Petronet LNG Ltd: Investment Thesis – Introspeck

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Industry and Company Overview

India has had an awful lot of challenges and misfortunes in increasing the use of natural gas. With the intent to move to cleaner fuel, active focus on developing domestic natural gas has been laid since early 2000’s. The Krishna Godavari Basin was discovered in 2003 and was touted to be the world’s largest natural gas field at that point of time (discovered by RIL, of course! No PEs chasing though). As this gas field started coming on stream, large infrastructure of pipelines, fertiliser plants and gas fired power plants were laid around it, anticipating a cheap source of fuel. However, the peak of production came up abruptly in 2011, at around 44 MMSCMD, while it was still in its ramp up stages and declined sharply thereafter.

With KGD6 not supplying any gas, industries like fertilizers and gas power suffered. Without going into the reasons of why this sudden decline happened (the controversies could fill in another blog), suffice to say that India had a lot of upstream capacity, but no downstream raw material. This situation was dire for gas fired power plants, all 25 GW of it became financially distressed. As former SBI Chairman put it succinctly to the parliament standing committee – “For gas-based power plants, honestly, if I have to submit, there seems to be no solution. It is because even when the gas was at around 2.5 dollars, even then these plants had viability issue. When these plants were set up, the underlying assumption was that the domestic gas from the Kaveri Basin will be available at a cheap price. Based on that, all these investment decisions were taken.”

With limited gas available from other fields of ONGC and Oil India, the government came up with rules whereby the GoI took a call on which sector could get the domestic gas at a priority, while all other customers were to rely on imported LNG (Liquified Natural Gas). And here is where we start delving into today’s company. Natural Gas in its primary state cannot be transported economically, for which, it is first liquefied at a liquefaction terminal, transported and then gasified again at a regasification terminal. Due to this process, prices of imported LNG are always higher than domestic LNG. Eg. In2018, India imported LNG cargoes in the range of USD 6.8 – 10.6 USD per MMBtu, while the domestic price (regulatory controlled) was USD 4.7 / MMBtu, as per IEA.

Along with domestic development of gas assets, the GoI also entered in long term contract with Qatar, world’s largest NG producer for purchase of LNG starting 2004 for a period of 25 years (the agreement will end in 2028). Petronet LNG Ltd., a public sector undertaking was created as a regasification terminal at Dahej, Gujarat to receive this liquid gas cargo from Qatar. Petronet signed 2 back to back agreements – one with RasGas of Qatar and other vendors for receipt of gas and another with GAIL and other offtakers for sale of the same. So although the inventory entered the Petronet’s books, it did not assume any risk on the same.

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Further, Petronet LNG was assigned a fixed regas margin which increased by 5% every year and was payable per MMbtu, with its cost structure largely employees, power, maintenance and depreciation. Starting off with 5 MMTPA (20 MMSCMD) in 2004, the company today has a capacity of 17.5 MMTPA at Dahej and 5 MMTPA at Kochi. It is also noteworthy to know that Petronet’s Dahej LNG capacity utilization has been above 100% in almost all years as all the long term contracts have been channelled through it. As of today, Petronet LNG owns 60% of all on stream regas capacity in India, with Dahej terminal accounting for 47% of the 37.5 MTPA.

Below is the snapshot of company’s fundamentals –

Particulars 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Sales 10,649 13,197 22,696 31,467 37,748 39,501 27,133 24,616 30,599 38,395
increase by   24% 72% 39% 20% 5% -31% -9% 24% 25%
EBIT  847 1,216 1,829 1,937 1,498 1,439 1,586 2,592 3,314 3,294
increase by   44% 50% 6% -23% -4% 10% 63% 28% -1%
EBIT Margin 8.0% 9.2% 8.1% 6.2% 4.0% 3.6% 5.8% 10.5% 10.8% 8.6%
PAT Margins 3.8% 4.7% 4.7% 3.7% 1.9% 2.2% 3.4% 6.9% 6.8% 5.6%
Asset Turns 1.8 1.8 2.5 2.8 3.2 3.5 2.1 1.7 1.9 2.5
Total Assets / NW 2.7 2.8 2.6 2.5 2.4 2.0 1.9 1.8 1.6 1.5
RoNW 18% 23% 30% 26% 14% 16% 14% 21% 21% 21%
Source: Company Filings

Petronet has earned above cost of capital returns over the last 10 years, while also turning net cash over last 3 years. However, since a large amount of gas handled by the company is pass through, a deeper dive needs to be taken to understand what moves its fundamentals, as the profit and sales diversion in 2014 and 2017 (marked in red) are quite intriguing.

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Petronet LNG is primarily a trading entity which receives a fix amount of margin for every Mmbtu it processes, due to which its profitability is linked to the volume, and not to the top line number, increase / decrease of which depends on the price of LNG sourced by final offtaker. Therefore, it makes sense to break Petronet revenues in 2 streams –

Particulars 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
LNG Sales 10,603 13,106 22,451 31,297 37,545 39,093 26,248 23,396 29,048 36,620
LNG Purchase   9,665 11,801 20,587 29,212 35,849 37,611 25,076 21,417 26,690 34,417
LNG Contribution  938   1,305   1,864   2,085   1,695   1,482   1,172   1,979   2,358   2,203
Regas + Others 46 92  245  170  203  408  886   1,220   1,551   1,776
Net Revenues  984   1,396   2,109   2,256   1,898   1,890   2,058   3,199   3,908   3,978
increase by   42% 51% 7% -16% 0% 9% 55% 22% 2%
Dahej LNG – TBTU  384  440  548  525  494  521  566  714  816  820
increase by   15% 24% -4% -6% 5% 9% 26% 14% 1%
Realization per mmBTU 25.6 31.7 38.5 43.0 38.4 36.3 36.4 44.8 47.9 48.5
increase by   24% 21% 12% -11% -6% 0% 23% 7% 1%

What we have done above is remove the impact of pass through effect of purchase and sale of natural gas and calculate the margin earned by Petronet LNG on both sales through long term contract, spot operations as well as offering regas services for other offtakers (pure service income). When analysed from this perspective, one realises that Petronet LNG is a quite a profitable entity basis –

Particulars 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Net Revenues 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%
Employee Costs 2% 2% 1% 2% 2% 3% 3% 2% 2% 3%
Depreciation 16% 13% 9% 8% 16% 17% 16% 12% 11% 10%
Power and Fuel 5% 5% 5% 7% 10% 10% 8% 5% 5% 5%
Other OH 7% 6% 7% 6% 9% 11% 11% 12% 8% 9%
OPM 70% 74% 78% 78% 63% 59% 61% 69% 74% 72%

Although its impressive margins, what I am currently stuck at is the realization per mmBTU, which should ideally increase by 5% every year, which has not been the case –

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Particulars 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Realization per mmBTU         25.6         31.7         38.5         43.0         38.4         36.3         36.4         44.8         47.9         48.5
increase by   24% 21% 12% -11% -6% 0% 23% 7% 1%

The variations in realizations could mean one of the following –

  1. The contracts signed by Petronet with GAIL / other offtakers are not completely pass through and there is some inventory risk that rests with Petronet.
  2. Petronet also buys and sells spot LNG as a trader and has these variations on account of profit/loss on trading.
  3. The volumes reported by the company are only for Dahej, while revenues include Kochi terminal too. However, this error should not be significant since the Kochi terminal has been operational around since 2015 and has been significantly underutilised.

For now, I have been unable to understand this. And with the possibility of point #1 or #2 above, there is much more risk in the company than what currently appears to be.

Business Analysis

A lot of discussion above has been about the Dahej terminal, and it is not in vain. For, Dahej gives a significant advantage to Petronet LNG as an ideal location to import gas from. What is noteworthy in the below table?

As can be observed, there is a wide variation in capacity utilization between the terminals of Dahej and Hazira and others, while Dahej capacity keeps getting bigger. An illustration below might help –

One can see a large number of pipelines originating from Dahej and Hazira crisscrossing India, all of them being established by GAIL over the years. Since pipelines are the cheapest mode of transporting gas over long distances, Dahej and Hazira stand at a significant advantage over other locations since establishing newer pipelines is long duration and cumbersome, and putting up more of these has slowed down ever since domestic production declined. New terminals established at Kochi, Ennore and Mundra have not yet reached the kind of utilization levels that incumbent terminals have.

In fact, scale advantages also make Dahej terminal the cheapest currently in regas charges, as can be seen from below –

Terminal ReGas charges per mmbtu
Dahej 50
Mundra 60.1
Ennore 57.2
Kochi 104

In that respect, the company does seem to possess some competitive advantage stemming from preferred location, capacity tied up in long term contracts and economies of scale with respect to storage and regasification, helping it earn superior margins and returns.

Capital Allocation and Corporate Governance

While the company has benefitted significantly from reinvesting in the Dahej Terminal, its Kochi terminal has been under very low utilization since Aug 2013, on account of delays in setting up pipeline infrastructure by GAIL, which resulted in the company transporting high cost gas in trucks and also charging almost 2x the regas charges. The pipeline was expected to be commissioned in April 2020. Further, the company is expected to put up capex of around INR 100 – 220 crores for LNG pumps on highways, on instructions of the petroleum ministry to increase the use of LNG in transportation.

Although the capex envisaged in LNG pumps is currently low, the same foreshadows the grim fate suffered by its parent GAIL, which turned from a profitable gas pipeline transmission company to an integrated trading behemoth with multiple interests which ruined its operations financially.

Finally, right when I was concluding my research, an article came to notice that there have been allegations of corruption against the CEO and other senior officials of Petronet LNG and as of now, they are suspended and under investigation. I thought I had come to the throes of an investible PSU, only to be proven wrong, thankfully, before committing any capital. However, do I consider all the previous research to be futile? Although I wont invest in this idea, learnings about Petronet LNG Ltd. has given me deeper insights into India’s gas industry, which hopefully helps me in other ideas.

Do reach with your comments or feedback, if any. Stay safe and happy investing!

Update – 6th July 2020

I asked the management of Petronet LNG the following questions in the call hosted by them on 30th June –

Q1. – I see a structural uptrend in margins starting from FY17. Could you help me understand the reasons for the same? A: The answer to the same was it is on account of better realizations of cargoes that the company has sold on its own accord and not the long term contracted cargoes, along with 5% increase in regas margins.

Q2: What % of company’s volumes come from 0 pricing risk and have a back to back offtake arrangement? A: the management reported that almost 100% of the cargoes have back to back contracts with the company carrying minimal pricing risk.

Both the above responses are in contrast to each other since if a large number of contracts dont have a pricing flexibility, the outstanding trading margins cannot be made, and due to this inability to understand the movement in margins, i am unable to arrive at a valuation. please feel free to write back in case you can decipher this dichotomy.

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Umang Shah

Umang Shah

Through his writing, Umang shares his perspectives on how he thinks of investing, decision making, books and life in general.
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