We expecT Vedanta?s acquisition plan to be cleared with no changes, allowing Cairn to implement its growth plans by raising production and exploration. Our new conservative oil price forecasts lead to a target price of Rs 348 (from Rs 340) and a Hold rating. Using current Brent futures would imply a valuation of Rs 392.

Vedanta?s announcement of plans to acquire Cairn India (CIL) has been followed by negative news flow for CIL in terms of delays in getting approval to raise oil production and to carry out further exploration work. Such delays have been partly related to CIL?s partner in the Rajasthan block (ONGC) having to bear all the royalty and seeking compensation for the same.

Given the high profile of the announced takeover and its potential to impact foreign investment in the Indian E&P (exploration & production) sector, we believe the Indian government (GOI) will approve the deal without making any changes in the PSC (production sharing contract) and after clarifying on compensation for ONGC. Given the national importance of the Rajasthan asset, we believe approvals for raising production and making further exploration work in Rajasthan will follow.

We raise our Brent crude oil forecasts to $83/bbl (barrel) in FY11 (up $5/bbl), $87/bbl in FY12 (up $3/bbl) and $89/bbl in FY13 (up $1/bbl). We forecast prices will decline to $82/bbl by FY15, rising gradually to $95/bbl by FY21. We have maintained our reserve estimates but assumed that the Mangala production ramp-up from 125kbd to 150 kbd (thousand barrels per day) is delayed by a quarter to Q2FY12.

On 16 August 2010, Cairn Energy plc (CEP) announced that it had agreed to sell a maximum of 51% in CIL to Vedanta at Rs 405/ share, out of which Rs 50/share has been termed as a non-compete fee. Hence, Vedanta has proposed to make an open offer to the remaining CIL shareholders at Rs 355/share. GOI officials have expressed concerns about not being consulted prior to the deal and on Vedanta?s lack of experience in the oil/gas sector.

There has been a difference of opinion between CEP and GOI on the level of prior consents required for the deal. CEP appears to have now complied with all GOI demands and the petroleum ministry is expected to decide on the merits of the deal by end of this month or early next month.

As per the terms of the PSC which are not disputed, ONGC has to pay 100% of royalty on Rajasthan production, despite a 30% stake. Based on discussions with ONGC, we have been assuming that the GOI will reimburse ONGC to the extent of royalty that it pays on behalf of CIL (70%). However, this issue is unresolved as of now. Given the stake sale by CEP to Vedanta and the GOI?s plans to divest 5% of its holding in ONGC before March 2011, ONGC would be looking to resolve this issue soon.

The current royalty system does not provide any incentive for ONGC to allow a higher production rate or fresh exploration efforts in Rajasthan. CIL cannot go ahead with its proposals without ONGC approval. Hence, we believe that CIL?s proposals to raise Mangala production will not make any headway unless the royalty issue is resolved.

We believe the GOI will approve the Vedanta deal and clarify on compensation for ONGC on royalty before March 2011.

?RBS