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Stocks discounting 50% sharing of under-recoveries. We believe the current stock
prices of ONGC and OIL are discounting a very unlikely scenario of upstream companies
bearing 50% of the gross under-recoveries. We would advise investors to make use of
the recent correction in stock prices to buy these stocks given potential upside of
19-22% to our 12-month target prices. We upgrade OIL to BUY from ADD and
maintain our BUY rating on ONGC. We have revised our earnings assumptions to reflect
(1) higher crude oil prices, (2) higher under-recoveries and (3) new exchange rate
assumptions.
Current stock prices suggest upstream companies will bear 50% of gross under-recoveries
We believe current stock prices are discounting a very unlikely scenario of upstream companies
bearing ~50% of gross under-recoveries. We do not foresee such a scenario given (1) upstream
companies have historically borne around 33.3% of total under-recoveries and (2) the recent
statement by the Indian oil secretary that the share of upstream companies will be restricted to
33.3%. Thus, we do not see a rationale for assuming such a pessimistic scenario. Our reverse
valuation exercise assumes (1) no change in retail prices from current levels, (2) crude oil price of
US$85/bbl and (3) diesel de-regulation to be implemented from 3QFY12E.
ONGC/OIL offer 10-14% potential upside even in a scenario of no diesel deregulation
We compute gross under-recoveries at `808 bn for FY2012E assuming (1) crude oil (Dated Brent)
price at US$85/bbl, (2) no diesel deregulation and (3) no changes in retail prices of regulated
products from current levels. We compute our fair value for ONGC and OIL at `1,400 and `1,505
in this scenario assuming upstream companies share 33.3% of the gross under-recoveries. We
note that even under this scenario the stock prices offer a healthy upside of 10-14% from current
levels.
Upgrade OIL to BUY, maintain BUY on ONGC
We have upgraded OIL to BUY from ADD previously noting that the stock offers a potential
upside of 19% to our revised target price of `1,630. We maintain our BUY rating on ONGC
with a target price of `1,500. We compute our fair value based on 10X FY2012E EPS plus
value of investments. We would advise investors to make use of the recent correction in the
stock prices. The valuations for ONGC and OIL are compelling with the stocks currently
trading at 8.9X and 8.6X FY2012E EPS.
3QFY11E earnings will likely be good
Exhibit 1 gives our 3QFY11E estimate for ONGC and OIL. We expect ONGC’s 3QFY11E net
income at `59.5 bn (+10.4% qoq and 95% yoy) and OIL’s net income at `9.7 bn (+5.6%
qoq and 36.9% yoy). The strong performance yoy reflects (1) higher net crude price
realizations and (2) higher APM gas prices. We assume gross under-recoveries at `170 bn in
3QFY11E versus `113 bn in 2QFY11 and `134 bn in 3QFY10.
Earnings revision and key assumptions
We have revised our earning estimates for ONGC and OIL to reflect (1) higher crude price
assumption, (2) higher gross under-recoveries and (3) change in exchange rate assumptions
Crude price assumption. We have revised our crude oil (Dated Brent) price assumption
to US$82/bbl for FY2011E and US$85/bbl for FY2012E versus US$79/bbl and US$81/bbl
previously. We maintain our long-term crude price assumption of US$85/bbl. We
highlight that net crude price realizations are more material. Exhibit 3 gives our key
assumptions behind the earnings model of ONGC and Exhibit 4 gives the same for OIL.
Our assumptions on under-recoveries (upstream companies bearing one-third of gross
under-recoveries) and diesel deregulation from 3QFY12E reflects in a US$6/bbl yoy
increase in net crude price realization in FY2012E for both ONGC and OIL.
We would note that ONGC had reported an EPS of `93 in FY2009 when the average
crude oil price was US$83/bbl and its net crude price realization, US$47.7/bbl only. Gross
under-recoveries were a significant `1.06 tn in FY2009 and ONGC’s shares was `282 bn.
Gasoline prices have been deregulated since then and this would result in likely lower
gross under-recoveries. Also, the APM gas price was only `3.2/cu m in FY2009, which has
been subsequently revised to `7.5/cu m. This alone would add about `20 to ONGC’s EPS.
Gross under-recoveries and subsidy-sharing arrangement. We compute gross underrecoveries
at `721 bn for FY2011E and `656 bn for FY2012E. This compares with a peak
under-recovery of `1.06 tn in FY2009. We assume that upstream companies will bear
33.3% of the gross under-recoveries.
Diesel deregulation. We now assume diesel deregulation to be implemented from
3QFY12E versus our earlier assumption of 1QFY12E.
Exchange rate assumption. We have revised our exchange rate assumption for FY2011-
13E to `45.6/US$, `45.5/US$ and `44/US$ from `45.5/US$, `44.5/US$ and `44.5/US$.
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