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Buy Oil and Natural Gas Corporation Ltd For Target Rs.198

The great conjunction for ONGC in 2023

Oil and gas production to improve 10% and 20% from mid-CY23, respectively

The Great Conjunction is a rare conjunction of the naked-eye planets – Jupiter and Saturn. It is an event that roughly occurs every two decades when Jupiter overtakes Saturn in its orbit. As Mother Aughra in the 1982 cult classic – The Dark Crystal – says, “The Great Conjunction is the end of the world…or the beginning… sometimes good, sometimes bad”, the year 2023 is likely to be a defining year for ONGC with two prominent triggers. These are: a) a rise in domestic oil & gas production, and b) possible floor on gas realization. Both are likely to play out in favor of the company, an outcome that makes us pitch ONGC as the top idea for 2023 in the sector.

* Delay in project execution hurts production…: For the past 16 years, ONGC’s Reserve Replacement Ratio (RRR) has been consistently above 1x. However, continued project execution delays, among other things, have resulted in lack of growth in oil production since FY05 and gas production since FY19.

* …but the floor price comes to the rescue: For 10 quarters, domestic APM gas price was below USD3/mmBtu (NCV), roughly the cost of gas production for ONGC. For another eight quarters, ONGC barely made any money on its gas production with domestic gas prices being below USD3.5/mmBtu (NCV). The floor of USD4.0/mmBtu recommended by Kirit Parikh, thus, provides a fillip to its profitability from the nominated fields as well as incentivizes ONGC to raise production that would garner a 20% premium over the prevailing APM gas price.

* The year 2023 to be a defining year for ONGC: With increased visibility of positive outcome based on these two triggers, we reiterate our BUY rating on the stock. We recommend ONGC as the top idea for 2023 in the sector. Valuing the standalone business at 6x Dec’24E EPS of INR28.2 and adding the value of investments of INR27, we arrive at our TP of INR198, implying 35% potential upside.

* Key downside risks: Capital misallocation, increase in windfall taxes or sharp decline in oil prices, and non-implementation of a floor for APM gas.

Long awaited production growth in sight

* For the past 10 years, the company has spent INR2,874b in its exploration projects. Hence, ONGC’s RRR (2P) – an indicator of sustainable production – has remained above 1x continuously.

* However, its oil/condensate production from domestic fields (ex-JVs) declined to 19.5mmt in FY22 from a peak of 26.5mmt in FY05. Similarly, gas production from domestic fields (ex-JVs) reached a peak of 24.7bcm in FY19, but that too decreased steadily to 20.6bcm in FY22.

* However, the much awaited KG-DWN-98/2 is forecasted to reverse this trend from May’23 by adding peak oil production of 40-45kbopd and peak gas production of ~10-12mmscmd (both by FY25). At the peak, this field would add ~10% to ONGC’s domestic oil production and ~20% to its current domestic gas production.

Much needed relief on gas pricing from the nominated fields

* Since the implementation of the existing gas price mechanism from Nov’14, domestic APM gas prices have remained below USD3/mmBtu (NCV) for 10 quarters due to the high weightage of Henry Hub in the pricing formula.

* For another eight quarters, domestic gas prices have remained below USD3.5/mmBtu. Comparing these with ONGC’s gas production cost of ~USD3/ mmBtu leads us to infer that it has been severely impacted by low gas prices.

* In light of the above, the recent recommendations of Kirit Parikh, valuing domestic APM gas prices to 10% of Brent could be a boon, if implemented. The recommendations also include a floor of USD4/mmBtu, which would protect the profitability of ONGC’s gas segment. To incentivize production from the age-old nominated fields, the Committee also proposed 20% premium over the prevailing APM gas price for incremental gas production.

Valuation and view: 2023 to be a defining year for ONGC; maintain BUY

* Aligning our forecasts: Since the implementation of the windfall taxes had no fixed expiry, we had assumed that these would last only until Dec’22. However, it looks unlikely that the government is going to unwind it any time sooner. Hence, while we do not change our Brent forecast of USD90/bbl for FY24, we cut our EPS forecast by 31% to INR44.2 (v/s consensus EPS of INR39.1), extending the windfall taxes to FY24.

* High dividend yield: Over the past three years, the dividend payout of ONGC has stood at ~33% of its consolidated PAT. In addition to the great conjunction of production growth and better gas segment profitability, this implies a strong dividend yield of 13.6% for FY23.

* Mozambique field could spring another surprise: Fueled by high LNG prices, Mozambique commenced its first LNG exports from the Coral field in mid-CY22. Already delayed, the Mozambique project in which ONGC has 16% stake, may see progress in 2023.

* Valuation: ONGC trades at 3.3x FY24E consolidated EPS of INR44.2 and 2.2x consolidated EV/EBITDA. Considering the great conjunction in addition to the cushion provided by the high dividend yield of 13.6% in FY23, we retain our BUY rating on ONGC with a TP of INR198, making it the top idea for 2023 in the sector.

* Key risks: Capital misallocation, increase in windfall taxes or sharp decline in oil prices, and non-implementation of a floor for APM gas.

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