As Good As It Gets

Though Reliance Petroleum's upcoming Jamnagar refinery enjoys many advantages, its current valuations have limited upside left

DESPITE A DECLINE in investors' confidence in the stock market and the turmoil in global financial markets over the past six months, there remain a few events which are eagerly awaited by all. One such event is the commissioning of Reliance Petroleum (RPL)'s refinery in Jamnagar special economic zone (SEZ) — which is being tracked not just by its 2 million shareholders and stock market experts, but by global energy analysts as well.
    The project is expected to serve as an example for its speed of execution, low capital cost and high complexity. However, the strength in global gross refining margins (GRMs) is unlikely to persist going forward, due to rising refinery capacity across the world. Though the positives associated with RPL's refinery are obvious, we believe its current valuations have limited upside left.
ADVANTAGES GALORE

• Low Capital Cost: RPL is being set up at a capital cost of only Rs 27,000 crore, i.e. around $6.5 billion, but a similar-sized refinery will currently require almost twice this amount. This is due to the fact that over the past three years, a number of refinery projects have been launched across the world, resulting in higher costs of equipment and engineering services.

• Fast Project Execution: The project was originally scheduled to be completed in 36 months by September '08, with commercial production due to start in December '08. However, the company intends to prepone the deadlines. It has already completed more than 90% of the work and the pre-commissioning activities in the main process units are progressing rapidly.
    In fact, Mukesh Ambani assured shareholders at the company's annual general meeting (AGM) last month that "the refinery is expected to be completed ahead of schedule."

• Ability To Earn Higher GRMs: RPL's refinery will have the ability to handle very heavy and high sulphur crude to produce the best quality products. Similarly, its product slate will be better, thanks to its ability to totally eliminate lowvalue products such as fuel oil. Considering that the heavy-light differential in crude prices has reached $20 a barrel, RPL will be able to earn higher GRMs compared to its peers.

• Tax Sops: The SEZ location and focus on exports will exempt RPL's profits from income tax (IT) fully for the first five years. The I-T exemption will be 50% for the next five years.
LIMITED UPSIDE
After enjoying a high tide in the past few months, Asian GRMs are now weakening. The International Energy Agency (IEA) in its monthly report for June '08 elaborated on this fact. "While diesel remains highly profitable, gasoline cracks remain subdued and fuel oil cracks have reached record lows." Even production of naphtha is generating losses.
    When overall GRMs turn weak, it is feared that commissioning of RPL's refinery will lead to a glut situation, thereby further bringing down GRMs. The supply from RPL's new refinery will represent almost 50% of the estimated incremental global oil demand in '09.
    Nearly 2 million bpd of global refining capacity (including RPL) is expected to commence in '09, which will weigh heavily on the GRMs.
    RPL operates in a business where there is little scope for volume-led growth compensating for a fall in margins. Hence, if GRMs turn weak from the current levels, the company's bottomline may shrink.
VALUATIONS
We estimate the refinery will earn a premium of around $9 per barrel over Singapore benchmark complex refining margins, which are expected to remain at around $8 per barrel during FY10.
    Considering interest and depreciation charges, the company's full-year net profit at 85% capacity level will stand at Rs 6,365 crore. This translates into a price-to-earnings (P/E) multiple of 10.9 on the current market price of Rs 154.
    Since petroleum refining is a capital-intensive cyclical business, it has traditionally commanded a single-digit P/E globally.
    Another way of looking at valuations, is the replacement cost of the refinery. RPL's current market capitalisation of Rs 69,300 crore is around 38% higher than the estimated cost of setting up a similar refinery.
    Similarly, at current m-cap, RPL's enterprise value (EV) is 8.5 times its estimated EBIDTA for FY10, which is slightly on the higher side compared to the global average. Hence, we believe that the upside in RPL's scrip is limited in the short run.
ramkrishna.kashelkar@timesgroup.com