Volatile oil prices made stock markets nervous in 2004. When crude hit $50 per barrel in October last year, it sent shivers across equity and bond markets.

But this time around, despite crude prices edging past $55 and analysts warning that prices could surge to $70-80, the markets do not seem to be unduly perturbed. Why? One could attribute this nonchalance to the 'irrational' exuberance of bull stock markets.

Or conclude that the markets have already factored in or reconciled themselves to the new reality. This new reality, however, may not just be about rising oil prices but the emergence of gas as an alternative fuel.

Despite being a cleaner fuel and economical, too, natural gas has not really replaced petroleum-based fuel due to inadequate supplies and poor distribution infrastructure. Now, that may well be set to change.

First, domestic supplies will start kicking in about two years' time with Reliance gas set to go on stream, and increased imports through Petronet and Shell.

Over the past decade, the complexion of the liquefied natural gas market has changed dramatically with both capital and logistics costs reducing dramatically to make gas available at half the price.

Besides, the use of CNG (compressed natural gas) as an alternative auto fuel and PNG (piped natural gas) as a substitute for LPG can only grow as sheer economics combines with changing government regulations to force the change.

While supplies are getting tied up, the distribution infrastructure, which has prevented the change so far, is all set to be beefed up with the government's directive to set up the national gas grid.

It is obvious that companies which have anything to do with gas - right from gas exploration and production, to transmission and distribution to gas pipeline makers - will be major beneficiaries of this large-scale demand shift. Stocks of gas companies do not seem to have factored in this optimism yet, but analysts are bullish about the sector in the long-term.

Gas is cleaner and cheaper

Gas demand is set to grow because of sheer economic compulsions. Of the three key feedstock fuels for industrial users (naphtha, coal and natural gas), coal is the cheapest.

Coal is also more polluting, and the high transportation cost makes it an expensive option for industries located in the western and northern parts of India.

Analysts believe that demand for natural gas will arise mainly from this region. On an average, the delivered price of LNG is about a third of naphtha's price.

Besides, natural gas prices are as fickle as naphtha prices, which depend on crude prices. The simple reason is that the commodity is not traded, unlike crude. Prices are negotiated for long-term contracts. In some ways, natural gas prices are benchmarked against crude prices but international LNG contracts are at varying discounts to crude prices.

At present, most contracts limit the variation within a price band of $16-$24/bbl. Petronet's purchase agreement with Ras Laffan is at a price of $2.53/million British thermal unit (mmbtu), which is pegged to an international crude price of $20/bbl for five years. The company sells LNG at around $3.2/mmbtu, not inclusive of distribution costs and taxes.

Currently, gas pricing in India is not uniform all across. The price of gas sold by ONGC [Get Quote] and OIL is subsidised and regulated by the government and the going price is $1.8/mmbtu.

Private players, however, sell natural gas at market-determined rates but are still cheaper than LNG. Petronet LNG's [Get Quote] prices are linked to a Japanese Crude Cocktail (which determines the 15 per cent variable component in its prices).

Government has been talking about de-regulation of gas prices but nothing concrete has emerged yet. In any case, new gas will come in at market-determined rates which are still substantially cheaper than alternate sources.

Users may be forced to switch

The main consumers -- or user industries -- of natural gas are fertiliser, power, steel, ceramics and glass. Besides, natural gas is an alternative fuel for automobiles and cooking gas/LPG. It is well known that environmental laws across the world, including China and India, favour using gas as fuel for public transport.

The conversion of buses to CNG in New Delhi has dramatically reduced air pollution. However, gas consumption in the automotive/transport sector is small and may not make any significant difference to total gas sales.

So the big push for the gas sector will materialise only when industrial users - especially power and fertiliser companies - decide to switch to the fuel. Chances are that this will happen sooner than later.

For instance, the operating cost of power will be around Rs 1.2 per kilowatt hour (kwh) if the power plant uses LNG (based on Petronet's current selling price of $4.1/mmbtu) as feedstock while the cost will be Rs 3.5 per kwh if it uses naphtha instead. The current natural gas price is even lower but insufficient supply is a major constraint. Several captive power generation plants being set up in the western and northern parts of the country are likely to be gas-based. The country's largest power generation company, NTPC, is planning its latest 2,600 mw power plants in Gujarat through gas-based power plants. Reliance has been the successful bidder with an extremely competitive offer price of $2.97 per mmbtu, better than even coal-parity prices.

Analysts expect about three-quarters of Reliance's gas produce will be consumed by NTPC and its own power subsidiary Reliance Energy [Get Quote]. Which means most other companies will rely on LNG which will be slightly more expensive than natural gas and coal but far cheaper than naphtha.

Also, according to the new fertiliser policy, all fertiliser plants in India are expected to shift to natural gas/LNG by 2006. Currently, nearly a quarter of fertiliser plants in the country use naphtha/furnace oil instead of natural gas/LNG.

This means there will be a huge demand for gas as these plants decide to make the switch. Since fertiliser production is subsidised by the government, companies do not really have too much incentive to reduce costs. But that could change as the government may now insist on fertiliser companies becoming more competitive.

Supply won't be a problem anymore

Till some time ago, gas availability itself was a problem with domestic production being very small. With no significant new discoveries, ONGC's gas supplies have also been modest.

Moreover, international supplies were unviable due to prohibitive transportation costs. This is changing. Over the next four years, gas supply is likely to grow at a CAGR of at least 15 per cent (See table). And all of it is waiting to be consumed, say industry sources.

First, Reliance's gas find in Krishna-Godhavari basin will will add 40 million standard cubic metres per day(mscmd) to supplies by 2008-09. Smaller fields like Cairn, Nieko and GSPC will also add to new supplies.

Even though supplies in the short-term will be dominated by domestic suppliers and regasified-LNG, in the long-term, a significant proportion of supplies would come in through cross-border pipelines. Currently, discussions are on for gas pipelines connecting the country with Iran, Bangladesh and Myanmar.

. . . nor will infrastructure

The biggest challenge for the growth of the gas industry is the infrastructure to connect supply sources with users. The physical infrastructure requires a dramatic expansion, covering inter-country pipelines to last mile connectively, or delivering gas to the user's doorstep.

The estimated cost of laying new pipelines itself is estimated around Rs 20,000 crore. The country's largest pipeline company, Gail, will step up its gap pipeline almost five-fold and has set aside Rs 3,200 crore to set up new pipelines in 2005-06. Other companies like GSPC and Gujarat Gas are also setting up pipelines.

Then again, demand for CNG and PNG is also growing rapidly, though these are relatively less significant as they are much smaller in scale. Growth in these products has also been inhibited due to the lack of distribution infrastructure. But with companies like Gail, Gujarat Gas and Indraprastha Gas [Get Quote] planning to ramp up distribution infrastructure this will also change.

As the sector enters an all-new growth phase, it is difficult to imagine any player losing out. If at all there's any loser, it could be the oil refining and marketing companies which currently sell naphtha.

As domestic demand shifts to gas, they may have to export their naphtha output which may depress their profitability. But, as an analyst points out, these companies could finally end up in a no-gain-no-loss situation as they could also start using gas as input for some of their refining operations, which itself could boost their refining margins. As gas takes a larger share of India's energy future, gas stocks could have a field day.

Gas Authority of India (Gail): Gas transmission and marketing company Gail will be a big beneficiary of the uptrend in gas supplies.

The company expects its transmission volume to more than double over the next five years, even if one does not include the proposed imports from Iran. From the FY05 volume of 72 mscmd, the company could clock volumes of 143 mscmd by FY10. Inclusive of imports from Iran, the number could be as high as 221 mscmd.

According to analyst estimates, Gail's operating profit could jump about 30-35 per cent over this period. But of course, this will depend on government policy on the gas grid which will determine how its proposal to create the national gas grid will progress.

Additionally, Gail plans to pick up a 9 per cent strategic stake in China Gas Holdings for $31 million which will help it get take advantage of the lucrative Chinese market through a 50:50 joint-venture with CGH. Though the company may not see a big leap in earnings due to high capital costs, its good health and long-term prospects should hold it in good stead. The stock trades at nearly 10x FY05 earnings.

Petronet LNG: Petronet LNG currently imports LNG from Rasgas (Qatar) and regasifies in its unit at Dahej and sells it to marketing companies Gail, IOC and BPCL [Get Quote] in the proportion 60:30:10.

The company earns a regasification charge that covers its costs and a certain return on equity, which is subject to a 5 per cent escalation every year.

Currently, the company has 5 million tonnes per annum (mtpa) regasification unit. The company has spent Rs 2,350 crore on building the import terminal and the regasification unit. It has financed it through a mix of equity and debt with total debt amounting to Rs 1,260 crore.

Now, the company plans to expand its regasification capacity to 10 mtpa in FY06. And the additional 5 mtpa is likely to be added at half the cost of building the first five mtpa capacity. This means LNG prices could be brought down from current levels.

For sourcing of LNG, Petronet has a purchase contract with Rasgas for 7.5 mtpa. The company plans to source the additional 2.5 mtpa from Iran and Yemen at a f.o.b. price of $2.4-2.5/mmbtu, which will be pretty much the same cost of sourcing LNG from Rasgas.

Petronet LNG has been able secure some committed buyers despite relative high pricing (compared to natural gas). However, these are outside the power and fertiliser sectors. Petronet will have to be more competitive, offering prices comparable to coal or natural gas, in order to get business from power and fertiliser companies.

Analysts are optimistic that the company will be able reduce its selling price and also to garner customers even if the price is slightly higher.

The company is expected to see a 40-45 per cent growth in revenues, driven by strong volume sales over the next five years. Strong cash flows will help it reduce its debt burden. Though the stock looks slightly expensive based on current earnings, it could be a profitable long-term buy.

ONGC: The biggest benefit for ONGC will come when gas prices are deregulated. Currently, ONGC realises $1.7 per mmbtu for the bulk of its gas sales.

In a deregulated scenario, the company's realisation may go up to at least the price at which Reliance - the most economical player - will supply gas, which could be anywhere between $2.2-2.5/mmbtu. With crude prices set to head higher, the company looks like the best bet in the oil sector currently.

Reliance Industries: Reliance is likely to commence gas production in 2008 and go fully on steam by 2009. Reliance won the NTPC contract for gas supplies for its 2600 mw power plant in Gujarat as it was the lowest bidder with a delivered price of $2.97 per mmbtu.

Against this, Petronet LNG's delivered cost worked out to $4.1/mmbtu. Assuming Reliance offers the rest of its gas output around the the same price or marginally higher, analysts value Reliance's Krishna-Godavari gas find at close to Rs 40-45 per share.

Indraprastha Gas: Delhi-based gas distribution company Indraprastha Gas should be a significant beneficiary of the rising demand for CNG/PNG. The company has already created a 24 kms steel pipeline, running across the capital.

It enjoys a natural monopoly in the region as there are entry barriers by way of both regulatory approvals and gas allocations. Analysts estimates that the rising auto population in Delhi and adjoining areas and the low penetration of CNG and PNG mean a huge opportunity for the company.

Right now, the penetration of CNG/PNG is pretty low and the apparent benefits of natural gas over petroleum products like petrol/diesel and LPG will ensure high-powered growth over the next few years.

Currently, the Environment Pollution Prevention and Control Authority has recommended that the Delhi government direct all light commercial vehicles (LCVs) with a payload of less than 7.5 mt to switch to CNG. Sources say that new LCVs registered post-April 2005 may be CNG-based only.

In other words, eight years from now the entire LCV population in Delhi will run on CNG. Again, CNG car kits are also to be approved by the Automotive Research Association of India. This means that the company can target the 55 lakh car population in Delhi now.

Besides, it is also set to strengthen its PNG sales. Since PNG works out cheaper and also is more user-friendly, customers may switch to PNG from LPG, given an option.

Currently, there are 35 lakh LPG customers in Delhi. This should ensure steady flow of business for Indraprastha Gas in the years to come. The company is set to clock a 25 per cent growth in bottomline over the next three years.