>INDIAN OIL & GAS / CHEMICALS (NOMURA)

RAISING THE BAR

The Bombay Stock Exchange’s (BSE) Oil & Gas index has underperformed the broader Sensex by 13% over the past three months, which we believe is due mainly to uncertainty surrounding key issues such as KG-D6 litigation and subsidies, among others. With most concerns priced in and several emerging positive catalysts, we believe risk-reward is becoming favourable. The sector’s 1Q FY10 earnings were above consensus estimates, due mainly to auto fuel sharing by upstream and inventory gains for oil marketing companies (OMCs). Although we still do not believe that the
Indian government will deregulate auto fuels or bear all cooking fuel losses, the concern about subsidies has abated considerably due to several positive statements of intent, lower y-y prices and retail price increases. The other positives include stronger petrochemical prices and the likely positive impact of recent direct tax code proposals. We raise our earnings estimates and outlook for most stocks under our coverage.

■ We upgrade GAIL (PT: INR390) and Cairn India (PT: INR300) to BUY (from Reduce).
Apart from gas volume increases, GAIL is benefiting from firm petrochem prices and a reduced subsidy burden. With an increased share of regulatory transmission (allowed 12% post-tax ROCE) earnings, we believe GAIL could re-rate as a utility company. Start of production from the Rajasthan Block is a near-term catalyst for Cairn, in our view. We continue to believe there remains potential upside in the Rajasthan Block.

■ We upgrade ONGC (PT: INR1,410) to BUY (from Reduce). ONGC shared only auto fuel losses in 1Q FY10. At our oil assumptions, we estimate very little auto fuel losses for FY10/FY11. It would be considerably positive for ONGC if it were to share only auto fuel losses going forward. Conservatively, we assume that upstream would also share 16.5% of cooking fuel losses. Removal of the ad-hoc approach to subsidy sharing will be the key to a re-rating of ONGC, in our view.

■ We upgrade Reliance Industries (PT: INR2,000) to NEUTRAL (from Reduce). We believe the market has priced in downside from the adverse High Court decision on KG-D6. With the final hearing in the Supreme Court commencing soon, and apparent urgency for all parties (including government), we believe the issue is in the end-game. Although the ongoing dispute will remain an overhang in the near term, we believe that once it is resolved market attention will shift to the company’s significant earnings growth prospects and upside from its large E&P portfolio.

■ We upgrade Indian Oil (PT: INR600) and HPCL (PT: INR360) to NEUTRAL from Reduce, and maintain NEUTRAL on BPCL (raise PT to INR525). Although OMCs were made to share all cooking fuel losses in 1Q FY10, we assume the burden will be reduced, based on government statements. We believe a clear policy on subsidies is critical for these stocks to re-emerge as long-term investment ideas.

To see full report: INDIAN OIL & GAS