Wednesday, July 8, 2009


Auto fuel price hikes: a bold step
The government increased auto fuel prices by 6-10%. While this is a bold step, such an ad-hoc increase also signals that pricing deregulation is unlikely near term. Higher prices translate into lower subsidies for ONGC; we upgrade EPS by 12-20%. The impact for the R&Ms would depend on the subsidy sharing equation; the upcoming budget could provide clarity. HPCL is the best relative pick; we maintain Upfs on ONGC, IOC and BPCL. We rate Cairn India a BUY where we expect a re-rating beyond DCF fair values as earnings multiples come into focus as production starts.

Auto fuel prices hiked by 6-10%

The price hike of Rs4/liter for petrol (10%), Rs2/liter for diesel (6%) will reduce overall retail under-recoveries in FY10 by Rs131bn (23%) to Rs450bn.

All R&Ms should gain but BPCL’s larger share of auto fuels means it will gain a disproportionate share (Rs34bn) as compared to HPCL (29bn) and IOC (Rs68bn).

While the breakeven for overall gross under-recoveries has now risen to $54/bbl Brent from $50/bbl, this is still lower than current prices and the R&Ms continue to lose money on all four fuels (Rs3.5/liter on petrol, Re1/liter on diesel).

A bold step but also mixed signals

The 6-10% price hike at this juncture took us by surprise, we had expected a decision after the key Maharashtra state elections were over (expected in Oct-09)

It is a bold step indicating that the government is willing to tackle higher oil prices.

The ad-hoc nature of the increase, however, also signals that pricing deregulation (including any price band formula) is unlikely near term. This could disappoint.

The subsidy sharing equation is uncertain

The earnings impact for the companies depends on the subsidy sharing equation.

We understand that the Ministry of Petroleum wishes to have direct budgetary support (or oil
bonds) for all cooking fuel under-recoveries (Rs307bn for FY10)
while residual auto fuel losses (Rs142bn) would be shared among the companies.

This could reduce earnings pressures significantly for all companies (including Gail) but the
contours remain uncertain; the upcoming budget could provide clarity.

In the interim, we keep our framework unchanged (one-third share for upstream, Rs100bn in aggregate share for R&Ms, residual losses via oil bonds).

We keep earnings estimates for IOC, BPCL and HPCL unchanged. We also keep estimates for Gail intact; it only shares cooking fuel under-recoveries.

Upgrading ONGC EPS by 12-20%, maintain U-PF

Lower under-recoveries (Rs131bn) imply lower subsidies for ONGC (-Rs39bn to Rs123bn) and higher net realisations (+$4.9/bbl to $50) leading to a 12% (Rs11) EPS upgrade for FY10. We upgrade FY11-12CL EPS by 18-20% (full year impact).

On our upgraded estimates (~Rs99-104/sh), ONGC trades at par with global peers on earnings based valuation multiples but we continue to see fundamental challenges ahead (higher costs, struggling production, falling return ratios).

Our upgraded target price (Rs950/sh) indicates 10% downside. Maintain U-PF. Crude prices remain the dominant variable

Crude prices remain the dominant variable for the R&Ms.
In this context, we continue to view them as crude-price and not deregulation plays and see earnings risks returning as crude rises. We forecast US$80/bbl long term Brent.

For example, every $10/bbl rise in crude increases gross under-recoveries by US$7.3bn – this is 1.25x the aggregate core FY10 Ebitda of the R&Ms (US$5.8bn).

Further, weak refining margins (Singapore Complex trading $3.9/bbl over the last four months) are an additional headwind with ever $ impacting EPS by 24-42%.

We maintain U-PF recs on IOC and BPCL. Investors who do not concur with our views on (rising) crude or the policy direction could choose HPCL given its lower valuations (0.8x PB) and higher upside in a low crude and deregulation scenario.

Cairn India is the only BUY rated stock in our coverage; we expect a re-rating beyond DCF fair values as earnings multiples come into focus as production starts. To see full report: INDIA OIL & GAS.

To see full report: INDIA OIL & GAS