Saturday, August 18, 2012

>Global uncertainty + Regulatory intervention = Overhang on Oil and Gas Sector

The global economy has been affected by the ongoing Euro-zone debt crisis and slowdown in China and India on account of anti inflationary policies. To our mind, a slowdown in global economy would lead to a fall in crude oil prices which bodes well for India’s Oil and Gas sector as it would lead to lower under recoveries. However, the fragile political situation in the Middle East and the ongoing tensions between Iran and US could lead to spike in crude oil prices on account of high risk premium. This could have serious implications for the India’s Oil and Gas sector which is already reeling under record high under recoveries.

The ongoing efforts by the gas sector regulator to control marketing margins and regulate tariffs have affected the valuations of companies operating in this sector. Further, the fall in domestic gas production on account of inability of RIL to increase production at its KG D6 fields has led to increase in imports of high priced LNG, thus increasing costs for gas suppliers and consumers.

Global oil market affected by economic and political uncertainties
The global economy has been once again put to test on account of the ongoing Eurozone debt crisis. We believe that the austerity measures being implemented in Europe will lower their demand for oil, which has already been on a decline since 2005. Further, both China and India are witnessing slowdown on account of anti-inflationary policies being pursued. The euro-zone crisis and subsequent austerity measures will further affect economic growth. Consequently, World GDP is expected to grow at a slower pace of 3.3%/3.2% in 2012e/2013e. In concurrence with lower economic growth, global oil demand is estimated to grow by 1.0%/0.9% in 2012e/2013e which is significantly lower than the average annual growth of 1.9% witnessed during 2002 - 2007.

We believe that the increased uncertainty on global economic growth would put downward pressure on crude oil prices. In the short run though, we expect crude oil prices to react to global geopolitical situations. Major upside risk to oil prices comes from the fragile political environment in the Middle East. With over 17mnbpd of oil (20% of global oil supplies) flowing through the Strait of Hormuz, any disruption to this flow would have serious repercussions on global economy and oil prices.

Refining facing headwinds on account of global capacity additions
Around 6.4mnbpd of incremental capacity is expected to come by 2015e, with over 50% of the incremental capacity expected in the Asia Pacific region. This, we believe, would put pressure on refining margins in the near future. The light-heavy differential has come off its highs witnessed during 2004-08 due to a) rise in demand for heavy crude oil from complex refiners and b) decline in Iran’s heavy crude oil production due to US’s economic sanctions. We do not expect any increase in light-heavy differential and expect it to stay at around $3/bbl for the next two years. We expect gasoil spreads to remain strong in the near future on account of higher demand for gasoil, while gasoline spreads would witness weakness on account of lower demand from key consuming centres - China and India. To our mind, naphtha spreads are in structural decline on account of lower demand from petrochemical sector which is witnessing increasing capacities of low-cost gas based plants. We expect FO spreads to remain strong in the near future as we expect production of FO to decline due to increase in capacity of secondary units (convert FO to lighter distillates).

OMCs – Uncertainty continues
We do not see diesel price deregulation happening anytime in the near future. At best, we expect the government to resort to ad hoc increases in diesel prices, but refrain from complete deregulation. With high crude oil price and increasing consumption of diesel in the economy, we believe that any real solution for the under recovery issue for OMCs needs to address the diesel subsidy burden in totality. Otherwise, as it is happening today, we see OMCs increasingly depending on ad hoc government policies to stay in the black. We expect lack of clarity on sharing mechanism to result in high earnings volatility for OMCs which would weigh down on their valuations.

Increasing importance of LNG on account of fall in domestic gas supplies
India’s domestic gas supplies failed to get the much needed boost from the KG D6 fields resulting in increasing imports of high priced LNG. As against this, demand for gas from India’s energy deficient economy is on the rise leading to a situation where India’s insatiable demand for gas continues to outpace supply. By 2015, we estimate gas demand to increase to 317mmscmd while supply is expected to grow to 202mmscmd, thus leading to a huge deficit of 115mmscmd. Post 2015, we estimate the gas deficit situation to ease on account of gas production ramp up from new gas fields and increasing LNG imports. Consequently, we estimate the gas deficit to come down to 78mmscmd in FY16e and to 40mmscmd by FY20e.