Oil India: Model Upstream, Earnings ‘Down’ Stream : Nirmal Bang

Model Upstream, Earnings ‘Down’ Stream After a surge of ~10% in Oil India’s stock price over the past one month on the back of softening crude oil prices, the valuation looks stretched with the market ignoring the twin blows of cess implementation from FY13 and the change in upstream subsidy distribution. We believe that given the change in the subsidy calculation method clubbed with its increasing exposure to unregulated oil, ONGC could emerge as a better play in Indian upstream space. We assign a Sell rating to Oil India with a target price of Rs450 as we believe all positives are priced in.

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Subsidy math may hurt profitability: In 4QFY12, the government changed its methodology to compute upstream subsidy distribution between ONGC and Oil India on the basis of volume, discontinuing its earlier practice of computation on the basis of profits. We expect crude oil sales ratio of Oil India to ONGC at 15.3%/15.5% in FY13E/FY14E (ratio key determinant for subsidy distribution), respectively, implying that under the new subsidy mechanism Oil India’s subsidy burden would rise to 14.8%/14.9% in FY13E/FY14E, respectively, from 13.4% in FY12 and 10.9% in FY11. With the double whammy of new subsidy mechanism and higher cess from FY13E, its 3-year earnings CAGR is likely to ease to 1% over FY12-15E from 16.0% over FY09-12. We expect Oil India to post net realisations of US$56.24/58.60/bbl in FY13E/FY14E, respectively, compared to US$60.3/bbl in FY12. On account of the new subsidy methodology, our EPS estimate is 8.8%/9.3% lower than consensus estimates for FY13E/FY14E. Nomination blocks’ volume growth better than that of ONGC: Oil India’s volume growth(O+G) from nomination blocks is expected at 6%/6%/9% in FY13E/FY14E/FY15E, better than that of ONGC at 5%/3%/6%, respectively, for the same period, but at the consolidated level, ONGC’s volume growth outpaces that of Oil India. While Oil India’s entire crude oil output is considered for subsidy computation, ONGC’s rising number of joint ventures (particularly, the Rajasthan field) along with ONGC Videsh (OVL) account for ~29% of ONGC group’s output in FY13 would be sold at market-determined rates. Return ratios turning unfavourable on twin regulatory blows: We expect the RoAE of Oil India to decline to 17%/16.2% in FY13E/FY14E, respectively, compared to the past five years’ average of 22.4% due to the following factors: (1) Lower realisation compared to previous years, (2) Increased cost structure because of more number of horizontal wells and J drilling, (3) Rising dry well costs on account of venturing into geographies other than the northeast India region Valuation stretched after the recent run-up: Oil India trades at 8.8x FY13E earnings and 1.4x its FY13E book value, with RoE declining to 17.0%. We value the stock on a weighted average basis with a target price of Rs450. We believe it is likely to trade at a 10% discount to target multiple of 9x of ONGC to reflect: (1) The company’s smaller size, (2) Presence only in one geography and no proven operational record outside its existing domain, (3) Risk pertaining to use of the significant cash balance, and (4) Higher exposure to subsidies.