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India Oil & Gas
Initiating coverage on RIL and IOCL : BofA Merrill Lynch
„OW-30% on RIL and IOC cash, OW-70% on RIL 5-yr CDS
The RIL bonds found strong sponsorship during issuance from US and European
investors which supported the Asian bid for the credit. At current levels, the ‘20s
look fair to global comps while the ‘40s look more attractive from a spread
perspective. The IOC ‘15s have been more defensive but have underperformed
compared to RIL with relatively modest spread tightening over the last 2 months,
and currently look attractive within the global refining space. We expect more
supply from RIL in the global bond markets, while quasi-sovereign/ corporate
supply from India is expected to pick up in 2011 which could limit spread
tightening for IOC. Compared to cash, the RIL CDS appears cheap give the
positive basis for the ‘20s, which is likely to normalize if we see new issuance. We
therefore initiate with an OW-70% on the 5-yr RIL CDS.
Spreads look fair, credits offer diversity
Comparing spreads across Asian BBB as well as global E&P BBB credits,
spreads on RIL and IOCL appear fair within the Asian spectrum while more
attractive in the global energy space (refer charts 2 & 3 in the report). RIL has a
stronger investor base in the US and therefore it is likely that the bonds would
continue to be supported on global RV, while IOC which draws a greater
proportion of its investor base within Asia looks fair from a regional standpoint.
RIL: Improving credit profile, but de-leveraging unlikely
RIL’s operating performance has improved since 2009 with the commissioning of
KG-D6. EBITDA in FY10 was up 30% YoY to US$6.5bn while LTM standalone
EBITDA grew to US$7.7bn in September 2010. Volume growth in E&P, improving
gross refining margins (GRM) especially in 2HCY10 and domestic petrochemical
demand all contributed towards improved cashflows. Given the company’s
operating outlook and growth plans, we expect credit profile to remain stable over
the next 6-12 months. However, growth capital needs are expected to result in
negative FCFs over the next 1-2 years and lead to potential supply in G3 markets.
IOC: Defensive quasi-sov. but higher operating volatility
Domestic demand for petroleum products has ensured high capacity utilization for
IOC’s refineries historically. Operating margins have however remained volatile
depending on crude price differential vs. domestic price caps, causing resultant
movements in borrowings for the company to fund the deficit. IOC’s Baa3 ratings
benefit from sovereign ownership, and the stable outlook currently reflects
improving industry dynamics as well as progress in de-regulation in India. We
expect ratings to remain stable unless there are material changes in business risk
and balance sheet leverage due to growth capex, or we witness a decline in the
government’s implied support to the company.
Initiating with an OW-30% on RIL and IOC cash,
OW-70% on RIL 5-yr CDS
RIL cash rally leaves spreads in fair value zone
We initiate coverage on the RIL and the IOCLIN ‘15 cash bonds with an OW-30%
recommendation. The Reliance bonds found strong sponsorship at issuance from
US and European investors which supported the Asian bid for the credit in
October 2010. On a spread basis, the bonds have performed well with the ‘20s
tightening about 40 bps since issue and the ‘40s by about 50bps (in Z spread
terms). Cash prices have dipped since October, however, led primarily due to the
treasury sell-off late last year. At current levels, the ‘20s look fair to global comps
while the ‘40s look more attractive from a spread perspective. However, we
expect more supply from the company in the global bond markets which could
cap significant tightening from these levels. The 5-year and 10-yr CDS, currently
quoted at around 155 and 180bps respectively, look wide given where the ‘20s
are trading (170 bps). With supply more likely in the bond markets as opposed to
the international loan markets we expect the positive basis to normalize, and
initiate coverage with an OW-70% recommendation on the 5-yr CDS.
IOC bonds defensive, though more exposed to policy and price controls
The IOCLIN bonds have held up better in cash price terms, declining from a high
of 107 in early November to about 103.5 currently and spreads ending the year
broadly unchanged at around 200bps, compared to new issue levels in January
2010. Compared to RIL, the IOC ‘15s have however underperformed with
relatively modest spread tightening over the last 2 months, and currently look
attractive within the global refining space as seen in Charts 2 and 3. Indian
corporate debt supply has remained limited thus far, which has helped IOC (and
RIL) to benefit from relative lack of paper. However, we expect more supply from
India this year with potential infrastructure and quasi-sovereign entities looking to
access the bond markets.
IOC’s quasi-sovereign risk profile (due to a 80% stake being held by the Govt. of
India) also makes it a good proxy risk for India and therefore comparable with
emerging market SOE credits. The IOC ‘15s are currently trading wider than
LatAm credits such as the PEMEX ‘20s (Z+207), PETBRA ‘20s (Z+195) ((We currently have an UW-30% recommendation on the PEMEX and PETBRA cash curves sue to supply
concerns and high leverage (for Pemex) )
on a duration adjusted basis, while trading flat to tight compared to Thai comps such
as the PTT ‘14s (Z+235) and PTTEPT ‘15s (Z+205). Within India, the SBIIN ‘15s
are currently trading at a Z-spread of about 198bps (mid). With greater supply
expected both from Indian banks as well as corporates, we believe that spread
tightening could be muted in the near-term for IOC despite current levels. We
therefore initiate with an OW-30% on the bonds, preferring the credit for investors
looking for a defensive quasi-sovereign exposure in Asia.
Strong domestic fundamentals support Indian
refiners
Both IOC and RIL remain levered to domestic consumption and petro-demand –
while over 95% of IOC’s refinery production is sold domestically, circa 50% of
RIL’s revenues are via domestic sales. India remains a net importer of crude and
oil intensity is expected to increase along with the strong expected GDP growth.
RIL benefits from its vertical integration as well as refining efficiencies, which
have consistently led to higher refining margins than industry benchmarks. While
the company remains geared towards aggressive growth, we expect underlying
demand to commensurately grow and support operating performance. IOC
remains dependant on government policies for de-regulating retail petroleum and
cooking gas prices, barring which the company’s under-recoveries need to be
compensated by either upstream E&P companies or by the government in the
form of cash subsidy or issuance of Oil Bonds. IOC’s operating metrics remain
volatile as a result, but its position as India’s main refiner and marketer and the
implied Government support mitigates these risks.
Spreads look fair, credits offer diversity
Comparing spreads across Asian BBB as well as global E&P BBB credits,
spreads on RIL and IOCL appear fair within the Asian spectrum (Chart 2) while
more attractive in the global energy space (Chart 3).The RIL bonds look attractive
compared to US names such as Husky, Marathon Oil and Hess for both the 10-yr
and 30-yr series, while the IOC ‘15s look attractive at the short end compared to
WPLAU ‘14s and SK Energy ‘13s. However, BBB non-energy credits in Asia such
as China Merchants, PCCW, China Resource Power and Noble offer higher
yields than the IOC ‘15s while the RIL ‘20s look fair compared to the higher-rated
Swire ‘19s and Pohang ‘20s. RIL has a stronger investor base in the US and
therefore it is likely that the bonds would continue to be supported on global RV,
while IOC which draws a greater proportion of its investor base within Asia looks
fair from a regional standpoint. Both credits offer diversification as well as
exposure to the Indian corporate segment, and we believe would continue to
attract investor demand based on India’s growth projections.
Macro outlook: crude upgrade for 2011
Crude prices have remained strong over the last 2 quarters of 2010, helped by
stronger than expected demand growth, lack of supply additions by OPEC and
fiscal stimulus support flowing into commodity prices. BofAML research estimates
put global oil demand growth at 2.3mmbbl/day in 2010, and 1.4mmbbl/day in
2011 which would result in total consumption of close to 90mmbbl/day next year,
which is a record high. While demand growth is expectedly led by Asia, OECD
demand has also remained strong providing upside impetus to prices. On the
supply side, while non-OPEC supply is expected to grow by 1.2-1.3% in 2011
OPEC could supply is expected to grow at about 1.6% next year. Inventory drawdowns have also accelerated in 2010, reducing pressure on oil prices. Finally,
marginal cost of crude production in increasing with projects like Canadian Oil
sands being sanctioned, which could put a floor price to crude oil. This bodes well
for E&P companies as well as integrated refiners who could benefit from higher
dollar margins. We have consequently upgraded crude price forecasts to
US$87/bbl and expect prices to touch US$100/bbl sometime during the year.
Global LNG markets remain oversupplied, however, leading to a more cautious
outlook for 2011 compared to crude oil. While Asian demand is expected to grow
with new storage and re-gassification terminals expected to open in 2011, US and
European markets are expected to remain subdued given high inventories and
low demand growth.
RIL – Company description
RIL is one of India’s largest conglomerates and is principally engaged in Oil &
Gas exploration, Refining and Petrochemicals businesses. E&P, Refining and
Petrochemicals accounted for substantially all of the group’s revenues in FY10.
While petrochemicals and refining have been the main earnings contributors to
the company’s historical performance, the commencement and the subsequent
ramp-up of production at their KG-D6 gas field in India in 2009 has resulted in
E&P becoming an important vertical, accounting for circa 7% of revenues and
30% of group EBIT in 1HFY11. RIL’s growth over the last decade has been both
organic as well as via acquisitions, and growth plans are focused towards
growing their upstream and petrochemical presence as well as investing in new
business segments that have been identified as high-growth by management.
The company’s key business segments are discussed below.
Existing businesses
Refining: The company owns and operates two refineries in Jamnagar in
Western India, which have a total processing capacity of 1.24MMBL/day.
According to management, the refineries are amongst the more complex set-ups
globally which enable higher yields of value-added petroleum products as well as
enable processing of heavier crude, both of which help boost margins for the
refinery. In 2010, RIL exported about 55% of its refinery production while selling
about 21% domestically and using the balance as feedstock for its
petrochemicals business.
Petrochemicals: This is RIL’s earliest business vertical, and involves of
converting feedstock from their refining operations into polymers, polyester and
other intermediates. The company’s operations are primarily based in India and it
is amongst the top 5 producers globally for polyesters and polymers. The
business is domestically-focused, with over 80% of their production being sold
locally.
E&P: RIL’s main operating assets in the exploration & production segment
comprise of the 30% stake in the Panna-Mukta-Tapti (PMT) offshore fields in
Western India and a 90% stake in the KG-D6 gas field in Eastern India, which is
the world’s largest deepwater gas facility. The company also has participating
interests in 29 exploration blocks and 3 Coal-Bed Methane (CBM) blocks in India.
Its overseas E&P portfolio consists of smaller assets in Peru, Yemen, Oman,
Colombia, East Timor and Australia. RIL’s entire gas production from KG-D6 and
PMT is sold domestically as per government regulations, while a majority of crude
is also sold to domestic refiners.
New Initiatives
US Shale gas: The company has identified shale gas as a growth segment within
its energy vertical, and has entered into 3 JVs in the US via its subsidiary
Reliance Holding USA (the issuer of the bonds) to participate in E&P in the
Marcellus and Eagle Ford Shale reservoirs. The company’s total acerage from
the 3 JVs totals 317k hectares, which it proposes to explore over the next 5
years.
Retail: Reliance Retail was established in 2006 to build out organized retail
outlets in India, which focus on a variety of segments such as supermarkets,
apparel, health & wellness, jewelry and books, music & entertainment and autos.
RIL currently has over 1,000 stores in India under these divisions
Telecom: RIL has re-entered the telecom space by acquiring a 95% equity stake
in Infotel Broadband in June 2010. Infotel has acquired the rights for pan-India
wireless broadband access, and RIL plans to roll out data services (and
potentially add internet telephony if permitted) over the next 2-3 years.
Power: With the restructuring of the non-compete agreement with ADAG (run by
RIL chairman’s brother Anil Ambani), RIL is now able to engage in power
generation/ distribution businesses (apart from gas-fired power). The company
plans to invest in coal and hydel power generation over the next few years to
benefit from India’s infrastructure development needs.
The RILIN bonds are guaranteed by RIL and its subsidiaries, with the exception
of its Retail and Telecom businesses which do not form part of the borrower
group.
Aggressive growth targeted
RIL’s growth over the last decade or so has been via aggressive organic
investments (either capacity expansions or backward integration) as well as
acquisitions and forays into new growth sectors. Since 2001 the company has
invested approximately US$34bn in capex until March 2010, resulting in a
negative FCF of US$4bn in the period. Over the same period, revenues and
EBITDA have grown at a CAGR of 19.5% and 20% respectively. RIL’s expansion
plans over the next 5 years include investments in petrochemicals, oil and gas
production and building out their retail and telecom businesses. Key projects to
be undertaken include:
Petrochemicals: PX plant of 1.4MTPA, Off-Gas cracker of 1.5MTPA, Coke
Gasification project, ~ 1MTPA polyester yarn and PET plant, 2.3MTPA
intermediate PTA and Butadiene and Styrene rubber plants.
E&P: Accelerating exploration and development of O&G blocks in India, and
increasing investments in Shale Gas
Our equity analysts estimate the cost of domestic developments in petrochem
and E&P to be circa US$30-32bn over the next 5 years. This would be in addition
to maintenance expenses, investments into power and telecom and any inorganic
growth opportunities that the group decides to pursue. While there is no guidance
from management on these growth capex needs, the rating agencies believe it
likely that RIL would utilize all of its operating cashflows over the next few years
for these investments. As a result, the group would be exposed to execution and
funding risks over this period as it executes the next phase of its growth plans.
We believe it is likely that RIL would re-visit the international bond markets in
1HFY11, especially if liquidity flows remain strong into Asia and all-in yields keep
overseas borrowings attractive.
Improving credit profile due to E&P, but deleveraging unlikely
RIL’s operating performance has improved since 2009 with the commissioning of
KG-D6. EBITDA in FY10, which was the first full year of the gas field production,
was up 30% YoY to US$6.5bn while LTM standalone EBITDA grew to US$7.7bn
in September 2010. Volume growth in E&P, improving gross refining margins
(GRM) especially in 2HCY10 and domestic petrochemical demand all contributed
towards improved cashflows for the company. Therefore, while gross borrowings
have increased from US$12.6bn in FY08 to US$15.2bn in September 2010,
leverage metrics have improved with gross leverage at 1.9x and net leverage of
1.5x (stand-alone numbers). Our equity analysts expect GRMs to remain strong
in 2HFY11, which coupled with stronger petrochemical earnings could result in a
17% EBITDA growth in FY11 (for detailed projections please refer to their report
via the link given alongside). GRM trends in 3QFY11 have remained strong, led
by strong global oil demand growth in CY10. Estimates for 2011 include growth in
oil demand by 1.2-1.4mmbbl/day which on the back of estimated 2-2.3mmbbl/day
increase in 2010 points to strong growth in oil demand, which is expected to
support operating performance.
Given the company’s operating outlook and growth plans, we expect credit profile
to remain stable over the next 6-12 months for the company. However, growth
capital needs are expected to result in potential supply in G3 markets in CY11.
Near-term liquidity outlook remains strong, with cash & equivalents of US$3bn as
on September 30 th augmented by treasury shares of about US$5bn which
coupled with operating cashflows should be sufficient for anticipated capex needs
over the next few quarters.
Key risks/ catalysts
Aggressive expansion strategy, resulting in higher leverage: The company’s
growth ambitions in all of its business verticals could result in lumpy cash needs which
could result in weakening in credit profile. While the company’s metrics and liquidity
currently remain strong, the pressure to deploy capital coupled with multiple highintensity capex avenues available could lead to additional risk on the balance sheet.
Historically, management has kept leverage moderate with net gearing of 30-40%,
and barring a step change in investment plans we do not expect this to change
significantly in the near term, as a base case scenario. However, we would look for
greater clarity in their growth plans (especially new ventures such as E&P, power and
telecom) to assess the magnitude of capital needs and the resultant credit impact for
the company over the next 12-18 months.
Decline in GRMs/ petrochemical margins: GRMs have been trending stronger
in 2HCY10 helped by widening light-heavy crude spreads. If these margins
persist in CY11, RIL’s operating performance would benefit materially. FY09 was
a case in point, when poor demand globally for crude resulted in a significant dip
for refiners – RIL’s leverage increased to 3.2x from 2.2x in the previous year.
Execution risks: RIL’s ambitions to grow rapidly in their existing business
segments as well as in hitherto unexplored businesses such as power, telecom
and shale gas increase execution risks for the group. Given the capex-intensive
nature of these businesses, delays or material operating setbacks could have an
appreciable impact on the group’s credit profile.
Ratings outlook remains stable, migration
unlikely
RIL’s improvement in operating performance over the last 18 months has helped
shore up its credit metrics which are now well within rating tolerances, as can be
seen in table 2 below. Given the sovereign ceiling cap and the group’s linkage to
the domestic Indian market, upward migration is unlikely in the next few quarters
unless the sovereign ratings also improve. However, downward pressure is also
unlikely given the improvement in underlying business fundamentals. The
company’s expansion plans are well-known and although the quantum of capital
investing is unclear, current ratings have likely factored in negative FCF over the
next 12-24 months. Therefore, downward pressure will emerge only if spending is
front-ended or coincides with a dip in operating performance, or management
engages in large debt-funded acquisition beyond what is currently anticipated.
While we hope to get more clarity on spending plans over the next few months,
we do not expect a step change in credit profile to warrant downward rating
pressures in the near-term.
Bond structure
The RILIN ‘20s and ‘40s have been issued by Reliance Holding USA Inc., which
is a subsidiary of RIL. Reliance Holding currently owns the group’s shale gas
assets which were acquired in 2010. However, it remains dependant on holdco
cashflows to service these bonds given none of the US assets are producing
fields. The bonds constitute senior unsecured obligations of the issuer and are
guaranteed by the parent company, also on a senior unsecured basis. The bonds
are not guaranteed by Reliance Retail Ltd. And Infotel Broadband Services Ltd,
the subsidiaries which run the group’s retail and telecom endeavors respectively.
Covenants are standard HG in nature, with no major clauses limiting additional
leverage.
IOCL – Company description
IOC is India’s largest refining company. It has a refining capacity of about
61MMTPA and operates 10 of India’s 20 refineries. The company is also engaged
in petroleum marketing in India, and is majority (82%) owned by the Government
of India. IOC owns over 10k km of pipelines and is also a dominant player in
downstream pipeline capacity in the country. They also operate gas stations, and
are a leading participant in the retail marketing segment. Key products/ segments
include:
Petroleum products: This is the company’s main segment and accounted for
over 90% of FY10 revenues. The company engages in production of refined
products such as high-speed diesel, motor spirit (gasoline), jet fuel, naphtha, LPG
and heavy fuel oil amongst others. Over 94% of the company’s production is sold
domestically with about 40% sold to institutional clients while the rest is sold
through retail outlets/ dealer distribution.
Petrochemicals: A by-product of the refining process, petrochemicals constitute
a small proportion of the company’s revenues (1-2%) and include products such
as PTA, LAB and MTBE. However, IOC is increasing investments in the
petrochemical business and has recently commissioned a naphtha cracker and
polymerization unit in North India
E&P: The company entered into the Exploration business in 1996 and currently
holds working interests in 19 blocks (including 9 overseas projects). None of
these are producing assets yet, and therefore the company remains dependant
on third-party crude procurement for its refineries.
IOC imports 75% of its crude requirements from overseas (including the Middle
East, Iran, Nigeria and Malaysia) while the balance is sourced domestically.
Operating performance impacted by retail
price caps on petroleum products
Sale of refined petrochemical products in India is subject to price controls by the
central government, which makes marketing companies dependant on subsidies
to cover the under-recoveries. Prices of products such as MS, diesel, LPG for
domestic use and kerosene sold under the public distribution system are
controlled by the government to control inflation and as a socio-economic
subsidization scheme. Refineries are not impacted by these price controls, and
marketing companies are subsidized by the E&P companies (ONGC, OIL and
GAIL) as well as the Government in the form of cash subsidies or Oil Bonds
which can be monetized. However, the mechanism for subsidy sharing is not
fixed and each year the Government announces the proportion of sharing of
under-recoveries by upstream companies and by the government. Therefore,
operational performance for marketing companies such as IOC tends to be more
volatile and dependant on Govt policies.
While de-regulation of prices has commenced with petrol prices being marketlinked since June 2010, the more sensitive diesel, LPG and kerosene products
still remain controlled. Given recent high inflation prints and rising crude prices,
the decision to de-regulate prices could be a difficult one in the near-term for the
government, which could delay the expected improvement in IOC’s operating
metrics.
Credit metrics display higher volatility, but
remain within rating tolerance
Domestic demand for petroleum products has ensured that capacity utilization for
IOC’s refineries has remained high historically – the last three years saw
production at over 100% of installed capacity across the group. Operating
margins have remained volatile depending on crude price differential vs. domestic
price controls, causing resultant movements in borrowings for the company to
fund the deficit. As can be seen in table 4, gross loss has widened with crude
price movements in FY09, while subsidy recovery from the government has
fluctuated leading to IOC having to bear the balance burden to varying degrees
over the last four years (table 3 alongside).
Operating metrics for the company also weakened in 2009 due to the decline in
crude prices as well as additional borrowings to fund their petrochemicals and
refinery investments, leading to gross leverage increasing to 3x and interest cover
declining to 3.3x. Operating metrics have improved moderately in 2010, but
remain prone to volatility. On-balance sheet liquidity remains low, with cash and
equivalents of US$240mn (September 2010) vs. gross debt of US$9.7bn of which
about 55% is short-term debt. While the group retains access to banking loans
domestically as well as internationally (over US$3.6bn of total debt are comprised
of overseas borrowings), fluctuations in operating performance and subsidy
recovery could have to be funded via borrowings. We note that the company has
over US$4bn of Oil Bonds on its balance sheet which could be monetized to fund
cash needs, and which supports their liquidity position.
Key risks/ catalysts
Sovereign rating changes, or decline in implied government support:
IOC’s ratings remain closely linked to the Indian sovereign ratings, reflecting the
strategic nature of the business and Governmental support via subsidies. An
upward move in the sovereign ceiling would have a knock-on impact on IOC’s
ratings. The government of India is also considering selling down their stake in
IOC and ONGC over the next one year, in order to raise capital and reduce the
fiscal deficit. It is however expected that the government would continue to have a
majority stake in the company and also continue to support their operations, and
any change in this implied support could have downward implications for the
company’s’ credit ratings.
Deregulation: Market-linked pricing of petroleum products would be the key
positive for the company, freeing it from subsidy dependence. While our India oil&
gas analysts expect progress on deregulation in CY2011, the political
ramifications could potentially delay the process further and thereby delay the
expected benefits for marketing companies. De-regulation would also result in the
potential entry of private sector companies in marketing, which could increase
competition and reduce margins for less efficient players/less complex refineries
in the long run.
Capex plans, and increasing exposure to petrochemicals: IOC has recently
commissioned their 850kTPA naphtha cracker and polymer unit in 2QCY2010.
This would increase the company’s exposure in the petrochemicals segment and
add diversification to their largely monoline business model. IOC’s capex plans
over the next 2-4 years are expected to cost around US$10-11bn, which include
upstream, refining as well as nuclear power generation capacities. Execution of
these growth plans could lead to volatility in their credit metrics, especially if we
see a dip in the global petrochemicals business.
Ratings outlook
IOC’s Baa3 ratings benefit from sovereign support, and the stable outlook
currently reflects improving industry dynamics as well as progress in deregulation of the domestic petroleum markets in India. We expect ratings to
remain stable unless there are material changes in business risk and balance
sheet leverage due to growth capex, or we witness a decline in the government’s
implied support to the company. Given their strategic importance to the domestic
markets, we view the possibility of a de-linking of IOC risk from the sovereign as
very low, and expect ratings to remain at current levels. The Government’s
support to marketing companies in India has been demonstrated over time, with
compensation for subsidies making up a significant part of the fiscal deficit every
year. Given IOC’s dominant position in retail gasoline, diesel and domestic LPG
sales in the country it is unlikely that the government support seen thus far is
reduced.
Upward pressures on ratings could emerge in the latter half of CY2011,
depending on the country’s rating outlook which is expected to also gradually
migrate upwards, linked to additional fiscal reforms.
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