Expect policy moves in two-three months
Govt reportedly reworking the subsidy sharing formula: Press reports indicate that the government is considering reworking the subsidy sharing formula and that a proposal on a new formula will soon be circulated to the Cabinet. If true, this could be a material positive for the upstream SOEs (state-owned enterprises), especially for ONGC, which has underperformed both the broader market (by 22%) and its smaller peer OIL (by 10%) in the last three months on the back of the overhang of the upcoming share sale and amidst the backdrop of the recent steep fall in global crude prices which could hurt upstream SOEs unless their subsidy burden falls commensurately.
Timing uncertain, but most likely in the next two months: While it is difficult to assess the timing of any such announcement and whether it would precede the 5% stake sale by the government (which, as per press reports, is slated for completion this month), we believe some clarity is almost certain to be available by the time the company announces its Q3FY15 results around mid-Feb, as the extant $56/bbl (barrel) subsidy discount formula which has been applied to arrive at H1 subsidies is unlikely to be sustained in Q3 given crude prices are trending >$20/bbl lower. In a recent analyst meet, the OIL management too expressed confidence that the government will ease the subsidy burden on upstream SOEs from Q3 as the current formula is unsustainable.
What could the formula be? The press reports indicate that the formula being considered could be a variant of the formula proposed by the Kirit Parikh committee in the past. In 2010, the committee had proposed a formula that saw nil subsidies for upstream companies up to $60/bbl of crude, and a marginal subsidy contribution of 20%/40%/60%/80% of the incremental crude price for crude between $60-$70/$70-$80/$80-$90/>$90 (incidentally, it had proposed full subsidy exemption for GAIL).
In 2013, the committee modified this formula to a 40% share of the crude price till crude <$80/bbl, 40% + $0.25 for each $1/bbl increase beyond $80, and 50% of crude price beyond $120. Some more recent press reports last month have indicated that the government is looking at providing a fixed R20/kg (i.e., R284/cylinder) budgeted subsidy on LPG, with the balance to be borne by the upstream companies, while losses on kerosene could be borne equally (50:50) between upstream and the government.
Quantifying the upside: Our current TP (target price) of R440 is based on 11x FY16e EPS (earnings per share) of R40/share, which assumes gross crude price of $97/bbl and net realisation of $50/bbl for ONGC (which equates to upstream companies bearing an all-time high 74% of the overall under-recovery burden). Assuming crude at $80/bbl and upstream companies bearing an equitable 50% of the burden, ONGC’s net realisations could improve to $59/bbl and EPS to R42/share. At the same 11x target multiple (which is 1 SD—standard deviation–above its historical mean), this could see ONGC’s fair value rising to R460/share, an upside of about 25% from the current levels. We maintain our Buy rating on ONGC as we await this key event-based trigger for the stock.