Reliance sells 30% stake in 23 oil & gas blocks to BP: what is the deal logic?

Reliance Industries parted with a substantial stake in its oil & gas exploration and production business to BP, in return for cash and technology to develop this business. They will also set up a joint venture for sourcing and marketing gas in the country.

The deal will require government approvals and comes at a time when Cairn Energy Plc is struggling to sell a controlling stake in Cairn India to the Vedanta group, not getting the required government approvals to close the deal.

Reliance will give BP a 30% stake in the production and sharing contracts of 23 oil and gas blocks. These include the KG D6 block (6 blocks), Mahanadi Basin/North East Coast (9 blocks), Cauvery/Palar Basin (4 blocks), Kerala/Konkan (2 blocks) and one each in Cambay Onland and Upper Assam basin. The combined output of these 23 blocks at present is 1.8 billion cubic feet of gas per day, about 30% of India’s total consumption and 40% of its production.

BP will pay $7.2 billion or Rs 32,400 crore to Reliance for this 30% participating interest in these blocks and will be entitled to get $1.8 billion more, depending on further discoveries and commercial success. The total payment to Reliance will be $9 billion but BP also says that the combined investment could go up to $20 billion. What BP is paying for now, is the existing investments made in these fields and the commercial success achieved. The $1.8 billion figure is for discoveries on the horizon. But future investments will be needed for further exploration efforts and to start production from these fields.

What does BP get from the deal?
BP is on a mission to acquire strategic assets. In January 2011, BP and Russia’s Rosneft agreed upon a strategic alliance, to explore and develop three license blocks awarded to Rosneft in 2010. As part of the deal, Rosneft took a 5% stake in BP in exchange for a 9.5% stake handed over to BP. The value of BP shares to be issued to Rosneft amounted to $7.8 billion based on prices at the time the deal was announced.

The Reliance transaction allows it to stay clear of the company’s businesses, not related to petroleum, such as retail, textiles, telecom or hotels. Since it is not picking up an equity stake, its exposure is restricted to the oil and gas business only.

It is paying $7.2 billion for a 30% share of profits, and in 2010, at the gross profit level, its share would have been Rs 1,336 crore on a profit before interest and tax basis. That’s a return of about 4% on its initial investment.

This may seem small but it does not include future revenues from the blocks. Reliance’s E&P business profit has risen by 38% in the nine months ended December 2010. BP’s return would go up to 5% as a result in 2010-11, assuming these 23 blocks’ share of production was unchanged.

BP secures one more source of inorganic growth for its exploration business. It gets a strong partner with expertise in navigating the policy obstacles, which are so common in this sector. It has the financial muscle to invest further in the business, which could further improve the paybacks from this investment.

What does Reliance gain from the venture?
Reliance benefits from having a strong international petroleum company as a partner, with considerable experience and skills in the exploration industry, and financial resources to support further investments. It gets about Rs 32,400 in cash, representing the present value of future cash flows from the 30% stake that it will cede to BP.

But money is unlikely to have been a key reason for Reliance to sell a 30% stake. As of December 30, it already had cash of about Rs 32,000 crore on its books, adding about Rs 3,000 crore every quarter in 2010-11 so far. Its net cash from operations was about Rs 20,000 crore in 2009-10. Despite having debt of about Rs 70,000 crore, as of December, its net debt to equity is only 0.3 times. That is a comfortable level. Reliance can use this money to either pay down debt or use it to fund future investments, without straining its balance sheet.

One of the key messages coming out of the joint statement is that Reliance’s project management and operations skills will be combined with BP’s deepwater exploration and production skills. Reliance was faring well till now, on its now, and has built these capabilities in-house over the years. At this stage, it is not clear what BP expects to accomplish or more specifically where exactly its technical expertise is going to be utilised.

In 2010-11, the output from Reliance’s KG D6 basin has been a bit disappointing, with gas production during the December quarter at 54.5 million metric standard cubic metres per day, compared to an average of 57.2 mmscmd during the quarter. Could BP’s entry increase the output of these wells or help Reliance better exploit some of the newer blocks that form part of the 23 blocks under question.

Or did Reliance get a very good price for these assets? If we assume that the 23 blocks contribute to about 80% of Reliance’s E&P profits (as they did in 2009-10), then the valuation for Reliance’s E&P business works out to about Rs 135,000 crore. This is based on the Rs 32,400 crore valuation for 30% of profits, from the 23 blocks in which BP has picked up a stake.

The valuation is approximately 40% of Reliance’s market capitalisation before the deal was announced. And, Reliance’s E&P business contributed to about 28% of the company’s PBIT in the 9 months ended December 2010. Therefore, the deal appears to be a fair one for Reliance, and BP has not paid over the top either, for an asset that has the potential to grow in the years ahead (line added later). The premium visible in the valuation is partly due to BP’s desire to pick up a strategic asset and anticipated growth in profits from these assets in the years ahead.

Reliance’s immediate benefit is the cash from the sale. But this is a one-time benefit. When the deal is done, if it is recognised through the profit and loss account, its other income will get a boost. But it will also lose 30% of the profits from these 23 blocks to BP. The deal will pay off for Reliance only when BP’s entry leads to the output from these blocks increases. And, rises to the extent that Reliance’s 70% share becomes much higher than the level, had this deal not happened.

Reliance’s share is up 4.5% as the sizeable cash inflow will have a positive effect on near term earnings.

Read the press statement from BP and Reliance here.

Read Mukesh Ambani’s speech here and read Robert Dudley’s speech here.

Download the list of the 23 blocks in which BP has picked up a stake here.

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