CLSA:: ONGC: Upgrade to Buy

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Upgrade to Buy
Driven by gas pool reimbursement of Rs18bn, ONGC’s 3QFY11 net profit is
expected to rise by 110%YoY to Rs64.1bn. Encouraging monthly production data
and ONGC’s internal FY12 production estimates suggest that decline in ONGC’s
domestic production may have been stemmed. ONGC’s expected FPO would
increase its float and should act as a long term positive. While the FPO price
remains unclear and may be a near-term overhang, at 4.3x FY12Ev/Ebitda, ONGC’s
19% discount to global peer average should limit downside. Newsflow ahead of
FPO should also be supportive for stock performance. Upgrade to BUY (+26%)

Reimbursements from gas pool account to boost 3QFY11 profits
Driven by gas pool reimbursement of Rs18bn, ONGC’s standalone 3QFY11 net profit
(Rs64.1bn) should rise by a strong 110%YoY/35%QoQ. While this is largely a one off,
we understand that government has recently notified to make gas pool
reimbursements on a more regular basis going forward. The US$10/bbl QoQ rise in
crude price is expected to be completely offset by a 50%QoQ jump in ONGC’s subsidy
burden to Rs45.4bn, keeping 3Q net realisation flat on a QoQ basis at US$63/bbl.

Decline in ONGC’s domestic production may have been stemmed
Given that production decline from ONGC's domestic fields has been a key concern, it
is encouraging to note that monthly momentum in crude production has been positive
since Aug’10. Even gas production in 3QFY11 grew by 0.2%QoQ to 63.2mmscmd.
Moreover, ONGC's internal plan for FY12 aims at a 0.6%YoY growth in crude (508kbpd)
and a stronger 2.4%YoY growth in gas production (64.3mmscmd). Notwithstanding
ONGC’s poor delivery record, these figures clearly point towards signs of improvement.

Upstream companies better placed in an unclear subsidy sharing framework
We do not expect the adhoc nature of subsidy sharing formula to change anytime
soon. Although this is negative for all the state owned companies, we prefer upstream
names given their lower sensitivity (1% on EPS for every 1ppt change in share) to any
adverse changes; the share of upstream (30-43%) has also been more stable
historically. We have cut our FY11-13CL estimate by 2-5%, building in higher
exploration write offs, lower JV production, exceptional in OVL and higher subsidies.

Upgrading to BUY as risk reward has turned more favourable
While the expected FPO in Mar’11 should act as a long term positive for the stock as it
will increase ONGC’s trading float as well as weight in key indices, we concede that FPO
pricing remains unknown and could be a short term overhang. Nevertheless, at 4.3x
FY12Ev/EBITDA and 10x FY12PE, ONGC is trading at 19-28% discount to global peer
average multiples and we see limited downside from these levels. Moreover, in the run
up to the FPO, we expect news flow to also turn supportive. For example, we estimate
that favourable changes to Pre-NELP agreements (like Cairn’s Rajasthan block) could
add Rs65/share to ONGC’s fair value. Upgrade to BUY (Target of Rs1500/share,+26%).