India Energy: Reform push to spark sector-wide re-rating

Religare Institutional Research's report on energy sector

The decisive victory of the pro-reform NDA government should support continued domestic fuel price reform – we now expect diesel U/R to be fully wiped out by end-FY15, improving earnings for upstream/downstream PSUs. Further, an increased focus on development of sectors such as infrastructure and utility, alongside energy security, could spur an earnings growth cycle for ONGC ,  OINL and GAIL . We reiterate our positive view on Oil & Gas PSUs and upgrade target multiples across the board on a brighter earnings outlook.

Continued reforms to rein in under-recoveries (U/R): The NDA Govt.'s decisive win should lend impetus to domestic fuel price reform. In light of the Rs 1.09/ltr hike in prices (May'14), diesel U/R now stands at Rs 5.77/ltr and is likely to drop to zero by end-FY15 upon full linkage to market price. We envisage gross U/R of Rs 1,039bn/Rs 590bn in FY15/FY16 if reforms continue at the current pace, ceteris paribus.

Improving macro outlook: We don't foresee significant upside in crude prices given a comfortable demand-supply scenario over FY15-FY16. Our U/R estimates build in Brent crude at US$ 107/bbl and an INR/US$ rate of Rs 60. As India's fiscal deficit improves amid a macro revival, the INR could also strengthen, opening up the possibility of even lower U/R. Appreciation of Rs 1/US$ lowers U/R by Rs 80bn.

Positive for upstream and downstream PSUs: A reduction in U/R and resulting subsidies would be earnings accretive for upstream and downstream PSUs. While lower U/R would reduce delayed receivables for OMCs, lowering working capital related debt and therefore interest cost, a lighter subsidy burden would ensure better crude realisation for ONGC and OINL. We model for realisations of US$ 55/57 per barrel for ONGC/OINL in FY15 and US$ 60/62 per barrel in FY16.

Maintain BUY on ONGC / OINL ; raise TP to Rs 460/Rs 650: ONGC/OINL have posted returns of 30-35% since we turned bullish on these names in Mar'14 (see Upstream PSUs undervalued – poised for re-rating). We remain positive on upstream PSUs and upgrade our Mar'15 TP to Rs 460 for ONGC (from Rs 380) and Rs 650 for OINL (from Rs 580) on revised valuation multiples. Apart from a reform push, we believe the new Govt. would facilitate organic/inorganic growth opportunities for ONGC and OINL.

Downgrade  BPCL to HOLD; prefer HPCL :  We upgrade our trading multiples and hence Mar'15 TP for BPCL to Rs 600 (from Rs 440) and HPCL to Rs 525 (from Rs 400), given that a reduction in U/R would materially lower OMC short-term debt requirement, in turn curbing interest costs and improving earnings/performance ratios – a case we first made in Aug'13 (see Pessimism overdone; time ripe to buy OMCs). Though BPCL has superior refining and E&P assets, we downgrade the stock from BUY to HOLD on rich valuations and recommend adding it on dips.

Maintain BUY on GAIL : GAIL has underperformed compared to ONGC, BPCL and HPCL despite absolution from U/R payment in H2FY14, primarily due to a muted gas transmission outlook and delays in commissioning of key pipelines due to politico-legal hurdles. However, we reiterate that GAIL has built difficult-to-replicate pipeline infrastructure, even as gas transmission volumes have likely bottomed out, and its tariffs should improve over FY15-FY16. Maintain BUY, TP Rs 475.

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