INSTITUTIONAL EQUITY RESEARCH OPEC, Non OPEC output...

INSTITUTIONAL EQUITY RESEARCH

Page | 1 | PHILLIPCAPITAL INDIA RESEARCH

OPEC, Non‐OPEC output cuts Will support oil prices, but compliance is necessary INDIA | OIL & GAS | Sector Update

12 December 2016

OPEC is to cut oil production by 1.2mb/d from 1st January 2017. As Nigeria and Libya are out of this deal (due to a sharp fall in production over the last 3‐4 years), they pose an upside risk. This is why strict adherence to the agreement and a 0.56mb/d of cuts announced by non‐OPEC producers (including Russia) is necessary for a desired outcome. We build a 50% compliance of cuts from all countries except affluent members such as Saudi, UAE, and Kuwait (assuming 100% compliance) while expecting higher US and Canadian output. With oil stabilising at ~US$ 55/bbl, US shale production is likely to continue recovering. We see the demand‐supply balance turning from ‐0.6mb/d in CY16 to +0.2mb/d in CY17. However further recovery in oil prices will depend on physical market dynamics. We maintain our recently revised forecast of US$ 55/60 Brent for FY18/19.

Higher oil prices to raise under‐recoveries and retail prices, but not significantly At US$ 55/bbl in FY18, we estimate under‐recoveries to increase by ~Rs 50bn yoy to Rs 233bn and at US$ 60/bbl in FY19 to almost Rs 300bn. The government has indicated no subsidy burden on upstream companies for FY17 while downstream absorption has also remained nil. We see budgeted subsidy available for the year at Rs 170bn; hence, ~Rs 185bn of projected under‐recoveries would largely be managed. Monthly kerosene hikes also raise the subsidy cushion for upstream players to Rs 15/ltr from Rs 12/ltr – which corresponds to US$ 60/bbl oil price realisation for upstream players. For every US$ 5/bbl change in oil prices, diesel RSPs per litre in Delhi should change by Rs 2.7 and petrol by Rs 3 to maintain gross marketing margins at Rs 2.7 for each fuel – hence, we foresee auto‐fuel price hikes. At ~US$ 58/bbl, retail per litre diesel prices would touch previous all‐time high of Rs 59, petrol at US$ 66/bbl. Excise duty rollbacks/VAT cuts can happen at US$ 60/bbl. Refineries would be impacted largely by higher fuel & loss costs, but there would be interim inventory gains.

Mixed impact on gas economics; spot LNG, APM gas to gain Gas‐to‐oil economics in the current scenario will be mixed, depending on pricing contracts. In case of oil‐linked LNG (such as Qatar RasGas for Petronet LNG and BG for Gujarat Gas) higher oil prices will increase R‐LNG prices (due to slope mechanism) – so, no economic benefits. However, spot LNG (which has decoupled with oil prices over the last 1‐2 years) could become more competitive. GAIL's US LNG is expensive and in the current scenario, its landed price in India is higher than most term and spot LNG as well as FO. However, higher oil price can be beneficial if it pushes higher US shale oil output, which would lead to rise in gas production and pull down Henry Hub prices. Benchmark gas prices under the APM gas‐pricing formula for 1HFY18 remain unchanged – so we estimate largely unchanged APM/domestic gas price effective April 2017 at US$ 2.7‐2.8/mmbtu. This is good for CNG as it becomes more competitive vs. petrol/diesel, besides supporting margins of CGD players. At US$ 55/bbl, CNG would be 56%/35% cheaper than petrol/diesel.

Upstream to benefit directly, no change in gas sector earnings While ONGC and Oil India are direct beneficiaries of higher oil prices, final subsidy sharing will affect their earnings. For every US$ 5/bbl increase in oil price, ONGC/OIL's (Not Rated) standalone EPS would change by Rs 3.6/6.4 annually.

We do not foresee any change in the earnings of gas utilities/companies. RIL's upstream segment would benefit from higher oil prices. For every US$5/bbl increase in Brent, we estimate RIL's FY19 consolidated EPS to rise Rs 2.8, which includes gains from crude sourcing, its petcoke gasification project, and gas‐based petrochemicals.

Since Castrol and GOLI are in petroleum retail, they will be negatively affected by higher oil prices if they do not pass these on. However, Castrol has managed higher oil prices well in the past and we expect it to do so this time due too, based on its strong brand and price leadership. GOLI is also margin focused.

Sabri Hazarika (+ 9122 6667 9756) [email protected]

OIL & GAS ‐ OPEC, Non OPEC Output Cuts SECTOR UPDATE

OPEC cut favours market balance; but compliance is necessary 1.2mb/d output cut led by Saudi and Iraq; Iran relieved: In line with the Algiers Accord, Organization of the Petroleum Exporting Countries (OPEC) has agreed to cut crude oil production by 1.2mb/d from October reference point to reduce its ceiling to 32.5mb/d effective 1st January 2017. The objective is to restore demand‐supply balance, accelerate drawdown of excess inventories (which is above five‐year average), and promote investments and jobs in the sector. The duration of this agreement is six months, extendable by another six. The deal is contingent on non‐OPEC producers (including Russia) agreeing to an output cut of ~0.6mb/d, under which Saudi Arabia needs to reduce output by 486kb/d to 10.06mb/d, Iran will cap it at 3.8mb/d (up to 0.1mb/d increase), Iraq will reduce by 0.2mb/d to 4.35mb/d, and UAE/Kuwait/Qatar will cut by a combined 0.3mb/d. Nigeria will not reduce and Indonesia's membership was suspended.

The OPEC deal is contingent on non‐OPEC producers agreeing to an output cut

OPEC crude oil production adjustments from reference levels

Source: OPEC; **Indonesia's membership is suspended The Iranian section in the table seems erroneous with 90kb/d additional output from almost 4mb/d reference production, actually reducing January levels to 3.8mb/d. However, this may be due to data mismatch among sources. We assume a third‐party reported October production of 3.7mb/d as reference point for Iran and accordingly, we calculate that the effective cut agreed upon would be 1,164kb/d to 32.7mb/d. OPEC production adjustments kb/d Reference Adjustment Jan‐17 outputAlgeria 1,089 ‐50 1,039Angola 1,751 ‐78 1,673Ecuador 548 ‐26 522Gabon 202 ‐9 193Indonesia 722 0 722Iran 3,707 90 3,797Iraq 4,561 ‐210 4,351Kuwait 2,838 ‐131 2,707Libya 528 0 528Nigeria 1,628 0 1,628Qatar 648 ‐30 618Saudi Arabia 10,544 ‐486 10,058UAE 3,013 ‐139 2,874Venezuela 2,067 ‐95 1,972Total 33,846 ‐1,164 32,682

Source: OPEC, Bloomberg, PhillipCapital India Research



Nigeria and Libya can see material output growth: Indonesia is reportedly suspended due to its inability to cut output. Nigeria and Libya are out of this agreement due to a sharp fall in their production over the last 3‐4 years because of sabotage, insurgency, and other local issues. However, upside risk to production from these two countries is a threat to this deal. Nigeria had a production of over 2.4mb/d four years ago against its current output of 1.6mb/d, and the country aims to raise this to 2.3mb/d. Libya has also upped output in 2HCY16 and authorities expect it to cross 1mb/d by early CY17. If Nigeria reaches 2mb/d and Libya a conservative 0.7mb/d, it would add 0.7mb/d to OPEC supplies, diluting the 1.2mb/d cut significantly.

If Nigeria reaches 2mb/d and Libya a conservative 0.7mb/d, it would add 0.7mb/d to OPEC supplies, diluting the 1.2mb/d cut significantly

Oil production in Nigeria and Libya

2.42.2

2.3

2.12.2 2.2 2.1

2.0

1.7 1.61.5

1.2

0.5

0.30.4 0.4 0.4 0.4 0.3

0.5

0.0

0.5

1.0

1.5

2.0

2.5

Jan‐13

Jul‐1

3

Jan‐14

Jul‐1

4

Jan‐15

Jul‐1

5

Jan‐16

Apr‐16

Jul‐1

6

Oct‐16

mb/d

Nigeria Libya

Source: IEA, JODI, PhillipCapital India Research Selected non OPEC producers agree to a 0.56mb/d cut: Non‐OPEC producers (including Russia, Mexico Azerbaijan, Kazakhstan, Oman, Bahrain, Bolivia, Malaysia, Equatorial Guinea, Brunei, Sudan and South Sudan) have agreed to a 558kb/d cut. Among these, Russia, Kazakhstan, and Oman's cuts are relevant (Russia and Kazakhstan were earlier planning to raise output by 0.4mb/d in CY17) as countries like Mexico and Azerbaijan are already under a natural decline. Russia has indicated that the cut will be gradual starting from CY17. Non OPEC production cuts (kb/d) Russia 300

Mexico 100

Oman 40

Azerbaijan 35

Kazakhstan 20

Others 63

Total 558

Source: Bloomberg, PhillipCapital India Research Non OPEC production cut is also required to turn the market demand heavy and cover for a potential supply increases from Nigeria, Libya and US.



Cut is sizeable and proper cooperation can push oil prices up further: Building in IEA's forecast of 1.2mb/d global oil demand growth yoy each in CY16/17 and supply estimates for countries not participating in the cuts, we model two scenarios (under full compliance to agreed cuts):

1) 1.8mb/d total cut and no increase in Nigerian/Libyan output. 2) 1.1mb/d net cut, assuming Libyan/Nigerian output increasing by

0.7mb/d from October reference levels. Demand‐supply balance versus production cuts For CY17E (mb/d) Scenario 1 Scenario 2

Effective cut by OPEC and non OPEC 1.8 1.1

Global demand 97.5 97.5 Non OPEC supply 56.6 56.6 OPEC supply (incl. Indonesia) 32.7 33.4

OPEC NGLs 7.0 7.0 Total supply 96.3 96.9 Demand‐Supply (balance) 1.2 0.6

Outlook Price spikes Steady price

Renewed market share wars by OPEC countries in the last few years and US shale oil outlook are threats to these agreements

Source: PhillipCapital India Research

Looking at the demand‐supply balance outlook, the production cuts seem significant. If output in Nigeria and Libya are stagnant or volatile, it would be a 1.8mb/d supply cut. This is almost 2% of CY16 output, which is significant in oil markets, considering demand growth of ~1.3%. Demand would outstrip supply by 1.2mb/d and lead to accelerated inventory drawdown (it would normalise OECD crude inventories in four months as per IEA reported numbers) resulting in oil price spikes, ceteris paribus. Under scenario 2, which is more realistic, demand would be 0.6mb/d higher than supplies (normalising OECD stocks in a year) and oil prices would rise gradually. Inventory levels in OECD Crude oil Crude+petroleum products

9371,016 981 977

1,127 1,179

0

200

400

600

800

1,000

1,200

1,400

Sep‐11 Sep‐12 Sep‐13 Sep‐14 Sep‐15 Sep‐16

mb

Americas EuropeOceania Total OECD

2,669 2,750 2,686 2,7182,954 3,068

0

500

1,000

1,500

2,000

2,500

3,000

3,500

Sep‐11 Sep‐12 Sep‐13 Sep‐14 Sep‐15 Sep‐16

mb

Americas EuropeOceania Total OECD

Source: IEA, PhillipCapital India Research Compliance is absolutely necessary: Although adherence to this agreement is very important if producers are serious about prices, it has not happened historically. Hence, on a theoretical cut of ~1mb/d, actual reduction can be lower. The latest deal has been net positive for a large player like Saudi Arabia. We noticed that a US$ 10/bbl positive movement in Brent prices before and after the deal implies a sizeable net gain of US$ 30bn annually. Nevertheless, renewed market share wars by OPEC countries in the last few years and US shale oil outlook are threats to these agreements. It is interesting to see Saudi Aramco cut December delivery propane butane prices, as it blurs the Kingdom's hydrocarbon pricing strategy. We believe only January 2017 OPEC production readings can give a clear picture of actual impact on physical markets.



American production rebound is another threat: US shale producers have fared better than expected in the last couple of years of low oil prices. As per reports, US producers have been actively hedging production at above US$ 50/bbl oil price and current price of ~US$55/bbl can lead to production recovery.

US oil rig count and production

4

5

6

7

8

9

10

150 350 550 750 950

1,150 1,350 1,550

Jan‐06

Aug‐06

Mar‐07

Oct‐07

May‐08

Dec‐08

Jul‐0

9

Feb‐10

Sep‐10

Apr‐11

Nov

‐11

Jun‐12

Jan‐13

Aug‐13

Mar‐14

Oct‐14

May‐15

Dec‐15

Jul‐1

6

US rig count US oil production (mb/d)

US production growth can offset OPEC cuts. Canada has also shown similar trend and IEA expects a 0.2mb/d yoy growth in Canadian output

Source: EIA, Baker Hughes, PhillipCapital India Research From a peak of almost 1,600 in October 2014, US rig counts fell to almost 315 in May 2016. However, since then, this number has steadily increased and the most recent figure (December) is 498. US core field production, which fell from a peak of 9.6mb/d in June 2015 to 8.4mb/d in July 2016, has also recovered to 8.7mb/d as of now. Hence, US production growth can offset OPEC cuts. Canada has also shown similar trend and IEA expects a 0.2mb/d yoy growth in Canadian output. IEA has forecasted flat total US oil output yoy at 12.5mb/d in CY17. However, we believe there could be increase at US$ 50‐60/bbl oil prices – and have modelled a 0.3‐0.4mb/d growth from Q4CY16 levels. Assume IEA's demand estimates for CY17 We build in IEA's 1.2mb/d yoy demand growth estimate for CY17 in our model, though there can be some set offs with events like demonetisation impacting Indian demand for a few months while US may see better than the 0.3% expected growth due to the infra push announced by president‐elect Donald Trump, who will assume office in January. Global oil demand outlook

Source: IEA, PhillipCapital India Research

76 77 78 7982 84 85 87 86 86

88 8991 92 93

95 96 98

1.2

1.2

‐1

0

1

2

3

4

60

65

70

75

80

85

90

95

100

mb/d

Total World Oil Demand Growth‐RHS



Our estimates imply a modest destocking and gradual rise in oil prices

In CY17 we estimate a 0.6mb/d effective decline in OPEC output from the October reference level

We assume a more modest cut in our supply model, building in 50% compliance to the 0.56mb/d cut proposed for non‐OPEC countries. Among OPEC countries, we assume 100% compliance for prosperous economies like Saudi Arabia, UAE, Kuwait, and Qatar, and 50% for other relatively weaker economies. We also assume 3.8mb/d production from Iran and 0.2mb/d increase each in Nigeria and Libya from October levels. Hence, in CY17 we estimate a 0.6mb/d effective decline in OPEC output from the October reference level. Global oil supply outlook Global oil demand‐supply (balance)

0

20

40

60

80

100

CY00

CY01

CY02

CY03

CY04

CY05

CY06

CY07

CY08

CY09

CY10

CY11

CY12

CY13

CY14

CY15

CY16E

CY17E

mb/d

Total World Oil Supply Total World Oil Demand

‐0.7

0.1

1.4

‐0.4‐0.7‐0.7

‐0.3

0.8

‐0.3‐0.1

0.8

0.3

‐0.2

0.7

‐0.5

‐1.5

‐0.6

0.2

‐2.0

‐1.5

‐1.0

‐0.5

0.0

0.5

1.0

1.5

2.0

CY00

CY02

CY04

CY06

CY08

CY10

CY12

CY14

CY16E

mb/d

Demand‐Supply Balance

Source: IEA, PhillipCapital India Research Based on our demand‐supply estimates, we see demand outstripping supply by ~0.2mb/d implying a modest inventory destocking. In CY16, we see supply being 0.6mb/d higher than demand – a reversal would support oil prices; we expect a gradual improvement from here. We estimate US$ 50‐60/bbl price range for CY17/FY18, unless OPEC as well as non‐OPEC compliance is strict. In that case, this range will be breached and vice versa. Oil/Brent prices

42.2

58.064.4

82.3 84.7

69.8

86.7

114.5 110.5 107.6

85.5

47.5 49.255.0 60.0

0

20

40

60

80

100

120

140

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

US$/bbl

Dated Brent price

We see demand outstripping supply by ~0.2mb/d implying a modest inventory destocking

Source: Bloomberg, PhillipCapital India Research We slightly raise our FY17 Brent price assumption to US$ 49/bbl (from US$ 47) and maintain our FY18/19 assumption at US$ 55/60 per barrel.



Higher oil prices will raise under‐recoveries and retail prices, but not significantly Kerosene and LPG under‐recoveries to rise by Rs 50‐120bn in FY18/19 We estimate losses on kerosene and LPG (Rs 78bn in 1HFY17) to rise to Rs 100bn+ in 2H; thereby, total under‐recoveries should be ~Rs 185bn for FY17 (on an average Brent price of US$ 49/bbl). For FY18 (US$ 55/bbl) these should increase by Rs 50bn yoy to Rs 233bn. For FY19 (US$ 60/bbl), these would be almost Rs 300bn. However, they would still be at a comfortable level considering they were at Rs 276bn in FY16 at an average Brent price of US$ 47.5/bbl. The reduction is partly because of reduced allocation of kerosene leading to lower consumption volumes (in FY17 YTD, volumes are down 14% yoy) and small price hikes initiated from July 2016. Kerosene and DBT LPG under‐recoveries

812 921 628

109 ‐ ‐ ‐ ‐

274 294

306

248

115 84 85 90

300

396

465

406

161 99 148 209

‐

200

400

600

800

1,000

1,200

1,400

1,600

1,800

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

Rs bn

Diesel U/R PDS Kerosene U/R Domestic LPG U/R

Source: PPAC, PhillipCapital India Research

We assume a 13%/10%/10% yoy decline in kerosene volumes. However, for LPG, we assume a 11%/10%/10% growth due to aggressive rural penetration. We incorporate small monthly hikes of 25paise/ltr and Rs 2/cylinder till FY17 end, keeping the same constant thereafter. Our sensitivity for kerosene and LPG losses for FY18 is Rs 56bn for every US$ 5/bbl change in Brent prices and Rs 9bn for every Rs 1/USD change in exchange rate. Kerosene and LPG sales volume growth

Source: PPAC, Company, PhillipCapital India Research

7%

2%

4%

10%9%

11%

‐8% ‐9%

‐4%

‐1%‐4%

‐14%‐15%

‐10%

‐5%

0%

5%

10%

15%

FY12 FY13 FY14 FY15 FY16 FY17

yoy grow

th

LPG Kerosene



Subsidy sharing mechanism unclear, but system pain is low The government has indicated no subsidy burden on PSU upstream companies for FY17 while downstream absorption has also remained nil. This is also in line with the Rs 12/ltr government subsidy on kerosene, as unit under‐recovery for FY17 would be Rs 11.3/litre even after accounting for higher oil prices. DBTL subsidy also flows directly from the budget. Additionally, we estimate budgeted subsidy available for the year at Rs 170bn; hence, ~Rs 185bn of projected under‐recoveries would be mostly taken care of. Subsidy budget Rs bn FY13 FY14 FY15 FY16 FY17EBrent Price 110.5 107.6 85.5 47.5 49.2Rs/US$ 54.4 60.5 61.2 65.5 67.1Gross Under‐recoveries 1,610 1,399 763 276 185Govt. Subsidy in Budget 400 618 571 285 242 Previous Year Rollover 385 450 350 93 71 Subsidy Left for the Year 15 168 221 192 170 1st Supplementary Grant 300 90 ‐ ‐ ‐2nd Supplementary Grant 235 100 ‐ ‐ ‐Total subsidy Till Feb/Mar (Budget) 550 358 221 192 170 Rollover/Q4 Govt. Subsidy 450 350 93 71 15Govt. Subsidy Actual 1,000 708 313 264 185Upstream Subsidy 600 670 428 13 ‐Net OMCs Under‐recoveries 10 21 22 ‐ (0)

Source: PPAC, Company, MoF, PhillipCapital India Research Interestingly, another mechanism of Rs 15/kg LPG subsidy was also announced earlier with excess provision being put in a pool account to tap in future periods of higher under‐recoveries (PLEASE FRAME THIS BETTER). We are not aware of the present status, but if it has been implemented, the excess subsidy pool (as on FY17 end) would be Rs 130bn+. This is because DBTL unit subsidy for FY17 is likely to be Rs 7.9/kg and is not likely to cross Rs 15/kg even at US$ 60/bbl oil prices, unless Aramco unilaterally raises propane‐butane prices. Under‐recoveries and subsidy sharing

Source: PPAC, Company, PhillipCapital India Research

1,385

1,610

1,399

763

276 184 233 299

550 600 670

428 13 ‐ ‐ ‐835 1,000 708 313 263 184 233 299

‐

200

400

600

800

1,000

1,200

1,400

1,600

1,800

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

Rs bn

Gross under‐recoveries Upstream subsidy Govt. subsidy

Kerosene price hikes raise upstream subsidy cushion to US$ 60/bbl The subsidy sharing mechanism for FY18 (or US$ 55‐60/bbl oil) is not finalised. However, monthly kerosene hikes from July 2016 to March 2017 would total Rs 3/ltr (bi‐monthly hikes in some cases) – which raises the subsidy cushion for upstream players to Rs 15/ltr from Rs 12/ltr, if the mechanism is followed. Hence, subsidy risks up to US$ 60/bbl (at which level kerosene under‐recoveries would be just under Rs 15/ltr) are low for ONGC/Oil India – thereby entailing them full‐oil realisations.



In LPG, too, the Rs 15/kg limit is not likely to be breached up to US$ 60/bbl oil prices. Nevertheless, we await the 2017 Budget announcement to assess government’s subsidy plan for the sector.

We expect a Rs 1.8 or 3% hike in diesel and Rs 2.6 or 4% hike in petrol prices on 16th December

Diesel RSPs to reach all‐time high at US$ 58/bbl oil, excise rollbacks may be needed With diesel and petrol prices being deregulated, retail selling prices would increase with higher oil prices. The current prevailing prices reflect a dated Brent price of ~US$ 46/bbl (it has already touched US$ 55/bbl). Ceteris paribus, for every US$ 5/bbl change in oil prices, diesel per litre RSPs in Delhi should change by Rs 2.7 and petrol by Rs 3 – in order to maintain gross marketing margins at Rs 2.7 for each fuel. However, due to some correction in GRMs since the last fortnight, and a slight rupee appreciation as well, we expect a Rs 1.8/ltr or 3% hike in diesel and Rs 2.6/ltr or 4% hike in petrol prices on 16th December. Auto‐fuel gross marketing margins Diesel Petrol

Source: Company, PhillipCapital India Research

0

1

2

3

4

5

1‐De

c‐15

1‐Jan‐16

1‐Feb‐16

1‐Mar‐16

1‐Ap

r‐16

1‐May‐16

1‐Jun‐16

1‐Jul‐1

6

1‐Au

g‐16

1‐Sep‐16

1‐Oct‐16

1‐Nov

‐16

1‐De

c‐16

Rs./ltr

Normative Gross Margin Realised Gross Margin

0

1

2

3

4

5

1‐De

c‐15

1‐Jan‐16

1‐Feb‐16

1‐Mar‐16

1‐Ap

r‐16

1‐May‐16

1‐Jun‐16

1‐Jul‐1

6

1‐Au

g‐16

1‐Sep‐16

1‐Oct‐16

1‐Nov

‐16

1‐De

c‐16

Rs./ltr

Normative Gross Margin Realised Gross Margin

At US$55/bbl Brent, building in US$2.5/bbl discount to Dubai crude, gasoil/gasoline cracks at US$ 10.5/12.5/bbl, and INR/USD at 67, we estimate Delhi diesel RSP per litre to increase to Rs 57.5 from Rs 54.6 presently, and petrol to Rs 69.9 from Rs 66.1. At ~US$ 58/bbl, diesel price will touch its previous all‐time high of Rs 59 (in Delhi) while for petrol, the corresponding Brent price will need to be US$ 66/bbl. We believe at US$ 60/bbl, excise duty rollbacks are likely, and possibly VAT cuts too. Near‐period peak and trough pricing for petrol and diesel Diesel (Delhi)

Status Effective Date

RSP (Rs./ltr)

Brent ($/bbl)

Excise (Rs./ltr)

Peak 1‐Sep‐14 59.0 100.9 3.6 Trough 1‐Sep‐15 44.5 45.0 10.3 CY16 Trough 1‐Feb‐16 44.7 28.9 17.3 Current 1‐Dec‐16 53.9 46.7 17.3 To reach former peak 59.0 58.0 17.3

Petrol (Delhi)

Status Effective Date

RSP (Rs./ltr)

Brent ($/bbl)

Excise (Rs./ltr)

Peak 14‐Sep‐13 76.1 113.7 9.5 Trough 1‐Feb‐15 56.5 46.4 17.5 CY16 Trough 1‐Mar‐16 56.6 33.3 21.5 Current 1‐Dec‐16 66.1 46.7 21.5 To reach former peak 76.1 66.0 21.5

Source: Company, PhillipCapital India Research At our forecasted US$ 55‐60/bbl Brent price range, diesel and petrol pricing and margin scenario for OMCs remains largely stable. However, at the upper range, political risks may come into play if there is a fuss about diesel prices crossing previous peaks. Excise duty and VAT rate cuts at that juncture would be structurally positive for OMCs and reduce the risk of adverse marketing margins. Any hit on margins beyond the threshold level of Rs 2.5/ltr would be negative for OMCs and also



jeopardise the spirit of deregulation. However, with an increase in LPG and kerosene subsidy burden and lower excise collection, higher oil prices would be adverse to the exchequer and fiscal deficit.

At US$ 55‐60/bbl, we do not see significant demand destruction and hence expect GRMs to remain in the mid‐cycle levels

Product margins broadly depends on individual markets, but some hit can be there Current price GRMs are generally dependent on petroleum product demand‐supply outlook. Oil prices affect these to the extent of demand destruction hitting product margins. At US$ 55‐60/bbl, we do not see significant demand destruction and hence expect GRMs to remain in the mid‐cycle levels, but there will be some impact on higher fuel and loss costs. Indian PSU refineries generally have an internal consumption of 6‐9%. Every US$ 5/bbl increase in oil prices would have a theoretical negative impact of 7‐15% on GRMs. Private refiners (such as RIL and Essar) rely heavily on non‐liquid fuels like LNG and coal, hence are better placed. Theoretical impact of higher oil prices on F&L costs and GRMs At US$45/bbl oil Volumes (mmt) 10.0 10.0 10.0 10.0Product Slate 94% 93% 92% 91%F&L 6% 7% 8% 9%Oil Price (US$/bbl) 45.0 45.0 45.0 45.0Crack (US$/bbl) 8.0 8.0 8.0 8.0Revenue (US$ mn) 3,637 3,598 3,559 3,521 Cost (US$mn) 3,285 3,285 3,285 3,285 GRM (US$mn) 352 313 274 236 GRM (US$/bbl) 4.8 4.3 3.8 3.2

At US$55/bbl oil10.0 10.0 10.0 10.094% 93% 92% 91%6% 7% 8% 9%

60.0 60.0 60.0 60.08.0 8.0 8.0 8.0

4,666 4,617 4,567 4,517 4,380 4,380 4,380 4,380 286 237 187 137 3.9 3.2 2.6 1.9

Source: Bloomberg, PhillipCapital India Research Margins of products like bitumen and sulphur depend on local demand‐supply. However, higher oil prices seem to be negative for margins as (1) demand is very price elastic, (2) these derivatives are illiquid, and (3) logistic challenges affect mobility and movement. Bitumen is a case in point – where cracks jumped after the fall in oil prices. Marketing margins of such products also follow a similar trend. Bitumen cracks and margins versus oil prices

Source: Company, Bloomberg, PhillipCapital India Research

‐

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

‐20

0

20

40

60

80

100

120

1‐Jan‐14 1‐Jul‐14 1‐Jan‐15 1‐Jul‐15 1‐Jan‐16 1‐Jul‐16

US$/bbl

Brent Bitumen cracks Bitumen marketing margins (Rs/mt)

In products like ATF, naphtha, and FO – which have better mobility – marketing margins depend on market conditions and companies’ strategies. At US$ 55‐60/bbl, we do not see any major threat of demand destruction. As per OMCs’ normative marketing margin strategy, margins in products like petrol, diesel and ATF are directly proportional to oil price movements, though by a very low magnitude of change. In the intermediate period, inventory gains will accrue to refiners, particularly PSUs, who hold inventories for 15‐30 days on an average. A US$ 5/bbl change in closing oil prices between quarters can entail inventory gain/loss of US$ 0.7‐1.5/bbl. In Q3, at the current run‐rate, Brent will close US$ 5/bbl higher between quarter ends.



Mixed impact on gas economics; spot LNG, APM gas to gain Oil‐linked LNG hedged to oil prices, spot LNG can be competitive The gas‐to‐oil economics under the current scenario will be mixed – depending on the pricing contract. In case of oil‐linked LNG (Qatar RasGas for Petronet LNG and BG for Gujarat Gas) higher oil prices will increase R‐LNG prices (due to slope mechanism). So there is no economic benefit unless refining cracks of the derivative liquid products (like FO) fluctuate, which will impact the discount/premium accordingly. Oil‐to‐gas economics Brent (US$/bbl) 45.0 50.0 55.0 60.0Naphtha (US$/bbl) 45.7 49.5 53.5 58.5FO (US$/bbl) 43.1 47.5 50.0 55.0LPG (US$/mt) 375 400 420 460Landed price (US$/mmbtu) Brent 7.8 8.6 9.5 10.3Naphtha 8.7 9.4 10.2 11.1FO 6.9 7.6 8.0 8.7LPG 8.0 8.5 8.9 9.8Spot LNG 6.0 6.8 7.0 7.0RasGas LNG 6.4 7.0 7.7 8.313.5% LNG 6.4 7.1 7.7 8.4Henry Hub 3.0 3.4 3.9 4.2GAIL Delivered US Gas 8.0 8.4 9.0 9.3


In India, as most companies deal with both term and spot LNG, the impact will be neutral to positive

Spot LNG has shown a tendency to decouple with oil prices over the last 1‐2 years – and could become more competitive. Currently, spot LNG prices are at ~US$ 7/mmbtu, supported by winter demand. Due to higher supplies from the US and Australia, these prices are likely to weaken. If we assume US$ 55‐60/bbl oil price giving support to spot LNG at US$ 7/mmbtu, it would still be cheaper than oil‐linked LNG prices of US$ 7.7‐8.3/mmbtu. Hence, spot LNG players can gain from such a scenario. In India, as most companies deal with both term and spot LNG, the impact will be neutral to positive. Spot LNG versus term LNG prices JKM LNG price

RasGas term LNG price

Source: Company, Platts, PhillipCapital India Research

0

5

10

15

20

25

Jan‐12

May‐12

Sep‐12

Jan‐13

May‐13

Sep‐13

Jan‐14

May‐14

Sep‐14

Jan‐15

May‐15

Sep‐15

Jan‐16

May‐16

Sep‐16

JKM Spot LNG Price ($/mmbtu)

02468

10121416

Q1FY13

Q3FY13

Q1FY14

Q3FY14

Q1FY15

Q3FY15

Q1FY16

Q3FY16

Q1FY17

Q3FY17

Q1FY18

Qatar RasGas Term LNG Price ($/mmbtu)

GAIL's US LNG is expensive and under the current scenario, its landed price in India is higher than most term and spot LNG prices; it is even higher than FO. However, higher oil prices can be beneficial if they push higher US shale oil output – which would lead to increase in natural gas production and pull down Henry Hub gas prices to more reasonable levels. Henry Hub prices have recovered significantly over the last year to US$ 3.7/mmbtu currently from a low of US$ 1.5/mmbtu, supported by oil prices and opening up of US LNG exports. We believe at US$ 55‐60/bbl oil, Henry Hub prices are likely to be around US$ 4/mmbtu unless there is gas oversupply in US.



Global benchmark gas prices


0

2

4

6

8

10

12

Jul‐1

3

Sep‐13

Nov

‐13

Jan‐14

Mar‐14

May‐14

Jul‐1

4

Sep‐14

Nov

‐14

Jan‐15

Mar‐15

May‐15

Jul‐1

5

Sep‐15

Nov

‐15

Jan‐16

Mar‐16

May‐16

Jul‐1

6

Sep‐16

Nov

‐16

Alberta ($/mmbtu) Henry Hub ($/mmbtu) NBP ($/mmbtu)

CNG to become more competitive versus petrol/diesel Benchmark gas prices – Henry Hub, Canada Alberta, and NBP – have all recovered from the bottoms of CY16. However, the last year average under the APM gas‐pricing formula for 1HFY18 has remained unchanged. Hence, we estimate APM/domestic gas prices (effective April 2017) largely unchanged HoH at US$ 2.7‐2.8/mmbtu. Domestic/APM gas price

Source: PPAC, Bloomberg, PhillipCapital India Research

4.20

5.615.17

4.243.39

2.78 2.74

0.0

1.0

2.0

3.0

4.0

5.0

6.0

H1FY15 H2FY15 H1FY16 H2FY16 H1FY17 H2FY17 H1FY18E

APM Gas Price ‐ NCV (US$/mmbtu)

This bodes well for CNG and domestic PNG, as they become more competitive to alternate fuels like petrol, diesel, and LPG – besides supporting margins. At US$ 55/bbl oil price, CNG would be 56% cheaper to petrol and 35% to diesel against 53% and 32% at US$ 45/bbl oil. Domestic PNG will also become more attractive than non‐subsidised LPG, but PNG sales are generally inelastic and outlook depends on network expansion and connections.



CNG economics At Brent US$ 45/bbl At Brent US$ 55/bblCar Petrol Diesel CNG Petrol Diesel CNG Delhi Price (Rs/ltr‐kg) 66.1 54.6 37.3 70.0 57.2 37.3 Mileage (km/ltr‐kg) 15.0 18.0 18.0 15.0 18.0 18.0 Cost (Rs/km) 4.4 3.0 2.1 4.7 3.2 2.1 CNG cheaper by (%) ‐53% ‐32% ‐56% ‐35% Daily running (km) 40 40 40 40 40 40 Daily cost (Rs) 176 121 83 187 127 83 Annual cost (Rs) 63,456 43,680 29,840 67,200 45,760 29,840 Savings vs. petrol (Rs) 19,776 33,616 21,440 37,360 CNG/diesel kit cost (Rs) 100,000 30,000 100,000 30,000 Payback period (months) 61 11 56 10 Mumbai Price (Rs/ltr‐kg) 72.5 60.2 40.8 77.5 63.2 40.8 Mileage (km/ltr‐kg) 15.0 18.0 18.0 15.0 18.0 18.0 Cost (Rs/km) 4.8 3.3 2.3 5.2 3.5 2.3 CNG cheaper by (%) ‐53% ‐32% ‐56% ‐35% Daily running (km) 40 40 40 40 40 40 Daily cost (Rs) 193 134 91 207 140 91 Annual cost (Rs) 69,600 48,160 32,656 74,400 50,560 32,656 Savings vs. petrol (Rs) 21,440 36,944 23,840 41,744 CNG/diesel kit cost (Rs) 100,000 30,000 100,000 30,000 Payback period (months) 56 10 50 9




Impact on companies We had upgraded our oil price forecast for FY18/19 after Q2FY17 results. However, we raise our FY17 estimate slightly to US$ 49/bbl from US$ 47/bbl – though it will not have an impact on our valuations, which are based on FY18/19 numbers. Covered universe Reliance Industries ‐ RIL's core downstream business is a processing/margin business. While higher oil prices can lead to demand destruction, at US$ 55‐60/bbl, we find the outlook stable and dependent on specific petroleum product and petrochemical markets. Additionally, RIL can gain through crude sourcing, petcoke gasification project (sticky priced petcoke replacing oil linked LNG), and gas‐based petrochemicals. The upstream segment would benefit from higher oil prices. For every US$ 5/bbl increase in Brent prices, we estimate RIL's FY19 consolidated EPS to rise by Rs 2.8 (assuming a 5.5% slope for Henry Hub gas prices) and valuation by Rs 35. We maintain our Buy rating with a target of Rs 1,190. Castrol India/Gulf Oil Lubricants – As both companies are in petroleum retail, they will be negatively affected by higher oil prices if they do not pass them on. However, Castrol has managed higher oil prices well in the past and we expect it to continue doing so based on its strong brand and price leadership. GOLI has also indicated that it would follow margin‐management. For every US$ 5/bbl rise in oil price and equivalent increase in base oil cost, Castrol/GOLI's CY17/FY18 EPS would fall by Rs 0.5/2.0, if no price hike is taken. The lubricant space is impacted by demonetisation and our channel checks have revealed that though November sales were stable, December may see some dips (20% estimated). However, this would recover as lubricants is a semi necessity. Further, a significant portion of the market is unorganised and counterfeit – which may go out of business, which could prove significantly positive for organised players like Castrol and GOLI. We await Castrol/GOLI's current quarter numbers and management guidance before reassessing our estimates. We maintain our Buy rating on Castrol/GOLI with a target of Rs 530/950. Castrol's margins versus oil prices


0

20

40

60

80

100

120

CY05 CY06 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16E

Brent price (US$/bbl) EBITDA/ltr (Rs)

Gas utilities ‐ We do not foresee any change in the earnings of gas utilities/companies like Petronet LNG, Indraprastha Gas, Gujarat Gas, Gujarat State Petronet and Mahanagar Gas (Not Rated) at this juncture.



Not Rated ONGC/Oil India/Cairn India: ONGC and Oil India are direct beneficiaries of higher oil prices, though final subsidy sharing would impact reported earnings. We see low subsidy risk up to US$ 60/bbl Brent price. For every US$ 5/bbl increase in oil price, ONGC/OIL's standalone EPS would change by Rs +3.6/+6.4 annually. Cairn India is out of the subsidy burden and consolidated EPS impact for it would be Rs 3. Indian Oil/BPCL/HPCL: The refining division of OMCs would see inventory gains in the intermediate period, though higher fuel and loss costs would follow. At US$ 55‐60/bbl, we do not see any material demand destruction affecting GRMs. We see a similar trend for marketing volumes and margins, except for immobile, locally sold products – which are very price and margin elastic. For major products like petrol and diesel higher costs would need to be passed on, resulting in price hikes that can be controlled by excise‐duty rollbacks. Subsidy burden on kerosene and LPG would increase but at Rs 300bn (at US$ 60/bbl Brent) it would remain much lower than historical levels and can be compensated. However if OMCs are asked to bear certain portion it would impact both earnings and target multiples (due to return of subsidy risks). MRPL/Chennai Petroleum: Refiners would see inventory gains in the intermediate period though that would be followed by higher fuel and loss costs. At US$ 55‐60/bbl, we do not see any material demand destruction affecting GRMs.




Rating Methodology We rate stock on absolute return basis. Our target price for the stocks has an investment horizon of one year. Rating Criteria Definition

BUY >= +15% Target price is equal to or more than 15% of current market price

NEUTRAL ‐15% > to < +15% Target price is less than +15% but more than ‐15%

SELL <= ‐15% Target price is less than or equal to ‐15%.

Contact Information (Regional Member Companies)

SINGAPORE: Phillip Securities Pte Ltd 250 North Bridge Road, #06‐00 RafflesCityTower,

Singapore 179101 Tel : (65) 6533 6001 Fax: (65) 6535 3834

www.phillip.com.sg

MALAYSIA: Phillip Capital Management Sdn Bhd B‐3‐6 Block B Level 3, Megan Avenue II,

No. 12, Jalan Yap Kwan Seng, 50450 Kuala Lumpur Tel (60) 3 2162 8841 Fax (60) 3 2166 5099

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HONG KONG: Phillip Securities (HK) Ltd 11/F United Centre 95 Queensway Hong Kong Tel (852) 2277 6600 Fax: (852) 2868 5307

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JAPAN: Phillip Securities Japan, Ltd 4‐2 Nihonbashi Kabutocho, Chuo‐ku

Tokyo 103‐0026 Tel: (81) 3 3666 2101 Fax: (81) 3 3664 0141

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Jakarta 10220, Indonesia Tel (62) 21 5790 0800 Fax: (62) 21 5790 0809

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CHINA: Phillip Financial Advisory (Shanghai) Co. Ltd. No 550 Yan An East Road, OceanTower Unit 2318

Shanghai 200 001 Tel (86) 21 5169 9200 Fax: (86) 21 6351 2940

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THAILAND: Phillip Securities (Thailand) Public Co. Ltd. 15th Floor, VorawatBuilding, 849 Silom Road,

Silom, Bangrak, Bangkok 10500 Thailand Tel (66) 2 2268 0999 Fax: (66) 2 2268 0921

www.phillip.co.th

FRANCE: King & Shaxson Capital Ltd. 3rd Floor, 35 Rue de la Bienfaisance

75008 Paris France Tel (33) 1 4563 3100 Fax : (33) 1 4563 6017

www.kingandshaxson.com

UNITED KINGDOM: King & Shaxson Ltd. 6th Floor, Candlewick House, 120 Cannon Street

London, EC4N 6AS Tel (44) 20 7929 5300 Fax: (44) 20 7283 6835

www.kingandshaxson.com

UNITED STATES: Phillip Futures Inc. 141 W Jackson Blvd Ste 3050

The Chicago Board of TradeBuilding Chicago, IL 60604 USA

Tel (1) 312 356 9000 Fax: (1) 312 356 9005

AUSTRALIA: PhillipCapital Australia Level 10, 330 Collins Street

Melbourne, VIC 3000, Australia Tel: (61) 3 8633 9800 Fax: (61) 3 8633 9899

www.phillipcapital.com.au

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INDIA PhillipCapital (India) Private Limited

No. 1, 18th Floor, Urmi Estate, 95 Ganpatrao Kadam Marg, Lower Parel West, Mumbai 400013 Tel: (9122) 2300 2999 Fax: (9122) 6667 9955 www.phillipcapital.in

Management(91 22) 2483 1919

Kinshuk Bharti Tiwari (Head – Institutional Equity) (91 22) 6667 9946(91 22) 6667 9735

Research IT Services Pharma & Speciality Chem

Dhawal Doshi (9122) 6667 9769 Vibhor Singhal (9122) 6667 9949 Surya Patra (9122) 6667 9768Nitesh Sharma, CFA (9122) 6667 9965 Shyamal Dhruve (9122) 6667 9992 Mehul Sheth (9122) 6667 9996Banking, NBFCs Infrastructure StrategyManish Agarwalla (9122) 6667 9962 Vibhor Singhal (9122) 6667 9949 Naveen Kulkarni, CFA, FRM (9122) 6667 9947Pradeep Agrawal (9122) 6667 9953 Deepak Agarwal (9122) 6667 9944 TelecomParesh Jain (9122) 6667 9948 Logistics, Transportation & Midcap Naveen Kulkarni, CFA, FRM (9122) 6667 9947Consumer & Retail Vikram Suryavanshi (9122) 6667 9951 Manoj Behera (9122) 6667 9973Naveen Kulkarni, CFA, FRM (9122) 6667 9947 Media TechnicalsJubil Jain (9122) 6667 9766 Manoj Behera (9122) 6667 9973 Subodh Gupta, CMT (9122) 6667 9762Preeyam Tolia (9122) 6667 9950 Metals Production ManagerCement Dhawal Doshi (9122) 6667 9769 Ganesh Deorukhkar (9122) 6667 9966Vaibhav Agarwal (9122) 6667 9967 Yash Doshi (9122) 6667 9987 EditorEconomics Mid‐Caps & Database Manager Roshan Sony 98199 72726Anjali Verma (9122) 6667 9969 Deepak Agarwal (9122) 6667 9944 Sr. Manager – Equities SupportEngineering, Capital Goods Oil & Gas Rosie Ferns (9122) 6667 9971Jonas Bhutta (9122) 6667 9759 Sabri Hazarika (9122) 6667 9756Vikram Rawat (9122) 6667 9986

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Corporate Communications

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Jignesh Shah (Head – Equity Derivatives)

Automobiles

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