Essar Oil: Unexplored potential: Elara

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Unexplored potential
Current valuations leave enough scope for re-rating
We initiate the research coverage on Essar Oil with a Buy rating and a
target price of INR180/share. We believe that Essar’s current valuations
largely neglect the upside that may emerge in Essar’s E&P portfolio
and reserves. With one of Essar’s Coal-bed Methane (CBM) blocks in
Raniganj, West Bengal expected to start commercial production and
sales by Dec’10, we think the time is ripe for E&P valuations to get built
in. We estimate that the refining currently contributes ~75% to the
overall valuations while the remaining ~25% valuations comes from
E&P, barely capturing the real the potential of Essar’s E&P portfolio.


Additionally, we think another INR155/share of valuations can emerge
in the longer term with more clarity on other Essar E&P blocks.
Short term valuation triggers may come from better GRMs
(INR36/share positive impact for USD1/bbl GRM) and diesel
deregulation (INR17/share positive impact due to annual retail EBITDA
of USD70mn).

Refinery upgrade, Mangala crude intake to boost GRMs
With the completion of refinery expansion from 14MMT to 18MMT
and complexity upgrade from 6.1 to 11.8, we expect Essar to deliver
GRMs of USD8-9/bbl, achieving a premium of USD3.5-4.0/bbl over
Singapore complex GRMs, similar to Reliance. Additionally, Essar would
be processing about 60kbpod of Cairn’s Mangala crude post the Phase
1, and this is likely to add another USD0.5-0.8/bbl to the GRMs. Finally,
the access to KGD6 gas in the coming quarters can add another
USD0.3-0.5/bbl to GRMs as fuel oil will be replaced by gas.

Global refining outlook remains subdued
Refiners in the US and Europe have continued to moderate their
refinery runs in an effort to recover margins lost since mid-CY10. With
the Asian maintenance season coming to an end, it should add some
capacity in the markets. Overall, product markets continue to be weak
thus we expect subdued GRMs over the next 2-3 quarters.

Valuation
We value the refining business at INR110/share, using an
EV/EBITDA of 6.4x on Essar FY13 earnings - its first full year of
earnings post the capacity expansion. We are assigning a multiple
6.4x after applying a 20% discount to the FY12 peer multiple of
8.0x. For our E&P valuation, we have considered only three of
Essar’s E&P blocks – Raniganj, Ratna and Rajmahal – as we feel that
only these three will be get some reasonable valuation in the
medium term due to the proximity to development in terms of the
timeline. Also, as more clarity regarding production profiles is
available for these three blocks, we value these on a DCF basis
arriving at our E&P valuation of INR70/share.