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Cairn India Ltd.
Asia’s Best E&P Play for ’11
Investment Conclusion: We resume coverage of Cairn
India with an Overweight rating and a price target of
Rs429/share, implying upside of 28% from the current
levels. Three key reasons for our OW rating: 1) Our
bullish view on crude; 2) Strong Production growth
ahead; 3) Valuations look compelling.
We are bullish on Crude oil prices on the back of
supply constraints and higher demand. Our
Commodities team expects global spare capacity to fall
to untenable levels near 1mn bpd at end-2013, which
would keep long-term oil prices at higher levels. Cairn is
one of the most levered oil stocks in Asia, with earnings
rising by 1.9% for each US$1/bbl increase in oil prices.
Strong Production Growth: We estimate Cairn’s
production to show an impressive 25% CAGR in
F2011-14, driven by the Rajasthan field ramping up from
current levels of 125kb/d to a little over 220kb/d by
F2014. Cairn has also been able to extend the life of its
Ravva field to over 18 years and in March 2010
revalidated a 2P reserve of 100mn bbls, which should
contribute 2.5% of overall production even in F2014.
Valuations looks attractive: Cairn trades at P/E of 7.4x
and EV/EBITDA of 4.7x on our F2012e earnings,
implying discounts of 48% and 28%, respectively, to its
global peers. The stock price is currently discounting an
implied crude oil price of US$74/bbl (WTI), one of the
lowest amongst Asian E&P players. The Free Cash flow
yield should move from 2.9% in F2011 to an impressive
13.1% in F2013 as compared to Asian average of ~6%.
Concerns on Cairn-Vedanta deal overdone;
outcome possible in Feb: Cairn has underperformed
the market by 5% since the deal was announced, and its
correlation with oil prices has turned negative, making
this an attractive time to buy the stock, we believe.
Risk-Reward Snapshot: Cairn India (CAIL.BO, Rs335, OW, PT Rs429)
Investment Thesis
• We are bullish on Crude oil prices
in the long term on supply constraint,
and we expect global spare capacity
to fall to untenable levels of ~1mb/d at
end-13, which would keep oil prices at
higher levels. Cairn is one of the most
levered oil stocks with 1.9% earnings
sensitivity per dollar change in oil
prices.
•Strong production growth: We
estimate Cairn India’s production to
show an impressive 25% CAGR in
F2011-14, driven by ramp-up in the
Rajasthan basin.
• Attractively Valued: Cairn trades at
P/E of 7.4x and EV/EBITDA of 4.7x on
our F2012e earnings, implying
discounts of 48% and 28%,
respectively, to its global peers. Cairn
India’s stock price is currently
discounting a crude oil price of
US$74/bbl.
Key Catalysts
• Leveraged to crude oil prices. Every
dollar change in realized crude oil
price affects Cairn’s earnings by
~1.9%, we estimate.
• Clarity on issues of Cess and crude oil
pricing.
• Approval of Cairn-Vedanta deal by the
Government of India.
Key Risks
• Crude volatility: Global crude prices
are cyclical and volatile, so Cairn’s
earnings may correlate with sector
cyclicality.
• Price of Rajasthan crude: Could be
limited by its viscous nature, which
would lower realizations relative to
Brent.
Investment Case
We resume coverage of Cairn (Cairn India) with an
Overweight rating and a price target of Rs429/share,
implying upside of 28% from the current level.
Three key reasons for our OW rating are:
1) We are bullish on Crude oil prices in the long term,
driven by higher demand and coupled with supply constraints.
We expect global spare capacity to fall to untenable levels of
2.5 mbpd in 2012, and worsen to 1 mbpd at end-2013, which
would keep oil prices at higher levels (Exhibit 17). The forward
curve has flattened in the past three months due to the
strength in crude oil prices, as against a contango earlier.
2) Cairn has Strong Production Growth with 25% CAGR in
F2011-14e, driven by ramp-up in the Rajasthan Basin, as well
as contribution of its existing asset in Ravva (Exhibit 1).
3) Valuation looks attractive: Cairn trades at P/E of 7.4x
and EV/EBITDA of 4.7x on our F2012e earnings, implying
discounts of 48% and 28%, respectively, to its global peers.
The stock price is currently discounting an implied crude oil
price of US$74/bbl (WTI), compared with our long-term
assumption of US$90/bbl. The Free Cash flow yield should
move from 2.9% in F2011 to an impressive 13.1% in
F2013 as compared to Asian average of ~6%.
Strong Execution skills demonstrated
Cairn has passed a significant milestone on the
execution front with its Rajasthan assets in the past 12
months, as shown in Exhibit 2. It has completed Phase I of
project delivery, which included:
a) Upstream development of Mangala field with plateau
production of 125kbd, construction of three
processing trains with a total capacity of 130kbd, and
b) Completion of the pipeline from the Mangala terminal
to Salaya in Gujarat.
In Phase II of its Rajasthan Basin project, Cairn is
1) Developing the Bhagyam and Aishwariya fields, and
constructing a fourth processing train of 75kbd;
2) Planning to extend the pipeline to Bhogat in 2011-12.
We estimate Cairn India’s production to show an
impressive 25% CAGR in F2011-14 as it ramps up
Rajasthan output from current level of 125kb/d to over
220kb/d by F2014.
As shown in Exhibit 1, we expect Cairn’s production to exit at
125kb/d in F2011 from Mangala field. We now assume
Bhagyam (40kb/d) and Aishwariya (10kb/d) commence
production from CY3Q11 and CY1Q12, respectively, taking
the F2012 exit production to 175kb/d. We also assume
Mangala achieves peak production of 150kb/d in CY1Q13 and
Aishwariya ramps up to 20kb/d in CY2Q12, taking the F2013
exit production to 210kb/d. With additional 10kb/d from
Bhagyam in 3Q13, we estimate the company will reach
220kb/d by F2014 with Mangala producing 150kb/d, Bhagyam
producing 50kb/d and Aishwariya producing 20kb/d.
Resource base getting better and bigger: During 2010,
Cairn India increased the estimate for its gross discovered
resource base for the Rajasthan block from 3.7bn boe to
4.0bn boe. Also, Cairn estimates that the Rajasthan basin
could have exploration upside with a potential resource
base of 2.5bn boe with gross risked prospective recoverable
resources estimated at 250mn boe, i.e., 175mnboe net to
Cairn. We now estimate overall reserve and resource of 5bn
for Cairn’s working interest, with a 2P of 1bn boe including
upside from EOR and Rajasthan exploration. Further, in a
presentation, Vedanta has indicated that there is in-place
resources potential of 7bn of oil on top of the current
6.5bn boe in the Rajasthan block. Although we believe it is
premature to build any upside based on this, it underscores
the future growth potential of the Rajasthan block.
Upside to our production estimates in long term
Cairn believes that Mangala production can be increased to
150kbpd and Aishwariya to 20kbpd, and hence overall
plateau production from MBA fields can go up to 210kbpd,
subject to GOI approvals. With exploration success and
additional investment, Cairn’s vision is to achieve production
of 240kbpd from the Rajasthan fields. Overall, we assume
Cairn’s MBA production to touch 220kbpd in F2014. A 20kbpd
increase in production would raise our EPS and DCF
estimates by ~10% and ~6%, respectively.
Cairn is one of the most levered oil stocks with
earnings sensitivity of 1.9% per dollar change in its oil price
realisation. In addition, Cairn’s stock price is highly correlated
to oil prices with two-year correlation at 0.90x. However, in the
past six months, Cairn’s stock price has actually shown
negative correlation with oil prices (Exhibit 5), and we believe
this is largely attributable to investor concerns about the
Cairn-Vedanta deal. We think that with a decision on the deal
likely by mid-Feb, the correlation could once again become
positive, providing advantage to oil price movement.
Cess on Rajasthan
Cairn has stated that the Rajasthan Production Sharing
Contract (PSC) does not specifically mention that it will be
liable to pay any cess on its crude oil. However, the Ministry of
Petroleum has notified Cairn that the Rajasthan block will be
liable to pay cess, which is currently Rs2,500/ton. Cairn has
been paying the cess under protest, but the issue is under
arbitration. In our conservative earnings forecast, we
assume that Cairn pays a cess of Rs2,500/ton and that
Rajasthan crude price realization is benchmarked at a
12.5% discount to Brent. We present our key financial
assumptions
Regulatory Concerns on Cairn-Vedanta Deal
Cairn has NELP and Pre NELP assets in India, and it believes
it does not need government and ONGC approval for its Pre
NELP assets in the Rajasthan, Cambay and Ravva blocks.
However, GOI has disputed Cairn’s initial claims that
government approval is not required for the deal, as this is a
corporate transaction rather than an asset sale.
Further, ONGC has the pre-emption right of first refusal for the
deal. Media reports (Bloomberg, Nov 29) have suggested that
Cairn Energy has submitted an application for government
approval for all the blocks, and the Petroleum Secretary has
indicated that the government will take a decision by
Feb/March 2011.
Cairn-Vedanta Deal Dynamics: Cairn Energy in August
2010 announced plans to sell to Vedanta up to 51% of its
stake in Cairn India. Vedanta will pay Cairn Rs405/share in
cash, comprising Rs355/share for the purchase and sale
agreement and Rs50/share for the non-compete
arrangements.
In accordance with SEBI regulations, Vedanta will also make
an open offer to Cairn India shareholders, at Rs355/share, for
up to 20% of the issued shares in Cairn India. Depending
upon the success of the open offer, the number of Cairn India
shares sold to Vedanta may be scaled back, subject to a
minimum of 40% of the fully diluted share capital of Cairn India
post completion of the transaction.
The remaining stake sale of up to 51% will be completed
through put and call arrangements, exercisable after July
2012 and July 2013, at an exercise price of Rs405/share. This
will ensure a sale of a majority interest in Cairn India to
Vedanta.
Cairn has underperformed the market by 5% post
announcement of the deal. We believe that investors
concerns related to the deal include: 1) Vedanta potential lack
of prowess in the crude oil industry; 2) Concerns about the use
of free cash flow of Cairn in future.
We believe the market’s concerns on the deal are
overdone. Both Cairn and Vedanta shareholders have
already approved the transaction and await government
approval. The Indian government has already stated that it
will take a decision on the deal in mid-February.
Will the ONGC and Government approvals come through
to Cairn to increase its production?
As per the terms of the Production Sharing Contract (PSC)
ONGC has to pay 100% of the royalty on Rajasthan
production despite owning a 30% stake in the field. Hence,
the current royalty system does not provide any incentive for
ONGC to allow a higher production rate or fresh exploration
efforts in Rajasthan. Media reports (Economic Times) have
suggested that ONGC is reluctant to increase production from
Rajasthan based on its concern that its investments in the
block will not yield economical returns or returns may turn
even negative depending on the oil price.
Investors are concerned that Cairn cannot go ahead with its
proposals of increasing Rajasthan production and further
exploration without ONGC’s approval unless the royalty issue
is resolved.
Our discussions within the industry suggest that the
government is working with ONGC to resolve the royalty issue
and it expects a resolution ahead of ONGC’s FPO in March
2011. Further, we believe that with India being a country with a
net deficit in crude oil and imports being ~80% of the total
crude oil requirement, the government would want companies
to increase domestic production. Hence, we are not overly
concerned about this issue from a 12-month perspective. We
believe that in the likely event of resolution of the royalty issue,
we do not see many headwinds for Cairn to get approval to
increase its Rajasthan production as well as its exploration
efforts.
Commodity Forecasting Methodology: We use a
standardized methodology at Morgan Stanley to forecast
commodity prices across the global upstream sector. Our
focus is transparency, relevancy, and global comparability.
Our estimates reflect the current NYMEX forward curve for
both 2011 and 2012. For 2013 and beyond, our estimates
reflect a 'normalized' commodity price outlook as agreed upon
by the global energy equity research team ($90/bbl
today). We expect that standardizing our global estimates at
levels approximating the current forward curve will provide a
better valuation tool for equity investors. Our global
commodities research team will continue to express views
concerning the direction and level of oil prices in both the short
and longer term, which will inform our view of the risks and
upside potential to our published estimates. We present our
estimates
Valuation
Valuation Based on Net Asset Value
To derive our base, bear and bull cases for Cairn India, we use
an NAV valuation for the company based on sum-of-parts and
DCF for individual fields. We then add the NAV of the total
resources to NAV of reserves to arrive at the base case
valuation.
Reserves: We use a DCF methodology to assess the cash
flow of individual fields owned by Cairn India based on its 2P
reserves. For our base case, we use an 11% cost of capital for
the life of the fields and a beta of 0.82x (Exhibit 13). We
calculate EV-based NAV at ~US$11.1bn.
Resources: We value the company’s contingent resources on
the basis of the imputed NAV/boe (US$/boe) based on our
level of conviction. Our contingent resources include higher
recovery of 15% from the Mangala field, Aishwariya and
Bhagyam based on the enhanced oil recovery (EOR)
techniques on which the company plans to focus during the
early production stage of these fields to increase their plateau
production life. We value EOR Resources at US$4.6bn.
For the Rajasthan other fields and Rajasthan Exploration
upside and KG Basin resources, we have used EV/BOE of
US$7/bbl, as we await more clarity on the field exploration and
development plan from the company. Based on this, we
compute a value of US$2.3bn for these resources.
Overall, we arrive at a net asset value of US$18bn, which
equates to Rs429/share
Our price target NAV for Cairn is Rs429/share, implying
25% upside potential from current levels.
Risks to Price Target
We see the following risks to our price target:
• Crude volatility: Global crude prices are cyclical and volatile,
so Cairn’s earnings, too, may correlate with sector cyclicality.
• Price of Rajasthan crude: Could be limited by its viscous
nature, which would lower realizations relative to Brent.
Supply-Constrained Market
Our Global Commodities team is bullish on Crude oil prices in
the long term on supply constraints; we expect global spare
capacity to fall to untenable levels near 2.5mb/d by end-2012,
which would keep oil prices at higher levels.
Our Bullish view on Oil emanates from the following:
1) Supply depletion, especially of the Non-OPEC: We
expect non-OPEC production (crude and NGLs) to decline by
380 kb/d to 52.2 mmb/d in 2011, and to 50.4 mmb/d by 2015.
OPEC production capacity is higher by 115kb/d in 2011 and by
1.5mb/d through 2015, but this outlook hinges on Iraqi
production (Exhibit 19).
2) Robust Demand growth from OECD and Non-OECD:
Globally, demand is posting new highs, with the IEA reporting
3Q10 demand at 88.7 mmb/d, up a notable 3.3 mmb/d YoY.
While growth from the non-OECD remains robust, rebounding
OECD demand has impressed. Through October, OECD
demand posted eight consecutive months of YoY growth,
averaging 1.3% YoY. In 2011, we see global demand growing
by 1.1 mmb/d to a record 88.5 mmb/d, driven by the
non-OECD.
3) Spare Capacity to fall to untenable levels: OPEC spare
capacity passed its peak earlier this year and is only poised to
fall further, to untenable levels near 2.5 mbpd by as early as
end-2012, supporting higher prices in the long term. Tighter
levels of spare capacity are likely in 2013-15 (Exhibit 17).
4) Fundamentals Improving: Petroleum product Inventories
are higher than we envisioned at the start of the year, but they
have been drawn down significantly in the past few months, as
shown in Exhibit 18.
Crude Oil Forward Curve: The forward curve has flattened in
the past three months as against a contango earlier due to the
strength in crude oil prices.
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