Action: Earnings cut by 25-31%; not much upside in a low oil price scenario, and visibility poor on upside if oil rises; downgrade
Nomura’s global oil/gas team has cut its Brent oil price assumption by up to 21-25%.Our new oil price assumptions are $53/55/60/70/bbl for FY16F /17F /18F/long term, respectively (vs previously $60/70/80/bbl for FY16/17/LT). The reductions to our oil price and gas price assumptions plus the new subsidy formula result in 25-31% earnings estimate cuts for FY16-18F. After sharp under-performance (1-year ONGC -48% vs Sensex -5%), we believe valuations are inexpensive (trading at 0.9x FY17F P/B and 8.1x FY17F P/E), but we believe there are not many catalysts ahead, hence we downgrade to Neutral.
Not many positives: Subsidy will not go even at low oil; gas price set to fall steeply; production growth outlook weak; and b/s becoming stretched making big ticket M&A in low oil environment difficult.
o The new FY16 subsidy formula (caps government support at R12/L for kerosene and R18/kg for LPG) implies ONGC will have to bear the subsidy unless the oil price falls below $46/bbl. This is more negative than the earlier proposal (no subsidy for oil < $60/bbl), and will likely lead to near flat realisations when oil is over $65/bbl.
o Domestic gas price will be reduced to $4.2-4.3/mmbtu from October 1, with further reductions in 2016. Such low prices will deter new investment. Production growth outlook remains weak for both domestic and for OVL.
Also, after its large acquisition in Mozambique (ONGC chased valuations in our view, and now ONGC is not a net cash company), ability to do large ticket opportunistic M&A in current low oil prices is lower, in our view.
Valuation: Cut TP to R250; prefer downstream among oil PSUs
Due to sharp 25-31% earnings cut, our P/B based target price falls to R250 (from R395). We downgrade ONGC to Neutral. Among Indian oil PSUs, we prefer downstream names (IOCL>HPCL>BPCL) over upstream (ONGC, Oil India).
Gross oil realisation to decline; net oil realisation decline sharper as subsidies will remain at low oil prices
For upstream oil producers, low long-term oil prices are very negative. For Indian oil PSUs, which did not benefit much from high oil prices (due to high subsidies), there were expectations that the subsidy burden would not be there when oil prices are low.
Indeed, under the earlier proposed formula for Q1 (there was no subsidy at an oil price <$60/bbl, 85% subsidy for oil between $60-100/bbl, 90% subsidy for oil >$100/bbl), there would have been no subsidy paid by upstream companies. However, this formula was not implemented even for Q1FY16. The Indian government (GoI) has now come up with a new upstream subsidy formula for FY16. As per this formula, subsidy sharing would be as below:
o Kerosene: The GoI budgetary support at R12/L and the remaining under-recovery will be borne by upstream companies.
o LPG: A fixed subsidy of R18/kg under the direct benefit transfer of LPG (DBTL).
This formula, in our view, is negative for upstream companies, and increases their problems, in the current environment of low oil prices.
o While for LPG, as the break-even price (including R18/kg government support) is ~$60/bbl, so there may be no subsidy sharing on LPG by upstream companies when oil prices are below $60/bbl.
o However, the break-even price for kerosene (including R12/L government support), is only $46/bbl. Thus upstream subsidy burden will continue even if the oil price remains below $60/bbl , and will vanish only when oil prices fall below $46/bbl.
Upstream net realisations will likely remain flat when oil moves over $65/bbl
Effectively under the newly adopted formula the upstream companies pay for all incremental subsidies for kerosene when oil prices are above $46/bbl, and all incremental LPG subsidies when oil prices are above $60/bbl.
As oil prices move up the subsidies on both LPG and kerosene are expected to rise very sharply (unless the retail prices are increased or government takes some section of consumers out of subsidy sharing for LPG). If upstream shares all incremental under-recoveries (over R18/kg for LPG, over R12/L for kerosene, as it currently is doing), we estimate that effective net oil price realisation will likely remain flat for ONGC/OIL when oil prices move over $65/bbl.
Gas prices declining; low prices deter new investment
Gas prices back to where it began, and will likely fall further
Last year when the government had adopted the new domestic gas pricing formula, we had highlighted that ‘gas price hike was not so good or well thought out’.
o The key reason for the industry seeking a higher gas price was to make current production more profitable and to encourage new investment. However, in our view, the basic intention (while modifying the Rangarajan formula) seemed to have been to limit price increases (to make increase more palatable for consumers).
o To keep prices low, GoI removed expensive LNG components (both Japanese and Indian imports) and instead included Alberta gas reference price and Russian price, in addition to retaining Henry Hub and NBP prices. In our view, primarily using gas-surplus/export regions (eg, US, Canada and Russia) to determine prices in a gas-deficit country like India was not logical. Moreover, to further keep prices lower, the GoI had excluded even the transport/gas treatment charges under different hubs.
While the gas prices increased 34% in November 2014 (from $4.2 to $5.6/mmbtu), these declined by 7% to $5.2/mmbtu when prices were first reset on 1-Apr-15. As international prices have further fallen, we expect a much steeper decline of 17-18%, and domestic gas prices will likely decline to just $4.2-4.3/mmbtu. Prices would then be at a similar level as when the new price formula was adopted.
Gas production has been falling; and new investments seem unlikely soon
As gas prices increase was not large, and prices are on a declining trend, it is not encouraging investment to sustain even current production, let alone development of existing discoveries. Similarly, as the government has not announced the premium for new discoveries (and expectations are not of very high premium), the likelihood of large scale investment remains low, in our view, in the short to medium term.
Operationally not much to cheer
Operationally, in our view, there are no major catalysts.
o ONGC has generally disappointed on production guidance.
o Its domestic oil production had declined for seven consecutive years till FY14. While the production decline trend was arrested last year, there is not much visibility of any meaningful production growth in the short to medium term, in our view. Similarly, gas production has largely remained stagnant over last several years. As we noted earlier, with the domestic gas price outlook remaining low, the outlook for any sharp domestic production growth remains weak, in our view.
ONGC’s overseas arm ONGC Videsh Limited (OVL) has also largely disappointed operationally over the last few years. Despite continued large investment, production has stagnated and profits declined sharply last year.