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Cairn India
Evaluating 'what if' scenarios
ONGC's claim that royalties are cost recoverable, if accepted, could reduce our
FY11-13F EPS 11-20% and our TP Rs68. However, the real threat is that delays in
approvals to raise ONGC's production could further reduce our FY12-13 EPS by
11-17%. Hold maintained, Rs348 TP.
Royalty issue refuses to die down
ONGC has not disputed its liability to pay 100% of the royalties on the Rajasthan block
where it holds a 30% stake, with Cairn India (CIL) holding 70%. However, it has recently
claimed that, as per the production sharing contract (PSC), the royalty payments are cost
recoverable. We estimate that if CIL accepts this claim, then we would need to cut our FY11-
13F EPS estimates by 11-20% and our valuation by Rs68/share. The Indian government
(GOI) is likely to consider ONGC’s concerns before it approves the proposal of Vedanta to
acquire CIL from its parent Cairn Energy plc (CEP). The CIL board has already stated that
“any condition tied to the approval of the transaction, which can negatively impact the value
of the company cannot be accepted”.
Longer-term concerns on approvals
We believe that that the CIL board will protect the interests of the minority shareholders and
will cancel the Vedanta deal if it is means lowering the underlying value of the oil assets (for
example, by accepting ONGC’s claim on royalties being cost recoverable). However, given
that CIL’s growth plans in Rajasthan are all contingent on approvals from ONGC/GOI, there
is a risk that the royalty issue, if not addressed, will negatively impact our FY11-13
production estimates. While we have estimated Rajasthan production rising to 240kbd based
on CIL guidance, the current production level approved by GOI is 175kbd. If the higher
production level is not approved, the negative impact on our FY12-13F EPS is 11-17%.
Hold maintained, TP Rs348
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. However,
we expect the uncertainty created by the news flow to continue to weigh on the stock until
GOI steps in to provide final clarity on pending issues. We maintain our Hold rating and
Rs348 TP.
Evaluating ‘what if’ scenarios
CIL’s stock price is failing to reflect improving asset valuations resulting from rising global
crude oil prices. For the stock to perform, in our view, GOI needs to provide clarity on both
the deal and on approvals for CIL’s projected production growth in Rajasthan.
Royalty issue refuses to die down
Vedanta deal is still awaiting clearance
On 16 August 2010, CEP announced that it had agreed to sell a maximum of 51% in CIL to
Vedanta at Rs405/share, 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/share, after receiving approval from the Securities and Exchange Board of India. As per
current shareholder approvals, the deal needs to close by 15 April 2011. For this to happen, and
given the time required to execute an open offer, the green signal from GOI needs to be received
in a week or so.
The timeframe provided by the petroleum ministry to clear the deal has also been changing, from
end-December 2010 to early 2011 and now to March 2011. The Business Standard newspaper
(16 February 2011) reported that the new petroleum minister intended to refer the deal to the
Cabinet Committee on Economic Affairs (CCEA) in two to three weeks.
ONGC’s royalty claims have changed in recent months
The Business Standard also quotes the petroleum minister as stating that “we will not compromise
on the concerns of ONGC. The claim of ONGC that royalty should be a cost-recoverable item is
supported by us.” Hence a brief background on the royalty issue is in order.
As per the terms of the PSC, which are not disputed, ONGC has to pay 100% of royalty on
Rajasthan production, despite having only a 30% stake. This is the case in some other pre-NELP
blocks as well, and, based on our prior discussions with ONGC, we have been assuming that GOI
would reimburse ONGC to the extent of royalty that it pays on behalf of CIL (70% stake).
In recent months, ONGC has stated that it believes that the royalty payments it makes are cost
recoverable as per the terms of the PSC. Oil production from the Rajasthan block started in
August 2009 and since then ONGC has been paying 100% of the royalty and initially at least not
claiming cost recoverability. That’s the reason why CIL’s revenue entitlement to date has been
close to 74% compared to its actual stake of 70%. CIL is disputing ONGC’s claim and this is likely
to be a highly legal matter given that both parties have different interpretations of the same PSC.
News claims would negatively impact CIL valuation
The table below gives the undiscounted summary of the financials (as per our model) of the
Rajasthan block over the life of the Mangala, Bhagyam and Aishwariya (MBA) reserves which are
currently estimated at 1bn bbls. The financials are given under two scenarios - whether or not
royalty is cost recoverable. Under both scenarios:
The field generates a revenue of around US$80bn;
Both CIL and ONGC spend on operating costs, cess and development capex in the ratio of
their stake in the joint venture (70:30);
ONGC spends 100% of the royalty payable;
CIL initially spends 100% of the exploration capex of US$570m;
So total cash spending on the block is US$33bn, US$14.4bn by CIL, rest by ONGC; and
To simplify, we have ignored the income tax calculations. The block enjoys a seven year tax
holiday, but both players would need to pay the minimum alternate tax (MAT) which is levied
on their total book profits. Hence the tax impact is different for both players,
If royalties are not cost recoverable (our current assumption), then the cost petroleum for the field
works out to US$20.4bn, resulting in profit petroleum of US$59.5bn. Cost petroleum is effectively
the revenues which are claimed by the JV partners to cover their cash spending.
We estimate GOI’s share at US$26.8bn, leaving rest for CIL/ONGC. Their respective shares of
cost petroleum and profit petroleum leads to their revenue entitlement which works out to
US$37.3bn for CIL and US$15.7bn for ONGC. Comparing this revenue with their cash spending
gives the cash inflow or outflow over life of the field.
If royalties become cost recoverable, then the cost petroleum figure rises to that extent
(US$12.7bn), reducing the share of profit petroleum for all three parties concerned – GOI (by
US$5.5bn), CIL (US$5bn) and ONGC (US$2.2bn). However, since the entire rise in cost
petroleum goes to ONGC, its share of the revenues rises by US$10.6bn.
The drop in profit petroleum for CIL of US$5bn over the life of the project works out to around
US$2bn in DCF terms, or Rs68/share. In terms of near-term earnings, CIL’s EPS over FY11-13F
could drop by 12-20%
Longer-term concerns on approvals
Approval process rather than deal approval is real concern
There has been a lot of press regarding the time taken to approve the Vendanta-CEP deal.
However, from the point of view of the minority shareholders, the deal is no longer a concern
given the rise in global oil prices subsequent to the deal announcement. CIL’s stock price was
trading around Rs330-340 when the deal was announced and the offer price of Rs355
represented a premium. However, Brent oil prices have moved from US$75/bbl (when the deal
was announced) to US$100/bbl recently. If the terms of the PSC are untouched, the value of CIL
assets has gone up irrespective of whether the deal is approved or not. So even if the deal is now
approved without any change in PSC, the value of assets is likely to be above the offer price (we
estimate Rs392/share based on current Brent futures) and the minority shareholders may well
choose not to submit their shares in the open offer.
CIL’s 3QFY11 press release stated that “the Cairn India board of directors has stated that any
condition tied to the approval of the transaction, which can negatively impact the value of the
company, cannot be accepted.” In our view, making CIL share the royalty burden or making the
royalties cost-recoverable would have significant negative implications for the value of CIL assets.
We believe the CIL board would refuse to approve any such conditions imposed by GOI and thus
the transaction between CEP & Vedanta would get cancelled.
In our view, the weakness in the CIL price is not due to concerns on deal approval, but on the
impact of the ONGC royalty issues on the longer-term value of CIL assets. Even if the deal is
cancelled, the issues raised by ONGC on royalties may need to be addressed either by GOI
directly (by reimbursing ONGC the excess royalty payments), or perhaps by a judicial process.
The biggest risk, in our view, is that unless the issue is resolved to the satisfaction of ONGC, CIL’s
growth plans in the Rajasthan block could well be impacted. Every investment decision relating to
raising the approved oil production level or to carry out further exploration work would first need
approval of the JV partner (ONGC) and then GOI.
The consensus valuation for CIL assets considers the reserve base of the MBA fields after
assuming successful enhanced oil recovery (EOR) techniques: this is 1bn boe. These reserves
have the potential to result in peak oil production of 240kbd, as per CIL management.
GOI has currently approved a production level of 175kbd (Mangala 125, Bhagyam 40, Aishwariya
10). Based on reserve base, CIL management believes that Mangala production can rise to
150kbd and Aishwariya can be 20kbd, thus raising production levels to 210kbd. Achieving peak
production of 240kbd relies on successful use of EOR techniques. Thus our valuation of CIL
assets is based on a rising production profile which needs to be approved by ONGC and GOI.
Our view has been that, given the national importance of the Rajasthan asset, approvals for
raising production levels and carrying out further exploration work within Rajasthan will follow.
However, given the delays in approval, we have been pushing the timeline of the Mangala field
ramp up (125kbd to 150kbd) from 4QFY11 (before the takeover was announced) to 2QFY12
currently. The risk is that there could be further delays if the royalty issue is unresolved.
In terms of sensitivity, if CIL is forced to produce only as per current approved production plan,
then our EPS estimates for FY12-13F would drop by 11-17%.
Maintain Hold, TP Rs348
Impact on E&P investment should result in early resolution
We believe that, given the low level of India’s oil/gas production relative to its requirements,
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, the outcome of which will 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, will have negative implications on future
investments. We are in no position to verify whether ONGC’s recent claims on royalty costrecoverability are accurate, but to our knowledge these claims were not made before the CEPVedanta deal was announced (one year of Rajasthan production had already passed by then).
But it is looking amply clear that unless the royalty issue is resolved, investor concerns on CIL’s
growth prospects will remain and the stock will not react to the rise in global oil prices.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Cairn India
Evaluating 'what if' scenarios
ONGC's claim that royalties are cost recoverable, if accepted, could reduce our
FY11-13F EPS 11-20% and our TP Rs68. However, the real threat is that delays in
approvals to raise ONGC's production could further reduce our FY12-13 EPS by
11-17%. Hold maintained, Rs348 TP.
Royalty issue refuses to die down
ONGC has not disputed its liability to pay 100% of the royalties on the Rajasthan block
where it holds a 30% stake, with Cairn India (CIL) holding 70%. However, it has recently
claimed that, as per the production sharing contract (PSC), the royalty payments are cost
recoverable. We estimate that if CIL accepts this claim, then we would need to cut our FY11-
13F EPS estimates by 11-20% and our valuation by Rs68/share. The Indian government
(GOI) is likely to consider ONGC’s concerns before it approves the proposal of Vedanta to
acquire CIL from its parent Cairn Energy plc (CEP). The CIL board has already stated that
“any condition tied to the approval of the transaction, which can negatively impact the value
of the company cannot be accepted”.
Longer-term concerns on approvals
We believe that that the CIL board will protect the interests of the minority shareholders and
will cancel the Vedanta deal if it is means lowering the underlying value of the oil assets (for
example, by accepting ONGC’s claim on royalties being cost recoverable). However, given
that CIL’s growth plans in Rajasthan are all contingent on approvals from ONGC/GOI, there
is a risk that the royalty issue, if not addressed, will negatively impact our FY11-13
production estimates. While we have estimated Rajasthan production rising to 240kbd based
on CIL guidance, the current production level approved by GOI is 175kbd. If the higher
production level is not approved, the negative impact on our FY12-13F EPS is 11-17%.
Hold maintained, TP Rs348
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. However,
we expect the uncertainty created by the news flow to continue to weigh on the stock until
GOI steps in to provide final clarity on pending issues. We maintain our Hold rating and
Rs348 TP.
Evaluating ‘what if’ scenarios
CIL’s stock price is failing to reflect improving asset valuations resulting from rising global
crude oil prices. For the stock to perform, in our view, GOI needs to provide clarity on both
the deal and on approvals for CIL’s projected production growth in Rajasthan.
Royalty issue refuses to die down
Vedanta deal is still awaiting clearance
On 16 August 2010, CEP announced that it had agreed to sell a maximum of 51% in CIL to
Vedanta at Rs405/share, 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/share, after receiving approval from the Securities and Exchange Board of India. As per
current shareholder approvals, the deal needs to close by 15 April 2011. For this to happen, and
given the time required to execute an open offer, the green signal from GOI needs to be received
in a week or so.
The timeframe provided by the petroleum ministry to clear the deal has also been changing, from
end-December 2010 to early 2011 and now to March 2011. The Business Standard newspaper
(16 February 2011) reported that the new petroleum minister intended to refer the deal to the
Cabinet Committee on Economic Affairs (CCEA) in two to three weeks.
ONGC’s royalty claims have changed in recent months
The Business Standard also quotes the petroleum minister as stating that “we will not compromise
on the concerns of ONGC. The claim of ONGC that royalty should be a cost-recoverable item is
supported by us.” Hence a brief background on the royalty issue is in order.
As per the terms of the PSC, which are not disputed, ONGC has to pay 100% of royalty on
Rajasthan production, despite having only a 30% stake. This is the case in some other pre-NELP
blocks as well, and, based on our prior discussions with ONGC, we have been assuming that GOI
would reimburse ONGC to the extent of royalty that it pays on behalf of CIL (70% stake).
In recent months, ONGC has stated that it believes that the royalty payments it makes are cost
recoverable as per the terms of the PSC. Oil production from the Rajasthan block started in
August 2009 and since then ONGC has been paying 100% of the royalty and initially at least not
claiming cost recoverability. That’s the reason why CIL’s revenue entitlement to date has been
close to 74% compared to its actual stake of 70%. CIL is disputing ONGC’s claim and this is likely
to be a highly legal matter given that both parties have different interpretations of the same PSC.
News claims would negatively impact CIL valuation
The table below gives the undiscounted summary of the financials (as per our model) of the
Rajasthan block over the life of the Mangala, Bhagyam and Aishwariya (MBA) reserves which are
currently estimated at 1bn bbls. The financials are given under two scenarios - whether or not
royalty is cost recoverable. Under both scenarios:
The field generates a revenue of around US$80bn;
Both CIL and ONGC spend on operating costs, cess and development capex in the ratio of
their stake in the joint venture (70:30);
ONGC spends 100% of the royalty payable;
CIL initially spends 100% of the exploration capex of US$570m;
So total cash spending on the block is US$33bn, US$14.4bn by CIL, rest by ONGC; and
To simplify, we have ignored the income tax calculations. The block enjoys a seven year tax
holiday, but both players would need to pay the minimum alternate tax (MAT) which is levied
on their total book profits. Hence the tax impact is different for both players,
If royalties are not cost recoverable (our current assumption), then the cost petroleum for the field
works out to US$20.4bn, resulting in profit petroleum of US$59.5bn. Cost petroleum is effectively
the revenues which are claimed by the JV partners to cover their cash spending.
We estimate GOI’s share at US$26.8bn, leaving rest for CIL/ONGC. Their respective shares of
cost petroleum and profit petroleum leads to their revenue entitlement which works out to
US$37.3bn for CIL and US$15.7bn for ONGC. Comparing this revenue with their cash spending
gives the cash inflow or outflow over life of the field.
If royalties become cost recoverable, then the cost petroleum figure rises to that extent
(US$12.7bn), reducing the share of profit petroleum for all three parties concerned – GOI (by
US$5.5bn), CIL (US$5bn) and ONGC (US$2.2bn). However, since the entire rise in cost
petroleum goes to ONGC, its share of the revenues rises by US$10.6bn.
The drop in profit petroleum for CIL of US$5bn over the life of the project works out to around
US$2bn in DCF terms, or Rs68/share. In terms of near-term earnings, CIL’s EPS over FY11-13F
could drop by 12-20%
Longer-term concerns on approvals
Approval process rather than deal approval is real concern
There has been a lot of press regarding the time taken to approve the Vendanta-CEP deal.
However, from the point of view of the minority shareholders, the deal is no longer a concern
given the rise in global oil prices subsequent to the deal announcement. CIL’s stock price was
trading around Rs330-340 when the deal was announced and the offer price of Rs355
represented a premium. However, Brent oil prices have moved from US$75/bbl (when the deal
was announced) to US$100/bbl recently. If the terms of the PSC are untouched, the value of CIL
assets has gone up irrespective of whether the deal is approved or not. So even if the deal is now
approved without any change in PSC, the value of assets is likely to be above the offer price (we
estimate Rs392/share based on current Brent futures) and the minority shareholders may well
choose not to submit their shares in the open offer.
CIL’s 3QFY11 press release stated that “the Cairn India board of directors has stated that any
condition tied to the approval of the transaction, which can negatively impact the value of the
company, cannot be accepted.” In our view, making CIL share the royalty burden or making the
royalties cost-recoverable would have significant negative implications for the value of CIL assets.
We believe the CIL board would refuse to approve any such conditions imposed by GOI and thus
the transaction between CEP & Vedanta would get cancelled.
In our view, the weakness in the CIL price is not due to concerns on deal approval, but on the
impact of the ONGC royalty issues on the longer-term value of CIL assets. Even if the deal is
cancelled, the issues raised by ONGC on royalties may need to be addressed either by GOI
directly (by reimbursing ONGC the excess royalty payments), or perhaps by a judicial process.
The biggest risk, in our view, is that unless the issue is resolved to the satisfaction of ONGC, CIL’s
growth plans in the Rajasthan block could well be impacted. Every investment decision relating to
raising the approved oil production level or to carry out further exploration work would first need
approval of the JV partner (ONGC) and then GOI.
The consensus valuation for CIL assets considers the reserve base of the MBA fields after
assuming successful enhanced oil recovery (EOR) techniques: this is 1bn boe. These reserves
have the potential to result in peak oil production of 240kbd, as per CIL management.
GOI has currently approved a production level of 175kbd (Mangala 125, Bhagyam 40, Aishwariya
10). Based on reserve base, CIL management believes that Mangala production can rise to
150kbd and Aishwariya can be 20kbd, thus raising production levels to 210kbd. Achieving peak
production of 240kbd relies on successful use of EOR techniques. Thus our valuation of CIL
assets is based on a rising production profile which needs to be approved by ONGC and GOI.
Our view has been that, given the national importance of the Rajasthan asset, approvals for
raising production levels and carrying out further exploration work within Rajasthan will follow.
However, given the delays in approval, we have been pushing the timeline of the Mangala field
ramp up (125kbd to 150kbd) from 4QFY11 (before the takeover was announced) to 2QFY12
currently. The risk is that there could be further delays if the royalty issue is unresolved.
In terms of sensitivity, if CIL is forced to produce only as per current approved production plan,
then our EPS estimates for FY12-13F would drop by 11-17%.
Maintain Hold, TP Rs348
Impact on E&P investment should result in early resolution
We believe that, given the low level of India’s oil/gas production relative to its requirements,
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, the outcome of which will 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, will have negative implications on future
investments. We are in no position to verify whether ONGC’s recent claims on royalty costrecoverability are accurate, but to our knowledge these claims were not made before the CEPVedanta deal was announced (one year of Rajasthan production had already passed by then).
But it is looking amply clear that unless the royalty issue is resolved, investor concerns on CIL’s
growth prospects will remain and the stock will not react to the rise in global oil prices.
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