Macquarie Research: Sell ONGC target 1182

Oil and Natural Gas Corp.
Trigger priced-in; substantial overhang
Event
 We adjusted up earnings and target price to incorporate a potential 10% gas
price hike to non-priority sector (30% of APM gas sales), as well as a minority
stake in Carabobo-1 project in Venezuela. ONGC may also benefit from mildly
lower subsidy burden following potential diesel de-regulation by March 2011.
 But, the stock has already rallied sharply by 20% in 3 months in
anticipation. Besides, downstream oil marketing companies (BPCL, HPCL
and IOCL) should be greater beneficiaries.
 Divestment, a substantial overhang: The government proposes to divest
5% of its stake during Jan-March 2011 amounting to US$3.5bn.
 We downgrade ONGC to Underperform from Neutral, and recommend
switching into BPCL in the downstream space or OIL India in the upstream space.
Impact
 Potential ~10% gas price hike on 30% of volumes. Gas prices were
recently doubled to US$ 4.2/mmBTU for fertiliser and power consumers - 70%
of gas offtake. For the balance 30% industrial users (sponge iron, petrochem,
etc) prices have remained steady for a few years at US$4.75/mmbtu. The
petroleum minister proposes a ~10% hike to US$5.25/mmbtu. We hike FY12E
PAT by 0.2%. Gas accounts for 35% of ONGC’s sales.
 ONGC may mildly benefit potential diesel de-regulation: Diesel is the
largest petroleum product accounting for 36% of India’s FY11E oil subsidy
(Fig 1). Given falling inflation, the government may de-regulate diesel ahead
of its proposed divestment in ONGC slated for Jan-March 2011. ONGC’s
profits could rise 5-7%, in the best case scenario of the government following
Dr Kirit Parikh’s advice of reducing upstream companies’ subsidy burden.
Earnings and target price revision
 No significant change in earnings estimates. TP increased to Rs1182 from
Rs1127.
Price catalyst
 12-month price target: Rs1,182.00 based on a DCF methodology.
 Catalyst: Gas price hike and diesel price de-regulation, perhaps by March 11.
Action and recommendation
 Switch to BPCL in the downstream space…BPCL’s profits would rise 25%
on diesel de-regulation and FY12E PER fall to 6.5x. Earnings rise would be
much greater than ONGC. Besides, BPCL enjoys multi triggers, including, a
new refinery start-up, unlocking land value and large upstream potential.
 ...or OIL India in upstream. OIL India quotes at similar valuations as ONGC,
but enjoys the world’s lowest finding and developmental cost of US$4.2/bbl,
amongst the highest reserve replacement ratio of 169% and a low
EV/reserves of 11/bbl. Besides, its volume growth is poised to accelerate from
5% pa currently, while ONGC struggles to maintain existing volumes.