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India upstream oil
Adjusting earnings, PTs for higher oil deck; upgrade
ONGC to OW
• Incorporating higher oil price deck – We increase our2011 Brent oil
price estimate from US$80/bbl to US$110/bbl: US$95/90bbl for
2012/13E (up from US$80/bbl) and US$85/bbl long term from 2014E (see
Fred Lucas' Integrated Oils, Arab Spring may bring an OECD winter, 1
April 11). Supply risk has increased substantially recently, with the loss of
Libya exports the main real factor, on top of risks around other MENA
exporters. Other OPEC countries are stepping in to replace lost oil from
Libya, but the market does not seem impressed and continues to price crude
at a high level. We believe the demand side will at some point react to the
higher prices, which along with more crude from OPEC (Iraq etc.) and non-
OPEC should bring prices to fundamentally justifiable levels.
• High crude will necessitate policy response…: We expect the
unsustainably high oil subsidy burden will necessitate a policy response,
which would be positive in the long term for the Indian SOE oil sector,
although short-term earnings concerns are likely to continue to have an
impact on stock performance. We are incrementally more constructive on
the SOE companies and upgrade ONGC to OW.
• …we see a window in June: We see a window for policy action after
the state elections in April/May with a likely moderation in inflation
print as y/y comps ease. We believe political posturing will have to yield
to the reality of higher oil prices. Already, the government is working on
direct subsidy payment for cooking fuels – we (perhaps optimistically)
build a Rs60bn saving in kerosene/LPG subsidy on this score. We also
build in a Rs4/3 rise in diesel in FY12/13 (60bp/42bp impact on
inflation) and no subsidy losses on petrol.
• SOE stock preference reflects a painful awareness of pitfalls:
Maintain Neutral on Cairn, but with higher PT: India’s ad-hoc policy
response to higher oil prices has underpinned our long-held cautious
view on the SOE oil sector. Even as we build in a more constructive
scenario for policy action, we choose to play this through stocks that
have lower downside if there is no follow-through on policy. In the
upstream sector, we prefer ONGC (upgraded to OW from N) for its
lower sensitivity to subsidies to OIL (retain UW). Cairn is a clear
beneficiary of higher crud; however, with the stock currently reflecting
US$105/bbl LT crude levels and a significant risk of negative earnings
impact if the royalty is made cost-recoverable, we retain our Neutral
rating on the stock.
Policy initiatives are necessary
Crude prices have moved decisively upwards over the past few months. Wavering on
policy reform is likely to become increasingly difficult for the government, in our
view. While we cannot rule out ad-hoc responses (as has been the norm in the past),
we are now more hopeful of some hard reform measures. Over the last year, a few
government initiatives have contributed to our renewed hope, including 1) gas
pricing reform, 2) partial implementation of Kirit Parikh Committee
recommendations on auto fuel pricing reform, and 3) plans for targeted direct
transfer of subsidies revealed in the budget. While the auto fuel pricing reforms have
stalled, possibly on account of the political calendar, we believe that the government
will avail itself of the political/inflation window we see mid-2011.
We introduce a new crude price deck, adjusting for the issues in the Middle East and
North Africa.
Table 1: New crude deck
Brent (US$/bbl)
FY12 106.25
FY13 93.75
FY14 88.75
FY15 85.00
Source: J.P. Morgan estimates.
Changes to subsidy assumptions
With crude remaining at persistently high levels, subsidy losses are reaching
unsustainable levels (FY12 subsidy could be Rs1.3trn if no reforms are initiated) –
making a policy response imperative, in our view.
We see a window for reform post the state elections in June, with inflation
moderating as well. We expect to see further rises in diesel prices (Rs4/Rs3) over
FY12/13, before a market determined price sets in for FY14. We also (perhaps
optimistically) expect a reduction in cooking fuel subsidies based on success of direct
targeting of subsidies. The government has announced that it intends to introduce
targeted direct transfers for cooking fuel subsidies, which is likely to help reduce the
diversion of subsidized kerosene towards adulteration of diesel (we expect a 15%
reduction in kerosene volumes in FY13). Targeted subsidy for LPG would also yield
benefits - we assume subsidized volumes will drop ~10% in FY13 (on lower
diversion to commercial application).
Valuations, risks
With an increase in our crude deck, and changes to our subsidy assumptions, we
adjust earnings for the upstream companies by 12%/10% (ONGC), 4%/8% (OIL) and
24%/4% (Cairn).
Key risks to our calls include:
• Higher subsidy share for the SOE companies;
• Lack of follow-through on reform agenda;
• ONGC’s Rajasthan royalty payments becoming cost recoverable (risk for
Cairn - positive for ONGC).
Oil and Natural Gas Corporation
• Comparatively resilient, upgrade to Overweight: We upgrade ONGC to
Overweight, with a Mar-12 PT of Rs390, as we expect the company to
benefit from positive policy initiatives in the face of high crude levels. Even
assuming a higher share of upstream in fuel subsidies, ONGC’s earnings are
positively impacted by higher crude price assumptions.
• We are building policy upside, but with caps for upstream: With crude
remaining persistently high, subsidy losses are reaching unsustainable
levels. We expect a light political calendar post state elections in May, and
moderating inflation to provide the government a “window” to carry out
reforms. However, we build in government raising upstream share of the
subsidy bill even as reforms are carried out, capping super-normal
profitability for the upstream SOE companies.
• Cooking fuel reductions possible: While a tad optimistic, our assumptions
build in success for government initiatives towards targeted subsidies,
helping reduce the extent of kerosene used for adulteration purposes and
contain use of LPG for commercial purposes.
• Valuations, PT, risks: While we are more constructive on the SOE space,
we prefer stocks that are more resilient to downside, in the event of
disappointment on policy moves. We upgrade ONGC to OW, with a new
Mar-12 PT of Rs390. We raise our FY12/13 estimates by 12%/10%
respectively. Key risks to our call include lack of follow-through on reform
measures, and a higher subsidy share for the upstream SOEs. Our PT is
based on 4x EV/EBITDA, at a discount to regional peers due to continuing
uncertainty on government policy.
Oil India Ltd.
• Still leveraged to policy; retain Underweight: We retain our cautious
stance on OIL, with a Mar-12 PT of Rs1325, as the company remains more
susceptible to changes in policy decisions. With pre-dominantly onland
crude production (higher ad-valorem royalty), OIL's earnings are not as
positively correlated to crude as ONGC's.
• We are building policy upside, but with caps for upstream: With crude
remaining persistently high, subsidy losses are reaching unsustainable
levels. We expect a light political calendar post state elections in May, and
moderating inflation to provide the government a “window” to carry out
reforms. However, we build in government raising upstream share of the
subsidy bill even as reforms are carried out, capping super-normal
profitability for the upstream SOE companies..
• Cooking fuel reductions possible: While a tad optimistic, our assumptions
build in success for government initiatives towards targeted subsidies,
helping reduce the extent of kerosene used for adulteration purposes and
contain use of LPG for commercial purpose.
• Valuations, PT, risks: While we are more constructive on the SOE space,
we prefer stocks that are more resilient to downside, in the event of
disappointment on policy moves. We retain our UW rating on OIL, with a
new Mar-12 PT of Rs1325. We raise our FY12/13 estimates by 4%/8%
respectively. Key risks to our call include a quick implementation of reform
measures, and a stable subsidy share for the upstream SOEs. Our PT is
based on 4x EV/EBITDA, at a discount to regional peers due to continuing
uncertainty on government policy.
Cairn India Limited
• Obvious beneficiary of high crude: Cairn’s earnings/value have a high
leverage to rising crude prices. However, the stock currently reflects LT
crude levels of US$105/bbl. With significant risk of negative earnings
impact if the royalty (paid by ONGC) is made cost recoverable, we retain
our Neutral rating on the stock.
• Cairn has continued to deliver operational performance – Mangala field
is producing at its currently approved peak production rate of 125kbopd,
and the company is awaiting government approval to ramp this up to
150kbopd. The Bhagyam field is expected to commence production
between July and October, with an eventual peak rate of 40kbopd. The
Aishwarya field is to start producing in 2HCY12, with a peak rate of
20kbopd. Cairn expects to augment these 3 fields with production from the
smaller associated formations, leading to a peak output of 240kbopd
(subject to government approvals).
• Valuations, PT, risks: We maintain our Neutral rating on Cairn, with a
new Mar-12 PT of Rs385. We value Cairn at a 20% premium to NPV, using
a long-term crude assumption of $85/bbl, with explicit crude forecasts upto
FY14. We adjust our cess assumption to Rs2625/MT from Rs927. Our NPV
uses a discount rate of 11%. Risks to our call include ONGC's royalty
payments becoming cost recoverable on the downside, and sustained higher
crude prices on the upside.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India upstream oil
Adjusting earnings, PTs for higher oil deck; upgrade
ONGC to OW
• Incorporating higher oil price deck – We increase our2011 Brent oil
price estimate from US$80/bbl to US$110/bbl: US$95/90bbl for
2012/13E (up from US$80/bbl) and US$85/bbl long term from 2014E (see
Fred Lucas' Integrated Oils, Arab Spring may bring an OECD winter, 1
April 11). Supply risk has increased substantially recently, with the loss of
Libya exports the main real factor, on top of risks around other MENA
exporters. Other OPEC countries are stepping in to replace lost oil from
Libya, but the market does not seem impressed and continues to price crude
at a high level. We believe the demand side will at some point react to the
higher prices, which along with more crude from OPEC (Iraq etc.) and non-
OPEC should bring prices to fundamentally justifiable levels.
• High crude will necessitate policy response…: We expect the
unsustainably high oil subsidy burden will necessitate a policy response,
which would be positive in the long term for the Indian SOE oil sector,
although short-term earnings concerns are likely to continue to have an
impact on stock performance. We are incrementally more constructive on
the SOE companies and upgrade ONGC to OW.
• …we see a window in June: We see a window for policy action after
the state elections in April/May with a likely moderation in inflation
print as y/y comps ease. We believe political posturing will have to yield
to the reality of higher oil prices. Already, the government is working on
direct subsidy payment for cooking fuels – we (perhaps optimistically)
build a Rs60bn saving in kerosene/LPG subsidy on this score. We also
build in a Rs4/3 rise in diesel in FY12/13 (60bp/42bp impact on
inflation) and no subsidy losses on petrol.
• SOE stock preference reflects a painful awareness of pitfalls:
Maintain Neutral on Cairn, but with higher PT: India’s ad-hoc policy
response to higher oil prices has underpinned our long-held cautious
view on the SOE oil sector. Even as we build in a more constructive
scenario for policy action, we choose to play this through stocks that
have lower downside if there is no follow-through on policy. In the
upstream sector, we prefer ONGC (upgraded to OW from N) for its
lower sensitivity to subsidies to OIL (retain UW). Cairn is a clear
beneficiary of higher crud; however, with the stock currently reflecting
US$105/bbl LT crude levels and a significant risk of negative earnings
impact if the royalty is made cost-recoverable, we retain our Neutral
rating on the stock.
Policy initiatives are necessary
Crude prices have moved decisively upwards over the past few months. Wavering on
policy reform is likely to become increasingly difficult for the government, in our
view. While we cannot rule out ad-hoc responses (as has been the norm in the past),
we are now more hopeful of some hard reform measures. Over the last year, a few
government initiatives have contributed to our renewed hope, including 1) gas
pricing reform, 2) partial implementation of Kirit Parikh Committee
recommendations on auto fuel pricing reform, and 3) plans for targeted direct
transfer of subsidies revealed in the budget. While the auto fuel pricing reforms have
stalled, possibly on account of the political calendar, we believe that the government
will avail itself of the political/inflation window we see mid-2011.
We introduce a new crude price deck, adjusting for the issues in the Middle East and
North Africa.
Table 1: New crude deck
Brent (US$/bbl)
FY12 106.25
FY13 93.75
FY14 88.75
FY15 85.00
Source: J.P. Morgan estimates.
Changes to subsidy assumptions
With crude remaining at persistently high levels, subsidy losses are reaching
unsustainable levels (FY12 subsidy could be Rs1.3trn if no reforms are initiated) –
making a policy response imperative, in our view.
We see a window for reform post the state elections in June, with inflation
moderating as well. We expect to see further rises in diesel prices (Rs4/Rs3) over
FY12/13, before a market determined price sets in for FY14. We also (perhaps
optimistically) expect a reduction in cooking fuel subsidies based on success of direct
targeting of subsidies. The government has announced that it intends to introduce
targeted direct transfers for cooking fuel subsidies, which is likely to help reduce the
diversion of subsidized kerosene towards adulteration of diesel (we expect a 15%
reduction in kerosene volumes in FY13). Targeted subsidy for LPG would also yield
benefits - we assume subsidized volumes will drop ~10% in FY13 (on lower
diversion to commercial application).
Valuations, risks
With an increase in our crude deck, and changes to our subsidy assumptions, we
adjust earnings for the upstream companies by 12%/10% (ONGC), 4%/8% (OIL) and
24%/4% (Cairn).
Key risks to our calls include:
• Higher subsidy share for the SOE companies;
• Lack of follow-through on reform agenda;
• ONGC’s Rajasthan royalty payments becoming cost recoverable (risk for
Cairn - positive for ONGC).
Oil and Natural Gas Corporation
• Comparatively resilient, upgrade to Overweight: We upgrade ONGC to
Overweight, with a Mar-12 PT of Rs390, as we expect the company to
benefit from positive policy initiatives in the face of high crude levels. Even
assuming a higher share of upstream in fuel subsidies, ONGC’s earnings are
positively impacted by higher crude price assumptions.
• We are building policy upside, but with caps for upstream: With crude
remaining persistently high, subsidy losses are reaching unsustainable
levels. We expect a light political calendar post state elections in May, and
moderating inflation to provide the government a “window” to carry out
reforms. However, we build in government raising upstream share of the
subsidy bill even as reforms are carried out, capping super-normal
profitability for the upstream SOE companies.
• Cooking fuel reductions possible: While a tad optimistic, our assumptions
build in success for government initiatives towards targeted subsidies,
helping reduce the extent of kerosene used for adulteration purposes and
contain use of LPG for commercial purposes.
• Valuations, PT, risks: While we are more constructive on the SOE space,
we prefer stocks that are more resilient to downside, in the event of
disappointment on policy moves. We upgrade ONGC to OW, with a new
Mar-12 PT of Rs390. We raise our FY12/13 estimates by 12%/10%
respectively. Key risks to our call include lack of follow-through on reform
measures, and a higher subsidy share for the upstream SOEs. Our PT is
based on 4x EV/EBITDA, at a discount to regional peers due to continuing
uncertainty on government policy.
Oil India Ltd.
• Still leveraged to policy; retain Underweight: We retain our cautious
stance on OIL, with a Mar-12 PT of Rs1325, as the company remains more
susceptible to changes in policy decisions. With pre-dominantly onland
crude production (higher ad-valorem royalty), OIL's earnings are not as
positively correlated to crude as ONGC's.
• We are building policy upside, but with caps for upstream: With crude
remaining persistently high, subsidy losses are reaching unsustainable
levels. We expect a light political calendar post state elections in May, and
moderating inflation to provide the government a “window” to carry out
reforms. However, we build in government raising upstream share of the
subsidy bill even as reforms are carried out, capping super-normal
profitability for the upstream SOE companies..
• Cooking fuel reductions possible: While a tad optimistic, our assumptions
build in success for government initiatives towards targeted subsidies,
helping reduce the extent of kerosene used for adulteration purposes and
contain use of LPG for commercial purpose.
• Valuations, PT, risks: While we are more constructive on the SOE space,
we prefer stocks that are more resilient to downside, in the event of
disappointment on policy moves. We retain our UW rating on OIL, with a
new Mar-12 PT of Rs1325. We raise our FY12/13 estimates by 4%/8%
respectively. Key risks to our call include a quick implementation of reform
measures, and a stable subsidy share for the upstream SOEs. Our PT is
based on 4x EV/EBITDA, at a discount to regional peers due to continuing
uncertainty on government policy.
Cairn India Limited
• Obvious beneficiary of high crude: Cairn’s earnings/value have a high
leverage to rising crude prices. However, the stock currently reflects LT
crude levels of US$105/bbl. With significant risk of negative earnings
impact if the royalty (paid by ONGC) is made cost recoverable, we retain
our Neutral rating on the stock.
• Cairn has continued to deliver operational performance – Mangala field
is producing at its currently approved peak production rate of 125kbopd,
and the company is awaiting government approval to ramp this up to
150kbopd. The Bhagyam field is expected to commence production
between July and October, with an eventual peak rate of 40kbopd. The
Aishwarya field is to start producing in 2HCY12, with a peak rate of
20kbopd. Cairn expects to augment these 3 fields with production from the
smaller associated formations, leading to a peak output of 240kbopd
(subject to government approvals).
• Valuations, PT, risks: We maintain our Neutral rating on Cairn, with a
new Mar-12 PT of Rs385. We value Cairn at a 20% premium to NPV, using
a long-term crude assumption of $85/bbl, with explicit crude forecasts upto
FY14. We adjust our cess assumption to Rs2625/MT from Rs927. Our NPV
uses a discount rate of 11%. Risks to our call include ONGC's royalty
payments becoming cost recoverable on the downside, and sustained higher
crude prices on the upside.
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