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Royal Dutch Shell Plc .com: Cairn’s big gamble pays off (stake bought from Shell for a giveaway price)

FROM THE FINANCIAL TIMES
By Khozem Merchant in Mumbai

Published: July 12 2006 03:00 | Last updated: July 12 2006 03:00

Sir Bill Gammell, chief executive of Cairn Energy, believes the Edinburgh-based company is “aligned” with booming India, and so it seems. Nine-tenths of the UK oil company’s value derives from India, notably the Rajasthan desert, where its oil fields go by Hindi names whose meaning carry a ring of good portent.

One big step towards monetising that value was taken on July 3. Cairn revealed a $1bn credit facility to finance production of Mangala, Aishwariya, Raagesh­wari and Saraswati, a quartet of fields whose development was approved by the Indian government in May.

The project is one of the largest single investments in Indian energy and, as Sir Bill remarks, “a huge undertaking, the biggest” for Cairn, the most successful foreign exploration company operating in India.

Certainly, the implications are immense for Cairn, whose share price has risen several-fold in the past three years, reflecting the rich potential of its Indian assets.

The fields in Rajasthan, known as MBA (Mangala, and Aishwariya, plus Bhagyam, to be developed in a second phase), should start gushing oil by the end of 2008 and, at their peak, yield 150,000 barrels a day, or the equivalent of 8 per cent of current India’s imports and one-quarter of its crude output of 650,000b/d. The discoveries are among 18 made by Cairn in the Raj­asthan acreage which, with smaller producing fields off India’s east and west coasts, will be bundled into a new company to be listed in Mumbai, via a new share offering pushed back by shaky capital markets into 2007.

Cairn India’s listing will be a remarkable climax to a bold punt. The parent company had had an unremarkable presence in India for a decade until 2004, when it bought for a giveaway price the stake it did not own in the Rajasthan acreage from Royal Dutch/Shell. Cairn drilled where Shell would not and struck gold: Mangala holds in-place reserves of 1.1bn barrels of oil, while the 18 discoveries hold three times more, says Cairn.

More than a decade in India has allowed Cairn “to build relationships at all levels”, says Sir Bill, understating a requirement to manoeuvre in India’s petroleum environment. One of the lessons is the need for good corporate citizenship, which will be evident in Rajasthan, one of India’s economically least developed states.

As well as the 300km of roads, 600 water collection points and nine schools it has built, Cairn hopes to set up skill-training and welfare centres for communities from which it will be recruiting hundreds of workers, rising to thousands, during the early phase of the project.

Advising it on its community programme is the International Finance Corporation, a unit of the World Bank that lends to the commercial sector. The IFC is also providing $150m of the $1bn credit raised by Cairn, its largest single investment in India. Critically, the IFC’s social and governance due diligence raised the comfort level for banks such as Royal Bank of Scotland and India’s ICICI to contribute part of the balance of $850m.

“The funds could have been raised but for a shorter period of time [and more expensively]. We needed to give banks maximum room to participate at a shorter maturity by bringing in a party who could carry the additional risk, such as IFC,” says Somit Varma, head of IFC’s energy division. The maturity of IFC’s portion of the debt is almost double that of the co-lenders. “There are multiple risks, for lender, sponsor and project but this is an optimal lending solution under the circumstances.”

Sir Bill knows the risks of India and he points to three that have defined Cairn’s presence there. First is technical risk. India is vastly underexplored and the Rs500m ($10.8m) the petroleum ministry has earned in fees for data information on blocks in its forthcoming auction reflects global energy majors’ keenness to learn about the technical risks. For example, blocks for sale in the Krishna Godavari basin off the east coast will demand more investment because of the need to drill deeper into older rock formations to find fuel.

Political uncertainty is a second risk that India has eased by relaxing foreign investment rules, especially as the requirement for risk capital is higher in deep-water drilling. Yet risks remain, as BP discovered this year when it abandoned a $3bn venture with Hindustan Petroleum amid worries that slow reform of pricing policies would hinder its progress in the market for refined products.

Finally, India’s growing domestic refined-fuel market in its buoyant economy has softened the commercial risk of committing big long-term capital to the country.

Cairn has invested $400m in exploration in Rajasthan, and $1.5bn – some in partnership – in India. Its latest $1bn of funding signals the next phase of its evolution: from a largely exploration-based company to one with a portfolio spread across exploration, discovery, development and production.

“Cairn has made its reputation as a successful exploration company. Cash flows from its producing fields offshore in east and west India, and [gas-producing] fields in Bangladesh, have underpinned its exploration efforts,” says Praveen Martis, analyst at energy consultancy Wood Mackenzie.

The perception of a company overexposed to south Asia is reinforced by the situation in Bangladesh: Dhaka’s denial of export licences means Cairn must sell gas in the shallow local market. All the same, Rajasthan will be central to the south Asia strategy.

Cairn operates fields in India that produce 87,000b/d, although its entitlement is less than one-fifth. Under a production-sharing deal for the Rajasthan acreage, 30 per cent of output will go to state-owned Oil and Natural Gas Corporation, India’s largest integrated energy group. Still, the returns will be handsome: with global crude prices touching $75 a barrel, the cost of developing the desert fields will be $3 to $3.5 a barrel. An ONGC subsidiary, Mangalore Refinery and Petrochemicals, in south India, is expected to refine the crude, although there is speculation that ONGC will build a refinery in Rajasthan. That would cement the deep partnership between the two companies. With two others, ONGC and Cairn also operate the Ravva field, producing 50,000b/d, in Krishna Godavari.

Last year, ONGC executives privately expressed keenness for a more formal alliance with Cairn. Sir Bill would not comment on such a link, and Cairn’s India initial public offering plans, and the unexpected departure in May of Subir Raha, ONGC’s chairman, a big advocate of growth through alliances, seems to have doused such talk.

Yet links with ONGC will persist. Sir Bill reveals Cairn will “certainly” bid for blocks in the next exploration round as part of “a consortium”. Leading the effort will be the new chief executive of the Indian entity, Rahul Dhir. He is not only an engineer and former Merrill Lynch banker, but he also happens to be the son of an ONGC executive.

Copyright The Financial Times Limited 2006

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