Kotak sees FY16 ONGC EPS at Rs 33, crude at $60/bbl

Tarun Lakhotia, Oil and Gas Analyst, Kotak Institutional Equities in an interview to CNBC-TV18 spoke about the impact on oil and gas stocks like ONGC, Oil India in case the government decides to adopt the new upstream subsidy formula.According to him the structural subsidy sharing formula is positive for oil & gas space and the fuel subsidy bill will be manageable for government if crude is around USD 60/bbl.With crude around USD 60/bbl he expects FY16 EPS for ONGC to be around Rs 33 and that of Oil India around Rs 63. The EPS for both would move up in case crudes goes to around USD 80/bbl, he adds.ONGC according to him is a pure play on crude oil prices.According to the new subsidy sharing mechanism proposed by the oil ministry, if crude stays  below or equal to USD 60 per barrel then there would be no upstream contribution but it goes above that then upstream companies will contribute 85 percent. And in case crude is above USD 100/bbl then contribution from upstream will be 90 percent.

Below is the transcript of Tarun Lakhotia's interview with Latha Venkatesh and Reema Tendulkar on CNBC-TV18.Reema: What the Delhi election and Aam Aadmi Party (AAP) win change anything for Indraprastha Gas Ltd (IGL)?A: I would like to clarify that we do not cover IGL and other city gas distribution companies. Having said that, we will have to see how the state government allows for the kind of profitability which these companies have earned by increasing CNG prices well ahead of the raw material cost increase and whether they are allowed to maintain that level of profitability going forward.Latha: The oil and gas - the fuel price formula is still awaited from the government and we are very strongly expecting it before the Oil and Natural Gas Corporation (ONGC) numbers, what is doing the rounds is that if the oil prices are below USD 60 per barrel, ONGC and Oil India Ltd (OIL) will be excused from any contribution to the under recovery kitty and if it is between USD 60 per barrel and USD 100 per barrel, 85 percent of the contribution would come from the crude petroleum. Is this something that makes life good for ONGC or this is a reason to sell the stock?A: A structured subsidy sharing formula is definitely positive from the sector standpoint as it gives clarity on the profitability of these companies and it also gives some confidence to the earnings estimates of analysts in the sense that we know what the subsidy sharing formula is at different level of crude prices and accordingly we can forecast our earnings. The issue at hand is at lower level of crude prices, which is if the crude remains at USD 60 per barrel, we are looking at a fuel subsidy bill of about Rs 27000 crore for FY16. So that number is pretty much manageable from the government’s kitty especially taking into account the incremental Rs 90000 crore of excise collection from diesel and petrol, which the government would get on a year-on-year (Y-o-Y) basis.However, if crude prices increased to the level of USD 80 per barrel, you are looking at an overall subsidy bill of Rs 62000 crore - assuming this formula is implemented by the government, the government would be required to compensate Rs 44000 crore of fuel subsidies. Now you have to keep in mind that the excise collections may also come down as the government may be required to cut the excise duty on diesel and petrol, which they have been increasing till now. Assuming it goes to higher levels in which case, the sustainability of this formula maybe brought to question.Our view is the government should take a few more steps than just providing the other subsidy sharing formula, the steps could be in the form of trying to curtail LPG subsidies by reducing the cap of subsidised cylinders from 12 per annum per household which we have right now to a more reasonable level of 9 or 6 because if you see on an average, the household in India consumes about 7-8 cylinders per annum. The other thing which the government may want to consider is monthly increase in LPG price, which was pretty successful in case of diesel so Rs 10 per month increase could save about USD 85-90 billion of fuel subsidies for next year. So if the government implements such things, which curtails the fuel subsidies on LPG and kerosene, we would get more confident on the sustainability of the subsidy sharing formula and it will also give us some clarity on the estimates for these companies and the valuations, which one should ascribe to that.Reema: If crude perhaps stabilises around that USD 60 per barrel to USD 80 per barrel mark then how attractively priced will ONGC and OIL look and what if it starts moving towards that USD 100 per barrel mark, then how would you play the oil and gas sector?A: If crude remains at USD 60 per barrel, I think ONGC is in fact pretty much discounting that kind of level. So at USD 60 per barrel assuming this formula to be implemented by the government, we are looking at an EPS of Rs 33 for next year also taking into account some reduction in gas price for the next year.At Rs 33 giving a ten time multiple, adding a value investments you get to about Rs 350-360 of fair value, which is where the stock is pretty much right now but if the crude goes to a level of USD 80 per barrel and this formula remains sacrosanct then you are looking at an EPS of Rs 41 for ONGC at a 10 time multiple adding value of investments you will get to about Rs 430 as a fair value, which still gives you 20-25 percent from the current levels.In case of OIL, its EPS, at USD 60 per barrel in the same scenario, comes to about Rs 63, the stock is at 8.5 times the earnings. If crude were to go to USD 80 per barrel the EPS will look like Rs 69-70 in FY16 and the stock is at 7 times that EPS. So I think OIL is still better placed and I would expect the valuation gap between OIL and ONGC to narrow at these level of crude prices as one would also start getting comfort on OIL’s production trajectory with some stability in oil production and some improvement in gas production to come through which may lead to a 20 percent increasing gas volumes for OIL. ONGC is more of a play on crude prices as one expects crude to recover over the next 12-18 months, the stock can give you 20-25 percent return assuming the formula remains a hold till then.Latha: We didn’t concentrate much on LPG - It is a stated policy of Narendra Modi that now LPG subsidies are going to come through direct benefit and that in pilot projects has yielded quite a bit in terms of savings. The second thing is post the Delhi result do you seriously think that they will reduce the 12 cylinders to 6 or even 9 for that matter or even raise prices, would you factor that in when you price your ONGC price targets?A: As of now, we are not building in any benefit on that account. I think the state elections are crucial from the government’s political agenda but having said that the next election due is in November, which is the Bihar elections. So that does give you a ten months period to initiate a few reforms. Government has a choice whether to focus on the overall economic environment and take decisions on the basis of that or probably just stay put at this time given the way the Delhi elections have turned out.