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Cairn India
Still no end to uncertainty
Cairn-Vedanta deal has been approved subject to royalty cost recoverability. We
maintain Hold and lower our TP to Rs310 to reflect the royalty claim. Using the
current Brent futures curve provides a higher valuation (Rs354), but growth
prospects remain vulnerable to the timing of government approvals.
We expect the CIL board to approve government pre-conditions
The Cabinet Committee on Economic Affairs (CCEA) has cleared the Cairn Energy (CEL)-
Vedanta deal relating to sale of shares in Cairn India (CIL). Two of the key conditions are
that royalties are made cost recoverable (not a surprise due to recent news flow) and that
CIL will withdraw the ongoing arbitration on cess payments (surprising, though with no
immediate financial implications). The CIL board could oppose the pre-conditions. But, in our
view, it will finally agree to them as CILís growth plans are still subject to approval from the
Indian government/ONGC and they could be delayed if there is any litigation.
CILís growth plans subject to ONGC/government approval
CIL management is targeting Rajasthan production at 240kbd. However, the current
production level approved by the government is only 175kbd (Mangala 125, Bhagyam 40,
Aishwariya 10). CIL needs approval to raise Mangala production by 25kbd and Aishwariya by
10kbd, and to use enhanced oil recovery techniques and to develop the rest of the resources
including tight oil at Barmer Hill. ONGC has rejected a Mangala production rise on technical
grounds while the draft CAG report has questioned the right of operators to carry out
exploration within existing development areas. We believe that there is significant risk of
delays in getting government approvals and, hence, in production ramping up.
Maintain Hold, TP Rs310
We have raised our Brent oil forecasts by US$3-15/bbl over FY12-14F. But, since we now
assume royalty cost recoverability in our estimates, we have cut our FY12-13F EPS
estimates by 17% and our target price from Rs360 to Rs310. Our Brent forecasts are
conservative and using the Brent futures curve would raise our valuation to Rs354. Use of
cash will also soon emerge as a key stock price driver given the rising cash pile and likely
change in top management.
Still no end to uncertainty
Given the uncertainty in the sector due to the CAG report we are not confident that
government approvals for CIL growth plans will easily flow through, even if the CIL board
approves the pre-conditions set by the government for the Cairn-Vedanta deal.
We expect CIL board to approve government pre-conditions
The CCEA has cleared the CEL-Vedanta deal relating to sale of shares in CIL, nearly 10 months
after the deal was originally announced. While a host of pre-conditions have been set, two key
ones which were objected to by both parties are that royalty payments would be cost recoverable
and arbitration on cess would be withdrawn.
ONGC pays 100% of the royalties on the Rajasthan block where it holds a 30% stake, CIL holding
balance 70%. Though our earnings estimates and valuation did not assume royalty cost
recoverability, we had outlined the negative impact of this possible development in our report on
CIL, Evaluating ëwhat ifí scenarios, dated 18 February 2011. Recent news reports have already
suggested that the government is likely to impose this pre-condition and, hence, the actual
decision has not come as a surprise. The government has clarified that this decision holds
irrespective of whether the deal goes through or not.
We are surprised by the decision on cess. CIL and ONGC have been paying cess at current rates
of Rs2,575/tonne (around US$8/bbl) though CIL believed that it should not be liable to pay cess
and if any cess was payable it would be at the lower rate of Rs927/tonne. In line with the
prescribed procedure in the production sharing contract, CIL has filed an arbitration claim in the
international court and hearings have commenced. The arbitration process is prescribed in the
PSC itself to sort out disputes between contract partners and it is surprising that government is
not allowing CIL to follow this procedure. Disallowing the arbitration has no negative implications
for our model, since we have not been assuming any upside on cess in any case.
By taking an 18.5% stake before getting government approval, Vedanta had already signalled its
intention to acquire CIL. CEP, meanwhile, has ensured that a majority of its holding is sold at
Rs355/share. While the government has given its conditions to CEP and Vedanta, the party
directly affected is actually CIL and its minority shareholders. For CIL as a separate entity, its
future prospects are not dependent on who are its promoter shareholders and, hence, there
should be no reason to accept a reduction in value of its assets just to help its promoters. Hence,
we believe that CIL board could oppose the pre-conditions. However, the ultimate decision of the
board may be driven by practical considerations. CIL is planning to significantly grow its oil
production and every investment plan has to be approved by both ONGC and the government. If
CIL launches litigation against the government pre-conditions, there is a risk that the required
approvals do not come through and the growth plans get pushed back by at least a year or two.
CILís growth plans subject to ONGC/government approval
Based on its current resource base, CIL management believes that it can raise Rajasthan oil
production to 240kbd. Out of this, 210kbd would come from core reserves of the three main fields
ñ Mangala (150kbd), Bhagyam (40kbd) and Aishwariya (20kbd). The balance 30kbd would come
from using enhanced oil recovery (EOR) techniques in the above three MBA fields (CIL estimates
EOR reserves at 300mmbbls) and being able to extract oil from the Barmer Hill formation.
What the government has already approved is a production level of 175kbd only (125kbd
Mangala, 40kbd Bhagyam and 20kbd Aishwariya). CIL had declared its ability to raise Mangala
production from 125kbd to 150kbd in March 2010, but has been unable to convince ONGC on the
merits of its proposal and, hence, the approval for this rise has not been forthcoming. ONGC has
declined approval on technical grounds and it remains to be seen whether accepting government
pre-conditions will make any changes to the approval process. Our estimates assume that the
approval for this production rise comes through in 3QFY12 so that Mangala production rises to
150kbd in 4QFY12.
On Bhagyam, management has guided for production commencing in 2HCY11 (we have
assumed October 2011) with peak production of 40kbd being achieved by end of CY11.
The rise in Aishwariya approved production level from 10kbd to 20kbd is based on CILís estimate
of higher reserve base, but the revised field development plan (FDP) is yet to be approved by the
government. CIL management has estimated Aishwariya production commencing in 1HCY12 and
we have again assumed it to start from October 2012.
For production from both EOR and Barmer Hill, CIL is carrying out pilot studies and is yet to file a
FDP. Our estimates assume that these pilot plans are successful, FDP plans are approved and
that production using EOR techniques commences in FY14 itself.
Thus, CIL can ramp up production as per our expectations only if it receives approval from ONGC
and the government in line with our expectations. Any delay in approvals would result in
consequent delay in timing of production ramp-up.
Draft CAG report could delay approvals
The comptroller and auditor general (CAG) of India has presented its draft report to the petroleum
ministry on certain PSCs including CILís Rajasthan block. The ministry is expected give its
comment after which the report would be finalised and presented to Parliament.
The draft report has raised serious concerns on the operation of the PSCs which, in our view,
could result in the government re-evaluating its procedures, which, in the medium-term, would
lead to delays in approving growth plans of the E&P players. Some of the CAG suggestions call
for a drastic overhaul. For example, that for future PSCs, the current system of profit-sharing be
replaced mainly by a royalty mechanism
In relation to the Rajasthan block, the CAG has commented that certain development areas given
by the government were not in line with PSC provisions and that the procedures prescribed in the
PSC for notification of potential commercial interest, submission of FDP, etc, have not been
followed. Perhaps the most significant observation from our viewpoint is the CAGís belief that the
development area is defined post the appraisal of existing discoveries and, hence, there is no
further scope for exploration within a defined development area. CIL management believes that
there is significant scope for further exploration within Rajasthan block, which it would not be able
to pursue if the CAG viewpoint is upheld.
In our view, all existing operations of CIL have been after approval of the upstream regulator
(DGH) and the government. However, both these agencies have to now respond to the CAGís
observations, which could result in a rethink of existing procedures and, hence, delays in
approval.
Maintain Hold, TP Rs310
Change in oil price estimates
We have raised our FY12-14 Brent oil forecasts in response to continuing strength, but would still
expect prices to retreat in 2012-14. Saudi Arabiaís policy of moderation in oil prices remains key
to the outlook, in our view. We continue to expect the rise of Iraqi output to weigh on prices in the
medium term. For a detailed discussion, please see our report, Oil & Gas ñ 2011-14 oil price
forecasts raised, dated 10 June 2011. Despite the increase, our forecasts are significantly below
the Brent futures curve
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Cairn India
Still no end to uncertainty
Cairn-Vedanta deal has been approved subject to royalty cost recoverability. We
maintain Hold and lower our TP to Rs310 to reflect the royalty claim. Using the
current Brent futures curve provides a higher valuation (Rs354), but growth
prospects remain vulnerable to the timing of government approvals.
We expect the CIL board to approve government pre-conditions
The Cabinet Committee on Economic Affairs (CCEA) has cleared the Cairn Energy (CEL)-
Vedanta deal relating to sale of shares in Cairn India (CIL). Two of the key conditions are
that royalties are made cost recoverable (not a surprise due to recent news flow) and that
CIL will withdraw the ongoing arbitration on cess payments (surprising, though with no
immediate financial implications). The CIL board could oppose the pre-conditions. But, in our
view, it will finally agree to them as CILís growth plans are still subject to approval from the
Indian government/ONGC and they could be delayed if there is any litigation.
CILís growth plans subject to ONGC/government approval
CIL management is targeting Rajasthan production at 240kbd. However, the current
production level approved by the government is only 175kbd (Mangala 125, Bhagyam 40,
Aishwariya 10). CIL needs approval to raise Mangala production by 25kbd and Aishwariya by
10kbd, and to use enhanced oil recovery techniques and to develop the rest of the resources
including tight oil at Barmer Hill. ONGC has rejected a Mangala production rise on technical
grounds while the draft CAG report has questioned the right of operators to carry out
exploration within existing development areas. We believe that there is significant risk of
delays in getting government approvals and, hence, in production ramping up.
Maintain Hold, TP Rs310
We have raised our Brent oil forecasts by US$3-15/bbl over FY12-14F. But, since we now
assume royalty cost recoverability in our estimates, we have cut our FY12-13F EPS
estimates by 17% and our target price from Rs360 to Rs310. Our Brent forecasts are
conservative and using the Brent futures curve would raise our valuation to Rs354. Use of
cash will also soon emerge as a key stock price driver given the rising cash pile and likely
change in top management.
Still no end to uncertainty
Given the uncertainty in the sector due to the CAG report we are not confident that
government approvals for CIL growth plans will easily flow through, even if the CIL board
approves the pre-conditions set by the government for the Cairn-Vedanta deal.
We expect CIL board to approve government pre-conditions
The CCEA has cleared the CEL-Vedanta deal relating to sale of shares in CIL, nearly 10 months
after the deal was originally announced. While a host of pre-conditions have been set, two key
ones which were objected to by both parties are that royalty payments would be cost recoverable
and arbitration on cess would be withdrawn.
ONGC pays 100% of the royalties on the Rajasthan block where it holds a 30% stake, CIL holding
balance 70%. Though our earnings estimates and valuation did not assume royalty cost
recoverability, we had outlined the negative impact of this possible development in our report on
CIL, Evaluating ëwhat ifí scenarios, dated 18 February 2011. Recent news reports have already
suggested that the government is likely to impose this pre-condition and, hence, the actual
decision has not come as a surprise. The government has clarified that this decision holds
irrespective of whether the deal goes through or not.
We are surprised by the decision on cess. CIL and ONGC have been paying cess at current rates
of Rs2,575/tonne (around US$8/bbl) though CIL believed that it should not be liable to pay cess
and if any cess was payable it would be at the lower rate of Rs927/tonne. In line with the
prescribed procedure in the production sharing contract, CIL has filed an arbitration claim in the
international court and hearings have commenced. The arbitration process is prescribed in the
PSC itself to sort out disputes between contract partners and it is surprising that government is
not allowing CIL to follow this procedure. Disallowing the arbitration has no negative implications
for our model, since we have not been assuming any upside on cess in any case.
By taking an 18.5% stake before getting government approval, Vedanta had already signalled its
intention to acquire CIL. CEP, meanwhile, has ensured that a majority of its holding is sold at
Rs355/share. While the government has given its conditions to CEP and Vedanta, the party
directly affected is actually CIL and its minority shareholders. For CIL as a separate entity, its
future prospects are not dependent on who are its promoter shareholders and, hence, there
should be no reason to accept a reduction in value of its assets just to help its promoters. Hence,
we believe that CIL board could oppose the pre-conditions. However, the ultimate decision of the
board may be driven by practical considerations. CIL is planning to significantly grow its oil
production and every investment plan has to be approved by both ONGC and the government. If
CIL launches litigation against the government pre-conditions, there is a risk that the required
approvals do not come through and the growth plans get pushed back by at least a year or two.
CILís growth plans subject to ONGC/government approval
Based on its current resource base, CIL management believes that it can raise Rajasthan oil
production to 240kbd. Out of this, 210kbd would come from core reserves of the three main fields
ñ Mangala (150kbd), Bhagyam (40kbd) and Aishwariya (20kbd). The balance 30kbd would come
from using enhanced oil recovery (EOR) techniques in the above three MBA fields (CIL estimates
EOR reserves at 300mmbbls) and being able to extract oil from the Barmer Hill formation.
What the government has already approved is a production level of 175kbd only (125kbd
Mangala, 40kbd Bhagyam and 20kbd Aishwariya). CIL had declared its ability to raise Mangala
production from 125kbd to 150kbd in March 2010, but has been unable to convince ONGC on the
merits of its proposal and, hence, the approval for this rise has not been forthcoming. ONGC has
declined approval on technical grounds and it remains to be seen whether accepting government
pre-conditions will make any changes to the approval process. Our estimates assume that the
approval for this production rise comes through in 3QFY12 so that Mangala production rises to
150kbd in 4QFY12.
On Bhagyam, management has guided for production commencing in 2HCY11 (we have
assumed October 2011) with peak production of 40kbd being achieved by end of CY11.
The rise in Aishwariya approved production level from 10kbd to 20kbd is based on CILís estimate
of higher reserve base, but the revised field development plan (FDP) is yet to be approved by the
government. CIL management has estimated Aishwariya production commencing in 1HCY12 and
we have again assumed it to start from October 2012.
For production from both EOR and Barmer Hill, CIL is carrying out pilot studies and is yet to file a
FDP. Our estimates assume that these pilot plans are successful, FDP plans are approved and
that production using EOR techniques commences in FY14 itself.
Thus, CIL can ramp up production as per our expectations only if it receives approval from ONGC
and the government in line with our expectations. Any delay in approvals would result in
consequent delay in timing of production ramp-up.
Draft CAG report could delay approvals
The comptroller and auditor general (CAG) of India has presented its draft report to the petroleum
ministry on certain PSCs including CILís Rajasthan block. The ministry is expected give its
comment after which the report would be finalised and presented to Parliament.
The draft report has raised serious concerns on the operation of the PSCs which, in our view,
could result in the government re-evaluating its procedures, which, in the medium-term, would
lead to delays in approving growth plans of the E&P players. Some of the CAG suggestions call
for a drastic overhaul. For example, that for future PSCs, the current system of profit-sharing be
replaced mainly by a royalty mechanism
In relation to the Rajasthan block, the CAG has commented that certain development areas given
by the government were not in line with PSC provisions and that the procedures prescribed in the
PSC for notification of potential commercial interest, submission of FDP, etc, have not been
followed. Perhaps the most significant observation from our viewpoint is the CAGís belief that the
development area is defined post the appraisal of existing discoveries and, hence, there is no
further scope for exploration within a defined development area. CIL management believes that
there is significant scope for further exploration within Rajasthan block, which it would not be able
to pursue if the CAG viewpoint is upheld.
In our view, all existing operations of CIL have been after approval of the upstream regulator
(DGH) and the government. However, both these agencies have to now respond to the CAGís
observations, which could result in a rethink of existing procedures and, hence, delays in
approval.
Maintain Hold, TP Rs310
Change in oil price estimates
We have raised our FY12-14 Brent oil forecasts in response to continuing strength, but would still
expect prices to retreat in 2012-14. Saudi Arabiaís policy of moderation in oil prices remains key
to the outlook, in our view. We continue to expect the rise of Iraqi output to weigh on prices in the
medium term. For a detailed discussion, please see our report, Oil & Gas ñ 2011-14 oil price
forecasts raised, dated 10 June 2011. Despite the increase, our forecasts are significantly below
the Brent futures curve
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