Energy: Floored but may rise :: Kotak Securities

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Floored but may rise. We believe global crude oil prices are unlikely to fall further as
we see near-term curtailment in production of high-cost shale oil in the US and oil
sands in Canada, which may reduce the current excess supply. IEA’s current supplydemand
estimates also suggest the call on OPEC crude will increase to nearly 30 mn b/d
(current production quota) in 2HCY15. We see recovery in oil prices to US$60-70/bbl
over the next 12 months; however, the stocks are already discounting that.

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Moderate reduction in rigs deployed in the shale regions of the US over the past two months
The weekly rig count data disclosed by Baker Hughes suggests a moderate reduction in rigs
deployed in the US over the past two months, reflecting reduction in drilling activities in the
shale regions after the recent sharp correction in global oil prices, which has deteriorated the
economics for US shale players. We expect reduction in rig deployment to continue in the near
term given lower crude prices, which will result in moderation of growth in US shale oil
production—essential to provide a balance to the global oil supply-demand. Exhibits 1-3 show
(1) 11-15% reduction in rigs deployed in key shale regions of Eagle Ford, Permian and Williston,
(2) 9% reduction in rigs deployed in horizontal drilling activities and (3) 13% reduction in rigs
deployed in oil wells, over the past two months. Exhibit 4 shows that rigs deployed in the US
shale regions had declined significantly in 1HCY09 after a sharp decline in global oil prices; we
expect a similar reduction over the next few months.
Canadian crude price have fallen to cash cost of oil sands production
We also see the possibility of curtailment of oil sands production in the near term and note that
Western Canada Select crude price has declined to US$34/bbl (see Exhibit 5), near the direct
cash cost of production of US$31-34/bbl for oil sands (Suncor’s guidance). We note that oil
sands contribute to about 2 mn b/d of crude oil production. Exhibit 6 shows Suncor’s cash cost
of production (ex-royalty) has been around US$40/bbl.
IEA estimates an increase in call on OPEC crude to nearly 30 mn b/d in 2HCY15
IEA’s supply-demand forecasts suggest an increase in call on OPEC crude production to nearly
30 mn b/d in 2HCY15, after a recent cut in non-OPEC production estimates (see Exhibit 7). We
expect moderation of growth in non-OPEC crude supply, which may increase the call on OPEC
crude. Ongoing issues in Libya and build-up of China’s strategic reserves may also help in
reducing excess barrels in the near term. Media articles suggest that crude oil production in
Libya declined to 0.2 mn b/d currently from 0.9 mn b/d in October 2014. China’s crude imports
increased sharply to 7.2 mn b/d in December 2014 versus an average of 6.2 mn b/d in CY2014,
presumably reflecting a build-up in strategic reserves.
Upstream stocks and GAIL are discounting recovery in crude prices to US$60-70/bbl
We see recovery in oil prices to US$60-70/bbl as the sweet spot for upstream companies and
GAIL, as it will provide some comfort regarding their profitability. However, current stock prices
are discounting a higher crude price scenario, in our view. Exhibit 8 shows that these stocks
have corrected modestly compared to a rather sharp decline in crude prices. Exhibit 9 shows our
FY2016 EPS estimates of ONGC, OIL, Cairn and GAIL at various levels of crude oil prices. ONGC
and OIL stocks trade at 10.6X and 8.5X FY2016E EPS, assuming Dated Brent crude price of
US$60/bbl and nil burden of subsidy. GAIL trades at 13.4X FY2016E EPS assuming Dated Brent
crude price of US$70/bbl and nil subsidies. Exhibit 10 shows our fair valuation of Cairn India at
various crude prices; the current stock price discounts US$74/bbl of Dated Brent crude price,
assuming 1.5 bn bbls of gross recoverable reserves from the Rajasthan block.


LINK
http://www.kotaksecurities.com/pdf/indiadaily/indiadaily21012015mo.pdf