A 53% drop in the realized crude price drove a 70% year-over-year decline in Cairn India's fiscal 2016 second-quarter earnings per share, down to Rs 3.6.
The significant fall in the crude selling price reflects increased competition as refiners switched to West African light, sweet crudes, given more attractive pricing. We anticipate a slight rebound in spreads, which will help Cairn’s average selling price recover, but the low price will likely remain for much of fiscal 2016. We now envision Cairn’s crude being priced at a 13% average discount to Brent crude, versus our prior estimates of an 11% discount for fiscal 2016. Therefore, we have reduced our fiscal 2016 earnings estimates by 8% to INR 12.5 per share, but have retained our fiscal 2017 earnings estimates of INR 15.2 per share, along with our fair value estimate of INR 250 per share. We still see Cairn as a narrow-moat company, as the oil-price recovery towards our midcycle price will restore excess returns on invested capital. Management remains disciplined on capital outlay, and we still forecast Cairn to be free cash flow positive, even with the planned capital expenditures of $500 million in fiscal 2016.
Besides the oil price, operating margins fell short from the front-loading of infill drilling and chemical injection program costs in first-half fiscal 2016. We expect this to normalise in second-half fiscal 2016 as production volumes catch up. Management has maintained its flat full-year production guidance. Second-quarter production gained 5.6% year over year to 205,361 barrels of oil equivalent per day. In addition, a tax reversal of INR 1.3 billion helped the company offset the fall in EBITDA margin to 41%, versus our estimate of 45%.
We view Cairn as undervalued, given the challenging energy sector outlook, uncertainty over its tax dispute and the extension of oil and gas field leases and parent Vedanta's merger share swap ratio, which we view as unfair to Cairn's minority shareholders.
