Oil and Natural Gas ONGC.NS ONGC INbreport.myiris.com/NFASIPL/OILNATGC_20150908.pdf · We downgrade ONGC to Neutral. Nomura’s global oil/gas team has cut its Brent oil price assumption

Oil and Natural Gas ONGC.NS ONGC IN

EQUITY: OIL & GAS/CHEMICALS

Low oil for longer; downgrade to Neutral

Valuation inexpensive, but triggers elusive

Action: Earnings cut by 25-31%; not much upside in a low oil price scenario, and visibility poor on upside if oil rises; downgrade

Global Markets Research 8 September 2015

Rating Down from Buy NeutralTarget price Reduced from 395 INR 250

Closing price 4 September 2015 INR 226

Potential upside +10.8%

Anchor themesLow oil for longer scenario is negative for upstream oil PSUs. We continue prefer downstream over upstream.

Nomura vs consensusOur FY16-17F EPS is 10-20% below. Our TP is 28% below consensus.

Research analysts

India Oil & Gas/Chemicals

Anil Sharma - NFASL [email protected] +91 22 4037 4338

Ravi Adukia, CFA - NFASL [email protected] +91 22 4037 4232

Nomura’s global oil/gas team has cut its Brent oil price assumption by up to 21-25%.Our new oil price assumptions are USD53/55/60/70/bbl for FY16F /17F /18F/long term, respectively (vs previously USD60/70/80/bbl for FY16/17/LT). The reductions to our oil price and gas price assumptions plus the new subsidy formula result in 25-31% earnings estimate cuts for FY16-18F. After sharp under-performance (1-year ONGC -48% vs Sensex -5%), we believe valuations are inexpensive (trading at 0.9x FY17F P/B and 8.1x FY17F P/E), but we believe there are not many catalysts ahead, hence we downgrade to Neutral.

Not many positives: Subsidy will not go even at low oil; gas price set to fall steeply; production growth outlook weak; and b/s becoming stretched making big ticket M&A in low oil environment difficult The new FY16 subsidy formula (caps government support at INR12/L for

kerosene and INR18/kg for LPG) implying ONGC will have to bear the subsidy unless the oil price falls below USD46/bbl. This is more negative than the earlier proposal (no subsidy for oil < USD60/bbl), and will likely lead to near flat realisations when oil is over USD65/bbl.

Domestic gas price will be reduced to USD4.2-4.3/mmbtu from 1 October, with further reductions likely next year. Such low prices will deter new investment, in our view.

Production growth outlook remains weak for both domestic and for OVL. Also, after its large acquisition in Mozambique (ONGC chased valuations in

our view, and now ONGC is not a net cash company), ability to do large ticket opportunistic M&A in current low oil prices is lower, in our view.

Valuation: Cut TP to INR250; prefer downstream among oil PSUs Due to sharp 25-31% earnings cut, our P/B-based TP falls to INR250 (from INR395). We downgrade ONGC to Neutral. Among Indian oil PSUs, we prefer downstream names (IOCL>HPCL>BPCL) over upstream (ONGC, Oil India).

Year-end 31 Mar FY15

Key company data: See next page for company data and detailed price/index chart

FY16F FY17F FY18F

Currency (INR) Actual Old New Old New Old New

Revenue (bn) 1,591 1,604 1,436 1,770 1,475 1,617

Reported net profit (bn) 183 305 229 344 238 269

Normalised net profit (bn) 183 305 229 344 238 269

FD normalised EPS 21.43 35.67 26.80 40.17 27.78 31.40

FD norm. EPS growth (%) -30.8 66.4 25.1 12.6 3.7 13.0

FD normalised P/E (x) 10.5 N/A 8.4 N/A 8.1 N/A 7.2

EV/EBITDA (x) 4.4 N/A 4.0 N/A 4.0 N/A 3.6

Price/book (x) 1.1 N/A 1.0 N/A 0.9 N/A 0.9

Dividend yield (%) 4.2 N/A 4.9 N/A 4.9 N/A 5.3

ROE (%) 10.4 16.0 12.3 16.2 12.0 12.7

Net debt/equity (%) 21.0 19.1 22.1 16.1 21.6 20.3

Source: Company data, Nomura estimates

See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts.

Nomura | Oil and Natural Gas 8 September 2015

2

Key data on Oil and Natural Gas Relative performance chart

Source: Thomson Reuters, Nomura research

Notes:

Performance (%) 1M 3M 12MAbsolute (INR) -15.3 -25.2 -48.4 M cap (USDmn) 29,022.3Absolute (USD) -18.8 -27.9 -53.1 Free float (%) 20.7Rel to MSCI India -8.7 -23.1 -45.1 3-mth ADT (USDmn) 18.1 Income statement (INRbn) Year-end 31 Mar FY14 FY15 FY16F FY17F FY18FRevenue 1,732 1,591 1,436 1,475 1,617Cost of goods sold -944 -849 -615 -638 -692Gross profit 789 742 820 837 925SG&A -461 -505 -504 -517 -563Employee share expense 0 0 0 0 0Operating profit 327 237 317 319 362EBITDA 578 529 597 604 662Depreciation -246 -283 -276 -280 -296Amortisation -5 -9 -5 -5 -5EBIT 327 237 317 319 362Net interest expense -6 -29 -24 -20 -19Associates & JCEs 0 0 0 0 0Other income 71 66 62 68 72Earnings before tax 392 274 354 368 415Income tax -128 -97 -120 -125 -141Net profit after tax 264 177 234 243 274Minority interests -2 6 -5 -5 -5Other items 2 0 0 0 0Preferred dividends 0 0 0 0 0Normalised NPAT 265 183 229 238 269Extraordinary items 0 0 0 0 0Reported NPAT 265 183 229 238 269Dividends -95 -98 -113 -113 -123Transfer to reserves 170 86 116 125 145Valuations and ratios

Reported P/E (x) 7.3 10.5 8.4 8.1 7.2Normalised P/E (x) 7.3 10.5 8.4 8.1 7.2FD normalised P/E (x) 7.3 10.5 8.4 8.1 7.2Dividend yield (%) 4.2 4.2 4.9 4.9 5.3Price/cashflow (x) 3.6 5.7 4.1 3.8 3.4Price/book (x) 1.1 1.1 1.0 0.9 0.9EV/EBITDA (x) 3.8 4.4 4.0 4.0 3.6EV/EBIT (x) 6.6 9.8 7.5 7.5 6.7Gross margin (%) 45.5 46.6 57.1 56.7 57.2EBITDA margin (%) 33.4 33.3 41.6 41.0 40.9EBIT margin (%) 18.9 14.9 22.1 21.7 22.4Net margin (%) 15.3 11.5 16.0 16.1 16.6Effective tax rate (%) 32.6 35.4 33.9 33.9 34.0Dividend payout (%) 35.9 53.2 49.2 47.5 45.9ROE (%) 16.3 10.4 12.3 12.0 12.7ROA (pretax %) 12.3 7.6 9.6 9.3 9.9Growth (%)

Revenue 7.3 -8.2 -9.7 2.7 9.6EBITDA 9.1 -8.4 12.8 1.2 9.6Normalised EPS 9.4 -30.8 25.1 3.7 13.0Normalised FDEPS 9.4 -30.8 25.1 3.7 13.0Source: Company data, Nomura estimates

Cashflow statement (INRbn) Year-end 31 Mar FY14 FY15 FY16F FY17F FY18FEBITDA 578 529 597 604 662Change in working capital 113 -102 -24 2 21Other operating cashflow -158 -87 -103 -98 -110Cashflow from operations 533 340 470 508 573Capital expenditure -616 -354 -402 -414 -452Free cashflow -83 -14 68 94 121Reduction in investments -26 0 0 0 0Net acquisitions Dec in other LT assets -36 -22 0 0 0Inc in other LT liabilities 90 32 15 15 15Adjustments -48 -7 4 6 10CF after investing acts -104 -11 87 115 145Cash dividends -98 -95 -108 -113 -128Equity issue 2 0 0 0 0Debt issue 247 32 0 0 0Convertible debt issue 0 0 0 0 0Others 1 -10 -24 -20 -19CF from financial acts 152 -73 -132 -133 -148Net cashflow 49 -84 -45 -18 -2Beginning cash 196 245 161 116 98Ending cash 245 161 116 98 96Ending net debt 211 378 424 442 444 Balance sheet (INRbn) As at 31 Mar FY14 FY15 FY16F FY17F FY18FCash & equivalents 245 161 116 98 96Marketable securities 0 0 0 0 0Accounts receivable 160 188 164 168 184Inventories 148 106 98 101 111Other current assets 301 358 374 389 405Total current assets 854 813 751 756 796LT investments 47 47 48 48 48Fixed assets 2,096 2,232 2,393 2,563 2,756Goodwill 184 201 197 192 188Other intangible assets 0 0 0 0 0Other LT assets 61 83 83 83 83Total assets 3,242 3,377 3,472 3,643 3,871Short-term debt 139 64 64 64 64Accounts payable 307 304 240 249 298Other current liabilities 228 171 194 210 223Total current liabilities 674 538 497 523 585Long-term debt 317 476 476 476 476Convertible debt Other LT liabilities 501 534 549 564 579Total liabilities 1,492 1,548 1,522 1,562 1,640Minority interest 29 25 30 35 40Preferred stock 0 0 0 0 0Common stock 43 43 43 43 43Retained earnings 1,586 1,665 1,757 1,858 1,979Proposed dividends 0 0 0 0 0Other equity and reserves 93 97 121 145 169Total shareholders' equity 1,722 1,805 1,921 2,046 2,191Total equity & liabilities 3,242 3,377 3,472 3,643 3,871

Liquidity (x)Current ratio 1.27 1.51 1.51 1.45 1.36Interest cover 52.4 8.1 13.0 15.8 18.8LeverageNet debt/EBITDA (x) 0.37 0.72 0.71 0.73 0.67Net debt/equity (%) 12.3 21.0 22.1 21.6 20.3

Per shareReported EPS (INR) 30.98 21.43 26.80 27.78 31.40Norm EPS (INR) 30.98 21.43 26.80 27.78 31.40FD norm EPS (INR) 30.98 21.43 26.80 27.78 31.40BVPS (INR) 201.22 210.92 224.52 239.11 256.10DPS (INR) 9.50 9.50 11.00 11.00 12.00Activity (days)Days receivable 33.1 40.0 44.8 41.0 39.8Days inventory 53.3 54.6 60.7 56.9 55.8Days payable 95.3 131.3 161.6 139.7 144.3Cash cycle -8.9 -36.7 -56.1 -41.7 -48.8Source: Company data, Nomura estimates


3

Oil prices to stay low for longer Nomura’s global oil/gas team is downgrading the average Brent oil price by 21% and 25% respectively for 2016 and 2017.

• Despite record-high global oil demand and surging China crude imports, potential supply growth from OPEC countries like Saudi Arabia, Iraq and Iran will keep a firm lid on oil price recovery.

• Potential US Fed rate hikes ahead also pose severe headwinds against any sustainable oil price rallies.

• US shale oil production has seen a steady decline since May and the current global oversupply of about 3m bopd could ease starting late 2016; thus we still forecast oil prices will rise mildly ahead, although we lower our long-term Brent price forecast from US$80 to US70/bbl from 2018F onwards.

• We believe global oil prices have bottomed at around US$40/bbl recently as pessimism peaked over widespread concerns of a slowdown in China amid global equity market routs.

Fig. 1: Average Brent oil price, historical and forecasts (new vs. old)

Source: Bloomberg, Nomura estimates

While many conventional oil projects such as those in the Middle East could still thrive at prevailing depressed oil prices, there are not enough of these low-cost projects around the world that could supply enough production growth to meet demand growth on a reliable basis. In our view, not only will abnormally low oil prices discourage the deployment of advanced technologies to mitigate mature field productivity declines, they may also trigger more project cancellations and existing field development delays, which ultimately could lead to a potential supply shortfall.

Fig. 2: Oil majors’ 1H15 capex vs. 1H14

Source: Company filings, Bloomberg

$55 $66

$73

$99

$63

$80

$111 $112 $109 $99

$53 $60

$55

$70 $60

$80 $70

$80

$-

$20

$40

$60

$80

$100

$120

-32%

-40%

-31%

-12%

-20% -19%

-13%

-45%

-40%

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%PetroChina Sinopec CNOOC Exxon-Mobil BP Shell Chevron

We believe the current oil price environment will trigger project delays and cancellations which will eventually cause a supply reduction.


4

Fig. 3: World petroleum supply and demand forecasts

Source: IEA

(For more details please refer to our oil and gas team’s detailed notes: “EU team’s oil price update” 08 Sep 2015 and “Asia oil & gas/chemicals: Oil prices to stay low for longer, 08 Sep 2015)

Fig. 4: Change in our India oil and gas price assumptions

FY16F FY17F FY18F LT

Brent (USD/bbl)

New 53 55 60 70

Old 60 70 80 80

Change -12% -21% -25% -13%

Domestic gas (USD/mmbtu)

New 4.7 4.0 4.0 4.0

Old 5.0 5.0 5.0 5.0

Change -6% -20% -20% -20%

Source: Nomura estimates

2006 2007 2008 2009 2010 2011 2012 2013 2014 1Q15 2Q15 3Q15 4Q15 2015 1Q16 2Q16 3Q16 4Q16 2016

Americas 25.7 25.8 24.5 23.7 24.1 24.0 23.6 24.0 24.1 24.2 24.1 24.5 24.7 24.4 24.5 24.2 24.6 24.9 24.5 Europe 15.7 15.6 15.5 14.7 14.7 14.3 13.8 13.6 13.4 13.6 13.4 13.8 13.5 13.6 13.3 13.5 13.8 13.5 13.5 Pacif ic 8.7 8.7 8.3 8.0 8.2 8.2 8.6 8.4 8.2 8.8 7.7 7.8 8.3 8.1 8.6 7.6 7.8 8.4 8.1

Total OECD 50.2 50.1 48.4 46.3 47.0 46.5 46.0 46.1 45.6 46.6 45.1 46.1 46.5 46.1 46.4 45.3 46.2 46.7 46.2

FSU 4.0 4.0 4.2 4.0 4.1 4.4 4.5 4.6 4.8 4.6 4.8 4.9 4.8 4.8 4.6 4.7 4.9 4.9 4.8 Europe 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 China 7.2 7.6 7.7 7.9 8.9 9.3 9.8 10.1 10.6 10.7 11.1 10.8 11.1 10.9 11.1 11.3 11.2 11.5 11.3 Other Asia 9.3 9.8 9.9 10.3 10.7 11.0 11.3 11.7 12.0 12.4 12.5 12.2 12.7 12.5 12.9 12.9 12.6 13.1 12.9 Latin America 5.2 5.3 5.6 5.7 6.1 6.2 6.4 6.6 6.8 6.7 6.9 7.0 7.0 6.9 6.8 7.0 7.1 7.2 7.0 Middle East 6.1 6.4 6.7 7.1 7.3 7.5 7.7 8.0 8.1 7.8 8.3 8.7 8.1 8.2 8.0 8.5 9.0 8.4 8.5 Af rica 2.9 3.3 3.3 3.4 3.5 3.5 3.7 3.7 4.0 4.1 4.1 4.0 4.2 4.1 4.3 4.3 4.2 4.3 4.3

Total Non-OECD 35.5 37.0 38.1 39.1 41.4 45.6 44.1 45.4 47.0 47.1 48.4 48.5 48.7 48.2 48.4 49.5 49.8 50.1 49.4 Total Demand 85.6 87.0 86.5 85.4 88.5 89.0 90.1 91.4 92.6 93.6 93.5 94.5 95.2 94.2 94.8 94.8 96.0 96.8 95.6

Americas 13.9 13.8 13.3 13.6 14.1 14.6 15.9 17.2 19.0 20.0 19.7 19.4 19.6 19.7 19.9 19.8 19.9 20.2 20.0 Europe 5.3 5.0 4.8 4.5 4.1 3.8 3.5 3.3 3.3 3.4 3.5 3.3 3.4 3.4 3.4 3.2 3.0 3.3 3.2 Pacif ic 0.6 0.6 0.6 0.6 0.7 0.6 0.6 0.5 0.5 0.4 0.4 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5

Total OECD 19.8 19.4 18.7 18.8 18.9 19.0 19.9 21.0 22.8 23.8 23.7 23.2 23.5 23.5 23.8 23.5 23.5 24.0 23.7

FSU 12.3 12.8 12.8 13.3 13.5 13.5 13.6 13.9 13.9 14.0 14.0 13.8 13.8 13.9 13.8 13.7 13.6 13.6 13.7 Europe 0.1 0.2 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 China 3.7 3.7 3.8 3.8 4.1 4.1 4.2 4.2 4.2 4.3 4.4 4.3 4.3 4.3 4.2 4.2 4.2 4.2 4.2 Other Asia 3.8 3.7 3.7 3.6 3.7 3.6 3.6 3.6 3.5 3.6 3.6 3.6 3.7 3.6 3.6 3.6 3.5 3.5 3.6 Latin America 3.6 3.6 3.7 3.9 4.1 4.2 4.2 4.2 4.4 4.6 4.6 4.6 4.6 4.6 4.6 4.7 4.7 4.7 4.7 Middle East 1.7 1.7 1.7 1.7 1.7 1.7 1.5 1.3 1.3 1.3 1.2 1.2 1.2 1.2 1.2 1.1 1.1 1.1 1.1 Africa 2.5 2.6 2.6 2.6 2.6 2.6 2.3 2.4 2.3 2.3 2.3 2.2 2.2 2.3 2.2 2.2 2.2 2.2 2.2

Total Non-OECD 27.8 28.2 28.4 29.0 29.9 29.9 29.5 29.7 29.8 30.4 30.2 29.9 29.9 30.1 29.9 29.6 29.4 29.5 29.6 Processing Gains 2.0 2.0 2.0 2.0 2.1 2.1 2.1 2.2 2.2 2.2 2.2 2.2 2.2 2.2 2.3 2.3 2.4 2.3 2.3 Global Biofuels 0.8 1.1 1.4 1.6 1.8 1.9 1.9 2.0 2.2 1.8 2.4 2.6 2.3 2.3 1.8 2.3 2.6 2.3 2.3 Total Non-OPEC 50.4 50.7 50.6 51.4 52.6 52.8 53.4 54.9 57.0 58.2 58.4 57.9 57.9 58.1 57.8 57.7 57.9 58.1 57.9

Crude 30.9 30.7 31.6 29.1 29.2 29.9 31.3 30.5 30.3 30.5 31.5 NGLs 4.3 4.3 4.5 4.9 5.6 5.9 6.3 6.3 6.4 6.5 6.6 6.7 6.7 6.6 6.8 6.8 6.9 6.9 6.9

Total OPEC 35.2 35.0 36.1 34.0 34.7 35.8 37.6 36.8 36.6 37.0 38.1 Total Supply 85.5 85.7 86.7 85.4 87.4 88.7 90.9 91.6 93.7 95.3 96.5 STOCK CHANGES AND MISCELLANEOUSReported OECDIndustry 0.2 (0.3) 0.3 (0.1) 0.1 (0.2) 0.2 (0.2) 0.4 0.9 1.1 Government - 0.1 - 0.1 - (0.1) 0.0 0.0 - - - Total 0.3 (0.2) 0.3 - 0.1 (0.3) 0.2 (0.2) 0.4 0.9 1.1 Floating Storage/Oil in Transit (0.1) - - 0.3 (0.2) (0.1) (0.0) 0.1 - (0.1) 0.2 Miscellaneous to balance (0.3) (1.1) (0.1) (0.3) (1.0) - 0.7 0.3 0.6 0.8 1.7

Total Stock Ch. & Misc (0.1) (1.4) 0.3 - (1.1) (0.4) 0.9 0.2 1.0 1.6 3.0 Memo items:

Call on OPEC crude 29.1 30.3 30.3 30.4 30.3 29.3 28.8 28.5 30.0 30.6 29.5 30.3 30.2 31.1 31.8 30.8

OECD DEMAND

NON-OECD DEMAND

OECD SUPPLY

NON-OECD SUPPLY

OPEC

http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=761595&appname=Email&cid=UDRTSDdLZ2F2Nnc90





5

Downgrade to Neutral

Gross oil realisation to decline; Net oil realisation decline sharper as subsidies will remain at low oil prices

For upstream oil producers, low long-term oil prices are very negative. For Indian oil PSUs, which did not benefit much from high oil prices (due to high subsidies), there was expectations that the subsidy burden would not be there when oil prices are low.

Indeed, under the earlier proposed formula for 1Q (there was no subsidy at an oil price <USD60/bbl, 85% subsidy for oil between USD60-100/bbl, 90% subsidy for oil >USD100/bbl), there would have been no subsidy paid by upstream companies.

However, the expectations were short lived, and this formula was not implemented even for 1QFY16. The Indian government (GoI) has now come with a new upstream subsidy formula for FY16. As per this formula, subsidy sharing would be as below:

• Kerosene: The GoI budgetary support at INR12/L and the remaining under-recovery will be borne by upstream companies.

• LPG: A fixed subsidy of INR18/kg under the direct benefit transfer of LPG (DBTL).

There will be no upstream subsidy unless oil falls below USD46/bbl (vs USD60/bbl previously). This formula, in our view, is negative for upstream companies, and increases their problems, in the current environment of low oil prices.

• While for LPG, as the break-even price (including INR18/kg government support) is ~USD60/bbl, so there will likely be no subsidy sharing on LPG by upstream companies when oil prices are below USD60/bbl.

• However, the break-even price for kerosene (including INR12/L government support), is only USD46/bbl. Thus upstream subsidy burden will continue even if the oil price remains below USD60/bbl (as these currently are), and will vanish only when oil prices fall below USD46/bbl.

While overall under-recovery/subsidy size has declined very sharply (from peak of USD29-30bn in FY12-13 to likely USD5-7b in FY16/17F), and GoI’s flexibility to compensate has increased (last year’s excise duty hikes on petrol/diesel lead to incremental annual revenue of ~USD11-12bn), we had previously expected the GoI to give relief to upstream companies from subsidy sharing when oil prices are below USD60/bbl. But, this is not the case now.

Fig. 5: Under-recoveries set to decline sharply FY12 FY13 FY14 FY15 FY16F FY17F FY18F

Brent price (US$/bbl) 114.5 110.6 107.7 85.6 53.0 55.0 60.0

Exchange rate (INR/US$) 47.9 54.4 60.4 61.1 65.0 65.0 65.0

Under-recoveries (per unit)

Diesel (INR/L) 10.4 11.3 8.4 2.7 - - -

PDS Kerosene (INR/L) 27 32 35 28 15 16 18

Domestic LPG (INR/cyl) 343 450 522 410 176 197 239

Domestic LPG (INR/kg) 24 32 37 29 12 14 17

Under-recoveries (INRbn)

Diesel 812 921 628 109 - - -

PDS Kerosene 274 294 306 248 132 140 155

Domestic LPG 300 396 465 366 - - -

Total under-recoveries 1,385 1,610 1,399 723 132 140 155

DBT on LPG - - - 40 191 222 283

Total Subsidies - INRbn 1,385 1,610 1,399 763 324 362 438

Total - USDbn 28.9 29.6 23.2 12.5 5.0 5.6 6.7

Source: Petroleum Planning & Analysis Cell (PPAC), Nomura estimates

We estimate fuel under-recoveries to decline to INR130-155bn for FY16-18F, less than 1/10th level from peak of INR1.6tn in FY13

Including DBT subsidy for LPG, the overall subsidy/under-recovery size is likely to decline to USD5-7bn vs peak of USD29-30bn


6

Upstream net realizations will likely remain flat when oil move over USD65/bbl Effectively under the newly adopted formula the upstream companies pay for all incremental subsidies for kerosene when oil prices are above USD46/bbl, and all incremental LPG subsidies when oil prices are above USD60/bbl.

As oil prices move up the subsidies on both LPG and kerosene are expected to rise very sharply (unless the retail prices are increased or government takes some section of consumers out of subsidy sharing for LPG).

If upstream shares all incremental under-recoveries (over INR18/kg for LPG, over INR12/L for kerosene, as it currently is doing), we estimate that effective net oil price realisation will likely remain flat for ONGC/OIL when oil prices move over USD65/bbl.

Fig. 6: Subsidy sharing : Net oil realisation for upstream will not increase much In low oil price environment, and capped govt subsidy, net realization for upstream will remain low FY12 FY13 FY14 FY15 FY16F FY17F FY18F

Total under-recoveries 1,385 1,610 1,399 763 324 362 438

Subsidy sharing (INRbn)

Government 835 1,000 708 313 298 327 386

- Kerosene 107 105 103

- DBTL 191 222 283

Upstream 550 600 670 428 25 35 52

- Kerosene 25 35 52

- DBTL - - -

OMCs 0 10 21 22 - - -

Subsidy sharing (%)

Government 60% 62% 51% 41% 92% 90% 88%

Upstream 40% 37% 48% 56% 8% 10% 12%

OMCs 0% 1% 1% 3% 0% 0% 0%

Upstream realisation (USD/bbl)

Brent 114.5 110.6 107.7 85.6 53.0 55.0 60.0

Upstream subsidy 56.0 56.0 59.3 37.7 2.1 2.8 4.0

Brent - Subsidy 58.5 54.6 48.4 47.9 50.9 52.2 56.0

Source: PPAC, Nomura estimates

Fig. 7: Upstream net-realisation scenario at different oil prices New subsidy share formula is inferior to earlier proposed formula. Upstream will need to pay subsidy till oil price fall below USD45-46/bbl, and upstream net-realisation will not move up when oil moves up over USD65/bbl Brent (USD/bbl) 45 50 55 60 65 70 80 90 100

Under-recoveries/subsidy (INRbn) 240 301 362 424 485 546 668 790 912

- Kerosene under-recovery 105 123 140 158 176 193 229 264 299

- DBT subsidy for LPG 135 179 222 266 309 352 439 526 613

New formula

Govt. support (INRbn) 240 284 327 371 393 393 393 393 393

Upstream share (INRbn) - 18 35 53 92 153 275 397 520

Upstream subsidy (USD/bbl) - 1.4 2.8 4.2 7.3 12.2 22.0 31.7 41.5

Net realisation (USD/bbl) 45.0 48.6 52.2 55.8 57.7 57.8 58.0 58.3 58.5

Earlier proposed formula

- Subsidy(USD/bbl) - - - - 4.3 8.5 17.0 25.5 34.0

- Net realisation (USD/bbl) 45.0 50.0 55.0 60.0 60.8 61.5 63.0 64.5 66.0

New vs earlier 0% -3% -5% -7% -5% -6% -8% -10% -11%


Despite much lower subsidy problem size, and much higher cushion with government to absorb fuel subsidies, upstream companies are bearing subsidies even when oil prices are below USD60/bbl.

Importantly, upstream companies net realisation will also not increase much even when oil prices move-up significantly under current formula.


7

Gas prices declining; low prices deter new investment

Domestic gas prices back to where it began, and will likely fall further Last year when government had adopted the new domestic gas pricing formula, we had highlighted that ‘gas price hike was not so good or well thought out’. (See Good decision on diesel/LPG, not so for gas, 20 October 2014 and Gas formula gets more -ve for upstream, 21 October 2014.)

• While the key reason for the industry seeking a higher gas price was to make current production more profitable and to encourage new investment. However, in our view, the basic intention (while modifying the Rangarajan formula) seemed to have been to limit price increases (to make increase more palatable for consumers).

• To keep prices low, GoI removed expensive LNG components (both Japanese and Indian imports) and instead included Alberta gas reference price and Russian price, in addition to retaining Henry Hub and NBP prices. In our view, primarily using gas-surplus/export regions (eg, US, Canada and Russia) to determine prices in a gas-deficit country like India was not logical. Moreover, to further keep prices lower, the GoI had excluded even the transport/gas treatment charges under different hubs.

• While the gas prices increased 34% in November 2014 (from USD4.2 to USD 5.6/mmbtu), these declined by 7% to USD5.2/mmbtu when prices were first reset on 1-Apr-15. As international prices have further fallen, we expect a much steeper decline of 17-18%, and domestic gas prices will likely decline to just USD4.2-4.3/mmbtu. Prices would then be at a similar level as when new price formula was adopted. As regional hub prices continue to remain low, we think prices will likely fall even further when prices reset next year.

No clarity yet on premium for new discoveries Also, while announcing the new gas price formula, government had talked of a premium over the price for higher cost development areas (like deep water). The government later clarified that such premiums would be applicable only to new discoveries made after 20-Oct-2014 gas price decision, thus ruling out such premium for existing deep-water discoveries (like ONGC’s KG-98/2 ultra-water discovery).Nearly a year has elapsed, and government is yet to spell out the premium.

Fig. 8: Domestic gas prices

Gas prices (USD/mmbtu)

Nov - Mar 15 April - Sept 15 Oct - Mar 16

USA - Henry Hub 3.8 3.9 2.8

Canada (Alberta) 3.0 3.6 2.5

Europe (NBP) 9.2 7.7 6.9

Russia (domestic) 2.5 2.5 2.3

India (GCV) 5.1 4.7 3.9

India (NCV) 5.6 5.2 4.3

Decline -7% -17%

Source: Bloomberg, PPAC, Nomura estimates

Fig. 9: Gas price back to same level before the new formula

Source: PPAC, Nomura estimates

Gas production has been falling; and new investments seem unlikely soon As gas prices increase was not large, and prices are on a declining trend, it is not encouraging investment to sustain even current production, let alone development of existing discoveries.

Similarly, as the government has not announced the premium for new discoveries (and expectations are not of very high premium), the likelihood of large scale investment remains low, in our view, in the short to medium term.

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The key rationale for adopting new price formula was to raise domestic gas prices to make current production attractive, and encourage new investment.

With prices declining so much, domestic production is not increasing, and new investment is not forthcoming.

http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=704623&appname=Email&cid=UWJqNWRyMnEzdHc90





8

Operationally not much to cheer Operationally, in our view, there are no major catalysts.

• ONGC has generally disappointed on production guidance.

• Its domestic oil production had declined for seven consecutive years till FY14. While the production decline trend was arrested last year, there is not much visibility of any meaningful production growth in the short to medium term, in our view.

• Similarly, gas production has largely remained stagnant over last several years. As we noted earlier, with domestic gas price outlook remaining low, the outlook for any sharp domestic production growth remains weak, in our view.

• ONGC’s overall production and other costs have increased over the last few years (figure 10).

• While ONGC has not curtailed capex much, this has not resulted in any significant drill-bit reserve accretion.

• ONGC’s overseas arm ONGC Videsh Limited (OVL) has also largely disappointed operationally over the last few years. Despite continued large investment, production has stagnated and profits declined sharply last year. (figure 17 to 21)

Fig. 10: ONGC – operating and other costs trend USD/boe FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 1QFY15 2QFY15 3QFY15 4QFY15 1QFY16

Brent 58.0 64.4 82.4 84.8 69.7 86.7 114.5 110.6 107.7 85.6 109.8 102.2 76.0 54.2 62.1

Operating costs 8.1 10.8 13.6 14.7 8.8 10.1 9.8 10.6 9.3 9.4 8.1 8.8 8.6 12.0 11.3

Statutory levies 7.5 8.6 10.3 8.4 8.6 10.3 11.7 13.5 12.6 12.9 13.3 12.6 11.6 14.1 12.4

DD&A 6.4 6.8 8.0 8.7 10.5 11.8 11.8 11.5 12.4 12.3 14.6 10.1 12.7 12.9 10.0

Total costs 21.9 26.3 31.9 31.8 27.8 32.2 33.4 35.5 34.3 34.6 36.1 31.4 32.8 39.0 33.8

Source: Company data, Nomura research

Fig. 11: Nominated blocks: Declining oil production Domestic oil production on declining trend


Fig. 12: Nominated blocks: gas production declined recently


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Fig. 13: 2P RRR of > 1 for the nine consecutive years


Fig. 14: ...but 1P reserves have remained largely stagnant


Fig. 15: ONGC’s total capex trends Avg. capex of INR300bn over last five years


Fig. 16: Exploration capex and write-off trends Write off over 80% of exploration capex Incurred over last 9 years


Fig. 17: OVL: Production trend Production peaked In FY11 & remained flat thereafter despite acquisitions


Fig. 18: OVL: Reserves trend Proved reserves remained flat; Mozambique boosted 2P reserves


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Fig. 19: OVL: Cumulative investment of USD24bn till FY15

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Fig. 20: OVL: Reported PAT trend

Source: Company data, Nomura

Fig. 21: ONGC chased valuations in Mozambique acquisition


Fig. 22: ONGC is now a net debt company


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Key modelling assumptions Fig. 23: Key assumptions and EPS estimates for ONGC

USD/bbl FY12 FY13 FY14 FY15 FY16F FY17F FY18F

Brent 114.5 110.6 107.7 85.6 53.0 55.0 60.0

Subsidy 56.0 56.0 59.3 37.7 2.1 2.8 4.0

Net realisation 58.5 54.6 48.4 47.9 50.9 52.2 56.0

Reported realisation (USD/bbl)

Gross 117.4 110.7 106.7 85.3 53.5 55.5 60.6

Reported subsidy ** 62.7 62.9 65.8 40.4 2.2 3.0 4.3

Net reported realisation ** 54.7 47.9 41.0 44.9 51.3 52.5 56.2

Gas price (USD/mmbtu) 4.2 4.2 4.2 4.8 4.7 4.0 4.0

EPS (INR.sh) 29.2 28.3 31.0 21.4 26.8 27.8 31.4

EPS Growth % 11% -3% 9% -31% 25% 4% 13%

Note: ** ONGC’s subsidy is calculated on its production volume of both oil & condensates based on government intimated subsidy number. However, it reports per bbl burden only on actual sales volume of oil (excludes condensates).


Fig. 24: ONGC production estimates

FY10 FY11 FY12 FY13 FY14 FY15 FY16F FY17F FY18F

Oil production (MMT)

- Nomination blocks 24.7 24.4 23.7 22.6 22.2 22.3 22.9 23.8 24.7

- Share of JVs 1.8 2.9 3.2 3.6 3.7 3.7 3.6 3.7 3.7

- Total 26.5 27.3 26.9 26.1 26.0 25.9 26.5 27.5 28.4

Y-Y% -2% 3% -1% -3% -1% 0% 2% 4% 3%

Gas production (BCM)

- Nomination blocks 23.1 23.1 23.3 23.6 23.3 22.0 23.2 24.5 28.1

- Share of JVs 2.5 2.2 2.2 1.8 1.6 1.5 1.4 1.3 1.3

- Total 25.6 25.3 25.5 25.3 24.8 23.5 24.7 25.8 29.4

Y-Y% 1% -1% 1% -1% -2% -5% 5% 5% 14%


Fig. 25: OVL production estimates

FY10 FY11 FY12 FY13 FY14 FY15 FY16F FY17F FY18F

Oil (MMT) 6.5 6.8 6.2 4.3 5.5 5.5 5.6 5.5 5.3

Gas (BCM) 2.4 2.7 2.5 2.9 2.9 3.3 3.5 3.5 3.4

Total 8.9 9.5 8.8 7.3 8.4 8.9 9.1 9.0 8.7

y-y % 7% -8% -17% 15% 6% 2% -2% -2%


Fig. 26: Sensitivity of ONGC’s EPS to key variables

FY16F FY17F

Base EPS 26.8 27.8

INR/share % INR/share %

Net reported oil realisation (USD/bbl) 51.3 52.5

- Increase by USD1/bbl 0.6 2.3% 0.6 2.1%

Gas price (USD/mmbtu) 4.7 4.0

- Increase by USD1/mmbtu 2.7 10.1% 2.7 9.9%

Exchange rate (INR/USD) 65.0 65.0

- INR1/USD depreciation 0.8 2.8% 0.7 2.6%


Nomura il and Natural Gas 8 September 2015 | O

12

TP revised to INR250; downgrade to Neutral

We continue to use a 1-year forward P/B multiple to value ONGC. Based on our revised average ROE estimate for FY16-17F of 12.3% (16.1% previously), cost of equity of 12.0% (unchanged) and growth rate of 3.5% (unchanged), we reach our 1yr forward P/B multiple target of 1.0x (1.5x previously). Our revised TP is therefore INR250 (from INR395).

Fig. 27: We value ONGC at 1.0x FY17F P/B multiple We use an average ROE (FY16-17F) of 12.3% and cost of equity of 12.0% to derive our target P/B multiple

new old

Avg. ROE (FY16-17F) 12.3% 16.1%

Cost of equity 12.0% 12.0%

Growth rate % 3.5% 3.5%

Target P/B multiple 1.00 1.50

FY17F book value per share 256 262

Implied Equity value per share 256 393

Price Target 250 395


Fig. 28: 1-year forward P/E band

Source: Datastream, Nomura estimates

Fig. 29: 1-year forward P/B band

Source: Datastream, Nomura estimates

Risks

Downside risks A higher-than-expected upstream subsidy burden could hurt ONGC’s financials. A negative Supreme Court ruling on the royalty issue may result in a sharp earnings impact. Possible delays in key projects and lower-than-expected production pose downside risks to our estimates.

Upside risks Higher oil price, lower subsidy burden, INR depreciation.

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Appendix A-1

Analyst Certification

We, Anil Sharma and Ravikumar Adukia, hereby certify (1) that the views expressed in this Research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this Research report, (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this Research report and (3) no part of our compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.

Issuer Specific Regulatory Disclosures The term "Nomura Group" used herein refers to Nomura Holdings, Inc. or any of its affiliates or subsidiaries, and may refer to one or more Nomura Group companies.

Materially mentioned issuers Issuer Ticker Price Price date Stock rating Sector rating Disclosures Bharat Petroleum Corporation BPCL IN INR 830 07-Sep-2015 Buy N/A Hindustan Petroleum Corporation HPCL IN INR 769 07-Sep-2015 Buy N/A Indian Oil Corporation IOCL IN INR 394 07-Sep-2015 Buy N/A Oil India OINL IN INR 432 07-Sep-2015 Buy N/A Oil and Natural Gas ONGC IN INR 226 07-Sep-2015 Neutral N/A

Oil and Natural Gas (ONGC IN) INR 226 (07-Sep-2015) Rating and target price chart (three year history)

Neutral (Sector rating: N/A)

Date Rating Target price Closing price 02-Jul-15 395.00 310.00 15-Jan-15 410.00 346.50 18-Dec-14 470.00 344.95 22-May-14 Buy 392.80 22-May-14 475.00 392.80 23-Jul-13 Neutral 312.15 23-Jul-13 330.00 312.15 14-Dec-12 225.00 259.50 18-Sep-12 Reduce 280.75 18-Sep-12 250.00 280.75

For explanation of ratings refer to the stock rating keys located after chart(s)

Valuation Methodology We use a P/B methodology to value ONGC. Based on an average ROE (FY16-17F) of 12.3%, a cost of equity of 12.0% and a growth rate of 3.5%, we arrive at a target P/B of 1.0x FY17F. At our target multiple of 1.0x FY17F P/B, we set our target price at INR250. The benchmark index for this stock is the MSCI India. Risks that may impede the achievement of the target price Downside risks:a higher-than-expected upstream subsidy burden, which could negatively affect ONGC’s financials; a negative Supreme Court decision on the royalty issue, which could result in a sharp earnings impact; and delays in key projects and lower-than-expected production, which pose downside risks to our estimates. Upside risks: Lower subsidy, higher oil price, rupee depreciation


14

Bharat Petroleum Corporation (BPCL IN) INR 830 (07-Sep-2015) Rating and target price chart (three year history)

Buy (Sector rating: N/A)

Date Rating Target price Closing price 02-Jul-15 1,055.00 900.00 18-Dec-14 810.00 653.30 22-May-14 675.00 559.65 23-Apr-14 580.00 475.10 23-Jul-13 465.00 352.75 05-Feb-13 490.00 411.75 18-Sep-12 Buy 337.45 18-Sep-12 430.00 337.45


Valuation Methodology We value BPCL's core refining and marketing business(including Bina and NRL) at 2.0x FY17F P/B based on adjusted book value per share of INR403/share. We give a value of INR125/share to E&P. We value BPCL’s investments in listed entities like Petronet, Indraprastha Gas and Oil India at a 20% discount to the current market price. We value current treasury shares at market price. Our target price for BPCL is INR1,055.The benchmark index for this stock is MSCI India. Risks that may impede the achievement of the target price We do not assume any sharing by OMCs for FY16-17F. However, if OMCs were made to share any under-recoveries it would pose downside risks to our estimates. Lower-than-expected GRMs and higher inventory / forex losses could also be negative for BPCL.

Hindustan Petroleum Corporation (HPCL IN) INR 769 (07-Sep-2015) Rating and target price chart (three year history)


Date Rating Target price Closing price 02-Jul-15 935.00 780.65 18-Dec-14 675.00 575.95 22-May-14 495.00 431.65 23-Jul-13 330.00 230.70 05-Feb-13 410.00 331.40 18-Sep-12 Buy 286.25


Valuation Methodology We value HPCL's core refining and marketing business at 1.75x FY17F P/B, based on adjusted book value of INR497/share. We value HPCL’s investments in listed entities, such as MRPL and Oil India, at a 20% discount to their current market price. Our target price for HPCL is INR935. The benchmark index for this stock is MSCI India. Risks that may impede the achievement of the target price We do not assume under-recovery sharing by OMCs for FY16-17. If OMCs were made to share any under-recoveries, this would pose downside risks to our estimates. Moreover, lower-than-expected GRMs and higher inventory/forex losses could be negative for HPCL.


15

Indian Oil Corporation (IOCL IN) INR 394 (07-Sep-2015) Rating and target price chart (three year history)


Date Rating Target price Closing price 02-Jul-15 515.00 412.40 18-Dec-14 450.00 330.00 22-May-14 405.00 355.35 23-Jul-13 325.00 225.70 05-Feb-13 390.00 332.45 18-Sep-12 Buy 248.35 18-Sep-12 325.00 248.35


Valuation Methodology We value the core refining and marketing business at 1.3x FY17F P/B (adj. BVPS: INR302 ex E&P and investments). We value the listed investments at a 20% discount to market price. Our TP is INR515. The benchmark index for this stock is the MSCI India. Risks that may impede the achievement of the target price We do not assume any subsidy sharing by OMCs for FY16-17F. However, if OMCs were made to share any under-recoveries, it would pose downside risks to our estimates. Lower-than-expected GRMs and higher inventory/forex losses could also be negative for IOC.

Oil India (OINL IN) INR 432 (07-Sep-2015) Rating and target price chart (three year history)


Date Rating Target price Closing price 02-Jul-15 570.00 454.15 15-Jan-15 650.00 532.15 18-Dec-14 710.00 561.80 22-May-14 Buy 618.90 22-May-14 690.00 618.90 23-Jul-13 Neutral 532.05 23-Jul-13 590.00 532.05 14-Dec-12 400.00 449.30 18-Sep-12 Reduce 476.30 18-Sep-12 405.00 476.30


Valuation Methodology We value Oil India based on P/B methodology. Based on average ROE (FY16-17F) of 12.7%, cost of equity of 12.0%, and a growth rate of 2%, we arrive at a target FY17F P/B of 1.0x. Applied to our FY17 book value per share forecast, we set our target price at INR440. The benchmark index for this stock is MSCI India. Risks that may impede the achievement of the target price Risks include higher-than-expected upstream subsidy burden, which could have a negative impact on OIL’s financials; lower-than-expected production growth, which poses downside risks to our estimates; and an adverse Supreme Court decision on the royalty issue, which could significantly affect OINL's earnings.


16

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Distribution of ratings (Global) The distribution of all ratings published by Nomura Global Equity Research is as follows: 47% have been assigned a Buy rating which, for purposes of mandatory disclosures, are classified as a Buy rating; 42% of companies with this rating are investment banking clients of the Nomura Group*. 42% have been assigned a Neutral rating which, for purposes of mandatory disclosures, is classified as a Hold rating; 55% of companies with this rating are investment banking clients of the Nomura Group*. 11% have been assigned a Reduce rating which, for purposes of mandatory disclosures, are classified as a Sell rating; 21% of companies with this rating are investment banking clients of the Nomura Group*. As at 30 June 2015. *The Nomura Group as defined in the Disclaimer section at the end of this report. Explanation of Nomura's equity research rating system in Europe, Middle East and Africa, US and Latin America, and Japan and Asia ex-Japan from 21 October 2013 The rating system is a relative system, indicating expected performance against a specific benchmark identified for each individual stock, subject to limited management discretion. An analyst’s target price is an assessment of the current intrinsic fair value of the stock based on an appropriate valuation methodology determined by the analyst. Valuation methodologies include, but are not limited to, discounted cash flow analysis, expected return on equity and multiple analysis. Analysts may also indicate expected absolute upside/downside relative to the stated target price, defined as (target price - current price)/current price. STOCKS A rating of 'Buy', indicates that the analyst expects the stock to outperform the Benchmark over the next 12 months. A rating of 'Neutral', indicates that the analyst expects the stock to perform in line with the Benchmark over the next 12 months. A rating of 'Reduce', indicates that the analyst expects the stock to underperform the Benchmark over the next 12 months. A rating of 'Suspended', indicates that the rating, target price and estimates have been suspended temporarily to comply with applicable regulations and/or firm policies. Securities and/or companies that are labelled as 'Not rated' or shown as 'No rating' are not in regular research coverage. Investors should not expect continuing or additional information from Nomura relating to such securities and/or companies. 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Benchmarks are as follows: United States: S&P 500; Europe: Dow Jones STOXX 600; Global Emerging Markets (ex-Asia): MSCI Emerging Markets ex-Asia. Japan/Asia ex-Japan: Sector ratings are not assigned. Explanation of Nomura's equity research rating system in Japan and Asia ex-Japan prior to 21 October 2013 STOCKS Stock recommendations are based on absolute valuation upside (downside), which is defined as (Target Price - Current Price) / Current Price, subject to limited management discretion. In most cases, the Target Price will equal the analyst's 12-month intrinsic valuation of the stock, based on an appropriate valuation methodology such as discounted cash flow, multiple analysis, etc. A 'Buy' recommendation indicates that potential upside is 15% or more. A 'Neutral' recommendation indicates that potential upside is less than 15% or downside is less than 5%. A 'Reduce' recommendation indicates that potential downside is 5% or more. A rating of 'Suspended' indicates that the rating and target price have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstances including when Nomura is acting in an advisory capacity in a merger or strategic transaction involving the subject company. Securities and/or companies that are labelled as 'Not rated' or shown as 'No rating' are not in regular research coverage of the Nomura entity identified in the top banner. Investors should not expect continuing or additional information from Nomura relating to such securities and/or companies. SECTORS A 'Bullish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a positive absolute recommendation. A 'Neutral' rating means most stocks in the sector have (or the weighted average recommendation of the stocks

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17

under coverage is) a neutral absolute recommendation. A 'Bearish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a negative absolute recommendation. Target Price A Target Price, if discussed, reflects in part the analyst's estimates for the company's earnings. The achievement of any target price may be impeded by general market and macroeconomic trends, and by other risks related to the company or the market, and may not occur if the company's earnings differ from estimates. Disclaimers This document contains material that has been prepared by the Nomura entity identified on page 1 and/or with the sole or joint contributions of one or more Nomura entities whose employees and their respective affiliations are also specified on page 1 or identified elsewhere in the document. 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