Cairn India plans to develop the Mangala, Bhagyam and Aishwarya (MBA) oil fields in its RJ-ON-90/1 block in Rajasthan and to start production by 2009. One of the main stumbling blocks to development of these fields is the resolution of issues related to a pipeline for evacuation of crude. CIL is ready to build the pipeline to evacuate the crude if the pipeline cost is allowed as recoverable. CIL has sought government approval for a pipeline from the Rajasthan fields to Salaya on the west coast of India near Jamnagar. CIL has been awaiting government approval.

The Indian government has granted permission to CIL to acquire right of use (RoU) for building the pipeline from Rajasthan. The Indian government is believed to have written to the state governments of Rajasthan and Gujarat to appoint agencies, which will help CIL get the RoU for the pipeline. The government appears to be in favor of pipeline cost recovery being allowed. However, no formal approval has yet been given.

Cost recovery being allowed is crucial for building the pipeline being NPV neutral for CIL. If cost recovery is not allowed and CIL still goes ahead with the pipeline, it will reduce CIL’s NPV. Hit to its NPV would be US$ 450-625 million (Rs 10-15 per share) depending on whether CIL incurs the entire cost of the pipeline of US$ 700 million or just 70%. If ONGC does not incur its share of pipeline cost (30%) CIL will have to bear the entire cost.

Revised FDP may be filed in October 2007; approval in 90 days Formal approval to cost recovery being allowed is likely after CIL files a revised Field Development Plan (FDP) for Mangala including the pipeline cost and the same is approved. CIL is likely to file a revised FDP including the pipeline cost in October 2007. The FDP, once filed, has to be dealt within a time bound manner (within 90 days) by the government.

In the interim until the revised FDP is approved, CIL is likely to focus on getting RoU from government agencies. In order to meet the projected schedule, the front end engineering and design for the pipeline has already been completed. The procurement process for several long lead items has commenced. Capex on the pipeline is, however, likely only after cost recovery has been formally approved.

Pipeline issue had become a stumbling block to oil fields development As per the PSC of the RJ-ON-90/1 block, CIL was

1) Required to deliver the crude to the government nominee at the delivery point, which was in the block

2) Entitled to price for the crude, which was in line with the fob price of the most similar international crude in terms of quality

ONGC, CIL’s partner in the block with 30% interest, along with its refining subsidiary MRPL had planned a 7.5mmtpa (150k bpd) refinery in Rajasthan. The
government in 2005 appointed MRPL as the nominee to buy CIL’s crude production from the block. However in mid-2006 the refinery project was shelved. MRPL continued to be the nominee. It was faced with the prospect of laying 500km pipeline to transport crude from Rajasthan to the Gujarat coast and then ship it to its existing refinery in Mangalore. MRPL was unwilling to pay the PSC price in the changed scenario. It is believed to have asked for a US$ 5/bbl discount to the PSC price of oil. This discount was to make up for the cost of evacuating the crude.

However a steep discount to PSC price, which MRPL asked for, was not acceptable to CIL. It instead proposed to lay the pipeline to evacuate the crude if the cost of laying and operating the pipeline was allowed as cost recoverable. Under the PSC there was an option to change the delivery point of the crude with mutual consent. CIL therefore submitted a proposal to the government to shift the delivery point where the pipeline ends as against in the oil field. If approved it would mean all costs before delivery of crude were the responsibility of CIL but these costs would also be recoverable. CIL got ONGC’s concurrence on the issue in April 2007, while the crucial government approval is now awaited.

The government’s approval for cost recovery would imply the following:

Production to start on schedule in April 2009: Crude oil production is likely to start from the Rajasthan block RJ-ON-90/1 in April 2009 as scheduled. Cairn management has indicated that early resolution of the cost recovery issue is key to production starting on schedule. The actual construction of the pipeline is likely to take only 9-12 months once RoU has been acquired.

Merrill Lynch sees good prospects of further accretion of reserves in the RJ-ON-90/1 block. There are three potential drivers of reserve accretion in this block:

10-20% (44-88m bbls) upside to 2P reserves in the Mangala and Bhagyam fields. CIL has been indicating since May 2007 that peak output may be 165-180k bpd as against 150k bpd expected earlier. The rise in peak output is in line with a corresponding upgrade in reserves in these two fields.

Enhanced oil recovery (EOR) techniques may increase recovery rate in the MBA fields by more than 20% vis-à-vis 10% (196mmboe) currently assumed.

More upside is also expected from other fields in the Rajasthan (Barmer Hill formation being the main) block. In-place oil in these fields is 1.7bn bbls but 2P reserves and resources assumed are just 68mmboe, implying just 4% recovery rate.

CIL had at the time of its IPO indicated that peak output would be 150k bpd from the Mangala, Bhagyam, Aishwarya, Saraswati and Rageshwari fields. Since May
2007 it has been indicating that it is confident of achieving 150k bpd peak output just from the Mangala and Bhagyam fields. CIL had indicated output from the
three other fields to be 15-30k bpd. Thus it now appears peak output could be 10-20% higher than originally indicated at 165-180k bpd. CIL also indicated this likely rise in peak output was in line with similar change in reserves. Thus it appears that CIL’s share of 2P reserves from these fields, which was earlier estimated at
442m bbls, may be higher by 44-88m bbls. If indeed recovery rates are boosted by more than 10%, there would be further rise in reserves to that extent. If for example the recovery rate rises to 10%, CIL’s share of reserves would rise by 138mmboe.

CIL has successfully completed laboratory tests on EOR techniques it plans to use in Rajasthan. EOR will boost recovery rates and help sustain peak output for 7-10
years instead of 3-4. It is now conducting simulation tests and believes it will have more clarity on EOR working in 2008. However, CIL plans to do field tests only in
2009. Thus, complete clarity on accretion of reserves due to EOR is likely in 2009.

The fields in the Rajasthan block other than the MBA fields have in-place oil of 1.7bn boe. The 2P reserves and resources assumed from these fields are just 68mmboe. Thus the recovery rate assumed implicitly is 4%. Recovery rate in the three main fields is expected to be 33% without EOR and 43% with EOR. As more
work is done in these other fields we see further reserve accretion. The Barmer Hill formation is the main area, where significant further reserve accretion is possible.

CIL is now focusing on monetizing discoveries in the larger fields discovered such as Mangala and Bhagyam. As issues relating to their development are sorted out,
attention will be focused on further exploration of other prospects including Barmer Hill. Hydraulic fracturing has been successfully tested in the Barmer hill formation. It is above the Mangala and Aishwarya fields. CIL has indicated that more clarity on potential reserve upside from the Barmer hill formation is likely in 2008 when CIL drills development wells in Mangala and Aishwarya.

There are also prospects of reserve accretion in other exploration blocks in which Cairn has interest. Cairn has 12 exploration blocks in India, including several in the
highly prospective basins like Krishna-Godavari (KG), Barmer and Cambay basins.

There are indications of reserve accretion in the KG-DWN-98/2 deep water block, in which CIL has 10% interest. ONGC, its partner in the block, has put in-place
gas reserves based on one discovery at 2tcf.

CIL is one of the very few private independent E&P companies in Asia. It is a potential acquisition target. The probability of acquisition would go up after the cost recovery issue is favorably resolved. Thus a potential acquisition could be a significant share price driver.

CIL is trading at 5x 2010E EPS and 4.3x 2010E P/CF. Merrill Lynch believes that investors would find it attractive at these valuations. This could trigger a rise in its share price. However, this attractive valuation may start acting as a share price driver only some time in 2009E.