On Saturday, the Indian government took a step forward towards reforms in the oil and gas sector. The government deregulated diesel pricing and linked the pricing of the domestically produced natural gas to international benchmarks versus regulated prices earlier for both of them.
Diesel pricing
As per government regulations, all companies which import or refine fuel are able to sell it through retail outlets in this country. These companies now have the freedom to price the diesel which effectively will follow market rates.
The oil marketing companies can also decide marketing margins which are add-on charges imposed on the fuel. This, we believe, state owned companies would like to increase in a bid to improve their finances.
Primary beneficiaries of the above reforms would be state owned oil marketing companies and upstream companies as there will be greater predictability on the under recoveries now. This will help in lowering the subsidy burden on the upstream companies and will positively impact the central government’s fiscal situation.
We also believe diesel deregulation will have a far reaching effect on the competitive landscape in the oil retail sector as private retailers will now be at a level playing field versus the state owned companies. Immediate returns or market share gains can not be expected for private players as state owned companies have a huge pan-Indian supply chain and network advantage while private companies will need many years to match the sheer retail outlet spread. Also, dealer commissions are far more competitive than they were a decade ago. We are not unduly excited about private companies entering the oil retail sector in the near term due to lower returns on invested capital.
Gas pricing
The government has approved a revised formula of pricing almost all domestically produced natural gas from November 1, 2014. The pricing has been linked to the average of prices at wellhead on three major trading points namely, Alberta natural gas, UK balancing point and Russian gas at actual prices. This implies removal of import components from the Rangrajan formula.
We believe this whole exercise of removing higher priced Indian imports from the earlier proposed formula is highly subjective and has largely played a part in lowering the proposed gas price to $6.2 per million metric British thermal unit (MMBtu) from about $8.4 per MMBtu earlier.
The price rise from $4.2 per MMBtu to $6.2 per MMBtu is lower than our expectations. However, since the government has stated that a premium would be available on the gas price for new deep-water and ultra-water discoveries, we believe gas pricing could move up for the new discoveries which will bode well both for Reliance Industries Ltd, or RIL, and ONGC. Overall, we consider it a progressive policy and a step towards the right direction of aligning with risk adjusted market prices.
The frequency of the revision has been set at 6 months which in our view should have been quarterly as suggested by Rangrajan committee. Crude and gas are globally traded volatile commodity markets and 6 months is a long time for adjustments to global prices. The next price revision would happen on April 1, 2015. The new pricing would be based on the prices prevalent between January 2014 and December 2014.
We believe our fair value of Rs 950 already incorporates higher gas prices of about $8 per MMBtu which to an extent now incorporates a premium for its new potential deepwater discoveries in MA fields. RIL's gas production constitutes 10-12% of the Indian gas production. The new price will get applied to about 35-40% of the current production of RIL. Price increase for the remaining 60% of the production will be subject to the result of the arbitration proceedings between government and RIL. Till the arbitration proceedings reach an outcome, proceedings from the increase in gas price for the D1 and D3 fields (60% of the current production) will go to a gas pool account maintained by GAIL.
The chief beneficiary of the increase in the gas price will be state owned companies which produce about 85-90% of the gas production in this country. We believe ONGC being the largest gas producer amongst the state oil and gas producers will get the highest benefit from this shift to market linked gas pricing regime.
