Rising crude oil prices: Subsidy issues come to haunt ONGC again

Oil and Natural Gas Corporation (ONGC), the country’s key public sector producer in the segment, is in the spotlight due to rising crude oil prices. While producers would earn more for every barrel of oil sold, with costs largely unchanged, the risk of a rising subsidy burden imposed by the government to cushion the impact of rising prices on end-consumers is proving a key worry. 

Recent news reports that the company might have to forgo its revenue from crude prices in excess of $70 a barrel was bound to impact Street sentiment. Though a subsidy sharing mechanism is not currently in force, ONGC’s stock price is likely to remain under pressure till clarity emerges, feel analysts.

Rising subsidy to exert pressure on earnings
ONGC’s investors saw their holding values lag the broader markets during 2014-2016 as global crude oil prices fell. They also felt heat when the company agreed (on government prodding) to acquire a majority stake in Hindustan Petroelum Corporation, the public sector oil refining and marketing entity.

As crude prices started rising, there was some hope for investors. However, even as these crossed $60 a barrel, it did not reflect in the share price -- the Street and analysts had begun factoring in the possible subsidy burden ONGC might have to bear. For instance, analysts at Edelweiss Securities, assuming an average crude price at $65 for FY19 and $66 for FY20 had been factoring net realisation for ONGC at $58 a barrel (assuming a per-barrel subsidy share of $7.1 and $8.1 in FY19 and FY20, respectively). Notably, despite more than a 10 per cent rise in the average Brent crude price expected from FY18 to FY19, the net realisation was expected to improve by only 3.5 per cent. 

Crude has since risen to around $80 a barrel. Should ONGC beasked to bear a higher than estimated subsidy burden, it would increase the pressure on its financials, with earnings estimates being revised lower. 

One way of asking ONGC to bear a part of the burden, analysts say, will be by capping oil prices beyond, say, $70 a barrel, through a windfall tax or another mechanism. Even so, analysts say, there is no clarity on how kerosene and cooking gas subsidies will be dealt with – whether part of a windfall tax or an additional hit. This adds to the uncertainties and could impact its earnings.

 An analyst at a domestic brokerage, not willing to be named, says at a cap of $70 a barrel, net realisation would be $60-62. However, he also awaits clarity on many issues and might have to then adjust his estimates. It is also not known if oil marketing companies such as HPC will be asked to bear some burden as well.

Analysts, then, await more clarity from the government and ONGC's management after next week'sannouncement of the company’s results. 

Meanwhile, domestic oil production and sales contribute more than half to ONGC’s sales mix, excluding joint ventures. Improving cash flow from this business are necessary to fund the company’s planned capital expenditure (capex). Having spent significantly on acquiring a majority stake in HPC (Rs 369 billion), ONGC might have to resort to higher borrowing for funding capex if profits from its oil business are impacted. This would put pressure on its balance sheet and financials. 

Its overseas subsidiary, ONGC Videsh, might not come under a subsidiary nurden sharing arrangement as in the past, believe analysts. However, even as it will benefit proportionately from a rise in oil prices, it contributes only a tenth to consolidated revenue.

For now, rising gas production and prices, which were to drive ONGC’s earnings, remain priced-in its share value. Uncertainties on subsidy sharing will continue to be an overhang. After outperforming the benchmark S&P BSE Sensex for six months, between late August 2017 and late January 2018 (up 30 per cent versus the Sensex’s 15 per cent), the stock has been a laggard. Since then, it is down 14 per cent (versus the Sensex’s five per cent fall). This week, the stock saw increased volatility; it fell 11 per cent, before rebounding 4.6 per cent on Friday. Clearly, the Street is nervous.