Why ONGC, Oil India rose 7-9%; CLSA sees 44% upside in one of worst-performing global upstream stocks

Oil & Natural Gas Corpn Ltd  (ONGC) and Oil India Ltd, one of the worst-performing global upstream stocks, soared up to 9 per cent in Tuesday's trade after the government in a surprise move cut the royalty charged on the production of crude oil & gas, which foreign brokerage CLSA said should add fair value of 7-9 per cent for ONGC and 9-11 per cent for Oil India.  

Following the development, Oil India shares rose 9.24 per cent to hit a high of Rs 498.75 on BSE. The ONGC stock rose 6.74 per cent to hit a high of Rs 299.90 apiece.

"The action is seen removing fear of an increase in upstream taxation through a 2022-like windfall tax, which have made ONGC & Oil India some of the worst performing global upstream stocks. At $80 per barrel, we see an over-50 per cent total return for ONGC as it is pricing-in $65 a barrel Brent. Reiterate high conviction O-PF," CLSA said. 

CLSA said the signal value of the action is significant as this has come at a time of rising crude oil prices and difficult financial times for government finances. 

"These higher crude oil prices have made people speculate and fear a windfall tax could be imposed on upstream producers similar to 2022. These fears have made these companies some of the worst performing E&P stocks in the world. This surprise action to cut upstream tax instead of raising it should put fears of a new windfall tax to rest," CLSA said.

The foreign brokerage said the actions confirm the government's intention to promote policies which boost upstream exploration and production and their stance to stick to the promise made under the new law passed last year to not impose new taxes on E&P.

"We find ONGC is pricing in just $65/bbl versus Oil India at US$80/bbl. With 43 per cent upside plus, a 7 per cent yield at $80/bbl oil, we reiterate our HC O-PF rating on ONGC," it said. The brokerage suggested a target of Rs 405 on ONGC, whihc suggested 44.4 per cent upside from Monday's closing price.

Detailing the development, CLSA said nomination blocks, which form a big chunk of current production for ONGC and Oil India, the existing royalty rate on crude oil from the onshore block is 16.66 per cent after subtracting a flat Rs 3,955/ton ($5.7 a barrel) and that for offshore is 9.09 per cent after subtracting a flat Rs 2,226/ton or $3.2). 

"These have been changed by making the deduction to a standard ad-valorem 20 per cent and then applying a rate of 12.5 per cent for onshore blocks and 10 per cent to offshore block. This implies an effective cut in royalty rate on onshore production from 16.66 per cent to 10 per cent and from offshore blocks to 9.09 per cent to 8 per cent. Applying the flat deduction of 20 per cent also means the royalty on natural gas declines to 8 per cent from 10 per cent earlier," CLSA said.

Given the disputed GST on royalty, another 18 per cent should be added to this reduction to calculate the effective savings, it said. 

The government also announced this flat deduction will stand at 15 per cent for all blocks other than nomination blocks. This will drive down royalties for all Vedanta's Rajasthan field from 16.67 per cent to 10.6 per cent. Similarly, it will also bring down royalties on many other fields to further encourage exploration and the development of upstream production in India. Specifically for blocks offered after 2019 under the new Hydrocarbon Exploration Licensing Policy (HELP), rates have been further
reduced to attract fresh investment in the upstream oil & gas sector.