Subsidy uncertainty, FPO mar near-term prospects

Higher than expected subsidy burden compressed Oil and Natural Gas Corporation's (ONGC) profit for the March quarter. While, uncertainty over subsidy sharing formula in 2011-12 continues, ONGC's upcoming Rs 12,000 crore follow-on public offer (FPO) in mid-July should prove to be an overhang on the stock in the near term. Any positive development towards the royalty issue with Cairn India should act as a catalyst.

While there are some near-term concerns, the long-term fundamentals of the company remain good. Thus, most analysts have a buy-rating on the stock, which at Rs 281.60, trades at 9.3 times and 7.8 times its estimated 2011-12 and 2012-13 earnings, respectively.

MARCH QUARTER: SUBSIDY HIT
For the quarter ended March 31, despite a 2.3 per cent y-o-y rise in the crude oil output (at 6.8 million tonnes) and stable natural gas production (6.3 billion cubic metres or bcm), ONGC's profits fell sharply. This was due to the higher subsidy sharing of Rs 12,135 crore (up 143 per cent y-o-y) as the government raised the subsidy share of upstream companies such as ONGC to 38.5 per cent (compared to 33 per cent in the last three years) of the total under-recoveries for 2010-11.
 

MARGIN SQUEEZE
In Rs crore	Q4’11	FY11
Revenues	16,108	113,067
% chg y-o-y	0.7	11.1
Ebitda (%)	49.5	42.8
Chg in bps	-940	-670
Net profit	2,791	22,456
% chg y-o-y	-26.1	15.7
P/E (x)	-

10.8 Source: Company data, analysts reports

Thus, ONGC gave additional discount of Rs 3,300 crore to the oil marketing companies in the quarter, leading to a 40 per cent fall in its net crude oil realisation to $39 a barrel (bbl) vis-à-vis $51 a barrel in the year ago quarter (and $65 in the December quarter). Some of this pressure was offset by a 136 per cent surge in gas realisation to Rs 4.3 per standard cubic metre thanks to the rise in administered gas price.

The company's employee costs for the quarter also jumped 61 per cent y-o-y to Rs 427 crore, which along with higher subsidy share and flat revenues led to a 940 basis points contraction in the Ebitda margin. In addition, depreciation (due to write-off of dry well, impairment and survey expenses) grew 7.6 per cent to Rs 4,788 crore, impacting profitability.

THE ROAD AHEAD
ONGC holds 30 per cent in the oil-rich Rajasthan block (Mangala, Bhagyashree and Aishwarya-MBA) while Cairn holds the balance. It has paid an estimated Rs 1,300 crore in royalty towards Cairn India's share in this block in 2010-11. While talks of moving to a cost recoverable model for royalty payment is underway, if not accepted it will be a burden for ONGC given that crude oil production at the MBA fields is being ramped up from current levels of 125,000 barrels a day. Positively, deregulation of diesel prices would help lower ONGC's subsidy burden thereby improving its profitability.

Meanwhile, incremental production from ONGC's existing fields, coupled with significant discoveries in high-potential Cambay, KG basin and Mahanadi fields could be materially earnings accretive for the company in the coming years. In addition, good volume growth coming in from ONGC Videsh, its subsidiary which has global oil and gas assets, by 2013 due to higher production at Myanmar, Sakhalin-I and Venezuela will further fuel growth.

Given that ONGC has been consistently improving its reserve replacement ratio (reflects how much the company added to its reserve in proportion to its annual output) indicates good growth visibility. According to an Emkay Global report, this has risen from 1.35 in 2006-07 to 1.44 in 2008-09 and further to 1.76 in 2010-11.