The Sovereign
Diesel price deregulation is credit positive for the sovereign because it will lower government spending on subsidies to bridge the gap between global market prices and domestic regulated prices. Additionally, deregulation proves to investors that the government remains committed to fiscal consolidation and structural reform. Because the government introduced the measure amid falling global oil prices, it will have a limited inflationary effect.
Over the past four years, the government has introduced several measures aimed at reducing its subsidy burden, including petrol price deregulation, incremental increases in regulated diesel prices and a reduction in the amount of liquefied petroleum gas consumption that the government subsidised. But the government continued to subsidise diesel and other fuels that households use, and as oil prices rose and the Indian rupee depreciated, the government's fuel subsidy bill grew nearly six-fold to INR855 billion in the fiscal year ended in March 2014, from INR150 billion in fiscal 2010.
Given India's widespread commercial use of diesel, price deregulation would have a greater economic and inflationary effect than it would for petrol, and for that reason it was more politically sensitive. But the 20% decline in global crude prices in the second half of this year allowed the government to introduce price reforms without risking an economic contraction or inflation.
The government's action will lower its fiscal deficit, which is credit positive. The total reduction of the subsidy bill will likely be lower this year because of lower oil prices: we estimate that diesel-related subsidies cost the government about 0.3% of GDP in fiscal 2014, down from 0.6% a year earlier, and that costs would have been lower in fiscal 2015. Removing diesel subsidies reduces the government's exposure to oil price and exchange rate shocks, which have added significantly to government expenditure in the past.
India's general government fiscal deficit (6.9% of GDP in fiscal 2014) and debt (66% of GDP) are high compared with similarly rated sovereigns, and the elimination of one source of higher deficits demonstrates that the government intends to continue along the path of fiscal consolidation that it outlined in its July budget. Moreover, by allowing markets to set prices, deregulation will also compel domestic demand to adjust more quickly to price signals, preventing the kind of balance-of-payments pressures that have built up when domestic consumption was sheltered from the effect of global oil price increases.
The possible inflationary effect of deregulation is limited by the global oil price scenario. In fact, diesel price deregulation was accompanied by a 5.7% drop in diesel prices. Therefore, we expect a minimal effect on India's Consumer Price Index inflation (which was 6.5% in September 2014) and GDP growth (which we forecast at 5% this fiscal year).
Oil And Gas Companies
Diesel price deregulation is credit positive for state-owned downstream oil marketing companies (OMC) such as Indian Oil Corporation Ltd. (IOC, Baa3 stable), Bharat Petroleum Corporation Limited (BPCL, Baa3 stable) and Hindustan Petroleum Corporation Limited (unrated) because they will no longer incur losses arising from any shortfalls between the government-set sale price of diesel and production costs (i.e., under-recoveries). As the fuel subsidy falls, it reduces the amount that the OMCs will have to borrow to fund fuel under-recoveries on kerosene and liquefied petroleum gas, the two remaining subsidized oil products, until the government reimburses the OMCs three to six months later.
The announcement is also credit positive for state-owned upstream producers Oil and Natural Gas Corporation Ltd. (ONGC, Baa2 stable) and Oil India Limited (OIL, Baa2 stable) because it reduces the fuel subsidy burden they share with the government.
We expect India's total under-recoveries to fall to INR1.0 trillion for the fiscal year ending 31 March 2015 from INR1.4 trillion a year earlier. This would result in an INR100-INR150 billion reduction in OMCs' borrowing requirement and an INR10-INR15 billion decline in interest expenses, which the government does not reimburse. Of the three OMCs, IOC will benefit most because it has the largest market share and thus the highest exposure to under-recoveries. We expect IOC's total borrowings this year to decline by INR50-INR80 billion from INR949 billion in fiscal 2014, while we expect BPCL's to fall by INR20-INR40 billion from INR332 billion in fiscal 2014.
Market-linked diesel prices will move in tandem with fluctuations in crude oil prices. Over the next few weeks, diesel price deregulation will lower diesel prices given the depressed crude oil environment. Although this will compress the margins of the downstream companies, we do not expect these conditions to persist because crude oil prices are cyclical.
Because the retail sale price of diesel is no longer regulated, and thus no longer controlled by the state-owned OMCs, other Indian refiners such as Reliance Industries Limited (RIL, Baa2 positive) and Essar Oil (unrated) can now market diesel. Although the entry of new players will increase competition, we do not expect these new entrants to threaten the OMCs owing to their well-entrenched market position in India and because we expect any erosion of the OMCs' market share to be gradual.
We expect ONGC's and OIL's portion of the fuel subsidy burden to fall as the country's total fuel subsidies decline. Although the producers' share of fuel subsidies in the April-June quarter did not change at $56 per barrel, India's Ministry of Petroleum and Natural Gas has proposed dividing total fuel subsidies equally between the government and state-owned upstream producers. With the lower burden, we estimate that ONGC's revenue would increase by INR185-INR195 billion in fiscal 2015 from INR1.8 trillion in fiscal 2014, while OIL's fiscal 2015 revenue would rise by INR10-INR18 billion from INR113.2 billion the previous year.
ONGC and OIL sell their crude oil to downstream refining and marketing companies at a discount (their share of the fuel subsidies) because the latter sell their refined-oil products at government-set prices, which are lower than their production costs. The government also takes on a share of the fuel subsidies by providing cash compensation to downstream companies. The downstream companies' under-recoveries, or losses resulting from any shortfalls between their selling prices and production costs, will decline as the selling prices of their products increase.
State-Owned Natural Gas Producers
The gas price increase is credit positive for upstream producers Oil and Natural Gas Corporation Ltd. (ONGC, Baa2 stable) and Oil India Limited (OIL, Baa2 stable) because they will benefit from an increase in revenues. However, the announcement is credit negative for Reliance Industries Limited (RIL, Baa2 positive) because it will not benefit from the revision until it resolves its ongoing arbitration with the government.
The gas price hike will have the largest effect on state-owned ONGC, India's largest natural gas producer. We estimate that ONGC's revenues will increase by $400-$600 million in the fiscal year ending in March 2015 and by $1.1-$1.3 billion in fiscal 2016, when the company benefits from a full year of higher gas prices. Gas sales accounted for INR194.2 billion ($3.2 billion), or 11%, of ONGC's total revenue in fiscal 2014. We expect OIL's revenues to rise by $40-$50 million in fiscal 2015 and by $100-$120 million in fiscal 2016. Gas sales accounted for INR17.1 billion ($283.2 million), or 15%, of OIL's total revenue in fiscal 2014. These increases could be even higher thereafter as the production of domestic gas increases with new discoveries. We expect that for every 1 billion cubic meters of gas produced there will be incremental revenue of around $50 million.
The current government's decision to implement a revised formula is also credit positive for the upstream oil and gas companies because it removes uncertainty around gas prices in India. Gas prices, which were scheduled to nearly double starting 1 April 2014, as per a pricing formula approved by the previous government, have been deferred three times by the government.
With the assurance of the revised prices, upstream producers can evaluate the commercial feasibility of exploratory fields. Additionally, higher gas prices will encourage upstream producers to invest further in exploration and production in India, particularly for offshore gas fields that are not commercially viable at current prices. The government has also indicated that there will be a premium on the gas prices at complex offshore fields, but has not provided further details.
For RIL, the government's decision to withhold the gas price increase at its largest producing block at the Krishna-Godavari (KG) basin is credit negative because it delays the increase in revenues that the company would have collected from the price hike. If RIL were able to benefit from the price increase, we would have expected its revenues to increase by $50-$60 million in fiscal 2015 and by $130-$150 million in fiscal 2016. Upstream oil and gas production is a small part of RIL's predominantly downstream business, accounting for INR107 billion ($1.8 billion), or 2%, of its total revenue in fiscal 2014.
RIL's natural gas output at its KG-D6 block has fallen below its target production over the past few years. The government has maintained that it will suppress gas prices at the block at $4.20/mmbtu until RIL makes good on the shortfall in gas volume and the ongoing arbitration is resolved. Output at the KG-D6 block averaged 12.8 million metric standard cubic meters per day in the July-September quarter, just 16% of its daily target.
The revised gas price formula does not include any Asian liquefied natural gas benchmarks, which typically command higher prices, but instead references Canadian and Russian domestic gas prices. As a result, this new formula results in a lower gas price than the $8.00-$8.40/mmbtu forecast under a pricing formula approved by the former administration, but never implemented.
Corporates
Falling Oil Prices Are Credit Negative for E&P, Drilling and Oil Field Services Companies
Oil prices have dropped more than 25% since June, and more than 5% in just the past two weeks, as a result of a convergence of demand concerns, increased supply and Saudi Arabia's statement that it plans to defend its market share. Lower prices are credit negative for exploration and production (E&P) companies. Their revenues will immediately take a hit, with most of the drop falling straight to the bottom line because of their high operating leverage. Persistently lower oil prices will also hurt drilling and oil field services companies as E&P companies reduce capital spending and their demand for services.
Oil prices have traded in a $20 band for several years, including a similarly sharp price drop in early 2012. The global market has been well supplied during this period, with prices supported by strong demand in China, India and other emerging markets, and ongoing geopolitical risk in the Middle East and North Africa.
This recent sharp drop in prices is the result of market expectations of weaker demand in China and Europe, and Saudi Arabia's threats that it will defend its 11% market share,1 rather than act as the Organization of the Petroleum Exporting Countries' (OPEC) - and the world's - swing producer. The other significant factor weighing on prices is the strengthening US dollar. The euro has weakened to about $1.28 from about $1.40 in June, and because oil is denominated in dollars, a stronger dollar leads to lower oil prices.
Despite growing supply, particularly in the US, longer-term pricing should remain above $80, primarily because of global demand growth. However, over the next several months we could easily see prices dip into the $70s. On 18 September, we lowered the base-case price assumptions we use for our credit analysis for West Texas Intermediate (WTI) to $85 per barrel from $90 and for European Brent to $90 from $95 through 2015. Those assumptions and our stress-case price of $60 per barrel remain unchanged.
To be sure, although the drop in oil prices will negatively affect producers, including integrated oil companies and national oil companies, hedges and lower operating costs can help offset the effect. In addition, despite the media's focus on the effect that the drop in oil prices will have on revenue, our analysis focuses more on unit costs and cash margins, which will drop proportionally less than prices.
E&P companies have the ability to adjust their capital expenditures and will begin to moderate their activity and slow down projects at the margin. Drillers and service companies will feel the most pain as producers react quickly to cut their costs. Even if there is not a dramatic drop in rig counts or activity, we would expect to see pushback on prices and dayrates that service companies are able to charge producers. Drillers and service companies without contracts or that work on a call out basis will be hurt the most.
If lower oil prices persist and E&P companies reduce their development activity, we would see production growth slow in North America. Shale wells typically have high initial decline rates, so a slowdown in activity would reduce throughput volumes for midstream companies. Gathering and processing companies with a percentage of proceeds contracts will see lower revenue. Retail fuel prices tend to be sticky on the way down, so refiners' margins will benefit until pump prices catch up with lower feedstock costs.
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