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Reliance Industries (RIL)
Energy
Wary of CAG audit regarding KG D-6 PSC. A recent draft report of Comptroller and
Auditor General (CAG) on the audit of production-sharing contracts (PSCs) highlights
several instances of alleged non-compliance with the PSC by several operators including
RIL (with respect to its KG D-6 block). We are wary of potential negative developments
(if any, assuming the ‘non-compliance’ is of a serious nature) and potential negative
implications for RIL. Accordingly, we retain our REDUCE rating despite a 17% potential
upside to our 12-month SOTP-based target price of `1,020.
Draft CAG report indicates several instances of non-compliance with PSC
The draft CAG report on audit of PSCs has highlighted several areas of non-compliance with PSC
provisions by RIL (as operator of the KG D-6 block) in the exploration, appraisal, development and
procurement activities. These include (1) non-submission of revised comprehensive development
plan and lack of details for the increase in field development cost, (2) continuance of exploration
on areas, which should have been relinquished, (3) placement of orders prior to submission of field
development plan and (4) no appraisal programs for several discoveries.
Watch out for any potential negative development; slippages across most blocks
We are not sure about the likely ramifications for RIL of the observations made by the CAG. We
note that the ministry of petroleum and natural gas (MoPNG) is drafting its response to the CAG
report, which will be taken into consideration before drafting the final report. Thus, it would be
premature to speculate about the implications of non-compliance (if any) with the PSC provisions
but believe it will likely act as an overhang on the stock performance in the near term. We note
that there have been several slippages in other RIL’s E&P assets, which may or may not have
resulted in violation of the specific conditions of their respective PSCs.
Scope of the CAG audit
The CAG audit has been conducted for hydrocarbons PSCs to evaluate whether the government’s
financial interests have been protected or not. We note that the CAG audit covered (1) scrutiny of
records with MoPNG and DGH of 21 PSCs for the period FY2004-08 and (2) supplementary
records of operators of KG-DWN-98/2 (KG D-6), PMT and RJ-ON-90/1 blocks for the period
FY2007-08. The primary objective of the audit was to determine if the revenue interest of the
government have been protected under the PSCs.
Maintain REDUCE due to several risks
We maintain our REDUCE rating on RIL with a target price of `1,020. We are constrained from
taking a positive view on the stock due to (1) uncertainty over effective deployment of cash (refer
our June 14, 2011 report ‘The size and success trap’, (2) downside risks in the E&P segment and
(3) potential negative developments from the ongoing CAG audit.
Key instances of alleged non-compliance with PSC provisions
Exhibit 1 gives a brief summary of the instances of non-compliance to PSC terms by RIL at its
KG D-6 block as highlighted in the CAG report. We explain some of the key observations in
detail below.
Observations by CAG audit regarding KG D-6 block
Irregular retention of entire contract area as discovery area
Unjustified extension of exploration phases
Non-drilling of exploration wells to 4,000/ 5,000 meters depth
Non-compliance to PSC provisions regarding notification of discovery and submission of test reports
Lack of appraisal programme in 14 out of 19 discoveries
Irregularly undertaken development activities for MA Fields before approval of development plans
Delay in obtaining Mining Lease
Delay in submission/ approval of FDP
Delayed action after FDP approval for D1-D3 gas discovery
Time and cost over-run due to delayed action for field development
Cost recovery preponed due to inclusion of US$745.76 million of estimated liabilities without payment
Additional spend for installation of subsea control system
Cost escalation due to abnormal increase in man-hours for detailed engineering of onshore terminal
Revision of rates for EPIC of offshore facilities
Cost plus contracts for terminal and jetty against single bid
Extra cost due to delayed hiring of deepwater drilling rig
Extra cost due to piece-meal charter hire of drilling rig
Rates revision for MEG plant ordered against single bid
Post-priced bid opening rates revision for reservoir monitoring system
Procurement of diesel at highe r price from affiliates
Seismic data acquisition and processing against single bid
Deficient tendering in hiring of multi support vessel
Exploration and Appraisal
activities
Procurement a ctivities
De velopment activities
Source: Kotak Institutional Equities
` Submission of IDP and AIDP not in line with PSC stipulation of comprehensive
development plan. RIL submitted (1) initial development plan (IDP) in May 2004 with
capex estimate of US$2.4 bn and (2) addendum to IDP (AIDP) in October 2006 with
revised capex estimate of US$5.2 bn for phase I and US$3.3 bn for phase II.
The CAG audit has noted that IDP and AIDP were not in line with PSC, which requires
submission of a comprehensive development plan. The CAG audit has also highlighted
that steep increase in capex estimate from IDP to AIDP is difficult to analyze given the
limitation of available information currently. Nonetheless, the CAG has identified several
areas of increase in costs, particularly in costs of production facilities where the cost
increased to US$3.74 bn from US$1.35 bn. The CAG has noted that the basis of
estimation of costs with supporting documents in the initial and revised FDPs have not
been provided to it. However, the CAG intends to cover this aspect in future audits from
2008-09 onwards. Exhibit 2 compares the costs of major items in the IDP, AIDP and
actual costs incurred up to June 2009 along with the CAG’s observations regarding the
increase in exploration and development costs.
` Irregular retention of entire contract area as discovery area. The CAG audit reveals
that the operator of KG D-6 block was allowed to retain the entire contract area as
discovery area contrary to the PSC stipulation of phased relinquishment of areas.
As per PSC articles 4.1 and 4.2, the contractor is allowed to retain a maximum of 75% of
contract area after Phase I and 50% of contract area after Phase II. However, RIL retained
the entire block area of 7,645 sq. km at the end of Phase I in June 2004 and Phase II in
June 2005. The operator also received approval from MOPNG to treat the entire contract
area as ‘discovery area’ in February 2009.
` Lack of appraisal program for 14 out of 19 discoveries. The CAG audit noted the lack
of appraisal program for 14 out of 19 discoveries including the D1-D3 gas discoveries and
D-26 oil discovery. The operator directly submitted the proposal for declaration of
commerciality after the announcement of discovery without conducting the appraisal
program, in violation of provisions of PSC.
As per PSC articles 21.5.2 and 10.3, the contractor is required to conduct the appraisal
program within three years of gas discovery and 30 months of oil discovery from the date
of notifying the Management Committee (MC) that the discovery is of potential
commercial interest to the submission of proposal of commercial discovery.
` Non-compliance of provisions regarding notification of discoveries. The CAG audit
indicated RIL failed to comply with norms relating to notification of discoveries for 13 out
of the 19 discoveries between October 2002 and July 2008. RIL had given direct
notification regarding commerciality of its discoveries without providing written
intimation to the MC and the Government.
Articles 10.1 & 10.2 of the PSC stipulates that when a discovery is made, the contractor
needs to (1) inform the MC and the Government within 30 days of the discovery, (2) run
tests to determine if the discovery is of commercial interest and (3) submit a report on the
potential commercial interest of the discovery within 60 days of completion of test.
` Development activities of MA fields before approval of FDP. The CAG audit noted
that RIL placed the order for various critical items required for development and product
activities for MA fields in 2006 much before approval of declaration of commerciality in
February 2007 and approval of FDP in April 2008. The operator was also allowed by DGH
to book US$808.53 mn for cost recovery till March 2008.
Delays in other blocks may invite the CAG’s attention
We note that the CAG has conducted an audit of 21 PSCs including nine blocks where RIL is
the major stakeholder and operator. However, the current audit does not cover blocks such
as NEC-25, KG-D3, KG D-9 and MN D-4, which contribute to the bulk of our `440 bn
(`148/share) valuation for RIL’s E&P segment. Exhibit 3 gives the details of our SOTP
valuation.
We would note that many of RIL’s blocks have seen large delays in exploration and
production compared to their original exploration schedules (see Exhibit 4). We do not know
if the delays will impact RIL’s ability to conduct E&P activity as per its original plan and
exploit the assets fully. As noted earlier, operators have to surrender a portion of blocks after
various phases of exploration. As details of individuals PSCs and work programs for various
phases of exploration are not available, it is hard to analyze if RIL is conducting E&P activity
in line with the PSC-specified exploration programs or it is behind schedule that may result
in relinquishment of the blocks or of certain areas of blocks without their full exploitation.
As noted previously, the CAG has highlighted irregularity in treatment of the entire KG D-6
block as a discovery area when drilling had not been done in a major area of the block.
Nonetheless, RIL has been allowed to retain the entire block as a discovery area. The same
could apply to the aforementioned blocks if RIL is well behind PSC-mandated exploration
schedules in those blocks. We quote the statement of the CAG in this regard. “This also
strikes at the root of the PSC which mandates a time bound exploration process with phased
relinquishment of undiscovered areas so that these can be re-auctioned for exploration and
development by other willing parties.”
In particular, we would watch out for any adverse development in the NEC-25 block, which
is well behind schedule. We note that the DGH has denied an extension for the appraisal
program for certain discoveries. Exhibit 5 gives details of key RIL’s blocks where it has made
discoveries and/or considered to be highly prospective along with dates of first discovery of
hydrocarbons and reserves (announced or prospective).
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Reliance Industries (RIL)
Energy
Wary of CAG audit regarding KG D-6 PSC. A recent draft report of Comptroller and
Auditor General (CAG) on the audit of production-sharing contracts (PSCs) highlights
several instances of alleged non-compliance with the PSC by several operators including
RIL (with respect to its KG D-6 block). We are wary of potential negative developments
(if any, assuming the ‘non-compliance’ is of a serious nature) and potential negative
implications for RIL. Accordingly, we retain our REDUCE rating despite a 17% potential
upside to our 12-month SOTP-based target price of `1,020.
Draft CAG report indicates several instances of non-compliance with PSC
The draft CAG report on audit of PSCs has highlighted several areas of non-compliance with PSC
provisions by RIL (as operator of the KG D-6 block) in the exploration, appraisal, development and
procurement activities. These include (1) non-submission of revised comprehensive development
plan and lack of details for the increase in field development cost, (2) continuance of exploration
on areas, which should have been relinquished, (3) placement of orders prior to submission of field
development plan and (4) no appraisal programs for several discoveries.
Watch out for any potential negative development; slippages across most blocks
We are not sure about the likely ramifications for RIL of the observations made by the CAG. We
note that the ministry of petroleum and natural gas (MoPNG) is drafting its response to the CAG
report, which will be taken into consideration before drafting the final report. Thus, it would be
premature to speculate about the implications of non-compliance (if any) with the PSC provisions
but believe it will likely act as an overhang on the stock performance in the near term. We note
that there have been several slippages in other RIL’s E&P assets, which may or may not have
resulted in violation of the specific conditions of their respective PSCs.
Scope of the CAG audit
The CAG audit has been conducted for hydrocarbons PSCs to evaluate whether the government’s
financial interests have been protected or not. We note that the CAG audit covered (1) scrutiny of
records with MoPNG and DGH of 21 PSCs for the period FY2004-08 and (2) supplementary
records of operators of KG-DWN-98/2 (KG D-6), PMT and RJ-ON-90/1 blocks for the period
FY2007-08. The primary objective of the audit was to determine if the revenue interest of the
government have been protected under the PSCs.
Maintain REDUCE due to several risks
We maintain our REDUCE rating on RIL with a target price of `1,020. We are constrained from
taking a positive view on the stock due to (1) uncertainty over effective deployment of cash (refer
our June 14, 2011 report ‘The size and success trap’, (2) downside risks in the E&P segment and
(3) potential negative developments from the ongoing CAG audit.
Key instances of alleged non-compliance with PSC provisions
Exhibit 1 gives a brief summary of the instances of non-compliance to PSC terms by RIL at its
KG D-6 block as highlighted in the CAG report. We explain some of the key observations in
detail below.
Observations by CAG audit regarding KG D-6 block
Irregular retention of entire contract area as discovery area
Unjustified extension of exploration phases
Non-drilling of exploration wells to 4,000/ 5,000 meters depth
Non-compliance to PSC provisions regarding notification of discovery and submission of test reports
Lack of appraisal programme in 14 out of 19 discoveries
Irregularly undertaken development activities for MA Fields before approval of development plans
Delay in obtaining Mining Lease
Delay in submission/ approval of FDP
Delayed action after FDP approval for D1-D3 gas discovery
Time and cost over-run due to delayed action for field development
Cost recovery preponed due to inclusion of US$745.76 million of estimated liabilities without payment
Additional spend for installation of subsea control system
Cost escalation due to abnormal increase in man-hours for detailed engineering of onshore terminal
Revision of rates for EPIC of offshore facilities
Cost plus contracts for terminal and jetty against single bid
Extra cost due to delayed hiring of deepwater drilling rig
Extra cost due to piece-meal charter hire of drilling rig
Rates revision for MEG plant ordered against single bid
Post-priced bid opening rates revision for reservoir monitoring system
Procurement of diesel at highe r price from affiliates
Seismic data acquisition and processing against single bid
Deficient tendering in hiring of multi support vessel
Exploration and Appraisal
activities
Procurement a ctivities
De velopment activities
Source: Kotak Institutional Equities
` Submission of IDP and AIDP not in line with PSC stipulation of comprehensive
development plan. RIL submitted (1) initial development plan (IDP) in May 2004 with
capex estimate of US$2.4 bn and (2) addendum to IDP (AIDP) in October 2006 with
revised capex estimate of US$5.2 bn for phase I and US$3.3 bn for phase II.
The CAG audit has noted that IDP and AIDP were not in line with PSC, which requires
submission of a comprehensive development plan. The CAG audit has also highlighted
that steep increase in capex estimate from IDP to AIDP is difficult to analyze given the
limitation of available information currently. Nonetheless, the CAG has identified several
areas of increase in costs, particularly in costs of production facilities where the cost
increased to US$3.74 bn from US$1.35 bn. The CAG has noted that the basis of
estimation of costs with supporting documents in the initial and revised FDPs have not
been provided to it. However, the CAG intends to cover this aspect in future audits from
2008-09 onwards. Exhibit 2 compares the costs of major items in the IDP, AIDP and
actual costs incurred up to June 2009 along with the CAG’s observations regarding the
increase in exploration and development costs.
` Irregular retention of entire contract area as discovery area. The CAG audit reveals
that the operator of KG D-6 block was allowed to retain the entire contract area as
discovery area contrary to the PSC stipulation of phased relinquishment of areas.
As per PSC articles 4.1 and 4.2, the contractor is allowed to retain a maximum of 75% of
contract area after Phase I and 50% of contract area after Phase II. However, RIL retained
the entire block area of 7,645 sq. km at the end of Phase I in June 2004 and Phase II in
June 2005. The operator also received approval from MOPNG to treat the entire contract
area as ‘discovery area’ in February 2009.
` Lack of appraisal program for 14 out of 19 discoveries. The CAG audit noted the lack
of appraisal program for 14 out of 19 discoveries including the D1-D3 gas discoveries and
D-26 oil discovery. The operator directly submitted the proposal for declaration of
commerciality after the announcement of discovery without conducting the appraisal
program, in violation of provisions of PSC.
As per PSC articles 21.5.2 and 10.3, the contractor is required to conduct the appraisal
program within three years of gas discovery and 30 months of oil discovery from the date
of notifying the Management Committee (MC) that the discovery is of potential
commercial interest to the submission of proposal of commercial discovery.
` Non-compliance of provisions regarding notification of discoveries. The CAG audit
indicated RIL failed to comply with norms relating to notification of discoveries for 13 out
of the 19 discoveries between October 2002 and July 2008. RIL had given direct
notification regarding commerciality of its discoveries without providing written
intimation to the MC and the Government.
Articles 10.1 & 10.2 of the PSC stipulates that when a discovery is made, the contractor
needs to (1) inform the MC and the Government within 30 days of the discovery, (2) run
tests to determine if the discovery is of commercial interest and (3) submit a report on the
potential commercial interest of the discovery within 60 days of completion of test.
` Development activities of MA fields before approval of FDP. The CAG audit noted
that RIL placed the order for various critical items required for development and product
activities for MA fields in 2006 much before approval of declaration of commerciality in
February 2007 and approval of FDP in April 2008. The operator was also allowed by DGH
to book US$808.53 mn for cost recovery till March 2008.
Delays in other blocks may invite the CAG’s attention
We note that the CAG has conducted an audit of 21 PSCs including nine blocks where RIL is
the major stakeholder and operator. However, the current audit does not cover blocks such
as NEC-25, KG-D3, KG D-9 and MN D-4, which contribute to the bulk of our `440 bn
(`148/share) valuation for RIL’s E&P segment. Exhibit 3 gives the details of our SOTP
valuation.
We would note that many of RIL’s blocks have seen large delays in exploration and
production compared to their original exploration schedules (see Exhibit 4). We do not know
if the delays will impact RIL’s ability to conduct E&P activity as per its original plan and
exploit the assets fully. As noted earlier, operators have to surrender a portion of blocks after
various phases of exploration. As details of individuals PSCs and work programs for various
phases of exploration are not available, it is hard to analyze if RIL is conducting E&P activity
in line with the PSC-specified exploration programs or it is behind schedule that may result
in relinquishment of the blocks or of certain areas of blocks without their full exploitation.
As noted previously, the CAG has highlighted irregularity in treatment of the entire KG D-6
block as a discovery area when drilling had not been done in a major area of the block.
Nonetheless, RIL has been allowed to retain the entire block as a discovery area. The same
could apply to the aforementioned blocks if RIL is well behind PSC-mandated exploration
schedules in those blocks. We quote the statement of the CAG in this regard. “This also
strikes at the root of the PSC which mandates a time bound exploration process with phased
relinquishment of undiscovered areas so that these can be re-auctioned for exploration and
development by other willing parties.”
In particular, we would watch out for any adverse development in the NEC-25 block, which
is well behind schedule. We note that the DGH has denied an extension for the appraisal
program for certain discoveries. Exhibit 5 gives details of key RIL’s blocks where it has made
discoveries and/or considered to be highly prospective along with dates of first discovery of
hydrocarbons and reserves (announced or prospective).
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