Friday, May 28, 2010


Growth in chaos
Despite the significant increase in supply from KG-D6, India remains chronically starved of gas. Current estimates of Indian gas demand are in the range of 225- 260mmscmd, while supply is only 155-160mmscmd. There isn’t enough capacity, because policy concerns are holding up investments upstream, midstream and downstream. Installed capacity is not fully available for supply because of pipeline bottlenecks. However, we believe these are teething problems in the early stages of potentially remarkable growth. We have BUY ratings on Reliance, KG-D6 producer, and transmission company GAIL. However, our spotlight is on four mid/downstream players, all rated BUY: Indraprastha Gas (city gas distribution, our top pick), Gujarat State Petronet (transmission, preferred over GAIL), Petronet LNG (importer of LNG) and Gujarat Gas (city gas distribution). Each of these companies faces some regulatory hindrance, but the stocks have outperformed the market over the past year on strong operational performance. Still, we believe valuations remain inexpensive and operational performance has plenty of room to surprise on the upside. In fact, our proprietary analysis of a regulatory blue-sky scenario finds that these four stocks may be trading at near half their potential fair valuations at current prices, which suggests to us that more than a reasonable element of risk is priced in.

“What if” chaos turns to order soon?
Regulatory concerns could be resolved sooner than expected
The existing confusion on regulatory / policy aspects is no doubt a concern and an overhang on the stocks. However, as we mentioned earlier, in our view the current state of confusion signifies the teething problems in a fast changing/growing industry. We also note that key constituents are all aware of the need to end the current scenario and appreciate the need to create an enabling environment. In our view, the first step in this direction could well be the long pending notification of Section 16 of the PNGRB (Petroleum & Natural Gas Regulatory Board) Act, granting power to authorise PNGRB. This would, in our view, be a big relief and could be the beginning of the end of acrimony between PNGRB and the Petroleum Ministry.

We note that Delhi High Court had ruled in January 2010, that PNGRB does not have powers to authorise, as section 16 is not notified, and now PNGRB has appealed against this in the Supreme Court. Recent media reports (Financial Chronicle, “Petroleum Regulator to offer licenses for piped gas network”, 26 April 2010) indicate that the Petroleum Ministry is now considering soon notifying Section 16. Similarly, news reports (Business Standard, “Gas highway authority plan put on back burner”, 28 April 2010) now indicate that the Petroleum Ministry has now put on the back burner the proposal to create a national gas highway development authority. A new regulatory authority, in our view, would have diluted the powers of PNGRB, and thus PNGRB was opposing this. Going slow or even cancelling this proposal would again be positive, in our view, for an early end to the regulatory/policy uncertainty.

Stocks for action
RIL and GAIL offer broadest exposure to the gas story. Petronet LNG, GSPL, IGL and Gujarat Gas all have strong growth in their respective niches. IGL is our favourite among downstream; we prefer GSPL (over GAIL) in gas transmission.

Large demand-supply gap — yet supply is suppressed
The government’s current estimates of Indian gas demand vary from 225- 260mmscmd, while current supply is only 155- 160mmscmd, even after sharp production growth in FY10F on account of KG-D6. The shortage is exaggerated by the lack of pipeline capacity. While exit gas domestic gas production in March- 2010 was up nearly 72% y-y, we think growth could have been 100% without pipeline bottlenecks. This is despite knowing for many years that supply would increase sharply as KG-D6 comes online and LNG import capacities increase. However, we believe supply will remain suppressed for most of 2010 and perhaps into early 2011F. Despite current capacity of 80mmscmd, KG-D6 production is contained at about 60mmscmd. Similarly, despite significant LNG re-gasification capacity increases, spot LNG volumes have nearly dried up.

India did not get ready for new gas
Despite knowing for many years that gas availability would increase, India did not prepare well. Pipelines seem to be the immediate problem, but concerns abound on many issues. Both regulations and regulators are in place, but without key powers. PSCs provide for marketing freedom and market-determined pricing — but the government seems reluctant to release control of pricing and allocation.

To read the full report: GAS SECTOR