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Energy
India
Some relief finally but it should last. We see the recent sharp decline in crude prices
(Dated Brent) to around US$100/bbl as a positive for the oil sector if prices sustain at
those levels. Lower crude prices will result in (1) likely lower gross under-recoveries and
(2) a favorable environment to usher in further reforms in the sector. We maintain our
positive view on government-owned oil stocks but are more positively inclined towards
the upstream companies noting their better reward-risk balance.
Crude around US$100/bbl means a better situation for everyone (almost)
We see the recent correction in crude prices as providing some relief to all the participants in the
subsidy-sharing mechanism (government, upstream and downstream companies) as decline in
crude oil prices will result in lower overall gross under-recoveries. We compute FY2012E gross
under-recoveries at `920 bn if crude remains at US$100/bbl for the remainder of the year versus
our current estimate of `1.04 tn based on average crude price of US$110/bbl for FY2012E. We
compute marketing margin of –`0.5/liter for diesel, subsidy loss of `21/liter for kerosene and
`261/cylinder for LPG at crude price of US$100/bbl.
Diesel deregulation a possibility with some luck and pluck; breakeven price for diesel is US$98/bbl
We see the possibility of diesel deregulation if crude prices sustain at around US$100/bbl for some
time. We note that the current breakeven price for diesel is US$98/bbl at an exchange rate of
`44.75/US$ and under-recovery at crude oil price of US$100/bbl is `0.5/liter. ‘Low’ crude prices
may give the government a good opportunity to deregulate diesel prices as was done with
gasoline in June 2010 (although with some hiccups). However, the government would need to
display commitment to the process of deregulation in sharp contrast to its past track record.
LPG and kerosene reforms may take some time but steps being taken in the right direction
We would watch for any positive developments on reforms related to subsidy on kerosene and
LPG. We highlight that an Empowered Group of Ministers (EGoM) has given an in-principle
approval to the interim report of the Task Force on Direct Transfer of Subsidies on Kerosene, LPG,
and Fertilizers. Please see our note ‘A new approach to some old problems’ released on July 11,
2011 on the same. We see the direct transfer of subsidy as recommended by the Task Force as a
pragmatic and implementable solution to tackle the problem of burgeoning subsidies.
Good potential upside in stocks but biased towards upstream stocks
We would advise investors to stay invested in the government-owned names given that the stocks
still offer decent potential upside of 16-35% to our fair valuations (see Exhibit 1) but give more
weight to the upstream stocks in their portfolios. We maintain our BUY ratings on ONGC (TP:
`385) and OIL (TP: `1,800) and ADD ratings on BPCL (TP: `800), HPCL (TP: `500), IOCL (TP: `435)
and GAIL (TP: `560).
Sharp decline in crude prices and what it means for everyone
Gross under-recoveries. We compute FY2012E gross under-recoveries at `920 bn
assuming US$100/bbl crude price for the remainder of FY2012E and no further change to
retail prices of regulated products versus our current estimate of `1.04 tn based on
average crude price of US$110/bbl for FY2012E. We highlight that the impact of ‘low’
crude prices is muted for FY2012E due to high gross under-recoveries of `435 bn in
1QFY12 itself. The government had increased retail selling prices and cut taxes on crude
oil and diesel on June 24, 2011, the benefits of which will be seen in subsequent quarters.
More important, the impact of lower crude oil prices will be meaningful in FY2013E given
the positive impact of higher retail selling prices and tax changes affected in June 2011.
We compute gross under-recoveries at `650 bn assuming average crude oil price at
US$100/bbl. We believe that this would be a manageable figure as the government share
would likely be between `335 bn and `370 bn depending on the burden to be borne by
upstream and downstream companies. Exhibit 2 gives the likely subsidy-sharing scenario
assuming upstream companies’ share at 33.3% and 39% of gross under-recoveries.
Upstream companies. The impact of decline in crude oil prices on valuation of PSU
upstream companies is slightly complicated as it involves several variables—(1) lower gross
realization (-ve impact), (2) lower subsidy burden (+ve impact), (3) higher multiple being
ascribed to value these companies given improved earnings visibility from lower subsidy
burden (+ve impact) and (4) potential deregulation of diesel (+ve impact). We see a
decline in crude oil prices as a net positive for upstream companies based on the
following factors.
Lower subsidy burden. We currently assume upstream companies to bear 39% of
the gross under-recoveries in FY2012-14E. However, we believe that the government
would restore the upstream share to 33.3% versus our current assumption of 39% if
the crude oil prices remain low. We compute a positive impact of 5%, 5.2% and
3.1% for ONGC, OIL and GAIL on our FY2013E estimates.
Lower realization from lower crude oil prices. We already assume crude oil price
at US$100/bbl for FY2013E. We compute a negative impact of 4%, 3.2% and 2%
for ONGC, OIL and GAIL on our FY2013E estimates if the crude oil price is lower by
US$2/bbl versus our assumption.
Higher multiple arising from more conviction of no irrational subsidy burden.
The current valuations of ONGC and OIL (trading at ~7.6X FY2012E EPS) reflect the
market’s concern about higher-than-expected subsidy burden being imposed on
them. However, we expect lower skepticism a scenario of ‘low’ crude oil prices. We
highlight that upstream companies had borne 30-33% of the gross under-recoveries
in FY2008-10. It would not be overly optimistic to expect the market to ascribe 10-
11X multiple if a consistent and transparent subsidy-sharing scheme is put in place.
We currently use 9X P/E multiple to value the upstream companies.
Diesel deregulation. As discussed previously, we do not rule out diesel
deregulation if crude oil prices sustain around US$100/bbl for some time. We see
lower-than-expected gross under-recoveries in such a scenario, which should benefit
upstream companies. We highlight that our assumption of gross under-recoveries of
`650 bn at crude price of US$100/bbl includes `122 bn from diesel. We compute a
positive impact of 6.9%, 7.2% and 4.3% for ONGC, OIL and GAIL on our FY2013E
estimates.
Downstream companies. We assume that the government will provide adequate
compensation to the downstream companies to maintain their profitability at a certain
level. We currently assume downstream companies will bear `74 bn as net underrecoveries
in FY2012-13E against `69 bn in FY2011.
We do not see upside to our earnings assumptions from upward/downward movement in
the crude oil prices as long as the government broadly follows its compensation
‘philosophy’. However, we do see an improvement in sentiment and greater conviction
about the companies’ earnings at lower levels of crude oil prices. We note that the
downstream companies are currently trading at 11-15X FY2012E EPS, which reflects the
market’s skepticism regarding the current opaque subsidy-sharing mechanism.
Downstream companies would benefit if the government is able to successfully introduce
other reforms in the sector such as (1) full deregulation of diesel prices, (2) targeted cash
subsidies on kerosene and LPG to identified households and (3) cap on number of
subsidized cylinders as an interim step to targeted cash subsidies. A combination of the
aforementioned developments could bring down gross under-recoveries to a level that
will allow the government to reduce the subsidy burden on the downstream companies
from our expected levels.
Cairn India. Cairn India stock price is discounting US$87/bbl in perpetuity and we see
limited impact of crude price volatility in a narrow range on the stock price. We currently
assume crude oil prices (Dated Brent) at US$110/bbl for FY2012E and US$100/bbl for
FY2013E. We highlight that the stock has historically shown a high correlation with crude
oil prices except for the period after the announcement of its proposed deal with Vedanta
Resources (see Exhibit 3). This has been the case despite the fact that Cairn India’s fair
valuation does not change significantly with change in assumption of near-term crude oil
price
Standalone refiners. We see a sharp decline in crude oil prices as a negative for
standalone refiners (RIL, MRPL, CPCL) as it would result in high inventory/adventitious
losses for the companies. However, this would be a one-off item. More important, we
would also watch for any negative impact on global oil demand of a global economic
slowdown (the reason for the current decline in crude oil prices) arising from the ongoing
sovereign-debt crisis in the US and Eurozone.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Energy
India
Some relief finally but it should last. We see the recent sharp decline in crude prices
(Dated Brent) to around US$100/bbl as a positive for the oil sector if prices sustain at
those levels. Lower crude prices will result in (1) likely lower gross under-recoveries and
(2) a favorable environment to usher in further reforms in the sector. We maintain our
positive view on government-owned oil stocks but are more positively inclined towards
the upstream companies noting their better reward-risk balance.
Crude around US$100/bbl means a better situation for everyone (almost)
We see the recent correction in crude prices as providing some relief to all the participants in the
subsidy-sharing mechanism (government, upstream and downstream companies) as decline in
crude oil prices will result in lower overall gross under-recoveries. We compute FY2012E gross
under-recoveries at `920 bn if crude remains at US$100/bbl for the remainder of the year versus
our current estimate of `1.04 tn based on average crude price of US$110/bbl for FY2012E. We
compute marketing margin of –`0.5/liter for diesel, subsidy loss of `21/liter for kerosene and
`261/cylinder for LPG at crude price of US$100/bbl.
Diesel deregulation a possibility with some luck and pluck; breakeven price for diesel is US$98/bbl
We see the possibility of diesel deregulation if crude prices sustain at around US$100/bbl for some
time. We note that the current breakeven price for diesel is US$98/bbl at an exchange rate of
`44.75/US$ and under-recovery at crude oil price of US$100/bbl is `0.5/liter. ‘Low’ crude prices
may give the government a good opportunity to deregulate diesel prices as was done with
gasoline in June 2010 (although with some hiccups). However, the government would need to
display commitment to the process of deregulation in sharp contrast to its past track record.
LPG and kerosene reforms may take some time but steps being taken in the right direction
We would watch for any positive developments on reforms related to subsidy on kerosene and
LPG. We highlight that an Empowered Group of Ministers (EGoM) has given an in-principle
approval to the interim report of the Task Force on Direct Transfer of Subsidies on Kerosene, LPG,
and Fertilizers. Please see our note ‘A new approach to some old problems’ released on July 11,
2011 on the same. We see the direct transfer of subsidy as recommended by the Task Force as a
pragmatic and implementable solution to tackle the problem of burgeoning subsidies.
Good potential upside in stocks but biased towards upstream stocks
We would advise investors to stay invested in the government-owned names given that the stocks
still offer decent potential upside of 16-35% to our fair valuations (see Exhibit 1) but give more
weight to the upstream stocks in their portfolios. We maintain our BUY ratings on ONGC (TP:
`385) and OIL (TP: `1,800) and ADD ratings on BPCL (TP: `800), HPCL (TP: `500), IOCL (TP: `435)
and GAIL (TP: `560).
Sharp decline in crude prices and what it means for everyone
Gross under-recoveries. We compute FY2012E gross under-recoveries at `920 bn
assuming US$100/bbl crude price for the remainder of FY2012E and no further change to
retail prices of regulated products versus our current estimate of `1.04 tn based on
average crude price of US$110/bbl for FY2012E. We highlight that the impact of ‘low’
crude prices is muted for FY2012E due to high gross under-recoveries of `435 bn in
1QFY12 itself. The government had increased retail selling prices and cut taxes on crude
oil and diesel on June 24, 2011, the benefits of which will be seen in subsequent quarters.
More important, the impact of lower crude oil prices will be meaningful in FY2013E given
the positive impact of higher retail selling prices and tax changes affected in June 2011.
We compute gross under-recoveries at `650 bn assuming average crude oil price at
US$100/bbl. We believe that this would be a manageable figure as the government share
would likely be between `335 bn and `370 bn depending on the burden to be borne by
upstream and downstream companies. Exhibit 2 gives the likely subsidy-sharing scenario
assuming upstream companies’ share at 33.3% and 39% of gross under-recoveries.
Upstream companies. The impact of decline in crude oil prices on valuation of PSU
upstream companies is slightly complicated as it involves several variables—(1) lower gross
realization (-ve impact), (2) lower subsidy burden (+ve impact), (3) higher multiple being
ascribed to value these companies given improved earnings visibility from lower subsidy
burden (+ve impact) and (4) potential deregulation of diesel (+ve impact). We see a
decline in crude oil prices as a net positive for upstream companies based on the
following factors.
Lower subsidy burden. We currently assume upstream companies to bear 39% of
the gross under-recoveries in FY2012-14E. However, we believe that the government
would restore the upstream share to 33.3% versus our current assumption of 39% if
the crude oil prices remain low. We compute a positive impact of 5%, 5.2% and
3.1% for ONGC, OIL and GAIL on our FY2013E estimates.
Lower realization from lower crude oil prices. We already assume crude oil price
at US$100/bbl for FY2013E. We compute a negative impact of 4%, 3.2% and 2%
for ONGC, OIL and GAIL on our FY2013E estimates if the crude oil price is lower by
US$2/bbl versus our assumption.
Higher multiple arising from more conviction of no irrational subsidy burden.
The current valuations of ONGC and OIL (trading at ~7.6X FY2012E EPS) reflect the
market’s concern about higher-than-expected subsidy burden being imposed on
them. However, we expect lower skepticism a scenario of ‘low’ crude oil prices. We
highlight that upstream companies had borne 30-33% of the gross under-recoveries
in FY2008-10. It would not be overly optimistic to expect the market to ascribe 10-
11X multiple if a consistent and transparent subsidy-sharing scheme is put in place.
We currently use 9X P/E multiple to value the upstream companies.
Diesel deregulation. As discussed previously, we do not rule out diesel
deregulation if crude oil prices sustain around US$100/bbl for some time. We see
lower-than-expected gross under-recoveries in such a scenario, which should benefit
upstream companies. We highlight that our assumption of gross under-recoveries of
`650 bn at crude price of US$100/bbl includes `122 bn from diesel. We compute a
positive impact of 6.9%, 7.2% and 4.3% for ONGC, OIL and GAIL on our FY2013E
estimates.
Downstream companies. We assume that the government will provide adequate
compensation to the downstream companies to maintain their profitability at a certain
level. We currently assume downstream companies will bear `74 bn as net underrecoveries
in FY2012-13E against `69 bn in FY2011.
We do not see upside to our earnings assumptions from upward/downward movement in
the crude oil prices as long as the government broadly follows its compensation
‘philosophy’. However, we do see an improvement in sentiment and greater conviction
about the companies’ earnings at lower levels of crude oil prices. We note that the
downstream companies are currently trading at 11-15X FY2012E EPS, which reflects the
market’s skepticism regarding the current opaque subsidy-sharing mechanism.
Downstream companies would benefit if the government is able to successfully introduce
other reforms in the sector such as (1) full deregulation of diesel prices, (2) targeted cash
subsidies on kerosene and LPG to identified households and (3) cap on number of
subsidized cylinders as an interim step to targeted cash subsidies. A combination of the
aforementioned developments could bring down gross under-recoveries to a level that
will allow the government to reduce the subsidy burden on the downstream companies
from our expected levels.
Cairn India. Cairn India stock price is discounting US$87/bbl in perpetuity and we see
limited impact of crude price volatility in a narrow range on the stock price. We currently
assume crude oil prices (Dated Brent) at US$110/bbl for FY2012E and US$100/bbl for
FY2013E. We highlight that the stock has historically shown a high correlation with crude
oil prices except for the period after the announcement of its proposed deal with Vedanta
Resources (see Exhibit 3). This has been the case despite the fact that Cairn India’s fair
valuation does not change significantly with change in assumption of near-term crude oil
price
Standalone refiners. We see a sharp decline in crude oil prices as a negative for
standalone refiners (RIL, MRPL, CPCL) as it would result in high inventory/adventitious
losses for the companies. However, this would be a one-off item. More important, we
would also watch for any negative impact on global oil demand of a global economic
slowdown (the reason for the current decline in crude oil prices) arising from the ongoing
sovereign-debt crisis in the US and Eurozone.
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