Prateek Gupta
Sumit Kumar
According to the International Energy Agency’s latest forecast, oil prices could remain below $60 a barrel till 2017. This is mainly due to the surge in production by OPEC nations; a weakening of global demand due to slowdown in China; increase in shale gas output in US; and nuclear deal between Iran and six world powers, raising the prospect that with sanctions lifted, Iran would ramp up crude oil exports in 2016-2017. All these possibilities suggest that oil prices will remain weak, thereby hitting Cairn India profits hard. Which is why Cairn India must find a way to diversify into a wider range of commodities. The graphic on ‘The Downshift’ shows the price of crude oil per barrel between March and August this year, and gives the projection until 2017.
Commodity price fall
There has been a significant fall in commodity prices lately and it is likely to remain weak in the coming years. A big factor driving this downturn can be due to the slowdown in China, which accounts for about half the global demand for industrial metals.
Concerns over weaker Chinese growth and rising commodity supply has led to a broader decline in copper, gold and other raw materials, pushing Bloomberg commodities index to a six year low. Hence, Vedanta Ltd. will have to find a way to maintain constant operating cash flows in future years to reduce its high debt, interest payments, and take care of its stakeholders.
In the long term, though, commodity prices will recover (see graphic “Future looks bright…”) as the majority of the world’s population lives in countries that are not yet industrialised, and it won’t be long until they do. Hundreds of mega-cities are taking shape around the world, and they will all be hungry for oil, copper and steel. So, the future prospect of Vedanta Ltd. looks bright. But it will have to find a way to grow in the near future amid weak commodity prices.
Merger will result in champion
Therefore, the merger will create India’s diversified natural resources champion, uniquely positioned to support India’s economic growth. A diversified portfolio, from metal to oil exploration, will help Vedanta de-risk earnings volatility in an economic slowdown, allocate capital to projects with better returns, build a stronger balance sheet and lower overall cost of capital.
We are in favour of the merger as it will result in improved financial flexibility to allocate capital to the highest return projects and sustain higher dividends.
The strategic rationale is as follows:
Diversified Tier-I portfolio de-risks earnings volatility and drives stable cash flows through the cycle.
Improved ability to allocate capital to the highest return projects across the portfolio.
Greater financial flexibility to sustain strong dividend distribution.
Cost savings and potential re-rating to benefit all shareholders. The transaction will contribute to further streamline the internal processes and improve productivity, beyond the previously announced $1.3 billion.
Stronger balance sheet will allow for the overall cost of capital to be reduced.
Consistent with stated corporate strategy to simplify the Group structure.
Offers long-term sustainable value enhancement for all shareholders.
Benefits for Cairn India shareholders
Attractive transaction terms.
Earnings will be de-risked through increased diversification, offering exposure to a larger, more resilient and diversified commodity mix.
Stable cash flow, supporting investment and dividends through the cycle, driving long-term value.
Offers Cairn India shareholders exposure to Vedanta Ltd’s well invested Tier-I, structurally low-cost, longer-life assets, including a best-in-class zinc platform, which have significant latent capacity ramping up.
Being part of a larger entity will allow Cairn India to benefit from increased economies of scale and improved free-float and trading liquidity.
The large equity share component allows Cairn India shareholders to participate in the upside potential at Vedanta Ltd as a result of the attractive growth profile and delivery of Vedanta Ltd’s on-going cost saving initiatives.
Increased participation in Vedanta Ltd’s previously announced $1.3-billion marketing and procurement cost-saving programme.
Retains proven management team and decision-making framework, retaining the Cairn India brand.
The merger will be a significant step towards achieving the long-term vision of a simplified group structure, with alignment of interests between all shareholders for the creation of long-term sustainable value.
(Prateek and Sumit, students of PGPM 2014-16 at Great Lakes School of Management, Chennai, are the fourth runners-up in the case study contest)