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Energy
India
Watch out for collateral damage. We see a modest impact on the earnings of GAIL
and RIL from potential regulation of marketing margins by the PNGRB on sale of natural
gas. However, we see significant risks to the earnings of PLNG and city gas distribution
companies (Indraprastha Gas and Gujarat Gas) if PNGRB’s mandate is extended to
re-gasification or distribution tariffs. We would wait for finalization of marketing
margins by PNGRB before reviewing our earnings estimates of GAIL and RIL. We would
exit PLNG and gas distribution companies noting their rich valuations and bullish market
expectations of their earnings and prospects.
PNGRB to regulate marketing margins on sale of natural gas
As per media reports, the Ministry of Petroleum and Natural Gas (MoPNG) has mandated the
Petroleum and Natural Gas Regulatory Board (PNGRB) to regulate the marketing margins on sale
of natural gas on the basis of marketing costs incurred by marketing entities. We see a very
modest negative impact on the earnings of the gas marketing segments of GAIL and RIL from
potential regulation of marketing margins by the PNGRB. We note that the US$0.135/mn BTU
marketing margin earned by RIL is quite small relative to RIL’s wellhead price of US$4.2/mn BTU
for gas produced from the KG D-6 block.
PLNG and gas T&D companies may be collateral victims if PNGRB’s mandate is extended to them
We see significant risks to the earnings of PLNG and city gas distribution (CGD) companies (IGL,
Gujarat Gas) if the PNGRB’s mandate is extended to them. We note that PLNG and city gas
distribution companies earn very high returns/profitability from sale of gas and their tariffs/margins
have virtually no link to underlying costs. In our view, re-gasification tariffs, transmission tariffs,
distribution tariffs and marketing margins are similar in nature since they constitute the final price
of gas to the consumer along with the base (wellhead or imported) price of gas. There is no reason
to believe that PNGRB will examine the costs related to marketing of gas by RIL only when other
companies such as LNG import terminals, transmission companies and city gas distribution
companies also sell/market gas.
Low clarity on methodology and timing but PNGRB may have to act expeditiously
We would wait for clarity on the methodology of determining costs and the nature of PNGRB’s
mandate to factor the impact of potential changes to margins and tariffs in our earnings estimates
of the relevant companies. Nonetheless, we analyze the impact from any proposed regulation
based on the current earnings of the marketing segments of GAIL and RIL. We note that the
PNGRB may be forced to act expeditiously, in this case, driven by the MoPNG’s directive.
Nonetheless, a mere whiff of regulation would be negative for PLNG and CGD stocks
We have long highlighted our concerns about the high returns/profitability of gas companies given
weak implementation of regulations (see our September 7, 2011 report titled A matter of (anti)
trust by our Strategy team). We see the proposed initiative on regulating marketing margins as a
step in the right direction as it is likely to control the super-normal profits of certain gas
distribution entities, which reflects (1) their monopoly status and (2) large arbitrage between prices
of liquid fuels and gas. We have been a proponent of regulating returns of T&D companies in India
given the utility nature of their business.
Modest risk to earnings of GAIL and RIL
The risk to earnings of GAIL exists but the impact may not be significant. We see
downside risk to the profitability of the trading segment of GAIL from potential regulation
of marketing margins by the PNGRB. However, we see a moderate risk to GAIL’s
profitability given that it charges MoPNG-determined marketing margins of `200/cu m
(US$0.112/mn BTU) on marketing of natural gas produced by ONGC and Oil India. In
addition, we highlight that GAIL does not earn marketing margins on KG D-6 gas.
Exhibit 1 shows the operating profits of GAIL’s trading segment from FY2007. We
highlight that the increase in the trading profits in FY2011 reflects the Government’s
decision to allow GAIL to charge marketing margins of USC11.2/mn BTU from June 1,
2010 as part of the revision in APM gas price. GAIL’s trading profits accounted for 15.2%
of its EBIT in FY2011. The share of trading profits was smaller in earlier years as it was
restricted to R-LNG and PMT gas only. The share of trading profits was only 8.2% in
FY2010.
We admit that GAIL would have benefited from a sudden surge of demand for LNG
cargoes in 1HFY12 and hence earned additional profits from ‘trading’. We note that
GAIL’s average margin from its trading business was US$0.23/ mn BTU in 1HFY12 against
US$0.15/mn BTU in FY2011 and reflects very high margins on spot LNG cargoes.
Very modest risk to RIL’s earnings. We see a very small downside risk to RIL’s earnings
from the proposed regulation on marketing margins on gas produced and sold from its
KG D-6 block. We note that RIL charges marketing margins of US$0.135/mn BTU on gas
supplied from its KG D-6 block. These are moderately higher than the MoPNG-allowed
marketing margins of `200/cu m (US$0.112/mn BTU) on marketing of natural gas
produced by ONGC and Oil India. We highlight that marketing margins on gas account
for less than 1% (`0.6-0.7) of RIL’s FY2012E-14E EPS.
High marketing margins on spot LNG imports by PLNG may not be sustainable
We see downside risks to high marketing margins charged by PLNG on spot LNG imports
from potential regulation of marketing margins on sale of natural gas. The definition of
natural gas as per the PNGRB Act 2006 includes imported LNG. We note that PLNG’s
earnings in recent years have been boosted by high margins earned on spot LNG.
We also see significant downside risks to the core earnings of PLNG if the PNGRB’s mandate
is extended to re-gasification tariffs of LNG import terminals. We clarify that the regasification
charges are presently outside the purview of the regulator. However, we believe
a review could result in significant downside risks to PLNG’s earnings given its (1) current
high re-gasification tariffs and (2) policy of 5% annual escalation in re-gasification tariffs,
which seems unreasonable given predominantly fixed costs of operations. Exhibit 3 gives the
RoAE, RoACE and CRoCI of PLNG for FY2006-12YTD
Significant risk to earnings of CGD companies (IGL, Gujarat Gas)
We expect CGD companies to be impacted most by the proposed regulation of marketing
margins given the composition of their profits. In our view, there is no distinction between
regulated distribution tariffs and marketing margins of CGD companies—selling price less
costs equals profitability (some combination of distribution tariff and marketing margin) on a
per unit basis. It indeed appears that CGD companies charge inordinately high marketing
margins since their returns are well above regulated levels. Exhibit 4 shows that the RoAE,
RoACE and CRoCI of IGL and Gujarat Gas are almost 2X regulated levels.
We doubt CGD companies would be able to sustain their very high returns given (1)
potential cuts in transmission tariffs and/or (2) proposed regulation on marketing margins.
CGD companies are allowed to earn 14% post-tax IRR over the concession period of their
projects. Even though the methodology of regulating marketing margins has not yet been
finalized, we expect earnings of CGD companies to decline significantly if and when the
regulations are finalized. We note that the proposed regulations will ensure that the overall
returns of CGD companies would be regulated versus the market’s expectation that the
PNGRB is authorized to regulate the returns of the transmission segment only and CGD
companies can charge unregulated (and high) marketing margins.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Energy
India
Watch out for collateral damage. We see a modest impact on the earnings of GAIL
and RIL from potential regulation of marketing margins by the PNGRB on sale of natural
gas. However, we see significant risks to the earnings of PLNG and city gas distribution
companies (Indraprastha Gas and Gujarat Gas) if PNGRB’s mandate is extended to
re-gasification or distribution tariffs. We would wait for finalization of marketing
margins by PNGRB before reviewing our earnings estimates of GAIL and RIL. We would
exit PLNG and gas distribution companies noting their rich valuations and bullish market
expectations of their earnings and prospects.
PNGRB to regulate marketing margins on sale of natural gas
As per media reports, the Ministry of Petroleum and Natural Gas (MoPNG) has mandated the
Petroleum and Natural Gas Regulatory Board (PNGRB) to regulate the marketing margins on sale
of natural gas on the basis of marketing costs incurred by marketing entities. We see a very
modest negative impact on the earnings of the gas marketing segments of GAIL and RIL from
potential regulation of marketing margins by the PNGRB. We note that the US$0.135/mn BTU
marketing margin earned by RIL is quite small relative to RIL’s wellhead price of US$4.2/mn BTU
for gas produced from the KG D-6 block.
PLNG and gas T&D companies may be collateral victims if PNGRB’s mandate is extended to them
We see significant risks to the earnings of PLNG and city gas distribution (CGD) companies (IGL,
Gujarat Gas) if the PNGRB’s mandate is extended to them. We note that PLNG and city gas
distribution companies earn very high returns/profitability from sale of gas and their tariffs/margins
have virtually no link to underlying costs. In our view, re-gasification tariffs, transmission tariffs,
distribution tariffs and marketing margins are similar in nature since they constitute the final price
of gas to the consumer along with the base (wellhead or imported) price of gas. There is no reason
to believe that PNGRB will examine the costs related to marketing of gas by RIL only when other
companies such as LNG import terminals, transmission companies and city gas distribution
companies also sell/market gas.
Low clarity on methodology and timing but PNGRB may have to act expeditiously
We would wait for clarity on the methodology of determining costs and the nature of PNGRB’s
mandate to factor the impact of potential changes to margins and tariffs in our earnings estimates
of the relevant companies. Nonetheless, we analyze the impact from any proposed regulation
based on the current earnings of the marketing segments of GAIL and RIL. We note that the
PNGRB may be forced to act expeditiously, in this case, driven by the MoPNG’s directive.
Nonetheless, a mere whiff of regulation would be negative for PLNG and CGD stocks
We have long highlighted our concerns about the high returns/profitability of gas companies given
weak implementation of regulations (see our September 7, 2011 report titled A matter of (anti)
trust by our Strategy team). We see the proposed initiative on regulating marketing margins as a
step in the right direction as it is likely to control the super-normal profits of certain gas
distribution entities, which reflects (1) their monopoly status and (2) large arbitrage between prices
of liquid fuels and gas. We have been a proponent of regulating returns of T&D companies in India
given the utility nature of their business.
Modest risk to earnings of GAIL and RIL
The risk to earnings of GAIL exists but the impact may not be significant. We see
downside risk to the profitability of the trading segment of GAIL from potential regulation
of marketing margins by the PNGRB. However, we see a moderate risk to GAIL’s
profitability given that it charges MoPNG-determined marketing margins of `200/cu m
(US$0.112/mn BTU) on marketing of natural gas produced by ONGC and Oil India. In
addition, we highlight that GAIL does not earn marketing margins on KG D-6 gas.
Exhibit 1 shows the operating profits of GAIL’s trading segment from FY2007. We
highlight that the increase in the trading profits in FY2011 reflects the Government’s
decision to allow GAIL to charge marketing margins of USC11.2/mn BTU from June 1,
2010 as part of the revision in APM gas price. GAIL’s trading profits accounted for 15.2%
of its EBIT in FY2011. The share of trading profits was smaller in earlier years as it was
restricted to R-LNG and PMT gas only. The share of trading profits was only 8.2% in
FY2010.
We admit that GAIL would have benefited from a sudden surge of demand for LNG
cargoes in 1HFY12 and hence earned additional profits from ‘trading’. We note that
GAIL’s average margin from its trading business was US$0.23/ mn BTU in 1HFY12 against
US$0.15/mn BTU in FY2011 and reflects very high margins on spot LNG cargoes.
Very modest risk to RIL’s earnings. We see a very small downside risk to RIL’s earnings
from the proposed regulation on marketing margins on gas produced and sold from its
KG D-6 block. We note that RIL charges marketing margins of US$0.135/mn BTU on gas
supplied from its KG D-6 block. These are moderately higher than the MoPNG-allowed
marketing margins of `200/cu m (US$0.112/mn BTU) on marketing of natural gas
produced by ONGC and Oil India. We highlight that marketing margins on gas account
for less than 1% (`0.6-0.7) of RIL’s FY2012E-14E EPS.
High marketing margins on spot LNG imports by PLNG may not be sustainable
We see downside risks to high marketing margins charged by PLNG on spot LNG imports
from potential regulation of marketing margins on sale of natural gas. The definition of
natural gas as per the PNGRB Act 2006 includes imported LNG. We note that PLNG’s
earnings in recent years have been boosted by high margins earned on spot LNG.
We also see significant downside risks to the core earnings of PLNG if the PNGRB’s mandate
is extended to re-gasification tariffs of LNG import terminals. We clarify that the regasification
charges are presently outside the purview of the regulator. However, we believe
a review could result in significant downside risks to PLNG’s earnings given its (1) current
high re-gasification tariffs and (2) policy of 5% annual escalation in re-gasification tariffs,
which seems unreasonable given predominantly fixed costs of operations. Exhibit 3 gives the
RoAE, RoACE and CRoCI of PLNG for FY2006-12YTD
Significant risk to earnings of CGD companies (IGL, Gujarat Gas)
We expect CGD companies to be impacted most by the proposed regulation of marketing
margins given the composition of their profits. In our view, there is no distinction between
regulated distribution tariffs and marketing margins of CGD companies—selling price less
costs equals profitability (some combination of distribution tariff and marketing margin) on a
per unit basis. It indeed appears that CGD companies charge inordinately high marketing
margins since their returns are well above regulated levels. Exhibit 4 shows that the RoAE,
RoACE and CRoCI of IGL and Gujarat Gas are almost 2X regulated levels.
We doubt CGD companies would be able to sustain their very high returns given (1)
potential cuts in transmission tariffs and/or (2) proposed regulation on marketing margins.
CGD companies are allowed to earn 14% post-tax IRR over the concession period of their
projects. Even though the methodology of regulating marketing margins has not yet been
finalized, we expect earnings of CGD companies to decline significantly if and when the
regulations are finalized. We note that the proposed regulations will ensure that the overall
returns of CGD companies would be regulated versus the market’s expectation that the
PNGRB is authorized to regulate the returns of the transmission segment only and CGD
companies can charge unregulated (and high) marketing margins.
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