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Oil India
Oil price leverage uncertain
We raise our FY11/12F EPS 29%/34% to reflect our new oil and gas price
assumptions. We assume upstream subsidy sharing of one-third of total underrecoveries,
but without full clarity, we base our DCF valuation on net crude
realisations being capped at US$60bbl. Raise to Hold with a new Rs1,460 TP.
Raise FY11/12F EPS 29%/34%
We incorporate our oil price estimates (Brent at US$78/bbl in FY11, US$84/bbl in FY12 and
US$88/bbl thereafter) as well as the hike in gas prices to US$4.2/mmbtu. In line with current
policy declared by the Indian government (GOI), we assume that upstream companies will
bear one-third of total under-recoveries of the oil marketing companies (OMCs). This results
in Oil India (OIL’s) net crude realisation rising from US$56.3/bbl in FY10 to US$66.9/bbl in
FY13, implying a 12% earnings CAGR.
Leverage to higher oil prices not clear
Historical subsidy-sharing by upstream companies has been in the 30-35% range (average
33%),but the policy framework implemented by GOI is still ad hoc and subject to change. If
we assume upstream subsidy of one-third, GOI-owned upstream companies such as OIL will
benefit from rising global oil prices. However, the one-third formula makes an implicit
assumption that GOI maintains a 50-60% subsidy support, to which the finance ministry has
been unwilling to commit, increasing the risk of a higher upstream subsidy share. Basically,
OIL’s earnings could be assumed to remain positively leveraged to higher oil prices only if
GOI implements a subsidy or tax system at various oil price levels.
New target price Rs1,460 assumes crude price cap of US$60/bbl
We use the one-third upstream sharing mechanism (in the absence of any alternative), but
OIL’s stock price is not positively correlated with rising international oil prices, which probably
reflects market scepticism on subsidies. Hence for the purpose of our reserves DCF
valuation, we cap oil realisations at US$60/bbl. Our overall SOTP valuation for OIL works out
to Rs1,410 (up from Rs925 earlier), resulting in a Hold rating. Without this cap, the target
price would rise to Rs1,580 (based on Brent US$88/bbl and an OIL net realisation of
US$66.9/bbl).
Oil price leverage uncertain
OIL’s stock price has not reacted to the recent US$10/bbl surge in global oil prices. We
believe this reflects market fears of a higher subsidy, which we have incorporated into our
DCF valuation by capping the crude oil realisation at US$60/bbl.
Raising FY11/12F EPS 29%/34%
We incorporate our current oil/gas price assumptions in our earnings model, which now forecasts
a 12% EPS CAGR over FY10-13. Our Brent oil price assumptions are conservative, we believe, at
US$78/bbl for FY11, US$84/bbl for FY12 and US$88/bbl thereafter. GOI (the Petroleum Ministry)
has stated that the upstream companies will bear one-third of total under-recoveries of the OMCs
in FY11. We take this assumption for our earnings model, resulting in our net oil price realisation
rising every year, from US$56.3/bbl for FY10 to US$66.9/bbl by FY13. This rise is partly aided by
some growth in oil production – our estimates incorporate management guidance for oil
production to rise from 3.6mmt in FY10 to 3.9mmt by FY13.
On the gas front, our estimates now reflect the rise in regulated gas price to US$4.2/mmbtu
effective from 1 June 2010, which alone raises annual EPS by Rs14.4/share. Our forecast of gas
production rising from 2.4bcm in FY10 to 2.9bcm by FY13 is also based on management
guidance.
Leverage to higher oil prices not clear
Historical analysis indicates that upstream companies (ONGC, OIL, GAIL) have been bearing 30-
35% of the total under-recoveries of the OMCs over FY04-10. The petroleum ministry has
indicated that in FY11, upstream share will be pegged at one-third of total under-recoveries, a
formula that has been implemented for the first two quarters of FY11.
Based on our oil price and refining margin estimates, we estimate OIL’s subsidy burden by
assuming that the total upstream contribution over FY11-13 will be one-third of total OMC underrecoveries
and OIL’s share within the upstream companies will be 11%.
First, the above described subsidy sharing formula is ad hoc and subject to change, and any such
change can have a very material impact on earnings. For example, if the upstream subsidy share
in FY11 were to rise to 40%, then OIL’s EPS would drop 8.4%, on our estimates, wiping out any
earnings growth for the year.
Second, the upstream sharing of one-third implies that the GOI’s share is in the 50-60% range.
GOI is also committed to ensuring that the OMCs do not incur losses and an analysis of historical
trends indicates that the OMC sharing of under-recovery is pegged at levels that ensure that the
most vulnerable company (HPCL) makes an 11-12% ROE. On our estimates, to ensure this target
ROE, OMCs can share only 8%. If the upstream share is one-third, then the GOI’s share would
need to be 58-59%, or Rs366bn, in FY11F. Higher oil prices would lead to higher underrecoveries,
further reducing the OMCs’ ability to share the subsidy and consequently raising the
GOI’s share (if the upstream share is to be maintained at one-third). We believe one reason the
market is still optimistic on upstream sharing remaining at one-third is the proposed divestment of
the GOI’s holding in ONGC, as announced by the Divestment Ministry.
However, the signals from the finance ministry (which writes the cheques for the GOI) have not
been encouraging. For 1HFY11, it has indicated its share at Rs130bn (only 41% of total underrecovery),
but even this amount has not been presented in the supplementary demands during
the winter session of Parliament. The Finance Secretary has been quoted (Business Standard 23
December) as saying that the GOI is willing to bear one-third of the under-recoveries in the
current year.
While this negotiation between the Finance Ministry and the Petroleum Ministry takes place every
year, it illustrates the point that the entire system is ad hoc and subject to change. The GOI’s
ability to pay out its share of the subsidy decreases at higher oil prices, increasing the risk that the
upstream share may rise. The upstream sector requires a clear-cut mechanism that specifies its
share of subsidy at various oil price levels, so that the net oil price realisation is predictable even if
Brent rises above US$100/bbl.
New target price Rs1,460; crude price cap US$60/bbl
Our earnings estimates assume upstream subsidy share of one-third (in the absence of any
alternative). Using this formula would lead to OIL’s net realisation rising to US$66.9/bbl at a Brent
price of US$88/bbl. Our SOTP valuation for OIL would be Rs1,580 using these assumptions.
However, we take a cautious stand on net oil realisations for the purpose of our valuation. OIL’s
net realisation has basically remained in the US$56-58/bbl range over the past three years and
would rise to US$58.7/bbl in FY11 and over US$60/bbl in FY12 and beyond, based on our oil
price assumptions and using the one-third formula. But, as stated above, the one-third formula
implies higher share from the GOI, on which there is no commitment. So for the purpose of our
DCF valuation of reserves, we cap OIL’s net oil realisations at US$60/bbl. This results in setting
our target price at Rs1,460/share, resulting in a Hold rating.
Our cautious view on subsidies for the purpose of valuation is also guided by the fact that the
subsidy payments are a form of tax that OIL has to pay, as it does not pay any profit petroleum on
the main oil fields. In the event that the subsidy payments drop to zero (say, due to auto fuel
pricing deregulation), we would expect the GOI to raise taxes to curb super profitability. It might be
too optimistic to assume that any positive move to lower upstream subsidy will immediately lead to
Despite the cautious view, our SOTP valuation has risen from Rs925 to Rs1,460. The DCF value
of proved reserves (using 11% WACC, unchanged) has risen due to doubling of the gas price (to
US$4.2/mmbtu), a 10% increase in oil production estimates as per management guidance, and a
10% rise in net oil price assumptions (despite the assumed cap of US$60/bbl).
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