Why has Reliance failed to keep up production of gas from its D6 field? The answer may reveal more about disincentivised pricing than capacity issues.
After establishing itself as India’s most valuable company—one with the largest market capitalisation—for four years straight, Reliance Industries Ltd (RIL) was unseated from its perch by government-owned Coal India Ltd last week. Two days later, RIL had the ignominy of seeing another government-owned concern, Oil and Natural Gas Corporation (ONGC), creep its way to within a hair’s -breadth of Reliance’s second place position. For a company that was a stock market star since 2007 by sheer weight of its energy business, RIL’s return to the top slot again is hardly a consolation. Its challengers are, after all, mammoth public sector giants known for their unwieldy scale and inefficient production.
All three companies are into the business of energy but are fundamentally different in the way they are run because of divergence in their ownership. Still, they share a few similarities today in that they are all cash rich firms facing stagnating production and pricing controls. The market, however, seems to be treating them somewhat differently. While it has not been favourable to ONGC because of a mounting subsidy burden, it seems to have discounted challenges faced by Coal India. More importantly, it seems to have punished the RIL scrip—essentially viewing it as a company that is running out of investment ideas.
The big question is, why has RIL not addressed investor concerns? After all, the company has hardly divulged anything meaningful on plans to ramp up gas production or what it intends to do with the piles of cash it is sitting on. Mostly, however, it has remained silent over the 25 per cent fall in production in the past few months. Could it be, that the price of gas, capped at $4.2 per million British thermal unit for five years by the government is proving to be a disincentive for production? Is it possible that RIL is simply waiting to re-negotiate the price at a more favourable level, and then ramp up production?(Click here for graphics)
In its submission to the Comptroller and Auditor General (CAG), RIL says that a rise in gas prices by even $1 for a million British thermal unit boosts the profitability of the project, making the government share reach higher tranches of profit sharing much faster. A close look at the production sharing contract that governs D6 reveals that the company has to pay a percentage of the profits from the block to the government, which varies with the Investment Multiple (IM). The company pays 10 per cent of profits when the IM is less than 1.5; 16 per cent between 1.5 and 2; 28 per cent between 2 and 2.5; and 85 per cent thereafter.
According to Niko Resources, RIL’s 10 per cent partner in the D6 block, the profit share with the government was 10 per cent as of March 31, 2011. Many in the petroleum sector suspect that the company does not want to produce more gas from its Dhirubhai 6 block at least till 2014 when it can ask for a higher price. Till then, it could be argued, it is content with smaller production of its finite reserves of gas. The removal of a tax holiday on gas production is the second important reason for the company not feeling incentivised to produce more gas, says industry watchers.
While an email sent to the company did not get any response, officials in the ministry of petroleum and natural gas say that RIL, in its discussions with them, maintains that producing higher volumes helps the company. At the same time, the company, in its response to an adverse CAG audit, said that the effect of lower prices on gas produced and sold has been to reduce considerably revenue from gas sales. While this may be the case, recovering costs faster through higher production of finite gas reserves without a higher set price will mean sharing more with the government without the benefit of higher margins.
RIL on its part has already is said to have invested $8.5 billion in D6, $7.2 billion of which it has in some ways recovered by selling off a 30 per cent stake in 21 blocks to petroleum giant BP. So, even if the investment multiple continues to be low, the company has been able to create value for itself without having to share a larger slice of profit with the government. Now, RIL and BP are putting together a team which is expected to come out with a plan to address geological snags and increase production.
The BP deal has not done much to ingratiate the company with certain analysts. According to the Royal Bank of Scotland, RIL has underperformed the market by 59 per cent since the rally in Indian stock markets in May 2009. “There have been lapses on execution (problems in KGD6, relative lack of success in new E&P discoveries, slower speed in new project execution) and recalibration of growth prospects (fewer opportunities for organic growth in core business, choices on inorganic growth not yet working out and zero progress on entry into power segment),” notes a recent RBS report.
While the production problems in KG-D6 have been the key disappointment on the execution side, RBS says it is equally true that the extent of RIL’s successes on new discoveries in deepwater has reduced significantly in the last two years (the majority of success has been in onshore discoveries, which are unlikely to be very material). “Further, the speed at which new projects are launched has also seemed slower. The bulk of the new capital expenditure over the next three years is in projects (new petrochemical cracker, petcoke gasification) that were announced way back in 2007. Projects in new businesses like retail and SEZs have also not scaled up to earlier market expectations.”
Analysts say the other concern relates to capital allocation or reinvestment opportunities. The company’s historical valuation premium to peers is based on its ability to execute new greenfield projects every few years at globally competitive cost structures which helped in substantial jump in revenue and profits. “Given RIL’s current size, finding sizeable projects in its core business to maintain the historical growth momentum will be a challenge, in our view. The de-rating in the stock reflects the view that there are not enough opportunities for organic growth in core business,” says RBS.
Moreover, the company in its interactions with analysts has indicated that a ramp-up of the current gas production of 49 mmscmd could take two to three years. A Citi report says that RIL has identified three locations in D1, D3 for drilling new wells, and is awaiting government approval, following which it can commence tendering activities. Together with the two unconnected wells in D1, D3 (18 out of 20 drilled wells are producing), the company plans to connect all five together as a cluster. In other words, these activities, the company hopes, should allay the fears of analysts and investors regarding its exploration activities.
The government has not yet approved the budget for beginning work on the wells which is critical for RIL to stem the production decline. Moreover, it isn’t as if RIL will benefit from an instant gusher—drilling could take two to three years to complete, and in the interim, production is unlikely to rise. D6 price revision will also be due around the same time. Till then, producing more gas can hardly be a top priority for the company.