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Energy
India
Gone with the gas. We see likely lower gas production from RIL’s KG D-6 block with
escalating concerns on gas supply in India over the next few years. We have revised our
earnings for gas transmission companies (GSPL, GAIL) to reflect lower gas supply in
India. GSPL’s new pipelines could face serious challenges in sourcing gas. We see
downside risk of 8-14% for RIL’s FY2012-13E EPS assuming gas production of 50 mcm/d
from its KG D-6 block. We will review RIL’s numbers at the time of 3QFY11 results
Production from RIL’s KG D-6 block could remain at 50 mcm/d until FY2014E
As per an industry journal (Indian Petro), RIL has informed DGH that it will not be able to ramp up
gas production from its KG D-6 block beyond 50 mcm/d until FY2014E. The company has
highlighted that there are some serious reservoir issues including water ingression in wells, sand
interference and pressure depletion. This development, if confirmed, poses significant downside
risk to RIL’s earnings; our FY2012E and FY2013E EPS for RIL will decline by `6 (-8.5%) and `11 (-
13.8%), if gas production declines to 50 mcm/d versus our current assumption of 70 mcm/d in
FY2012E and 88 mcm/d in FY2013E.
Lower-than-expected production from KG D-6 block raises concerns on gas supply in India
We see a case for significant disappointment on estimates for gas supply in India over the next 5-7
years. Our concern has been further exacerbated by the likelihood of lower-than-expected gas
production from RIL’s KG D-6 block. Our base-case scenario estimates that gas supply in India will
ramp up to 335 mcm/d by FY2017E from 177 mcm/d in FY2011E (see Exhibit 1). However, we see
significant downside risk to our estimates from (1) lower-than-expected production from RIL’s KG
D-6 block, and (2) delay in commencement of production from RIL’s NEC-25, KG D-3 and KG D-9
blocks to beyond FY2017E. Our worse-case scenario implies a modest increase of 67 mcm/d in gas
supply by FY2017E (see Exhibit 2).
Disappointment on gas supply creates earnings risk for transmission companies (GSPL, GAIL)
We see downside risk to earnings of gas transmission companies (GSPL, GAIL) from potentially
lower gas supply in India, which could result in lower gas transmission volumes for the companies’
pipelines. Additionally, GSPL’s new pipelines will face serious challenges in sourcing gas.
Revise earnings for transmission companies to reflect lower gas volumes
We have revised our FY2011-13E EPS for GAIL to `29.8 (+4.8%), `35.9 (-9.7%) and `42.7 (-2.3%)
to reflect (1) lower gas volumes, (2) higher LPG and petchem prices, (3) higher subsidy burden,
(4) changes in exchange rate assumptions, and (5) other minor changes. We downgrade GAIL to
ADD rating from BUY with a revised 12-month SOTP-based target price of `555 (`565 previously)
given moderate upside of 11% from current levels. We have revised our FY2012-13E EPS for GSPL
to `7.3 (-10%) and `8.3 (-8%) to reflect (1) lower gas volumes and (2) higher transmission tariffs.
We retain our SELL rating on GSPL with a revised 12-month DCF-based target price of `89 (`87
previously) given 17% downside to our fair value from current levels.
Impact on key players from lower-than-expected production from KG D-6 block
We analyze the impact of lower-than-expected production from RIL’s KG D-6 block on RIL,
GAIL and GSPL.
RIL. Our FY2012E and FY2013E EPS for RIL will decline to `66 (-8.5%) and `70 (-13.8%),
if gas production declines to 50 mcm/d versus our generous assumption of 70 mcm/d in
FY2012E and 88 mcm/d in FY2013E. We also see downside risk to valuation of RIL’s E&P
business from (1) downward revision in recoverable reserves from KG D-6 block, (2) lower
value being ascribed to RIL’s other discovered blocks and (3) lower option value being
ascribed to RIL’s potential new E&P discoveries.
GAIL. We have reduced GAIL’s gas transmission volumes to 129 mcm/d (-8 mcm/d) in
FY2012E and 149 mcm/d (-3 mcm/d) in FY2013E versus 118 mcm/d in FY2011E. We note
that GAIL’s pipeline tariffs for the new pipelines (barring DV-GREP upgradation) are yet to
be fixed by the regulator and may be adjusted (up) if gas volumes are lower versus our
expectations—the new pipelines operate under regulated returns (12% post-tax IRR).
Also, the pipeline tariffs fixed for GAIL’s extant HVJ pipeline and DV-GREP upgradation
may be adjusted upwards to compensate for lower gas volumes, when the tariffs are
reviewed by PNGRB. This will moderate the negative impact on GAIL’s SOTP-based fair
valuation.
We believe GAIL is in a better position versus GSPL regarding availability of gas since two
of its new pipelines (Dabhol-Bangalore and Kochi-Mangalore-Bangalore) will get gas from
LNG import terminals at Dabhol and Kochi. GAIL will also have first priority for supply of
gas, in our view, given it supplies to fertilizer and power plants, priority sectors as per the
government’s gas allocation policy.
GSPL. We now model gas transmission volumes for GSPL at 42.6 mcm/d (-4.5 mcm/d) in
FY2012E and 48.6 mcm/d (-5 mcm/d) in FY2013E versus 37.3 mcm/d in FY2011E. We
have revised GSPL’s transmission tariffs to `0.74/cu m (+5.2%) in FY2012E and `0.68/cu
m (+4.5%) in FY2013E. The regulator is yet to decide on GSPL’s transmission tariffs but it
will likely factor in reduced volumes for computation of GSPL’s transmission tariffs.
We highlight our concerns on supply of gas for GSPL’s two new pipelines (Mallavaram-
Vijapur-Bhilwara and Mehsana-Bhatinda with a total capacity of 96 mcm/d), which it has
bid under a competitive bidding process. We note that the tariffs for these pipelines
cannot be revised, even if volumes fall short of its base assumptions. We doubt India will
see meaningful increase in supply of gas to feed these two pipelines by FY2014E, when
these pipelines will start operations. The incremental gas supply will be absorbed by
GAIL’s extant and new pipelines, which will be commissioned well before GSPL’s new
pipelines.
PLNG. We note that increase in spot LNG cargoes due to lower domestic gas supply may
improve the earnings for PLNG in the medium term. We are anyway modeling a strong
increase in spot LNG volumes to 2.1 mn tons in FY2012E and 3 mn tons in FY2013E. We
note that high-priced LNG may not be easy to sell in the domestic market, particularly in
the price-sensitive fertilizer and power sectors. We note that state electricity boards have
reduced purchase of expensive merchant power given their precarious financial condition.
We note that the price of power generated using spot LNG will be significantly higher
than imported coal’s (see Exhibit 3, which compares the price of power based on various
fuels). We do not see high-priced LNG imports as a replacement of domestic gas given
high landed cost of spot LNG at over US$11/mn BTU versus a comparable price of
US$4.2-5.7/mn BTU for domestic gas.
As per an article in Petrowatch, GSPC’s spot LNG cargo from Stream was diverted to
Shell’s Hazira terminal on November 28, 2010 due to overcapacity at PLNG’s Dahej
terminal. We note that PLNG continues to grapple with high inventory level, which is
likely to persist in the future. We highlight that upside to the volumes of PLNG will be
curtailed by the terminal capacity of 10.5 mn tons till the second jetty is commissioned.
Earnings revision for GAIL
Exhibit 4 gives our key assumptions for GAIL. We have revised our FY2011-13E EPS
estimates to `29.8, `35.9 and `42.7 from `28.4, `39.7 and `43.7 due to the following
changes.
Gas transmission volumes. We have revised gas transmission volumes for FY2012E and
FY2013E to 129 mcm/d and 149 mcm/d versus our earlier assumptions of 137 mcm/d
and 152 mcm/d to reflect lower gas supply in India.
Crude oil and LPG price. We have revised our FY2011E, FY2012E and FY2013E crude oil
(Dated Brent) price assumptions to US$82/bbl, US$85/bbl and US$85/bbl from
US$79/bbl, US$81/bbl and US$85/bbl. This results in higher LPG and petrochemical
prices, positive for GAIL’s earnings.
Subsidy amount. We model subsidy amount for FY2011E, FY2012E and FY2013E at
`17.5 bn, `15.8 bn and `12.6 bn compared to `14.9 bn, `10.2 bn and `11.6 bn. The
higher figure reflects higher under-recoveries due to upward revision to crude oil prices
and likely delay in diesel deregulation. We assume that upstream companies will bear
one-third of total under-recoveries and GAIL will bear 7.6% of subsidy burden on
upstream companies, in line with its 1HFY11 share.
Petrochemical margins. We have increased our petrochemical price assumptions for
FY2011-13E in line with the upward revision to crude oil prices. We note that the
petrochemical (PE) prices are more relevant for GAIL compared to PE spreads over
naphtha; it produces PE from natural gas.
Rupee-dollar exchange rate. We now model exchange rate for FY2011E, FY2012E and
FY2013E at `45.6/US$, `45.5/US$ and `44/US$ versus `45.5/US$, `44.5/US$ and
`44.5/US$ earlier.
Earnings revision for GSPL
We have revised our FY2012-13E EPS estimates to `7.3 and `8.3 from `8.1 and `9.1 due to
the following changes.
Gas transportation volumes. We now model gas transmission volumes for FY2012E
and FY2013E at 42.6 mcm/d and 48.6 mcm/d versus our earlier assumptions of 47.1
mcm/d and 53.6 mcm/d to reflect lower gas supply in India.
Gas transportation charges. We have revised FY2012E and FY2013E gas transportation
tariffs to `0.74/cu m (+5.2%) and `0.68/cu m (-4.5%). We note that our assumptions
result in a healthy 17.3% CROCI in FY2012-13E.
Exhibit 5 shows sensitivity of GSPL’s valuation to transmission tariff assumptions. Our 12-
month DCF-based target price of `89 is based on tariff assumptions, which result in very
high CROCI of 16.5% in FY2012-21E. If we assume 2QFY11 tariff of `0.78/cu m in
perpetuity, we get a 12-month forward DCF valuation of `126 and average CROCI of
21.1% in FY2012-21E. However, the same drops to `69 with average CROCI of 14% in
FY2012-21E based on a constant tariff of `0.52/cu m in perpetuity. We believe the last
scenario may be more reflective of reality. The new regulations for gas transmission
companies permit 12% post-tax or 18.18% pre-tax return on capital employed.
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