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Event update: Oil & Gas - A surprise proposal to change gas allocation policy

EVENT – Change contemplated in domestic gas allocation policy to CGDs

A high powered Committee (comprising Niti Aayog Vice-Chairman and Cabinet Secretary, PK Sinha, Oil Secretary, MM Kutty, and Department of Economic Affairs, SC Garg) has recommended withdrawal of concessional rates to compressed natural gas (CNG) users and in turn, proposed direct subsidy only to domestic piped natural gas (PNG) customers. City Gas Distribution (CGD) companies (IGL/MGL/GGL/Adani Gas), as a result, will be required to pay a higher price for LNG for these two segments, as they would cease to get domestic gas at a lower price.

IMPACT: Negative for the CGD business

CNG retail selling prices could rise: The proposed recommendation, if implemented, will have an immediate 35-40% bearing on retail selling prices of CNG/PNG, if we were to assume a rise of US$3-4/mmbtu in effective gas costs. CGDs could face margin compression caused by a material reduction in pricing power of the two segments. Given that the committee has recommended direct transfer of subsidy for the domestic segment, this could compress the margins of CGDs, as pricing would de facto come under government supervision for calculation of direct subsidy.

Negative impact on demand growth/profitability: In terms of absolute price impact, a $1/mmbtu change in effective gas costs for IGL/MGL could result in ~Rs5/kg price increase (keeping margins at current levels); however, if margins compress, the price hike could be lower. While there would still be a differential versus petrol/diesel, we believe the discount would lessen to a point where petrol/diesel users would find it unattractive to switch (to < 15% from 50% currently). Both scenarios would be a negative, as demand would be hit in the former case, while profitability for CGDs would take a hit in the latter (our calculations suggest a 300bps decrease in demand growth for CNG would impact FY20E and FY21E EPS of IGL/MGL/GGL by 5%/3%/3% and 9%/7%/6%, respectively.

PNG connections may rise: According to the Committee, the subsidy to the domestic PNG connections could be given to consumers in the form of Direct Benefit Transfer (DBT), akin to LPG consumers. Given that there is no explicit subsidy element involved in the price, we remain curious as to how this would be implemented. In any case, any compensation to customers, which makes PNG prices more affordable, could result in consumers converting from LPG to piped natural gas connections. We expect absolute retail price of domestic PNG to increase by 30-35%, in case the move is implemented.

CGD bid economics to change: The aggressive targets for CNG/PNG by the winning bidders in the recent 9^th and 10^th round of CGD auctions have been done, assuming a continuation of the current gas allocation policy and hence, a sudden change can adversely impact the economics and business cases for several cities. We see this as a material negative for new players like Adani Gas who have built a substantial portfolio of new districts in the 9^th round and have put in multiple bids in the 10^th round as well.

VIEW: Negative for CGDs, contrary to government’s aim to expand gas usage

The term subsidy itself is a misnomer for the segment, as the gas being supplied to domestic/CNG segments is at domestic prices, which is based off a formula decided by the government and is a weighted average price of 4 international prices (USA/Russia/Canada and Europe). Hence, there is only a concessional rate of gas being supplied to the CGDs and no subsidy is present in the same. We are negatively surprised by this recommendation, as the direct impact of a 40% increase in CNG prices runs contrary to government’s intention to expand gas usage and encourage switch from liquid petroleum fuels. However, the move to directly subsidise PNG in the form of Direct Benefit Transfer (DBT) could encourage conversions from LPG to PNG, in our view. Although we continue to believe this recommendation would be rejected, but if accepted, could cause volume growth of all CGDs to come under pressure in the near term. We remain positive on the long-term prospects of CGDs, but in the current news environment, the player with lowest dependence on domestic PNG/CNG segment (GGL) would stand out among CGDs. We reiterate our Outperformer rating on IGL, MGL and GGL, with GGL as our preferred pick.