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Time To Row Upstream

Author: Administrator Account/Tuesday, February 23, 2010/Categories: Stocks

Time To Row Upstream

The fortunes of India’s energy sector companies are heavily influenced by government policy. A government mandated increase in pricing of fuel is often the single biggest determinant of their financial performance. With softening of crude oil price and diesel price getting partially deregulated, many analysts believe the earnings of upstream PSUs such as ONGC and OIL will get better in in FY14 and FY15. The earnings could be further enhanced by a domestic gas price hike which seems to be very likely in the near term. However, gas companies are likely to remain weak due to availability and affordability concerns. There is an acute shortage of domestic gas. The plans of city gas distribution companies depend on easy availability of reasonably priced gas. In today’s scenario when piped gas is far more expensive than bottled LPG, consumers won’t be attracted.

Medium-term projections indicate that crude oil prices will average between $100 and $105 per barrel with rupee stabilizing between 52 and 54 to a dollar in FY14 and FY15. Under recoveries (the difference between actual market price and the subsidized rates PSUs have to sell) for diesel are likely to stabilize around Rs 3/litre in FY15. Net under recoveries could come down to Rs 1140 billion in FY14 and Rs 970 billion in FY15 if the government pursues the path of fiscal prudence and gradual subsidy roll backs.

Gas Price Hike

The Oil Ministry has proposed to the Cabinet to approve gas pricing formula ($6.77/mmbtu) recommended by the Rangarajan Committee in order to incentivize producers without hitting the end consumers adversely. Our analysis shows there will be an increase in earnings per share of Rs 3 and Rs 4.5 for ONGC and Oil India respectively for every $1/mmbtu increase in gas price.

Upstream PSUs a Better Bet

Upstream PSUs seem more attractive in the oil and gas pack given that the prospect of zero under recoveries and dismantling of LPG and kerosene subsidy is real.

Languishing supplies from domestic fields and lower demand for expensive Regassified LNG (RLNG) will continue to hit the earnings of gas distributors. This might be a good time to buy ONGC and OIL.

The top 10 consumers of oil are witnessing dip in their GDP growth as well as their vehicle sales growth. The emerging economies – who contribute most to incremental consumption globally – have already started witnessing demand contraction. The OECD economies have been witnessing negative growth in demand since last four consecutive quarters. The industrial fuels have been replaced with alternative and heavier fuels, thus reducing demand for lighter crude oil.

The crude oil price has been unable to hold strong above $105 despite OPEC

cutting its production by 5% in last one year. The incremental non-OPEC supplies from OECD economies and spare capacity of OPEC is adequate to cater to incremental demand from the developing countries. Thus a demand-supply imbalance that could trigger off a further spike in crude prices is virtually ruled out.

The diesel price has been hiked from Rs 40.9/litre in March 2012 to Rs 49.7/litre in May 2013. This has reduced the under recovery to Rs 3.8/litre as against Rs 12-13 /ltr a year back. Assuming crude to stabilize at $105/bl in FY14, even if the government settles for 3-4 hikes (of 50 paise every month) for the year considering upcoming elections, FY14 earnings are expected to jump 23% and 17% Y/Y for ONGC and OIL respectively.

Let’s take a closer look at some of individual oil and gas stocks.


ONGC reported a flat net realization of Rs 2607/bl in FY13 despite 17% higher under recoveries and lower volumes, as upstream share of subsidy burden reduced from 39% to 37.3%. Keeping upstream share at 39% we expect 23 % increase in the net realization in FY14 to Rs. 3220/bl. Even after accounting for recent depreciation in rupee, downsides to the earnings are unlikely as realization from natural gas segment and ONGC Videsh (OVL) improve. We don’t expect under recoveries to cross Rs 6/litre even with rupee at 58 on account of some more diesel hikes and softening crude oil price.

The volumes are expected to be under pressure as there is no incremental output expected apart from D1 fields and C Series formation. However these are likely to make up for loss in the ageing fields. The prospective resources in KG basin will take 3-4 years to materialize. We also expect OVL’s output to improve marginally to about 8 MMT as volumes from Sudan and Syria come back to normal.

We expect a 16% CAGR increase in net profit till FY15 as we assume some more diesel hikes and 40% reduction in under recoveries. Besides, the gas price hike is expected to add to the earnings.


The reduction in volumes from KGD6 has reduced the transmission volumes to 99 mmscmd from 120 mmscmd. Incremental production from fields of ONGC and Dahej and Kochi terminal expansions are not expected o fetch significant volumes for GAIL in next couple of years.

Besides, probable domestic gas price hike is expected to shrink petrochem and LPG margins and negate increase in profitability due to reduction in subsidy burden and petchem expansion.

GAIL has been meeting demand for core sectors through its pipelines from the domestic fields of Mumbai and KG offshore. However, as the domestic gas production weakens in the next few years, transmission volumes of Gail is expected to be under pressure. The demand from non-core sectors is unlikely to make a meaningful chunk of volumes for an existing capacity of 200 mmscmd and upcoming capacity of 220 mmscmd.

Softening crude oil price is expected to trim petrochem and LPG realizations. Any price hike in the domestic gas is expected to shrink the margins further as LPG extraction and polymer units use domestic gas for extraction. We expect a contraction of Rs. 1.5 in the EPS per $/mmbtu increase in the gas price.

The volumes are expected to stay muted until there is a substantial increase in the domestic production and some drastic reforms within the core segment users (Power and Fertilizer). The margins are expected to shrink as the trading margins are at peak and petrochem and LPG margins are likely to be under pressure as domestic gas price gets hiked.


Oil India reported a marginal improvement in net realization of Rs 2916/bl in FY13 despite 17% higher under recoveries and 5% lower volumes, as upstream share of subsidy burden reduced from 39% to 37.3%. Keeping upstream share at 39% we expect 11% increase in the net realization in FY14 to Rs 3251/bl. Even after accounting for recent depreciation in rupee, downsides to the EPS is Rs 4/share (still 7.5 % growth annually) as realization from natural gas segment improves and the under recoveries are still lower Y/Y. We don’t expect under recoveries to cross Rs 6/litre even with rupee at 59 on account of some more diesel hikes and softening crude oil price.

The volumes are expected to be under pressure as there is no incremental output expected from anything apart from the existing Assam Arakan Fields. The prospective resources in KG basin as well as Mizoram will take 3-4 years to materialize. We expect oil output to stay flat at 3.75 MMT and gas to improve by 0.7 mmscmd in FY15 on the back of off take by BCPL.

Indraprastha Gas

IGL has been immune to the earning uncertainties in the oil and gas segment. Being cheaper than alternative fuels and having lower penetration in CNG market, their earnings have been buoyant. We expect the volume growth to taper off in the near future as the cost of CNG and PNG increases further, however margins will make up for the dip as the competitive fuels are still expensive. Although the earnings are likely to be under pressure, we believe it is still attractively valued due to regulatory uncertainties.

IGL reported 9.3% volume growth in FY13 as against more than 20% growth in previous couple of years. It has been successfully passing through higher LNG cost as well as the cost of the weakening rupee. However the pass through has come at the cost of volume growth. The CNG volume growth has come down to 8% from 12%, whereas PNG volume growth was 18% compared to 57% previously.

The annual margins for FY13 were higher by 9% despite cost pressure on the back of regular pass through to the end users. The dip in the volume growth is offset by higher margins to a large extent. The CNG prices have been increased from Rs 34 /kg to Rs 39.2/kg in last four quarters whereas PNG prices have been increased by more than Rs 3/scm. A fall in earnings for FY15 vis-à-vis FY13 keeping in mind the Uncertainties of the Supreme Court judgment has been factored in . Despite regulatory uncertainties, IGL seems to be attractively valued at 11.5x FY15E. Any reduction in volume growth could be made up with buoyant margins. However any rally followed by a favourable decision by Supreme Court should be an opportunity to book profits

Cairn India

Cairn  has  guided  optimistic  volumes  for  FY14  with  an  expectation  of  commencement  of  Aishwarya  fields;  ramping  up  of  Bhagyam  fields  to  the  approved  peak  of  40000  bopd  and  commencement  of  production  from  Barmer.  We have  factored  these  as  well  as  all  the  potential  resources in our assumptions. Softening crude oil price outlook is expected  to keep the valuations under pressure.

Weakening  macro  scenario  in  the  European,  Asia  Pacific  and  emerging  countries is likely to restrict crude oil price at current levels and correct going  forward. Our sensitivity analysis indicates  Rs 15  /share  variation to every  $5/bl  movement  in  crude  oil  price. A  weakening  rupee  is  likely  to  avert the dip  in  the  valuation to  a  certain extent.  Our  impact  analysis  suggests  Rs 5/share  variation to  every  rupee  increase.  At  a crude  oil  price  of  $105/bl  and  rupee  at 58 the valuation comes to Rs 390/share.

The company’s management  is  optimistic  as  reservoir  issues  with  Bhagyam  fields  have  been  sorted  out  and  it  is  expected  to  ramp  up  to  its  approved  rate  of  40000  bopd from  19000  bopd  in  2HFY14.


The Rupee-Rangarajan Impact on the Energy Sector

The Oil Ministry has proposed to the Cabinet to approve gas pricing formula recommended by the Rangarajan Committee to bridge the gap until 2016-17, by when the ministry is expecting another panel to devise market determined gas pricing strategy. The Oil Ministry is proposing a price of $6.77/mmbtu as against $4.2/mmbtu.

Upstream PSUs will largely benefit from the decision. Each per dollar increase in the gas price is likely to add to ONGC and Oil India’s (OIL) earnings per share (EPS) by Rs 3 and Rs 4.5 respectively. The downstream volumes will remain under pressure as key end users get affected. This is how each sector will be impacted.

Power Sector: Each per dollar hike in domestic gas price is likely to increase the tariff by Rs 0.55/unit. The state electricity boards, for political considerations, will find it difficult to pass on to the general public. Besides coal-based plants supply power cheaper at Rs 2.5/unit. The power load factor of existing power plants will be adversely affected with a gas price hike. Incremental demand from the plants lying idle for new gas supplies from ONGC’s fields also becomes dicey. Unless accompanied by a steep hike in tariffs by the power regulator (which is unlikely in an election year) or assurance of subsidy compensations to SEBs by the states, domestic gas price hike is not viable for the power sector.

Fertilizer Sector: Each per dollar increase in gas price is expected to increase fertilizer prices by Rs 1500/ tonne. Again, this will be a non-starter for political reasons. Therefore the losses are expected to increase by Rs 25 billion. This might discourage additional 5MMT conversion of naphtha/fuel oil -based plants to gas-based, thus reducing the incremental off take of natural gas.

Refineries, Petrochem and CGD companies: Although price hike is not going to affect these entities due to pass through ability and expensive alternative fuels, lack of demand from power and fertilizer players might reduce their accessibility to gas sources as pipeline connectivity is lower.

Higher domestic gas price is expected to offset gains from PATA expansion and lower LPG subsidy burden. There could be an impact of Rs 1.2/share on GAIL India’s EPS for every $1/mmbtu increase in the gas price. The earnings could drop further if crude oil price corrects, as it will reduce realizations. IGL and Gujarat Gas source about 60%-70% of gas requirements from the domestic gas fields. Although they are the least affected by the price hike, increasing proportion of regassified LNG in their consumption has resulted in 40% increase in their cost in last four quarters. Since they have been successfully passing it through, they have been taking a hit on their volumes.

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