Has Covid-19 Accelerated The Shift Toward City Gas Distributors?BloombergQuintOpinion
The city gas distribution sector has outperformed the Nifty in the first half of 2020, aided by margin expansion and a strong balance sheet, free cash flow profile.
In post-Covid India, two forces are likely to define energy consumption:
- The availability of much cheaper and environmentally-friendly gas for end-consumers.
- The ability to source it conveniently for industry and individuals alike.
The fact that prices of petrol and diesel are no longer ‘deregulated’—if anything, they are regulated to stay high—enhances the need for a much cheaper vehicular fuel. As for home use - ask any homemaker who has moved from an area with piped CNG to an area with LPG cylinders, and you would know the difference in customer satisfaction and desire for piped natural gas.
A Morgan Stanley report notes that natural gas demand held up relatively better than most fuels during the pandemic, and even at the peak of the lockdown it had declined only 30% from pre-Covid levels. Industrial and household consumers used piped gas as the fuel of choice. It is, therefore, a fair hypothesis to make that with cheap prices and easy access, natural gas may see a faster increase in acceptance, relative to other alternatives. The convenience, cost, and environmental benefits all fit in. Experts who look at long-term patterns would argue that city gas distribution could drive India’s energy patterns away from coal and oil towards gas, leading to a metamorphic impact on all sectors and on the economy itself. Analysts expect consumer energy bills to fall, some predict by up to a third.
Put together, does this make a compelling investment thesis?
The Market Dynamics
Volume growth would be a key determinant. Despite being categorised together by the market and the regulator, the business models of Indraprastha Gas, Mahanagar Gas, and Gujarat Gas are quite different. Where over 75% of Gujarat Gas’ volumes come from industrial supply, IGL and MGL volumes have a higher contribution of CNG as auto fuel . Thus, the current volume growth picture, and the pace of recovery might differ for the three players. A Jefferies note puts the volume growth assumptions into perspective. It says that while IGL has delivered a volume CAGR of 12.6% over FY16-20 aided by policy tailwinds against substitute liquid fuels, it could be challenging to beat the 10.5% longer-term volume growth priced in by the market as the base effects kick in. Gujarat Gas’ implied long term volume growth of 9.7% though has to be seen in the context of the company still having a less mature portfolio—and hence higher volumes as the portfolio matures—and upside potential from other industrial areas where it is already dominant.
For CNG-oriented MGL, the revival in the core segment would have be slower than expected as Mumbai remained a ‘red zone’ through the lockdown. But in a normalised world, these volumes could return to pre-Covid levels and then continue on the conventional trajectory. What would be lost would be volumes and earnings for a quarter or two. Investors would probably accept that.
Reason For Optimism?
The companies can focus on increasing per capita consumption of gas, by increasing gas usage in households through gas geysers, home heating, etc. Gas demand could get a boost if gas-based power plants move their utilisation rates higher, aided by cheaper gas prices. Supply-side changes are happening with more equipment suppliers now giving equipment on lease. There is also a belief that franchisee CNG stations may increase, which reduces the capex for CGD players.
A free-market price of domestic gas, at a time when imported gas prices are not very different from local benchmarks due to a global glut, does limit any sustainable negative impact on demand or margins for city gas companies. There has been high demand elasticity in gas prices in the past, largely due to a shift to alternative fuels. But with imported gas becoming available at a significant discount, there might be limited impact on demand or margins.
While the domestic administrated price mechanism prices declined for the April-September period, the crash in oil and gas prices in the first few months of 2020 is likely to result in low gas prices for October to the coming March, too. The CGDs though, have kept a portion of the gas price cut in April and not passed it on. Thus, they are likely to earn higher margins. The ability to let go of some growth to protect margins shows intent on maintaining operational metrics, and the confidence of making up for probable volume loss due to consumer switching.
The Regulatory Puzzle
Is Petroleum and Natural Gas Regulatory Board allowing further competition a big deal for city gas distributors? While investors have concerns on a market share erosion away from the incumbents toward the oil marketing companies or GAIL for CNG sales, there is an arrangement between these players where OMCs earn commissions from city gas distributors for allowing the latter to sell gas in OMC fuel stations. In cities where the exclusivity is going away, a third party would get access to 20% volumes. Even if OMCs capture 25% of that, the cost-benefit ratio—of investing in infrastructure versus the EBIDTA earned—is not that great. So, the for reasons of the return on investment as well as potential loss of commission, there is limited upside for OMCs to go disrupt the city gas distributors.
There might be incentives for newer players like IOCL-Adani Gas (Total JV) to gain share, but with a number of other areas available, would they want to venture into geographies dominated by the incumbent CGD players? The concern that further competition would result in a price-war is unfounded. Prices are already competitive in most regions and may not see much impact due to further competition. Also, competition is likely to be staggered. PNGRB is unlikely to terminate all eligible monopolies at one go.
Call For Caution?
While overall natural gas demand stayed relatively steady through the pandemic, the volume of piped gas supplied—as in the national capital region that is serviced by Indraprastha Gas—witnessed a lot of volatility. A Credit Suisse report notes that April volumes fell to 10% of normal, May was at 20%, and the part of June measured was still below 50% of pre-Covid levels. The same report also says that Gujarat Gas declared that its early June volumes were at 55% of the pre-Covid level.
As pointed out earlier, the difference in the recovery between the two could be attributed to the fact that over 75% of Gujarat Gas’ supply is to industrial users, versus 73-75% of IGL’s volumes is as CNG for automobile use.
How long before volumes return to pre-Covid levels? IGL has said that it may take another 4-5 months. Work-from-home, lesser business for restaurants and hotels may impact volumes. This uncertainty makes the job of assigning a fair valuation even harder.
At current valuations, IGL is at already at the average multiple of the last five years, The multiples for Gujarat Gas, despite the robustness of its industrial supply, are lower than the 5-year averages because of the market perception of slower growth as well as the impact of the regulatory changes like open-access.
Morgan Stanley argues though, that with around 14% earnings CAGR over F21-F25e and around 28% RoCE, valuation does not look expensive for the sector. Add to that, if the volumes return, and if the other growth triggers fall in place, as the slang goes, it won’t be all gas.
Niraj Shah is Markets Editor at BloombergQuint.