Morgan Stanley: Gas Price Hike: Path-Breaking Gas Price Reform Executed

We have been highlighting gas price reforms as a
key industry catalyst: Media reports (CNBC-TV18,
June 27) suggest that the Indian government has
approved an increase in gas prices from US$4.2/mmbtu
now to US$8.4/mmbtu, based on the mechanism
suggested by the Rangarajan committee earlier this
year. The new gas price mechanism is believed to be
effective from April 1, 2014 and is valid for five years.
Within our coverage, the key gainers are E&P
producers ONGC and RIL: Assuming the higher gas
price of US$8.4/mmbtu and higher INR/USD of ~58, we
project upside of ~39% for ONGC and ~20% for RIL for
our F2015 earnings estimates. At constant currency, we
estimate the earnings upside at 26% for ONGC and 4%
for RIL. We highlight that the incremental EPS
contribution for RIL from gas prices is higher in F2017
and beyond, when production is expected to increase.
We estimate upside risks to our DCF value at 14% or
Rs55/share for ONGC and ~3% or Rs27/share for RIL.
GAIL is likely to face for higher gas costs for its
petrochemical and transmission division: We
assess the downside risks to GAIL’s earnings at
~10-12% and to our target price at Rs32/share.
Impact on economy and consuming groups: Of the
total domestic gas volumes of ~86mmscmd, three key
economically sensitive sectors – power, fertilizer and
LPG – consume ~67mmscmd. We see additional
burden for them of Rs197bn or 0.16% of GDP. If this
were to be completely passed on to end consumers, we
believe electricity tariffs for a gas-based plant need to be
moved >45% higher. The required increase in urea
prices would be over 60%
We maintain our estimates and await more clarity
on details of the gas price mechanism: The Oil
minister has suggested to the media that he and the
Finance minister will provide more details on Friday.

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What is the gas price formula proposed by the
Rangarajan Committee?
The Rangarajan Committee has proposed to link the prices for
domestic natural gas in India to international prices, to give
incentives to production and attract further investments into the
energy sector.
According to the proposed pricing formula, domestic gas prices
will be calculated as the average of two prices:
1) Average global producer price for Indian imports: This
is the volume-weighted average of ‘netback prices’ of
Indian LNG imports at the wellhead of the exporting
countries. These prices will therefore exclude pipeline
tariffs, liquefaction costs, shipping costs, import duties,
etc., which do not accrue due to production activity. This
would represent the average global price for Indian
imports.
2) Average of major global markets: The volume-weighted
average of natural gas prices in three major markets – the
US (Henry Hub price), UK (NBP or National Balancing
Point price), and Japan (netback price at the supply
source).
Based on the proposed formula, we estimate that natural gas
prices at US$8.4/mmbtu (Exhibit 1).
Based on media reports (CNBC-TV18, June 27) we
understand that the gas prices will be revised every quarter
based on this formula. We await more clarity from the
government on the exact mechanism of this.


Valuation Methodology and Risks
Reliance Industries: Our price target of Rs961 is derived from
our base case scenario, which is based on an SOTP valuation.
The refining and petrochemicals businesses are valued at
F2014e EV/EBITDA of 6x and 6.5x, respectively, in line with
the global average, as RIL is an integrated refining and
petrochemical player, and hence we expect it to trade in line
with global peers. The E&P business is valued as the sum of
DCF (Risk Free Rate of 8%, Beta of 1, WACC -11%) and
optional value of RIL's E&P blocks. RIL's investments are
valued at F2013e book value, and treasury shares are valued
at CMP. The price target assumes a 5% conglomerate discount
to the fair EV.
Downside risks: 1) Market correction affecting RIL (historical
correlation 0.85x); 2) Sharp decline in global economic growth;
Unfavorable exploration results; 3) Removal of the tax holiday
for the E&P business; 4) Potential delays in the execution of the
company’s business plan.
ONGC: Our price target of Rs397 for ONGC is the sum of the
DCF values of ONGC and ONGC Videsh Ltd (OVL – ONGC’s
100% subsidiary). We use Risk Free Rate of 8%, Beta of 1 and
WACC 11.5% and terminal growth of 0%. We add the value of
equity investments in IOC, GAIL and MRPL at a 15% discount
to their current market prices, to factor in market volatility.
Downside Risks: a) Delay in field developments, resulting in
slower-than-expected production growth; b) Share issue
overhang due to the possibility of 5% stake sale by the
Government of India; c) Huge capex cycle.
Upside Risks: a) Increase in gas price; b) Lower-than-
expected subsidy share; c) Better-than-expected production