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Cairn India
Growth prospects still robust
We expect Vedanta's acquisition plan to be cleared with no changes, allowing
Cairn to implement its growth plans by raising production and exploration. Our
new conservative oil price forecasts lead to a target price of Rs348 (from Rs340)
and a Hold rating. Using current Brent futures would imply a valuation of Rs392.
Uncertainty created by the acquisition announcement is only short term, in our view
Vedanta’s announcement of plans to acquire Cairn India (CIL) has been followed by negative
news flow for CIL in terms of delays in getting approval to raise oil production and to carry
out further exploration work. Such delays have been partly related to CIL’s partner in the
Rajasthan block (ONGC) having to bear all the royalty and seeking compensation for the
same. Given the high profile of the announced takeover and its potential to impact foreign
investment in the Indian E&P sector, we believe the Indian government (GOI) will approve
the deal without making any changes in the production sharing contract (PSC) and after
clarifying on compensation for ONGC. Given the national importance of the Rajasthan asset,
we believe that approvals for raising production and carrying out further exploration work
within Rajasthan will follow.
New conservative Brent oil price forecasts
We raise our Brent crude oil forecasts to US$83/bbl in FY11 (up US$5/bbl), US$87/bbl in
FY12 (up US$3/bbl) and US$89/bbl in FY13 (up US$1/bbl). We forecast prices will decline to
US$82/bbl by FY15, rising gradually to US$95/bbl by FY21. We have maintained our reserve
estimates but assumed that the Mangala production ramp-up from 125kbd to 150kbd is
delayed by a quarter to 2QFY12.
Our DCF-based fair value (which is our new target price) after rolling forward our model is
Rs348 (Rs326 earlier), resulting in our Hold rating being maintained. But if we use the Brent
forward price curve (US$96-99/bbl), our fair value estimate would rise to Rs392. We also
believe the concerns raised by the GOI on Vedanta’s oil/gas credentials during the takeover
approval process will ensure that CIL’s free cash flow is not used for non-oil/gas activities. In
our view, clearance to the deal without compromising CIL’s growth potential would be the key
trigger for the stock price to reflect the recent rise in global oil prices
Growth prospects still robust
CIL stock price has not responded to the US$20/bbl rise in global oil prices in the last three
months, due to concerns on the Vedanta deal. We believe that clearance of the deal without
any change in the PSC would be a catalyst for stock price performance.
Uncertainty created by the acquisition is short term
News flow post Vedanta takeover announcement has been negative
On 16 August 2010, Cairn Energy plc (CEP) announced that it had agreed to sell a maximum of
51% in CIL to Vedanta at Rs405/sh, out of which Rs50/share has been termed as a non-compete
fee. Hence, Vedanta has proposed to make an open offer to the remaining CIL shareholders at
Rs355/sh, after receiving approval from the Securities and Exchange Board of India.
GOI officials have publicly expressed concerns about not being consulted prior to the deal
announcements and on the lack of experience of Vedanta in the oil/gas sector. There has been a
difference of opinion between CEP and GOI on the level of prior consents required for the deal.
CEP appears to have now complied with all GOI demands and the petroleum ministry is expected
to decide on the merits of the deal by end of this month or early next month. However, from the
time of the deal announcement, several news stories have emerged, which could have negative
implications for minority shareholders of CIL:
Non-approval to raise production at Mangala field;
Lack of approvals to carry out further exploration work within the Rajasthan block; and
GOI approval being contingent on Vedanta agreeing to bear royalty and withdrawing CIL
arbitration claims on cess.
Production rise linked to ONGC royalty issue
As per the terms of the PSC which are not disputed, ONGC has to pay 100% of royalty on
Rajasthan production, despite a 30% stake (and this payment is not cost recoverable). Based on
discussions with ONGC, we have been assuming that the GOI will reimburse ONGC to the extent
of royalty that it pays on behalf of CIL (70%). However, this issue is unresolved as of now. Given
the stake sale by CEP to Vedanta and the GOI’s plans to divest 5% of its holding in ONGC before
March 2011, ONGC would be looking to resolve this issue soon.
The current royalty system does not provide incentive for ONGC to allow a higher production rate
or fresh exploration efforts in Rajasthan. CIL cannot go ahead with its proposals without ONGC
approval. Hence, we believe that CIL’s proposals to raise Mangala production will not make any
headway unless the ONGC royalty issue is resolved.
We believe the GOI will approve the Vedanta deal and clarify on compensation for ONGC on
royalty before March 2011, paving the way for approval to raise production. Given the national
priority on raising domestic oil production, we believe the delay on this issue could be a quarter or
two at best because of pending decisions on the Vedanta deal and ONGC divestment, but not
much longer.
Higher exploration efforts will be in national interest
The Economic Times dated 10 January 2011 reported that the GOI has rejected some of CIL’s
discoveries within Rajasthan saying that some of its discoveries came after the authorised
exploration period had ended. Other reports have suggested that the upstream regulator (DGH)
has asked the GOI to clarify whether CIL will be allowed to carry out further exploration work
within the Rajasthan block. ONGC the other joint venture partner would also not be keen to allow
further exploration work until its royalty issue is resolved.
CIL has already been granted three development areas within the Rajasthan block. Any part of
these areas cannot be handed over to any third party for exploration until the expiry of the PSC
with CIL. It would be difficult to assume that the GOI would not allow further exploration efforts,
especially since nobody else can carry out exploration in any case. In our view, while there may
be some ambiguity in terms of the wording of the PSC on carrying out further exploration once a
development area has been allotted, it would be in national interest to allow further exploration
efforts (unless the PSC specifically prohibits further exploration). Any further discoveries made
can be brought into production at low costs (since evacuation infrastructure has already been
built) and within a short time period. CIL management has also stated that, while it has made 25
discoveries within the Rajasthan block, not all of them would be economical to produce. The
reserves attributed to discoveries that have been disputed by DGH work out to just 20mmboe
compared to current estimate of recoverable reserves of 1154mmboe for Rajasthan.
Only CIL board can approve changes in Rajasthan PSC
The Economic Times dated 18 January 2011 reported that the oil ministry wants Vedanta to
unconditionally accept the GOI’s views in legal disputes with CIL (ie, the cess issue) before it
approves its deal to acquire CIL. Earlier reports had also suggested that the oil ministry wanted
Vedanta to accept payment of royalty on the Rajasthan block before deal clearance. Agreeing to
pay royalty or give up its right to contest the cess claim would lower the value of the assets held
by CIL and have negative implications for minority shareholders.
We note that the GOI has a PSC with CIL and any changes to this PSC can be carried out only
with the consent of the CIL board. Vedanta prior to acquiring CIL cannot give any assurances on
behalf of CIL. CIL’s board currently consists of three directors representing CEP, three operational
directors and four independent directors, and we would expect the operational and independent
directors to protect the interests of the minority shareholders and oppose any changes in the PSC
that could lower the value of CIL’s assets. In fact, CIL has already set up a committee of two
independent directors (who are not on the board of either CEP or Vedanta), who will interact with
minority shareholders and provide an independent opinion on the CEP-Vedanta deal.
Impact on E&P investment would be a key issue
We believe that, given the low level of India’s oil/gas production relative to its requirement, inviting
foreign investment in the E&P business is a GOI objective. In line with this objective, the
petroleum ministry has been holding extensive international roadshows to market its exploration
blocks offered under the New Exploration Licensing Policy (NELP). The CEP-Vedanta deal is a
high profile one, whose outcome would have implications on future foreign as well as domestic
investments in the Indian E&P sector. We believe that making any change in the PSC or lowering
the value of assets held by CIL in any other manner would have negative implications on future
investment. Also, given the high national priority to raise domestic oil production, we believe that
approvals for raising Rajasthan production and for carrying out further exploration work will come
through, thereby crystallising the growth prospects of CIL.
New conservative Brent oil price forecasts
Our forecasts are significantly below the futures market rate
Our oil price forecasts (see table below) are predicated upon our assumptions about Opec’s
behaviour. Specifically, we assume that Saudi Arabia retains a preference for an oil price within a
band of US$70-90/bbl in real terms. We believe that rising oil production in Iraq has the potential
to become a sector theme, not just for 2011 but also for much of this decade, as we believe that
rising production in Iraq will pressure prices from 2013; from then on, we assume that oil trades in
the lower half of Opec’s target range. For details, see RBS report, Oil and Gas – Navigating
through 2011, dated 18 January 2011. These Brent price forecasts would feed through to higher
oil realisations for CIL. At this point though, our forecasts are significantly below traded oil prices,
as evidenced by the Brent oil futures, which is trading in the US$96-99/bbl range over FY12-20.
One quarter delay in production ramp-up
The current approved production plateau for the Rajasthan block is 175kbd (Mangala field
125kbd, Bhagyam 40kbd and Aishwariya 10kbd). CIL believes that, based on the reserves,
Mangala can rise to 150kbd and Aishwariya to 20kbd and hence overall plateau production from
the three “MBA” fields can go up to 210kbd (subject to GOI approval). We had assumed the
150kbd average production level at Mangala to be achieved in 1QFY12, but, given the delays in
getting approval for the Vedanta deal (which is also linked to GOI’s compensation plan for ONGC
on the royalty issue), we have pushed back the production ramp-up timing by a quarter to
2QFY12. Hence, the only change to our production forecasts is a 3.8% cut to Rajasthan crude oil
volumes in FY12.
Target price a function of oil price
Our DCF-based fair value (which is our new target price) after rolling forward our model is now
Rs348 (Rs326 earlier), based on our Brent crude oil forecasts (Table 1), Rs/USD rate of 45.6 and
a discount rate of 10% (last two factors unchanged). In the event that CIL is successful in
reducing the cess rate to Rs927/tonne (from current payment of Rs2,575/tonne) through the
arbitration process, our fair value would rise to Rs375.
Our oil price forecasts are conservative, especially when compared to the current Brent futures
curve. If we use the forward price curve (Table 1), our fair value estimate would rise from Rs348
to Rs392.
We believe that in the event that the Vedanta deal is cleared by the GOI without any changes in
the PSC, the stock price is likely to react positively and move well above the Vedanta open offer
price of Rs355 to reflect current strength in global oil prices (Brent at US$97/bbl).
Any acquisition by Vedanta will likely raise concerns about the use of CIL’s free cash flow
following such an acquisition, due to the former’s conglomerate status. One way to try and factor
in this concern is to raise the discount rate to 11%. This would bring down our fair value to Rs336
if our oil price forecasts are used and to Rs378 if the Brent forward price curve is used. However,
we believe that concerns raised by the GOI on Vedanta’s oil/gas credentials during the takeover
approval process should ensure that CIL’s free cash flow is not used for non-oil/gas activities.
We have worked out the fair value at various levels of Brent crude prices, discount rates and
exchange rates (tables below). However, note that these values are based on the crude price
mentioned in the table being constant from FY13 onwards. For FY11 and FY12, our existing Brent
oil forecasts of US$83/bbl and US$87/bbl are used.
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