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GAIL and ONGC: Multiple growth catalysts beckon!

* We met with the senior management of GAIL and ONGC recently. GAIL is our top idea in the O&G sector, and it has delivered a 27% YTD return. The upstream sector and ONGC/Oil India are also our preferred picks (with returns of 12%/24% YTD).

* In our view, GAIL remains in a structural upturn marked by: 1) its improving volume growth outlook (FY24-26: 7% CAGR), 2) the potential for 10-12% tariff hikes in the transmission business in 2HFY25-26, and 3) the completion of the transmission and petrochemical projects (worth INR294b) that will boost its RoE and RoCE. With the impending end of the investment cycle, we forecast INR40.4b of FCF for GAIL in FY26.

* ONGC remains a value BUY in our opinion, trading at 0.9x consol. FY26E P/B despite boasting a consol. FY26E RoE of 17.2%. A sharp re-rating of HPCL (55% subsidiary) and other listed investments (INR44/share, ex-HPCL) remain the key catalysts. However, the lack of a credible asset development pipeline beyond the KG-98/2 and Daman’s upside development hurts its medium-term volume growth outlook, in our view.

GAIL: Multiple catalysts in 2HFY25-26

* Potential tariff hikes of 10-12% in 2HFY25-26: We believe the probability of gas price-related tariff hikes coming through remains high, as PNGRB had considered a gas price of USD12.46/mmbtu for GUJS recently. We anticipate that GAIL could benefit from a 10-12% tariff increase, potentially boosting the company’s FY26E PAT by 5%.

* Robust transmission volume outlook: The refining, power, and CGD sectors are expected to drive the majority of the 20mmscmd increase in volumes. In addition, we believe that the delay in the completion of the integrated Jagdishpur-Haldia-Bokaro -Dharma pipeline and Dharma-Haldia pipeline is unlikely to adversely impact the volume guidance. In the 4QFY24 earnings call, management had guided a 10-12mmscmd increase in volumes to 130- 132mmscmd in FY25 and 140-142mmscmd in FY26.

* Healthy FCF spurt expected in FY26 and beyond: INR163b worth of transmission projects and INR131b of petchem projects (PDH-PP and JBF petrochemicals) are scheduled for completion in the next two years. We are building in an FY26E RoE of 14.6%. With the impending end of the capex cycle, we understand that, for now, there are no mega projects in pipeline except for the ethane cracker project, which is still in the initial stages of evaluation. The company could decide to pump in more capital in the small-scale LNG and CBG projects or even in LNG pumps for transport. However, these are unlikely to entail significant investments.

* Soft spot LNG price presents opportunity to raise competitiveness in the gas portfolio: The recent long-term LNG contracts, such as with Vitol/Adnoc, have been at a slight discount to the previous gas contracts, which were done at a 12- 13% slope to Brent. The weakness in spot LNG prices, coupled with a robust volume growth outlook, could potentially create more opportunities to improve the overall competitiveness of the gas portfolio for the future.

ONGC: Development of the production pipeline can drive a re-rating!

* Development pipeline continues to evolve: We believe KG 98/2 and Daman’s upside development will act as near-to-medium-term production growth engines. According to media reports, ONGC is also considering roping in global consultants to raise production from the Mumbai-High fields, even as the ownership/operatorship of the fields is unlikely to change.

Long-term advantage from implementing a 20% higher crude price slope:

*  The Directorate General of Hydrocarbons has formed a Committee, which will look into the modalities of how to implement the 20% higher slope model. As per our understanding, if the model is implemented in about five years, up to 35-40% of the overall gas production portfolio will become eligible for the 12% slope (assuming a 7-8% annual decline).

* Petrochemicals and Green Energy: Continuing expansion opportunities

* Management highlighted that petrochemicals and green energy remain the growth avenues, though the specifics are yet to be decided. The Indian PE and PP markets experienced 18.0% and 8.5% growth, respectively, during FY24. The low per capita consumption in India, at INR14kg (the world average being INR39kg), is expected to drive polymer demand by 8-9%.

* Although OPAL remains a key avenue for investment in the petrochemical sector, the company is also open to JVs/partnerships with other companies.

*  We understand that the company could follow a similar approach with respect to green energy, where its lacks expertise for now. This remains critical since ONGC primarily focuses on solar and wind energy and aims to achieve 0.18mmtpa of green hydrogen by FY30.

* HPCL’s balance sheet to strengthen even further

* HPCL adds INR22 to our TP for ONGC. However, HPCL tends to drag ONGC’s valuation multiple amid its balance sheet-related concerns.

* HPCL’s ND/E has improved to 1.3x in FY24 from 2.1x in FY23, and we are building in a ND/E of 1.0x for FY26. We model a marketing margin of INR3.3/lit for both MS and HSD in FY25-26E, while the current MS and HSD marketing margins are INR8.7/lit and INR2.8/lit, respectively.

Valuation and View

* GAIL: We reiterate our BUY rating with a TP of INR260. During FY24-26E, we are modeling PAT to report a 8.2% CAGR driven by:

* rise in natural gas transmission volumes to 137mmscmd in FY26 from 120mmscmd in FY24;

* substantial improvement in petrochemical segment’s profitability over 2HFY25- FY26, as new petrochemical capacity will be operational and low inventories globally will drive re-stocking demand, thus improving spreads; and ? healthy trading segment profitability with EBIT guided at INR40-45b.

* We expect GAIL’s RoE to improve to ~14.6% in FY26 from 9.5% in FY23, with a healthy FCF generation of INR40.4b in FY26 (vs. -INR45.3b in FY23), which we believe can drive a re-rating for the stock.

* ONGC: Management had earlier guided a 6% production volume CAGR over the next three years, driven by rising production from KG 98/2 asset, Daman’s upside development, and the monetization of stranded gas reserves. While the volume guidance is upbeat, execution is vital, and should ONGC achieve guided volumes, we see an upside risk to our and the Street’s earnings estimates.

* ONGC is trading at 3.2x FY26E EV/EBITDA (SA) and 7.8x FY26E P/E (SA). We value the company at 7x FY26E adj. EPS of INR33 and add the value of investments to arrive at our TP of INR330. We reiterate our BUY rating on the stock

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