ONGC: Lack of clarity on subsidy sharing and FPO are overhangs

Valuations are attractive and should provide downside support; analysts are bullish.

The stock of the country’s biggest oil producer, Oil and Natural Gas Corporation, fell four per cent to Rs 263.15 on the Bombay Stock Exchange, even as the markets recorded gains of a little over 1.5 per cent on Tuesday. The key reason was the announcement that the company’s follow-on public offer (FPO) would hit the market around mid-September. In the past 12-15 months, too, announcements pertaining to the FPO had led to a decline in the share price.

On Monday, the board approved the red herring prospectus for the FPO, and expects to file it in the next 10 days. Through the FPO, the government will be offering 427.7 million shares, which at the current price is worth Rs 11,255 crore. After the FPO, the government's stake would come down to 69.14 per cent from 74.14 per cent now.
 

SOTP VALUATION
	Rs per share
ONGC Standalone	249.09
ONGC Videsh (OVL)	53.51
MRPL	25.84
Core value	328.44
Investment value *	10.29
Exploration upside- Carabobo (OVL)	5.12
Royalty recoverable (Rajasthan-Cairn)	16.00
Total value	359.86
* Holding in Petronet LNG, GAIL, IOC Source: Nirmal Bang Institutional Equities Research

  

SUBSIDY WOES
EPS Rs estimates for ONGC	FY12E	FY13E
Assuming 39% (base case)	37	41
Assuming 33.33% share	41	43
No subsidy burden	60	55
Subsidy share is for upstream companies             Source: Kotak Institutional Equities

Analysts say the valuations are attractive but the stock could remain under pressure in the interim. The increase in supply of paper is one factor and the other is the lack of clarity on the subsidy sharing mechanism.

Hence, they expect the FPO to be priced at a good discount to the current market price. A five per cent discount (over Tuesday’s closing price) would mean the government will be able to raise about Rs 10,700 crore. At a 10 per cent discount, this works out to Rs 10,130 crore.

ISSUES
Ashutosh B, analyst at Nirmal Bang, says: “ONGC’s FPO is not likely to get a warm response unless clarity emerges on the subsidy sharing formula (for retailing petro products). The company is still undervalued, as the market is entirely focused on upstream contribution to subsidies, overlooking improving business fundamentals in its local as well as overseas operations.”

The government has been following an ad hoc subsidy sharing mechanism. While the upstream companies, ONGC and Oil India, typically shared a third of all under-recoveries, this was increased to 39 per cent for 2010-11 (announced in April 2011). Notably, ONGC contributes 80 per cent of the entire subsidy burden borne by the upstream oil and gas companies.

On the flip side, the government recently allowed ONGC to recover as cost the royalty it paid on the Barmer block in Rajasthan, operated by Cairn India. ONGC has paid close to Rs 2,000 crore as royalty in the past two years. With this, the management expects to clock in a one-time gain of about Rs 1,600 crore in this financil year from a refund. Importantly, the company would no longer suffer on this count.

The other positive is the subdued outlook for crude oil prices, consequent to fears of a slowing in key world economies. Normally, higher crude oil prices would mean higher profits for an oil producing company like ONGC. However, since ONGC bears a large part of the subsidy burden, lower prices would mean lower subsidies (discounts to oil marketing companies). Second, it will be able to extract higher realisations.

For the June quarter, though its gross realisation was $121.3 per barrel, net realisations were just $48.7 per barrel. Crude oil prices have softened recently. The management said that at $100 a barrel and a subsidy share at 33.33 per cent, its net realisation should work out at $60 a barrel. The September quarter will witness the full impact of recent fuel price rises and duty cuts in the form of lower under-recoveries and boost ONGC's profitability.

OUTLOOK, VALUATIONS
Sanjeev Prasad of Kotak Securities believes gas volumes from ONGC's own field would remain stable, as against the official expectation of a 14 per cent rise over 2010-14. Analysts believe the company's estimated earnings per share (EPS) for 2013-14 will be lower by a rupee if the management fails to meets this target. ONGC expects to start some of its new fields (currently under development) by 2013-14, which would fuel further growth.

Besides, the company is exploring alternative energy domains such as nuclear energy, solar energy and hydrogen cells, which should drive growth in the long term. Its overseas subsidiary, ONGC Videsh (OVL), does not have to bear any subsidy burden and should aid ONGC's consolidated earnings in times of high crude oil prices. The contribution from OVL to EPS is likely to increase by 17 per cent in 2011-12, compared to 10 per cent in 2009-10, led by higher volumes. In this backdrop, most analysts are bullish on the stock and are not ruling out gains of 25-30 per cent on a one-year horizon.