Energy - Windfall Tax Issue

Stock prices of private oil companies (Reliance and Cairn India) have come off due to the potential risk of windfall taxes. In our view, the risk of higher fiscal levies (in whatever form) is greater for the private refiners than the E&P companies. The extent of risk is completely subjective and depends upon how much 'subsidy' is meant to be extracted from the private refiners, as was the case in FY06. We retain our Buy rating on Cairn India as our Brent oil price assumptions (US$75/bbl long-term) are conservative enough to take into account any potential additional tax. Our Sell rating on Reliance Industries is partly based on our negative view on the refining and petrochemical cycle and does not factor in any additional taxation.

Genesis of the windfall tax debate
The Indian government (GOI) has been protecting its citizens from rising oil prices by regulating the domestic prices of the four retail products. This has resulted in very large under-recoveries for the three main GOI-owned oil marketing companies (OMCs): BPCL, HPCL and IOC. The financial burden of these companies has historically been shared by other GOI-owned companies in the upstream sector – ONGC, GAIL and Oil India. The private companies in the upstream sector (mainly Reliance Industries, Cairn India) are governed by production sharing contracts (PSCs), which specify the levels of royalty as well as profit sharing. Material production from the private players is likely to commence only in future – Reliance’s gas production around September 2008 and Cairn India in 2HCY09.

The refining sector has been forced to provide explicit subsidies only once, in FY06 (Rs15bn for the industry). Out of this, the real contribution was only from Reliance Industries (Rs7.5bn), since the rest of the refining capacity is controlled largely by the OMCs for whom it was mainly a transfer from the refining arm to the marketing arm. The refining sector has taken a hit in terms of sharp reduction in import duty protection, but the impact on profitability has been relatively limited due to rising levels of gross refining margins (GRMs).

On 4 June 2008, the GOI announced a package to tackle the rising under-recoveries of the OMCs. This included an increase in retail prices (borne by the customers), some underrecoveries
been borne by the OMCs and the GOI-owned upstream companies and the rest borne by GOI via cuts in taxes and oil bonds. The Samajwadi Party (which at that point was not part of the government) had criticised the package stating that no contribution was being demanded from private oil companies and they should be asked to pay “windfall tax”. This demand has gained credence due to the changing political equations. With the Congress party looking likely to go ahead with the nuclear deal and the left parties announcing their intention to withdraw support, the continuation of the current government might depend on the support of the Samajwadi party.

Upstream companies: need to change PSCs
If GOI wishes to extract higher taxes from private oil companies, it would need to change PSCs
that have already been signed, thereby impacting future investment in the sector. Further, all the PSCs under the new exploration policy have a profit sharing mechanism, whereby cash flows
earned over and above investments made are shared with GOI. This, in a way, is a windfall tax.
Though GOI is always free to change existing fiscal levies (as other major oil/gas producing countries have done), in our view, it would be meaningless to change PSCs unless the amounts that can be collected by levying additional taxes are significant. Companies can pay only when they start producing and the current level of production from the private oil companies is very limited. In FY08, the joint ventures with private oil companies (where ONGC also holds around a 40% stake) produced crude oil of 5.1mt (15% of total domestic oil production) and natural gas of 7.7bcm (24%). Significant production from Reliance Industries and Cairn India is yet to commence.

RIL E&P – gas price itself is a windfall tax
We expect gas production from RIL’s KG-D6 block to progressively rise to 89mmscmd, which would double the country’s gas production. We believe there would be limited justification to levy any additional taxes on this production given the low level of gas price that has already been fixed for the first five years of production – US$4.2/mmbtu. This gas price is well below current levels of international gas prices (US$10-12/mmbtu) and translates to an oil price of US$25/bbl, just 18% of prevailing oil prices. Given this low gas price, it would be difficult to argue for any additional taxation, especially since the PSC also has a profit sharing agreement with GOI.

Cairn India – our oil price assumptions are conservative
There could be a risk that GOI would change Cairn’s contracts and not grant them the full international oil prices. The method of tax collection is immaterial; it could be via change in royalty rates, levying additional taxes which could rise in line with crude prices, artificially capping realisation for Cairn crude, etc. The problem we foresee is that the desperate measure to levy additional tax is basically meant to tide over the problems being faced in FY09, whereas Cairn can provide meaningful revenue only from FY11F. Our DCF value for Cairn (Rs259) and the target price (Rs315, based on cash flow multiple) are based on very conservative oil price assumptions. While Cairn would start producing from 2HCY09, our Brent oil price forecasts are US$100/bbl in CY09, US$90/bbl in CY10 and US$75/bbl thereafter, with Cairn crude being priced at an 8% discount to the Brent price. Since the current Brent price (US$140/bbl) is virtually double our long-term price assumption, we believe there is sufficient buffer to take into account any additional “windfall taxes”.

Private refiners at risk
If the objective is to collect contributions in FY09, the axe could most likely fall on the private refiners – RIL and Essar Oil. Both of these companies have been in the process of rolling out their retail gas station networks, which have now been aborted due to GOI’s price regulations. However, given the robust global refining margin environment, product of both refineries is largely exported. In fact, the RIL refinery is now an export-oriented unit (EOU) and is forced to export. Thus, both companies have managed to avoid any losses on domestic retail operations (other than the cost of their existing domestic infrastructure being under-utilised) and could report bumper results if GRMs continue to remain elevated.

From a administrative and legal angle, it would perhaps be easiest to collect additional taxes from private refiners. GOI would need to merely levy a new export tax on refined products (especially retail products like diesel, gasoline, LPG and kerosene). This would hurt only the private refiners and not the refineries owned by the OMCs. The extent of the tax would really depend on the amounts that GOI wants to extract from the private refiners. In FY06, when the refiners last made explicit subsidy contributions, the total amount collected (Rs15bn) was largely based on negotiations that decided the amount that RIL was willing to pay.

Summary
We have not factored in any additional taxes on the sector. However, given the clout that the Samajwadi party could enjoy post exit of the left parties, stock prices of the private oil companies
would likely continue to face a “windfall tax discount” until this issue is cleared either way. In our
view, if there is any additional tax to be levied, then an export tax on selected oil products is most likely. The level of tax would depend on GOI’s objective in terms of tax collection. We maintain ONGC and Cairn as our top sector picks and retain our Sell rating on Reliance Industries.