RIL: The arbitration withdrawal impact

Last week, Mint reported that Reliance Industries Ltd (RIL) will be withdrawing from its ongoing arbitration with the government on natural gas pricing. In March, the government approved pricing and marketing freedom for natural gas produced from difficult terrain (albeit capped with a ceiling price). It also said the new rules will be applicable only on conclusion/withdrawal of pending arbitration or litigation pertaining to gas pricing.

In that backdrop, RIL becomes eligible for higher prices when it withdraws from the arbitration. The company will now be able to fetch higher prices for its discoveries that are yet to start production. However, it’s worth remembering that it will take a while for gas to flow from the fields and the impact will not be visible in the numbers immediately.

In any case, the decline in domestic production has meant that the significance of RIL’s oil and gas business has declined. The chart alongside shows stand-alone oil and gas business revenue has declined by three-fourths over FY11-FY16. On the other hand, Ebit (earnings before interest and taxes) from this business has pretty much evaporated, falling nearly 99% over the same time frame. Lower oil/condensate prices, apart from lower production, have also affected FY16 performance.

Small wonder then that analysts aren’t ascribing much value to RIL’s oil and gas business at the moment. For perspective—Macquarie Capital Securities (India) Pvt. Ltd had assigned a value of Rs.54 per share for the domestic upstream business in RIL’s sum-of-the-parts valuation of Rs.1,594 a share, in its March quarter results review report.

The downstream businesses of refining and petrochemicals account for as high as 80.7% of the value in Macquarie’s valuation. The brokerage firm has considered 20% conglomerate discount to arrive at a target price of Rs.1,275 per share (see chart). In FY16, the refining and petrochemicals businesses accounted for 68.5% and 30.3% of total stand-alone Ebit, respectively.

Currently, one RIL share trades at around 11 times estimated earnings for this fiscal year. The operating environment has worsened after the March quarter. Singapore gross refining margin (GRM) has declined so far this quarter to about $5 per barrel from $7.7 a barrel last quarter. That could weigh on RIL’s GRM performance for the current quarter.

From a medium-term perspective, the company’s downstream expansion projects and telecom launch will be key metrics to follow. “Compared to a compounded annual growth rate (CAGR) of -1% over FY11-15, RIL’s Ebitda (earnings before interest, taxes, depreciation and amortization) grew by 18% in FY16. Over the next three years, we estimate an ex-telecom Ebitda CAGR of 11%,” wrote Nomura analysts in a report on 25 April.