ONGC an underperformer, target Rs 1065: HDFC Sec

HDFC Securities has maintained underperformer rating on ONGC with target price of Rs 1065.

HDFC Securities research report on ONGC

Investment positives….are they really enough? • ONGC Videsh’s (OVL) reserve accretion (2P reserves are about 8.4% of consolidated reserves, though OVL has downgraded its 1P reserve estimate in FY07) and the absence of subsidy burden, to be key to consolidated profits in the medium term.

The deregulation of APM gas prices in India to be key to ONGC’s earnings going forward. Though the process of deregulation has slowly begun, considering the political situation, the chances of further price hikes are remote. Though we model a robust Brent crude oil price of USUSD73/ bbl & USUSD78/bbl in FY08E & FY09E, we expect a modest realization growth for ONGC in the band of USUSD 47 approx USUSD 49/bbl. The gains in crude realization are largely capped due to an 8.9% appreciation in the rupee and higher subsidy payouts.

Successful EOR/IOR implementation at Bombay High and media reports of huge gas finds in the KG basin, indicate domestic E&P turning around, which is a positive. However, we await more such announcements before calling it a turnaround. ONGC has underperformed the Sensex by 26% & 13% during the last 6 & 3 months respectively. We understand, over the next 18 months, there will not be any significant increase in production. Moreover, the uncertainty over the subsidy burden is likely to prevail. And with the general election in 2009, (earlier if the recent political noise is anything to go by) any increase in natural gas or fuel prices is remote. In the absence of near term catalysts, as our base case, we rate ONGC as an “Underperformer” on an SOTP based target price of Rs 1065, implying an EV/boe of USD7.7.

Any exploration success (considering the large acreage in the highly prolific KG basin) and clarity on reduction in subsidy burden would make us upgrade our recommendation. On an optimistic basis, we value the fair price at Rs 1150 or USD8.4 EV/boe, translating into an 18% upside from current levels.

Weaknesses 

ONGC has made no significant commercially approved new finds in 6 years. Moreover, reserves being added are mainly of lower value gas as opposed to oil. Most of ONGC’s assets are ageing ( Age of gas assets are about 22yrs) and gas realizations are at a significant discount to imports/through other sources. For example, ONGC’s APM gas price is USD1.97/mmbtu against RIL’s gas price at USD4.2/mmbtu.

Threats 

Rising rupee remains a matter of concern, as it hurts revenues more than decreasing subsidy. Every rupee rise against the dollar erodes ONGC’s revenue by Rs 9.5bn and reduces the industry’s under-recovery by Rs8.5bn. • Any fall in crude oil prices is likely to affect ONGC’s earnings. Every one USD/bbl rise in crude oil prices, is expected to increase ONGC’s EPS by Rs1.42, assuming market dynamics function without the subsidy element, which is obviously not the case. • Inherent risks of the exploration business remain.

Strengths • Near monopoly and high entry barriers:

ONGC currently accounts for 84% of the domestic natural gas and crude supply. Its domestic exploration licenses cover a total area of approximately 6,80,800 sq. kms and has been awarded almost 50% of the total blocks that have been granted under New Exploration & licensing Policy (NELP). 

Benefits of downward integration:

ONGC has been granted a license to set up retail outlets for marketing petroleum products. It has a 72.16% stake in MRPL, which marks its entry into the refinery business.

OVL’s encouraging business model:

OVL has a good mix of exploration, development and assets across the globe, which we believe has the potential to surprise on the upside in the future. It has picked up stakes in oil equities in 15 countries and has a target to expand its oil equity base to 20 MT by 2010.

Opportunities • Deregulation of gas prices:

ONGC’s gas from nominated fields (about 80%) is currently under the APM regime, where the realizations are at USD 2.5/mbtu, which is at 64% discount to imported LNG. However, it is believed that the sector would get deregulated in some years and ONGC would be the biggest gainer. ONGC has been pursuing Enhanced Oil Recovery (EOR) & advanced techniques to arrest resource decline from ageing fields and enhance recovery of oil & gas. Any exploration success or reserve accretion through outright purchases by OVL.