phases, even rational investors get carried away. Or, they may make a cynical judgment that they will be able to buy high and sell higher.

Something similar appears to be happening right now with two erstwhile sister-concerns that possess far more down-to-earth business profiles than IT. Reliance Petroleum and Reliance Natural Resources are both key players in the energy cycle.

RPL is building a greenfield refinery and polypropylene plant in Jamnagar - this will be the sixth-largest refinery in the world. RNRL is an exploration and distribution play in the natural gas sector. It has recently applied for City Gas Distribution licenses.

Both companies have impeccable management credentials and they are backed by very strong groups. Both have interesting future plans. Neither is really in business yet and there is no way to judge from current financials what the future holds.

RPL's refinery is proceeding according to schedule. It should comfortably meet its target of full production by late 2008. The first full year of production will be 2008-09 as indicated in the IPO.

At that stage, RPL believes the petro-cycle will be good, refiner margins will be high, demand will be strong enough to stretch global refining capacity. RPL will be among the cheapest and most flexible of refineries and hence, have the best industry margins. Given the group focus on backwards integration into exploration & production as well as forward integration into petro-retail, it will be well-insulated from shocks.

RNRL's business prospects are less certain though potentially as lucrative. It will presumably get its CGD licenses. Maybe the coal-bed-methane blocks it has under exploration will yield big discoveries. At the moment however, it is essentially a fuel sourcing agent for group company, Reliance Energy.

RPL's prospects hang on what happens to crude prices and resulting margins. In general, refining margins tend to fall, when crude prices are high and vice-versa. But RPL has great flexibility in terms of feedstock; it has assured supply and it will do better than standalone refineries, regardless of the cycle timing.

The RPL IPO was launched at Rs 60/share in April-May on the basis of exactly those expectations. Nothing has really changed -- the price of crude has gone up 30 per cent but it could come down by the time RPL is in production.  Or, it could rise further. In terms of policy, the government retains retail price control over key products. RPL could get around that by a focus on exports. But is it worth Rs 170-plus now if went public at Rs 60, 18 months ago?

RNRL will also go through policy uncertainty on the CGD front. Demand for gas is huge and growing and  there's no arguement about that. But industry policy is in flux. Nobody knows how effective the new Petroleum and Natural Gas Regulatory Board is going to be or the tariffs the government will allow CGDs to charge.

In the overall gas market, the current mix of market price/subsidy is insane, both in basic logic and also in complexity. Will marketing and distribution functions be broken up as they have been elsewhere by regulators? What would that do to incumbent GAIL? In turn, how would it affect RNRL? Is the stock worth Rs 90-plus?

In both cases, the valuations are difficult to justify or critique. Historically, these are not high PE businesses. In India, policy issues will continue to plague the energy sector. There will be generic price volatility through the next year or two due to general elections. Without a fix on fundamentals, these two stocks could yoyo more than the overall market does. If you hold either, especially if you're an allotee, it seems like common sense to book at least some profits and reduce exposure.

Devangshu Datta in New Delhi
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