Upgrading to Buy: A potent mix of rising crude and a falling currency have played havoc with the upstream PSU stocks, with Oil & Natural Gas Corp (ONGC), Oil India Ltd (OIL) shares down 20/24% since our July downgrade to Neutral. Diesel losses have since widened (now Rs 14/litre), and with no incremental clarity on potential gas ?subsidies?, but we believe valuations at 8x (times)P/E (price-to-earnings multiples), even on reasonably conservative assumptions, warrant another look. We revisit the subsidy arithmetic on our new currency assumptions, with lower potential gains from higher gas prices, and we still see sufficient upside even on our lower TPs (target prices). Upgrade to Buy.
Subsidy fears have worsened: We now forecast gross under-recoveries for FY14/15e (estimates) at Rs 1.39/0.89 trillion (vs Rs 1.61tr in FY13) on our $102/96 crude and Rs 60/63 currency forecasts. This assumes sustenance of the monthly ~R0.5/litre diesel hikes (and no more). However, we now base our earnings on lower net realisations for ONGC/OIL, which decline from $48/54 (FY13) to $38/46 (FY14e) and $40/47 (FY15e), equating to upstream share at 50/75%. Further, we now assume the benefit of higher ($8) gas price only for 1/3rd of total volumes (sold to non-power/fertiliser consumers).
Growth expectations reset downwards: Production trends have remained fairly muted for ONGC/OIL. Following its Q1 results, ONGC management lowered its standalone (ex-JV) guidance from 25.3 to 24.1 MMT (million metric tonne) for FY14 (vs. 23.7/22.6 MMT in FY12/13), primarily due to slippages in some of its marginal field developments (we remain more conservative at 23.5 MMT). OIL management, too, has cited risks to its 3.95 MMT FY14 guidance (vs 3.88/3.70 in FY12/13.)
But valuations are approaching lows? ONGC/OIL currently trade at P/Es of 8-9x FY14e and 7x FY15e on our crude, currency, subsidy, production, and gas price forecasts, comparing favourably with their historical 7-12x trading band. Even assuming no effective gas price hike (i.e., all the gains are ?subsidised? away) and lower net realisations ($37/45), the FY15e multiples remain low at 8x. Whilst the market appears unwilling to price the stocks on FY15e earnings given the lack of visibility on crude/currency, a stabilisation of trends on these parameters could trigger a change.
?and the government is mulling steps to contain losses: Several press reports of late suggest that the government is exploring raising the quantum of monthly diesel hikes from ~Rs 0.5/litre currently and/or implementing a one-time hike of anywhere between ~Rs 2- 5/litre, which could bring some much needed relief. We note that even if subsides are recalculated using export parity pricing given the govt?s fiscal strains, and upstream is left to shoulder the entire incremental burden (Rs 180 bn), this could be completely offset by a Rs 5/litre hike if taken in September, ensuring earnings remain largely protected.
Subsidy-sharing assumptions: We assume that OMCs? (oil and marketing companies) under-recoveries will fall to Rs 1.39/0.89 litre over FY14/15e from Rs 1.6 litre in FY13. This reduction is mainly driven by our bearish views on crude, which we assume to average $102/96 over FY14/15e, and continuing diesel price hikes of Rs 0.5/ litre every month, though our weaker rupee assumptions of R60/63 have offset a significant portion of the decline.
As crude falls to ~$93 in FY16e (on our global commodity team?s forecasts), it is likely that diesel losses would have been completely done away with, assuming that the government maintains its discipline on regular price hikes (which it has, thus far, with eight effective hikes since January).
?Citi
