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UBS Investment Research
Asia On The Ground: India Oil and Gas
K G gas decline—win some, lose some
We met officials at the ministry, an industry association, and fertiliser cos.
With falling production from KG-D6 and in light of the importance of the fertiliser
sector in the natural gas markets, we met with leading industry sources last week.
These included industry associations, ministry officials, and gas and fertiliser
companies.
Looking to understand the impact of lower gas volumes
Our key objective was to get an industry view on: 1) the fertiliser sector’s response
to the lower volumes from KG-D6; 2) how important it is for the government to
allocate domestic gas according to sector priorities; 3) those impacted, both
negatively and positively, by the decision to allocate KG-D6 gas according to
sector priorities.
Urea is too price sensitive for imported gas, will get priority
Our meetings suggest that: 1) domestic gas volume production will not keep pace
with demand and earlier projections; 2) international urea prices are sensitive to
demand from India so there is little scope of India increasing its urea imports; 3)
the fertiliser sector derives maximum value from gas compared to other sectors and
is politically more sensitive; and 4) imported gas will continue to cater to top-up
demand and new urea capacity on imported gas is not economically viable.
GAIL top pick; steel, petchem, refineries to be negatively impacted
Growth in domestic gas production will be muted, and we believe this will deter
new entrants to the cross-country pipeline infrastructure business. Hence GAIL
should be able to maintain its leading position and near monopoly, in our view.
Petchem, refineries, and steel plants stand to lose most from the reallocation of
KG-D6 gas, in our view.
Meeting fertiliser sector stakeholders
We met with various industry participants to understand the impact of lower
natural gas volumes from domestic fields, which sectors will be negatively
impacted, and the alternatives. We concentrated on demand for natural gas in the
fertiliser sector during this trip. We wanted to place demand in the perspective
of pricing. We met with:
- The department overseeing upstream within the ministry of petroleum
and natural gas
- Three fertiliser companies, gas producer ONGC, and distributer GAIL
- Fertiliser Association of India
Looking for response to lower gas production
from domestic fields and its implications for
other sectors
The fertiliser sector accounts for about 28% of natural gas used in India, the
second largest after power at 38%. In the fertilizer industry, gas is primarily
used as feedstock in the production of ammonia to produce urea and also as fuel
for captive power.
This was an opportune time to meet the industry participants as lower KG-D6
volumes combined with the increasing fertiliser subsidy burden have set off
internal debates among industry participants. On the other extreme, there have
been media reports about the possible decontrol of urea pricing.
We believe the ministry is under pressure from rising oil prices, falling domestic
gas production, and the recent elections. In addition, rising inflation is another
issue that needs to be tackled. Therefore while a simple solution will be to hike
consumer price, it is likely that the price hikes will be moderate and that
alternate solutions will be considered. One of them could be to allocate higher
volumes of domestic gas (which is cheaper) to the important sectors such as
fertilizer and power, at the cost of others.
In essence this means the government will choose which sectors will
benefit/lose to spare the consumer sharp price hikes. This is possible as
allocation of domestic gas and oil is within the government’s ambit.
The government has directed Reliance to provide gas according to sector
priorities. Please see our note, Low KG D6 volumes: government response,
published on 13 April 2011, for details. Further, we also wanted to find out the
stocks impacted, both negatively and positively, following this decision.
What did we discuss in our meetings?
Gas volume decline is indeed hurting the industry. Industry consensus appears to
be that imported gas anywhere above US$8-10/bbl, depending on the vintage of
the plant, is too expensive to sustain a fertiliser plant.
Among all the sectors that use gas, the fertiliser sector derives the maximum
value add. Although a small portion is also used as fuel, the sector uses gas
mainly as feedstock versus say power that derives benefit from the calorific
value of gas ie burning and can turn to alternate sources such as coal. Hence
the government will continue to treat fertiliser as its priority sector.
Further, the fertiliser sector caters to the agricultural sector, which is
politically sensitive. Among all fertilisers, India uses urea the most and hence
the farming community is most sensitive to its pricing.
The lack of assured supply of reliable feedstock at economically viable
prices has been the key reason why there has been only de-bottlenecking and
no greenfield expansion of urea. Currently the delivered price of gas to
fertiliser companies is around US$6.5-7.5/mmbtu. At this level their
production cost is US$220-240/ton, below the level of US$370-400/ton for
imported fertiliser. However, the farmer pays ~US$110/ton for urea. This
implies a subsidy of US$110-130/ton on an average. The sector cannot buy
higher priced gas as it increases the government’s subsidy burden.
India forms a significant portion of the international urea market. If the
demand for urea from the country increases, international urea prices will be
impacted directly and hence the government subsidy payout will increase
sharply. Currently India imports about 5-6mmT of its 25-26mmT urea
requirement annually and is one of the biggest buyers in the international
markets. The country’s ability to move international urea prices by a
significant margin is a deterrent to higher imports for prolonged periods as a
policy.
Industry consensus appears to agree with us that domestic gas production
will not keep pace with demand and will be lower than earlier projections. In
our projections we already incorporate a lower volume growth from
Reliance’s KG-D6 block. Further, according to our channel checks, other gas
developments in the KG basin are also likely to start only post 2014-2015,
compared with official estimates of 2013/2014.
Until now all the gas made available to the domestic sector has been
absorbed. We do not believe gas can be imported at such high prices on a
sustainable basis, the key reason being that imported gas fed either the
smaller scattered industries with even more expensive alternatives or was
being used as a top-up or replacement feedstock/energy source. We expect
this to continue to be the case and large users of gas that rely on expensive
imported gas will not develop.
GAIL to maintain its leadership in gas pipeline
infrastructure
We earlier highlighted increased competition in the gas business. Please refer to
our note, Too many players in the pipeline, published on 13 January 2011. We
highlighted how irrational exuberance regarding gas supply in the country could
lead bidders to bid unprofitably hurting ROEs in the long term.
As evidence emerges that the growth in domestic gas supply in the country will
remain muted and that anchor customers for imported gas will not be easy to
find, we expect competition in the cross-country gas pipeline in the business to
be muted (we describe those customers who promise a large enough off take and
hence justify the capex required for a pipeline as ‘anchor customers’).
Our volumes forecast for GAIL did not include additional gas from KG, so the
current decline has not hurt it yet (though if volumes fall below 50,mmscmd
GAIL will start to be impacted). Hence, GAIL, the near monopoly incumbent
would continue to remain a clear winner. The company is our top pick in the
sector.
Steel, petchem, and refiners will be negatively
impacted
As a response to lower production from KG–D6, the government has asked
Reliance to provide gas in the following order: 1) first meet all the contracted
demand for fertiliser units; 2) plants extracting LPG from natural gas; 3) power
firms; and 4) city gas distribution companies selling CNG to automobiles.
Within a sector, the gas sales cut will be on a pro-rata basis. The priority sector
allocation totals 47.59 mmscmd, close to current production levels, leaving
almost nothing for steel plants, refineries, and petrochemical units.
In the table below we analyze the impact of the decreased supply to the
impacted sectors. We calculate the raw material cost increase by assuming the
company will replace all of its requirement of gas with imported gas at a higher
cost. The impact is based on volumes of 55mmscmd versus current levels of 50-
52mmscmd i.e. incremental losses may be lower as companies are already
getting lower gas since October/November 2010. It also assumes that all of the
KG gas will be replaced, so the financial impact is the worst-case scenario.
The increase in raw materials cost in this worst case scenario is approximately
1.5-2% of the EBITDA for RIL, BPCL, HPCL and IOC.
Government is under pressure due to mounting
subsidy bills
As energy prices increase across the board, be it crude price or coal price, the
government is coming under pressure due to the mounting subsidy bills.
Currently the government bears the subsidy bill for key sectors: 1) subsidy on
petroleum products; 2) subsidy on fertilisers; and 3) mounting losses of state
electricity boards.
This is the reason for DGH, the oil regulator, to have inspected Reliance’s
facilities in the KG basin. DGH continues to push for higher number of wells to
stem this decline in the face of resistance from Reliance
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
UBS Investment Research
Asia On The Ground: India Oil and Gas
K G gas decline—win some, lose some
We met officials at the ministry, an industry association, and fertiliser cos.
With falling production from KG-D6 and in light of the importance of the fertiliser
sector in the natural gas markets, we met with leading industry sources last week.
These included industry associations, ministry officials, and gas and fertiliser
companies.
Looking to understand the impact of lower gas volumes
Our key objective was to get an industry view on: 1) the fertiliser sector’s response
to the lower volumes from KG-D6; 2) how important it is for the government to
allocate domestic gas according to sector priorities; 3) those impacted, both
negatively and positively, by the decision to allocate KG-D6 gas according to
sector priorities.
Urea is too price sensitive for imported gas, will get priority
Our meetings suggest that: 1) domestic gas volume production will not keep pace
with demand and earlier projections; 2) international urea prices are sensitive to
demand from India so there is little scope of India increasing its urea imports; 3)
the fertiliser sector derives maximum value from gas compared to other sectors and
is politically more sensitive; and 4) imported gas will continue to cater to top-up
demand and new urea capacity on imported gas is not economically viable.
GAIL top pick; steel, petchem, refineries to be negatively impacted
Growth in domestic gas production will be muted, and we believe this will deter
new entrants to the cross-country pipeline infrastructure business. Hence GAIL
should be able to maintain its leading position and near monopoly, in our view.
Petchem, refineries, and steel plants stand to lose most from the reallocation of
KG-D6 gas, in our view.
Meeting fertiliser sector stakeholders
We met with various industry participants to understand the impact of lower
natural gas volumes from domestic fields, which sectors will be negatively
impacted, and the alternatives. We concentrated on demand for natural gas in the
fertiliser sector during this trip. We wanted to place demand in the perspective
of pricing. We met with:
- The department overseeing upstream within the ministry of petroleum
and natural gas
- Three fertiliser companies, gas producer ONGC, and distributer GAIL
- Fertiliser Association of India
Looking for response to lower gas production
from domestic fields and its implications for
other sectors
The fertiliser sector accounts for about 28% of natural gas used in India, the
second largest after power at 38%. In the fertilizer industry, gas is primarily
used as feedstock in the production of ammonia to produce urea and also as fuel
for captive power.
This was an opportune time to meet the industry participants as lower KG-D6
volumes combined with the increasing fertiliser subsidy burden have set off
internal debates among industry participants. On the other extreme, there have
been media reports about the possible decontrol of urea pricing.
We believe the ministry is under pressure from rising oil prices, falling domestic
gas production, and the recent elections. In addition, rising inflation is another
issue that needs to be tackled. Therefore while a simple solution will be to hike
consumer price, it is likely that the price hikes will be moderate and that
alternate solutions will be considered. One of them could be to allocate higher
volumes of domestic gas (which is cheaper) to the important sectors such as
fertilizer and power, at the cost of others.
In essence this means the government will choose which sectors will
benefit/lose to spare the consumer sharp price hikes. This is possible as
allocation of domestic gas and oil is within the government’s ambit.
The government has directed Reliance to provide gas according to sector
priorities. Please see our note, Low KG D6 volumes: government response,
published on 13 April 2011, for details. Further, we also wanted to find out the
stocks impacted, both negatively and positively, following this decision.
What did we discuss in our meetings?
Gas volume decline is indeed hurting the industry. Industry consensus appears to
be that imported gas anywhere above US$8-10/bbl, depending on the vintage of
the plant, is too expensive to sustain a fertiliser plant.
Among all the sectors that use gas, the fertiliser sector derives the maximum
value add. Although a small portion is also used as fuel, the sector uses gas
mainly as feedstock versus say power that derives benefit from the calorific
value of gas ie burning and can turn to alternate sources such as coal. Hence
the government will continue to treat fertiliser as its priority sector.
Further, the fertiliser sector caters to the agricultural sector, which is
politically sensitive. Among all fertilisers, India uses urea the most and hence
the farming community is most sensitive to its pricing.
The lack of assured supply of reliable feedstock at economically viable
prices has been the key reason why there has been only de-bottlenecking and
no greenfield expansion of urea. Currently the delivered price of gas to
fertiliser companies is around US$6.5-7.5/mmbtu. At this level their
production cost is US$220-240/ton, below the level of US$370-400/ton for
imported fertiliser. However, the farmer pays ~US$110/ton for urea. This
implies a subsidy of US$110-130/ton on an average. The sector cannot buy
higher priced gas as it increases the government’s subsidy burden.
India forms a significant portion of the international urea market. If the
demand for urea from the country increases, international urea prices will be
impacted directly and hence the government subsidy payout will increase
sharply. Currently India imports about 5-6mmT of its 25-26mmT urea
requirement annually and is one of the biggest buyers in the international
markets. The country’s ability to move international urea prices by a
significant margin is a deterrent to higher imports for prolonged periods as a
policy.
Industry consensus appears to agree with us that domestic gas production
will not keep pace with demand and will be lower than earlier projections. In
our projections we already incorporate a lower volume growth from
Reliance’s KG-D6 block. Further, according to our channel checks, other gas
developments in the KG basin are also likely to start only post 2014-2015,
compared with official estimates of 2013/2014.
Until now all the gas made available to the domestic sector has been
absorbed. We do not believe gas can be imported at such high prices on a
sustainable basis, the key reason being that imported gas fed either the
smaller scattered industries with even more expensive alternatives or was
being used as a top-up or replacement feedstock/energy source. We expect
this to continue to be the case and large users of gas that rely on expensive
imported gas will not develop.
GAIL to maintain its leadership in gas pipeline
infrastructure
We earlier highlighted increased competition in the gas business. Please refer to
our note, Too many players in the pipeline, published on 13 January 2011. We
highlighted how irrational exuberance regarding gas supply in the country could
lead bidders to bid unprofitably hurting ROEs in the long term.
As evidence emerges that the growth in domestic gas supply in the country will
remain muted and that anchor customers for imported gas will not be easy to
find, we expect competition in the cross-country gas pipeline in the business to
be muted (we describe those customers who promise a large enough off take and
hence justify the capex required for a pipeline as ‘anchor customers’).
Our volumes forecast for GAIL did not include additional gas from KG, so the
current decline has not hurt it yet (though if volumes fall below 50,mmscmd
GAIL will start to be impacted). Hence, GAIL, the near monopoly incumbent
would continue to remain a clear winner. The company is our top pick in the
sector.
Steel, petchem, and refiners will be negatively
impacted
As a response to lower production from KG–D6, the government has asked
Reliance to provide gas in the following order: 1) first meet all the contracted
demand for fertiliser units; 2) plants extracting LPG from natural gas; 3) power
firms; and 4) city gas distribution companies selling CNG to automobiles.
Within a sector, the gas sales cut will be on a pro-rata basis. The priority sector
allocation totals 47.59 mmscmd, close to current production levels, leaving
almost nothing for steel plants, refineries, and petrochemical units.
In the table below we analyze the impact of the decreased supply to the
impacted sectors. We calculate the raw material cost increase by assuming the
company will replace all of its requirement of gas with imported gas at a higher
cost. The impact is based on volumes of 55mmscmd versus current levels of 50-
52mmscmd i.e. incremental losses may be lower as companies are already
getting lower gas since October/November 2010. It also assumes that all of the
KG gas will be replaced, so the financial impact is the worst-case scenario.
The increase in raw materials cost in this worst case scenario is approximately
1.5-2% of the EBITDA for RIL, BPCL, HPCL and IOC.
Government is under pressure due to mounting
subsidy bills
As energy prices increase across the board, be it crude price or coal price, the
government is coming under pressure due to the mounting subsidy bills.
Currently the government bears the subsidy bill for key sectors: 1) subsidy on
petroleum products; 2) subsidy on fertilisers; and 3) mounting losses of state
electricity boards.
This is the reason for DGH, the oil regulator, to have inspected Reliance’s
facilities in the KG basin. DGH continues to push for higher number of wells to
stem this decline in the face of resistance from Reliance
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