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This too shall pass
The CAG’s tenacious draft report on Reliance’s KG-D6 project has weighed heavily
on the stock in the last month. Newsflow headwinds will remain near term,
especially if Reliance is forced to relinquish part of KG-D6, but we expect sanity to
prevail eventually. Costs that may be disallowed for recovery are immaterial in the
overall scope while at ~US$5/boe, KG-D6 is one of the most competitive executed
in India and compares favourably with F&D costs of most global peers. We cut our
target to Rs1,050/sh to factor in lower E&P reserves and refining multiples. BUY.
What does the draft CAG report say? The CAG audit of Reliance’s KG-D6 block
throws up several alleged deviations during exploration, development and
procurement. The most salient have been Reliance’s non-relinquishment of parts of the
block as mandated in the contract and the sharply higher development costs and
inconsistent tender processes that may have contributed to the rise in project costs.
The KG-D6 project is cost competitive. While the headline increase in capex from
May-2004 Class-V estimate of US$2.5bn to the US$8.8bn Class-II estimate in Oct-
2006 for the KG-D6 D1-D3 project looks adverse, we note that the project scope rose
1.5-3x. Nonetheless, at US$5.3/boe, the project is one of the most competitive
globally evident from peer F&D costs of +US$20/boe. It also compares favourably with
projects in India like Cairn-MBA (US$4.4/boe, onshore), GSPC-DD (US$6/boe, shallowwater) and even ONGC’s current brownfield re-development projects (US$9.1/boe,
shallow, onshore). Indeed, ONGC’s three year rolling F&D costs are now at US$13/boe.
Disallowance of some costs for recovery will have marginal impact. CAG’s
tenacious report also documents some 25 instances of inconsistent tender processes;
our aggregation of CAG’s estimate of potentially unproductive capex due to this is
US$620m for the D1-D3 project. While this may result in some costs being disallowed
for recovery as the audits are completed, the overall impact is marginal. It is just 12%
of the US$5.1bn that Reliance had spent till the outer limit of the CAG audit (Jun-09),
for example. Indeed, Reliance has spent only another US$600m on D1-D3 since then
taking spends to US$5.7bn - just 63% of the US$8.8bn indicated in the Oct-2006 plan.
Will Reliance be forced to relinquish part of KG-D6? A trickier issue for Reliance is
CAG’s assertion that it was allowed to retain the entire KG-D6 block despite provisions
that required it to relinquish non development or discovery areas after the exploration
phase. A literal reading of the contract which mandates exploratory drilling as a
precondition to classify acreage as a discovery area may indeed require it to relinquish
large parts of KG-D6. Should the government act against Reliance on this after the
CAG report is finalised over the coming weeks, it will be a negative headline but the
value and EPS impact is limited. For example, our fair value of the 16 discoveries
outside of D1-D3 and MA (which we expect Reliance to retain in any case) is just
Rs11/sh or 1% of our SOTP while we ascribe just Rs4/sh as future exploration upside.
Maintain BUY. We are lowering FY13-14 EPS by 1-3% to factor in cut in reserves and
production and our target to Rs1,050/sh to factor in lower refining EV/Ebitda multiples,
lower reserves, output. Nonetheless, this still indicates +20% upside; maintain BUY.
Valuations (+25% discount to Sensex, 0-20% discount to peers) are also supportive.
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