Earnings upgrade for ONGC likely if subsidy burden dips

Earnings may rise 30% on higher output and lower subsidy burden

A day after the government deferred its decision on raising gas prices by three months, shares of Oil and Natural Gas Corporation (ONGC) lost five per cent. While this might be negative in the short term, the stock has plenty of other triggers, say analysts. The market is expecting finance minister Arun Jaitley to give a clear road map  next month on subsidy reduction. The government has shown its commitment by continuing with the monthly increases in diesel prices, expected to eliminate the diesel subsidy burden in four-five months. Currently, the diesel subsidy stands at Rs 2.8 a litre and with underrecoveries coming down further, ONGC's profits might increase 25 per cent, says Edelweiss Securities.

The Street expects the subsidy share of upstream companies to fall substantially. Earlier, the Street was factoring in a 50 per cent fall in the subsidy burden but the market is now reconciled to a lower figure. Motilal Oswal Securities is assuming a subsidy reduction of 40 per cent against the likely 50 per cent reduction in underrecoveries reduction. With such a contraction in subsidy burden and no gas price rise, it expects a 30 per cent upside in ONGC's earnings over FY14. The understanding is that the government will first lower subsidy for upstream companies and then for the marketing companies.

According to analysts, the government might not have much choice on higher gas prices. ONGC’s cost of production has been increasing, though output has not increased from the same fields, which points to rising costs. Even if ONGC does not get the entire benefit of the gas price hike, a $1/mBtu increase in gas price will impact ONGC's earnings per share by Rs 2.8 a share, a positive.

ONGC also has conveyed to analysts that it expects production to increase by 1-1.5 million tonnes in FY15 thanks to enhanced oil recovery. The increase in production is expected from the June quarter itself. In May, ONGC’s production stood at 300,000 barrels against 290,000 barrels in April.

The market broadly feels the public-sector oil companies are set to see a structural re-rating as operational metrics are expected to improve. If liquefied petroleum gas (LPG) reforms are rolled out along with diesel deregulation, ONGC could be a strong candidate for an earnings upgrade. According to IIFL, the stock currently trades at 9.7x FY16 earnings and with a lower subsidy burden from LPG reforms, volume growth and improvement in gas profitability, valuation should re-rate to 13x.