Gas Reserves - headline at 40tcf, new discoveries not yet measured

Niko disclosed an upgrade in the Resources Estimate leading to 2P+Best OGIP of 26.7tcf (23.2tcf earlier) and 3P+High of 40.0tcf (35.4tcf). While this incorporates results from 2 of 5 gas discoveries in FY07 and some in FY06, it leaves out MG-1, P2 and the R1 wells. The R1 well drilled to the deepest water depth is significant as it suggests that success achieved in shallower water segments could be repeated.

Oil Reserves on the lower side

For the MA fields in the D6 block, Niko also disclosed OIP-High Case of 391MMBO (255MMBO recoverable). The targeted production level is 30-35kbpd beginning 2Q08. While the oil resources are on the lower side, it is compensated by likely higher recovery, early-commissioning and ready market. In any case, we have not considered any contribution from oil revenues in our E&P business valuation based on EV/FCF.

Capex targets for D6 indicate mid-2008 commissioning

Company expects F&D capex of USD 3.25 billion in FY08 i.e. cumulative capex by end-FY08 likely to be USD 4.0 billion, out of the development capex of USD 5.2 billion for the recovery of 11.3tcf. Note that our DCF valuation of core D6 gas reserves assumes an ultimate recovery of 16.2tcf, lower than the updated 2P reserves of 16.9tcf.

Risks

Slower ramp up in gas production, lower-than-expected gas price realization (USD 4.5/mmbtu) and delay in exploratory drilling in non-D6 blocks (due to rig shortage) are key risks.

Investment thesis

We rate RIL Buy/Low Risk with a target price of Rs 2,005. We expect regional refining margins to remain robust due to project delays in the Middle East, with RIL enjoying an enhanced premium for its superior complexity. E&P business has delivered positive surprise and looks set to become more meaningful in the next 3-4 years as KG D6 field commences production and new discoveries are brought on stream. Upgrade of reserves in KG basin adds to the value, although the NAV of the gas find depends on development capex and the demand profile from anchor customers. Given the track record of exploratory success and the evolving portfolio (much beyond KG D6), RIL's E&P business needs to be valued as a going concern rather than a combination of assets. We have therefore valued E&P business (Rs 631 per share) on more traditional EV/FCF multiple rather than the consensus NAV approach. While petrochemicals will likely face pressure in FY09E, this will be offset by diversity of products to some extent. Factors such as diversity of revenues, integration across product chains, and volume growth should help RIL tide over downturns in product cycles.

Valuation

Our target price of Rs 2,005 is based on a sum-of-the-parts value: 1) RIL's core petrochem and downstream oil business is valued on an EV/EBITDA of 6.5x mid-FY09E, in line with the regional chemicals and refining peers; 2) Total E&P assets including oil & gas prospects and other blocks are valued at Rs 631 per share based on 10x steady state (FY11E) FCF; 3) Investment in IPCL and RPL valued at 8x profit contribution to consolidated profits; 4) Organized retail business value is rolled forward to Mar-08E and factored in at Rs 125 per share, as per Citigroup's Retail Analyst, Princy Singh; and 5) Treasury stock is valued at RIL's target price.