Slow, Stable & Steady

Fall in global crude prices, phased diesel price regulation and the hike in prices of natural gas are expected to be the three major game-changers for the domestic oil & gas industry.
The continuous fall in crude oil prices have come as a major relief for the Indian economy. Oil cartel OPEC´s decision to not cut production despite the dip in oil prices coupled with a slowdown in a few major economies have meant that crude will continue to come under pressure in the first half of 2015. Along with these factors, the glut in production from US shale gas has also queered the pitch for the oil industry. A Reuters survey of 30 economists and analysts has projected Brent to average $74.00 a barrel this year and $80.30 in 2016.

Apart from the obvious benefits to the Indian economy, a few players in India feel that falling global crude prices can turn out to be an excellent opportunity for beefing up its exploration & development infrastructure. Says Ashish Bhandari, CEO, Oil & Gas, GE South Asia (see interview): ´It is a good time for India to attract global service players for high-end technology such as deep water drill ships, HPHT and fracking. The downturn will drive focus on cost and technology, ultimately strengthening the industry in the long run.´

And the government remains committed to stay on the reform path for the sector, according to a number of economists. ´While the government´s intent will be tested at higher oil prices, we believe reforms are here to stay given the (a) gasoline deregulation experience, (b) intent to limit LPG subsidy and (c) government´s own realisation in terms of economic and political difficulties. We expect the diesel deregulation and gas price hike, likely to be followed by subsidy rationalization, will lead to a structural upturn in earnings and valuation of OMCs (HPCL, BPCL and IOCL) and PSU upstream (ONGC, OINL),´ says Motilal Oswal in a research note.

According to Rajesh Agarwal, Sr Vice President, Infrastructure Group, SBI Capital Markets Limited, ´In the oil & gas sector, the government has implemented the long-pending demand for deregulating the price of diesel. This will not only reduce the fiscal deficit (by reducing the oil subsidy burden), but also allow upstream oil companies (which had to share the subsidy) to utilise their surplus funds for acquisition and development of new assets, thereby contributing to the country´s energy security.´

Gas Prices
After much wavering, the government finally decided to hike prices of natural gas to $5.61/mmBtu, but a few market-watchers feel that the price may drop even further. ´We find under the current formula, the price of currently produced gas will gradually fall to $5/mmBtu over the next three years from the current $5.61/mmBtu, implying falling margins as costs rise,´ says Goldman Sachs. The financial major argues that clear direction is required for high-cost projects like deepwater ventures to induce more E&P capex. Under the new gas pricing formula, the price of $5.61 per unit was to apply for normal discoveries. For all new discoveries in the ultra-deep, deepwater areas and high pressure-high-temperature areas, the government has said that a premium will be given, but further clarity is awaited from the Centre. ´The price of domestic gas has been revised to $5.61/ mmBtu from $4.2/mmBtu, effectively putting an end to the uncertainty over gas pricing, which is expected to bring in investments in the sector including LNG terminals, gas transmission networks and city gas projects,´ says Agarwal.

Ergo, though the government is moving in the right direction, ´more is needed to drive an aggressive campaign on exploring and mapping a significant majority of our sedimentary basins. The two biggest actions would be a healthy premium for deepwater and ultra deepwater; and a new NELP that encourages risk taking and international participation,´ says Bhandari.

Industry watchers have also predicted a ´stable´ outlook for the domestic oil & gas sector. Prior to the crash in global oil prices, indications were that most analysts were negative on the sector. Fitch has said in its latest note: ´The rating outlook for Indian oil and gas entities remains stable in 2015. The benefits from oil price reforms and lower global oil prices for refining and marketing companies will be offset by their large capex needs in the medium term that will lead to negative free cash flows.´ ICRA says: ´The outlook on Indian downstream companies in the oil & gas sector is also stable in view of fall in under-recoveries following softening of crude oil prices, deregulation of diesel prices and rollout of direct transfer of fuel subsidies to consumers.´

Summing Up
India has also signed landmark deals with Russia in the oil & gas sector, and is in the process of stitching up arrangements with key African producers and also with New Zealand, Myanmar, Bangladesh, Brazil, Vietnam and Turkey. Domestic appetite for oil & gas is also on the rise. Though the macroeconomic situation should continue to be stable, the key test of the government would be in its ability to push next-generation reforms… which would truly make 2015 a watershed year for the Indian oil & gas industry.

Outlook for the Indian oil & gas sector
Prices of global crude oil have declined significantly to around $60/bbl given OPEC´s decision to desist from production cuts and at the same time slowdown in economic growth of major economies in Europe and Asia. As a result, average price of Indian crude oil basket fell from $105.6 in April 2014 to $63.2/barrel in December 2014. Prices of Brent crude are expected to revive from the current low, but average price for 2015 is likely to be lower than 2014. In 2014, the Indian oil & gas sector witnessed two major developments in the form of phased diesel price de-regulation and hike in natural gas prices. These two developments would have a significant impact on the revenue growth and profitability in the sector.

Fall in crude oil prices would have a mixed impact on Indian oil & gas exploration companies. Although revenue growth of both public and private companies in the sector would be impacted, the extent of impact will vary. Drop in oil prices would reduce the under-recoveries incurred by oil marketing companies (OMCs) which in turn would reduce the overall subsidy burden in the sector.

Since public sector companies in the upstream oil & gas sector shoulder a higher proportion of subsidy, this reduction in under recovery would directly reduce their subsidy burden. Reduction in subsidy burden would translate into improved revenue performance for public sector companies in the upstream segment. Thus a drop in crude oil prices would not be entirely negative for public segment of oil & gas upstream sector.

However the scenario is different for the private sector, where the companies are not covered by subsidies. Revenue growth in the private sector depends entirely on the price fluctuations of crude oil.

In the event of a drop in international crude oil prices, revenue growth of private upstream companies would slow down.

This moderation in revenue growth is expected to continue in the coming year as average international crude oil prices in 2015 are widely expected to be significantly lower than 2014 levels.

In addition the proposed changes in subsidy sharing mechanism would improve the revenue growth in the upstream segment. As per the proposed mechanism, Oil Industry Development (OID) cess currently paid by upstream companies to the government would be considered as part of the subsidy. Further the new mechanism also proposed to divide under recovery equally between government and upstream companies. Implementation of this new subsidy sharing arrangement would significantly reduce the subsidy level incurred by public sector companies in upstream oil & gas companies which would directly reflect in the form of improved revenue performance.

In the coming year, profitability in OMCs is expected to improve on the back of lower input costs. Crude oil is the input cost for OMCs whose price has been dropping. Since crude oil price is expected to remain lower in 2015 (as compared to 2014), profitability of OMCs is expected to improve.

Devarajan Mahadevan