Oil & Gas - Hope of reforms fading? 􀂄 :: BofA Merrill Lynch

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Oil & Gas
Hope of reforms fading?
􀂄 Reforms outlook poor for next 2 years; risk of de-rating
A hike in petrol and diesel prices was expected after the state elections, which
ended on March 3. However, there were no hikes last week and no hikes appear
to be likely during the ongoing Parliament session. The state election results have
increased the dependence of the government on allies, who have opposed
product price hikes. We believe petrol and diesel prices may be hiked in June
2012 or later if oil price remains high or strengthens and the rupee remains weak
or weakens further. However, the political scenario suggests poor outlook for
reforms until the term of this government ends in mid-2014. Oil PSUs may be derated
if indeed there is no significant progress on reforms, oil price remains high
or the rupee remains weak.
Higher subsidy share main risk to upstream FY12 earnings
9M FY12 recurring profit of ONGC and Oil India (OIL) was up 20-31% YoY
despite upstream share in subsidy being 37.9% (33% in 1H). We expect ONGC
and OIL’s FY12E earnings to be up 22-31% YoY if subsidy sharing is on the same
basis as in 9M. However, upstream companies’ share in subsidy could rise to 42-
43% if R&M companies are not able to bear too much subsidy. In that case,
ONGC and OIL’s FY12E earnings growth would be lower at 6-17%.
If no reforms higher risk of adverse subsidy sharing in FY13
FY13 subsidy would be Rs1.48tn (US$29.5bn) at Brent price of US$112/bbl and
exchange rate of Rs50 if there are no price hikes. Hefty price hikes are required to
significantly cut subsidy. FY13 subsidy will remain high if there is no or only
modest hikes in subsidized products in the next 12 months. When subsidy is high
the risk of upstream share in subsidy being disproportionately high also goes up.
Sharp fall in oil price & stronger rupee could improve outlook
15-54% hike in subsidized products and excise and import duty cut on diesel and
petrol since June 2010 has cut subsidy by US$26bn. However, high oil prices and
a weak rupee has meant that subsidy is high despite the price hike and tax cut.
However, FY13 subsidy would be sharply lower at US$8.6bn if Brent declines to
US$90/bbl and the rupee appreciates to Rs45.
APM gas price hike may be easier than oil subsidy reforms
Press reports indicate that the government is considering a hike in KG D6 gas
price of Reliance Industries (RIL). If indeed KG D6 gas price is hiked, we believe
a similar hike in regulated (APM) gas price of ONGC and OIL cannot be ruled out.
APM gas price hike may be politically easier than a hefty hike in diesel, LPG and
kerosene price. Upside to FY13E EPS of ONGC would be Rs4.2 (13%) and to
OIL's EPS Rs19.2 (14%) if gas price is hiked to US$6/mmbtu from April 2012
according to our estimates. A hike in APM gas price would boost OIL and
ONGC’s EPS to the same extent as 5-6% diesel price hike.



Price objective basis & risk
Oil India Ltd (XLCRF; INR1269.85; C-1-7)
Our sum-of-the-parts PO of Rs1,618 includes the DCF value of its 2P reserves
(Rs1,150), best-case resources (Rs18) and exploration upside (Rs66). It also
includes net cash (Rs354), value of the product pipeline on an EV/EBITDA basis
(Rs28) and investments at cost (Rs20). We have used a WACC of 13.6pct to
calculate DCF value. The DCF value is based on a long-term Brent price forecast
of US$95/bbl. However, given our subsidy assumptions, the PO is effectively
based on oil price realization net of subsidy of US$68.1/bbl. We think that DCF is
the most appropriate measure to value E&P assets. Downside risks are (1)
Standard oil and gas industry operating risks, which include exploration,
development and production risks, oil price fluctuations, currency risk and reserve
estimation, (2) sovereign risks, which are changes in the government and/or
policies (e.g., withdrawal of the tax holiday), which may have a direct impact on
the business, cash flow and profit, (3) OIL's subsidy hit being higher than
assumed by us, (4) terrorist attacks in North East India, causing significant
damage to OIL's installations and facilities. Upside risks are: (1) Reforms that
permanently reduce or eliminate OIL's subsidy hit, (2) Large oil or gas discovery
leading to significant reserve and value accretion.
ONGC (XOFOF; INR293.75; C-1-7)
Our DCF-based PO of Rs358 incorporates the DCF of 2P reserves, 2C resources
and exploration upside in Rajasthan of Rs310/share. Of this, value for 2P
reserves, 2C resources and exploration upside in Rajasthan is Rs31/share. PO
also includes net cash of Rs26/share and market value of investments of
Rs21/share. We have assumed WACC of 12.9pct while calculating DCF value.
DCF value is based on long-term Brent price forecast of US$95/bbl. However, our
fair value is effectively based on long-term oil price net of subsidy of US$69.2/bbl
given our subsidy assumptions. We think that DCF is the most appropriate
measure to value E&P assets. Risks are (1) Standard oil and gas industry
operating risks which include exploration, development and production risks, oil
price fluctuations, currency risk and reserve estimation, (2) ONGC's subsidy hit
being higher than assumed by us, (3) sovereign risks, which include changes in
the government and/or policies which may have a direct impact on the business,
cash flow and profit, and (4) Significant decline in value of ONGC's investments in
IOC and GAIL.