The accelerated decline in KG-D6 gas production does not auger well for Reliance Industries earnings and the downstream gas sector. RILs refining and petchem conversion margins continue to be subdued, given the unfavourable global supply-demand balance. However, valuations reflect optimism around higher gas price, recovery in gas production, improvement in operating conditions and value creation from cash on the balance sheet.
Gas production from RILs KG-D6 block declined below 23 mcm/d in the recent weeks following shutdown of the seventh producing well in D1 and D3 fields due to high water ingress and sanding issues. We note that KG-D6 gas production has declined by ~4 mcm/d on a quarterly basis over the past four quarters.
A sustained decline in KG-D6 gas production poses meaningful downside risks to RILs production guidance of 22.6 mcm/d for FY14 and 20 mcm/d for FY15.
We are surprised by the Streets excitement on potential reversal in production decline from the recent start of drilling work in KG D-6 satellite fields. We do expect satellite fields and R-series discovery to augment KG D-6 production, but not before FY16, given a virtually new development project and limited weather window for operations. The FDP-approved production profile indicates sharp decline in production from satellite fields (D2, D6, D19 and D22) from 10 mcm/d in the first year to nil in eight years.
The sustained decline in RILs gas production will affect Indias domestic gas supply, leading to reduced supplies to power and other non-fertiliser sectors. This could further strain the financial condition of some gas-based power companies and impact utilisation of downstream gas transmission companies. Imports of coal, LNG and fertilisers will also add to Indias ballooning current account deficit.
We rule out meaningful improvement in conversion margins over the next 12-18 months. At 12.6X FY2014E EPS (adjusted), the RIL stock is not cheap and reflects the Streets optimism on higher gas prices, recovery in gas production and improvement in operating environment. We retain reduce rating on the RIL stock with a target price of R775.
Kotak Institutional Equities