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UBS Investment Research
Oil & Natural Gas Corporation
Upgrade on higher oil prices, lower royalty
�� Multiple triggers to drive stock performance
We upgrade ONGC to a BUY & raise PT by 8% to Rs1,600/sh from Rs1,475/sh.
This is due to 1) Increase to our global oil price forecast to $85/bbl, from
US$79/bbl, coupled with an expected domestic diesel price hike, which will raise
ONGC’s net realization by US$3/bbl. 2) ONGC to make lower royalty payments
for the MBA fields (we forecast NPV of additional royalty payment to reduce from
Rs85 to Rs65/sh for ONGC).
�� Key catalysts - diesel price hike, lower royalty at JV field
Media reports suggest a 5% govt sell down in ONGC early next year. Ahead of
that, though not necessarily due to it we expect positive news flow: 1) an expected
diesel price hike due to the rising global prices, which should reduce its share of
subsidy burden. We raise earnings estimates for FY12 and FY13 by 8.0% and
7.5% resp. 2) favourable govt action on MBA fields where ONGC bears 100% of
royalty burden though only has a 30% stake and hence makes losses.
The stock has lagged the Sensex by 4.8% & 4.0% resp over the last 3MTD and
6MTD. We believe that the market has priced in disappointment over deregulation.
Therefore any news on deregulation/price hikes should be positive.
�� Valuation: Stock trades at a discount to peers on PE and EV/bbl
We think the stock is attractive given it is trading at 11x FY12E EPS with a 4.5%
dividend yield. Despite its US$6bn capex ONGC is cash positive and hence we
expect high dividend payout. Trades at a discount to peers on several valuation
matrices.
Investment Thesis
We upgrade ONGC to a BUY on our expectation that ONGC will be able to
benefit from the increase in crude oil prices as we believe the government will
hike diesel prices to pass on some of the burden from higher oil prices to the
consumer. We also expect the Government to reduce ONGC additional royalty
payment for the Rajasthan fields, so as to make that investment profitable from a
loss/breakeven currently. We raise our target price to Rs1,600 and FY12E
earnings by 8.0%. The diesel price hike lifts our TP by 5% and lower royalty
adds another 3.5% to our TP. We find the stock attractive at current levels as it
trades at a discount to its peers on P/E multiple and EV/bbl basis. ONGC is
trading at a FY12e P/E multiple of 11.0 which is one of the lowest among Asian
E&P companies. It trades at $9.2 EV/boe of reserves which is at a significant
discount as compared to peers like CNOOC ($38.9) and Cairn India ($28.2).
Key reasons for the upgrade
(1) Increase in UBS’s global crude oil price expectation to US$85/bbl. Every
US$1 increase adds 2-3% to consolidated earnings. However given the
regulated market, it will require a diesel price hike to provide upside.
(2) We expect the higher international oil price to result in a 4-5% diesel price
hike (post a government resolution); this should increase ONGC’s net
crude price realization by US$3/bbl to US$70/bbl for FY12 and
consequently earnings by 8.0%.
(3) We believe that ONGC’s 30% stake in the Rajasthan fields is not a
profitable venture as it pays 20% royalty for the entire 100%, production.
We estimate that if royalty were to be reduced to 15%, the venture will be
profitable. What this would do is to reduce the NPV of additional royalty
payment from approx Rs85/sh to Rs65/sh. We have conservatively added
an upside of Rs20/sh to our TP.
(4) We increase our Target Price by 8.5% to Rs1600/share on the back of the
expected diesel price hike and reduced royalty payment. We believe we are
being conservative in assuming a 4-5% price hike in diesel by Jan/Feb and
nothing beyond that. On the royalty issue we believe there could be higher
upside if the Government were to agree on ONGC not paying the
additional royalty altogether.
Every US$1/bbl raises under-recoveries of the OMCs (Oil marketing
companies) on the sale of petroleum products by Rs38bn. Of this the subsidy on
diesel forms the major chunk of Rs30bn and LPG and kerosene account for the
remainder. The reason for higher under-recovery in diesel is 1) higher volume,
and 2) higher taxes.
Triggers which can provide upside to our target price include:
(1) Further hike in Diesel prices into FY12 and beyond. Currently we
maintain our stance that the government will move to giving more freedom
for diesel price hikes post the budget in Feb 2011. Another diesel price hike
will result in higher crude oil price realization for ONGC. We are, however,
cautious given this is political and putting a timeline is difficult, and have
not factored this into our earnings forecasts.
(2) Rajasthan fields: Currently ONGC has a negative carry on its 30%
ownership of the Rajasthan block (Cairn India is the operator with a 70%
stake). However, ONGC pays royalty for the entire block - its own 30%
and the additional 70%. We estimate the value of the additional royalty at
Rs85/sh for ONGC (based on NPV, this additional royalty varies between
US$300-700mnpa depending on volumes). The options before the
Government are 1) scrap the additional payment; 2) reduce the additional
royalty to allow for modest profits. We have factored in the latter
alternative in our TP.
Valuation
Our target price of Rs1,600/share is based on a sum-of-the-parts methodology.
We value the stock on the NPV of its properties. We use DCF to value the
domestic business – we think this is the most appropriate valuation methodology
for upstream companies as the assets have a finite life and a relatively stable
operating cost line. We value the overseas subsidiary OVL reserves on EV/boe
basis, applying US$12/boe of reserve for oil and US$3/boe for the gas reserves.
We believe this is fair though looks conservative given the lack of company
guidance and no information of production sharing.
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