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Energy
India
It’s not just about a few oil companies. The rapid escalation of political unrest in the
MENA region exposes India’s energy sector, CAD and FD to grave risks. With the only
practical solution of price increases largely unavailable due to the government’s political
constraints and high inflation, it would be a challenge for India to extricate itself from
the huge negative impact of high oil prices. Stock ratings are largely academic currently;
OIL and ONGC are the only investible ideas now but even they may face challenges.
There is no Plan A, let alone Plan B or C or….
The government’s blinkered approach on pricing of fuels and inability to increase prices in small
doses over the past few years (in order to align them to global levels) exposes India’s energy sector,
CAD and FD to grave risks from high oil prices. The situation is unmanageable at US$105/bbl; a
supply shock due to extended political upheavals in one or more major oil-producing nations could
push crude oil prices higher. India has very little defense against high crude oil prices given its twin
deficits and a general inability to confront issues (until they spiral out of control).
Events in Libya and beyond can really hurt India
At 1.8 mn b/d of production capacity and 1.58 mn b/d production in January 2011, Libya’s oil is
important for global oil markets. 22% or more of Libya’s production is already shut by global oil
companies operating in Libya as preemptive measures and more could be at risk if events escalate
in Libya and beyond. Saudi Arabia’s spare capacity of 3.5 mn b/d can help but it should realize the
risks to global economic recovery from high prices and consequent demand destruction. It has
adopted a ‘business-as-usual’ attitude, which may be a grave mistake, in our view.
`1.39 tn of under-recoveries, 3.7% CAD/GDP in FY2012E if oil averages US$105/bbl
At US$105/bbl (Dated Brent basis), FY2012E total under-recoveries on diesel, kerosene and LPG
could be around `1.4 tn (1.5% of GDP) if the government does not raise retail selling prices. At
the same time, CAD/GDP could slip to 3.7%, which could put pressure on India’s BOP and
currency unless capital inflows surprise positively. BP’s US$7.2 bn investment in RIL’s oil and gas
blocks will help but that is equivalent to US$9/bbl higher crude oil price only; a US$1/bbl increase
in crude oil price adds US$900 mn to India’s imports and CAD.
Investment view on energy stocks is (once again) academic
An unpredictable subsidy amount, low clarity on the subsidy-sharing mechanism and macro
concerns make it impossible to forecast the earnings of oil companies and take an investment view
on them. We note that even GAIL, OIL and ONGC will get hit negatively if the government persists
with its one-third subsidy-sharing formula for upstream companies in FY2012E. As for BPCL, HPCL
and IOCL, the government will have to ring-fence their under-recoveries to a certain fixed amount;
they can bear maximum `100 bn of net under-recoveries without reporting abysmal profits.
Libya’s problems may not be contained within the oil-rich nation
Exhibit 1 shows stated production capacity and production over the past few months of
OPEC broken down by countries. As can be seen, Libya accounts for a substantial share with
1.58 mn b/d of production in January 2011 out of 29.85 mn b/d of total OPEC production.
Various independent oil companies operating in Libya have already shut production, leading
to a loss of around 22% (more as per some reports) already. More producers may wind
down production as they evacuate production personnel and contractors also withdraw their
personnel from the oil fields and loading ports.
We note that OPEC has sufficient spare capacity to weather the storm in Libya if only it
decides to ramp up supply. So far, it has decided to continue production at current rates and
has not paid heed to price signals; prices have run up rapidly over the past two months and
especially over the past few days once news of political unrest in Libya first broke out. Saudi
Arabia believes that the world market is well-supplied. In our view, OPEC’s ‘business-asusual’
stance is a grave mistake in that it risks damaging global economic recovery through
high crude oil prices. Of course, it is another matter that many other countries in OPEC may
face similar political upheavals. All bets are off in that case; prices could easily spiral to
US$120/bbl where we could see some demand destruction.
India has no defense against high oil prices
We note that India has very little defense against high oil prices given its high twin deficits
(CAD, FD) and high inflation. It has no strategic reserves also in case of supply shortages due
to supply problems in the Middle East; although it is in the process of building strategic
reserves, all the three projects in this regard have been delayed significantly.
Exhibit 2 shows our estimates of under-recoveries on diesel, kerosene and LPG for FY2012E
in case the government does not increase domestic retail selling prices. At US$105/bbl
(Dated Brent basis), we estimate gross under-recoveries at `1.39 tn. Diesel is the big swing
contributor given its large share in India’s consumption of petroleum products. The
government’s plans to deregulate diesel (as announced on June 25, 2010) have floundered
in the wake of high inflation and high global prices.
We note that the government can reduce excise duty on diesel and gasoline and import duty
on crude oil to provide some relief to the downstream oil companies (see Exhibit 3).
However, the government would stand to lose an equivalent amount of tax revenues, which
it can ill-afford currently given its weak fiscal position.
We compute an impact of Rs334 bn on under-recovery from lower duties
Impact on subsidy burden from lower duties, March fiscal year-end, 2012E (Rs bn)
Consumption of gasoline (mn tons) 1 5
Consumption of diesel (mn tons) 6 4
Impact of lower excise duty
Change in excise duty (Rs/liter) 2
Impact of lower excise duty on gasoline 4 1
Impact of lower excise duty on diesel 155
Impact of lower excise duty on petrol and diesel (A) 1 95
Impact of lower customs duty
Change in customs duty on diesel, gasoline and crude oil (%) 5.15
Impact of lower customs duty on gasoline 2 9
Impact of lower customs duty on diesel 110
Impact of lower customs duty on gasoline and diesel (B) 1 39
Total impact of lower duties (A) + (B) 3 34
Source: Kotak Institutional Equities estimates
Exhibit 4 gives our estimates of India’s GDP and BOP at various levels of crude oil prices. At
US$105/bbl, we estimate CAD/GDP at 3.7% against our base-case scenario of 2.8%. We
note that a US$1/bbl increase in crude oil price adds about ~US$900 mn to India’s net oil
imports and CAD.
Ratings are largely academic
We see ratings on Indian energy stocks as largely academic in the absence of any rule-based
subsidy-sharing mechanism. The government has historically asked upstream companies to
bear one-third of gross under-recoveries and has given compensation to the downstream oil
companies in the form of cash and oil bonds to make up for the bulk of their underrecoveries.
The net under-recoveries of the downstream oil companies have been fairly
volatile
Likely large under-recoveries in FY2012E make the task of forecasting earnings very difficult;
in any case, the stocks reflect very poor earnings and low probability of positive government
intervention. The market has largely given up valuing these stocks on earnings and will likely
look at their book values to derive some comfort about their valuations at current high levels
of crude oil prices. Exhibit 6 shows historical P/B of the downstream oil stocks. The only
consolation is that the stocks do not fall beyond a certain level and find support at low P/B
levels (around 0.7X forward-year’s book for HPCL and 1X for BPCL).
We note that even GAIL, OIL and ONGC may get hit if the government does not reduce
their share of under-recoveries from the current one-third of under-recoveries. We estimate
that the sales of crude oil by OIL and ONGC and LPG by GAIL in FY2012E at 32 mn tons,
35% of FY2012E sales of diesel, kerosene and LPG (89 mn tons). Exhibit 7 gives detailed
calculations. Even adjusting for royalty payments on crude oil, we note that GAIL, OIL and
ONGC may find it hard to bear one-third of gross under-recoveries without their net profits
being negatively impacted versus FY2011E levels (ignoring any change in production
volumes).
Upstream companies can bear a maximum of 35% of under-recoveries
Potential subsidy sharing for upstream companies (%)
Consumption of regulated products (mn tons)
Diesel 66
LPG 14
Kerosene 9
Total 89
Oil-equivalent sales (mn tons)
ONGC 26
OIL 4
GAIL 2
Total 32
Potential subsidy sharing (%) 35
Source: Kotak Institutional Equities estimates
In particular, we note that GAIL sells about 1.6 mn tons of LPG and petrochemicals per
annum, which is much lower than its likely share of under-recoveries in product-equivalent
terms (2.27 mn tons or 2.56% of 89 mn tons) in FY2012E. GAIL’s share of under-recoveries
among upstream companies in 9MFY11 was 7.7% or 2.56% of gross under-recoveries.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Energy
India
It’s not just about a few oil companies. The rapid escalation of political unrest in the
MENA region exposes India’s energy sector, CAD and FD to grave risks. With the only
practical solution of price increases largely unavailable due to the government’s political
constraints and high inflation, it would be a challenge for India to extricate itself from
the huge negative impact of high oil prices. Stock ratings are largely academic currently;
OIL and ONGC are the only investible ideas now but even they may face challenges.
There is no Plan A, let alone Plan B or C or….
The government’s blinkered approach on pricing of fuels and inability to increase prices in small
doses over the past few years (in order to align them to global levels) exposes India’s energy sector,
CAD and FD to grave risks from high oil prices. The situation is unmanageable at US$105/bbl; a
supply shock due to extended political upheavals in one or more major oil-producing nations could
push crude oil prices higher. India has very little defense against high crude oil prices given its twin
deficits and a general inability to confront issues (until they spiral out of control).
Events in Libya and beyond can really hurt India
At 1.8 mn b/d of production capacity and 1.58 mn b/d production in January 2011, Libya’s oil is
important for global oil markets. 22% or more of Libya’s production is already shut by global oil
companies operating in Libya as preemptive measures and more could be at risk if events escalate
in Libya and beyond. Saudi Arabia’s spare capacity of 3.5 mn b/d can help but it should realize the
risks to global economic recovery from high prices and consequent demand destruction. It has
adopted a ‘business-as-usual’ attitude, which may be a grave mistake, in our view.
`1.39 tn of under-recoveries, 3.7% CAD/GDP in FY2012E if oil averages US$105/bbl
At US$105/bbl (Dated Brent basis), FY2012E total under-recoveries on diesel, kerosene and LPG
could be around `1.4 tn (1.5% of GDP) if the government does not raise retail selling prices. At
the same time, CAD/GDP could slip to 3.7%, which could put pressure on India’s BOP and
currency unless capital inflows surprise positively. BP’s US$7.2 bn investment in RIL’s oil and gas
blocks will help but that is equivalent to US$9/bbl higher crude oil price only; a US$1/bbl increase
in crude oil price adds US$900 mn to India’s imports and CAD.
Investment view on energy stocks is (once again) academic
An unpredictable subsidy amount, low clarity on the subsidy-sharing mechanism and macro
concerns make it impossible to forecast the earnings of oil companies and take an investment view
on them. We note that even GAIL, OIL and ONGC will get hit negatively if the government persists
with its one-third subsidy-sharing formula for upstream companies in FY2012E. As for BPCL, HPCL
and IOCL, the government will have to ring-fence their under-recoveries to a certain fixed amount;
they can bear maximum `100 bn of net under-recoveries without reporting abysmal profits.
Libya’s problems may not be contained within the oil-rich nation
Exhibit 1 shows stated production capacity and production over the past few months of
OPEC broken down by countries. As can be seen, Libya accounts for a substantial share with
1.58 mn b/d of production in January 2011 out of 29.85 mn b/d of total OPEC production.
Various independent oil companies operating in Libya have already shut production, leading
to a loss of around 22% (more as per some reports) already. More producers may wind
down production as they evacuate production personnel and contractors also withdraw their
personnel from the oil fields and loading ports.
We note that OPEC has sufficient spare capacity to weather the storm in Libya if only it
decides to ramp up supply. So far, it has decided to continue production at current rates and
has not paid heed to price signals; prices have run up rapidly over the past two months and
especially over the past few days once news of political unrest in Libya first broke out. Saudi
Arabia believes that the world market is well-supplied. In our view, OPEC’s ‘business-asusual’
stance is a grave mistake in that it risks damaging global economic recovery through
high crude oil prices. Of course, it is another matter that many other countries in OPEC may
face similar political upheavals. All bets are off in that case; prices could easily spiral to
US$120/bbl where we could see some demand destruction.
India has no defense against high oil prices
We note that India has very little defense against high oil prices given its high twin deficits
(CAD, FD) and high inflation. It has no strategic reserves also in case of supply shortages due
to supply problems in the Middle East; although it is in the process of building strategic
reserves, all the three projects in this regard have been delayed significantly.
Exhibit 2 shows our estimates of under-recoveries on diesel, kerosene and LPG for FY2012E
in case the government does not increase domestic retail selling prices. At US$105/bbl
(Dated Brent basis), we estimate gross under-recoveries at `1.39 tn. Diesel is the big swing
contributor given its large share in India’s consumption of petroleum products. The
government’s plans to deregulate diesel (as announced on June 25, 2010) have floundered
in the wake of high inflation and high global prices.
We note that the government can reduce excise duty on diesel and gasoline and import duty
on crude oil to provide some relief to the downstream oil companies (see Exhibit 3).
However, the government would stand to lose an equivalent amount of tax revenues, which
it can ill-afford currently given its weak fiscal position.
We compute an impact of Rs334 bn on under-recovery from lower duties
Impact on subsidy burden from lower duties, March fiscal year-end, 2012E (Rs bn)
Consumption of gasoline (mn tons) 1 5
Consumption of diesel (mn tons) 6 4
Impact of lower excise duty
Change in excise duty (Rs/liter) 2
Impact of lower excise duty on gasoline 4 1
Impact of lower excise duty on diesel 155
Impact of lower excise duty on petrol and diesel (A) 1 95
Impact of lower customs duty
Change in customs duty on diesel, gasoline and crude oil (%) 5.15
Impact of lower customs duty on gasoline 2 9
Impact of lower customs duty on diesel 110
Impact of lower customs duty on gasoline and diesel (B) 1 39
Total impact of lower duties (A) + (B) 3 34
Source: Kotak Institutional Equities estimates
Exhibit 4 gives our estimates of India’s GDP and BOP at various levels of crude oil prices. At
US$105/bbl, we estimate CAD/GDP at 3.7% against our base-case scenario of 2.8%. We
note that a US$1/bbl increase in crude oil price adds about ~US$900 mn to India’s net oil
imports and CAD.
Ratings are largely academic
We see ratings on Indian energy stocks as largely academic in the absence of any rule-based
subsidy-sharing mechanism. The government has historically asked upstream companies to
bear one-third of gross under-recoveries and has given compensation to the downstream oil
companies in the form of cash and oil bonds to make up for the bulk of their underrecoveries.
The net under-recoveries of the downstream oil companies have been fairly
volatile
Likely large under-recoveries in FY2012E make the task of forecasting earnings very difficult;
in any case, the stocks reflect very poor earnings and low probability of positive government
intervention. The market has largely given up valuing these stocks on earnings and will likely
look at their book values to derive some comfort about their valuations at current high levels
of crude oil prices. Exhibit 6 shows historical P/B of the downstream oil stocks. The only
consolation is that the stocks do not fall beyond a certain level and find support at low P/B
levels (around 0.7X forward-year’s book for HPCL and 1X for BPCL).
We note that even GAIL, OIL and ONGC may get hit if the government does not reduce
their share of under-recoveries from the current one-third of under-recoveries. We estimate
that the sales of crude oil by OIL and ONGC and LPG by GAIL in FY2012E at 32 mn tons,
35% of FY2012E sales of diesel, kerosene and LPG (89 mn tons). Exhibit 7 gives detailed
calculations. Even adjusting for royalty payments on crude oil, we note that GAIL, OIL and
ONGC may find it hard to bear one-third of gross under-recoveries without their net profits
being negatively impacted versus FY2011E levels (ignoring any change in production
volumes).
Upstream companies can bear a maximum of 35% of under-recoveries
Potential subsidy sharing for upstream companies (%)
Consumption of regulated products (mn tons)
Diesel 66
LPG 14
Kerosene 9
Total 89
Oil-equivalent sales (mn tons)
ONGC 26
OIL 4
GAIL 2
Total 32
Potential subsidy sharing (%) 35
Source: Kotak Institutional Equities estimates
In particular, we note that GAIL sells about 1.6 mn tons of LPG and petrochemicals per
annum, which is much lower than its likely share of under-recoveries in product-equivalent
terms (2.27 mn tons or 2.56% of 89 mn tons) in FY2012E. GAIL’s share of under-recoveries
among upstream companies in 9MFY11 was 7.7% or 2.56% of gross under-recoveries.
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