Ind-Ra: ONGC's Acquisition of HPCL to be Credit Neutral for HPCL

Oil and Natural Gas Corporation Ltd's (ONGC) acquisition of Hindustan Petroleum Corporation Limited (HPCL; 'IND AAA'/Stable) by FYE18 would be credit neutral for the ratings of HPCL, believes India Ratings and Research (Ind-Ra). ONGC, which is 68.94%-held by the government of India (GoI), will acquire the GoI's 51.11% stake in HPCL for INR369.2 billion. Thus, the GoI will indirectly own 35.23% in HPCL. Despite the change in ownership, HPCL will continue to operate as a separate entity with a strong brand. Its strategic importance to the GoI is likely to remain intact, given the company's role as the GoI's extended arm for fuel policy implementation.

Meanwhile, the acquisition of HPCL is likely to result in additional borrowings for ONGC. In Ind-Ra's opinion, ONGC is likely to fund the acquisition by end-January 2018 and could use one or more of the three sources for funding: fresh debt, cash and cash equivalents, and monetisation of its stake in entities such as GAIL (India) Limited ('IND AAA'/Stable), Indian Oil Corporation Limited ('IND AAA'/Stable) and Petronet LNG Ltd ('IND AAA'/Stable/'IND A1+'). The combined value of its stake in the three entities is about INR344 billion. Ind-Ra expects ONGC's consolidated net leverage to remain comfortable at 1.3x-1.5x on a pro forma basis in FY19 (FY17: 0.8x), depending on the funding mix.

 

Benefits to HPCL

Ind-Ra believes HPCL could receive the following benefits from the transaction.

1. The acquisition may possibly result in some synergies in terms of low crude procurement cost for both HPCL and Mangalore Refinery and Petrochemicals Limited (MRPL; 71.63%-owned by ONGC and 16.96%-owned by HPCL). HPCL, along with HPCL-Mittal Energy Limited ('IND AA'/Positive) and MRPL, represented 15.3% of India's total crude import volume of 249 million metric tons (MMT).

2. HPCL may be able to capitalise on ONGC's petrochemical expertise while expanding its footprint in the segment.

3. The acquisition may result in the merger of MPRL with HPCL. This would be beneficial as it would allow the combined entity to leverage its purchasing power. Moreover, the combined entity would be the third-largest refiner in India, with a refining capacity of 43.1MTPA, after Indian Oil Corporation (80.8MTPA) and Reliance Industries Ltd. ('IND AAA'/Stable; 60MTPA).

In case ONGC eventually looks to integrate MRPL (which has market cap of about INR229 billion) with HPCL and HPCL has to buy out ONGC's stake in a cash transaction valued at INR164 billion, HPCL may have to resort to additional borrowings. The reason behind additional borrowings is that HPCL is likely to register negative free cash flows over FY18-FY21 owing to its large impending capex (about INR421 billion) and limited cash and cash equivalents (FYE17: INR52.3 billion). Moreover, HPCL may consider a combination of share swap and cash payout, where ONGC would get additional stake in HPCL against its shareholding in MRPL. In the event of MRPL merging with HPCL, Ind-Ra expects HPCL's net leverage to remain below 3.0x over FY18-FY20.

Moreover, Ind-Ra does not expect the acquisition to alter budgetary and upstream support to HPCL for its gross under-recoveries on both kerosene and LPG. The share of oil marketing companies in under-recoveries has been zero since FY16 on account of fuel reforms undertaken by the GoI in the past. The lower fuel subsidy bill was also a result of a decline in international crude price.

The agency notes that given the sharp increase in international crude price, oil marketing companies may be required to bear a part of the under-recoveries as the government, in the past, capped the subsidy burden it was willing to share per kilogram and per litre on LPG and kerosene, respectively. Any under-recovery over and above the level up to which the GoI can bear is to be borne by upstream and oil marketing companies. Although there is no mathematical basis for deciding the share of the subsidy to be borne by upstream or oil marketing companies, upstream companies have historically shared the bulk of the remaining subsidy burden post the government share.

Benefits to ONGC

The acquisition of HPCL is likely to increase ONGC's market share by 18.5% in the domestic space for downstream petroleum products. The consolidation of HPCL could aid in reducing the volatility in ONGC's cash flows to a certain extent, as a decline in the upstream margins of ONGC could be offset by an increase in refining margins of HPCL in the event of weakening crude prices and vice versa. Moreover, the acquisition helps in creating a large oil and gas company with a scale comparable to those of global giants.

Overall, Ind-Ra believes the acquisition is a win-win for both ONGC and HPCL.

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