As per channel checks, the government is presently in discussions with the state owned E&Ps – majorly OGDC and PPL – to settle their outstanding circular debt dues (related to the indigenous gas sales only). We understand that this will include a combination of the below measures:
Issue of some government security (PIBs or Sukuk) against the receivables of the two E&Ps,
Increase in consumer gas tariff, and
Elimination of outstanding tax payments to the government (GDS, GIDC, GST).
Details of the plan and its timing remain uncertain, but we assign more than 50% probability to such an event happening in the next 12 months. In the first measure, the government will require the two E&Ps to announce a special dividend of the same amount as the injection. For illustration, if the government raises PKR200bn through a Sukuk issue, and inject half of that cash to OGDC and PPL each, which will subsequently announce dividends together worth PKR200bn. Since the government owns 67% in both OGDC and PPL, about 70% of the injection or PKR140bn will be repaid to the government in the form of dividends and taxes (on dividends to minority shareholders). Assuming both OGDC and PPL receive PKR100bn, they will have to announce dividends of around PKR23/sh and PKR37/sh, respectively.
In our view, only the government and minority shareholders will be beneficiaries of the first measure – not the E&Ps. The government will quickly reduce the pile of outstanding circular debt (estimated above PKR2.0tn), which has been one of the sticking points in the negotiations with IMF. E&Ps will not be able to retain the cash to invest in exploration and development activities (visibly affected by circular debt in recent past); only their receivables will come off by, say, PKR100bn each. The plan also does not ensure any improvement in future payments (from gas utilities) to the E&Ps and in turn lower exposure to circular debt. We believe that more sustainable solutions to eradicate circular debt are privatization of power and gas distribution companies and more regular tariff hikes. However, both are not plausible in the present political environment, in our view.
Nonetheless, we highlight that settlements with IPPs in the past 2-3 years have improved cash generation throughout the Energy chain – even though E&Ps received very little money directly. Those measures included two Sukuk issues of PKR200bn and another one entailing truncated tariffs of IPPs (reduced ROEs). Ever since, both OGDC and PPL have guided for improving recoveries (c.80-90% until June 2021 results). Therefore, we think that this settlement (involving payouts) should ultimately benefit E&Ps with slower buildup of circular debt, all else the same.
Moreover, given that power generation in Pakistan has skewed away from using furnace oil as fuel, and blackouts in Pakistan have dwindled in the recent past; the incentive for government to improve the liquidity of state-owned E&Ps has also reduced significantly, in our view. FO contributed c.5% of total power generation in FY21 vs. c.30% in FY16. Hence, the above plan could be the only opportunity in many years for E&Ps to settle their dues with the government, in our view.
OGDC and PPL are significantly undervalued – at forward P/Es of c.3.0-3.6x and EV/EBITDAs of 1.0x; stock prices do not reflect the near doubling of international oil prices since November 2020. Both stocks have significantly underperformed the overall KSE-100 index and other E&Ps – POL and MARI, which are least affected by circular debt – over the past five years (refer charts below). Worsening circular debt, ensuing dividends cuts and lack of real growth (production) extended the underperformance and had exacerbated the effect of foreign investors’ selling.
If this government plan materializes, it will be a significant catalyst for price discovery for the two stocks. Our June 2022 TPs for OGDC and PPL are PKR165/sh and PKR155/sh, based on oil price assumptions of US$75/75/70 per barrel for FY22/23f/LT and without incorporating any settlement. OGDC/PPL have already returned 8%/15% in the past two weeks.