Credit Suisse, on ONGC:: Wait for policy change

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● Recent retail price increases/oil tax cuts have reduced Indian
retail fuel losses. Given the tight fiscal, and without policy clarity,
the hopes of significant ONGC EBITDA growth may be premature,
we believe.
● Expectations of a new upstream policy, with ONGC realisations
capped at c.US$60/bbl are strong, which could lead to modest
EBITDA upgrades. We expect ONGC’s domestic oil production to
grow to 30 MMT by FY15. Gas output should increase to 28 BCM
by FY14. OVL volumes should cross 13 MTOE by FY14.  
● The overhang of the large stock sale and the expectation that the
government will offer a discount could constrain immediate stock
moves. Near-term risks include: (1) cancellation of the FPO, (2)
an attempt to FPO without any policy clarity. We would wait for the
announcement of the policy to evaluate subscribing to the FPO.
● ONGC trades at 4x FY12E consensus. Assuming US$60/bbl cap
is instituted, and ONGC re-rates to 5x FY12E EBITDA, the stock
could be worth c.Rs360/share. If upstream paid 60% of headline
losses in FY12, ONGC could be worth only Rs197 (4x FY12E
EBITDA). Maintain NEUTRAL.
The tide seems to have turned for ONGC before the proposed
government stock sale. Retail price increases/tax cuts have reduced
system losses. The cost recoverability of royalties at the Cairn block
has been recommended, and there is strong expectation of a new
policy on upstream subsidy sharing. We would not buy ONGC ahead
of this policy clarity, and wait for the announcement to evaluate
subscribing to the FPO. Medium-term volume growth could be a
material attraction; continued subsidy uncertainty is a major risk.
Lots of subsidy action
The government’s recent action on prices and oil taxes materially
reduced retail fuel loss estimates in India. By implication, ONGC’s
subsidy payments decline and EBITDA grows under most
assumptions; this outlook has led to large upgrades. Top down, we
believe the tight fiscal is a big concern—the government may not be
able to afford large EBITDA growth at ONGC. Net realisations may
not grow as sharply as expected. In the current situation, we are wary
of buying ONGC without subsidy policy clarity. There is also the
expectation that policy clarity is imminent (ahead of the proposed
FPO) and that ONGC will have realisations capped at US$60/bbl. If
implemented, this could lead to modest EBITDA upgrades, with room
for multiple expansions. Fixed realisations also mean that operations
and volume outlook can become relevant/significant. We would wait
for the government to announce a new subsidy policy, rather than run
the risk of it trying to sell the stock without additional policy clarity.  
Changing earnings drivers
Growing retail fuel consumption in India has significantly changed
ONGC earnings drivers. Its 16% EPS CAGR between FY04 and FY09
was led by a 13% CAGR growth in net realisations. Even if upstream
companies pay 33% of total losses, this will not recur, as ONGC
domestic crude sales volumes are now close to its exposure to retail
sales (82% of 33% of HSD/LPG/SKO consumption). Increasing
cash/non-cash costs exert additional pressure on the PnL. Earnings
now have much higher dependence on government action. ONGC
needs to grow domestic volumes to deliver ‘inherent’ EPS growth.
Finally, some volume growth
ONGC has struggled to keep volumes intact despite large capex and
high reported reserve replacement—something the market has not
taken kindly to. Yet, on our bottom up project wise production model,
we believe ONGC’s domestic oil production can increase from 24.4
MMT in FY11 to 30.4 MMT by FY15. Gas production volumes should
also increase from 23.1 BCM in FY11 to 28 BCM by FY14. Output
from new projects should more than compensate the c.8% declines at
existing fields. This should be accompanied by material increases at
OVL, where total output should increase from 9.45 MTOE in FY11 to
13.4 MTOE by FY14. While questions on ONGC’s ability to sustain
this IOR/EOR-fuelled volume growth over the long term remain, the
medium-term increase in volumes could significantly drive earnings
and be a major attraction, especially if the government provides
assurance on realisations through a new policy, as is now expected.
Valuations
With some government action on oil policy seemingly around the
corner, we leave our ONGC numbers unchanged. ONGC trades at
4.7x FY11E EBITDA and 4x FY12E consensus, compared with 6–6.5
times for global comps. Given the large capex, it is 14.4 times FY11E
FCF per share. Assuming the US$60/bbl cap is instituted, and ONGC
re-rates to 5x FY12E EBITDA, the stock could be worth
c.Rs360/share. If upstream paid only 33% of under-recoveries in
FY12, ONGC could be worth Rs406 (5x FY12E EBITDA), but could be
worth Rs197 at 4x EBITDA if upstream paid 60% instead. Maintain
NEUTRAL.