Asia insight: reforms on a roll

Updated: Feb 11 2013, 08:47am hrs
Full reform implementation could lift industry profits by more than 50% in two years

The Indian government seems to be on a roll in executing various reforms in the nations oil industry. Even if half its strategy works, industry profitability would still improve. In our view, full reform implementation could lift industry profits by more than 50% in two years and lower the fiscal deficit by 68 bps. In our base case, we assume a 20% profit rise. We upgrade ONGC and HPCL to overweight and GAIL to equal-weight. BPCL remains our top pick because of its E&P hedge.

Diesel accounts for the majority of the fuel subsidy: Diesel accounts for 54% of Indias overall petroleum subsidy. It is categorised into two sections: (i) Bulk consumersaccounting for 18% of volumes; (ii) Retail consumers - accounting for 82% of volumes.

The government decontrolled the bulk diesel selling price on January 18. Since then, the price increased by 25%, marking to market losses and even providing marketing margins for the operators. Approximately 8% of sales volumes for BPCL and HPCL come from bulk diesel. Lowering diesel volumes has lowered overall subsidy by 9%, and this should increase industry profitability by almost 10%. This is equivalent to raising prices by R2 per litre overall in diesel.

The oil companies have also raised the pretax retail price of diesel by R0.45 per litre (post-tax by over R0.5 per litre ) across the country. OMCs (oil and marketing companies) can do small diesel price hikes on a regular basis. We understand this would be without the intervention of the Cabinet, and thus a lot timelier. Our discussions with various industry players also suggest that the intention is to raise prices on a monthly/timely basis over 24 months to nullify/reduce the entire diesel subsidy. We project that every hike of R1/litre in diesel prices has the following effects: (i) It lowers subsidy by R70 billion and fiscal deficit by 0.04%, (ii) It increases ONGCs earnings by 5%, GAILs by 3%, BPCLs by 5%, and HPCLs by 7%.

Further downside to subsidy is possible: Earlier in the Budget 2011, the government had announced its intention to move toward such a system for SKO and LPG. A Task Force was formed under Nandan Nilekni which recommended use of these cards to identify the target group and then transfer the entitled subsidy directly to their bank accounts.

The pilot scheme is currently under implementation in a few districts (Alwar, Mysore) in the country. Once the pilot success is established the government is hopeful that it will be able to roll out the programme across the entire nation in next two-three years. As per the government, the subsidy on kerosene is targeted for people who are Below the Poverty Line. Currently the government sells subsidised kerosene through a public distribution system (PDS). The government is of the view that over 20% of kerosene volumes are being diverted and not used by the targeted group. The government is aiming to eliminate this problem by directly identifying the target group through the use of the Aadhar Card. In our base case, we do not assume any savings from the direct transfer scheme, but we think SKO subsidy could decline by 20% if the scheme were to be implemented across the country.

Potential for downside in Indias fiscal deficit: We estimate the current subsidy on diesel was R9.5 per litre pre-tax and R13 per litre post-tax before the Indian government revised prices on January 18, 2013. Including the current price hike, it would take 24 months to revise prices at R0.5 per litre post-tax to remove the overall subsidy. In our base case, we assume a midway diesel subsidy reductionvia a price hike of R5 per litre through FY14.

This would lower the subsidy by 29% in FY14 and 39% in FY15 from FY13 levels. Also assuming a disproportionate share in the savings for the Indian government its subsidy share could go lower to 50% from current 60% in F2012/13e. This implies that the government would bear R562 billion as against R960 billion the previous year, as saving of 46 bps in the fiscal deficit. The savings would increase to 58 bps in FY15 and FY16, which have the full impact of the price hike.

In our bull case, we assume a price hike of R10 per litre pre-tax including a marketing margin for the OMCs. This would get the fiscal deficit savings up to 68 bps in FY15, largely keeping savings similar in FY14 for the government. Assuming the USD-INR exchange rate moves down from the current level of R54.5 per dollar to R50 per dollar, the overall diesel under-recovery would fall to R6.5 per litre and the fiscal saving could inch up to 73 bps.

What is different between June 2010 and today in governments deregulation

In June 2010, the government announced that the pricing of petrol and diesel would be market-determined and raised diesel prices by R2 per litre. It also suggested that OMCs would be able to increase prices further in consultation with them. Since then, however, the government has been able neither to raise diesel prices in a regular fashion nor to curtail the subsidy burden.

However, we believe two things are quite different in the current reforms. Overall subsidy burden for FY13e has ballooned more than three times as compared to FY10. The governments share has increased from 0.2% of GDP to 0.9% of GDP in FY13e, impairing its fiscal balance. This in our view leaves no option for the government but to control the situation.

In effect, the government has increased the overall price of diesel by R2.5 per litre, now including the impact of deregulating prices for bulk customers. In our view, further frequent increases of R0.5 per litre likely imply less direct pain for consumers than large R4-5 per litre hikes announced infrequently.

Analysing the impact on OMCs: In our view, the decontrol of diesel prices influences the profitability of OMCs in two ways: (i) At the Ebitda levelOMCs are likely to earn marketing margins on diesel sales. (ii) At the net profit levelby way of reduction in interest expenses as balance sheets improve.

In our view, near-term impact on balance sheet is significant. We highlight that for OMCs, a significant part of their net debt is used to fund working capital - which in our view is bloated due to the time lag between the government announcing compensation and actual cash payout to OMCs. The delayed cash flows imply that OMCs typically need to borrow from markets/banks to manage their working capital till the time they receive the actual cash from the government.

As the subsidy burden goes down and government compensation gets timelier, we expect OMCs' working capital cycles to improve significantly, which should effectively reduce their net debt. This in our view could lead to significant savings in interest expenses (and OMCs earnings could grow materially in FY15. In addition, as the profitability for OMCs improves in future, we highlight that ROEs (return on equity) are also expected to improve in tandem. Both BPCL and HPCL registered average ROE of 11% during FY07-12, which has now declined to 7-9%. However, since we expect improvement in their profitability, we now project that ROEs should start to inch up, moving back towards their historical averages by FY15e.

Impact on upstream: We see the following two key positives, which will improve the profitability of the upstream companies: (i) Lower subsidy bill improves the net realisations for the companies, as shown in Exhibit 24, this even assuming a higher share of burden; and (ii) If gas prices reforms as suggested by the Rangrajan Committee are implemented, they could provide significant upside to earnings.

We highlight that as the subsidy burden goes down, upstream players also benefit as their net realisation increases, assuming the entire savings in subsidy reduction is not kept by the government alone. In our base case, we conservatively assume upstream to share 50% share of overall subsidy burden and in this case, we estimate, net-realisation could improve to $58 per barrel in FY14e and $60 per barrel in FY15e from FY13 YTD (year-to-date) run-rate of $48 per barrel and $55 per barrel in FY12.

BPCL remains our top pick, target R534: BPCLs stock has outperformed the Sensex by 13% since January 1 and is up 15% on an absolute basis. Despite this, we see material upside from these levels. BPCLs upstream footprint has proven to be a game changer in our view. We value BPCLs E&P business at $2.5 billion, or R197 per share, which is over 46% of its current market price of R415.

Domestic fuel marketing business, contributes less than 22% of BPCLs current value, based on our Whats in the price analysis. We believe, Bina refinery will start contributing meaningfully to earnings. BPCL owns 50% of Bina, a high complexity refinery with Nelson Complexity of 9 and capacity of 6 million tonnes per annum, which is now ramped up to run at 100% utilisation. We expect Bina to contribute 13-14% in BPCLs consolidated Ebitda and 3-6% of PAT in F2013-15e. Currently, we value BPCLs investment in Bina refinery at 1.0x P/B.

Upgrade HPCL to Overweight; target R455: HPCL is more skewed to the domestic marketing business compared to other OMCs, as 60% of its value comes from its fuel marketing business. Hence, it is a levered play on the fuel price reforms theme. We believe HPCL could see material earnings upside purely based on interest cost savings which are likely to come as the working capital situation improves with a reducing subsidy. Every R1 per litre hike in diesel, in our view, implies 7% earnings upside for HPCL assuming only interest cost savings from reduction in working capital. The stock is currently trading at 0.9x P/B which is in line with historical average and 20% discount to global peers.

Upgrade ONGC to Overweight, target R397: For FY14, we highlight that ONGC could earn net-realisation of $56 per barrel, which is on its standalone production which is likely to go up to $65 per barrel in FY15, in our view. Every dollar change in net realisation increases ONGCs earnings by 1.7%. ONGC spent $27 billion in capex (capital expenditure) over the last five years. We expect these projects to start delivering volume growth starting FY14.

If the Rangrajan Committee recommendations on gas prices are implemented, virtually doubling ONGCs gas prices, this could lead to material earnings ugrades. We see incremental EPS (earnings per share) and DCF (discounted cash flow) of R10 and R49 implying upside of 24% and 10% to our base case 2014 EPS and DCF, respectively. ONGC is trading at P/E of 9x , EV/ebitda of 3.7x on FY14e estimates, implying discounts of 25% and 18%, respectively, to global peers. Its EV/BOE of $4.9 per barrels of oil equivalent is one the cheapest among the E&P stocks under our coverage.

Morgan Stanley Research