Fuel for the future

Carrying 1.2 lakh tonne of natural gas at 1600C, the LNG tanker, Meridian Spirit, pulled up at Gail’s re-gasification plant at Dabhol on March 25. The 900-ft-long vessel had concluded its 25 day long voyage, bringing in India’s first-ever cargo of imported gas from the US. 

Meridian Spirit’s shipment is part of a sale and purchase agreement between the state-owned Gail and US-based Cheniere Energy. Over the next 20 years, India will import 35 lakh tonne of LNG every year from the US at a cost of $548 million per year till the contract runs out.

India’s ambitious plans for the gas sector aims to more than double the share of natural gas to 15% by 2030. That will come on the back of a 7.2 % CAGR in the country’s gas consumption to 115 billion cubic meters (bcm) for the next 12 years. 

But, India’s current gas production is not sufficient to even meet the presentrequirement. In FY17, India produced 31 bcm of gas, which was just enough to cater to 62% of the requirement. Domestic gas production has declined by 40% since 2010. After hitting a peak of 50 bcm in 2010, India has been producing just about 30 bcm of gas for the last three years. This pitiable situation is due to decrease in output at Reliance’s KG basin field and ONGC’s maturing fields. By 2022, domestic gas is expected to rise to 41 bcm, yet it will be inadequate to meet even the present demand (See: Stepping on the gas). 

Imports is the other alternative. Even though landed price of LNG at $8 mmbtu is 2.6x the price of domestically-produced gas, the government is looking at imports to bridge the gap. At present, India is operating with four re-gasification terminals owned by Petronet LNG, Shell and Ratnagiri Gas and Power, which have a combined capacity of 250 lakh tonne. There are not enough terminals that can store imported LNG and re-gasify it for end-use. 

Despite the challenges, the government wants to reduce India’s reliance on crude oil and instead, focus on natural gas, a cleaner and less expensive fuel. No wonder, the government’s push along with a more favourable regulatory environment is making fund managers and analysts bullish on the sector. “Globally, there is an oversupply of gas, which is keeping prices low. In India, we have seen the judiciary intervening and banning the use of petcoke and fuel oil in some states. All this augurs well for gas-related companies,” says a fund manager. And in the current market where growth remains evasive for most sectors, gas-related companies offer several opportunities with a clear earnings visibility.  

So, who do you bet on? Analysts reckon gas-infrastructure companies will be the best bet as they will have to fill the large gaps in India’s gas pipeline and re-gasification network, offering huge room for growth. 

Petronet’s terminal growth
With more than 60% of India’s re-gasification capacity operating through its terminals in Dahej and Kochi, Petronet LNG is likely to benefit due to the surge in LNG imports. Analysts expect the company’s earnings to compound at 20% annually over FY17-FY20 (See: What’s in the pipeline?). 

Currently, the Dahej terminal’s capacity is already booked above its nameplate capacity. To handle the incremental growth in imports (expected to rise 53% to 300 lakh tonne by 2020), Petronet has completed 70% of the project to set up additional capacity of 2.5 MMT at Dahej. Meanwhile, its Kochi terminal’s capacity utilisation stood at just 15% as of Q3FY18 due to lack of adequate pipeline connectivity. However, by next fiscal, the terminal is expected to operate at 40% utilization as it would start supplying to Karnataka through Gail’s upcoming Kochi-Mangalore pipeline project expected to be completed by the end of this fiscal. Both, the ramp-up in capacity utilisation at Kochi and the capacity expansion at the Dahej terminal should provide a volume growth of 5%-7% for Petronet,” says Mayur Matani, analyst at ICICI Securities. “Besides, its back-to-back purchase-sale agreements also make the business model predictable,” he adds. Also Petronet LNG has an internal mechanism of taking a 5% tariff hike every January. It is an already negotiated and agreed upon number with the customers. 

As a matter of fact, Petronet’s growth is also de-risked as 90% of its capacity is pre-sold on use-or-pay terms. This prevents customers from switching to other terminals, thereby providing long-term volume visibility. Thus, even in the recent market sell-off, shares of Petronet LNG have remained flat. The stock is currently trading at 15.2x one-year forward earnings, which is not much considering the company’s earnings growth potential.  

Gail’s pipeline dream
Gail, which operates 11,000 km of gas pipelines accounting for 75% of India’s pipeline network, will also benefit as more gas is facilitated through its pipelines. “Gail has multiple growth drivers in the medium-term,” claims Avishek Datta, analyst at Prabhudas Lilladher. The main trigger will be gas transmission volume, which is expected to grow at 8% CAGR over FY17-FY20. 

The growth in volume would be spurred by demand from urea producers and city gas distributors as they ramp-up their capacities. At present, fertilizer companies’ urea production capacity stands at 21 million tonne. By FY20, the capacity is expected to rise to 24.8 million tonne as the government plans to revive some of the shut fertilizer plants. By FY22, the capacity is estimated to reach 28.6 million tonne. 

The second driver for Gail will be city gas distribution. By FY22, the government plans to have as many as 312 city gas projects up and running. This would mean a 50% increase in gas consumption from current levels. 

According to analysts, by FY20, Gail’s pipelines could be handling about 25% more volume than a year ago. The stable flow of gas volume could improve the utilisation levels of Gail’s pipeline network, and boost the company’s earnings by 16% per annum over the same period. 

Gail is laying a 2,655-km gas pipeline from Jagdishpur in Uttar Pradesh to Haldia in West Bengal, extending to Bokaro in Jharkhand and finally ending at Dhamra in Odisha, to improve gas connectivity in eastern parts. 

The western and northern parts of India are presently well covered: over 70% of India’s total gas pipeline network (of 16,470 km) provides gas connectivity to these parts. However, there is a lot of latent demand in eastern and southern parts that can be tapped. Being built at a cost of #12,900 crore, the pipeline is expected to be ready by 2020. If Gail is able to complete its pipeline projects ahead of schedule, there could be a positive surprise on the volume front. 

Then again, Gail’s earnings could grow at an even faster rate if the Petroleum and Natural Gas Board accepts the proposal of unified tariff. The tariff proposed is 60% higher than the average tariff Gail earned in FY17. If this happens, analysts predict a 35%-45% rise in Gail’s earnings. “Unified tariff is very likely, but it is difficult to guess when it will be implemented. The pending tariff orders on Gail’s individual pipelines could be approved sooner though,” says Matani.   

Even with the present modest tariff rates, Gail’s operating margins are expected to reach 17.5% in FY20, according to Harshvardhan Dole, analyst, institutional equities, IIFL.

Over the last six months, Gail's stock has remained flat. The company is currently trading at 10.4x one-year forward earnings. Matani at ICICI Securities says, “Valuations are attractive.”

The City gas network effect
There is ample opportunity for city gas distributors as well. With gas distribution contracts covering 156 districts open for bidding, analysts expect city gas distribution projects to more than double to 84 by FY20. This is a great opportunity for players such as Mahanagar Gas, Indraprastha Gas and Gujarat Gas to expand their reach and grow volume, but not all of them are looking at growth with the same lens.  

Gujarat Gas is likely to emerge as the most aggressive player, focused firmly on growth. While sharing his company’s plans for the recent round of bidding, Nitin Patil, Gujarat Gas’ CEO said in a recent media interaction that the company would even be looking to bid for franchises as far as Chennai. Mahanagar Gas, on the contrary, is likely to stay conservative in order to maintain its margins. Indraprastha Gas, again, intends to retain areas around the NCR region and gain from network effects. 

Analysts thus estimate that while Gujarat Gas’ earnings will leap at over 30% CAGR over FY17-FY20, Indraprastha Gas and Mahanagar Gas will grow at a modest rate of 17% and 14%. 

What works well for Indraprastha Gas is the regulatory tailwinds and easing of infrastructure congestion in Delhi NCR. The judiciary has also been actively taking interest in expansion of public transport buses, which will help in decongesting the capital city. Entry into new geographical areas (Rewari, Karnal and part of Gurugram) also bodes well. The recent Supreme Court order banning use of petcoke and fuel oil in and around Delhi will make industrial PNG the next leg of growth. Indraprastha Gas is also likely to benefit from conversion of private cars from liquid fuel to CNG. Lately, conversions have gone up to 3,000-3,500 per month. The stock trades at 27x one-year forward earnings. 

Gujarat Gas’ growth will chiefly ride on the rising demand from its key industrial clusters. For instance, Morbi, which accounts for 54% of Gujarat Gas’ industrial volume is expected to see volume growth of 12% CAGR over the next three years. Growing focus on exports and shift to vitrified tiles will drive volume in Morbi. Industrial volume accounts for 70% of Gujarat Gas’ total volume. Industrial areas in Gujarat have already seen some regulatory push in the direction of cleaner fuel. Further regulatory push in industrial areas like Vatwa, which fall within the city limit, is also highly likely. Also, as many sub-sectors like chemicals, tiles and ceramics become export-focused, using a cleaner fuel to meet environmental norms would become inevitable. The stock trades at 33x one-year forward earnings, reflecting the potential.

The cheapest stock in the city gas pack is Mahanagar Gas, trading at 19x one-year forward earnings. The Mumbai-based distributor is trading at 42% discount to Gujarat Gas and 30% discount to Indraprastha Gas. In the last six months, the company’s share price has declined 15%. The discount is justified. That’s because Mahanagar Gas does not benefit from anti-pollution measures like those in the Delhi/NCR region. It also has little opportunity to replace natural gas in the industrial sector, unlike Gujarat Gas. In case of Mumbai, industries are moving out of the city. At 6% CAGR over the next two years, Mahanagar Gas’ volume growth is likely to lag behind volume growth of Indraprastha Gas (11%) and Gujarat Gas (21%) over the same period.

However, as possibility of regulatory push to increase gas use in Mumbai cannot be ruled out, the relatively cheap valuations can serve as a good opportunity to enter the stock. To its credit, Mahanagar Gas has the highest margins (Rs.8 per standard cubic meter) among city gas companies due to higher proportion of compressed natural gas and domestic piped natural gas. The company also boasts of higher return ratios of 33% compared to Indraprastha Gas’ 17% and 14.4% of Gujarat Gas. 

But all three companies are well placed to benefit from a wider use of gas. “As long as gas prices remain competitive against its substitutes, gas consumption will go up in an energy-deficit country like India, and these companies will directly benefit,” says Sudeep Anand, analyst at IDBI Capital.

As things stand, gas is a cheaper fuel compared to crude oil. Over FY16-FY20, the global gas export capacity (LNG) is likely to grow at 10.7% CAGR. At least for the next few years, the gas prices are likely to remain cheap given the global oversupply. With a structural story underway, gas sector yields plenty of opportunities. In a volatile market environment, stable growth over medium- to long-term is not such a bad idea.