Equity analyst Piyush Jain has initiated coverage of Cairn India Ltd and has assigned the company a narrow economic moat based on two dominant reasons.
1) The attractive resource potential, including number of drilling locations and the amount of recoverable hydrocarbons at each location.
Cairn India has a portfolio of 3 established oil- and gas-producing properties, and 6 additional properties at various stages of surveying and exploration across frontier and mature basins. Recoverable reserves of 1.3 billion barrels of oil equivalent (boe) are sufficient for 15 years life based on 2014's production of 76 million boe. However, at our 8% forecast annual growth rate, reserves will last just over 10 years. We believe reservoir management and new fields will add to reserves over our 5-year forecast period, sufficient to support a narrow economic moat.
2) Another reason for the narrow moat is lower unit production costs which take into account royalties, leasehold outlays, drilling and completion costs, lifting expenses, and taxes.
The Rajasthan Basin is onshore, shallow, and has multiple stacked reservoirs. This keeps drilling costs low, as multiple targets are accessed from a single hole. Another consideration is that it's cheaper to drill onshore fields than it is to drill deep-water targets. Currently, 80% of Cairn India's production comes out of the Rajasthan Basin, which boasts operating costs of under $4 per barrel.
To gain a better understanding of moats, read How we use moats in equity analysis and Explaining economic moats to an 8-year old.
Piyush expects Cairn to deliver excess returns for at least the next 10 years. Strong energy demand should keep crude prices stable, and a 50% increase in the Rajasthan block production will keep it the dominant source of income for Cairn. Assuming a stable exchange rate, this would result in 10% and 9% compounded annual growth in production and revenue, respectively, over the 2015-19 period.
In 2014, return on invested capital was an impressive 31%. The company’s production-sharing contract with the Indian government allows it to recover 100% of investment (costs incurred in exploration, development and production) before sharing petroleum revenue. Low-cost production, coupled with this relatively attractive production sharing contract, helped Cairn to report one of Asia’s highest net profit per barrel ($65) in 2014.
With rising costs of onshore production outside of Rajasthan and somewhat more expensive enhanced oil recovery techniques in the Rajasthan block, we expect after-tax profit per barrel to drop to $44 in 2019. Even at that level, unit profitability will still remain one of the highest in Asia.
The company has a strong balance sheet with stability in production and cash flow. The year 2013 saw the start of dividend payments. Management has proved to be a good steward of shareholder capital with a minimum of debt and equity issuance, and a focus on delivering above-average returns on capital.
Cairn India's financial position is strong. The balance sheet had net cash of about $ 3.8 billion at end of fiscal 2014. With large net operating cash flows, the company can sustain a level of capital expenditure sufficient to drive growth.
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