Mukesh Ambani’s Problem of Plenty

When Bill Cleese took the stage at Houston on March 10, it didn’t take him much to get the 2,000 strong audience representing the who’s who of the international oil industry to double up in laughter. All that the CEO of Valero Energy, the largest independent oil refiner in the US, did was to use the image of a shell shocked, half plucked rooster in full strut to describe the predicament all of them are in. Wafer thin margins and forced shutdowns are now a way of life for refiners. Cleese is trying to find buyers for two of his refineries and thinks 2010 will be an even darker year for the business. He reckons at least two million barrels per day (mbpd) of refining capacities will have to be taken out if margins are to improve.

It isn’t clear who represented the Mukesh Ambani-led Reliance Industries (RIL) at the conference. Neither is it known what message the representative took back to Ambani, who calls the shots at India’s largest petrochemical major. But one thing is clear. The mood at RIL headquarters in Mumbai is very different from that at Houston, the Mecca of the world’s energy trade.

In the last one year, RIL doubled refining capacities and added one of the world’s largest gas facilities. Ambani worked three years to simultaneously implement two of India’s largest and most complex hydrocarbon projects — the 580,000 bpd second refinery at Jamnagar and gas production from the company’s deep water oil fields in the Krishna-Godavari (KG) Basin. To get it done, he deployed $12 billion and kept a few hundred variables on a tight leash that could have derailed the project.

It is tempting therefore to imagine Mukesh Ambani doesn’t have a care in the world. But that isn’t true really. Goldman Sachs reckons over the next couple of years, RIL will generate $25 billion in excess cash. Then there’s another Rs 9,500 crore it is sitting on after sale of treasury stock over the last three months. What will he do with all this money?

From another perspective, margins in the refining business are down to half of what they used to be. To that extent, in spite of the doubling of capacities, RIL’s earnings are stagnant. How can he therefore deploy this money in creative ways to ensure the growth engine doesn’t slow down? “The low debt equity and increased pressure will add to the psychological pressures on RIL to do something with the money,” says Deepak Pareek, an oil analyst at the Mumbai-based Angel Broking.

Attempts to tackle these questions led to answers like retail and real estate through the special economic zone route. By all accounts though, both of these projects where Ambani invested Rs. 500 crore and Rs. 2,000 crore, respectively, haven’t quite taken off. All indicators are he’s chosen to take his foot off both and focus on the core business.

His most recent attempt was to make a play for the Rotterdam headquartered petrochemicals major LyondellBassel. The ailing company has a global footprint and a distribution network that holds the potential to allow RIL to make a transition into markets outside India.

When it entered the fray at $12.5 billion, the price seemed right as well. Ambani had attempted something similar in 2005 when he asked his A-team to go after Innovene, a subsidiary of BP. But it lost out on the bid to UK-based chemicals company Ineos.

Unfortunately for RIL, soon after it pitched for LyondellBassel, Apollo Management, a private equity firm, got into the game and upped the ante by offering $15 billion. On his part, Ambani was unwilling to offer anything more than $14.5 billion.

To seasoned Ambani-watchers, this didn’t come as a surprise. At $14.5 billion for the bankrupt firm, it translated into eight times next year’s earnings before interest, tax, depreciation and amortisation. This price would have been in line with valuations in the global chemicals business and RIL’s projections. Anything more than that would have been out of character for a company that has a reputation of being conservative with cash.

So, just what are Ambani’s options?
Option 1: Focus on becoming an integrated oil major and eventually aim for breaking into a league now occupied by the six biggest in the world (derisively called Big Oil). Though it prides itself on being integrated, RIL does not have the balance of upstream oil exploration, production and refining capabilities the majors have. “There are big gaps in terms of exposure to key oil and gas basins, that are vital and need to be filled,” says Neil Beveridge, senior analyst covering Asian integrated oil companies at Sanford Bernstein in Hong Kong. RIL is better positioned than any other Indian oil and gas company to get there, he says.

Option 2: Become a bigger petrochemicals and refining player, with increased global presence, through acquisitions like LyondellBassel.

But, says Beveridge, returns will be higher if RIL opts for the high risk, high investment first option. While the refining business has been profitable, there is overcapacity now. And little value can be created by getting bigger, he argues.

Which one will it be then?

Of course, there is a view that RIL need not look at opportunities outside Indian borders. Stock market commentator S.P. Tulsian is a votary of that school of thought. He reckons the cash on hand can be absorbed and deployed profitably in domestic projects. For instance, he argues, ramping up gas production to beyond 120 million standard units per day or for that matter funding new oil and gas finds in the blocks RIL owns can bring in growth.

It seems unlikely, though Ambani subscribes to this school. Sources close to Ambani say he is increasingly dissatisfied with the kind of returns that now accrue in the oil refining business. The second refinery at Jamnagar was built to deal with more complexity crudes to produce cleaner fuels. The bet was it would eventually deliver higher margins riding on the back of growing demand in India and other parts of the world. While the company doesn’t declare information on both refineries separately, results since the time the project went on stream show little improvement.

This is because when the tide went out, RIL was caught as much by surprise as anybody else. There is nothing companies can do to control prices of crude or products — the difference between the two is what you call refining margins. Not just that, petrol and diesel prices in India are still controlled. RIL had hoped they would be decontrolled.

The other constraint to hunting for growth in India is that most capital intensive areas in the infrastructure space like roads and power, where RIL could have used its project management skills effectively, are off limits, thanks to a no-compete clause with younger brother Anil Ambani. To that extent, it would seem Mukesh Ambani has made up his mind.

Some signals emerging out of RIL’s headquarters indicate Ambani is shaping the firm to change course and look for opportunities outside the country. That explains the bid for LyndonBassell and another $2 billion bid for a Canadian oil sands company called Value Creations — not much of which is known in the public domain.

Ambani has also been building management bandwidth. The most recent entrant to the group is Walter van de Vijver, former head of Shell’s global exploration and production business where he had a rather interesting time. Following a controversy at the company that it had overstated oil reserves, Shell got into trouble with investors and regulators. In the melee that ensued, Shell sacrificed Vijver. Enraged, he got into a legal tangle with Shell and the matter was finally closed when Shell agreed to pay him £2.5 million as settlement. He took the money and moved to the US where he set up a private equity firm, Delta Hydrocarbons, to invest and acquire interests in oil and gas fields across the world. Last year, he quit Delta over differences with the other promoters.

His appointment at RIL is being seen as a signal that it will step up activity in the upstream oil business. For the nine months ending December 2009, this part of the business contributed more than a quarter of the earnings before interest and tax, from just 5 percent of revenues.

Opportunities are a dime a dozen in the space. Over $40 billion worth of assets are said to be on sale worldwide in places like the Caspian region, the Gulf of Mexico in the US and the Brazilian offshore.
“One big advantage RIL has in bidding for these assets over aggressive rivals like the state owned China National Oil Company (CNOC) is that RIL is a private entity with no strategic shareholding by any government,” says Beneridge. While companies like CNOC face political opposition, no such misfortune hits the dozens of deals on the oil patch with independent foreign oil companies like RIL.

If all indicators are that Ambani will focus on becoming a large integrated player, what in the devil’s name was he doing trying to snap up LyndonBassel? If you look at it as an opportunistic buy as opposed to a strategic purchase, things begin to fall in place. Ambani pitched for it because he reckoned it was cheap. It offered access to some markets and advantages in research and a ready, ongoing operation.

But that was until Apollo came in and upturned the price. Ambani eventually walked out. LyondellBassel is now in the past. What remains to be seen is, what will his next big buy be?