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Sunday, December 10, 2006

Cairns IPO: On a sticky field


The biggest risk an investor will be assuming is that Cairn is unable to produce the peak quantum of oil projected from the Rajasthan field due to technical reasons. Oil reserve estimation and projection is a specialised activity and the best of methods employed could fail to provide the exact picture.

If the plateau production, which refers to the peak production that is sustainable over a period without causing irreversible damage to the field itself, turns out to be lower than the 1,50,000 barrels projected, the revenue and earnings picture could change adversely.

The infrastructure for transportation, ideally to be developed along with the field itself, is lagging and there is a disagreement between Cairn and the government nominee for the oil, MRPL, on who should set up the infrastructure. There is no clarity on the subject as yet; if anything, it is getting murkier and, ultimately, Cairn may be forced to set up the pipeline on its balance-sheet.

Though Cairn may well prefer it as a more secure option, given that the field is likely to have a 40-year life, it could lead to an increase in project costs by Rs 1,800-3,000 crore ($400-700 million).

Cairn is now in the midst of negotiations to get the best possible deal on this issue but a further delay in beginning work on the transport infrastructure could lead to either a delay or low production from the field. There could be other cascading effects as well, as disbursement of the syndicated loan is also linked to the transportation infrastructure being finalised.

The Rajasthan crude is thick, heavy and waxy which solidifies at lower temperatures. This calls for specialised production techniques such as hot water injection into the wells. While the technology is not new and has been employed elsewhere in the world, it has not been tried out on a scale that is envisaged by Cairn. A likely fallout of this technology not working satisfactorily is lower production from the field as the well pores could get blocked by the wax in the oil. Access to non-stop water supply and energy for heating the water is also critical here.

Cairn plans to use the associated gas production from its smaller fields in the South to produce power for heating the water, which will come from a saline ground aquifer in the vicinity of the project.

The price at which the crude will be sold will be decided closer to the production date. The price will be based upon a basket of crude oils similar in quality to the Rajasthan crude and has to be agreed upon by Cairn and the main buyer, ONGC/MRPL.

Given the quality of the crude, it is likely to sell at a discount of 5-10 per cent to Brent, an industry benchmark. A disagreement on pricing could lead to litigation with implications for revenue and earnings.

Cairn and the government have not been able to come to an understanding on the issue of cess on the oil produced. Cairn, relying on the production-sharing contract terms, disputes the government contention that it is liable to pay cess. The present cess is Rs 2,500 per tonne ($8.14 per barrel) and, according to the existing practice in other fields, can be recovered as cost by Cairn. But it will still mean lower earnings for the company.

Cash flows from the project will begin only in 2009/10; in the interim, Cairn is likely to suffer negative cash flows due to its being in the investment phase. This risk gets accentuated if one factors in the fact that the Ravva oil and Gauri gas production are projected to decline from 2007; gas production from the Lakshmi field has entered the decline phase.

This could have cash flow implications as about Rs 1,890 crore ($420 million) of the total Rajasthan project cost is expected to be funded by cash flows from the existing assets.