Buy Reliance Industries: KG-D6 impasse further exacerbates; Reliance begins arbitration proceedings against government: Nomura

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COMPANY QUICK COMMENT
Reliance has begun arbitration ahead of the government’s likely move of restricting cost recovery, on the grounds of lower-than-expected production. The PSC has no such provisions of restricting cost recovery. On our estimates, if cost recovery of US$2.0-2.5bn is not allowed, RIL’s NAV declines by a modest INR15-20/sh. But such a decision would be a further set-back in an already deteriorated E&P environment in India. Arbitration proceedings could be long drawn and extend the current E&P impasse. We maintain Buy as valuations remain undemanding, but note key E&P triggers remain elusive.

KG-D6 impasse further exacerbates; Reliance begins arbitration proceedings against government

To settle the cost-recovery issue, and ahead of the government’s planned move of limiting cost recovery, Reliance has begun arbitration proceedings against Government of India (GoI).

· Reliance’s decision has come based on press reports that Ministry of Petroleum and Natural Gas (MoP&NG) would seek to restrict the amount of the cost recovered by the company from revenues generated by sale of gas.

· Media had earlier reported that Solicitor General of India (SGI) opined that “the cost/expenditure incurred in constructing production/ processing facilities and pipelines that are currently underutilized/have excess capacity cannot be recovered”. (“No cost recovery of underutilized facilities for RIL: Solicitor General of India”, Economic Times, 14 Sep 2011)

· Last week, as per media reports, the MoP&NG secretary had indicated that the Law Ministry had given an opinion (likely agreeing with SGI opinion), and the Ministry was considering action again Reliance Industries in 3-4 weeks. (“Action against Reliance in three-four weeks: G C Chaturvedi, Oil Secretary”, Economic Times, 22 November 2011)

· As per Reliance’s press release, the company had sought confirmation of such action from MoP&NG, and on receiving no such confirmation has initiated the arbitration proceedings.

· As per RIL, the PSC has no provision which entitles the GoI to restrict the cost recovered by the company by reference to factors such as the level of production or the extent to which field facilities are utilized. In the media report (quoted above) the MoP&NG secretary had indicated that the government is studying the PSC provision and the government will not hesitate to “amend the PSC if required”.

Our view:

· We believe that the beginning of arbitration further exacerbates the impasse on KG-D6 block and also the overall E&P investment climate in India.

· We see limited impact of such cost-recovery disallowance on Reliance’s NAV. On our estimate the disallowance of US$2.0-2.5bn of investment could impact the NAV by INR15-20/share, not a material impact on our RIL’s SOTP value of INR1, 060/share.

· However, such arbitration proceedings and also the planned move (if true) to amend the existing Production Sharing Contract, primarily to penalize contractors, would be a negative for further and much needed investments in Indian E&P, in our view.

· In recent years, investor concerns on E&P have significantly increased over regulatory and policy uncertainties. These have included government’s move to decline tax holiday on gas, government’s interference in pricing and marketing of gas, long delays in approval process of discoveries, work programs and budgets, etc.

· Government’s tough stance on royalty and cess issue while approving Cairn India ownership change (a virtual arm-twisting, in our view) has also not gone down well with investors in our view.

Such policy/regulatory uncertainties, is reflected in significantly reduced interest in new NELP rounds, and also significantly curtailed exploration & development efforts in recent years.

We continue to like Reliance Industries (Buy, PT 1,060). Valuations remain undemanding after significant under-performance over last two years. However, near term concerns remain on negative news-flow on E&P. We continue to believe in long-term potential of its large E&P acreage, but triggers in near-term remain elusive.