Core business facing headwinds

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SummaryRefining margins revert to lower levels; petchem margins remain under pressure.

We see near-term headwinds for RIL’s core businesses from (i) lower refining margins, (ii) subdued chemical margins and (iii) a sharp decline in KG D-6 production. Value creation from RIL’s new projects is 3-4 years away and will depend on (i) assumptions of conversion margins and (ii) incremental gas production. We revise our rating on the RIL stock to Reduce from Sell after the recent sharp correction. An out-of-turn gas price increase is the key risk to our view.

We expect subdued refining margins over the next 12-18 months given our cautious outlook on the refining cycle due to (i) large net additions to global refining capacity and (ii) weak oil demand resulting from a global slowdown. Singapore complex margins have declined to break-even levels currently from $3.8/bbl in mid-October led by a sharp contraction of spreads for petrol, diesel and ATF. We highlight that these products contribute 65-70% of product slate for RIL’s refineries. There has been a $4/bbl dip in refining margins since mid-October; this is partly mitigated by a $1/bbl increase in the light-heavy differential.

The margins for key polymers remained weak in recent quarters, closer to their lowest levels in a decade. Though we have assumed lower petrochemical margins for RIL in FY2013-14, we do not rule out downside risks to our assumptions given continued weakness in global downstream demand.

We see downside risks to the management guidance on FY2013-15 production from KG D-6 block noting the recent sharp decline in (i) gas production to 24 mcm/d currently from 30 mcm/d in H1FY13 and (ii) oil and condensate production to 6.8 kb/d from 10.7 kb/d in H1FY13. A reversal of decline in production from a revised development plan for the producing fields and incremental production from approved satellite fields is unlikely before FY2016-17e. Development work may also be delayed further due to the ongoing issues with the government on (i) gas pricing, (ii) scope of the CAG audit and (iii) cost recovery. On the positive side, the government may allow a price rise before April 1, 2014; we model $7/m BTU starting April 1, 2014.

Assumptions behind the earnings model

Refining margins: We model FY2013e (estimates), FY2014e and FY2015e refining margins at $8.5/bbl, $8.3/bbl and $8.3/bbl. We expect refining margins to be subdued over the next 12-18 months led by (i) net additions of 2.8 mn b/d to global refining capacity in CY2013-14e, (ii) 0.4m b/d of hike in OPEC NGLs (natural gas liquids) supply and (iii) downside risks to incremental oil demand of 2.1m b/d in CY2013-14e from a slowdown in the global economy.

Chemical margins: We model a decline in chemical margins in FY2013e compared with historical levels, which results in lower Ebitda (earnings before interest, taxes, depreciation and amortisation) despite assuming a weaker rupee. However, we expect margins to improve subsequently to reflect gradual improvement in global operating rates and potential recovery in downstream demand.

E&P segment: We model FY2013-15e KG D-6 gas production at 28 mcm/d, 23 mcm/d and 20 mcm/d. Our estimates of gas production from KG D-6 block are comparable with Niko’s estimates. We highlight that Niko has already factored the development of key satellite fields in its estimates and hence, we rule out meaningful upside to the same.

We have assumed gas price of $4.2/m BTU (British thermal unit) over FY2013-14 and $7/m BTU from FY2015. We doubt that the government will increase domestic gas prices beyond $6-8/mn BTU given its negative impact on the price-sensitive power and fertilizer sectors.

Other income: We model RIL’s other income to likely grow strongly over the next few years driven by its increasing cash pile. We expect RIL to generate R677 bn of free cash flow over FY2013-15.

We revise our rating on the RIL stock to Reduce with a 12-month forward SOTP (sum of the parts)-based fair value of R775.

Kotak Institutional Equities

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