Margin pressure ahead as city gas distribution majors continue to struggle

The city gas distribution (CGD) sector is struggling to cope with a sharp reduction in allocation of administered price mechanism (APM) gas.

Effective October 16, APM gas allocations have been reduced to about 50 per cent.

The government has cut APM allocation to CGDs by 21.2 per cent from 19.68 mmscmd to 15.5 mmscmd from October 16, 2024. This cut is on account of the 20 per cent premium pricing of APM gas from new wells of ONGC and Oil India.

The one-time extent of reduction is a negative surprise.

Alternative supplies would be from a mix of high pressure high temperature (HPHT) gas (with ceiling price $10.16/mmbtu), new well gas from APM fields (12 per cent of oil), Henry Hub-linked LNG ($8-9/mmbtu), or oil indexed/spot LNG ($12-13/mmbtu).

Ballpark estimates are that gas costs will rise Rs 3.0-3.2/scm for CGDs which would require Rs 5.0-5.5/kg CNG price increase to offset that cut.

Given the weak demand, and lower price arbitrage versus petrol/ diesel, and upcoming Assembly elections, price increases will be gradual, hitting margins across H2FY25.

In earlier periods, when APM was in short supply, CGDs were forced to source expensive LNG with costs rising 5-6 times.

In order to improve supply to CGDs, allocation for internal consumption was cut by GAIL and ONGC (which uses it for ethane/propane production for its subsidiary OPaL).

OPaL is now making losses at the operating profit level.

As part of the restructuring of OPaL, the government has re-allocated up to 3.2 mmscmd APM gas (from new wells).

This has led to APM gas reducing 20-21 per cent for CGDs.

APM supply was at 85 per cent in April 2023 and it is now down to around 52 per cent. Gas costs are likely to rise even more as APM shortfalls widen and prices further increase.

The electric vehicle or EV threat is also becoming more serious. Priority sector allocation may potentially reduce to 4.5 mmscmd for Indraprastha Gas (IGL), 2 mmscmd for Mahanagar Gas (MGL) and 2.3 mmscmd for Gujarat Gas for FY26.

This implies a hit of Rs 2.7 per scm for IGL and Rs 2.4/scm for MGL and Rs 1.5 per scm for Gujarat Gas in gas costs in FY25.

To sustain, margins will be a challenge. There may, however, be a downside trend to blended/non-APM gas prices which are assumed at $13–16/MMBtu for FY25, given the weak geopolitical trends.

The differential with petrol and diesel prices is at 35–48 per cent currently but this arbitrage may reduce if crude prices fall.

However, CGD companies will look to hike prices judiciously. Since APM gas production is set to fall structurally at the rate of 7.5-9 per cent per annum, there could be further cuts in allocations, unless there’s some clear policy directive to the contrary. This is a long-term concern.

This is a positive for upstream producers since it formally implements a 20 per cent premium pricing policy for APM gas from new wells.

One possibility is that more gas would be made available to CGDs at a 12 per cent premium price to Brent.

At current prices, this would be $9/mmbtu vs the prevailing $6.5/mmbtu, with spot gas also available at $13.5/mmbtu and ONGC's KG basin gas may also become available at $10/mmbtu.

CGD companies would have to maintain arbitrage versus diesel and petrol.

Another possible point of relief may be GST or excise cuts to offset the impact of this allocation reduction.

Analysts are downgrading operating profit and earnings per share of CGD companies while upgrading ONGC and OIL accordingly.

Valuation multiples will also be downgraded at least until there is some policy clarity.