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Reliance Industries (RIL)
Energy
To be or not to be. We believe any potential restriction of cost-recovery from RIL’s KG
D-6 block due to lower-than-expected production would be contingent on the (1) terms
of the production sharing contract (PSC) and (2) the actual production achieved over
the life of the asset. We are not privy to the actual PSC signed between RIL and the
government; however, we try to evaluate the impact on RIL based on the terms of the
model PSC. We maintain our BUY rating on RIL stock given 27% potential upside to our
revised SOTP-based target price of `1,000 (`1,045 previously).
Media reports on potential non-allowance of cost recovery (proportionately) from KG D-6 block
given lower-than-expected production
As per media articles, the oil ministry is planning to restrict cost-recovery of development costs for
KG D-6 block to US$3.4 bn versus actual capital expenditure of US$5.7 bn on D-1 and D-3 fields
in proportion to the current gas production of 37 mcm/d from D-1 and D-3 fields versus 61.9
mcm/d of planned gas production; RIL has already recovered US$5.3 bn of development costs till
date. We believe that any potential impact on RIL would depend on (1) terms of the production
sharing contract, (2) eventual production achieved over the life of the asset and (3) the actual
cause of lower-than-expected production from the block. RIL is likely to challenge any such move
in the courts as per media reports. We discuss the various possibilities that may emerge from any
potential restriction on cost recovery.
Scenario A: RIL eventually ramps up production to 80 mcm/d
We do not see a meaningful impact in this scenario as RIL will be able to recover the entire
exploration and development cost once it ramps up production to a peak level of 80 mcm/d from
its D1 and D3 fields. We do not see a meaningful impact on our fair value of RIL assuming that the
company will be allowed to recover the entire capex once it ramps up gas production to peak
levels. We note that the restriction of cost recovery will be a timing issue in this scenario.
Scenario B: RIL is not able to ramp up production to 80 mcm/d during the life of the asset
If RIL is unable to ramp up production from its KG D-6 field to its peak level, it would suggest a
change in reservoir behavior versus initial expectations. The eventual outcome and liability in this
scenario will likely be dependent on the reason for lower production. We doubt that a penalty
could be imposed on the contractor unless it is able to prove misconduct or negligence on the part
of the contractor. We provide the relevant sections of the PSC that deal with the non-allowance of
costs (Section 3.2) and force majeure (Article 31.2) that deal with the relevant issue. In a force
majeure event of the company not being able to ramp up gas production from its KG D-6 block,
RIL may be allowed to recover the full capex as it was expensed in line with the field development
plan, along with requisite approvals from MOPNG and DGH.
Relevant extracts from the model production sharing contract (PSC)
We provide the relevant provisions from the model PSC which deal with the issue of cost
recovery.
• Article 8.1 states, “Subject to the provisions of this Contract, the Contractor shall have
the following rights:
(a) subject to the provisions of Article 12, the exclusive right to carry out Petroleum
Operations to recover costs and expenses as provided in this Contract. The right
shall exclude exploitation of coal/lignite bed methane (CBM) by the Contractor in
the Contract Area.”
• Article 31.1 of the PSC states, “Any non-performance or delay in performance by any
Party hereto of any of its obligations under this Contract, or in fulfilling any condition of
any License or Lease granted to such Party, or in meeting any requirement of the Act,
the Rules or any License or Lease, shall, except for the payment of monies due under
this Contract or under the Act and the Rules or any law, be excused if, and to the extent
that, such non-performance or delay in performance under this Contract is caused by
Force Majeure as defined in this Article.”
• Article 31.2 of the PSC states,” For the purpose of this Contract, the term Force Majeure
means any cause or event, other than the unavailability of funds, whether similar to or
different from those enumerated herein, lying beyond the reasonable control of, and
unanticipated or unforeseeable by, and not brought about at the instance of, the Party
claiming to be affected by such event, or which, if anticipated or foreseeable, could not
be avoided or provided for, and which has caused the non-performance or delay in
performance. Without limitation to the generality of the foregoing, the term Force
Majeure shall include natural phenomena or calamities, earthquakes, typhoons, fires,
wars declared or undeclared, hostilities, invasions, blockades, riots, strikes, insurrection
and civil disturbances but shall not include the unavailability of funds.”
• Section 3 of the PSC dealing with the accounting procedure lays down the following
with the respect to costs not recoverable and not allowable under the Contract.
“The following costs and expenses shall not be recoverable or allowable (whether
directly as such or indirectly as part of any other charges or expense) for cost recovery
and profit sharing purposes under the Contract :
(xi) costs and expenditures incurred as a result of misconduct or negligence of the
Contractor; “
Stock price is implying nil value for RIL’s E&P segment
Exhibit 1 gives our SOTP-based fair valuation of RIL. We value RIL stock without its E&P,
retailing and SEZ segments at `786/share with (1) the refining and petchem segments
contributing to `567/share and (2) cash, capital wip and liquid investments (including loans
and advances) at `219/share. This implies that the market is not ascribing any value to RIL’s
E&P business, which seems to be an overly pessimistic assumption. We admit that the
market may be ascribing lower multiples to RIL’s refining and chemical segments given a
bleak global economic outlook. However, we believe that cyclicality of a business should not
change its value over time and the multiples should be adjusted appropriately to reflect the
earnings cycle.
Revised earnings; maintain BUY with a target price of `1,000
We have revised our FY2012E, FY2013E and FY2014E EPS estimates for RIL to `69.2, `71.1
and `74.6 versus `67.4, `74.9 and `80.4 previously to reflect (1) lower gas production from
KG D-6 block, (2) lower refining and petchem margins, (3) revised exchange rate assumption
for FY2012E and (4) other minor changes. We maintain our BUY rating on the stock with a
revised SOTP-based target price of `1,000 (`1,045 previously). Exhibit 2 & 3 gives our key
assumptions for RIL’s refining and chemical segments and Exhibit 4 gives a financial
summary.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Reliance Industries (RIL)
Energy
To be or not to be. We believe any potential restriction of cost-recovery from RIL’s KG
D-6 block due to lower-than-expected production would be contingent on the (1) terms
of the production sharing contract (PSC) and (2) the actual production achieved over
the life of the asset. We are not privy to the actual PSC signed between RIL and the
government; however, we try to evaluate the impact on RIL based on the terms of the
model PSC. We maintain our BUY rating on RIL stock given 27% potential upside to our
revised SOTP-based target price of `1,000 (`1,045 previously).
Media reports on potential non-allowance of cost recovery (proportionately) from KG D-6 block
given lower-than-expected production
As per media articles, the oil ministry is planning to restrict cost-recovery of development costs for
KG D-6 block to US$3.4 bn versus actual capital expenditure of US$5.7 bn on D-1 and D-3 fields
in proportion to the current gas production of 37 mcm/d from D-1 and D-3 fields versus 61.9
mcm/d of planned gas production; RIL has already recovered US$5.3 bn of development costs till
date. We believe that any potential impact on RIL would depend on (1) terms of the production
sharing contract, (2) eventual production achieved over the life of the asset and (3) the actual
cause of lower-than-expected production from the block. RIL is likely to challenge any such move
in the courts as per media reports. We discuss the various possibilities that may emerge from any
potential restriction on cost recovery.
Scenario A: RIL eventually ramps up production to 80 mcm/d
We do not see a meaningful impact in this scenario as RIL will be able to recover the entire
exploration and development cost once it ramps up production to a peak level of 80 mcm/d from
its D1 and D3 fields. We do not see a meaningful impact on our fair value of RIL assuming that the
company will be allowed to recover the entire capex once it ramps up gas production to peak
levels. We note that the restriction of cost recovery will be a timing issue in this scenario.
Scenario B: RIL is not able to ramp up production to 80 mcm/d during the life of the asset
If RIL is unable to ramp up production from its KG D-6 field to its peak level, it would suggest a
change in reservoir behavior versus initial expectations. The eventual outcome and liability in this
scenario will likely be dependent on the reason for lower production. We doubt that a penalty
could be imposed on the contractor unless it is able to prove misconduct or negligence on the part
of the contractor. We provide the relevant sections of the PSC that deal with the non-allowance of
costs (Section 3.2) and force majeure (Article 31.2) that deal with the relevant issue. In a force
majeure event of the company not being able to ramp up gas production from its KG D-6 block,
RIL may be allowed to recover the full capex as it was expensed in line with the field development
plan, along with requisite approvals from MOPNG and DGH.
Relevant extracts from the model production sharing contract (PSC)
We provide the relevant provisions from the model PSC which deal with the issue of cost
recovery.
• Article 8.1 states, “Subject to the provisions of this Contract, the Contractor shall have
the following rights:
(a) subject to the provisions of Article 12, the exclusive right to carry out Petroleum
Operations to recover costs and expenses as provided in this Contract. The right
shall exclude exploitation of coal/lignite bed methane (CBM) by the Contractor in
the Contract Area.”
• Article 31.1 of the PSC states, “Any non-performance or delay in performance by any
Party hereto of any of its obligations under this Contract, or in fulfilling any condition of
any License or Lease granted to such Party, or in meeting any requirement of the Act,
the Rules or any License or Lease, shall, except for the payment of monies due under
this Contract or under the Act and the Rules or any law, be excused if, and to the extent
that, such non-performance or delay in performance under this Contract is caused by
Force Majeure as defined in this Article.”
• Article 31.2 of the PSC states,” For the purpose of this Contract, the term Force Majeure
means any cause or event, other than the unavailability of funds, whether similar to or
different from those enumerated herein, lying beyond the reasonable control of, and
unanticipated or unforeseeable by, and not brought about at the instance of, the Party
claiming to be affected by such event, or which, if anticipated or foreseeable, could not
be avoided or provided for, and which has caused the non-performance or delay in
performance. Without limitation to the generality of the foregoing, the term Force
Majeure shall include natural phenomena or calamities, earthquakes, typhoons, fires,
wars declared or undeclared, hostilities, invasions, blockades, riots, strikes, insurrection
and civil disturbances but shall not include the unavailability of funds.”
• Section 3 of the PSC dealing with the accounting procedure lays down the following
with the respect to costs not recoverable and not allowable under the Contract.
“The following costs and expenses shall not be recoverable or allowable (whether
directly as such or indirectly as part of any other charges or expense) for cost recovery
and profit sharing purposes under the Contract :
(xi) costs and expenditures incurred as a result of misconduct or negligence of the
Contractor; “
Stock price is implying nil value for RIL’s E&P segment
Exhibit 1 gives our SOTP-based fair valuation of RIL. We value RIL stock without its E&P,
retailing and SEZ segments at `786/share with (1) the refining and petchem segments
contributing to `567/share and (2) cash, capital wip and liquid investments (including loans
and advances) at `219/share. This implies that the market is not ascribing any value to RIL’s
E&P business, which seems to be an overly pessimistic assumption. We admit that the
market may be ascribing lower multiples to RIL’s refining and chemical segments given a
bleak global economic outlook. However, we believe that cyclicality of a business should not
change its value over time and the multiples should be adjusted appropriately to reflect the
earnings cycle.
Revised earnings; maintain BUY with a target price of `1,000
We have revised our FY2012E, FY2013E and FY2014E EPS estimates for RIL to `69.2, `71.1
and `74.6 versus `67.4, `74.9 and `80.4 previously to reflect (1) lower gas production from
KG D-6 block, (2) lower refining and petchem margins, (3) revised exchange rate assumption
for FY2012E and (4) other minor changes. We maintain our BUY rating on the stock with a
revised SOTP-based target price of `1,000 (`1,045 previously). Exhibit 2 & 3 gives our key
assumptions for RIL’s refining and chemical segments and Exhibit 4 gives a financial
summary.
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