* Government to sell 5 pct stake in share auction
* Floor offer price set at 290 rupees
* Successful sale could revive privatisation agenda
* Foreign investors, local funds, insurance cos seen bidding
* ONGC shares up more than 5 pct (Adds quotes, background, updates share price)
By Sumeet Chatterjee and Prashant Mehra
MUMBAI, Feb 29 (Reuters) - India is set to raise at least $2.5 billion selling a 5 percent stake in Oil and Natural Gas Corp (ONGC), aiming to patch up its widening fiscal deficit and revive its stalled privatisation agenda.
The long-delayed ONGC sale, set to rank among India's five biggest equity offerings and the largest this year, will be done via an auction on the stock exchange, a test case for this newly approved method which avoids expensive roadshows and saves time.
Shares in ONGC, the country's largest oil and gas producer and second-largest listed firm in India by market value, rose more than 5 percent on Wednesday, outpacing the wider market, amid expectations that the offer would meet strong demand.
"There is no doubt that the issue will be fully subscribed considering there are state-run financial institutions and others who will bid," said R.K. Gupta, managing director at Taurus Mutual Fund. "And a strong response to this issue opens the door for more government divestment programmes."
The floor price for the company's share auction was set at 290 rupees, the company said, a 2.3 percent premium to Tuesday's closing price of 283.40 rupees. On Wednesday, the stock closed at 293.20 rupees.
"We should see a good response. We expect foreign investors, large domestic mutual funds and insurance companies to participate," said Sidhartha Pradhan, additional secretary at the government's Department of Disinvestment (DoD).
The auction will be launched on Thursday at 9:15 a.m. (0345 GMT) and will close at 3:30 p.m., the company statement said.
The ONGC deal comes on the back of a strong rally by equity markets in India, with the main stock index climbing nearly 15 percent as foreign funds scooped up beaten shares worth more than $7 billion.
Nearly $2.85 billion has been raised in India share sales via eight deals so far in 2012, nearly a third of the $8.75 billion in all of 2011 from 84 transactions, according to Thomson Reuters data.
The government had earlier planned to sell ONGC shares through a public offer but that plan was scrapped last October after a tepid response from investors amid weak equity markets.
India's stalled divestment programme also calls for reduced holdings in other state-run firms such as Bharat Heavy Electricals and Steel Authority of India.
New Delhi is widely expected to miss its deficit target of 4.6 percent of GDP for the current fiscal year ending March, partly due to its inability to meet the budget target for more than $8.1 billion in state-company share sales.
So far this fiscal year, the government has only raised about $250 million.
India's stock market posted its first annual fall in three years in 2011, losing nearly 25 percent. Shares in ONGC fell 20 percent in the same period.
ONGC, which accounts for 79 percent of India's domestic oil and gas production, trades at a forward price to earnings ratio of 8.7 times.
In comparison, India's Reliance Industries trades at 11.5 times, China Shenhua Energy at 10.7 times and Petrochina at 12.7 times, according to Thomson Reuters data.
The ONGC share sale comes amid news the company and state-run GAIL India may join a bidding war for Cove Energy, becoming the second Asian state-run group seeking to trump Shell's $1.6 billion offer.
Little if any of the proceeds are expected to flow back to ONGC and help with any bid for Cove, given the government's objective is to pay down its own deficit.
The government will sell about 428 million of its ONGC shares, cutting its stake in the firm, which the market values at more than $49 billion, to 69.1 percent from about 74 percent.
The Securities & Exchange Board of India said last month it would allow shareholders of the country's top 100 companies by market value to raise funds by auctioning their stakes through stock exchanges.
Bankers said investors would be able to participate in the auction in the same way as a traditional secondary share offer, but the government would save time and money.
Citigroup, Bank of America Merrill Lynch, HSBC , Morgan Stanley, Nomura and India's JM Financial are the banks on the deal. ($1 = 49.1 rupees) (Additional reporting by Devidutta Tripathy in New Delhi and Elzio Barreto in Hong Kong; Editing by Mark Bendeich and David Holmes)