How gas price hike will impact oil cos? Macquarie's take

The Cabinet Committee on Economic Affairs (CCEA) is expected to meet today evening to discuss the sensitive issue of domestically produced natural gas pricing. While, the Power Ministry continues to oppose the proposed increase in domestically produced gas price to more than USD 5/mmBtu, the Petroleum & Natural Gas Ministry is proposing a gas price of about USD 6.77/mmBtu. (Gas pricing dilemma: Will government bite the bullet?)

Every USD 1 increase in price will lead to a viability of 9 tcf additional output, says Jal Irani, Managing Director -Oil & Gas Research at Macquarie Group. "USD 6.8/mmBtu, which is healthy, is a far cry from international prices of USD 15-20/mmBtu," he told CNBC-TV18. Though he agrees that it would be a good start, he says it still wouldn't really allow any of the players, not just Reliance Industries, very aggressive in the space. "The formula suggests that the price of the gas escalates very quickly to about USD 8/mmBtu by early next year. In fact, (if) the Rangarajan Committee formula has to be implemented in full, it could well go in excess of USD 12/mmBtu by FY16, which then full unleashes India's full potential for significant gas reserves," he says. Jal says Oil India and ONGC are likely to be the biggest beneficiaries of the gas price hike. For every dollar increase in gas prices, Oil India's profits go up 14 percent, while for ONGC it goes up by 10 percent, according to Macquarie estimates. "Of course it remains to be seen whether the government imposes some sort of cess or enhanced subsidy burden on these companies," Jal says. Below is the edited transcript of his interview with CNBC-TV18: Q: Everybody is waiting with great anticipation, you have written about it but if we go get to something like USD 6.6 in terms of pricing going up to over USD 8 over the next couple of years - do you think that will be pricing incentive enough for companies like Reliance Industries to come ultra aggressive on getting more gas production or ramping up gas production? A: Essentially to start with, India has got very significant potential gas resources and that every threshold of price certain amount of these resources can be extracted. If we are talking about a price of USD 6.8 which is about 60 percent increase we will have say about 20-25 trillion cubic feet (TCF) more which is about 50 percent of additional gas reserves in India becoming viable and that would be a good start. But there is significantly more to be extracted at even higher prices. Roughly for every dollar increase in price about 9 TCF becomes viable and even at USD 6.8 million metric British thermal units (mmBtu) which is healthy but which is a very far cry from international prices of USD 15-20 mmBtu. It would be a good start but it still wouldn’t allow any of the players leave alone Reliance to become very aggressive in this space. Notably, this USD 6.77 mmBtu which is being talked about is based on a formula. The formula suggests that this is just the initial price. The price of the gas escalates very quickly to about USD 8 and by early next year. In fact, if the Rangarajan Committee formula has to be implemented in full it could well go in excess of USD 12 by financial year (FY) 2016 which then truly unleashes India’s full potential for significant gas reserves. _PAGEBREAK_ Q: Two part question here. First, do you think if that indeed is the formula that has worked out it is going to take some time for some of these stocks to react or pick up significantly because of the gas price hike. Secondly, how meaningful do you think it is going to be for the two PSU names involved – Oil and Natural Gas Corporation (ONGC), Oil India Limited (OIL)? A: There are two elements to this. First, the most significant and obvious beneficiaries from an earnings perspective are going to be Oil India and ONGC. For every dollar increase in gas prices, Oil India’s profits go up by 14 percent according to our estimate and ONGC by 10 percent. Of course, it is to be seen whether the government imposes some sort of a Cess or enhanced subsidy burden on these companies. But these by far, would be the most significant beneficiaries. Q: Whether this will take a long time to play out and the potential will not be unlocked any time in the next few quarters? A: For production to increase within the next two quarters is virtually impossible. The first material increase in production we would see is perhaps in a year’s time and in fact two years time. So, even the existing wells of Reliance KG-D6, D1,D3 area the work over programes to clear out the sand and the water ingress, itself would take about one or two years. First relevant increase in production would take at least a year but the nature of the upstream business especially gas because one requires a lot of infrastructure and linkage is one of long-term. It is after two years that one will see things starting to rocket and the newer fields will perhaps take as much as five years. But the benefits will start flowing through within the next two years, I would say. Q: The concern is with ONGC because what the government may give with one hand it may take away with another by levying an extra subsidy burden, that has been the problem with that – do you think that is the way that it might pan out that on paper ONGC benefits but when the actual numbers come in their realizations are pretty much stuck at the same level?

A: That is a possibility and in fact probability as well. If I may answer this in two parts - Firstly, if we look at history, about three years back when ONGC did get a doubling in gas prices its realisations were less than USD 2 which were hiked to USD 4.2. The government did increase effectively the subsidiary burden but over a period of two years ONGC was allowed a profit increase of 35 percent odd, which is pretty healthy. The bottom-line here is that the government recognises that there is a need to give higher cash flows, higher prices, otherwise one is not going to get a higher production.

 

The important point here is that ONGC’s cost of production for gas is USD 3.8 mmbtu. Despite, Mumbai High accounting for about 60 percent of its production and Mumbai High being one of the most prolific and the lowest cost producing fields in the world, even there the cost is nearly at the selling price. Unless one gives a reasonable price one cannot produce.

The third thing is that, unlike the NELP (New Exploration Licensing Policy) blocks, which are pretty much the newer blocks such as the one for Reliance Industries. For ONGC and Oil India almost all their production comes from the nomination blocks where there is really other than royalty ranging between 10-20 percent, there is really no other taxes, there is no profit share.

 

Even on oil there is a fixed cess of about USD 12 per barrel for the nomination blocks for Oil India and ONGC which is absent in gas altogether. So, the point being that it is only fair that a modest amount of the upside does accrue to the government in the form of incremental taxes. As long as ONGC and Oil India still get a reasonable net increase in any case which in the past the government has demonstrated that it is willing to do.