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India: Energy
Equity Research
Return of global cyclicals to mark 2011; raise RIL to Conviction Buy
Our stock preference shifts within the Indian oil and gas sector as
strong demand brings focus back to the global cyclicals
With strong oil demand likely to consume OPEC spare capacity over the
medium term, the refining cycle turning a corner and the ethylene cycle
likely to bottom out in 2HCY11, we see the investment theme in Indian
energy in CY11 shifting to cyclicals after two years of focus on local themes
like regulatory reforms and natural gas. Although domestic gas plays could
still give some upside from current levels, risk-reward from here is more
favourable for the out-of-favour cyclicals, in our view. We add Reliance
Industries (RIL) to our Asia Pacific Conviction Buy list, keep Buy on Cairn
India and GSPL and retain Sell on HPCL and Petronet LNG. Among the
state-owned companies, we prefer GAIL (Buy), which we remove from the
CL, seeing better upside in RIL.
Fuel price reforms – rising oil prices, sticky inflation and weakening
INR-USD exchange rates pose threats
While further fuel pricing reforms have been delayed because of rising oil
prices and sticky inflation, we believe that weaker of INR-USD exchange
rates and political considerations for the upcoming provincial elections
from 2QCY11 could further limit near-term regulatory triggers. Although
the oil marketing companies’ (OMC) stocks are not pricing in diesel deregulation any more, we believe that at current valuations, they still remain
vulnerable to further rise in under-recoveries, resulting in lower earnings.
Domestic natural gas and transmission volume growth still
provide structural investment theme
We believe exposure to domestic gas volume growth, with an eye for the
potential of city gas business, still provides a structural theme in the sector
– especially in GAIL and GSPL. Though we prefer domestic gas theme over
LNG, the gas transmission companies benefit irrespective, in our view.
RIL (CL) is our top sector pick followed by Cairn India; keep Buy on
GSPL and GAIL; keep Sell on PLNG and HPCL; GAIL off CL
RIL is the best stock in our coverage to gain exposure to recovery in
refining and likely turnaround of ethylene cycle in 2HCY11. Any positive
newsflow on E&P, telecom or retail would further re-rate the stock, in our
view. Our SOTP-based 12-m TP of Rs1,250 implies 23% upside. We like
HPCL the least as we believe it has no catalyst apart from policy action. Our
EV/EBITDA-based 12-m TP of Rs354 implies 7% downside.
Return of global cyclicals to mark ‘11; raise RIL to Conviction Buy
With strong oil demand likely to consume OPEC spare capacity over the medium term, the
refining cycle turning a corner and the ethylene cycle likely to bottom out in 2HCY11, we
see the investment theme in Indian energy in CY11 shifting to cyclicals after two years of
focus on local themes like regulatory reforms and natural gas. Although domestic gas
plays could still have some upside from current levels, the risk-reward from here is more
favourable for the out-of-favour cyclicals, in our view.
Upgrade RIL to Conviction Buy (please refer to the report on RIL by same author titled
“Reliance Industries (RELI.BO) Buy: From 0/3 last year to at least 2/3 in 2011; add to
Conviction Buy list”, dated 17-Jan-2011).
We retain Buy ratings on Cairn India, GSPL and GAIL. We have taken GAIL off the Asia
Pacific Conviction list as we see better upside in RIL.
We maintain Sell ratings on HPCL and PLNG.
With RIL’s leverage to recovering complex refining margin, and the global ethylene cycle
likely to bottom out in 2HCY11, we believe the outlook for two of RIL’s three core
businesses (Refining and Petchem) is improving going forward. With the delay in D-6
volume ramp-up widely known and likely priced in, any positive news flow on the E&P
front could further re-rate RIL stock, in our view. We also believe that there could be
updates on RIL’s broadband and retail businesses in 2HFY12.
Focus back on the global cyclicals; RIL/Cairn are key beneficiaries
Oil price likely to grind higher as inventories decline and OPEC
spare capacity comes down
We expect global oil demand to continue to grow faster than supply throughout the
period 2010- 2012, even after including supply from Iraq and OPEC NGLs. With 4Q2010
global oil demand marking a full recovery to pre-recession levels, we expect the bullish oil
market balance to start translating to visible draws in oil inventories and OPEC spare
capacity. While non-OPEC supply did surprise on the upside in 2010, it has been fully offset
by higher demand, in our view.
The medium term oil demand growth of more than supply would lead, in our view, to 97%
OPEC capacity utilization (up from 89% in 2009) and the likely need of a price that reduces
demand in the less efficient consuming countries. We think effective OPEC spare
capacity (i.e., excluding Nigeria shut-in production and Saudi over 10 million b/d) will
be below 2 mn b/d by 2012 - the level of spare capacity that worried the market in
2007-08. Our Brent price forecasts are US$100/bbl in 2011 and US$110/bbl in 2012.
Refining cycle has turned the corner; to remain in upswing until
2014E
We believe that strong non-OECD oil demand growth and stable OECD demand will pull
the global refining sector into cyclical recovery over the medium term. We are now
expecting the refining cycle to remain in upswing until 2014E, when a wall of refining
capacities from China, Middle East, and Africa is scheduled to hit the market.
While the recovery in the refinery utilization rates is most prominent for Asia Pacific, we
find that it will likely manage to pull the global utilization rates to new all-time high by 2013.
The pace and degree of recovery in margins in the different regions, however, will
likely depend on local demand characteristics, vulnerability to imports from lower
cost suppliers, and access to growing export markets.
We expect Singapore complex margins to improve into 2011 on the back of higher
utilization rates. We expect middle distillate product cracks to continue to rise due to strong
demand for these products in the region. We believe stronger oil demand, a delay in new
capacities in Asia, and a widening light-heavy oil price differential going forward provide
an upside case to the margins of the complex Asian refiners, in our view.
Ethylene cycle likely to bottom out in 2HCY11
We believe the capacity expansion in the industry will pass its peak in 1H2011. The
bulk of current ethylene capacity expansion is in Asia and the Middle East and original
plans called for completion and startup in 2010-2011. The expansion peak seems likely to
be 1H2011 due to delays in Middle Eastern startups and/or low operating rates at startup,
and it should mark the bottom for capacity utilization. We think there will be little capacity
expansion beyond 1H2011. We estimate that global ethylene capacity will grow at an
annual pace of 2.6% during 2011-2015, falling short of our annualized global GDP
growth forecast (4.9%) and therefore leading to improvement in supply/demand and an
increase in capacity utilization (see Exhibit 7).
The ethylene margin—the spread between the ethylene spot price and the naphtha price
(the raw material used to make ethylene)—started falling in mid-2010, reflecting slack
supply/demand and reached US$200/tonne, which has historically been a rough marker of
the bottom of the cycle (Exhibit 8). We believe the ethylene margin could fall below
US$200/tonne in 1H2011, but it should start to widen from 2H2011 as capacity
utilization improves. We also see similar situations for ethylene derivatives.
Reliance Industries is the best stock in our coverage to gain from the exposure to
recovery in refining and from the likely turnaround of ethylene cycle in 2HCY11. RIL
will be a key beneficiary of distillate crack recovery and a potentially widening light-heavy
crude differential, in our view. Higher utilization of ethylene capacities and increasing
margins would also provide a boost to the earnings.
Fuel price reforms – rising oil prices, sticky inflation and weakening
INR-USD exchange rates pose threats
While further fuel pricing reforms have been delayed due to rising oil prices and sticky
inflation, we believe that weaker INR-USD exchange rates and political considerations for
the upcoming provincial elections from 2QCY11 could further limit near-term regulatory
triggers. Although the oil marketing companies’ (OMC) stocks are not pricing in diesel deregulation any more, we believe that at current valuations, they still remain vulnerable to
further rise in under-recoveries, resulting in lower earnings.
Natural gas story still offers some upside in transmission names
We believe that growth in natural gas volumes still provides a structural investment theme
in the Indian energy space, despite uncertainties in the medium term over growth in
domestic gas volumes.
We prefer plays on transmission volume growth, which benefit from both domestic and
imported gas, with an eye for the potential of city gas distribution businesses, which is at
the cusp of taking off, in our view.
In the gas supply model for India, we are not assuming any incremental supply ramp-up
from RIL for FY12, which could have upside potential based on the government’s target of
60mmsmcd D-6 gas production by March 2011. Currently we assume that RIL will start
ramping up gas volumes again after FY12 and that other domestic gas sources will add to
the domestic production after FY13.
While the lack of higher RIL volumes would increase the demand supply gap leading to
further imports of LNG, we believe that the increase in LNG imports will not be to the
extent of the shortfall, owing to cost sensitivity of the large end consumers, notably power
and fertiliser units. Particularly for power plants, imported coal would be preferred
over LNG to lower costs at price above US$8.5/mmBtu, as per our calculations.
Moreover, expensive LNG would need to blended with cheaper domestic gas to make it
affordable to end consumers, in our view and hence lack of domestic supply could pose a
limitation to significant ramp-up of LNG volumes in the country.
Therefore, we believe that the Indian gas story is going to be primarily driven by
domestic gas in India and not Imported LNG.
India’s city gas business is today where China’s was 7-9 years back
We believe that India’s city gas industry is currently undergoing the early days of the “landgrab” phase that characterized the Chinese industry 7-9 years back. In India, the process is
likely to be faster due to more visibility of gas supply than that China had in early 2000s.
We believe that auctions of geographical Areas (GAs) offer long term growth potential to
the gas companies beyond the upfront capex phase. It is a high margin part of the gas
value chain since there is an element of pricing power in a largely regulated industry.
Looking back at the price performance of the Chinese gas distribution stocks, we find that
the leaders in the auction phase were the better performing gas stocks over the longer
term as the city gas business started growing in size and scale.
In India, the city gas business is likely to be dominated by GAIL Gas, unlisted subsidiary of
GAIL, which is likely to emerge as the largest city gas player, in our view. Going by
conservative Asian peer group EV/GA (EV/geographical area) valuation, we estimate
that GAIL Gas could easily have an EV of US$7bn by FY15E, which is not currently
included in our base case for GAIL.
With more auctions of Geographical Areas (GAs) by the Indian gas regulator, and emerging
clarity of GAIL Gas’ capex and roll out plans in the city gas business in the coming quarters,
we believe we may need to start reflecting some value for GAIL Gas in our base case
assumptions for GAIL.
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