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Committee favors higher gas price, safeguard govt interest

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January 03, 2013

Rangarajan committee recommends price and production linked bidding and revenue sharing with the govt as against current practice based on cost recovery. Recommends gas pricing based on average netback price of Indian LNG import at the wellhead of the exporting countries and weighted average price of US, UK and Japan markets If gas pricing proposal implemented it would be positive for RIL in medium term. However, ONGC and OIL too would get benefited in the long run. Negative for GAIL

Rangrajan committee has submitted its report to PMO. The recommendations are mainly focused on two aspects 1) Existing Production Sharing Contracts (PSC) and its structure 2) Gas pricing formula

Some of the Key recommendation

1) On PSC
i) Sharing of Revenue with the government without offsetting cost As per current terms of PSC, the contractor is first allowed to recovery its capex first and after that the sharing with government starts. However the proposal recommends government sharing starts from day 1 of production and is linked to production volumes. Impact on players/contractors - Negative Our take This recommendation has been made in response to the issues witnessed in the case of RILs KG basin, wherein CAG has claimed that there was cost escalation in view of the declining in gas production. With the new proposal government intends to discontinue the priority given to contractors to recover their cost, only post which the government sharing starts based on the concept investment multiple. Any such change will only be effective prospective and is negative for contractors compared to current regulation. (ii) To boost the overall investment in E&P space; committee recommended increasing the tax holiday from 7 years to 10 years. (iii) Bidding criteria in the proposed new system: (a) Companies will be required to bid for the Government share of production, after royalty, as per the matrix provided. The bid has to be made separately for oil & gas cases.
Exhibit 1: Matrix for bidding Shallow water offshore block (Oil case) Daily Production (Mbod) < or = 10 > 10 to < or = 30 > 30 to < or = 50
Source: Rangarajan Committee report Note: Matrix for On- land, shallow waters and deep waters for oil and gas have to formed separately

Oil Price ($/Bbl) < or =75 > 75 to < or = 90 > 90 to < or = 105 Government Take (%) > 105 to < or = 120 > 120

(b) The production share for each combination of price-class and incremental productiontranche in the matrix would be biddable by the Contractor. The bid has to be progressive and incremental in terms of the Government take, i.e., the Government take will be in ascending order for corresponding increases in production and price. Thus, under the proposed system, Government take will be progressive with respect to both production and prices. (c) Bidding in constant terms or fractional bidding will not be permitted.

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Bid evaluation criteria (BEC):

(a) Government NPV @ 10% will be calculated for each price band separately for oil & gas only for the Government production share offered (excluding royalty and income tax) and summed up. (b) Government NPV will be calculated on benchmarked production profile. (c) Highest oil & gas price of each band and US $ 140 / Bbl for oil and US $ 12 / MMBtu for gas (as the case may be) for the highest tranche will be used for calculating Government NPV. (d) Company offering highest NPV @ 10% combined for oil and gas can be awarded highest score on the fiscal package in the process for award of the block.
Exhibit 2: Comparison current PSC and proposed model Current PSC a) Realizations b) Less royalty c) Less production costs d) Less exploration costs e) Less development costs (f) Cost petroleum=(c+d+e) (g) Profit Petroleum which is divided between Contractor and Government (c) Profit Petroleum which is divided between Contractor and Government based on investment multiple=(a-f) based on investment mutiple=(a-b) Note: i) Currently, Cost recovery is the independent variable and determines the profit petroleum, which is the dependent variable. ii) The shares of the Operator and the Government in profit petroleum in a particular year are calculated on the basis of PTIM actually achieved by the Contractor at the end of the preceding year.
Source: Emkay Research

Proposed model a) Realizations b) Less royalty

i) No deductions will be allowed after the incidence of royalty and before the petroleum split between the Government ii) Production-sharing between the Government and the Contractor will be linked to the average daily production and prevailing average of oil and gas prices in a well-defined period

2) On Gas pricing
Since India does not have market determined price for domestically produced gas, committee has recommended a policy on taking average pricing of natural gas from below two gas prices -

Average price prevailing at trading points of transaction at the hubs or balancing points of major markets in US (the Henry Hub), UK (the National Balancing point) and Japan (netback prices at the source of supply) Average netback price of Indian LNG import at the wellhead of the exporting countries for the trailing 12 months

Impact on players/contractors Positive

Formula on gas pricing

Netback price = Imported LNG price on netback FOB Liquefaction costs Transportation and treatment cost from wellhead to liquefaction plant

Where:

PAV = (PIAV + PWAV) / 2 Netback Price, N = A B C (I) PIAV = (N1 * V1 + N2 * V2 + ) / (V1 + V2 + V3+ .) (II) PWAV = (A1*PHH + A2*PNBP + A3*PJAV) / (A1 + A2 + A3) (III)

PAV = Appropriate price for domestic producers PIAV = Average Producer Net Back for Indian Imports for trailing 12 months PWAV = Weighted average price to producers in the global markets

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Where:

Netback Price, N = A B C (I)

A = Imported LNG Price on Netback FOB available from World Energy Intelligence B = Liquefaction costs at the respective loading port (source) C = Transportation and treatment costs of natural gas from wellhead to liquefaction plant

Where:

PIAV = (N1 * V1 + N2 * V2 + ) / (V1 + V2 + V3+ .) (II)

N1, N2 are Producers Netback, calculated as per Formula (I). V1, V2 are volumes applicable to N1, N2 Available from World Energy Intelligence or Platts V1, V2, V3 and A shall be for trailing 12 months period.

Where:

PWAV = (A1*PHH + A2*PNBP + A3*PJAV) / (A1 + A2 + A3) (III)

A1= Total volume consumed in North America at average Henry Hub prices on yearly basis PHH = Annual average of daily prices on Henry Hub for the relevant year A2=Volume consumed through various hubs in Europe/Eurasia in the relevant year (entire consumption of Europe and FSU) PNBP = Annual average of daily prices on National Balancing Point (NBP) in the UK for the relevant year A3= Volume imported by Japan in the relevant year PJAV=Yearly weighted average producers netback price of gas in Japan for the relevant year (weighted by the total volume of long term and spot imports) PJAV shall also be calculated as PIAV is calculated in Formula (I).

Our take on committee recommendations

RIL biggest beneficiary in medium term on gas pricing

RIL is the biggest immediate beneficiary if gas prices are increased. For every $1/mmbtu increase in the gas price NPV would increase by ~1.5-2%. However this is likely to be effective only by April 2014 when its KG basin gas price is up for revision.

ONGC-OIL expected to benefit gradually in long run

Accepting the recommendation on gas pricing is sentimentally positive as ONGC and OIL sells APM gas which is at $4.2/mmbtu. Out of the total APM gas sold by both the company, ~45-48% of this gas goes to Fertilizer and Power sector. So every increase in gas price would have a negative impact on both the sector which is priority for the government. Hence we dont see price hike in APM gas in near term considering the negative impact on the sectors. However, in future government can use this formula/price to justify the 20-30% hike in APM gas price.

Negative for GAIL

Any increase in domestic gas prices would be negative for GAIL as it uses gas as feedstock for its petrochemical operations. Since the prices of its final product i.e. polyethylene is benchmarked to international prices, GAIL would not be able to pass on the increase in the price of feedstock.
Exhibit 3: Price sensitivity Gas price Sensitivity RIL ONGC OIL GAIL $1/mmbtu $1/mmbtu $1/mmbtu 10% Earnings sensitivity 3% 8% 8% -3%

Source: Emkay Research Note: GAIL has negative impact of increase in gas prices due to its petrochemical plant, where gas is used as feed stock

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Downstream sectors to take a hit

Any increase in domestic prices would negative impact the downstream consuming sectors, predominantly power and fertilizer sectors. While power generation cost would increase necessitating an increase in power tariffs, increase in feedstock cost for fertilizer sector would lead to increase in governments outlay on fertilizer subsidy. Currently power and fertilizer combined consume Currently power and fertilizer sectors combined consume about 2/3rd of domestic gas. For other industries which consume domestic gas as fuel the alternative fuel choice is liquid fuels. As a result any increase in domestic gas price is not likely to affect its competitiveness vis--vis other liquid fuels. (Refer Exhibit 4)
Exhibit 4: Sectoral Impact on Gas price Hike Sectoral Impact on Gas price Hike Power Fertilizer

Impact

Negative - Every $1/mmbtu increase in gas cost of generation would increase by ~Rs.0.35/kwh Negative - Every $1/mmbtu increase in gas subsidy burden would increase by ~Rs.20bn Other industries follow wild pass on the higher cost of gas. Even after a price hike, domestic gas is likely to be cheaper than other fuels (Refer Exhibit 4)

Others
Source: Emkay Research

Exhibit 5: Comparison of Cost of other fuels International Price - $/bbl Crude Naphtha Fuel Oil Diesel LPG Petrol Coal Natural Gas Currently Proposed - based on suggested formula
Source: Emkay Research

International Price - $/MT 807 897 604 908 953 995 100

Calorific value - (Kcal/kg) 10,270 10,500 9,600 10,400 10,800 11,300 6,000 8500 8500

Price $/mmbtu 19.8 21.5 15.9 22 22.2 22.2 4.2 4.2 8

108 100 93 122 82 117

Applicability of recommendations
While some recommendations made by Rangarajan committee would be applicable only to future PSCs, some of the recommendations would be applicable even to existing PSC. However to note that while pricing recommendation would be applicable to existing PSCs too any change in gas price would be prospective.
Exhibit 6: The terms of reference of the committee and applicability of recommendations: The terms of reference of the committee were as follows: (i) Review of the existing PSCs, including in respect of the current profit-sharing mechanism with the Pre-Tax Investment Multiple (PTIM) as the base parameter (ii) Exploring various contract models with a view to minimize the monitoring of expenditure of the contractor without compromising Future PSC firstly, on the hydrocarbons output across time and, secondly, on the Governments take (iii) A suitable mechanism for managing the contract implementation of PSCs, which is being handled at present by the representation of Regulator/Government nominee appointed to the Managing Committee (iv) Suitable governmental mechanisms to monitor and to audit Government of Indias share of profit petroleum (v) Structure and elements of the guidelines for determining the basis or formula for the price of domestically produced gas, and for monitoring actual price fixation
Source: Rangarajan Committee report

Its Applicability Future PSC

Existing PSC

Existing PSC Existing PSC with prospective effect

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Annexure
Exhibit 7: Sector-wise Demand of Gas during the 12th Five-Year Plan Sector Power Fertilizer Demand (Price-Elastic) Sub-Total City Gas Industrial Petrochemicals/ Refineries/ Internal Consumption Sponge Iron/ Steel Demand(Relatively Price-Inelastic) Sub-Total Total Demand
Source: Rangarajan Committee repor

2012-13 135 55 190 15 20 54 7 96 286

2013-14 153 61 214 19 20 61 8 108 322

2014-15 171 106 277 24 22 67 8 121 398

2015-16 189 106 295 39 25 72 8 144 439

2016-17 207 106 313 46 27 72 8 153 466

Exhibit 8: Total Projected Gas Availability during the 12th Five-Year Plan Period 12th Five-Year Plan (Figures in mmscmd) Domestic Availability Imports-LNG Expected Total Availability
Source: Rangarajan Committee report

2012-13 124 63 187

2013-14 149 87 236

2014-15 170 87 257

2015-16 177 129 306

2016-17 209 150 359

Exhibit 9: The supply of gas from all sources during 2011-12 company/field-wise distribution SL. No. Source Selling Price of Gas Average supply during 2011-12 (mmscmd) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 TOTAL
Source: Rangarajan Committee report

NOCs APM Gas NOCs Non-APM Gas PMT Ravva Ravva Satellite KG-D6 Niko-Hazira CB-OS/2 CB-ONN-2000/2 Hermac Joshi Technologies (Dholka) CBM Focus Energy (RJON/6) HOEC (PY-1) Term R-LNG Spot R-LNG

$2.52-$5.25/mmbtu $4.2/mmbtu $4.2-$5.73/mmbtu $4.2/mmbtu $4.3/mmbtu $4.2/mmbtu $2.673-$5.346/mcf $4.75-$6.22/mmbtu $ 6.6/mcf Rs. 9.02 - Rs.11.67/scm Rs. 4.80/scm $ 5.1 - $6.79/mmbtu $ 4.11/mmbtu $ 3.63/mmbtu $ 6.97 - $ 9.06/mmbtu $ 12.52 - $17.44/mmbtu

50.7 7.45 11.03 0.53 0.97 42.32 0.48 0.52 0.08 0.01 0.02 0.2 0.17 0.38 25.51 14.11 154.48

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Exhibit 10: Contractual Provisions SL.No Issues 1 Exploration period In the existing NELP PSC, the exploration period is restricted to seven/ eight years. Moreover, there is a timeline for commencing development of a gas discovery within ten years from the date of the first discovery well.

Event Update

Proposed Changes Exploration period may be enhanced to ten years (with an initial period of six years, and a subsequent period of four years) in case of frontier, deep water blocks and ultra-deep water blocks. Moreover, due to the proposed basic shift in the fiscal model, any restriction on further exploration can be removed.

(a) Development of these discoveries takes considerable time There may be contractual provisions for joint development of Development of Discoveries due to lack of infrastructure and cost-effective production commercial discoveries made by the Contractor in adjoining discoveries with different dates. in Deep Water technology and Frontier Areas (b) At times, proper technology may not be available at commercial rate to develop a discovery in frontier areas like ultradeep waters. (c) In case the time taken for preparation and approval of the Field Development Plan (FDP) is long, little time is left for the Contractor to initiate development activities

Force Majeure

At present, force majeure notice has to be served by the (a) Force majeure notice period may be enhanced to thirty Contractor within seven days of occurrence of the event. business days. (b) Article 3.5 may be made more specific with regard to turning down of an Operators request for invocation of force majeure (a) At present, the Contractor is not allowed to carry out any exploration during the appraisal period, even if additional exploration objectives are met at different stratigraphic levels in the appraisal area. During implementation of the appraisal programme, the Contractor may be allowed to probe the potential of additional reservoirs, if any, through additional exploration activities for proper assessment of commercial viability within the Discovery Area. This would save time and money for probing hydrocarbon potential of such prospects by means of additional wells, at a later date.

Appraisal Programme and Its Period

(b) The Contractor is not allowed to integrate appraisal of contiguous discoveries made in similar geological set-up 5 Flexibility in (a) In many cases, logistic, environmental, or other constraints Carrying Out make it difficult for the Contractor to achieve the committed Minimum Work MWP. This may warrant change in planning of exploration inputs. Programme (MWP) Activities (a) The PSC may be made more flexible with regard to swapping MWP. Post award, if logistics and/or other constraints make a particular committed survey difficult, Government may consider carrying out an alternate survey, so long as state-ofthe-art technology is utilized and the alternate survey, so long as state-of-the-art technology is utilized and the Contractor is spending equivalent or more money.

(b) There are instances when in a given acreage, hydrocarbon (b) Provision may be introduced in the contract for permitting occurrence is observed at shallower levels than envisaged earlier revision of target depth of wells, restructuring the MWP, and and there is a commitment for a specified number of deep wells. avoiding drilling of barren meter age. 6 Illogical These blocks often witness bids with commitment of physical Bidding in S work programme defying technical logic. This is particularly so in Type Blocks case of a number of exploratory wells, as the Liquidated Damages (LD) for unfinished well in on-land block is only US $ 1 million per well. A clause for a minimum level of fulfillment of the work programme may be built in for qualifying for the requirement to pay LD before the contractor is allowed to quit the contract. This may be about 50% of the committed programme.

Source: Rangarajan Committee report, Emkay Research

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Exhibit 11: Valuation Matrix Price Company BPCL Cairn India GAIL Gujarat Gas GSPL HPCL Indian Oil Indraprastha Gas Petronet LNG Oil India ONGC Reliance Industries
Source: Emkay Research

Event Update

Target price (Rs.) 406 385 406 292 86 360 320 Under Review 194 573 313 827

Market cap (Rs. bn) 265 611 463 39 43 101 660 35 120 283 2349 2777

PE (x) FY13E 15.6 5.6 12.5 13.0 8.7 7.1 8.0 10.5 11.2 7.6 8.9 13.4 FY14E 12.4 6.8 11.1 12.5 8.8 6.7 8.0 9.6 11.3 7.5 8.7 13.0

P/B (x) FY13E 1.5 1.1 1.9 3.1 1.5 0.7 1.0 2.5 2.7 1.4 1.5 1.9 FY14E 1.4 1.0 1.7 2.6 1.3 0.7 1.0 2.1 2.3 1.3 1.4 1.7

EV/EBIDTA (x) FY13E 9.6 3.4 8.5 6.5 5.2 8.3 5.8 4.9 7.7 3.1 3.6 8.2 FY14E 8.2 3.7 7.4 5.9 5.2 7.6 5.5 4.5 6.9 2.6 3.3 8.6

Recommendation (Rs.) Accumulate Buy Buy Hold Accumulate Buy Accumulate Under Review Buy Accumulate Accumulate Hold 366.5 320.0 364.8 305.4 76.1 296.8 272.0 250.8 160.5 470.8 274.6 848.0

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