With the markets taking a tumble at 15k levels, there are many who are looking out for alternative investments. And here, there are several avenues that are springing up. Commodities have been getting strong attention in the past few months and are expected to provide some solace. Clearly, natural resources are expected to hog the limelight here.

But venturing into this zone directly can be dicey for many. Hence, there have been sector-focussed funds that are coming on to the centre-stage. Funds like Reliance Natural Resources and Sundaram Thematic Energy have garnered more than Rs 8,000 crore in the past few months. Another fund, launched by DSP Merrill Lynch called DSP Natural & Energy is currently open. These funds will look at drawing from the promise of scarce natural resources and the booking demand for energy. They seemed to be gung-ho about the prospects. Here’s why.

The NELP VII (new exploration and licensing policy) round has offered 57 oil and gas exploration blocks, nine in shallow water, 19 in deep-sea, and 29 on land, and the bids will close on April 11, 2008. This is the highest number of blocks being offered ever in the previous NELP. NELP has attracted a lot of interest by the companies from unrelated businesses due to relaxed entry norms for bidding the small blocks. The previous oil and gas blocks in the Krishna-Godavari basin, Rawa, awarded to some of the big oil companies in India, like Reliance Industries, ONGC, Cairn Energy, and various other entities, would be ready to extract oil and gas from these awarded blocks this year.

Rationale

Awarding of these blocks to oil and various other companies has renewed the interest and given a good business opportunity for the companies engaged directly or indirectly in the oil and gas sector. Lots of sub-sectors like offshore, drilling, rigging would benefit in this process of oil exploration, as well as some others like gas distribution companies. We could see incremental investments in the sector for exploration and capacities enhancement. The start of the gas extraction and awarding of the oil blocks this year should deliver good results in 3-4 years. ‘This sector could see a CAGR growth of 25-30% in three to five years’ confirms S Krishna Kumar, fund manager, Sundaram BNP Paribas thematic energy opportunities fund.

Other than these factors, oil and gas itself is a necessary resource for the economy to run smoothly. On top of that, we have been seeing depleting oil reserves leading to higher prices, which touched $110 per barrel recently. Due to the growing need and simultaneous shortage of crude oil in the future, everyone will be looking to safeguard their energy requirements and also find various other alternatives to feed the energy demand. India is dependent on oil imports for its requirement. India’s crude oil production was 29.3 lakh tonne in 2006-07 and meets 75% of its total oil requirement through imports. Also, in the case of natural gas, 75 mmcm is produced in the country and the consumption is 96 mcm, so the balance is provided through imports. To fulfil consumption domestically, it is estimated that the blocks awarded to Reliance Industries alone could give production of 80 mcm. Other than this, blocks awarded to ONGC and Cairn India will also lead to higher production of crude oil in the country to meet the requirement. All this will see an investment of more than $4 billion in oil and gas exploration.

What is it?

This huge investment reflects healthy growth in the coming years. To tap this opportunity, some of the mutual funds have launched funds, which focus on energy and natural sectors. Specifically, the ones engaged principally in the discovery, development, production, or distribution of natural resources. Natural resources companies include oil, natural gas, and precious metals. The companies providing related services such as mining, drilling, rigging, chemicals, related parts, and equipment will also be affected along with the energy sector. Those companies engaged in transporting, distributing, and processing natural resources should be targeted. Oil-marketing companies do not have as much scope as the restrictions on increasing retail prices parallel to crude oil prices hampers their profitability.

The funds will also look at non-conventional energy companies. ‘However, there are very few companies listed that are related to this category. So our focus would be on conventional energy,’ says Kumar.

Since December 2007, mutual fund companies have launched three funds dedicated to the energy sector. The first fund was Sundaram BNP Thematic Energy Opportunities fund and then came the Reliance Natural Resources Fund, and the DSP Merrill Lynch natural resources and energy fund, which is currently opened for subscription. All these three funds focus on the energy sector. The objective and investment strategy of all the funds are almost similar. The difference is in the type of scheme; Reliance and DSP being open-ended and Sundaram being closed ended with a lock-in period of three years.

One more difference in the investment objective between the funds is that Reliance Natural will not invest in non-conventional energy. Now here, if in the near future we see lot of companies, which are into non-conventional energy getting listed on the exchanges, then we could see Sundaram and DSP benefiting from this additional advantage, which Reliance doesn’t have.

The response for these funds was very good considering the asset size. Sundaram Thematic fund collected about Rs 2,400 crore at the market due to a positive condition in the equity market. Reliance Natural fund was able to get the second highest collection ever in any fund and the asset size is Rs 5,200 crore. These funds have included investing in overseas markets in their investment strategy depending upon the limit prescribed by the regulator.

Performance of the existing funds

We have seen various mutual funds came out with thematic or sectoral funds on banking, power, FMCG, IT, etc. There was a mixed performance by sectoral funds, as FMCG and IT had delivered negative returns, and banking and power delivering very good returns in the previous bull period. There was only the UTI Petro fund, launched in 1999, which invested only in petroleum companies. However, it was renamed to UTI energy fund and simultaneously widened its scope to cover the entire energy sector. Since inception, the fund has delivered returns of 22.21% and 29.97% in the last five years. However, post name-change, the fund has delivered 11.53%. The same situation is with other newly launched ones. Sundaram has declined from its face value of Rs 10 to Rs 8.05, giving -21.30% and Reliance natural -2.7% returns. We have seen a high volatility with sudden decline in the market from its all time high due to stretched valuations.

Opportunities

It is the complete value chain in the oil and gas sector, which would benefit from increasing exploration activities. These include not only oil and gas exploration companies but also the ones who provide services to these companies like offshore services, drilling, and platform rigs. The reason is, oil companies incur huge expenditure for exploration irrespective of whether they find gas or not. Also, there are very less companies providing these services and we have seen the rates of drilling and rigging going up in a very short period. Pipeline companies would also be one of the beneficiaries for laying pipes for transportation purposes from the exploration place to the refinery.

In India there is huge demand supply gap for natural gas. Due to higher production of gas, distribution of gas entities will also gain. And considering the shortage of oil and gas globally, the price is expected not to decline.

Some of the state governments have awarded coal blocks for future raw material requirement in power, steel, and various other purposes. We could have a huge demand for coal as a source of raw material for power generation. There is also a shortage of power supply in the country and the government targets to build 78,000 MW capacity in the eleventh five year plan. This would benefit power companies, who are and will be awarded the building of the power plant and subsequently will sell power to power distribution companies.

Other than big oil companies, there are certain small and medium companies who have small oil blocks. These companies have not shown growth in their core business or have been stable. Due to this, the companies command a lower price-to-earnings and the scope for growth is much higher after the oil blocks awarded.

Oil and Gas index

Mutual fund companies ideally benchmark their funds with a specific index on the exchange. The performance of the energy funds could be best linked with the BSE oil and gas index. The index includes heavy weights like Reliance Industries (RIL), ONGC, Reliance petroleum, RNRL, Essar Oil, and Cairn India. The oil and gas sector has been the under-performer as compared to the benchmark index on the BSE. From 2004 till date the oil and gas index has delivered returns at a CAGR of 33%. The higher growth of 33% per year for a period of four years was due to the non-stop spurt seen post May 2006. The post-May 2006 run up was due to a rise in the prices of the Reliance pack, like RIL, RPL, and RNRL. In the oil and gas index, RIL has the highest weightage of 54.91%, followed by ONGC (14.22%) and Essar oil (6.96%).

RIL, commanding more than half of the weightage of the index, has seen the price going up by more than three and half times in the last year and a half. The remaining part of the index includes oil-marketing companies like HPCL, BPCL, and IOC, which have been laggards in the index due to losses made by them because of increasing crude oil prices. The oil and gas index touched its high of 14,051 on January 8, 2008 and then subsequently decline by around 40% to 10,021 points on March 13, 2008 due to the overall market correction. The decline was also because of rapid decrease in the price of Reliance packs scrips.

Policy changes

In this massive corrective period we also saw a couple of changes in the mutual fund industry. We saw changes in the regulation in respect of a waiver of entry load for direct investors. This would not have significantly affected the performance of the funds.

Another change which happened recently was removal of amortisation of marketing expenses. It means that the expenses incurred on the new fund offer will be a one-time deduction before the net asset value is published after the launch. This particular change was applicable only for close-ended funds. The NAV will decline and go below Rs 10, which was not the case before the change.

The change, being a one-time exercise, would bring more transparency in the NAV prices because previously investors were not aware about the amortisation and the returns would decline equal to amortisation percentage.

This policy change would discourage mutual funds to launch close-ended funds, as it attracts a higher commission than open-ended funds. Energy or natural resources funds would not be affected because Reliance and DSP are open-ended, and Sundaram being close-ended, it is not expected to be affected, as it was launched before the announcement.