India's Proposal to Split Subsidies with Oil Producers Is Credit Positive

Rachel Chua, Associate Analyst & Vikas Halan, VP - Senior Credit Officer, Corporate Finance Group, Moody's Investors Service Singapore

Last Wednesday, various media reported that India's Ministry of Petroleum and Natural Gas was seeking to divide the country's total fuel subsidies equally between the government and the two state-owned upstream oil and gas producers, Oil and Natural Gas Corporation (ONGC, Baa2 stable) and Oil India Limited (OIL, Baa2 stable). The producers' share would include an oil industry development levy, an existing tax based on their crude-oil production.

The plan, if implemented as we expect it will be, would be credit positive for ONGC and OIL because we expect their share of the fuel subsidies to decrease by 36%, or around INR220 billion, thereby improving their cash flows and profitability. They currently share the fuel subsidy burden with the government on an ad-hoc basis as decided by the government.

If the government pays half of the fuel subsidies, we estimate that ONGC's revenue and operating cash flows would increase by INR185-INR195 billion in the fiscal year ending in March 2015, while OIL's would rise by INR10-INR18 billion. These estimates reflect our expectation that total fuel subsidies will decline to INR1.0 trillion in fiscal 2015 from INR1.4 trillion a year earlier as diesel prices become fully deregulated over the next few months. ONGC and OIL could use the increased cash flows for investments in exploration and production.

Upstream producers' 50% share of India's fuel subsidy would be around INR500 billion in fiscal 2015 (fuel subsidies of around INR400 billion and an oil industry development tax of around INR100 billion), down from INR670 billion a year ago (see exhibit).

The proposed change in the fuel-subsidy mechanism reflects the newly elected government's support for India's oil and gas sector. Earnings of the state-owned oil and gas producers would increase further if the government increases the price of domestic gas to $8.00 per million British thermal units (mmbtu) from $4.20. The government has delayed approval of this proposed increase twice this year.

ONGC and OIL sell their crude oil to downstream companies at a discount (their share of the fuel subsidies) because the latter sell refined-oil products (diesel, kerosene and liquefied petroleum gas) at government-set prices, which are lower than their production costs. The government also takes a share of the fuel subsidies by giving cash compensation to the downstream companies.

The downstream companies' under-recoveries, or losses resulting from any shortfalls between their selling prices and production costs, will decline as the selling prices of their products rise. The government has allowed diesel prices to increase by INR0.40-INR0.50 per litre each month since early 2013, which will lead to full deregulation over the next few months.

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