>ONGC (CITI)

Sell: US$60-70 Crude Reduces Deregulation Hopes

■ Oil forecasts revised — We are adjusting our global oil (Brent) forecasts tovUS$56/bbl (US$48) for 2009E, US$65 (US$55) for 2010E, and US$65 (US$60/bbl) for 2011E. Our LT assumption (2012E+) stays at US$65/bbl.

■ Modestly increasing FY10-11E earnings — Our assumptions for ONGC are increased marginally, by 1-5% over FY10-11E. The FY10E estimate change is primarily on account of the APM gas price hike (15-20%) that we are now assuming, in line with the likely Cabinet proposal. This however falls short of the market’s heightened expectations ($4.2/mmbtu). For FY11E, while our crude assumption increases from US$60 to US$65, the EPS increase is more subdued at 5%, as net realisations on domestic crude remains flat at ~US$50.

■ Subsidy burden to increase in FY11 — Our earlier FY11E assumptions incorporated only LPG/SKO under-recoveries (Rs319bn total; 1/3rd sharing) at US$60 crude, which we now expect to rise to Rs466bn (incl. auto fuel losses) at US$65 crude, suppressing net realisations. While full deregulation of auto fuels could lead to a lower figure (Rs374bn), our assumption is premised on some losses on auto fuels as well, as the quantum of price hikes will likely lag the required increases as long as crude is between US$60-70.

■ Maintain Sell; Rs910 target price — We maintain Sell with a target price of Rs910 (Rs820 earlier) as we roll forward to Sep-10E (Mar-10E) while maintaining our 10x target P/E. The stock trades at 11x P/E, the upper end of its historical 7-11x trading band. Any move by the government to fully deregulate auto fuel will be a positive surprise and upside risk to our estimates.

To see full report: ONGC

>ESSAR OIL (IDFC SSKI)

A giant in the making!

Essar Oil (EOL) is inching closer to becoming an integrated player in the Indian energy space. Expansion plans at its Vadinar refinery are gathering pace, and phase I (10.5m to 16m tpa) is well on track for commissioning in Q4FY11E. The uncertainties around global economic outlook and funding issues have affected timelines in the past, but we believe the relative stability in global economy and easing liquidity will aid execution of phase II (16m to 34m tpa) as well. This huge capacity addition by Q4FY12E is expected to help EOL leverage the product demand revival over FY10- 12E, while increase in complexity will improve GRMs. The nascent, but exciting, E&P portfolio has high value accretion potential as well. The slowdown in global refinery expansion plans implies a good opportunity for EOL to deliver in a tight supply environment over FY11-13E. However, a deeper economic slump may push timelines on the expansion backwards, and is a risk to our estimates. Reinitiating coverage with Outperformer and an SOTP-based price target of Rs242 per share.

EOL – moving towards scale and efficiency: The capacity expansion to 16m tpa in phase I and 34m tpa in phase II over FY10-13E would impart scale to EOL. Post expansion, EOL will have one of the largest single-location refineries in the world, which would lend sourcing flexibility and improve operational efficiencies. The complexity of the refinery would also expand considerably from 6.1 to 12.8 post phase II expansion.

Increased complexity to drive margin expansion: Higher Nelson Complexity would drive optimization of sourcing with ability to process a wider and tougher range of crude to produce superior quality products (38 varieties of crude processed in FY09). The additional secondary processing units will allow for greater middle distillate production, improving realizations and profitability of the refinery.

Valuation – firm GRMs and E&P provide upsides: Our optimism on the stock stems from the potential size and scale of the business, along with an attractive E&P portfolio. We see E&P proving to be a significant growth driver for EOL in the long term, and have attributed a value of Rs58 per share to the reserves. Based on higher volumes, improving GRMs and the value-accretion potential in E&P portfolio, we reinitiate coverage on the stock with Outperformer and a price target of Rs242.

To see full report: ESSAR OIL

>FLASH ECONOMICS (ECONOMIC RESEARCH)

The loss of confidence in dollar denominated assets continues to grow

In this Flash we will look at the nature and severity of the loss of confidence resulting from the extremely expansionary fiscal and monetary policies being implemented in the United States. We must take into account the particular situation of the United States: if the US external deficit increases, central banks in many countries are forced to accumulate dollar-denominated assets
in order to stabilise the dollar:

■ the deterioration in the creditworthiness of the public debt (due to excessive fiscal deficits, the Treasury’s purchases of risky assets, etc.) is leading investors to increasingly prefer private-sector assets to public assets. This does not pose any problem for central banks: the dollar can be shored up through purchases of dollar-denominated private-sector securities. The result of this first stage of loss of confidence in the dollar is a rise in interest rates on public debts relative to private debts;

■ the deterioration in the quality of the Federal Reserve’s assets, due to the large number of programmes to buy risky assets, may entail a loss of confidence of a different kind, i.e. in the money issued by the Federal Reserve. This may trigger a flight-from-money phenomenon: economic agents get rid of money and buy real assets (real estate, companies, commodities, durable goods, etc.), and this triggers a surge in real asset prices (also known as "hyperinflation").

If central banks in countries posting a surplus reject dollar money as well, the stability of the dollar's exchange rate can no longer be maintained. In an initial phase, if the flight from dollar money concerns only private economic agents, central banks’ holding of dollar-denominated assets must significantly increase.

To see full report: FLASH ECONOMICS

>BANKING SECTOR (KARVY)

ASSET QUALITY TO THE FORE

Asset quality in Indian banking is rearing its ugly head but is not immediately discernible on account of regulatory forbearance that has allowed banks to classify poor quality loans as restructured standard loans with minimal provisioning requirements. Such a practice, sadly, results in severe under-reporting of non-performing loans and inflation of past and future net profits. Our study reveals that the government banks' poor quality loans (net nonperforming loans and restructured standard loans) for FY2009 constitutes around 48% of the it’s net worth as compared with nearly 18% of net worth in FY2008 and the segment is therefore in need of equity recapitalization
which the government can ill-afford on account of fiscal constraints.

Non-performing assets (NPA) disclosure does not accurately reveal extent of the problem: In our sample of 26 (23 government and 3 private) banks; gross NPAs in FY2009 increased by 18% to Rs 558bn while net NPAs rose by 23% to Rs 261bn. As a percentage of loans, the data shows an improvement with gross NPAs declining to 2.2% from 2.3% in FY2008 while net NPAs falling to 1% from 1.1% in the same time period. As a percentage of net worth, net NPAs rose marginally from 10.2% in FY2008 to 10.8% in FY2009. The all-important coverage ratio reported a decline to 53.3% in FY2009 from 55.3% in FY2008. On the reported NPAs there appears to be no major cause of concern but that is because a significant amount of poor quality loans were reported as restructured standard loans instead of NPAs.

Significant increase in restructured standard loans: While NPAs increased less alarmingly, the huge increase in restructured standard loans is an ominous sign that all is not well in Indian banking. In our opinion, restructured standard loans have to be classified as non-performing as we believe that without restructuring the terms of the loans, such loans would have had to be classified as NPA. Total restructured standard loans in our sample of 26 banks increased 4.2x over FY2008 to Rs650bn. which was more than the gross NPAs of Rs558bn. Within restructured standard loans, the bulk of the increase is coming from non-corporate debt restructuring (CDR) standard loans which implies that the broad underlying loans in the banking sector from small & medium enterprises (SME), retail and agriculture are deteriorating. The huge increase in restructured
standard loans is a more accurate depiction of the deterioration in asset quality in FY2009. As a result, gross impaired loans (gross NPAs plus restructured standard loans) increased by 93% in FY2009 to Rs1,208bn while net impaired loans (net loans plus restructured standard loans) rose by 149% to Rs910bn.

To see full report: BANKING SECTOR