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The final CAG report
The final report by CAG on Reliance’s KG-D6 block appears less trenchant than the
draft report, especially on the rise in development capex, but holds on to assertions
related to the non relinquishments of parts of the block. It continues to highlight
contractual inconsistencies too but has dropped several objections here. The
recommendations remain an irritant, especially the alleged proximity of Reliance
and DGH in prior years, but the value at risk from their implementation is less than
2% even as the stock trades at a 20% PE discount to Sensex and peers. BUY.
Key issues raised by CAG. The draft report by CAG on Reliance’s KG-D6 block had
raised several issues but the key ones related to non-relinquishment of parts of the
block as mandated in the contract, the inadequately explained rise in development
costs and inconsistent contractual processes that may have contributed to this rise.
Reliance and upstream regulator DGH had replied earlier refuting these allegations.
The final report. The final report released yesterday appears less trenchant but the
CAG has held on its key assertions. On the contentious issue of non-relinquishment of
parts of KG-D6, for example, it comes down on DGH for a mid-course change in stance
in favour of Reliance and recommends that the MoPNG should define the discovery
area based on the strict contract definition of successful exploratory drilling. If
implemented, this may require Reliance to indeed relinquish large parts KG-D6.
Less harsh on rise in capex. The CAG also appears to have toned down its criticism
of the increase in D1-D3 development capex from US$2.5bn to US$8.8bn noting that
acceptance of costs can only be certified after future audits. Instead it focuses more on
contractual inconsistencies. Here too, though, we find that many of the instances cited
in the draft report have been dropped leading to a cut in the aggregate alleged
unproductive capex in D1-D3 from US$620m to US$350m. Nonetheless, it advises the
MOPNG to carefully evaluate these contracts, especially ones with the Aker Group
(including the US$1.1bn FPSO for MA) to ensure that government interest is protected.
Limited SOTP impact. The US$350m capex at risk is ~5% of D1-D3 spend so far;
any disallowance has limited impact, therefore. Similarly, we ascribe just Rs11/sh as
value of the smaller discoveries in KG-D6 and Rs4/sh as future exploration upside in
the block limiting the downside from a forced relinquishment of the entire block
outside of D1-D3 and MA to just Rs15/sh. Further, with the MOPNG and DGH appearing
to have sided with Reliance on these issues earlier while replying to the CAG, we view
this as a low probability event especially as retrospective implementation is difficult.
Maintain BUY. Nonetheless, the recommendations will remain an irritant till the
government decides on the feasibility of their implementation as also its own
willingness to implement; the CAG’s insinuation of undue alleged proximity of DGH and
Reliance in prior years is especially tricky. Nevertheless, with the stock trading at a
19% discount to Sensex and 20% to global peers on FY12 PE, we stay BUYers.
Rise in costs in the FPSO contract related to MA (Vendor: Aker Contracting)
CAG comment in draft report: CAG came down heavily on Reliance for flawed and
inconsistent tender processes. Details of costs were not provided to CAG. Further, the
price for the FPSO went up over three fold from the DOC stage (US$300m), initial cost
quoted by AFP was US$572mn, cost of FPSO as per FDP was US$733mn and even final
order value awarded was US$1.1bn.
Reliance’s reply: The US$300m estimate considered only capital costs and was net of
the estimated salvage value of the vessel that was estimated to be 40% of the capital
costs. The US$572m figure in the priced bid was the buy price for Phase I only. The
combined buy price for both phases was quoted at US$922m. As result of optimisation
work' undertaken by RIL, substantial savings for Phase II were achieved with a total
buy price of US$ 733 million, representing projected reduced total Phase I plus Phase
II costs. The figure of US$1,075 billion referred to by CAG as the final order value is in
fact the aggregate cost for a 10 year charter period not simply the buy price at the
outset of the contract.
CAG has misunderstood the nature of the FPSO contract and confused the buy price for
the FPSO for Phase I with the combined buy and charter hire price (for ten years) for
Phases I and II together. The optimisation efforts made by RIL resulting in total costs
for 10 year charter when properly calculated amount to some US$1.075bn, as opposed
to US$1.425bn and, in turn, represent a saving of approximately US$350m.
The purpose of a DoC is not to establish definitive estimates of development costs and
a full estimate would be wholly premature at this stage. The DoC merely provides
preliminary estimates to establish commercial viability of the discovery. Definitive
estimates can only be established in connection with preparation of the FDP, which
involves a more comprehensive process and can only be done at a later stage after
commerciality has been declared.
RIL cannot be criticised if, by following the procurement procedures under the PSC (as
it was obliged to do), the market produced only one technically conforming bidder at
the conclusion of the bidding process. AFP's priced bid was submitted when multiple
bidders were still in contention, rendering the price which it bid competitive. At the
time it bid, AFP had no way of knowing it would not be in competition with other
bidders.
CAG comment in final report:
The operator's claim that the estimate submitted in the DoC was only preliminary and
for evaluation purpose is not acceptable because the Operator, being in the E&P
business, should have sound knowledge of the business and prevailing market prices.
Moreover, RIL had issued RFP for charter hiring of FPSO and subsea hardware supply
and installation one month before submission of the DoC proposal to the MC, and
should have been in possession of robust data regarding estimated costs.
Operator's reply that FPSO cost in DoC was net of 40 per cent salvage value appears to
be an after-thought, since there is no mention of 40 per cent salvage value in the DoC
proposal. We do not agree with the operator's argument, endorsed by the
Government, that expenditure incurred on "pre-development activities" was at the risk
of the Operator. Carrying out pre-development activities before approval of FDP was
irregular.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
The final CAG report
The final report by CAG on Reliance’s KG-D6 block appears less trenchant than the
draft report, especially on the rise in development capex, but holds on to assertions
related to the non relinquishments of parts of the block. It continues to highlight
contractual inconsistencies too but has dropped several objections here. The
recommendations remain an irritant, especially the alleged proximity of Reliance
and DGH in prior years, but the value at risk from their implementation is less than
2% even as the stock trades at a 20% PE discount to Sensex and peers. BUY.
Key issues raised by CAG. The draft report by CAG on Reliance’s KG-D6 block had
raised several issues but the key ones related to non-relinquishment of parts of the
block as mandated in the contract, the inadequately explained rise in development
costs and inconsistent contractual processes that may have contributed to this rise.
Reliance and upstream regulator DGH had replied earlier refuting these allegations.
The final report. The final report released yesterday appears less trenchant but the
CAG has held on its key assertions. On the contentious issue of non-relinquishment of
parts of KG-D6, for example, it comes down on DGH for a mid-course change in stance
in favour of Reliance and recommends that the MoPNG should define the discovery
area based on the strict contract definition of successful exploratory drilling. If
implemented, this may require Reliance to indeed relinquish large parts KG-D6.
Less harsh on rise in capex. The CAG also appears to have toned down its criticism
of the increase in D1-D3 development capex from US$2.5bn to US$8.8bn noting that
acceptance of costs can only be certified after future audits. Instead it focuses more on
contractual inconsistencies. Here too, though, we find that many of the instances cited
in the draft report have been dropped leading to a cut in the aggregate alleged
unproductive capex in D1-D3 from US$620m to US$350m. Nonetheless, it advises the
MOPNG to carefully evaluate these contracts, especially ones with the Aker Group
(including the US$1.1bn FPSO for MA) to ensure that government interest is protected.
Limited SOTP impact. The US$350m capex at risk is ~5% of D1-D3 spend so far;
any disallowance has limited impact, therefore. Similarly, we ascribe just Rs11/sh as
value of the smaller discoveries in KG-D6 and Rs4/sh as future exploration upside in
the block limiting the downside from a forced relinquishment of the entire block
outside of D1-D3 and MA to just Rs15/sh. Further, with the MOPNG and DGH appearing
to have sided with Reliance on these issues earlier while replying to the CAG, we view
this as a low probability event especially as retrospective implementation is difficult.
Maintain BUY. Nonetheless, the recommendations will remain an irritant till the
government decides on the feasibility of their implementation as also its own
willingness to implement; the CAG’s insinuation of undue alleged proximity of DGH and
Reliance in prior years is especially tricky. Nevertheless, with the stock trading at a
19% discount to Sensex and 20% to global peers on FY12 PE, we stay BUYers.
Rise in costs in the FPSO contract related to MA (Vendor: Aker Contracting)
CAG comment in draft report: CAG came down heavily on Reliance for flawed and
inconsistent tender processes. Details of costs were not provided to CAG. Further, the
price for the FPSO went up over three fold from the DOC stage (US$300m), initial cost
quoted by AFP was US$572mn, cost of FPSO as per FDP was US$733mn and even final
order value awarded was US$1.1bn.
Reliance’s reply: The US$300m estimate considered only capital costs and was net of
the estimated salvage value of the vessel that was estimated to be 40% of the capital
costs. The US$572m figure in the priced bid was the buy price for Phase I only. The
combined buy price for both phases was quoted at US$922m. As result of optimisation
work' undertaken by RIL, substantial savings for Phase II were achieved with a total
buy price of US$ 733 million, representing projected reduced total Phase I plus Phase
II costs. The figure of US$1,075 billion referred to by CAG as the final order value is in
fact the aggregate cost for a 10 year charter period not simply the buy price at the
outset of the contract.
CAG has misunderstood the nature of the FPSO contract and confused the buy price for
the FPSO for Phase I with the combined buy and charter hire price (for ten years) for
Phases I and II together. The optimisation efforts made by RIL resulting in total costs
for 10 year charter when properly calculated amount to some US$1.075bn, as opposed
to US$1.425bn and, in turn, represent a saving of approximately US$350m.
The purpose of a DoC is not to establish definitive estimates of development costs and
a full estimate would be wholly premature at this stage. The DoC merely provides
preliminary estimates to establish commercial viability of the discovery. Definitive
estimates can only be established in connection with preparation of the FDP, which
involves a more comprehensive process and can only be done at a later stage after
commerciality has been declared.
RIL cannot be criticised if, by following the procurement procedures under the PSC (as
it was obliged to do), the market produced only one technically conforming bidder at
the conclusion of the bidding process. AFP's priced bid was submitted when multiple
bidders were still in contention, rendering the price which it bid competitive. At the
time it bid, AFP had no way of knowing it would not be in competition with other
bidders.
CAG comment in final report:
The operator's claim that the estimate submitted in the DoC was only preliminary and
for evaluation purpose is not acceptable because the Operator, being in the E&P
business, should have sound knowledge of the business and prevailing market prices.
Moreover, RIL had issued RFP for charter hiring of FPSO and subsea hardware supply
and installation one month before submission of the DoC proposal to the MC, and
should have been in possession of robust data regarding estimated costs.
Operator's reply that FPSO cost in DoC was net of 40 per cent salvage value appears to
be an after-thought, since there is no mention of 40 per cent salvage value in the DoC
proposal. We do not agree with the operator's argument, endorsed by the
Government, that expenditure incurred on "pre-development activities" was at the risk
of the Operator. Carrying out pre-development activities before approval of FDP was
irregular.
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