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Updated on Jan 12, 2002

The KSE - Overview: Upbeat Sentiment Continues ...

The KSE-100 Index opened on a positive note at 1374 level, a continuation of last weeks upbeat momentum. The market spiraled up on the back of developments at the SAARC summit that led to prospects of peace on the Pakistan - India issue. However, over the week ADV declined by 28% to 94mn shares as compared to 131mn shares last week, reflecting low investor appetite for long term commitments. The scrips that managed to capture foreign investors' interest were HUBCO and Fauji, technically a continuation of the previous weeks spate.

On Monday the Index briefly touched the 1400 level, which acted as a physiological barrier to the local investors and as a result of unavailability of a support level, the local institutions started offloating or what you may say as 'profit taking' at high levels. Tuesday, the market bottomed to 1369 level reflecting a decline of 29 points compared to the previous day. The downturn can be attributed to the variation of the on-going tension between India and Pakistan and Tony Blair's unsuccessful attempt to pacify the situation between the two countries. There were mixed sentiments in the last three trading days with a bear run on Wednesday and a rebound on Thursday that continued to close the market positively on Friday.

Strategist's Note

There are two dimensions of the Pakistan-India situation that we wish to note, because we do not believe that they have been adequately addressed by other media.

1) The almost paranoid fixation of the general public in Pakistan of the whole world being out to get them is unrealistic. In our opinion, this world view is naive, and only wish the world were that simple. Such a fixation has also been apparent during Mr. Blair's visit to the subcontinent, where his proclamations about terrorism have been taken to be aimed at us. The fact is that he also made a significant concession to Pakistan, which has been overlooked. His call for dialogue between Pakistan and India was borrowed directly from the GoP's own stated position which in "diplomatic-speak" is very significant.

2) It is important also to understand that imposing war is not the only reason a state builds up troop concentration with the border with another. The buildup is also used to get the other country to agree to a proposal or move their position closer to it.

President Musharraf has a track record now of being well able to handle crisis such as these. So stay bullish. But be wary of the greatly exaggerated hype...that is not the time to buy.

OMC Sector: Shell FY02 Results...RIP

The word on the street recently about the OMC sector is to keep away as expected especially after a 10% decline in POL consumption during 1H02 as reported by the industry sources. We have always maintained a very cautious approach towards investing in the OMC sector over the last year due to the changing industry profile going forward.

Changing Industry Dynamics - A brief Overview

The government has been historically keen on reducing Pakistan's reliance on imported crude oil and POL products not only due to rising oil import bill and limited foreign exchange reserves but also because of the price differential advantage (lower cost) that could be gained by the local industry.

With almost declining crude oil reserves compared to our energy needs and higher prospects of finding new natural gas reserves, we believe the government in treading on the right track. Over the last ten years, oil consumption in Pakistan has risen by a CAGR of over 7% in 2000 to 18.03 mn TOE. Local crude oil production has declined by a CAGR of over 2% whereas the import of crude oil has seen a rise of 1% CAGR over the last ten years. POL import, on the other hand, increased by a CAGR of over 12% for the ten-year period under review.

Furthermore, there are certain developments, which need to be monitored closely to ascertain their impact on the OMCs viability in the future.

a) Conversion of cement plants to natural gas and coal from furnace oil
b) Increased supply of natural gas to power plants for substitution of furnace oil to reduce power generation costs
c) Deregulation of import-export of major POL products with government allowing WAPDA and other users to import POL products (furnace oil and diesel) for consumption
d) Complete deregulation of the oil sector by lH03 which could increase price competition and thus reduce already squeezed profit margins
e) Government's drive to enhance Pakistan's hydel power generation capacity through increased investment in building various dams and reservoirs

Domestic Natural Gas Sector - OMC's Dilemma

The developments that took place during the last year within the Ministry of Petroleum and Natural Resources were aimed at enhancing the role of the natural gas sector to meet the future energy needs of Pakistan. In our opinion, these developments, mentioned below, are certainly going to impact the consumption patterns of the OMC sector going forward. a) Replacement of FO at Power Plants b) Substitution of Motor Spirit and Diesel in the Transport Sector c) Replacement of Kerosene in Domestic and Commercial Sectors

This would, according to industry sources, increase the share of natural gas in primary energy mix from existing 41% to 47% by 2010. And with the increased probability of imported gas from the Central Asian Republics from 2010 and beyond, the share of natural gas would further improve by 11% to 57% going forward.

FY02 Volumes and Prices

As already mentioned above, the drop of over 10% in POL consumption and falling international oil prices during lH02, have already played havoc with the POL industry sales. Shell, as a result, is bound to see a fall of over 11% in total POL sales during FY02. However, due to a recent agreement signed last year between WAPDA and Shell for the sale of furnace oil (FO) is likely to increase Shell's FO volumes going forward.

The upturn in economic activity during FY03 would enhance the total sales volume of Shell during FY03 in our opinion. We have assumed a proportional jump in sales for various POL products with furnace oil as an exception. Even though the total industrial FO sales would go down going forward due to reasons discussed above, Shell, in our opinion, would be able increase it's market share in FO business by 4-5% from the existing 17.5% going forward.

FY02 Results Briefly

The numbers for FY02 are evident of the fact that demand/consumption and falling oil prices are bound to reduce the bottom line of Shell tremendously. The revision in the distribution margins by the GoP is only possible after a complete deregulation of the OMC sector which, according to government sources, is planned somewhere after June 2002.

This, in our opinion, limits possibility of any relief to Shell during FY02 from GoP and it is left to the market forces going forward to determine its bottom line. And this is where the problem lies. Shrinking volumes and squeezing margins do not bode well for Shell during FY02 and as a result could see a fall of over 50% in it's FY02 EAT.

And a continuous decline in margins (gross, operating and net) from FYOOA to FY02F paints a rather negative picture of Shell's operations going forward. However, due to its lower exposure because of its smaller size and low market share, especially in FO and HSD, makes it less vulnerable as compared to PSO going forward.

Recommendation and Valuation

What does it all mean especially to investors interested in the OMC sector? In our opinion, FY02 is going to result in a markedly lower bottom line not only for Shell but also other OMC's as well (PSO and Caltex). For FY03, as we expect a turnaround in economic activity, we believe Shell with less exposure due to its smaller size and market share would find it easier to regroup and turnaround than PSO. The rise in its market share, due to higher FO sales, would to some extent support the declining bottom line. But in our opinion, the changing industry dynamics will keep its sales volumes almost flat and a five year CAGR EPS of -0.20% going forward.

We, thus, change our intermediate recommendation on Shell to REDUCE and maintain a long-term NEUTRAL on the stock.






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.Source: KSE, MSCI, KASB