OIL 2.

0 THE RISE OF INDIAS 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 Indias 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 INDIAS MIDDLE CLASS

To Our Potential Investors
In todays 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 Indias 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

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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

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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.

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

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.

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

From Ester Duflo and Abhijit Banerjees 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, Indias current energy profile will need to change.

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

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.

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

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 countrys 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. Indias 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. Indias state-owned Oil and Natural Gas Corporation is the largest oil company. ONGC is the leading player in Indias upstream sector, accounting for roughly 75% of the countrys 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

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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. Indias 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 Indias 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

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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 Low Density Flows freely at room temperature Low viscosity Low specific gravity High API* gravity due to presence of a high proportion of light hydrocarbon fractions Low wax content Higher price Used to produce gasoline

Heavy crude Higher density than light crude Does not flow as easy as light crude at room temperature High viscosity Higher specific gravity than light crude Any liquid petroleum with an API gravity less than 20 Extra heavy oil is defined with an API gravity below 10 Higher wax content Lower price 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

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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, OPECs willingness or ability to quickly increase production when necessary makes them a consistent major player in the oil industry

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Indias 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 Indias 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

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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. 137

117

Indian Crude Basket Brent Crude

Price in USD

97

WTI Crude OPEC Basket

77

57

37

17 May-99 Oct-00 Feb-02 Jun-03 Nov-04 Mar-06 Aug-07 Dec-08 May-10 Sep-11 Jan-13
Figure 7: Indian Crude Basket compared to WTI, Brent and OPEC prices

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125 115 105

Indian Crude Basket Brent Crude WTI Crude OPEC Basket

Price in USD

95 85 75 65

55
45 35 Sep-08 Mar-09 Oct-09 May-10 Nov-10 Jun-11 Dec-11 Jul-12 Jan-13

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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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 (OMCs) 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 underrecoveries for the OMCs. Under-recoveries are calculated as the difference between the cost price and the regulated price at which petroleum products are finally sold by the OMCs 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 NOCs (National Oil Companies). The remaining portion remains uncompensated for OMCs. The Table below shows these values for the year 20102011.

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

The cash assistance to OMCs 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, OMCs 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

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Figure 12: Subsidized Diesel pricing

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Indian Fiscal Budget 2013 2014
Budget 2013 released on 28th February 2013 by Finance Minister P. Chidambaram offers a realistic plan to meet Indias 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.

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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 SUVs). 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 Indias 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 Indias 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.

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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.

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CAIRN INDIA NSE: CAIRN | Market Cap: $10.19B Our team recommends a long position in Cairn India. The company is Indias 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 Indias 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 Indias total domestic production. The following graph shows how significant the companys 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.

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Table 2: Cairn India Financial Highlights

Cairn India (Million USD) Revenue EBITDA Net Income

2013 (Expected) $3,198.51 $2,368.85 $2,286.33

2012 $2,165.14 $1,597.69 $1,449.02

2011 $1,876.22 $1,312.57 $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).

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Table 3: Aggressively expanding footprint

Oil Block

Cairn Stake 70% 22.50% 40% 100% 60%

Oil Production (Million bpd)

Gas Production (Million Standard Cubic Feet) Expected in 2013 55 18

Rajasthan Oil Block Ravva CB/OS-2 Sri Lanka Oil Field South Africa Gas Block

175,000 27,165 5,204

Phase 2 Exploration Phase 1 Exploration

This data shows that the companys 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 countrys infrastructure a much needed boost. Correlation to oil and currency movement
Table 4: Correlations

Risk Oil Price USD/INR Exchange Rate

Correlation (12 month) 0.505 0.477

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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 Indias 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 countrys long term energy demand. The company currently supplies greater than 70% of the countrys 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) Revenue EBITDA Net Income

2013 E $ 14,821.10 $ 7,588.54 $ 4,304.31

2012 $ 14,035.62 $ 7,490.45 $ 4,586.14

2011 $ 12,531.73 $ 6,447.28 $ 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

ONGCs 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 countrys demand. Correlation to oil and currency movement
Table 6: Correlations

Risk Oil Price USD/INR Exchange Rate

Correlation (12 month) -0.084 0.237

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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:

Essar Oil

Exploration

Refining

Marketing

8 Oil and Gas blocks with 100% Ownership

Total Capacity: 750,000 BPD

1400+ retail outlets providing Non-Fuel Retail

1.7 Billion Barrels of Oil Equivalient

Stakes in three refineries: Vadinar (India), Stanlow (UK) and KPR (Kenya)

Agreements with Public Sector Oil Marketing Companies

2700 sq. Km of land in India

10% of India's total refining capabilities

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 Indias vision to make India a global refining hub, filtering crude oil for other resource constrained countries. The companys 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

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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) Revenue EBITDA Net Income

2013 (Expected) $1,641.00 $53.00 $(23.00)

2012 $1,065.00 $38.00 $(23.00)

2011 $859.00 $51.00 $(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

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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 shareholders value. The companys future operations look bright, considering that its integrated operations, good management and large asset base place it on the brink of profitability. Correlation to oil and currency movement
Table 8: Correlations

Risk Oil Price USD/INR Exchange Rate

Correlation (12 month) -0.209 -0.299

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OIL E&P COMPANY COMPARISONS This is a good break point to compare the Oil E&P companies of the world to our portfolios 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/Es that are lower than the industry average. Reliance, one of Indias 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.

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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

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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)

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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. Correlation to oil and currency movement
Table 9: Correlations

Risk Correlation (12 month) Oil Price 0.143 USD/INR Exchange Rate -0.023 Due to long term contracts, there only slight correlation between the stock price performance and market movements.

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OIL 2.0: THE RISE OF INDIAS MIDDLE CLASS

GREAT EASTERN SHIPPING NSE: GESHIP | Market Cap: $650M Our team recommends a long position in Great Easting Shipping. GE Shipping is Indias 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

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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 Q3 FY'13
880.95 773.06 836.44 736.6

Q2 FY'13

Q3 FY'12

Q2 FY'12

441.51 292.65

336.15 323.73 191.84 81.2 87.46 27.31

Revenue

EBITDA

Net Profit

Figure 23: Income statement highlights in INR (Crore)

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OIL 2.0: THE RISE OF INDIAS MIDDLE CLASS

Q3 FY'13
14407.43

Q2 FY'13

Q3 FY'12

Q2 FY'12

14007.55 13782.23 13455.3

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

Q3 FY'13
598.08 263.4 188.36 320.97 63.53

Q2 FY'13

Q3 FY'12

Q2 FY'12

372.15 217.44 120.26

-41.79 -62.23 -192.8 -318.41 From operating activities From investing activities -137.08 -251.25

-29.64 -8.91

From financing activities

Net cash inflow/(outflow)

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

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OIL 2.0: THE RISE OF INDIAS MIDDLE CLASS

Q3 FY'13
12.1

Q2 FY'13

Q3 FY'12

Q2 FY'12

5.21

5.81

1.77

1.03

1.01

1.11

1.04

Return on Equity (%)

Gross debt/Equity Ratio (x)

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 FY13 to 12.6 in Q3 FY13. Correlation to oil and currency movement
Table 10: Correlations

Risk Correlation (12 month) Oil Price -0.535 USD/INR Exchange Rate -0.361 Due to long term contracts, there only slight correlation between the stock price performance and market movements.

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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.

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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.

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OIL 2.0: THE RISE OF INDIAS MIDDLE CLASS

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

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OIL 2.0: THE RISE OF INDIAS MIDDLE CLASS

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.

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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.

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OIL 2.0: THE RISE OF INDIAS MIDDLE CLASS

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.

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OIL 2.0: THE RISE OF INDIAS MIDDLE CLASS

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

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OIL 2.0: THE RISE OF INDIAS MIDDLE CLASS

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.

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OIL 2.0: THE RISE OF INDIAS MIDDLE CLASS

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
Essar Shipping Great Eastern Shipping Essar Oil Cairn India ONGC Rupee Futures USO Margin Requirements Total

Allocation
16.25 % 22.5 % 40 % 40 % 25 % - 22.5 % - 18.75 % 2.5 % 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 Short Exposure Gross Exposure Average historic monthly volatility (portfolio) Average historic monthly volatility (SPY) Largest drawdown (last 12 months)

143.75% 41.25% 185% 5.58% 3.7% 8.42%

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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 Cairn India ONGC Essar Oil GE Shipping Essar Shipping

Daily Average Trading Amount 925M INR ($1.68M) 954M INR ($1.74M) 55M INR ($1M) 7M INR ($127,000) 1.18M INR ($21,500)

35%

25%

Portfolio Oil USDINR NSEI

15%

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Return

5%

-5%

-15%

-25%

-35%

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

OIL 2.0: THE RISE OF INDIAS MIDDLE CLASS

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 Indias 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 Indias yearly budget announcement at the end of February, our entry exit strategy mentioned above can be implemented to realize gains over a time period.

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Contact Information

MANAV BHATIA

TANVEER CHANDOK

RAYMOND DECUIR

Tel 847 337 3066 Email [email protected]

Tel 404 731 7776 Email [email protected]

Tel 225 287 5360 Email [email protected]

154 5th Street NW, Atlanta, GA 30313

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