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The underperforming KG-D6 gas field has dragged RIL down along with it. After the 4QFY11 results
announcement, with no further clarity on KG-D6 and consistent negative press surrounding the issue, RIL
stock has dropped a further 9%. Though, there have also been concerns on the sustainability of its margins
in its refining business, the issue dominating the discussion around RIL has been upstream performance.
While the gas reservoir may be more complex than anticipated, we believe they are resolvable and that
Reliance will be able to ramp up to planned output targets as additional wells are drilled.
Reliance has significantly underperformed the Sensex over the past 12 months since production at
the KG-D6 (Dhirubhai) gas field started to decline and production targets were missed.
Lower production output is primarily a function of the hiatus in development drilling. While it
seems likely that the reservoir is more complex than originally anticipated, performance on a per well
basis has not been too dissimilar to the original field development plan. Instead the lower number of
development wells drilled (18 vs. 26 planned) is primarily is the reason for the underperformance.
Completion of the 1 drilling programme plus initiation of the Phase 2 drilling programme will
restore production growth. While additional surveillance data will help Reliance to better locate infill
wells (and possibly higher prices) we think it is only a matter of time before additional drilling kicks off
which will bring production up towards the target of 80MCM/d.
The $7.5bn farm-in by BP to Reliance acreage gives us confidence that a turn-around in KG-D6
will be achieved. BP will have been aware of the production issues at D6 prior to farming-in. We expect
the arrival of a major IOC to not only bring world class reservoir management practices to KG-D6 but to
also accelerate exploration across east coast of India.
While Reliance has disappointed upstream, downstream performance has been strong. Refining
margins have improved (c. $10/bbl) over the past 4 quarters in line with the Singapore benchmark
indicator. While spreads relative to Singapore have been a little weaker than expected, we expect refining
margins to remain firm for the remainder of 2011.
Petrochemical performance also continues to be extremely robust with higher margins and
volumes. Reliance has been able to benefit from both strong volume growth and record margins as prices
have firmed on demand growth for plastics and polyester given the surge in cotton prices. We remain
positive on the petrochemical cycle and with further additional capacity planned we expect continued
growth in the petrochemical segment ahead.
Investment Conclusion
Reliance has underperformed the Sensex in line with the disappointing performance of its flagship
Dhirubhai gas field. Even a relatively strong performance from its downstream divisions has failed to offset
the gloom which has set in around the future Dhirubhai. Ultimately, the outlook for Reliance comes down
to the future of Dhirubhai. Whether KG-D6 has the 7-8TCF of booked gas reserves and whether the
downward production trend can be reversed. We believe it can be and that the reversal from decline to
growth may be closer than some expect. Our key observation is that despite lower overall production,
performance per well is not materially different to originally planned. Instead, the shortfall in production
can be largely attributed to the shortfall in wells drilled as a result of greater reservoir complexity.
The arrival of BP who has recently farmed into the offshore acreage will help, both in terms production and
exploration. BP will certainly have been aware of the KG-D6 issues and their willingness to farm-in not
only confirms our positive view that Dhirubhai production can be turned around, but also that the offshore
acreage which has significant potential and is critical for India which is gas short. The catalyst for Reliance
is the announcement that Phase 2 development drilling will resume and improvement in D6 output. We also
believe that higher gas prices are a possibility given the importance of this project to India.
We value Reliance on a sum-of-the parts basis. The recent weakness in the stock presents an attractive entry
point for investors with little downside risk from current valuations. We maintain our OP rating with a price
target of INR1250.
Details
Reliance Industries announced its Full Year 2011 results on the 21
st
of April and the 4QFY11 EPS of
Rs16.4 fell slightly short of analyst expectations. The stock has subsequently underperformed and is down
9% since then. However, the reason for the underperformance of the stock since the results announcement,
and indeed since June 2010, has not been weaker earnings per se, but the rapid slowdown in production
from its flagship KG-D6 gas field.
The market was looking for some concrete actionable proposals or at the least some guidance from
management on bringing the field back to the normal production schedule. However, the lack of any
substantial announcement on plans to improve the production profile of KG-D6 has acted as a dampener on
the stock. In the results presentation, there was a short note on the fact that the company is finding the
reservoir more complex than envisaged earlier, nothing different from what had been said before on the
subject.
We believe that the KG-D6 situation is more complex than first envisioned, but not as complex as feared by
the market. In this report, we show that the declining output is simply a function of the lower number of
wells currently in production. Though it is difficult to get an accurate assessment of the situation without
having access to detailed reservoir data, it is indeed very possible that the reservoir is more complex than
originally thought and the management is waiting for additional data to optimize the capital investment i.e.
the drilling of wells. However, it is unlikely that the worst fears of the market - that of a much smaller
reservoir and/or permanently lowered output profile from the reservoir - are true.
RIL share price performance has been disappointing primarily due to KG-D6 underperformance
The Indian oil and gas stocks, and in particular the largest player RIL haven’t had a good 2010. Since the
start of 2010, the RIL stock has underperformed the NIFTY by nearly 20% (see Exhibit 1). RIL started
underperforming the NIFTY in the three months starting July 2010 due to reduced expectations of gas
production out of KG-D6 (Dhirubhai). From start of Jul10 till the end of Sep 10, RIL underperformed the
Nifty by 18 percentage points. During the same period, ONGC outperformed the NIFTY by 8% points as
investors moved over their funds to the 2nd biggest energy company in the country.
The deal with BP announced in Feb 11 served to provide some temporary relief to the RIL stock but the
negative press surrounding the KG-D6 field production and afterwards the 4QFY11 results miss and the
lack of any further clarity on the KG-D6 issue has hammered the stock down.
The decline in KG-D6 output is impacting Indian gas production
Dhirubhai, India's largest offshore gas field started up in April 2009. The impact on India's offshore and
total gas production has been significant (see Exhibit 2). Following 1 year of production ramp up however,
the field reached a monthly high of 2.3bcf/d (65MCM/d) before dropping back to current levels of 1.8bcf/d
or 50MCM/d. The drop off in volumes from D6 has resulted in a significant slowdown in indigenous gas
output in India. Indeed, Indian gas output in Mar11 was 11% lower than year ago levels.
Lower production is a result of the lower number of wells and the decline over time is natural
The E&P business of RIL is the fulcrum around which the stock moves. The travails of the RIL stock
starting June 2010 started when, contrary to expectations, the output from the Dhirubhai field started
declining during 1QFY11 (see Exhibit 3). Any good or bad news out of this unit will be the primary driver
of the stock in the near term.
So what do we expect over the next few quarters?
We believe that the natural rate of the decline in production for the KG-D6 wells is around 20% annually,
or around 5% per quarter, not substantially different from similar fields around the world. In case RIL
doesn’t take any more action on the drilling of wells and connecting those to the reservoir and continues
operating with 18 wells, we expect the production to reach a level of around 37-38mmscmd (1.3bcfd) (see
Exhibit 9) by FY2013. However, we regard that as a remote possibility.
Declining volumes 2 years into start up of Dhirubhai was not the plan. The initial target was to reach
2.8bcf/d (or 80MCM/d) from the initial 22 wells and then add 28 additional wells (up to 50 wells in total) to
maintain plateau of 2.8bcf/d for up to 8 years. So far 18 wells have been drilled, with another 2 wells
completed but not connected to the field. A further 2 wells are expected to be completed over the coming
few months and come online before the end of the current fiscal year.
We also expect RIL to bring on line additional wells over the course of the next fiscal year as a part of the
phase 2 drilling programme. We continue to believe that RIL to can reach the plan production level of
80mmscmd by 2QFY14.
So, what is the technical problem with Dhirubhai?
The Dhirubhai gas reservoir consists of a number of complex stacked sands which were deposited in deep
waters. The channels, analogous to rivers of sand within a deep ocean environment have sinuous geometries
which are stacked together bore vertically and laterally. The quality of the sands which make up the
reservoir units which contain the gas varies considerably across the field. How these sands connect up was a
major uncertainty at the time of field development.
Given the production problems to date it would appear that the field is not behaving as a 'single tank' and
that there are many different compartments within the field which contain gas (see Exhibit 10 and Exhibit
11). As such, understanding locating additional wells in the field needs to be planned carefully to avoid
draining the same compartments with the same wells. Other potential problems include early break-through
of water or build up of sand in the reservoir, although no specific details have been provided by Reliance.
The issue of gas pricing
Though Dhirubhai is turning out to be more complex than originally anticipated, there is a broader problem
– gas pricing. In India's first gas war between RIL and RPL, RIL triumphed with the Supreme Court setting
the gas price at the government approved price of USD4.20/mscf rather than the USD2.40/mscf sought by
RPL. It was a pyrrhic victory however. Under new regulations the Indian government effectively sets gas
pricing and gas allocation rather than having this set on a commercial basis as per the original PSC terms.
The problem is that at current gas prices of USD4.20/mscf (USD25/boe) it is simply uneconomic to develop
new gas fields in deep water offshore India's east coast. This should be obvious to all. After 10 years since
the first NELP (New Exploration Licensing) round, there has only been 1 major deep water gas
development despite over 50 gas discoveries and 50TCF of gas in place discovered. While licensing of
acreage has been successful, de facto regulation of gas prices to low levels has stalled the development of
much needed gas off India's east coast.
While there are technical issues with D6, what is being played out is a negotiation by proxy between
Reliance and the Indian government on gas pricing. Lower gas output is not good for Reliance shareholders,
but it also not good for India Inc, which has to import more gas and LNG. In our view it is obvious that gas
prices will need to be raised to levels with re-numerate investment. India will be a large energy and gas
consuming country in the future. With limited indigenous resources, development of domestic gas is a must.
The drop off in volumes from D6 has resulted in a significant slowdown in indigenous gas output in Inida.
Indeed, Indian gas output declined 11% YoY in Mar11 YoY. As a result India has imported more LNG and
more oil to make up for the shortages in domestic natural gas (see Exhibit 12). While domestic gas in D6 is
US$4.20/mscf at the beach, imports of LNG and oil are running at US$10-15/mscf.
With its domestic demand expected to grow by more than 10% per annum, India is expected to consume
more than 250 MMSCMD by 2014-15. With such high demand in the offing, India as a country can ill
afford such a high level of LNG imports while its rich domestic reserves lie untapped and unexploited. The
increase of the regulated gas price will not only deservedly compensate the E&P companies for their past
investment but also spur additional investment, which will go a long way in making the country energy
independent.
DGH and the government continue to put pressure on RIL
The Directorate General of Hydrocarbons (DGH) was not satisfied with RIL's explanation for the reasons
for the drop in production from KG-D6 and news reports suggest that they have sent a team of experts to
the KG offshore basin to investigate the reasons for the sharp drop in production. RIL, in its defence, asserts
that they can only take action after the technical review by BP, its partner in the gas fields, which will take
more time. DGH is also pressurising RIL to drill more wells notwithstanding RIL's argument that they need
to wait to find out the reason for the declining rate before investing more capital in drilling.
Another way the government is pressurising RIL is by directing it to supply gas on a preferential basis to
the priority sectors of power and fertiliser. RIL is currently supplying the gas on a pro-rata basis to all
sectors, including refineries, steel makers and petrochemical companies. Currently, the power and fertilizer
sectors consume nearly 45mmscmd of gas leaving the rest for other users including RIL's Jamnagar refinery
and its petrochemical plants. We estimate RIL consumes between 3 to 4mmscmd of gas and given the low
priority for gas allotment to the refinery and petrochemical sectors, if RIL is indeed forced to provide gas
on a priority basis to the power and fertiliser sectors, it will not be able to supply its own units with gas. If
that scenario does indeed come to pass, then RIL will have to import the gas for use in its refinery and
petrochemical unit leading to a decline in profitability. In the short term, however, we don’t expect RIL to
starve its own units of gas while supplying the government PSU's with gas at a subsidised rate.
We believe that this is a proxy fight between the government and RIL. We believe that RIL doesn’t believe
it worth its while to invest additional capital in drilling wells when the price at the beach remains at
$4.20/mscf. The government, on the other hand, wants to exert as much pressure as it can to get RIL to
provide its PSU's with subsidised gas. Higher production is in the interests of both parties and we believe
they will be able to come to an agreement on a higher gas price soon, which will allow RIL to kickstart its
drilling program.
RIL represents an option on future E&P success
RIL represents an option on the E&P success in the Indian Offshore region. In April 2011, RIL announced a
rich gas and condensate discovery in the first well drilled in the block CY-PR-DWN-2001/3(CYPR-D6) in
the Cauvery- Palar basin (see Exhibit 13). We believe this represents the first of many successful finds in
this region.
Refining: We expect delta with the Singapore complex to increase as crude price comes down
Since the amalgamation of Reliance Petroleum Limited transformed Reliance into one of the largest global
refiners, Reliance has operated its refineries at near full capacity and above regional utilization averages in
North America, Europe and Asia. Consequently, refining throughput growth will be constrained by capacity
over the next few years. Without capacity expansion – we are not aware of any at this point – throughput
volumes are likely to stay flat for the next few years.
Reliance's refining business' GRM has traditionally been higher than the Singapore Complex benchmark
because of the higher complexity of the Reliance refineries and its unique ability to take advantage of the
arbitrage of the petroleum products between the US and European markets. Global refining margins have
rebounded since the start of the year and the Singapore complex margin, in particular, rebounded sharply
from its lows at the end of last year (see Exhibit 18). Therefore, there was an expectation that the RIL gross
refining margin GRM will increase sharply, in line with the uptick in global refining complex margins.
Petrochemicals business: Margins have peaked
While Reliance's refining business has been operated at more than full capacity, the company's
petrochemicals business has delivered record growth in production. Over the past 6 years, petrochemicals
production has increased from less than 2MMT in 1Q FY06 to a quarterly average of over 5MMT in
FY2010 and FY2011. In the latest quarter however, production declined from 5.7MMT in 3QFY11 to
5.2MMT in 4Q11, a little lower than our and market expectations (see Exhibit 22).
The decline in production volumes was, however, more than made up by a spike in the average realised
price and hence EBIT margins. EBIT margins in this division increased sharply to their highest level since
2006 . This margin expansion was achieved in spite of a sharp increase in Naphtha prices
over the course of the quarter. We believe that this spike in the EBIT margin and the average realised price
per tonne is unsustainable and hence expect to see a correction in the near term.
High cotton prices providing support for polyester prices
Global polyester usage has been increasing with the bounce-back in economic growth and rising cotton
substitution providing a fillip to the margins of this division. Firstly, continuing growth in automobiles,
consumer durables, and infrastructure sectors in China and India has generated strong demand growth for
polymers across the spectrum of petrochemicals products. This demand growth has been so strong that it
supported polymer prices and margins despite new supply from capacity additions in Asia and the Middle
East in 2010.
Secondly, cotton prices have shot up sharply since the start of the recent commodity rally at the middle of
last year and the delta between the cotton prices and the polyester prices has increased to an all time high,
providing further tailwind to the substitution of cotton with polyester. This cited by the company as one of
the reasons for the high margins in its Petrochemical business in 4Q11. In 4Q11, RIL also gained from
cracker shutdowns in Japan because of the earthquake.
The most significant determinant of RIL Avg realised price is LDPE – Naptha spread
We have done extensive regressions of RIL petrochemical margins and the spread of various petrochemical
products versus Naphtha. RIL petrochem margins exhibit the largest correlation with low density
polyethylene product set, both LDPE and LLDPE, with the highest R-squared and correlation exhibited
against the Film Grade Poly LDPE in SE Asia and other markets. Injection grade polypropylene across the
various markets also exhibited significant correlation to RIL petrochem margins.
We built a model to estimate RIL margins using as independent variables the Naphtha-spreads of the two
petrochemical products whose spreads with Naphtha had the strongest correlation with RIL Average
realised price per ton (see Exhibit 24). The resulting regression equation has a very good relationship to the
RIL actual realised price with an excellent multiple R-Squared of 72%
Petrochemical volume expansions will further increase the profitability of this business
In April 2011, RIL announced capacity additions to its polyester plans in India over the next few years. It
plans to add 2.3MMT PTA capacity at Dahej with an option of increasing it further by 1.15MMT at a later
stage. Other planned expansion projects announced include 0.54MMT of PET at Dahej, with an option to
increase it by another 0.54MMT, and 890KT of other polyesters at its facilities. The capacity expansion
project is at an early stage and will take a few years to impact the bottom-line. For the moment we don’t
have this new announced capacity in our numbers.
The BP deal. What will RIL do with the cash? We don’t know and we don’t care...
RIL is flush with cash, and cash management will become one of the problems for RIL management over
the next few quarters. Though this is not a bad 'problem' to have to deal with, particularly in the current
environment and in a country with a high cost of capital, this cash management 'problem' will be
compounded by the consummation of the BP deal. RIL will find itself with USD $7.2bn more of cash with
USD $1.8bn on the way. Though, we don’t quite know what RIL management plans to do with this cash,
going by their track record, we are quite confident that whatever they intend to do will more than cover the
cost of capital and hence be in the best interests of the shareholders.
Forecasts
We expect an increase in profitability in all the business units of Reliance and forecast an EPS of Rs 71.5 in
FY 2011/12.
Valuation Methodology
We value large cap oil and gas companies by identifying the forward price to book multiples they should
trade at based on returns on equity, long term earnings growth expectations, dividend payout ratio and cost
of equity. Our starting point is that Fwd P/B = (ROE x PO) / (Ke – g), where is our estimates of ROE for
2012, PO is the dividend payout ratio, Ke is the cost of equity, and g is the long term growth rates. Our
target price for RIL using this methodology is INR1250.
We have also done a sum of the parts (SOTP) valuation for RIL
Risks
Risks to our Reliance price target include further operational complications at the Dhirubhai field which
result in a significantly lower than expected production output. Sustained weakness in refining and
petrochemical margins could be a further downside risk if economic recovery is slower than expected and
demand growth remains weak.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
The underperforming KG-D6 gas field has dragged RIL down along with it. After the 4QFY11 results
announcement, with no further clarity on KG-D6 and consistent negative press surrounding the issue, RIL
stock has dropped a further 9%. Though, there have also been concerns on the sustainability of its margins
in its refining business, the issue dominating the discussion around RIL has been upstream performance.
While the gas reservoir may be more complex than anticipated, we believe they are resolvable and that
Reliance will be able to ramp up to planned output targets as additional wells are drilled.
Reliance has significantly underperformed the Sensex over the past 12 months since production at
the KG-D6 (Dhirubhai) gas field started to decline and production targets were missed.
Lower production output is primarily a function of the hiatus in development drilling. While it
seems likely that the reservoir is more complex than originally anticipated, performance on a per well
basis has not been too dissimilar to the original field development plan. Instead the lower number of
development wells drilled (18 vs. 26 planned) is primarily is the reason for the underperformance.
Completion of the 1 drilling programme plus initiation of the Phase 2 drilling programme will
restore production growth. While additional surveillance data will help Reliance to better locate infill
wells (and possibly higher prices) we think it is only a matter of time before additional drilling kicks off
which will bring production up towards the target of 80MCM/d.
The $7.5bn farm-in by BP to Reliance acreage gives us confidence that a turn-around in KG-D6
will be achieved. BP will have been aware of the production issues at D6 prior to farming-in. We expect
the arrival of a major IOC to not only bring world class reservoir management practices to KG-D6 but to
also accelerate exploration across east coast of India.
While Reliance has disappointed upstream, downstream performance has been strong. Refining
margins have improved (c. $10/bbl) over the past 4 quarters in line with the Singapore benchmark
indicator. While spreads relative to Singapore have been a little weaker than expected, we expect refining
margins to remain firm for the remainder of 2011.
Petrochemical performance also continues to be extremely robust with higher margins and
volumes. Reliance has been able to benefit from both strong volume growth and record margins as prices
have firmed on demand growth for plastics and polyester given the surge in cotton prices. We remain
positive on the petrochemical cycle and with further additional capacity planned we expect continued
growth in the petrochemical segment ahead.
Investment Conclusion
Reliance has underperformed the Sensex in line with the disappointing performance of its flagship
Dhirubhai gas field. Even a relatively strong performance from its downstream divisions has failed to offset
the gloom which has set in around the future Dhirubhai. Ultimately, the outlook for Reliance comes down
to the future of Dhirubhai. Whether KG-D6 has the 7-8TCF of booked gas reserves and whether the
downward production trend can be reversed. We believe it can be and that the reversal from decline to
growth may be closer than some expect. Our key observation is that despite lower overall production,
performance per well is not materially different to originally planned. Instead, the shortfall in production
can be largely attributed to the shortfall in wells drilled as a result of greater reservoir complexity.
The arrival of BP who has recently farmed into the offshore acreage will help, both in terms production and
exploration. BP will certainly have been aware of the KG-D6 issues and their willingness to farm-in not
only confirms our positive view that Dhirubhai production can be turned around, but also that the offshore
acreage which has significant potential and is critical for India which is gas short. The catalyst for Reliance
is the announcement that Phase 2 development drilling will resume and improvement in D6 output. We also
believe that higher gas prices are a possibility given the importance of this project to India.
We value Reliance on a sum-of-the parts basis. The recent weakness in the stock presents an attractive entry
point for investors with little downside risk from current valuations. We maintain our OP rating with a price
target of INR1250.
Details
Reliance Industries announced its Full Year 2011 results on the 21
st
of April and the 4QFY11 EPS of
Rs16.4 fell slightly short of analyst expectations. The stock has subsequently underperformed and is down
9% since then. However, the reason for the underperformance of the stock since the results announcement,
and indeed since June 2010, has not been weaker earnings per se, but the rapid slowdown in production
from its flagship KG-D6 gas field.
The market was looking for some concrete actionable proposals or at the least some guidance from
management on bringing the field back to the normal production schedule. However, the lack of any
substantial announcement on plans to improve the production profile of KG-D6 has acted as a dampener on
the stock. In the results presentation, there was a short note on the fact that the company is finding the
reservoir more complex than envisaged earlier, nothing different from what had been said before on the
subject.
We believe that the KG-D6 situation is more complex than first envisioned, but not as complex as feared by
the market. In this report, we show that the declining output is simply a function of the lower number of
wells currently in production. Though it is difficult to get an accurate assessment of the situation without
having access to detailed reservoir data, it is indeed very possible that the reservoir is more complex than
originally thought and the management is waiting for additional data to optimize the capital investment i.e.
the drilling of wells. However, it is unlikely that the worst fears of the market - that of a much smaller
reservoir and/or permanently lowered output profile from the reservoir - are true.
RIL share price performance has been disappointing primarily due to KG-D6 underperformance
The Indian oil and gas stocks, and in particular the largest player RIL haven’t had a good 2010. Since the
start of 2010, the RIL stock has underperformed the NIFTY by nearly 20% (see Exhibit 1). RIL started
underperforming the NIFTY in the three months starting July 2010 due to reduced expectations of gas
production out of KG-D6 (Dhirubhai). From start of Jul10 till the end of Sep 10, RIL underperformed the
Nifty by 18 percentage points. During the same period, ONGC outperformed the NIFTY by 8% points as
investors moved over their funds to the 2nd biggest energy company in the country.
The deal with BP announced in Feb 11 served to provide some temporary relief to the RIL stock but the
negative press surrounding the KG-D6 field production and afterwards the 4QFY11 results miss and the
lack of any further clarity on the KG-D6 issue has hammered the stock down.
The decline in KG-D6 output is impacting Indian gas production
Dhirubhai, India's largest offshore gas field started up in April 2009. The impact on India's offshore and
total gas production has been significant (see Exhibit 2). Following 1 year of production ramp up however,
the field reached a monthly high of 2.3bcf/d (65MCM/d) before dropping back to current levels of 1.8bcf/d
or 50MCM/d. The drop off in volumes from D6 has resulted in a significant slowdown in indigenous gas
output in India. Indeed, Indian gas output in Mar11 was 11% lower than year ago levels.
Lower production is a result of the lower number of wells and the decline over time is natural
The E&P business of RIL is the fulcrum around which the stock moves. The travails of the RIL stock
starting June 2010 started when, contrary to expectations, the output from the Dhirubhai field started
declining during 1QFY11 (see Exhibit 3). Any good or bad news out of this unit will be the primary driver
of the stock in the near term.
So what do we expect over the next few quarters?
We believe that the natural rate of the decline in production for the KG-D6 wells is around 20% annually,
or around 5% per quarter, not substantially different from similar fields around the world. In case RIL
doesn’t take any more action on the drilling of wells and connecting those to the reservoir and continues
operating with 18 wells, we expect the production to reach a level of around 37-38mmscmd (1.3bcfd) (see
Exhibit 9) by FY2013. However, we regard that as a remote possibility.
Declining volumes 2 years into start up of Dhirubhai was not the plan. The initial target was to reach
2.8bcf/d (or 80MCM/d) from the initial 22 wells and then add 28 additional wells (up to 50 wells in total) to
maintain plateau of 2.8bcf/d for up to 8 years. So far 18 wells have been drilled, with another 2 wells
completed but not connected to the field. A further 2 wells are expected to be completed over the coming
few months and come online before the end of the current fiscal year.
We also expect RIL to bring on line additional wells over the course of the next fiscal year as a part of the
phase 2 drilling programme. We continue to believe that RIL to can reach the plan production level of
80mmscmd by 2QFY14.
So, what is the technical problem with Dhirubhai?
The Dhirubhai gas reservoir consists of a number of complex stacked sands which were deposited in deep
waters. The channels, analogous to rivers of sand within a deep ocean environment have sinuous geometries
which are stacked together bore vertically and laterally. The quality of the sands which make up the
reservoir units which contain the gas varies considerably across the field. How these sands connect up was a
major uncertainty at the time of field development.
Given the production problems to date it would appear that the field is not behaving as a 'single tank' and
that there are many different compartments within the field which contain gas (see Exhibit 10 and Exhibit
11). As such, understanding locating additional wells in the field needs to be planned carefully to avoid
draining the same compartments with the same wells. Other potential problems include early break-through
of water or build up of sand in the reservoir, although no specific details have been provided by Reliance.
The issue of gas pricing
Though Dhirubhai is turning out to be more complex than originally anticipated, there is a broader problem
– gas pricing. In India's first gas war between RIL and RPL, RIL triumphed with the Supreme Court setting
the gas price at the government approved price of USD4.20/mscf rather than the USD2.40/mscf sought by
RPL. It was a pyrrhic victory however. Under new regulations the Indian government effectively sets gas
pricing and gas allocation rather than having this set on a commercial basis as per the original PSC terms.
The problem is that at current gas prices of USD4.20/mscf (USD25/boe) it is simply uneconomic to develop
new gas fields in deep water offshore India's east coast. This should be obvious to all. After 10 years since
the first NELP (New Exploration Licensing) round, there has only been 1 major deep water gas
development despite over 50 gas discoveries and 50TCF of gas in place discovered. While licensing of
acreage has been successful, de facto regulation of gas prices to low levels has stalled the development of
much needed gas off India's east coast.
While there are technical issues with D6, what is being played out is a negotiation by proxy between
Reliance and the Indian government on gas pricing. Lower gas output is not good for Reliance shareholders,
but it also not good for India Inc, which has to import more gas and LNG. In our view it is obvious that gas
prices will need to be raised to levels with re-numerate investment. India will be a large energy and gas
consuming country in the future. With limited indigenous resources, development of domestic gas is a must.
The drop off in volumes from D6 has resulted in a significant slowdown in indigenous gas output in Inida.
Indeed, Indian gas output declined 11% YoY in Mar11 YoY. As a result India has imported more LNG and
more oil to make up for the shortages in domestic natural gas (see Exhibit 12). While domestic gas in D6 is
US$4.20/mscf at the beach, imports of LNG and oil are running at US$10-15/mscf.
With its domestic demand expected to grow by more than 10% per annum, India is expected to consume
more than 250 MMSCMD by 2014-15. With such high demand in the offing, India as a country can ill
afford such a high level of LNG imports while its rich domestic reserves lie untapped and unexploited. The
increase of the regulated gas price will not only deservedly compensate the E&P companies for their past
investment but also spur additional investment, which will go a long way in making the country energy
independent.
DGH and the government continue to put pressure on RIL
The Directorate General of Hydrocarbons (DGH) was not satisfied with RIL's explanation for the reasons
for the drop in production from KG-D6 and news reports suggest that they have sent a team of experts to
the KG offshore basin to investigate the reasons for the sharp drop in production. RIL, in its defence, asserts
that they can only take action after the technical review by BP, its partner in the gas fields, which will take
more time. DGH is also pressurising RIL to drill more wells notwithstanding RIL's argument that they need
to wait to find out the reason for the declining rate before investing more capital in drilling.
Another way the government is pressurising RIL is by directing it to supply gas on a preferential basis to
the priority sectors of power and fertiliser. RIL is currently supplying the gas on a pro-rata basis to all
sectors, including refineries, steel makers and petrochemical companies. Currently, the power and fertilizer
sectors consume nearly 45mmscmd of gas leaving the rest for other users including RIL's Jamnagar refinery
and its petrochemical plants. We estimate RIL consumes between 3 to 4mmscmd of gas and given the low
priority for gas allotment to the refinery and petrochemical sectors, if RIL is indeed forced to provide gas
on a priority basis to the power and fertiliser sectors, it will not be able to supply its own units with gas. If
that scenario does indeed come to pass, then RIL will have to import the gas for use in its refinery and
petrochemical unit leading to a decline in profitability. In the short term, however, we don’t expect RIL to
starve its own units of gas while supplying the government PSU's with gas at a subsidised rate.
We believe that this is a proxy fight between the government and RIL. We believe that RIL doesn’t believe
it worth its while to invest additional capital in drilling wells when the price at the beach remains at
$4.20/mscf. The government, on the other hand, wants to exert as much pressure as it can to get RIL to
provide its PSU's with subsidised gas. Higher production is in the interests of both parties and we believe
they will be able to come to an agreement on a higher gas price soon, which will allow RIL to kickstart its
drilling program.
RIL represents an option on future E&P success
RIL represents an option on the E&P success in the Indian Offshore region. In April 2011, RIL announced a
rich gas and condensate discovery in the first well drilled in the block CY-PR-DWN-2001/3(CYPR-D6) in
the Cauvery- Palar basin (see Exhibit 13). We believe this represents the first of many successful finds in
this region.
Refining: We expect delta with the Singapore complex to increase as crude price comes down
Since the amalgamation of Reliance Petroleum Limited transformed Reliance into one of the largest global
refiners, Reliance has operated its refineries at near full capacity and above regional utilization averages in
North America, Europe and Asia. Consequently, refining throughput growth will be constrained by capacity
over the next few years. Without capacity expansion – we are not aware of any at this point – throughput
volumes are likely to stay flat for the next few years.
Reliance's refining business' GRM has traditionally been higher than the Singapore Complex benchmark
because of the higher complexity of the Reliance refineries and its unique ability to take advantage of the
arbitrage of the petroleum products between the US and European markets. Global refining margins have
rebounded since the start of the year and the Singapore complex margin, in particular, rebounded sharply
from its lows at the end of last year (see Exhibit 18). Therefore, there was an expectation that the RIL gross
refining margin GRM will increase sharply, in line with the uptick in global refining complex margins.
Petrochemicals business: Margins have peaked
While Reliance's refining business has been operated at more than full capacity, the company's
petrochemicals business has delivered record growth in production. Over the past 6 years, petrochemicals
production has increased from less than 2MMT in 1Q FY06 to a quarterly average of over 5MMT in
FY2010 and FY2011. In the latest quarter however, production declined from 5.7MMT in 3QFY11 to
5.2MMT in 4Q11, a little lower than our and market expectations (see Exhibit 22).
The decline in production volumes was, however, more than made up by a spike in the average realised
price and hence EBIT margins. EBIT margins in this division increased sharply to their highest level since
2006 . This margin expansion was achieved in spite of a sharp increase in Naphtha prices
over the course of the quarter. We believe that this spike in the EBIT margin and the average realised price
per tonne is unsustainable and hence expect to see a correction in the near term.
High cotton prices providing support for polyester prices
Global polyester usage has been increasing with the bounce-back in economic growth and rising cotton
substitution providing a fillip to the margins of this division. Firstly, continuing growth in automobiles,
consumer durables, and infrastructure sectors in China and India has generated strong demand growth for
polymers across the spectrum of petrochemicals products. This demand growth has been so strong that it
supported polymer prices and margins despite new supply from capacity additions in Asia and the Middle
East in 2010.
Secondly, cotton prices have shot up sharply since the start of the recent commodity rally at the middle of
last year and the delta between the cotton prices and the polyester prices has increased to an all time high,
providing further tailwind to the substitution of cotton with polyester. This cited by the company as one of
the reasons for the high margins in its Petrochemical business in 4Q11. In 4Q11, RIL also gained from
cracker shutdowns in Japan because of the earthquake.
The most significant determinant of RIL Avg realised price is LDPE – Naptha spread
We have done extensive regressions of RIL petrochemical margins and the spread of various petrochemical
products versus Naphtha. RIL petrochem margins exhibit the largest correlation with low density
polyethylene product set, both LDPE and LLDPE, with the highest R-squared and correlation exhibited
against the Film Grade Poly LDPE in SE Asia and other markets. Injection grade polypropylene across the
various markets also exhibited significant correlation to RIL petrochem margins.
We built a model to estimate RIL margins using as independent variables the Naphtha-spreads of the two
petrochemical products whose spreads with Naphtha had the strongest correlation with RIL Average
realised price per ton (see Exhibit 24). The resulting regression equation has a very good relationship to the
RIL actual realised price with an excellent multiple R-Squared of 72%
Petrochemical volume expansions will further increase the profitability of this business
In April 2011, RIL announced capacity additions to its polyester plans in India over the next few years. It
plans to add 2.3MMT PTA capacity at Dahej with an option of increasing it further by 1.15MMT at a later
stage. Other planned expansion projects announced include 0.54MMT of PET at Dahej, with an option to
increase it by another 0.54MMT, and 890KT of other polyesters at its facilities. The capacity expansion
project is at an early stage and will take a few years to impact the bottom-line. For the moment we don’t
have this new announced capacity in our numbers.
The BP deal. What will RIL do with the cash? We don’t know and we don’t care...
RIL is flush with cash, and cash management will become one of the problems for RIL management over
the next few quarters. Though this is not a bad 'problem' to have to deal with, particularly in the current
environment and in a country with a high cost of capital, this cash management 'problem' will be
compounded by the consummation of the BP deal. RIL will find itself with USD $7.2bn more of cash with
USD $1.8bn on the way. Though, we don’t quite know what RIL management plans to do with this cash,
going by their track record, we are quite confident that whatever they intend to do will more than cover the
cost of capital and hence be in the best interests of the shareholders.
Forecasts
We expect an increase in profitability in all the business units of Reliance and forecast an EPS of Rs 71.5 in
FY 2011/12.
Valuation Methodology
We value large cap oil and gas companies by identifying the forward price to book multiples they should
trade at based on returns on equity, long term earnings growth expectations, dividend payout ratio and cost
of equity. Our starting point is that Fwd P/B = (ROE x PO) / (Ke – g), where is our estimates of ROE for
2012, PO is the dividend payout ratio, Ke is the cost of equity, and g is the long term growth rates. Our
target price for RIL using this methodology is INR1250.
We have also done a sum of the parts (SOTP) valuation for RIL
Risks
Risks to our Reliance price target include further operational complications at the Dhirubhai field which
result in a significantly lower than expected production output. Sustained weakness in refining and
petrochemical margins could be a further downside risk if economic recovery is slower than expected and
demand growth remains weak.
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