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RIL: Back to fundamentals

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The final report of the (CAG) on the effectiveness of the production sharing contract (particularly KG-D6) was tabled in Parliament on Thursday. While the report has come down heavily on the government and the Directorate General of Hydrocarbons (DGH), analysts believe the language against is substantially toned down, compared to the draft report. Shares of RIL have shown a smart recovery since the news of the report came in.

A report by Citi says the report has made no mention of the $746 million of expenses included but not incurred (tantamount to front-loading of expenses) that was referred to in the draft report. Goldman Sachs says: “While the report reiterated that RIL violated terms of its production sharing contract (PSC) for D6, it stopped short of questioning the validity of the increase in D6 capex from $2.4 billion to $8.8 billion between 2004 and 2006.” Analysts claim the CAG has remained silent on the contentious issue of higher capex and only questioned the fall in gas production, despite making such heavy capital investments. RIL issued a detailed press release on Friday, explaining its stand. Quoting from E&Y’s procurement audit, the release says: “There was no evidence identified suggesting that costs were overstated in purchases from third parties or purchases from related parties and affiliates and in respect of other costs, including allocated costs and non-purchase order-based expenditure.” Of the total project cost of $ 8,166 million relating to exploration and development incurred till March 31, 2011, in KG-D6, only one per cent was incurred through related parties.

The report appears to be critical of the oil ministry and upstream regulator DGH, due to their oversight on issues such as high-value procurement by RIL and non-confirmation with the provision of relinquishing 25 per cent of the contract area of the block after each phase of exploration. The government has defended this criticism before the CAG.

According to JPMorgan Asia Pacific Equity Research, the CAG has questioned the basic premise of Nelp (New Exploration Licensing Policy) incentives and the production sharing contract bidding system, given planning of capex can improve returns for operators. “We note that the Nelp was set up to incentivise private sector investment in the exploration and production sector. A profit motive would be necessary to encourage private sector players into high-risk deepwater exploration/development.

While we agree a stronger procedural and oversight mechanism needs to be in place, as pointed out by CAG excessive government scrutiny would be a deterrent to investment.” RIL’s release says the petroleum fiscal system in force does not create any incentive for the contractor to overspend. Given that the near-term overhang on the stock has been taken away, it’s back to fundamentals for RIL. Parliament’s Public Accounts Committee stated it would look into the report and decide on a future course of action. Going forward, what will drive the stock’s performance will be refining and petro-chemical margins, increase in output from D6 and incremental returns from deployment of surplus cash.

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