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Reliance Industries Limited
The ‘value’ and the ‘growth’
Investment rationale
Refiners back in demand
After sluggish refining margins for last two years, we expect refining margins
to remain in an upward trajectory structurally led by strong oil products demand
growth and expected slow-down in refining capacity addition over 2011-13.
We see distillate demand led by industrialisation and transportation demand
from emerging markets to be the key driver of this growth. Distillate yield biased
Asian refiners like RIL are therefore expected to be in a sweet spot, in our view.
We upgrade our refining margins assumption for RIL to USD10.7/bbl for
FY12e on account of its high complexity and 80% transportation fuel yields.
E&P - Deep value
Lack of clarity on KG-D6 production ramp-up to 80mmcmd has affected the
valuations of RIL’s E&P business. We believe clarity on KG-D6 volume growth
to emerge mid FY12e and production ramp-up is expected in FY13e (DGH).
RIL is expected to file FDP for R-cluster discoveries and NEC-25 (optimised
development plan) in the immediate future, approval of which gives certainty
in terms of production schedule and reserves under development to improve
the valuations. RIL and partners have promising exploration blocks, where
significant upsides are yet to be captured. Expansion into shale gas to help
access to diverse technology and earnings in the long term.
Petchem - All cylinders firing
RIL reported consecutive better earnings from petrochemicals. Though risk
from new polymer projects remains, buoyancy in demand and delay in new
capacities has led to a rise in key petrochemical prices and margins. Also,
polyester integration to help RIL in improving the Petchem profitability as
margins expand across the chain.
Valuation and outlook
We upgrade RIL to BUY with an SOTP-based target price of INR1,152.
Investment rationale
Refiners back in demand
The prevailing view in the market seems to be that the Asian refining margins are
likely to remain flattish in FY11e and FY12e due to significant refining capacity additions
in the same period. Contrary to the market, we believe that the market will continue to
see net incremental demand (i.e., incremental demand > incremental supply) for the
global refining industry over the next two years.
Refiners witnessed three years of sluggish refinery margins during 2008-10 due
to poor oil products demand growth and significant refinery capacity addition
over the same period.
However, oil products demand in 2010 has bounced back very sharply with IEA,
in its recent report, estimating a 2.5MMbbl/d demand growth for 2010. IEA also
estimates continuation of strong demand growth over the next few years led by
China, India and other emerging markets.
Our refinery capacity addition model suggests a slowdown in refinery capacity
addition over the next few years and also refinery closures to help the refiners.
We do not expect utilisation levels to increase significantly in the near term due to
delayed refinery expansion plans, ~3MMbbl/d of refinery capacity closures
announced (both temporary and permanent) as well increasing trend of unplanned
outages as 41% of refineries being operated globally for 40 years and above.
We thus believe that refinery margins are expected to remain in an upward trajectory
structurally over FY11e-13e before next wave of capacity addition moderates that
growth. We see distillate demand led by industrialisation and transportation demand
from emerging markets to be the key driver of oil products demand. Distillate yield
biased Asian refiners like RIL are therefore expected to be in a sweet spot, in our view.
We upgrade our refining margins assumption for diesel and gasoline to reflect the
above scenario. After bottoming out in FY10, we estimate RIL’s GRMs to improve to
USD10.7/bbl in FY12e, up 29% YoY. These margins are still 30% lower than peak
margins of USD15/bbl reported by RIL in FY08.
Valuing the refiners
We employ EV/EBITDA to assess the fair value of refiners as we recover from trough
to play the refining cycle. We value RIL refining at 7x EV/EVITDA on FY12e EBITDA of
INR188bn, which gives us a value of INR443/share for refining business.
The refining industry is cyclical and at various points of the cycle different valuation
tools need to be applied. As we recover from the trough of the cycle, we have to
derive the valuations using higher earnings multiple to factor in when we approach
peak cycle.
E&P - Deep value
RIL's E&P portfolio comprises a total of 40 domestic operational blocks including 28
NELP, 7 Pre-NELP and 5 CBM blocks. 70% of its domestic portfolio consists of deep
water fields and most of them are concentrated in KG and Mahanadi basin. Apart
from domestic acreage, RIL also has interest in 13 international blocks with total
acreage of 93,526sqkm (~50% deepwater acreage). Yemen Block9 is the only
producing block in RIL's international portfolio. RIL along with its 100% subsidiary,
REP DMCC is operated in 11 of these blocks.
RIL currently has 48 discoveries to date and an overall exploration success ratio of 54%.
Out of all discoveries, RIL currently has 3 producing blocks namely - D1, D3 and D26
(MA) all in KG-D6 block. The status of all the announced gas discoveries where
commerciality has been submitted and development plans is underway
We have valued RIL's E&P division applying different methodologies according to the
stages of production, exploration or development of its assets. We believe that for
valuing RIL's E&P business, we need to focus on existing/under-approval development
plans/declaration of commerciality (DoC) submitted before ascribing any value to
future exploration successes. This, we believe, should remove concerns over valuing
the E&P business for RIL.
Currently producing oil and gas assets: We value them on earnings
multiple and DCF. PMT on EV/EBITDA and KG-D6 on DCF.
Assets where commerciality is submitted/development plan expected
to be submitted. These are assets where exploration and appraisal are through,
i.e., major risk activities are over. (For example, satellite discoveries in KG-D6, NEC-
25 block, etc.) These assets are valued on USD/boe multiple, as production profile,
capital expenditure and reserve quantities are still to be known with certainty.
Assets where exploration is under progress. The valuation of these assets
depend on probabilistic estimation of success, history of previous exploration
successes in the block, experience and technical expertise of the operator, and the
risk appetite of investors. In our valuations, we ascribe nil value to these assets
Valuation of E&P: Our valuation model suggests that based on current
development plans and estimated capex, KG-D6' Dhirubhai 1 and 3 and MA
fields (both oil and gas) alone is worth USD14bn or (INR208/share). The entire
E&P division, including CBM, PMT, is worth INR466/share. We have added
another INR48/share in for Shale gas JVs.
Petrochemicals - buoyancy to benefit the integrated players
We believe that the petrochemical segment has seen its trough periods during FY08-
09 and is geared up for a strong and a sustained growth for the next few years.
Moreover, Polyester margins are also expected remain strong due to current tightness
in cotton market. Thus, buoyancy in Petchem cycle to help RIL in improving its Petchem
earnings further and reaps benefits as biggest integrated player. We value Reliance's
petrochemical business at 7x FY12e EBITDA to arrive at the EV of INR764bn or
INR257/share for RIL.
Valuation and outlook
We upgrade RIL to BUY with an SOTP based target price of INR1,152.
Key macro risks
There are four key macro risks to our earnings forecasts and ratings:
Domestic or global economic slowdown may reduce refining and chemicals demand.
Volatile crude and oil product prices may affect refining and petrochemical margins,
and E&P earnings.
Underestimation of capacity additions and how fast the new capacity will come
on-stream may affect our bullish view on margins.
Volatility in foreign exchange may affect the earnings as revenues are dollar
denominated.
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