Sector Update

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March 3, 2006

We expect the government to consider the implementation of the Rangarajan Committee recommendations in part or whole within the next three months and address the core issues pertaining to this much beleaguered sector. The lack of any budgetary measures/support to the sector had resulted in a sharp decline in prices of oil stocks even as the rest of the market rallied after the budget. Till the time the government plans decisive action on the Rangarajan Committee recommendations and addresses the core issues, we maintain our Neutral stance. In this report, we have given details of the Rangarajan Committee recommendations and the different scenarios – if the suggestions are implemented in whole or parts. The Rangarajan Committee submitted its report to the government with recommendations on the petroleum product pricing policy and related issues in February 2006. The key recommendations of the report were:
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Shift from import parity pricing for petroleum products to a mix of import and export parity pricing. Reduction in customs duty for MS and HSD. Specific excise duty for MS and HSD instead of a mix of ad valorem and specific duty. Higher prices of MS, HSD, LPG and SKO. Removal of subsidy burden from upstream companies and increase in cess on crude oil to compensate (partly) for it.

In our view, the government would not increase the prices of LPG and SKO on the back of political issues. Assuming all other recommendations are implemented, we expect:
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Adverse impact on refiners due to decline in ex-refinery prices. Lower overall subsidy burden, and the payment of subsidy through cess would exclude the direct involvement of upstream companies in subsidy. Positive impact on ONGC as a pre determined rate of cess would depict a clearer picture in terms of net earnings of the company. Currently, ONGC contributes to the subsidy burden on a quarterly basis as determined by the government in an ad hoc manner. Therefore, this would lead to better visibility of earnings.

Amit Agarwal
+91 22 55069927 amit.agarwal@investsmartindia.com

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As the marketing capacities of BPCL, HPCL, IOCL are higher than the refining capacities, we expect them to benefit marginally by the shift from import parity pricing to trade parity pricing. BPCL, HPCL and IOCL stand to gain to the extent of the differential in marketing and refining capacities.

A quick glance at Rangarajan Committee’s recommendations:
Current Ex-refinery pricing Change from import parity pricing To mix of import and export parity Pricing in ratio of 80:20 for ex-refinery price Petroleum product price rise Increase in prices of MS by Rs1.21/lt Increase in prices of HSD by Rs1.96/lt Increase in prices of LPG by Rs75/cylinder Increase in price of SKO by approx Rs6.01/lt Duty structure on petroleum products Reduction in customs duty on MS and HSD To 7.5% Excise duty- MS to be specific at Rs14.75/lt Excise duty- HSD to be specific at Rs5/lt Upstream-ONGC Cess to be Rs4, 800/MT on crude oil Upstream not to be involved in subsidy burden Source: MOPNG Rs1,800/MT Increase from USD5.4/bbl to USD14.6/bbl Positive for ONGC At 10% 8% +Rs13/lt 8%+ Rs3.25/lt Reduction of subsidy Negative for refiners Neutral for Government At current rates Import parity pricing Reduction in subsidies Negative for refiners Positive for ONGC Comments/implications

We have analyzed the changes in the subsidy burden assuming three scenarios to illustrate the possible impact of Rangarajan Committee on the oil sector and its constituents. These are

Case A: The shift in the petroleum product pricing policy from import to trade parity pricing and its impact. (Excluding the recommendation to raise the prices of petroleum products) Case B: The full implementation recommendations. of Rangarajan Committee

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Case C: Implementation of Rangarajan Committee recommendations except for increase in prices of LPG and SKO.

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Case A: If the pricing policy is changed from import to trade parity pricing and its possible impact The Rangarajan Committee has recommended a shift from import parity pricing (ex-refinery) to a mix of import and export parity in ratio of 80:20 (trade parity). Assuming every thing else remains constant, we expect the subsidy burden to decline from Rs413bn to Rs351bn in FY06E. Subsidy burden is the difference between the import parity based retail price and the actual retail price. A shift in this direction will reduce the ex-refinery price leading to lower subsidy burden as shown in Table 1 below. The table below shows the change in contribution from every participant after the committee report is implemented.
Table1: Change in subsidy burden based on change in pricing policy
Rs mn Contribution to total subsidy Government Upstream Refinery Oil bonds Increase in prices Marketing companies Total Source: IL&FS Investsmart New pricing 24,696 115,852 28,085 94,788 45,639 42,006 351,066 (%) 7 33 8 27 13 12 100 Old pricing 24,696 136,578 33,110 111,746 53,804 53,940 413,873 (%) 6 33 8 27 13 13 100

The Table 2 below gives the subsidy burden (Rs/per unit or litre) if the new pricing policy is implemented. Table 2: Change in subsidy burden
Decline in the exrefinery price Import parity pricing policy 50.3 36.3 457 22.9 New pricing policy Sale price (April FY06) Current subsidy In Rs per unit New pricing* subsidy 3.7 1.8 149.3 13.1

MS (Rs/lt) HSD (Rs/lt) LPG (Rs/cylinder) SKO (Rs/lt)

48.2 34.6 444.3 22.1

44.5 32.8 295 9.01

5.8 3.5 162 13.9

Note (1): These estimates do not include the hikes in petroleum prices as recommended by the Rangarajan Committee. Source :IL&FS Investsmart, Media.

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Case B: The entire Rangarajan Committee report This scenario speaks of full implementation of the committee report – including the hike in petroleum product prices and change in the pricing policy The suggested price rise in petroleum products is given below in Table 3.
Table 3: Price rise suggestion Increase in prices suggested by committee
MS (Rs/lt) HSD (Rs/lt) LPG (Rs/cyl) SKO* (Rs/lt) 1.21 1.96 75.00 6.01

Note (1): We have assumed that only 40% of SKO is sold below poverty line. For above poverty line the price is increased to Rs19.01/lt. Source: IL&FS Investsmart, Media.

In terms of change in the pricing policy – one can assume the scenario played out in case A. The customs duty is expected to be reduced on MS and HSD from 10% to 7.5% while excise duty is likely to be fixed at Rs14, 750/KL for MS and Rs5, 000/KL for HSD. Currently, the excise duty for MS is 8%+Rs13, 000/KL and HSD is 8%+Rs3, 250/KL.
Table 4: Impact on subsidy of Rangarajan Committee recommendations
Contribution to total subsidy (Rs mn) Government Upstream Refinery Budget Increase in prices Marketing companies Total Source: IL&FS Investsmart, Media New pricing - Rangarajan Committee (%) 24,696 69,650 2,902 18,835 116,083 21 0 60 2.5 16 Current 24,696 136,578 33,110 111,746 53,804 53,940 413,873 Percentage contribution (%) 6 33 8 27 13 13

Table 4 shows a decline in subsidy burden from Rs413bn currently to Rs116bn in FY06E. Since change to the trade parity principle would lead to a decrease in the ex-refinery prices, we have assumed that refineries would not contribute to the subsidy burden. However, the cess on crude oil is expected to be increased from Rs1, 800/ton to Rs4, 800/ton after the Rangarajan Committee suggestions are implemented.

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Case C: All the recommendations in case B are implemented except for the suggested increase in prices of LPG and SKO. Therefore, the scenario as delineated in case B can be assumed for case C. This is expected to result in a changed subsidy burden as given in table 5 below. We believe that the government is going to choose this third option of case C.
Table 5: Expected change in subsidy burden
Contribution to total subsidy (Rs mn) Government Upstream Refinery Budget Increase of prices Marketing companies Total Source: IL&FS Investsmart New pricing 24,696 166,271 5,938 40,625 237,531 Share (%) 10 0 70 2.5 17 Current 24,696 136,578 33,110 111,746 53,804 53,940 413,873 share (%) 6 33 8 27 13 13

Impact of recommendations of the Rangarajan Committee report on the upstream company – ONGC: The Rangarajan Committee has recommended that the upstream sector should be excluded from direct sharing of the subsidy. Instead, it has recommended that cess of Rs1,800/MT should be increased to Rs4,800/MT and should be utilized by the government for subsidy relief.
Table 6: Current subsidy burden on ONGC
Upstream (Rs mn) ONGC Oil India GAIL Total Subsidy burden-ONGC (Rs mn) Sales-mn bbls Subsidy burden (Rs/bbl) Exchange rate (INR/USD) Subsidy burden (USD/bbl) Source: IL&FS Investsmart estimates. Upstream subsidy burden -existing pricing 111,606 8,170 16,802 136,578 111,606 172 650 44 14.8

Currently, the upstream sector shares 33% of the total subsidy burden. The share of the upstream subsidy burden is divided between the constituents in ratio of the previous year’s profits. Table 6 shows the calculation of the subsidy burden for ONGC for FY06E.

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The table 7 shows the change as proposed by the Rangarajan Committee.
Table 7: Rangarajan Committee and its expected impact on ONGC
ONGC (USD/bbl) Cess Subsidy burden Total * Estimated Source: IL&FS Investsmart estimates. Current 5.4 14.8* 20.2* Rangarajan Committee 14.7 14.71

Impact 1: Reduction in the total cess and subsidy burden Currently, the total expense of cess (USD5.4/bbl) and subsidy burden (USD14.8/bbl) is USD20.2/bbl on ONGC. If the Rangarajan Committee recommendations are to be implemented, the subsidy burden is expected to be nil. However, the total cess would increase to USD14.7/bbl. Therefore, after implementation of suggestions by the Rangarajan Committee, the burden would decline from USD20.2/bbl to USD14.7/bbl. Impact 2: Better visibility of earnings Also, the implementation of the Rangarajan Committee recommendation would remove ONGC from direct subsidy burden - thus improving the visibility of earnings.

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Sreesankar R Head of Research/ Strategy/Logistics/Shipping/Retail/Sugar Telecom/IT Oil & Gas/ Lifestyle Telecom/IT Cement/Banking Textiles/Chemicals/ Paper/Fertilizers/Power Auto/Auto components Pharma Capital Goods/Building Material/Metals/Infrastructure Sugar/Ship Building/ Shipping Retail/Media Logistics Capital Goods/Metals/Infrastructure Textiles/Chemicals/ Paper/Fertilizers/Power Economist Research Support Research Support Editor Production sreesankar@investsmartindia.com sheriar.irani@investsmartindia.com agarwal.amit@investsmartindia.com ashish.aggarwal@investsmartindia.com devang.patel@@investsmartindia.com jayesh.sundar@investsmartindia.com mihir.jhaveri@investsmartindia.com milind.bhangale@investsmartindia.com vishal.mishra@investsmartindia.com chaturya.tipnis@investsmartindia.com gaurav.chugh@investsmartindia.com kamal.gupta@investsmartindia.com sameer.dalal@investsmartindia.com shardul.pradhan@investsmartindia.com anjali.verma@investsmartindia.com prachi.kulkarni@investsmartindia.com ember.pereira@investsmartindia.com rupali.ghanekar@investsmartindia.com charudatt.vartak@investsmartindia.com amola.jhaveri@investsmartindia.com shah.dharmen@investsmartindia.com rita.pani@investsmartindia.com sandeep.shah@investsmartindia.com Sales support geetha.nair@investsmartindia.com anish.marfatia@investsmartindia.com anmol.shanbhag@investsmartindia.com firdus.ragina@investsmartindia.com khozem.jabalpurwala@investsmartindia.com mohan.joshi@investsmartindia.com nipul.kenia@investsmartindia.com 55069914 55069918 55069927 55069925 55069922 55069944 55069933 55069940 55069943 55069926 55069916 55069917 55069921 55069941 55069946 55069924 55069940 55069915 55069923

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