Royalty payment on onshore assets an overhang for ONGC stock

After good Q3 results and production ramp-up, it may see part of these gains getting offset if royalty issue scope is expanded

The Supreme Court’s direction to Oil and Natural Gas Corporation (ONGC) to pay royalty to the Gujarat government based on market price of crude oil compared to post-subsidy price that ONGC used to pay has led to rise in concerns. For now, the impact may be limited as the royalty payment is restricted to Gujarat only. Secondly, it is to be paid from the month of February versus Gujarat government’s demand for payment to be effective 2008. However, the risks remains that if implemented from an earlier period or also made applicable to ONGC’s production in other states, the company will have to take a bigger hit.

It is incidents like this that leads to the ONGC stock trading at substantial discount to its fair value, even as news flow on the operational front remains positive. For instance, the company is expected to see a ramp up in oil and gas production, benefit from diesel price hikes as well as can see strong gains accruing from proposed gas price increases from April 1 this year. Since mid-2009, the stock has traded around Rs 240-365.  At current levels of 277, the stock is marginally up post results last Thursday and is close to its three-month low of Rs 268, wherein it trades at a reasonable PE of 7.5 times FY15 estimated earnings and lower than analysts’ target prices of over Rs 320. Valuations are also below international peers. Until clarity emerges, the hangover of higher royalty pay-out and uncertainty on subsidy sharing will keep the upside for the stock under check.

The Royalty decision
Last Thursday’s decision of Supreme Court on royalty payment is expected to erode FY15 EPS of ONGC by Rs 1.7 a share, as per estimates of Nitin Tiwari at Religare Capital Markets. Analysts at IDBI Capital have cut their FY15 EPS estimates by seven per cent and sum-of-the parts target price from Rs 324 to Rs 314 now.

However, the final take of extending the ambit of this decision can have a significant impact on ONGC’s earnings. The decision on royalty adjustment for previous years will be taken in the next hearing scheduled in April 2014. The earlier order of the High Court had ruled ONGC to pay up for the previous years too, which comes to about Rs 10,000 crore, add analysts at IDBI Capital.

Rohit Nagraj at Sunidhi Institutional research says that for now he expects the decision to result in about Rs 200 crore a month increase in royalties. He adds, if it becomes applicable for all India-based onshore crude production of ONGC, the impact on earnings would be about seven-eight per cent. He has not accounted for the same in his estimates as of now, and is awaiting clarity.

Diesel price rises & subsidy
The diesel price rises undertaken since the start of 2013 have accrued positive results for the oil and gas companies, including ONGC. Regular increases in diesel prices have helped reduce under-recovery for diesel to Rs 7.4 a litre in January compared to Rs 10.3 a litre in December 2013 and Rs 9 in January 2013, despite rupee depreciation. Analysts are hopeful that regular price hikes will continue and now peg FY15 under-recoveries (difference between selling price and cost price of fuels) at Rs 105,000-120,000 crore compared to earlier estimates of Rs 1,40,000 crore. The international crude oil prices are stable with supplies from Iran and Libya increasing. The rupee is also seen trading in the band of Rs 62-64, say experts.

In this backdrop, the subsidy provisioning of Rs 65,000 crore provided in the interim budget on Monday seems adequate looking at the current estimates of subsidy burden, say analysts like Bhavesh Chauhan at Angel Broking. However, analysts say what matters more is the actual pay-out and the timing of pay-outs which has a bearing on the oil companies, given that government’s re-imbursements mostly come with a lag or at times are rolled over to next financial year. It is because of these issues, the market discounts positives only when they accrue. For instance, Tiwari says ONGC’s stock price is yet not factoring in the gains from gas price increases.

Better Q3, rising output
Meanwhile, in the quarter ending December 2013 (Q3), ONGC reported standalone net sales of Rs 23,355 crore up 10.7 per cent year-on-year. While net dollar-based realisation was slightly lower, a weak rupee helped. Margins thus improved 570 basis points to 59.5 per cent and profits grew 28 per cent to Rs 7,126 crore. However, even after adjusting for the one-off income (other income jumped 108 per cent to Rs 2,662 crore) and fall in other expenditure (due to change in accounting policy), the operational performance was in line with estimates. This was despite 10 per cent rise in subsidy to Rs 13,765 crore.

With ONGC having successfully integrated five of the 32 marginal fields, it should contribute around 4.8 mmscmd of natural gas and 29,000 barrels per day of crude oil in the coming quarter. Going ahead, it will add more marginal fields to support output. The company maintained its standalone oil/gas production guidance of 28.3 mt/26.9bcm for FY15 versus analysts’ estimates of 27.24 mt/25.29bcm in FY14. (mt is million metric tonnes; bcm is billion cubic metres).

ONGC Videsh, which accounts for about a sixth of ONGC’s output, is expected to see production rise seven to eight per cent annually during FY13-15. Since it does not have to bear any subsidies, expect gains to flow through to the consolidated bottomline.