GAIL is likely to find it challenging to get customers for the 5.8 mmtpa import contracts it has signed with US companies. A hit of $1/mmBtu on these long-term take-or-pay contracts could wipe out 20% of its EBITDA. Incremental benefits from transmission, trading and petrochemicals are limited. Return ratios are likely to be under stress due to capex on long-gestation pipeline projects. We revise our stock rating to Sell. Our target price of `357 implies 11% downside.
US shale contracts turn expensive in current environment
GAIL has a total of 5.8 mmtpa contracts signed with two US companies — 3.5 mmtpa with Cheniere and 2.3 mmtpa with Dominion Cove. Due to high liquefaction and transportation cost, they are priced 20-30% higher than spot LNG in Asia-Pacific. As a result, GAIL has been unable to find customers, though off-take is expected to commence latest from early 2018. We do not see destination change to Europe as very lucrative due to low pricing environment in Europe. Unless the central government initiates some policy intervention to take care of these volumes, we expect a hit of `20 billion annually for every $1/mmBtu decline in realisation.
Transmission volumes to grow steadily, but utilisation still low
With an increase in domestic gas production and LNG consumption, we expect GAIL’s gas transmission volumes to increase 5% in FY18 and 10% in FY19. While final tariffs of six pipeline networks have been finalised, the final initial tariffs of the HVJ pipeline and DUPL/DPPL are yet to come. After assuming 1%/6% annualised growth in blended gas transmission tariff in FY18/19, we arrive at 6%/16% growth in gas transmission EBITDA in FY18/19.
Petrochemical segment stabilises, but margins may be under pressure
We expect 90% utilisation of Pata in FY18 and 95% in FY19. However, due to large expansion of 30% in US ethylene capacity in the next 2-3 years, we expect margin compression. We assume 4-8% decline in margins, going forward. Due to lower utilisation of 64% in FY17, we expect petchem segmental EBITDA to increase by 34% in FY18 and 8% in FY19.
LPG segment margins too may be under stress
Led by low gas cost and a rise in oil prices, EBITDA for the LPG segment is likely to grow 26% in FY18 but at a slower 15% in FY19. 60% of global LPG is gas-based and the rest is from refining. Increase in US shale gas-based LPG is likely to put long-term margins under stress.
Valuation and view
Led largely by the petrochemicals and LPG segments, we expect EBITDA to increase by 24% in FY18. Gas transmission and LPG would further support 11% increase in EBITDA in FY19. EPS should grow 22% in FY18 and 15% in FY19. However, RoE at 12.5% and RoCE at 10.7% for FY19 would still remain 5% lower than a decade ago due to increased balance sheet size. Threat of losses on US shale gas import contracts looms large and may wipe out 20% of EBITDA for each $1/mmBtu loss. We value GAIL using SOTP at `357/share, implying ~11% downside. The core business is valued at 9x FY19E EPS adjusted for other income. We add another `87 for listed and unlisted investments. We downgrade the stock to Sell.
Supply glut to keep LNG prices low
Against a capacity of 340 mmtpa, the global LNG trade in 2016 stood at 258 mmt, implying 76% utilisation. International Gas Union (IGU) estimates liquefaction capacities under construction at 115 mmtpa. Additionally, 700 mmtpa of projects have been proposed, though most of these may not see light of the day due to weak prices. Yet, if prices were to rise, some of these would be implemented, thereby keeping prices under check.
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US contracts expensive
GAIL has a 20-year contract to buy 3.5 mmtpa of LNG from Cheniere’s Sabine Pass LNG terminals. The contract has a fixed charge of $3/mmBtu and variable charge of 115% of Henry Hub. We estimate that in the current environment, US LNG would be 30% more expensive than prevailing spot prices in the Asia Pacific. GAIL has another contract with Dominion Cove Point for utilising 2.3 mmtpa of its capacity from the terminal expected to be commissioned in 2HCY17. Liquefaction charges are also similar to those at Cheniere’s Sabine Pass LNG terminal. This would also have the same economic disadvantage as Cheniere’s LNG.