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The melting commodities!

India StrategyThematic | September 2014

Sector: Commodity

Research Team ([email protected])

India Strategy

15 September 2014 2

The melting commodities!

Page No.

Summary ................................................................................................................ 3-4

Story in charts ................................................................................................... 5-7

Global slowdown and transatlantic policy shifts weighs on commodities ...... 8-11

Falling commodities: Advantage India ............................................................. 12-15

OIL & GAS ........................................................................................................... 16-23

AUTO ................................................................................................................... 24-26

METALS ............................................................................................................... 27-31

FINANCIAL ..................................................................................................... 32-33

Investors are advised to refer through disclosures made at the end of the Research Report.

15 September 2014 3

India Strategy

The melting commodities Economy and many sectors poised to reap dividends

Global slowdown and transatlantic policy shift weighs on commodities

Global growth has disappointed again belying expectations of a quick recovery. IMF

downgraded growth estimates for 2014 and 2015 for most major economies of the

world. The emerging economies particularly China and India, continue to grow at a

much faster rate than the advanced countries. On the other hand, withdrawal of

extraordinary monetary accommodation by US contrasts with continued

accommodation by Europe, Japan and China. This transatlantic policy divergence is

creating ripples in the financial market with sharp increase in USD contrasting with a

sharp drop in both oil and many other hard and soft commodities.

Falling commodities has wide ranging implications on Indian economy, government

finance and external balances and multiple sectors. In our view, direct beneficiaries

of declining commodity prices would be OMCs, upstream oil & gas, Auto and

Financials. Additionally, few companies within Consumers, Cement and Industrials

are also likely to benefit as RM cost eases.

Falling commodity prices raises many questions & interesting possibilities –

our attempt to answer some of them:

1 Should RBI moderate and are markets factoring that already? Refer Pg 13

2 Is Crude turning into a buyer’s market? Refer Pg 17

3 Could Oil Subsidy become a matter of past? Refer Pg 14

4 Can 70-40 become 30-70 for ONGC? Refer pg 20

5 Can OMC’s go back to their old glory? Refer Pg 21

6 Would the trend of dieselization be reversed? Refer Pg 24

7 Are steel prices heading for a sharp correction? Refer Pg 27

8 What will be the impact of falling commodity prices on Indian Financials? Refer

Pg 32

Indian economy is poised to reap rich dividends of these trends

� WPI inflation is headed downwards due to significant weight of manufacturing

in the WPI basket. However, the benefit would largely be secondary in case of

CPI with a much larger weight of agriculture and services into its composition. At

the current crude price WPI inflation estimates would be scaled down to 5% in

place of 5.8% for FY15. Similarly CPI inflation would soften by 20bp to 7.5%.

These estimates for FY16 would stand revised from 5.5% to 3.5% for WPI and

from 6.5% to 6% for CPI.

� Benefit to government finance and external balance too are of consequence. As

per our estimate lower oil price (by USD5-10 per barrel) would nudge the fiscal

deficit to GDP ratio during FY15 to 4% from 4.1% estimated earlier while for

FY16 the estimates would go down to 3.4% from 3.6% estimated earlier. The

CAD/GDP would go down to 1.7% v/s 1.8% for FY15 estimated earlier while FY16

estimates would be scaled down to 1.7% v/s 2% estimated earlier.

Oil has dipped to double

digit levels after 26 months

Source: IMF, MOSL

96.7

9

118.

11 115

97.292

100

108

116

124

Sep

-12

De

c-1

2M

ar-

13

Jun

-13

Sep

-13

De

c-1

3M

ar-

14

Jun

-14

Sep

-14

Brent Crude Oil

Prices US$/BL

15 September 2014 4

India Strategy

Oil and gas: Game changing era for upstream companies and OMCs’

� Crude is becoming a buyers’ market driven by uncertain and subdued demand,

significant production increase in the North America and need of oil sales to

support Middle East economies

� India is well poised to benefit from this trend through potential lowering of

under recoveries by 70% and its share in GDP coming down from alarming 1.6%

to 0.5%.

� These trends will also lead to multifold earnings increase for oil PSU’s and shift

from trading to structural investment plays.

� The best plays in our view are ONGC/OINL in upstream also benefiting from

impending gas price hike, and OMC’s (HPCL is most leveraged) whose

profitability will also be boosted by likely increase in marketing margins.

Auto: Petrol-diesel parity could reverse the dieselization trend and lead to

significant demand growth in PVs

� Auto sector suffered till recently from the double trouble of high inflation and

low demand.

� Reduction in global oil prices, recovering Indian economic growth and reversal in

dieselization trend owing to deregulation of diesel are the three potential

drivers for auto sector.

� The best play in our view is MSIL driven by strong volume growth and benefits

of operating leverage.

Financials: Interest rate fall: PSBs and Bulk borrowers to benefit the most

� Looking at the liquidity situation, lower demand and improving twin deficit,

systemic rates may come down in the near term

� This trend will benefit (a) Bulk borrowers like NBFCs, Small private banks and

PSU banks (b) PSU banks especially due to higher share of G-Sec portfolio (MTM

gain on AFS portfolio) and (c) overall growth and asset quality in the system.

� To play expected fall in bulk rates and G-Sec rates our top picks are YES, AXSB,

PNB, LICHF, SBIN and CBK.

Metals: Declining steel prices to put pressure on integrated steel producers;

non-integrated players to remain resilient led by declining iron ore prices

� Steel prices have corrected driven by weakness in Chinese HRC export prices

and global trade. Slowdown in steel demand in China, along with surging

supplies continues to impact steel raw material prices.

� International Iron ore prices are making new lows every day, down 15% over the

last 2-3 weeks. Coking coal is also down 3%-4% in the last few days.

� Iron ore supply is likely to ease with permission being granted for liquidation of

inventories lying at mines. This will ease the supply and put pressure on

domestic iron ore prices.

� Integrated steel producers (Tata Steel and SAIL) are unlikely to benefit from fall

in iron ore prices instead increased royalty and closure of iron ore mines in

Jharkhand will add to costs. Declining steel price will further put pressure on

margins. Non-integrated steel producers like JSW Steel may not see pressure on

margin as cheaper iron ore and coking coal prices reduce costs for them.

Oil subsidy would become

negligible from current level of

0.8% of GDP

Source: MOSL

Iron ore prices (62% fines)

have declined further,

down to USD82/t cfr China

Source: Company, MOSL

Iron ore prices (62% fines)

have declined further,

down to USD82/t cfr China


0.0

0.3

0.6

0.9

1.2

0 400 800

1,200 1,600

FY0

4

FY0

8

FY1

2

FY1

6E

Under recovery (INRb)Oil subsidy (INRb)

Oil subsidy (as % of GDP)

0

25

50

75

FY

04

FY

05

FY

06

FY

07

FY

08

FY

09

FY

10

FY

11

FY

12

FY

13

FY

14

1Q

FY

15

Ju

l'1

4

Au

g'1

4

Se

p'1

4

Petrol Diesel

INR24/Ltr

INR12/Ltr

INR12/

Ltr

Period of Diesel price

deregulation

134

117

96

82

70

90

110

130

150

Se

p-1

3

Oct-1

3

No

v-1

3

De

c-1

3

Ja

n-1

4

Fe

b-1

4

Ma

r-1

4

Ap

r-1

4

Ma

y-1

4

Ju

n-1

4

Ju

l-1

4

Au

g-1

4

Se

p-1

4

CIF FOB

15 September 2014

Story in charts

IMF downgraded world growth projections for 2014 for major

regions and countries

US Policy tightening is reflecting in Dollar gains

Source: Bloomberg, MOSL

Oil has dipped to double digit levels after 26 months


-0.3-0.4

0

-1.1

-0.2

-0.6

-1.1

Wo

rld

Ad

van

ced

Eco

s

Eu

ro a

rea

Un

ite

d S

tate

s

EM

& D

eve

lop

ing

Bra

zil

Ru

ssia

IMF 2014 growth …

84.6

79.278

80

82

84

86

Sep

-12

No

v-1

2

Jan

-13

Ma

r-1

3

Ma

y-1

3

Jul-

13

Sep

-13

No

v-1

3

Jan

-14

Dollar Index

96.79

118.11

92

100

108

116

124

Sep

-12

De

c-1

2

Ma

r-1

3

Jun

-13

Sep

-13

De

c-1

3

Brent Crude Oil Prices US$/BL

IMF downgraded world growth projections for 2014 for major

Source: IMF, MOSL

The world however, continue to grow at two speeds for advanced

and EM countries



In contrast, Japan has followed a policy of depreciation

suggesting transatlantic policy split

after 26 months


The commodity prices have retraced back to their levels two and

half years ago

0

-0.2

-0.6

Ind

ia

Ch

ina

Sou

th A

fric

a

3.4

1.8

1.1

1.7

4.6

Wo

rld

Ad

van

ced

Eco

s

Eu

ro a

rea

Un

ite

d S

tate

s

EM

&

2015

84.3

Jan

-14

Ma

r-1

4

Ma

y-1

4

Jul-

14

Sep

-14

75

85

95

105

115

Sep

-12

No

v-1

2

Jan

-13

Ma

r-1

3

Ma

y-1

3

Jul-

13

115

97.2

Ma

r-1

4

Jun

-14

Sep

-14


3354

3847

3000

3200

3400

3600

3800

4000

Jan

-12

Ap

r-1

2

Jul-

12

Oct

-12

Jan

-13

Rogers International Commodity Index

5

India Strategy

The world however, continue to grow at two speeds for advanced

Source: IMF, MOSL

In contrast, Japan has followed a policy of depreciation

suggesting transatlantic policy split


The commodity prices have retraced back to their levels two and


4.6

1.30.2

5.4

7.4

1.7

EM

&

De

velo

pin

g

Bra

zil

Ru

ssia

Ind

ia

Ch

ina

Sou

th A

fric

a

96.7

105.3 106.9

Jul-

13

Sep

-13

No

v-1

3

Jan

-14

Ma

r-1

4

Ma

y-1

4

Jul-

14

Sep

-14

USD/JPY

3847 3752

3390

Ap

r-1

3

Jul-

13

Oct

-13

Jan

-14

Ap

r-1

4

Jul-

14

Rogers International Commodity Index

15 September 2014

Commodity fall to bring larger drop in WPI inflation

Source: Bloomberg, Government, MOSL

Imports may fall by 1.4% of GDP due to commodities fall

Source: Government, MOSL

Diesel under recoveries: Diesel prices almost de

with recent fortnight loss of INR0.08/ltr (INR/ltr)

Source: PPAC, MoPNG, IOC, MOSL

Oil Price realization (USD/bbl): ONGC net realization set to

increase….


5.8

7.7

5.0

7.5

5.5

3.5

WPI Inflation CPI inflation

FY15 old FY15 new FY16 old

22.3 % of

GDP

0

100

200

300

400

500

FY15E (no commodities fall) FY15 (commodities fall)

Non-POL items Crude & products

Total imports

USDb

20.4

1.5

14.9 13.9 17.1

3.7

(5)

0

5

10

15

20

25

1Q

FY

07

1Q

FY

07

1Q

FY

08

1Q

FY

09

1Q

FY

10

1Q

FY

11

1Q

FY

12

No

v-1

1

Jan

-12

Ma

r-1

2

Ma

y-1

2

Jul-

12

Se

p-1

2

No

v-1

2

Jan

-13

Ma

r-1

3

Ma

y-1

3

38 42 44

53 48

56

54

55 48

0

25

50

75

100

125

FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13

Gross Upstream Discount

Commodity fall to bring larger drop in WPI inflation

Source: Bloomberg, Government, MOSL

CPI however, remained high with gap with WPI expected to widen

mports may fall by 1.4% of GDP due to commodities fall


External accounts can improve further on

Diesel under recoveries: Diesel prices almost de-regulated

with recent fortnight loss of INR0.08/ltr (INR/ltr)


With diesel set to be de-regulated, expect under recoveries

to be down >50% (INRb)

Oil Price realization (USD/bbl): ONGC net realization set to


HPCL: EPS upsides to reforms

7.5

6.56.0

CPI inflation

FY16 old FY16 new

0

2

4

6

8

10

12

Jan

-13

Ma

r-1

3

Ma

y-1

3

Jul-

13

Sep

-13

No

v-1

3

Jan

-14

474

RBI's Jan

20.9 % of

GDP

FY15 (commodities fall)

Crude & products

-7.8

5.9

-7.2

Trade deficit Invisible surplus

As

% o

f G

DP

FY15E (no commodities fall)

14.5

0.1

Jul-

13

Se

p-1

3

No

v-1

3

Jan

-14

Ma

r-1

4

Ma

y-1

4

Jul-

14

Se

p-1

4

201 400

494

773

1,033

461

0

500

1,000

1,500

2,000

FY05 FY06 FY07 FY08 FY09 FY10

Petrol Diesel

41

61 66 68

FY13 FY14 FY15E FY16E FY17E

Net

34.7

7.0

15.5

Adj. FY14

EPS

Interest

reduction

MM

@INR0.5/ltr

HPCL EPS (INR)

6

India Strategy

CPI however, remained high with gap with WPI expected to widen


External accounts can improve further on account of this


regulated, expect under recoveries


Source: MOSL, Company

Jan

-14

Ma

r-1

4

Ma

y-1

4

Jul-

14

Sep

-14

No

v-1

4

Jan

-15

Ma

r-1

5

203

bp 125

bp

226

bp

RBI's Jan-15 target of 8%

CPI - WPI

-1.9

5.9

-1.3

Invisible surplus Current A/c deficit


461

780

1,381

1,610 1,399

948 750 689

FY10 FY11 FY12 FY13 FY14 FY15E FY16E FY17E

Kerosene LPG Total

54.9

15.5

-0.8

MM

@INR0.5/ltr

Mkt share

loss @15%

New likely

EPS

15 September 2014 7

India Strategy

Fuel cost inflation moderating, after over 11% CAGR since

FY11, auguring well for PV demand


Reducing petrol-diesel price disparity augurs well for MSIL

due to its relative weakness in diesel engine


Iron ore prices (62% fines) have declined further, down to

US$82/t cfr China; would benefit non-integrated steel players


Coking coal after consolidating at US$110-112/t fob Australia

is down to US$108/t


-10

0

10

20

30

FY

04

FY

05

FY

06

FY

07

FY

08

FY

09

FY

10

FY

11

FY

12

FY

13

FY

14

1Q

FY

15

Jul'

14

Au

g'1

4

Se

p'1

4

FY

16

??

?

FY

17

??

?

Petrol Diesel

33 34 35 36

48

5853 50

13 15 19 1824

3732 32

FY08 FY09 FY10 FY11 FY12 FY13 FY14 1QFY15

Diesel volumes (as % of total) Industry

134

117

96

82

70

90

110

130

150

Se

p-1

3

Oct

-13

No

v-1

3

De

c-1

3

Jan

-14

Fe

b-1

4

Ma

r-1

4

Ap

r-1

4

Ma

y-1

4

Jun

-14

Jul-

14

Au

g-1

4

Se

p-1

4

CIF FOB

153

113 112

108100

110

120

130

140

150

160S

ep

-13

Oct

-13

No

v-1

3

De

c-1

3

Jan

-14

Fe

b-1

4

Ma

r-1

4

Ap

r-1

4

Ma

y-1

4

Jun

-14

Jul-

14

Au

g-1

4

Se

p-1

4

Spot coking coal (fob Australia) - US$/t

15 September 2014 8

India Strategy

Global slowdown and transatlantic policy shifts weighs on commodities Growth outlook creates policy divergence

1. Renewed slowdown fear: The hope of a quick turnaround in the world economy

been faded with IMF downgrading growth projections for most major

economies of the world. Europe, after seeing a few quarters of anemic recovery,

mainly driven by Germany, have slipped back into stagnation, prompting a fresh

round of monetary stimulus by ECB. Many commentators have sounded

worrying signals about China growth story. However, uneven growth continue

to characterize world economy with relatively muted growth in advanced

countries contrasting with still respectable growth of many emerging

economies, particularly China and India.

IMF downgraded world growth projections for 2014 for major regions and countries

Source: IMF, MOSL

The world however, continue to grow at two speeds for advanced and EM countries

Source: IMF, MOSL

2. Transatlantic monetary policy shift: Meanwhile in the US, the extra ordinary

monetary accommodation that was accorded as a post crisis response, is

unwinding. US FED has scaled down the extent of quantitative easing to USD25b

from USD85b earlier. This may be followed by a period of actual shrinking of

money supply in the economy and eventually an increase in rates. However, in

Europe fear of slowdown has led to further monetary stimulus while in Japan

-0.3-0.4

0

-1.1

-0.2

-0.6

-1.1

0

-0.2

-0.6

Wo

rld

Ad

van

ced

Eco

s

Eu

ro a

rea

Un

ite

d S

tate

s

EM

& D

eve

lop

ing

Bra

zil

Ru

ssia

Ind

ia

Ch

ina

Sou

th A

fric

a

IMF 2014 growth downgrades

3.4

1.8

1.1

1.7

4.6

1.30.2

5.4

7.4

1.7

Wo

rld

Ad

van

ced

Eco

s

Eu

ro a

rea

Un

ite

d S

tate

s

EM

&

De

velo

pin

g

Bra

zil

Ru

ssia

Ind

ia

Ch

ina

Sou

th A

fric

a2015

15 September 2014 9

India Strategy

accommodation continues as part of a medium term growth strategy. While

China has kept the rates relatively stable, it is yet to begin its tightening cycle.

Thus monetary policy at present is in opposite direction on the two sides of

Atlantic creating varying response from the financial markets. Expectedly, USD

has strengthened sharply in recent times in contrast to currencies of the

countries where monetary accommodation is still underway.

Only US is tightening while other either easing or stable

Source: Central Banks, MOSL

Central bankers diverged in their assessment of the economy and policy response

Source: Central Banks, MOSL

Date US Fed Date ECB

30-Jul -14 Sca les down QE to USD25b (USD10b MBS + USD15b

Treas ury)

4-Sep-14 Pol icy rates lowered by 10 bas is points

18-Jun-14 Sca les down QE to USD35b (USD15b MBS + USD20b

Treas ury)

7-Aug-14 Pol icy rates left unchanged

30-Apr-14 Sca les down QE to USD45b (USD20b MBS + USD25b

Treas ury)

3-Jul -14 Deta i l s of the targeted longer-term refinancing

operations announced

19-Mar-14 Sca les down QE to USD55b (USD25b MBS + USD30b

Treas ury)

17-Jun-14 Extends US dol lar l iquidi ty-providing operations

beyond 31 July 2014

29-Jan-14 Sca les down QE to USD65b (USD30b MBS + USD35b

Treas ury)

5-Jun-14 Introduces a negative depos i t faci l i ty interes t rate

Date Bank of Japan Date People's Bank of China

4-Sep-14 To continue to target expans ion of monetary base

by YEN 60-70t

Lates t Kept interes t rate stable at 6% from Jul -12 when

benchmark rates were cut by 25bp

8-Aug-14 To continue to target expans ion of monetary base

by YEN 60-70t

20-Jul -14 Sets a two year timetable to l ibera l i ze interest

rates

15-Jul -14 To continue to target expans ion of monetary base

by YEN 60-70t

13-Jun-14 To continue to target expans ion of monetary base

by YEN 60-70t

21-May-14 To continue to target expans ion of monetary base

by YEN 60-70t

Janet Yellen, US FED "But i f progress in the labor market

continues to be more rapid than

anticipated by the Committee or i f

infla tion moves up more rapidly than

anticipated, resul ting in faster

convergence toward our dua l

objectives , then increas es in the

federa l funds rate target could come

sooner than the Committee currently

expects and could be more rapid

thereafter."

Mario Draghi, ECB "The provis ion of publ ic guarantees

s hould be cons idered to support

lending [to smal l and medium-s ized

enterpris es , or SMEs ], as other

countries do, such as the US."

Haruhiko Kuroda, BoJ "I told the prime minis ter that we wi l l

fi rmly proceed with the current eas ing,

and make the utmos t efforts to

achieve the 2% target."

Zhou Xiaochuan, PBOC "PBOC could use a range of meas ures

to a id the economy i f growth s trays

too far from the government's targeted

range."

15 September 2014 10

India Strategy



In contrast Japan has followed a policy of depreciation


3. Commodities falling on global factors: The slowing growth coupled with

withdrawal of monetary accommodation in US is causing a rather sharp

correction in global commodities and asset prices. The most striking among all

and one with the most strategic significance, has been the global crude oil

prices. Among the most critical assets, gold - that was the most favored during

periods of uncertainties - has caved in. Even some of the soft commodities

including food are correcting sharply with many of them ruling below their Jan-

11 levels.

Oil has dipped to double digit levels after 26 months


Gold prices corrected by 4% from their peak


Iron ore prices has slid back by five years


Coal prices too are at multi year low


84.6

79.2

84.3

78

80

82

84

86

Sep

-12

No

v-1

2

Jan

-13

Ma

r-1

3

Ma

y-1

3

Jul-

13

Sep

-13

No

v-1

3

Jan

-14

Ma

r-1

4

Ma

y-1

4

Jul-

14

Sep

-14

Dollar Index

96.7

105.3 107.1

75

85

95

105

115

Sep

-12

No

v-1

2

Jan

-13

Ma

r-1

3

Ma

y-1

3

Jul-

13

Sep

-13

No

v-1

3

Jan

-14

Ma

r-1

4

Ma

y-1

4

Jul-

14

Sep

-14

USD/JPY

96.79

118.11115

97.292

100

108

116

124

Sep

-12

De

c-1

2

Ma

r-1

3

Jun

-13

Sep

-13

De

c-1

3

Ma

r-1

4

Jun

-14

Sep

-14


1900

12501100

1350

1600

1850

2100

Sep

-11

De

c-1

1

Ma

r-1

2

Jun

-12

Sep

-12

De

c-1

2

Ma

r-1

3

Jun

-13

Sep

-13

De

c-1

3

Ma

r-1

4

Jun

-14

Sep

-14

Gold ($/OZ)

188

87

159

8250

90

130

170

210

Ma

r-0

9Ju

n-0

9Se

p-0

9D

ec-

09

Ma

r-1

0Ju

n-1

0Se

p-1

0D

ec-

10

Ma

r-1

1Ju

n-1

1Se

p-1

1D

ec-

11

Ma

r-1

2Ju

n-1

2Se

p-1

2D

ec-

12

Ma

r-1

3Ju

n-1

3Se

p-1

3D

ec-

13

Ma

r-1

4Ju

n-1

4Se

p-1

4

Iron Ore - China (USD/MT)

67

130

6850

75

100

125

150

De

c-0

9

Ma

r-1

0

Jun

-10

Sep

-10

De

c-1

0

Ma

r-1

1

Jun

-11

Sep

-11

De

c-1

1

Ma

r-1

2

Jun

-12

Sep

-12

De

c-1

2

Ma

r-1

3

Jun

-13

Sep

-13

De

c-1

3

Ma

r-1

4

Jun

-14

Sep

-14

Coal - Richard Bay index (USD/MT)


India Strategy

China HR still near their Sep-12 low


Palm oil near their post crisis lows


Rubber prices at 30% of their peak value


Agriculture product prices are falling rapidly too

Source: Rogers, MOSL

Rice prices are falling since post crisis period


After the spike, wheat prices moderated again


761

513 524

450

520

590

660

730

800

Ma

r-0

9Ju

n-0

9Se

p-0

9D

ec-

09

Ma

r-1

0Ju

n-1

0Se

p-1

0D

ec-

10

Ma

r-1

1Ju

n-1

1Se

p-1

1D

ec-

11

Ma

r-1

2Ju

n-1

2Se

p-1

2D

ec-

12

Ma

r-1

3Ju

n-1

3Se

p-1

3D

ec-

13

Ma

r-1

4Ju

n-1

4Se

p-1

4

China HR Steel (USD/MT)

3927

2027

2038

1700

2300

2900

3500

4100

Ma

r-0

9Ju

n-0

9Se

p-0

9D

ec-

09

Ma

r-1

0Ju

n-1

0Se

p-1

0D

ec-

10

Ma

r-1

1Ju

n-1

1Se

p-1

1D

ec-

11

Ma

r-1

2Ju

n-1

2Se

p-1

2D

ec-

12

Ma

r-1

3Ju

n-1

3Se

p-1

3D

ec-

13

Ma

r-1

4Ju

n-1

4Se

p-1

4

Palm Oil - Malaysian Ringit Per MT

52

198

5445

90

135

180

225

Ma

r-0

9Ju

n-0

9Se

p-0

9D

ec-

09

Ma

r-1

0Ju

n-1

0Se

p-1

0D

ec-

10

Ma

r-1

1Ju

n-1

1Se

p-1

1D

ec-

11

Ma

r-1

2Ju

n-1

2Se

p-1

2D

ec-

12

Ma

r-1

3Ju

n-1

3Se

p-1

3D

ec-

13

Ma

r-1

4Ju

n-1

4Se

p-1

4

Thailand Rubber (THB/GRAM)

3,300

3,400

3,500

3,600

3,700

3,800

Jan

-14

Jan

-14

Feb

-14

Ma

r-1

4

Ma

r-1

4

Ap

r-1

4

Ma

y-1

4

Ma

y-1

4

Jun

-14

Jul-

14

Jul-

14

Au

g-1

4

Sep

-14

Rogers Agriculture

200

400

600

800

1000

Jan

-07

Ma

y-0

7O

ct-0

7Fe

b-0

8Ju

n-0

8O

ct-0

8Fe

b-0

9Ju

n-0

9O

ct-0

9Fe

b-1

0Ju

n-1

0O

ct-1

0Fe

b-1

1Ju

n-1

1O

ct-1

1Fe

b-1

2Ju

n-1

2O

ct-1

2Fe

b-1

3Ju

n-1

3O

ct-1

3Fe

b-1

4Ju

n-1

4

Rice

600

650

700

750

800

850

900

Jan

-13

Ma

r…

Ma

y…

Jul-

13

Sep

-…

No

v-…

Jan

-14

Ma

r…

Ma

y…

Jul-

14

Wheat


India Strategy

Falling commodities: Advantage India Direct benefit for inflation, fiscal and external account

1. WPI is crashing: The most direct beneficiary of the global commodity softening are the transportation and manufacturing sector where input costs comes down proportionately. As a result, WPI manufacturing, WPI core and indeed overall WPI is expected to soften widely. As per our calculations around 66% of the WPI basket is influenced by international price trend. Thus WPI may soften by 80-200 bp during FY15 and FY16 respectively, on the back of easing commodities

2. CPI is falling too: While part of the CPI fuel sector would benefit, a large part of the CPI basket is comprised of food (50%) and services (26%) that are largely functions of domestic price pressures. We estimate around 17% of the product basket of CPI being affected by international commodity prices, yielding a benefit ranging between 20-50bp during FY15 to FY16.

WPI and CPI has very different commodity basket with WPI having more globally linked commodities Inflation indicator Weight Inflation indicator Weight WPI 100.0 CPI 100.0

Primary articles 20.1 Food, beverages & tobacco 49.7 Food articles 14.3 Cereals and products 14.6 Non-food articles 4.3 Pulses and products 2.7 Minerals 1.5 Oils and fats 3.9

Fuel & power 14.9 Egg, fish and meat 2.9 Coal 2.1 Milk and products 7.7 Mineral oils 9.4 Condiments and spices 1.7 Electricity 3.5 Vegetables 5.4

Manufactured products 65.0 Fruits 1.9 Food products 10.0 Sugar etc. 1.9 Beverages, tobacco & tobacco products 1.8 Non-alcoholic beverages 2.0 Textiles 7.3 Prepared meals etc. 2.8 Wood & wood products 0.6 Pan, tobacco and intoxicants 2.1 Paper & paper products 2.0 Fuel & light 9.5 Leather & leather products 0.8 Clothing, bedding & footwear 4.7 Rubber & plastic products 3.0 Housing 9.8 Chemicals & chemical products 12.0 Miscellaneous 26.3 Non-metallic mineral products 2.6 Medical care 5.7 Basic metals, alloys & metal products 10.8 Education, stationery etc. 3.4 Machinery & machine tools 8.9 Recreation and amusement 1.4 Transport, equipment & parts 5.2 Transport and communication 7.6

Personal care and effects 2.9

Household requisites 4.3

Others 1.1

Note: Shaded commodities are likely to benefit more from the global commodities fall. Source: Rogers, MOSL

15 September 2014

In the past, gap between CPI and WPI has gone up to as high

as 8.6%


3. Gap between CPI and WPI to widen

resulted in the two measures of WPI and CPI diverging widely in the past going

as high as 8.6% during FY10. In recent times however, this gap was closing on

the back of gradual decline in food prices. This is set to

disproportionate nature of benefits of international price moderation on the

two indicators.

4. Should RBI moderate and are markets factoring that already?

phenomena call into question the prudence of selection of

indicator (viz., CPI) as a target inflation indicator. As the brief history of new CPI

series shows that

is a need to revisit the choice of indicator taking into account the

measures of

remained soft despite liquidity challenges on the back of these developments

Similarly the heavily regulated 10

despite RBI maintai

further in the coming months.

This calls for a closer look for choice of indicators for monetary policy

7.2

-3.3-4

-1

2

5

8

11

FY8

4

FY8

6

FY8

8

FY9

0

FY9

2

FY9

4

FY9

6

FY9

8

FY0

0

FY0

2

FY0

4

Gap between CPI and WPI

0

2

4

6

8

10

12 Avg CPI: 9.5%

In the past, gap between CPI and WPI has gone up to as high


The gap between CPI and WPI that has narrowed is

expected to rise again

Gap between CPI and WPI to widen: The differing commodity composition has



the back of gradual decline in food prices. This is set to


two indicators.

Should RBI moderate and are markets factoring that already?

phenomena call into question the prudence of selection of


series shows that on an average CPI rules nearly 3% higher than WPI. Thus

is a need to revisit the choice of indicator taking into account the

measures of inflationary trend. The market determined interest rates have

remained soft despite liquidity challenges on the back of these developments

Similarly the heavily regulated 10-year G-sec too has seen significant softening

despite RBI maintaining a tight stance. These trend

further in the coming months.


8.6

FY0

4

FY0

6

FY0

8

FY1

0

FY1

2

FY1

4

Gap between CPI and WPI

0

2

4

6

8

10

12

Jan

-13

Ma

r-1

3

Ma

y-1

3

Jul-

13

Sep

-13

No

v-1

3

Jan

-14

474

Jan

-12

Ma

r-1

2

Ma

y-1

2

Jul-

12

Sep

-12

No

v-1

2

Jan

-13

Ma

r-1

3

Ma

y-1

3

Jul-

13

Sep

-13

CPI WPI

Avg CPI: 9.5%

13

India Strategy

The gap between CPI and WPI that has narrowed is


The differing commodity composition has



the back of gradual decline in food prices. This is set to widen again due to very


Should RBI moderate and are markets factoring that already?: The above

phenomena call into question the prudence of selection of exclusively one


on an average CPI rules nearly 3% higher than WPI. Thus there

is a need to revisit the choice of indicator taking into account the broader

he market determined interest rates have

remained soft despite liquidity challenges on the back of these developments.

sec too has seen significant softening

trends are likely to accentuate


Source: CSO, MOSL

Jan

-14

Ma

r-1

4

Ma

y-1

4

Jul-

14

Sep

-14

No

v-1

4

Jan

-15

Ma

r-1

5

203

bp 125

bp

226

bp

RBI's Jan-15

target of 8%

CPI - WPI

Sep

-13

No

v-1

3

Jan

-14

Ma

r-1

4

Ma

y-1

4

Jul-

14

Avg WPI: 6.6%


India Strategy

The market interest rates have shown softening bias


Even the heavily regulated 10-yr G-sec has fallen too


5. Oil subsidy could become a matter of the past: The subsidy overhang has

stressed the government finance since mid-2000s. A sharp decline in oil price

would help restrain total subsidy bill to 2% of GDP while oil below USD105/bbl

would even create some space to meet the shortfall on account of lower tax

collections, etc. This gives greater credibility to fiscal deficit goals. However,

diesel deregulation reaching its conclusion lowers the extent of benefit the

government can reap on an ongoing basis out of continued drop in oil prices. As

per our calculations, the benefit of every USD10 decline in oil prices, results in

around 10bp drop in fiscal deficit to GDP ratio.

Oil subsidy would become negligible from current level of 0.8% of GDP

Source: CSO, MOSL

6. Trade and CAD to improve by 0.3% of GDP: The lower commodity prices would

restrain import growth which can correct by 1.4% of GDP on a full year basis.

While exports too is likely to fall in value as seen in previous such occasions in

the past, the current account can still correct by 0.3% of GDP. This would imply

that FY15 CAD/GDP ratio could be as low as 1.6% providing further stability to

external sector. This would further reduce the dependence on foreign capital

flows and also provide and opportunity to RBI to build forex reserves.

8.5

9.0

9.5

10.0

2-A

pr

16

-Ap

r

30

-Ap

r

14

-Ma

y

28

-Ma

y

11

-Ju

n

25

-Ju

n

9-J

ul

23

-Ju

l

6-A

ug

20

-Au

g

3-S

ep

AAA 1 yr CP 1 yr

8.0

8.2

8.4

8.6

8.8

9.0

9.2

2-A

pr

16

-Ap

r

30

-Ap

r

14

-Ma

y

28

-Ma

y

11

-Ju

n

25

-Ju

n

9-J

ul

23

-Ju

l

6-A

ug

20

-Au

g

3-S

ep

10-Year G-Sec

0.0

0.3

0.6

0.9

1.2

0

500

1,000

1,500

2,000

FY0

4

FY0

5

FY0

6

FY0

7

FY0

8

FY0

9

FY1

0

FY1

1

FY1

2

FY1

3

FY1

4

FY1

5E

FY1

6E

FY1

7E

Under recovery (INRb) Oil subsidy (INRb) Oil subsidy (as % of GDP)


India Strategy

Imports may fall by 1.4% of GDP due to commodities fall


External accounts can improve further on account of this


22.3 % of

GDP20.9 % of

GDP

0

100

200

300

400

500


Non-POL items Crude & products

Total imports

USDb

-7.8

5.9

-1.9

-7.5

5.9

-1.6

Trade deficit Invisible surplus Current A/c deficit

As

% o

f G

DP



India Strategy

Oil & Gas / Auto to benefit from falling oil prices

I. THE BEGINNIG OF A NEW ERA Is crude becoming a buyers’ market?

1. Crude prices range bound in the last four years: Despite heightened

geopolitical tensions in the oil producing countries benchmark Brent crude price

hovered ~USD110/bbl for the last four years, unlike previous decade where it

varied between USD20/bbl to USD130/bbl. However, now it has fallen below

USD100/bbl and given the underlying factors can fall further.

Unlike previous decade, crude prices range bound in recent years (Brent crude, USD/bbl)

*Monthly average Source: Bloomberg, MOSL

2. US driving oil supply growth singlehandedly Historically, oil prices have reacted

sharply to any geopolitical issues in the oil producing countries. However, recent

disruptions in the oil producing countries Libyia, Syria and sanctions on Iran

does not seem to have profoundly impacted oil prices significantly. The answer

lies in the shale oil led production increase in US who contributed to 84% of the

last five year production increase at 3.2mmbbl/d. On the consumption side

world oil consumption grew at a slowest 5-year CAGR in 2013 led by recent

global slowdown in the last two decades.

Annual Production Change (mmbbl/d): US/Canada production increase has more than compensated OPEC production decline

Source: OPEC, IEA, EIA, BP Statistical review, MOSL

90

100

110

120

130

Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14

Brent crude price (USD/bbl)

3.9 3.2

0.9 0.8 0.7 0.7 0.6 0.6 0.5 0.4 0.4 0.3 0.3 0.2 0.2

(0.3) (0.3) (0.4) (0.4) (0.6) (0.6) (0.7) (0.8) (0.8)

Wo

rld

US

Sa

ud

i Ara

bia

Ru

ssia

Ca

na

da

Ira

q

UA

E

OP

EC

(n

et)

Qa

tar

Co

lom

bia

Ch

ina

Ku

wa

it

Ka

zakh

.

Bra

zil

Nig

eri

a

Me

xico

Su

da

n

Syr

ia

Alg

eri

a

Ve

ne

zue

la

No

rwa

y

UK

Lib

ya

Ira

n

World Oil Production Change

2013 over 2008 (mmbbl/d)

OIL & GAS

Please refer to our detailed

report “Breaking free”

released in July 2014


Please refer to our detailed

report “Breaking free” part

2 released in August 2014



India Strategy

US oil production on the rise led by shale oil (mmbbl/d)

Source: EIA, Bloomberg, MOSL

3. Is crude turning into buyers market? As history has shown, crude markets are

highly unpredictable but the recent data points suggest that there is a high

probability of crude markets turning into buyers market. This we believe will be

driven by

a. Recent discounts offered by Saudi Arabia (Media reports)

b. Continued increase in the North American oil production

c. Relative slowdown in the Chinese economy

d. Uncertain demand scenario reflected in the recent demand forecast

downgrades by IEA, OPEC and EIA.

e. Improved energy efficiencies and focused approach to develop renewable

energy sources.

As we write geopolitical tensions still continue and OPEC could anytime decide to

cut production quotas to defend oil prices. However, with uncertain demand

scenario, oil prices are expected to remain range bound – a positive development

for India.

IEA and EIA has recently downgraded 2014 oil demand forecast

Source: IEA, EIA, OPEC, MOSL

Benefit India – Under recoveries down by more than 50%

1. Government bites the bullet, sets ball rolling for sector reforms: Retail

petroleum prices for controlled products (Diesel, Gasoline, Kerosene and LPG) in

India historically witnessed ad-hoc increases and that too with a lag, leading to

significant under-recovery for the oil marketing companies. With backs to wall

8.364

6.409

5.108

8.5

0

3

6

9

Jun-87 Jun-90 Jun-93 Jun-96 Jun-99 Jun-02 Jun-05 Jun-08 Jun-11 Jun-14

1.2

1.3

1.4

1.4

1.3

1.3

1.2

1.0

1.4

1.3

1.4

1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.2 1.2

1.3

1.2

1.2

1.2

1.3

1.3

1.3

1.0

1.5

1.3

Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Jul-14 Aug-14

2013A 2014E 2015E

2014 IEA OPEC EIA

Saudi Arabia 2012

“Our wish and hope is we

can stabilise this oil price

and keep it at a level

around $100 [a barrel],”

Saudi Aramco 2014

“Supply and demand will

play a key role. OPEC will

take the price as it comes.”


India Strategy

due to likely sovereign rating downgrade Indian government in January 2013

announced several oil sector reforms like (1) limiting subsidized domestic LPG

cylinders to 12 per year per household, (2) increasing diesel prices monthly by

INR0.5/ltr and (3) bulk diesel to be market priced.

2. Diesel is deregulated, finally!!: After more than 20 months on diesel price

increase the recent under recovery stood at INR0.08/ltr i.e. almost market

pricing. Government had already deregulated petrl in June 2010 and now with

diesel getting deregulated, it will remove one of the largest component of the

under recoveries.

Diesel under recoveries: Diesel prices almost de-regulated with recent fortnight loss of

INR0.08/ltr (INR/ltr)


3. Will LPG / kero reforms follow diesel? PDS kerosene has been an important fuel

for the economically weaker sections in rural India. Hence, we expect the

Government to first take up LPG price deregulation ahead of kerosene. The

initial thrust should be on widening the base for direct benefit transfer scheme,

followed by removal of dual pricing in LPG and kerosene.

4. Under recoveries to reduce by more than 50%: With diesel de-regulation we

expect ~50% reduction in gross under recoveries to INR750b by FY16. And a

realistic kero/LPG hike could cut under-recovery by 70%.

With diesel set to be de-regulated, expect under recoveries to be down >50% (INRb)

Source: PPAC, MoPNG, MOSL

20.4

1.5

14.9 13.9 17.1

3.7

14.5

0.1

(5)

0

5

10

15

20

25

1Q

FY

07

1Q

FY

07

1Q

FY

08

1Q

FY

09

1Q

FY

10

1Q

FY

11

1Q

FY

12

No

v-1

1

Jan

-12

Ma

r-1

2

Ma

y-1

2

Jul-

12

Se

p-1

2

No

v-1

2

Jan

-13

Ma

r-1

3

Ma

y-1

3

Jul-

13

Se

p-1

3

No

v-1

3

Jan

-14

Ma

r-1

4

Ma

y-1

4

Jul-

14

Se

p-1

4

201 400

494

773

1,033

461

780

1,381

1,610 1,399

948 750 689

0

500

1,000

1,500

2,000

FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15E FY16E FY17E

Petrol Diesel Kerosene LPG Total


India Strategy

Post Petrol de-regulation in 2010, monthly price hikes helped diesel de-regulation (INR/ltr)

Source: MoPNG, PPAC, MOSL

5. Indian fiscal situation to improve: Share of under recoveries in India’s GDP and

as a % of import bill to be down significantly.

Gross under recoveries as a % of GDP set to reduce

Source: MoPNG, GoI, PPAC, MOSL

Gross under recoveries as a % of oil import bill set to reduce

Source: MoPNG, GoI, PPAC, MOSL

With market linked pricing in both petrol and diesel, do not expect further increases

if crude remains subdued and would result in healthy auto fuel demand growth.

Petrol demand dropped during its deregulation period, similar trend witnessed in Diesel

..however with stable prices diesel demand bounces back

Source: PPAC, IOC, MOSL

20

40

60

80

Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Sep-14

Petrol price (INR/ltr) Diesel price (INR/ltr)

Petrol

de-regulated

Diesel monthly hikes

begin

0.6

1.1 1.2

1.5

1.8

0.7

1.0

1.5 1.6

1.2

0.8

0.6 0.5

FY

05

FY

06

FY

07

FY

08

FY

09

FY

10

FY

11

FY

12

FY

13

FY

14

FY

15

E

FY

16

E

FY

17

E

19.8

26.727.6

34.6 35.5

17.4

24.9

30.6 30.2

24.4

15.712.4 11.1

FY

05

FY

06

FY

07

FY

08

FY

09

FY

10

FY

11

FY

12

FY

13

FY

14

FY

15

E

FY

16

E

FY

17

E

-5%

0%

5%

10%

15%

20%

25%

Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Jan-13 Jul-14

Petrol 3M avg YoY Chg (%) Diesel 3M avg YoY Chg (%)


India Strategy

Game changing era for upstream: Can 70-40 become 30-70?

1. High and ad-hoc subsidy has marred ONGC profitability: Upstream companies

have suffered financially a lot in the last decade due to high and ad-hoc subsidy.

While the gross realization for ONGC stood at USD107/bbl in FY14, its net

realization was only at USD41/bbl led by subsidy sharing of USD66/bbl.

2. Can 70-40 become 30-70? Ongoing diesel reforms have the potential to reverse

this upstream subsidy trend from 70-40 (subsidy-net realization) to 30-70 i.e.

subsidy will reduce from USD70/bbl to 40/bbl and net realization will increase

from USD40/bbl to USD70/bbl.

3. ONGC earnings could grow at 20% CAGR: At a Brent crude of USD100/bbl and

at INR60/USD, gross under recovery could stand at INR724b in FY16, 48% lower

than FY14 under recovery of INR1,399b. Upstream subsidy sharing in FY14 was

at 48% and if were to model ~50% sharing in FY15/FY16/FY17 then ONGC’s net

realization could increase to USD61/66/68/bbl (gross @USD100/bbl) resulting in

EPS CAGR of ~20%.

a. For every USD10/bbl increase in ONGC’s net realization its earnings will

improve by INR6/sh.

b. For every USD1/mmbtu increase in ONGC’s gas price its earnings will

increase by INR3/sh.

Oil Price realization (USD/bbl): ONGC net realization set to increase….


ONGC Cons. EPS (INR): ...resulting in high earnings growth (INR)

*Factors upstream subsidy at 50% in FY15/16/FY17 and gas price at USD5.3/6.3/mmbtu in FY16/FY17


38 42 44

53 48

56

54

55 48

41

61 66 68

0

25

50

75

100

125


Gross Upstream Discount Net

16.8 18.0 20.8

23.2 23.1 22.7 24.5

30.4 28.3 31.0

41.9

48.8 52.5



India Strategy

Expected structural policy changes to boost earnings and increase ONGC’s fair value to

INR612 (v/s base case of INR485); while fair value increases to INR865 at nil subsidy

*Percentage value in box is stock price upside Source: MOSL

Life changing era for OMCs’: Can they go back to their old glory? 1. OMC’s profitability down due to under recoveries: OMC’s profitability suffered

(RoE’s down from 20-30% to single digit for HPCL and IOCL in recent years) in

the last decade led by (a) controlled petroleum retail prices leading to under

recoveries and higher debt to fund them and (b) delayed and ad-hoc subsidy

sharing. The combined debt of OMCs had increased at 22% CAGR in the last 10

years and interest cost increased at a CAGR of 27%.

HPCL’s debt increased 20x in the last decade primarily due to

delayed subsidy and working capital loans to fund the same…


…leading to significant rise in interest cost


And largely flat PAT in the last decade (INRb)

RoE moved from healthy double digits to a single digit


42.3 1.8 2.5 5.2 1.7

22.2 75.7

485 505 534 593 612

865 865

Ba

se E

PS

Ke

ro h

ike

(IN

R0

.5/l

tr

pe

r m

on

th)

LPG

hik

e

(IN

R1

0/c

yl

pe

r m

on

th)

Su

sid

y sh

are

(@5

0%

)

Ga

s P

rice

(@U

SD

7/

mm

btu

)

Nil

su

bsi

dy

Ne

w li

kely

EP

S

ONGC fair value in grey shade

9% 14% 20% 33% 38% 94%

15 20

66

104

165

221 211

249

296 323 314

FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY140.0

0.4

0.8

1.2

1.6

2.0

FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14

Interest as a % of sales (%)

-

10

20

30

40

50

-

500

1,000

1,500

2,000

2,500

FY04 FY06 FY08 FY10 FY12 FY14

PAT - RHS Sales

0

7

14

21

28

FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14

RoE(%)


India Strategy

2. Diesel de-regulation to substantially reduce interest cost: OMC’s interest cost

as a % of sales had increased from lows of 0.1% in FY04 to ~1.2% led by funding

for diesel under recoveries. During the last 12 months diesel under recoveries

have come down significantly leading to meaningful reduction in the OMC’s

working capital requirement. We estimate OMCs debt to reduce by 15-25%,

leading to 8-16% EPS benefit, with HPCL at 16%, followed by BPCL at 9% and

IOCL at 8%.

3. OMC’s in better shape to face private competition: In the previous period of

brief deregulation (FY04-07), private players’ market share had reached ~5% in

gasoline and ~10% in diesel. However, this time around, we do not expect the

journey to be smooth for private players, given that over the last decade, OMCs

have been improving purity perception, extending reach, customer engagement

and increased automation. Further, challenging retail fuel pump economics will

be a major issue for private player expansion.

4. Marketing margins to boost OMC profitability: The marketing margin

component for OMCs’ marketing sales was fixed by the Government in 2006 and

despite the cost increases of 8-10%, OMCs got only ~4% of annual escalation.

This led to a severe reduction in the marketing division’s profitability. Post the

deregulation, we expect OMCs’ marketing division profitability to increase

meaningfully as we expect they will be able to charge higher marketing margins.

Global comparison shows that the current marketing margin in diesel in India at

~INR1.4/ltr is way below the global averages. HPCL being the highest leveraged

to marketing volumes (standalone marketing/refining ratio of 2x), we estimate

an EPS increase of INR15.5/sh for INR0.5/ltr increase in the diesel marketing

margins, followed by BPCL and IOCL.

Global diesel marketing margin meaningfully above India’s level (INR/ltr)

Source: PPAC, IMF, Shell, Industry, Australia govt, MOSL

1.4

5.4

4.5

2.8 3.5 3.4

7.3

India US Canada Thailand South

Africa

Australia UK


India Strategy

Fair value sensitivity to reform related upsides (INR/share)


HPCL: EPS upsides to reforms

BPCL: EPS upsides to reforms

IOCL: EPS upsides to reforms


HPCL profitability could increase meaningfully if we were to model additional INR1/ltr marketing margin on diesel

INR Billion FY04 FY05 FY06 FY07 FY08 FY09 FY13 FY14 FY15 FY16 FY17 FY18

Marketing sales (mmt) 19.5 20.1 19.4 21.7 24.5 25.4 30.3 31.0 31.9 32.8 33.7 34.5

GRM (USD/bbl) 4.5 5.2 2.3 3.6 5.6 5.2 2.1 3.4 3.2 3.3 3.5 3.5

Net Sales 515 599 709 890 1,047 1,253 2,065 2,231 2,168 2,179 2,143 2,160

EBITDA 32 21 8 24 16 29 39 52 43 52 57 66

Depreciation 6 7 7 7 9 10 19 22 24 26 28 30

Interest 1 1 2 4 8 21 18 15 7 6 6 5

Other Income 4 3 3 7 12 9 12 11 10 10 11 12

PBT 29 16 3 20 12 7 15 26 22 29 34 43

Tax 11 4 (1) 4 (0) 1 6 9 7 10 11 14

PAT 18 13 4 16 12 6 9 17 14 20 23 29

EPS (INR) 54 38 12 46 35 17 27 51 42 58 68 85


496

700

401

646

952

528

801

1,063

588

HPCL BPCL IOCL

Current Price

Diesel de-regulation + addl. mktg margin of INR0.5/ltr

Diesel de-regulation + addl. mktg margin of INR1/ltr

34.7

54.9

7.0

15.5

-0.8

Adj. FY14

EPS

Interest

reduction

MM

@INR0.5/ltr

Mkt share

loss @15%

New likely

EPS

HPCL EPS (INR)

43.7 55.8

4.2 9.3

-1.4

Adj. FY14

EPS

Interest

reduction

MM

@INR0.5/ltr

Mkt share

loss @15%

New likely

EPS

BPCL EPS (INR)

32.7 39.8

2.5 5.4

-2.3

Adj. FY14

EPS

Interest

reduction

MM

@INR0.5/ltr

Mkt share

loss @15%

New likely

EPS

IOCL EPS (INR)


India Strategy

Falling crude prices and petrol-diesel parity could reverse the dieselization trend and lead to significant demand growth

Fuel prices witnessed high growth since FY11, with petrol prices rising 11% and

diesel prices rising 13.5%. Higher fuel prices coupled with weak economic

environment impacted PV demand, resulting in flat domestic passenger vehicle

volumes since FY11. This was reflected in share of first time buyers declining from

~50% in FY12 to ~37% in FY14.

With falling global crude prices and stable Fx, we expect fuel prices to reduce over

the coming months. This trend coinciding with economic recovery in India, could

lead to significant demand growth for PVs, driven by significant pent-up demand.

Further, fuel price disparity has been corrected significantly with gradually diesel

price deregulation, resulting in price gap between petrol and diesel being at 10 year

low levels at ~INR12/ltr. As a result, we expect reversal of dieselization trend

witnessed during FY11-14 where diesel powered vehicle contribution increased

from ~35% to ~58% (FY13) for the industry (37% v/s 18% for MSIL).

We estimate diesel vehicle contribution to stabilize at 40-45% of total volumes for

the industry (from 1QFY15 level of ~50%).

Fuel cost inflation moderating, after over 11% CAGR since

FY11, auguring well for PV demand


Pricing gap between petrol & diesel at lowest level in last 10

years


MSIL: A key beneficiary of potential reversal in dieselization trend

Higher growth in fuel prices mostly impacted entry level cars, resulting in MSIL’s

entry level car volumes declining 11% CAGR. Reversal of dieselization trend augurs

well for MSIL, considering its strength in petrol engines. While we estimate ~16%

CAGR in volumes for MSIL during FY14-17E, full benefit of above mentioned trend

could result in volume CAGR in excess of 20%.

With strong recovery in entry level vehicle, we estimate discounts to narrow

meaningfully from peak of 1QFY15. This coupled with operating leverage benefits,

MSIL can deliver EPS CAGR of over 40% (FY14-17E) v/s our base case CAGR of ~31%.

Strong volume momentum, margin expansion and very strong earnings growth

could drive MSIL stock to potentially be 2x from current levels.

-10

0

10

20

30

FY

04

FY

05

FY

06

FY

07

FY

08

FY

09

FY

10

FY

11

FY

12

FY

13

FY

14

1Q

FY

15

Jul'

14

Au

g'1

4

Se

p'1

4

FY

16

??

?

FY

17

??

?

Petrol Diesel

0

25

50

75

FY

04

FY

05

FY

06

FY

07

FY

08

FY

09

FY

10

FY

11

FY

12

FY

13

FY

14

1Q

FY

15

Jul'

14

Au

g'1

4

Se

p'1

4

Petrol Diesel

INR24/Ltr

INR12/Ltr

INR12/

Ltr

Period of Diesel price

deregulation

AUTO


India Strategy

Stable petrol prices augurs well entry level cars…


…as demand from First Time Buyers was impacted the most

(% of total MSIL volumes)…


…also reflected in drop in contribution of entry level cars for

MSIL


Reducing petrol-diesel price disparity augurs well for MSIL

due to its relative weakness in diesel engine


Discounts moderation to be driven by recovery in entry level

cars…


…leading to significant improvement in profitability


-30

-20

-10

0

10

20

30

FY

07

FY

08

FY

09

FY

10

FY

11

FY

12

FY

13

FY

14

1Q

FY

15

Jul'

14

Au

g'1

4

Se

p'1

4

FY

16

??

?

FY

17

??

?

MSIL Entry Level Cars Growth (%) Petrol Price Chg (%)

35

4750

4037

43

50

FY08 FY11 FY12 FY13 FY14 1QFY15 FY16???

FY08 FY11 FY12 FY13 FY14 1QFY15 FY16???

48 49

45

38 38

28 28

32

FY09 FY10 FY11 FY12 FY13 FY14 1QFY15 Jul'14

MSIL Entry Level Cars (% of total)

33 34 35 36

48

5853 50

13 15 19 1824

3732 32

FY08 FY09 FY10 FY11 FY12 FY13 FY14 1QFY15

Diesel volumes (as % of total) Industry

10,539 9,610 9,57512,029 12,049

17,038

21,000

13,000

FY09 FY10 FY11 FY12 FY13 FY14 1QFY15 FY16???

MSIL 's blended discounts (INR/unit)

4.1 3.4 3.4 3.9 3.3 4.6 5.7 3.4

45

23

35

56

4249

61

40

FY09 FY10 FY11 FY12 FY13 FY14 1QFY15 FY16???

% of realizations % of PBT


India Strategy

Pent up demand + Conducive fuel prices + economic revival + Improving consumer sentiment = Modi-fied Era


… Can lead to stock delivering ~90% return in 1 year


MSIL's FY17 earnings sensitivity to JPY/USD

JPY/USD

EBITDA

Margins

(%)

EPS (INR) Cash EPS

(INR) PE (x)

TP (17.5x

Consol.

EPS)

90.000 12.4 174.5 279.9 17.5 3,054

95.000 13.3 190.4 295.8 17.5 3,332

102.000 14.4 210.0 315.4 17.5 3,676

Prevailing rate 107.000 15.1 222.5 327.9 17.5 3,893

110.000 15.5 229.4 334.8 17.5 4,014

115.000 16.1 240.1 345.5 17.5 4,202

120.000 16.6 250.0 355.4 17.5 4,374


91

82

58

82

94

13

0

16

6

21

3

213

274

FY10 FY11 FY12 FY13 FY14 FY15E FY16E FY17E

EPS Modi-fied EPS

18

10 11

-3

136

16

2731

22

3743

Volumes EBITDA EPS

FY08-11 FY11-14 FY14-17E (Base) FY14-17E (Modi-fied)

3,721

5,500

Base @ 17.5x Modi-fied @ 20x

FY17 Target Price (INR/sh)


India Strategy

India steel prices under pressure from cheaper Chinese imports

India HRC import prices have declined to US$520/t after holding in the range of

US$535-545/t range for the past 5-6 months. The recent correction has been driven

by weakness in Chinese HRC export prices and global trade. As Indian HRC prices are

moving in tandem with import parity, this will have a direct impact on realization of

Indian steel mills’ flat products.

Long products pricing in India is driven largely by domestic demand and cost of

production of secondary producers. Steel scrap (and sponge iron), being the key

input cost for secondary steel producers, is the key driver of cost of production for

them. Hence, the landed cost steel scrap imports is mostly the key driver of Indian

sponge iron and thereby long product prices. Long product imports rarely worried

Indian steel markets. This however may not hold true. Chinese long products on

landed cost basis are now cheaper by nearly USD60/t. Institutional consumers have

already started importing rebar. The month of august witnessed big surge in imports

of long products. The trend is likely to continue due to further weakness in Chinese

long product prices.

India HRC import prices have weakened

Source: MOSL

Indian rebar (TMT) prices are at nearly USD60/t premium

Source: MOSL, Bloomberg

Indian steel mills are lobbying with steel ministry for anti-dumping duty on Chinese

imports to protect domestic market. It is to be seen if govt. of India will move to

protect domestic steel industry.

India steel demand growth has yet to accelerate

India steel demand has been tepid so far growing by just 0.3% YTD (Apr-Aug 2014),

with the overall positive sentiments yet to flow into actual consumption. Recent

trends indicate demand is likely to pickup in 2HFY15 with cement consumption up

by 11% YTD and passenger vehicle and 2 wheeler sales up by 4.46% and 14.79%

respectively. Overall, Industrial activities are expected to pick up. In terms of trade,

India has again turned a net importer of steel, which we believe is driven by lower

international steel prices, amidst the overall weak demand environment.

33,000

35,000

37,000

39,000

41,000

43,000

Se

p-1

3

Oct

-13

No

v-1

3

De

c-1

3

Jan

-14

Fe

b-1

4

Ma

r-1

4

Ap

r-1

4

Ma

y-1

4

Jun

-14

Jul-

14

Au

g-1

4

Se

p-1

4

HRC Mumbai (INR/t)

32,000

34,000

36,000

38,000

Se

p-1

3

Oct

-13

No

v-1

3

De

c-1

3

Jan

-14

Fe

b-1

4

Ma

r-1

4

Ap

r-1

4

Ma

y-1

4

Jun

-14

Jul-

14

Au

g-1

4

TMT Mumbai (INR/t)

METALS

HRC prices are down by

USD15-20/t WoW after a

long period of stability

Long product prices too are

under threat

Steel mills lobbying for anti-

dumping duty for long

products


India Strategy

Domestic steel demand remains tepid

Source: JPC

While India has turned a net imported to steel YTD July

Source: JPC

China domestic demand weakening; surging exports

China’s domestic steel demand has slowed down considerably with July demand

coming flat YoY. YTD July FY15 apparent steel demand has increased by just 2% as

against 8% for same period last year. Aided by weaker raw material prices, Chinese

steel product prices have corrected sharply driving up exports. China net exports in

July came at 6.3 mt, the highest since 2007 and surging by 74% yoy. YTD July FY15

net exports are up by 57% yoy.

China steel demand weakening – was flat yoy in July…


…driving exports – net exports at their all time highs


China is the cheapest source of steel products in world. Weakening of Russian

currency (~ 20%) is also making exports attractive for Russian steel mills, potentially

negative for European Mills (e.g. Tata Steel Europe) and US mills.

China rebar prices vs. major regions

Source: MOSL, Metal bulletin

China HRC prices vs. major regions

Source: MOSL, Metal bulletin

-15.0

-10.0

-5.0

0.0

5.0

10.0India steel consumption yoy (%)

-400

-200

0

200

400

600

Jan

-12

Ap

r-1

2

Jul-

12

Oct

-12

Jan

-13

Ap

r-1

3

Jul-

13

Oct

-13

Jan

-14

Ap

r-1

4

Jul-

14

India net steel imports ('000 t)

-10%-5%0%5%

10%15%20%25%

Fe

b-1

1

Ma

y-1

1

Au

g-1

1

No

v-1

1

Fe

b-1

2

Ma

y-1

2

Au

g-1

2

No

v-1

2

Fe

b-1

3

Ma

y-1

3

Au

g-1

3

No

v-1

3

Fe

b-1

4

Ma

y-1

4

Apparent steel consumption growth yoy (%)

(2.0)

-

2.0

4.0

6.0

8.0

Oct

-07

Ap

r-0

8

Oct

-08

Ap

r-0

9

Oct

-09

Ap

r-1

0

Oct

-10

Ap

r-1

1

Oct

-11

Ap

r-1

2

Oct

-12

Ap

r-1

3

Oct

-13

Ap

r-1

4

China net steel product exports (mt)

433

538 565 570 575 600 583

-

100

200

300

400

500

600

700

China

export

fob

CIS

export

fob

Turkish

export

fob

LatAm

export

fob

EU

import

cfr

US

import

cfr

India

cfr

503 542

595 549

620 567

-

100

200

300

400

500

600

700

China

export

fob

CIS

export

fob

LatAm

export

fob

EU

import

cfr

US

import

cfr

India cfr


India Strategy

Sliding RM prices driven by oversupply, unlikely to support steel prices

Slowdown in steel demand in China, along with surging supplies continues to impact

raw material prices. China, who gobbled all of exponential growth in raw material

supply, is key driver of raw material prices. A pick up in Chinese steel demand is key

to prevent further slide in raw material prices and thereby steel prices.

Iron ore prices are making new lows every day, down 15% over the last 2-3 weeks at

US$82/dmt cfr China. While coking coal, after consolidating at US$111-113/t (fob

Australia) for nearly six months is down 3%-4% in the last few days.

Iron ore prices (62% fines) have declined further, down to

US$82/t cfr China


While coking coal after consolidating at US$110-112/t fob

Australia is down to US$108/t


Export prices of iron ore (USD82/t cfr China), and coking coal (USD108 fob Australia)

are largely in-line with our forecast 2 years ago. HRC prices however are trading at

significant premium perhaps because of demand improvement in rest of world (ex-

China). In seasonally weak second half (of CY2014), there is possibility of gap

narrowing. This doesn’t augur well for Indian steel prices.

Amendment to the mining act; potential risk to Tata & SAIL

The government, in July, notified an amendment to the mining act, doing away with

the deemed mining lease extension provision. Thus if a mine is not specifically

granted a mining lease post the expiry of the first extension period, it is presumed to

be de-allocated. This is against the earlier provision which provided deemed lease

extension unless the state government does not act otherwise. Further, the

amendment says mines operating for more than 40 years will not be provided lease

renewals.

Under the amendment, Odisha government de-allocated 6 non-iron ore mines

which were operating under the 2nd deemed extension provision. While for the iron

ore mines, which were ordered to be stopped under the Supreme Court order,

mines of Tata Steel, SAIL and OMC only were allowed to operate and that too only

under an express order and not through lease renewal/extension.

Jharkhand also recently ordered mining stoppage for its iron-ore mines operating

under the 2nd deemed extension provision, including captive mines of Tata Steel and

134

117

96

82

70

90

110

130

150

Se

p-1

3

Oct

-13

No

v-1

3

De

c-1

3

Jan

-14

Fe

b-1

4

Ma

r-1

4

Ap

r-1

4

Ma

y-1

4

Jun

-14

Jul-

14

Au

g-1

4

Se

p-1

4CIF FOB

153

113 112

108100

110

120

130

140

150

160

Se

p-1

3

Oct

-13

No

v-1

3

De

c-1

3

Jan

-14

Fe

b-1

4

Ma

r-1

4

Ap

r-1

4

Ma

y-1

4

Jun

-14

Jul-

14

Au

g-1

4

Se

p-1

4

Spot coking coal (fob Australia) - US$/t

Iron ore down by 12% over

the last 2-3 weeks, coking

coal down by 2-3%

Odisha government de-

allocated 6 non-iron ore

mines which were

operating under the 2nd

deemed extension provision


India Strategy

SAIL. However, unlike the Odisha government, it has not granted work permits to

these captive mines under an alternate route as work in these mines remain on

hold.

It remains difficult to gauge the impact of this amendment due to lack of clarity

from the state governments on their interpretation of the law. We believe, holders

of captive miners are less at risk given their end-use plant and major economic

impact of plant shutdown on the local economy. However, we do highlight the

increase risk profile of these companies (and merchant operators) given the

amendment to the law.

Indian iron ore supply to ease and will put pressure on domestic steel prices

Iron ore supply is likely to ease with permission being granted for liquidation of

inventories lying at mines. Recently, Odisha high court has allowed Ramesh Prasad

Sao (RP Sao) for dispatches of stocked Iron ore at mines head located in mineral rich

belt of Barbil (Odisha). These permits are valid for 3-months (i.e. from 4th Sep- 4th

Dec 2014). However, mining is still restricted. RP Sao is one of the largest merchant

miners in the region, with an annual capacity of 4.5mtpa. According to SteelMint, RP

Sao has about 1mt of Iron fines stocked, which can be liquidated.

As this sets a precedent, more iron ore mines are likely to get permits to liquidate

inventories. According to industry estimates, a total of 40-50mt of iron ore

inventories may become available to steel producers. This will ease the supply and

put pressure on domestic iron ore prices, which have so far remained very resilient

unaffected by volatility in international market. As the supply of iron ore improves,

the prices of pellets, sponge iron and long products will witness correction.

Margin pressure for integrated steel producers but not others

As steel prices come under pressure, the margins for integrated steel producers will

come under pressure. Integrated steel producers (Tata Steel and SAIL) are unlikely

to benefit from fall in iron ore prices instead increased royalty (from 10% to 15%

w.e.f. 1st Sept, 2014) and closure of iron ore mines in Jharkhand will add to costs.

The margins are likely to come under pressure. The target price of Tata steel and

SAIL will be impacted by 10% and 20% respectively for every INR1000/t compression

in EBITDA per ton. Non-integrated steel producers like JSW Steel may not see

pressure on margin as cheaper iron ore and coking coal prices reduce costs for

them.

Jindal steel & Power faces risk of coal block de-allocation, which can shave off

INR126/share from our target price. If penalty of INR295/t is imposed on already

mined coal, net debt will increase by further INR30b (INR33/share). If the margins in

steel business come under pressure, there is downside of INR27/share for every

INR1000/t compression in margin.

NMDC iron ore pricing too is likely come under pressure. According to our

calculations, the landed cost of iron ore at west cost of India is 10% more expensive

for fines and 25% more expensive for lumps at IODEX of USD82/dmt cfr north China.

If IODEX doesn’t rebound, NMDC will come under pressure to cut prices as iron ore

supply improves. JSW Steel is top pick among steel stocks.

High Court allows inventory

liquidation for RP Sao iron

ore mine in Odisha…

As this sets a precedent, a

total of 40-50mt of iron ore

may become available


India Strategy

Sensitivity of target price w.r.t. change in margins

Company CMP TP

Sensitivity of margins (Rs mn) Remarks

EBITDA EV/Mkt INR/ impact

INR/t INR m at (6.5x) share (%) on TP

Tata Steel 517 650 1000 9,541 62,017 64 10% 9.5mt TSI volumes in FY16

SAIL 79 115 1000 14,705 95,583 23 20% 14.7mt volumes in FY16

JSW Steel 1,348 1,647 1000 12,880 83,720 346 21% margins will be resilient

JSPL 237 403 1000 3,849 25,019 27 7% 3.8mt volumes in FY16

NMDC 177 222 300 10,136 65,881 17 7% 33.8mt domestic volume in FY16

Sensitivity of target price w.r.t. change in EV/EBTIDA

1,647

650

115 403

222

1,182

507

93 338

199

-

500

1,000

1,500

2,000

JSW TSL SAIL JSPL NMDC

INR/shareAt 6.5x At 5.5x

Source: MOSL

Our target price are based

on EV/EBITDA of 6.5x


India Strategy

Interest rate fall: PSBs and Bulk borrowers to benefit the most Growth acceleration and fall in stress loans indirect benefit for the system

A decline in commodity prices over the past few weeks augurs well for the

inflationary outlook (especially WPI) in the economy. As the sensitivity of decline in

commodity prices is lower on CPI (key benchmark for policy rates), cut in policy

rates is unlikely to be material in our view. Nevertheless, looking at the liquidity

situation, lower demand and improving twin deficit, systemic rates may come down

in the near term which will benefit (a) Bulk borrowers like NBFCs, Small private

banks and PSU banks (b) PSU banks especially due to higher share of G-Sec portfolio

(MTM gain on AFS portfolio) and (c) overall growth and asset quality in the system.

To play expected fall in bulk rates and G-Sec rates our top picks are YES, AXSB, PNB,

LICHF, SBIN and CBK.

1. Yes Bank would be a key beneficiary of decline in the wholesale deposit rates.

Deposits with maturity of upto 1Yr forms around 73% of o/s deposits (as of

FY14). More than 60% of the deposits are largely corporate/bulk in nature.

Further, it also has large corporate bond portfolio (19% of the customer assets)

and monetization of which will provide capital gains and release capital for

future growth.

2. Axis Bank: Traditionally AXSB had higher share of deposits maturing/re-pricing

within a year vs loans while the ALM profile has improved significantly over the

couple of years, mismatch still remains high. Thus, in our view, re-pricing of

liabilities is likely to be faster than assets which will be margin accretive.

Deposits maturing within a year form ~47% of o/s deposits (as of FY14). Even

AXSB has the higher share of corporate bond book in the overall balance sheet.

3. SBI/PNB is highly levered to macro-economic conditions. Fall in interest rates

would alleviate asset quality and growth fears. PNB has the highest share of AFS

portfolio and duration amongst the PSU banks. Every 100bp change in yields will

lead to 28bp ROA (pre-tax) improvement for PNB.

4. CBK has a high share of bulk deposits in overall deposits. AFS portfolio forms

~27% of the overall investments book. Every 100bp decline in yields will lead to

25bp ROA (pre-tax) improvement on account of MTM gains.

5. LICHF Will benefit from cooling wholesale rates; as 65% of LICHF’s funding is via

NCD route (which have seen rates cool off by ~50bps over last three months).

LICHF will see NCDs reprising of INR 44b in 2HFY15 (will happen at lower rates)

and loans reprising of INR60b, moreover incremental funding of ~INR 100b will

happen via this route. LICHF also plans to replace bank borrowings by NCDs

(since funding via NCD route is cheaper by 100bp vis-à-vis bank borrowings). On

the assets side 56% of LICHF’s book is at fixed rates and remaining is unlikely to

be reprised as banks are already lending at base rates. This will help improve the

spreads by 10-15bps.

FINANCIALS


India Strategy

Wholesale funded banks perform better with falling inflation

* Stock prices rebased to 100 as on Jan-2006 Source: Company, MOSL

Maturity profile of deposits for banks (% of total deposits): YES and CBK high share of short term deposits


PNB and CBK to be biggest beneficiary (for 100bp decline in yields)

Banks

Gross Inv.

Book

(INR b)

AFS Inv.

(INR b)

AFS (%) to

Gross Inv.

AFS

Duration

(Yrs)

MTM Gains

(INR b)

FY15E PBT

(INR b)

% of FY15E

PBT

% of FY15E

Avg Assets

SBIN 3,983 797 20.0 3.10 25 225 11.0 0.13

PNB 1,383 388 28.1 4.24 16 83 19.9 0.28

BOB 1,217 197 16.2 3.40 7 81 8.3 0.10

BOI 1,207 333 27.6 4.10 14 45 30.4 0.22

UNBK 918 211 23.0 2.63 6 34 16.2 0.15

CBK 1,299 345 26.6 3.80 13 37 35.3 0.25

OBC 596 138 23.1 3.84 5 20 26.3 0.23

INBK 457 101 22.2 3.00 3 16 18.7 0.16


-5

0

5

10

15

0

500

1000

Jan

-06

Jun

-06

No

v-0

6

Ap

r-0

7

Se

p-0

7

Fe

b-0

8

Jul-

08

De

c-0

8

Ma

y-0

9

Oct

-09

Ma

r-1

0

Au

g-1

0

Jan

-11

Jun

-11

No

v-1

1

Ap

r-1

2

Se

p-1

2

Fe

b-1

3

Jul-

13

De

c-1

3

Ma

y-1

4

AXSB YES CBKSBIN PNB BankexInflation (WPI, RHS)

22.6 24.0 28.8 25.2

50.0 49.25.112.9

17.8 23.4

10.923.4

HDFCB ICICIBC AXSB FB IIB YES

Upto 6M 6M-1Y

24.3 24.5 25.636.2 32.5

39.0

11.6 13.7 13.5

13.430.6

26.1

UNBK PNB SBIN BOI CBK BOB

Upto 6M 6M-1Y


India Strategy

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