Closure on the Cairn India Ltd deal seems to be in sight. The cabinet committee on economic affairs (CCEA) has extended a conditional approval of the deal. The conditions are that the royalty paid by Oil and Natural Gas Corp. Ltd (ONGC) on the Rajasthan block be made cost-recoverable and that Cairn India should withdraw the ongoing arbitration on the cess issue.
Currently, ONGC bears the entire royalty burden despite holding only 30% stake in the Rajasthan block.
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An indication that the royalty could be made cost-recoverable (added to project cost, which is deducted from oil sale revenue before profits are shared) came last week when the deal value was lowered.
Cairn Energy Plc and Vedanta Resources Plc decided to waive off the non-compete fee—Rs50 per share—which translates to around a 9% decline in the purchase price for Vedanta.
That implies there are good chances the Cairn India board may accept the pre conditions. If that happens, analysts’ maintain it would knock off Rs50-65 per share from their target price for Cairn India.
But, much to the Street’s surprise, the Cairn India stock shot up by around 5% on Friday to Rs326 a piece.
Why did that happen?
One reason could be that the uncertainty surrounding the deal is reduced with this development. Secondly, it’s likely the road ahead, as far as the core business operations are concerned, would now be smoother as frictions between the big stakeholders stand reduced.
Cairn India intends to exit the calendar year with production of 175 kilo barrels per day (kpbd), including 150 kbpd from the Mangala field and 25 kbpd from the Bhagyam field.
At present, the Mangala field produces 125 kbpd. “Our enhanced understanding of the Mangala reservoirs, following development drilling in the field, indicates a production potential of 150 kbpd, subject to JV (joint venture) and GoI (government of India) approval,” said the company in its March 2011 results statement.
Prior to the recent developments, some analysts had highlighted in their March quarter post-results updates that the approvals for incremental Mangala output would be one of the key hindrances to Cairn India achieving its production guidance because the approval for the deal was pending.
“The near-term impact aside, a change in the contract terms may finally align the government (which was unhappy on cess) and ONGC (which was unhappy on royalty) with Cairn, and help exploit the full potential of the Rajasthan basin,” wrote analysts from CLSA Asia-Pacific markets in a note to clients last month, when a group of ministers had recommended the CCEA should clear the deal only if royalty is made cost-recoverable and the ongoing arbitration on cess is withdrawn.
Simply put, if Cairn and Vedanta agree to the conditions, they can go ahead and increase output.
The CLSA note adds, “Mangala output could ramp up from 125 kpd to 150 kbpd quickly if approvals come through, taking output beyond 175 kbpd by end-2011.”
Of course, there are serious issues of whether the government can indeed change the conditions of a contract so cavalierly, and whether it can browbeat companies to withdraw arbitration proceedings.
If the board accepts CCEA’s pre conditions, it would be contrary to what Cairn India and Vedanta have been saying all this while about protecting the interests of minority shareholders, since they have maintained minority shareholders will be hurt by any decision to recover royalty.
But it’s also true that crude prices are now much higher, which should offer a lot of comfort.
Since the announcement of the deal in August, Cairn India stock has lost 8%, compared with a 3% gain in the benchmark Sensex index on the Bombay Stock Exchange during the same period.
Investors in Cairn India, the only pure crude play in the country, could not benefit when crude prices increased considerably due to the uncertainty surrounding the deal.
Perhaps, the good thing now if the deal is sealed will be that the stock can go back to being a pure crude play.
Meanwhile, ONGC is having the last laugh in this drama. This column wrote last week that sentiments have improved for ONGC from a medium-term perspective after the recent fuel price hike and the likely imposition of a royalty burden on Cairn India.
Needless to say, this would give a boost to ONGC’s upcoming follow-on public offer (FPO).
However, one must keep in mind that government FPOs have typically come at a discount to prevailing market prices to attract good response from investors.
That should act as an overhang on the stock, going by what happened to other FPO candidates. Moreover, the subsidy issues remain.
Graphic by Ahmed Raza Khan/Mint
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