Oil Gas

Sector Update Institutional Equity

NEUTRAL

Oil & Gas

Sensex: 10,595, Nifty: 3,147

Hopes lies ahead

March 3, 2006

We expect the government to consider the implementation of the Rangarajan Committee recommendations in part or whole within the next three months and address the core issues pertaining to this much beleaguered sector. The lack of any budgetary measures/support to the sector had resulted in a sharp decline in prices of oil stocks even as the rest of the market rallied after the budget. Till the time the government plans decisive action on the Rangarajan Committee recommendations and addresses the core issues, we maintain our Neutral stance. In this report, we have given details of the Rangarajan Committee recommendations and the different scenarios – if the suggestions are implemented in whole or parts. The Rangarajan Committee submitted its report to the government with recommendations on the petroleum product pricing policy and related issues in February 2006. The key recommendations of the report were: ♦

Shift from import parity pricing for petroleum products to a mix of import and export parity pricing.

♦

Reduction in customs duty for MS and HSD.

♦

Specific excise duty for MS and HSD instead of a mix of ad valorem and specific duty.

♦

Higher prices of MS, HSD, LPG and SKO.

♦

Removal of subsidy burden from upstream companies and increase in cess on crude oil to compensate (partly) for it.

In our view, the government would not increase the prices of LPG and SKO on the back of political issues. Assuming all other recommendations are implemented, we expect:

Amit Agarwal

♦

Adverse impact on refiners due to decline in ex-refinery prices.

♦

Lower overall subsidy burden, and the payment of subsidy through cess would exclude the direct involvement of upstream companies in subsidy.

♦

Positive impact on ONGC as a pre determined rate of cess would depict a clearer picture in terms of net earnings of the company. Currently, ONGC contributes to the subsidy burden on a quarterly basis as determined by the government in an ad hoc manner. Therefore, this would lead to better visibility of earnings.

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As the marketing capacities of BPCL, HPCL, IOCL are higher than the refining capacities, we expect them to benefit marginally by the shift from import parity pricing to trade parity pricing. BPCL, HPCL and IOCL stand to gain to the extent of the differential in marketing and refining capacities.

A quick glance at Rangarajan Committee’s recommendations: Current

Comments/implications

Import parity pricing

Reduction in subsidies Negative for refiners

Ex-refinery pricing Change from import parity pricing To mix of import and export parity Pricing in ratio of 80:20 for ex-refinery price

Positive for ONGC

Petroleum product price rise Increase in prices of MS by Rs1.21/lt Increase in prices of HSD by Rs1.96/lt Increase in prices of LPG by Rs75/cylinder Increase in price of SKO by approx Rs6.01/lt Duty structure on petroleum products Reduction in customs duty on MS and HSD

Reduction of subsidy

To 7.5% Excise duty- MS to be specific at Rs14.75/lt Excise duty- HSD to be specific at Rs5/lt

At 10%

Negative for refiners

8% +Rs13/lt 8%+ Rs3.25/lt

Neutral for Government At current rates

Rs1,800/MT

Increase from USD5.4/bbl to USD14.6/bbl Positive for ONGC

Upstream-ONGC Cess to be Rs4, 800/MT on crude oil Upstream not to be involved in subsidy burden Source: MOPNG

We have analyzed the changes in the subsidy burden assuming three scenarios to illustrate the possible impact of Rangarajan Committee on the oil sector and its constituents. These are

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♦

Case A: The shift in the petroleum product pricing policy from import to trade parity pricing and its impact. (Excluding the recommendation to raise the prices of petroleum products)

♦

Case B: The full implementation recommendations.

♦

Case C: Implementation of Rangarajan Committee recommendations except for increase in prices of LPG and SKO.

2

of

Rangarajan

Committee

Oil & Gas

Sector Update Institutional Equity

Case A: If the pricing policy is changed from import to trade parity pricing and its possible impact The Rangarajan Committee has recommended a shift from import parity pricing (ex-refinery) to a mix of import and export parity in ratio of 80:20 (trade parity). Assuming every thing else remains constant, we expect the subsidy burden to decline from Rs413bn to Rs351bn in FY06E. Subsidy burden is the difference between the import parity based retail price and the actual retail price. A shift in this direction will reduce the ex-refinery price leading to lower subsidy burden as shown in Table 1 below. The table below shows the change in contribution from every participant after the committee report is implemented. Table1: Change in subsidy burden based on change in pricing policy Rs mn Contribution to total subsidy

New pricing

(%)

Old pricing

(%)

Government Upstream Refinery Oil bonds Increase in prices Marketing companies

24,696 115,852 28,085 94,788 45,639 42,006

7 33 8 27 13 12

24,696 136,578 33,110 111,746 53,804 53,940

6 33 8 27 13 13

Total

351,066

100

413,873

100

Source: IL&FS Investsmart

The Table 2 below gives the subsidy burden (Rs/per unit or litre) if the new pricing policy is implemented. Table 2: Change in subsidy burden Decline in the exrefinery price

In Rs per unit

Import parity pricing policy

New pricing policy

Sale price (April FY06)

Current subsidy

New pricing* subsidy

MS (Rs/lt) HSD (Rs/lt)

50.3 36.3

48.2 34.6

44.5 32.8

5.8 3.5

3.7 1.8

LPG (Rs/cylinder) SKO (Rs/lt)

457 22.9

444.3 22.1

295 9.01

162 13.9

149.3 13.1

Note (1): These estimates do not include the hikes in petroleum prices as recommended by the Rangarajan Committee. Source :IL&FS Investsmart, Media.

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Sector Update Institutional Equity

Case B: The entire Rangarajan Committee report This scenario speaks of full implementation of the committee report – including the hike in petroleum product prices and change in the pricing policy The suggested price rise in petroleum products is given below in Table 3. Table 3: Price rise suggestion Increase in prices suggested by committee MS (Rs/lt) HSD (Rs/lt) LPG (Rs/cyl) SKO* (Rs/lt)

1.21 1.96 75.00 6.01

Note (1): We have assumed that only 40% of SKO is sold below poverty line. For above poverty line the price is increased to Rs19.01/lt. Source: IL&FS Investsmart, Media.

In terms of change in the pricing policy – one can assume the scenario played out in case A. The customs duty is expected to be reduced on MS and HSD from 10% to 7.5% while excise duty is likely to be fixed at Rs14, 750/KL for MS and Rs5, 000/KL for HSD. Currently, the excise duty for MS is 8%+Rs13, 000/KL and HSD is 8%+Rs3, 250/KL. Table 4: Impact on subsidy of Rangarajan Committee recommendations Contribution to total subsidy (Rs mn)

New pricing - Rangarajan Committee (%)

Current

Percentage contribution (%)

Government Upstream

24,696 -

21 -

24,696 136,578

6 33

Refinery Budget

69,650

0 60

33,110 111,746

8 27

Increase in prices

2,902

2.5

53,804

13

Marketing companies

18,835

16

53,940

13

Total

116,083

413,873

Source: IL&FS Investsmart, Media

Table 4 shows a decline in subsidy burden from Rs413bn currently to Rs116bn in FY06E. Since change to the trade parity principle would lead to a decrease in the ex-refinery prices, we have assumed that refineries would not contribute to the subsidy burden. However, the cess on crude oil is expected to be increased from Rs1, 800/ton to Rs4, 800/ton after the Rangarajan Committee suggestions are implemented.

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Oil & Gas

Sector Update Institutional Equity

Case C: All the recommendations in case B are implemented except for the suggested increase in prices of LPG and SKO. Therefore, the scenario as delineated in case B can be assumed for case C. This is expected to result in a changed subsidy burden as given in table 5 below. We believe that the government is going to choose this third option of case C. Table 5: Expected change in subsidy burden Contribution to total subsidy (Rs mn) Government

New pricing

Share (%)

Current

share (%)

24,696

10

24,696

6

Upstream

-

-

136,578

33

Refinery Budget

166,271

0 70

33,110 111,746

8 27

Increase of prices

5,938

2.5

53,804

13

Marketing companies

40,625

17

53,940

13

Total

237,531

413,873

Source: IL&FS Investsmart

Impact of recommendations of the Rangarajan Committee report on the upstream company – ONGC: The Rangarajan Committee has recommended that the upstream sector should be excluded from direct sharing of the subsidy. Instead, it has recommended that cess of Rs1,800/MT should be increased to Rs4,800/MT and should be utilized by the government for subsidy relief. Table 6: Current subsidy burden on ONGC Upstream (Rs mn)

Upstream subsidy burden -existing pricing

ONGC Oil India

111,606 8,170

GAIL

16,802

Total

136,578

Subsidy burden-ONGC (Rs mn)

111,606

Sales-mn bbls

172

Subsidy burden (Rs/bbl) Exchange rate (INR/USD)

650 44

Subsidy burden (USD/bbl)

14.8

Source: IL&FS Investsmart estimates.

Currently, the upstream sector shares 33% of the total subsidy burden. The share of the upstream subsidy burden is divided between the constituents in ratio of the previous year’s profits. Table 6 shows the calculation of the subsidy burden for ONGC for FY06E.

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Oil & Gas

Sector Update Institutional Equity

The table 7 shows the change as proposed by the Rangarajan Committee. Table 7: Rangarajan Committee and its expected impact on ONGC ONGC (USD/bbl)

Current

Rangarajan Committee

Cess Subsidy burden

5.4 14.8*

14.7 -

Total * Estimated Source: IL&FS Investsmart estimates.

20.2*

14.71

Impact 1: Reduction in the total cess and subsidy burden Currently, the total expense of cess (USD5.4/bbl) and subsidy burden (USD14.8/bbl) is USD20.2/bbl on ONGC. If the Rangarajan Committee recommendations are to be implemented, the subsidy burden is expected to be nil. However, the total cess would increase to USD14.7/bbl. Therefore, after implementation of suggestions by the Rangarajan Committee, the burden would decline from USD20.2/bbl to USD14.7/bbl. Impact 2: Better visibility of earnings Also, the implementation of the Rangarajan Committee recommendation would remove ONGC from direct subsidy burden - thus improving the visibility of earnings.

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Oil & Gas

Sector Update Institutional Equity

Institutional Equity Name of the Analyst

Email

Tel. No.

Research Sreesankar R

Sheriar Irani Amit Agarwal Ashish Aggarwal Devang Patel Jayesh Sundar Mihir Jhaveri Milind Bhangale Vishal Mishra Chaturya Tipnis Gaurav Chugh Kamal Gupta Sameer Dalal Shardul Pradhan

Head of Research/ Strategy/Logistics/Shipping/Retail/Sugar

[email protected]

55069914

Telecom/IT

[email protected]

55069918

Oil & Gas/ Lifestyle

[email protected]

55069927

Telecom/IT

[email protected]

55069925

Cement/Banking

devang.patel@@investsmartindia.com

55069922

Textiles/Chemicals/ Paper/Fertilizers/Power

[email protected]

55069944

Auto/Auto components

[email protected]

55069933

Pharma

[email protected]

Capital Goods/Building Material/Metals/Infrastructure

[email protected]

55069940 55069943

Sugar/Ship Building/ Shipping

[email protected]

55069926

Retail/Media

[email protected]

55069916

Logistics

[email protected]

55069917

Capital Goods/Metals/Infrastructure

[email protected]

55069921

Textiles/Chemicals/ Paper/Fertilizers/Power

[email protected]

55069941

Economist

[email protected]

55069946

Prachi Kulkarni

Research Support

[email protected]

55069924

Ember Pereira

Research Support

[email protected]

55069940

Rupali Ghanekar

Editor

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55069915

Charudatt Vartak

Production

[email protected]

55069923

[email protected] [email protected] [email protected]

55069912

Anjali Verma

Sales Amola Jhaveri Dharmen Shah Rita Pani Sandeep Shah Geetha Nair

[email protected]

55069919 55069906 55069907

[email protected]

55069947

[email protected] [email protected] [email protected]

55069909 55069903

[email protected] [email protected]

55069902 55069910

[email protected]

55069911

Sales support

Dealing Anish Marfatia Anmol S. Shanbhag Firdaus Ragina Khozem Jabalpurwala Mohan Joshi Nipul Kenia

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55069905

Oil & Gas

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Disclaimer Clause This report has been prepared by the Research Department of IL&FS Investsmart Limited (IIL). The information and opinions contained herein have been compiled or arrived at, based upon information obtained in good faith from sources believed to be reliable. Such information has not been independently verified and no guaranty, representation of warranty, express or implied, is made as to its accuracy, completeness or correctness. All such information and opinions are subject to change without notice. This document is for information purposes only. Descriptions of any company or companies or their securities mentioned herein are not intended to be complete and this document is not, and should not be construed as an offer or solicitation of an offer, to buy or sell any securities or other financial instruments. IIL, its directors, analysts or employees do not take any responsibility, financial or otherwise, of the losses or the damages sustained due to the investments made or any action taken on basis of this report, including but not restricted to, fluctuation in the prices of shares and bonds, changes in the currency rates, diminution in the NAVs, reduction in the dividend or income, etc. IIL and other group companies, its directors, associates, employees may have various positions in any of the stocks, securities and financial instruments dealt in the report, or may make sell or purchase or other deals in these securities from time to time or may deal in other securities of the companies /organisations described in this report. This report is not directed to, or intended for display, downloading, printing, reproducing or for distribution to or use by, any person or entity who is a citizen or resident or located in any locality, state, country or other jurisdiction where such distribution, publication, reproduction, availability or use would be contrary to law or regulation or what would subject IIL or its affiliates to any registration or licensing requirement within such jurisdiction. If this report is inadvertently send or has reached any individual in such country, especially, USA, the same may be ignored and brought to the attention of the sender. This document may not be reproduced, distributed or published for any purposes with out prior written approval of IIL. Foreign currency denominated securities, wherever mentioned, are subject to exchange rate fluctuations which could have an adverse effect on their value or price, or the income derived from them. In addition, investors in securities such as ADRs, the values of which are influenced by foreign currencies effectively assume currency risk.

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