While the measures announced by the government for the sector are positive, they are not enticing enough to attract new upstream investments
The Union government has announced several measures:
i)Most important was the much-awaited new gas price formula for undeveloped discoveries in difficult offshore areas.
ii)The government also cleared a new hydrocarbon exploration licensing policy (HELP), providing for uniform licence for all hydrocarbons with a shift to revenue sharing models (from existing profit sharing models).
iii) It also announced an extension policy for 28 medium/small fields. These decisions were long pending, and their formal announcement is certainly positive. However, in our view, these changes will not make investment in upstream E&P (which have suffered for last several years) enticing enough to attract new investments, particularly in the current low oil/gas price environment. The fact that these moves are not enticing was also reflected in the muted stock reaction (RIL down 3%, ONGC and OIL flat vs. Sensex down 0.7%).
New gas price formula not very enticing at low oil prices
After a long delay, the government finally announced the new gas price formula applicable for discoveries in difficult areas (like high pressure-high temperature fields, deep-water and ultra-deep water blocks). Based on the first 9MFY16 average price, the likely price of $8/mmbtu is attractive, but on our estimate based on recent 2-month prices, the likely price of about $4/mmbtu is not enticing enough to attract new investments.
A positive is that the new price will also be applicable to existing discoveries (where commercial production has not commenced as on 1 January 2016), provided contractors withdraw any ongoing litigation on gas prices.
A negative is that the government has sought to restrain ‘marketing freedom’ by putting a cap on gas prices. The ceiling is based on lowest of (i) imported fuel oil price; (ii) weighted average price of substitute fuels (0.3x coal + 0.4x fuel oil + 0.3x naphtha); and (iii) LNG import price.
On our estimate, the weighted average price will largely determine the price cap. And 30% weight to imported coal will tend to keep the ceiling down. We don’t see much logic in this weighted average formula, except that perhaps the government wanted to keep prices lower for consumers.
In our view, coal competes with gas mainly for power generation and it is nearly always cheaper than gas. Purely on the price of power produced, gas cannot compete with coal, particularly for base-load generation. However, for peak generation needs, gas-based generation is more suitable.
Similarly, gas is an environmentally greener fuel versus both fuel oil and naphtha. Also, as India is a large net exporter for fuel oil and naphtha, the linkage to import parity price of fuel oil does not seem very reasonable to us.
As the realised price is higher, few operators may choose to develop existing discoveries. We do not expect existing litigation on gas prices to be withdrawn.
Uniform licensing a positive, but revenue sharing not so
The key features of new HELP are: (i) uniform licence for all forms of hydrocarbon; (ii) move to open acreage licensing; (iii) move to a revenue sharing model (from prevailing investment multiple, and cost recovery/production linked models); and (iv) marketing and pricing freedom. HELP also seeks to provide a graded system of royalty rates for offshore areas (royalty rates to decrease from shallow to deep water areas) to recognising higher risk in deeper areas. Also, similar to earlier NELP (new exploration licensing policy) the cess (on oil production) and import duty (on capital imports) will not be applicable. In our view, adoption of a uniform licensing policy is a positive move, and will allow companies to simultaneously explore conventional and unconventional resources (such as coal bed methane, shale oil & gas, tight gas and gas hydrates).
However, in our view, a move to revenue sharing is somewhat backward. The E&P business has significant upfront risks that are mainly taken by contractors. Thus, production sharing contracts (PSCs) should provide for the recovery of investments first before any profit sharing with the government. The legacy PSCs provided such incentives, and hence attracted significant investments in several NELP rounds. However, in recent years the implementation of profit sharing PSCs saw many conflicts between contractors and the government. Revenue sharing will certainly ease administration. However, in our view, it will make new investment less attractive for contractors, particularly in the current low oil price environment.
Seeking 10% profit share may be imprudent in the current environment
The decision for a blanket extension of existing PSCs for 28 medium/size fields is certainly a positive move. However, in our view, the government seeking 10% higher profit share (from normal sharing calculated as per existing PSC provision) may not be a prudent move, especially in the current low oil price environment. As such, these are marginal fields, and some may become even less attractive if the government profit share increases.