Investment Highlights

• Petros role formalised as sole gas aggregator. On 13 May this year, the Sarawak Ministry of Utility and Telecommunication (MUT) announced that Petroliam Nasional (Petronas) and Petroleum Sarawak (Petros) have agreed to enter into a Definitive Agreement which formalises Petros’ take-over as the sole gas aggregator in Sarawak in line with the enactment of the state’s Distribution of Gas (Amendment) Bill 2023. The agreement enables Petros to conclude gas purchase agreements (GPAs) with all upstream producers involved in the production of natural gas in Sarawak and gas sales agreements (GSAs) with all downstream buyers, foreign or domestic. Consequently, Petronas will cease all buying and selling activities of the product in the state and hand over its natural gas distribution network and system to Petros.

• Sarawak gains greater control of natural gas resources. The role effectively empowers Petros with control over the supply and flow of natural gas produced within Sarawak, and the corresponding tariff charged to customers. According to Sarawak MUT minister Datuk Julaihi Narawi, the prior arrangement via Petronas created a challenging environment for the state government to attract foreign investors who require gas for industrial consumption. Currently, only 6.7% of the natural gas supply fed to the Petronas LNG Complex, Bintulu is used for domestic consumption – a significant gap from the state’s 30% target.

• Gas as one of the major backbones of Sarawak’s growth. The state government has established a 10-year Sarawak gas roadmap (SGR), which aims to use natural gas to fuel development through a hub-and-spoke model to 4 centres - Kuching, Bintulu, Samalu and Miri - that are involved in power, heavy and light industrial sectors and petrochemicals. We expect to see massive requirements for natural gas for the state’s domestic consumption in the medium term. To illustrate, Petronas and Petros previously entered a memorandum of understanding (MOU) in 2021 to gradually increase the supply of natural gas to Sarawak for implementation of the SGR from 450mil standard cubic feet per day (MMscfd) to 1,200 MMscfd by 2030, a whopping 2.7x increase. We observe the Sarawak government already making inroads with announcements of proposed combined cycle gas turbine (CCGT) power stations in Miri and Bintulu by Sarawak Energy and the announcement by Petronas Chemicals Group Bhd (HOLD, FV: RM6.20) to conduct a joint feasibility study with Sarawak Petchem to develop a low-carbon ammonia and urea plant in Bintulu.

• Cost competitiveness in play. To secure a competitive edge as an industrial hub, we see Sarawak holding true to its core advantage in cost competitiveness. As Sarawak accounts for more than 50% of Malaysia and 10% of Asia Pacific natural gas reserves, Petros may be able to supply gas to internal consumers at a cheap rate, in our view. This is broadly in tandem with its other cost offerings: electricity tariffs at US$0.05 per kilowatt hour (kWH) or 40% less than in Peninsular Malaysia and water tariffs of US$0.22-0.30 per 1,000 litre, the lowest in all states in Malaysia.

• Downside to Petronas’ earnings. We see this as a negative on Petronas’ upstream earnings if the lower price is shared with upstream operators in any way mixed with a flattish outlook on global liquefied national gas (LNG) demand, particularly from major Asia Pacific LNG customers in Japan, South Korea and Taiwan due to increasing use of nuclear and renewables in its energy mix. Recall that Petronas reported a 1QFY24 decline of 12% YoY to RM19.2bil, after accounting for net impairment and write-backs, attributable to broad-based weakness led by the gas segment by -28% YoY after experiencing lower average realised prices of LNG. For reference, the upstream segment accounted for 53% of the Petronas’ profit after tax (PAT) and 68% of its 2.6mil barrel of oil equivalent production per day (boepd).

• Potential Petronas capex revision. In a worst-case scenario, we are wary that this may lead to a revision in the group’s capex commitment moving forward. Petronas had previously communicated a RM300bil capex guidance in the next 5 years (2023-2027), which translates to an annual capex of RM60bil annually. We turn more cognisant over the recent shortfalls in expectations with 1QFY24 capex of RM10.7bil (+2% YoY) which came in at only 18% of full-year expectation. Notably, the capex spent is mainly towards the upstream segment’s ongoing investments in Argentina, Brazil and Iraq. Notably, Petronas spent RM5.5bil domestically, which translates to an increase of 20% YoY or +18pts vs. the overall capex growth of 2% YoY. The domestic capex was primarily on: (a) the near shore floating LNG facilities in Sabah, and (b) Kasawari CO2 sequestration facilities in Sarawak.
   
• More cautious stance with attractive entry points. With this in mind, we believe investors should adopt a more cautious stance on prospects for the oil and gas (O&G) sector with the following approaches:
   
  • Avoid greenfield-related services contractors. We believe O&G contractors involved within the exploration phase of the supply chain will be the most impacted as new field developments may be scaled back, particularly Velesto (Not Rated). Though much of the group’s jack-up rigs are already contracted for with utilisation rates expected at 80% for FY24F and 62% for FY25F, we believe the stock is exposed to downside risks from a relatively larger derating, further exacerbated by capped daily charter rates (DCR) if rigs from the Middle East were to be mobilised to Southeast Asia.
     
  • Brownfield maintenance contractors will still win but be wary of high expectations from umbrella contracts. Petronas is likely to maintain its long-term production target of 2mil boepd despite the cut in capex, to ensure Malaysia’s energy security. Hence, we believe Petronas will dish out contracts for maintenance, construction and modification (MCM) and hook-up and commissioning (HUC) services albeit at a lower than previously expected quantum. We see 4 primary beneficiaries at this juncture: Deleum (BUY, FV: RM1.66), T7 Global (Not Rated), Carimin Petroleum (Not Rated) and Petra Energy (Not Rated). Additionally, we are more favourable to services which are instrumental in improving production levels such as slickline services.
     
  • Offshore support vessel (OSV) players are likely to stay flattish after current run. We believe OSV players remains fairly sheltered given the significant gap in supply and demand dynamics, which has translated in current DCR levels which we gather is close to peaks (note: accommodation workboat DCRs have reached the peak levels seen in 2013- 2014 with anchor handling tug ship DCR at 10% below-peak). Our channel checks indicate that Petronas is looking towards hiring OSV players on a term contract basis moving forward, which may translate to a slight discount of 10% to spot DCRs. The beneficiary within this field is Keyfield (Not Rated).
     
  • Select resilient earnings base with diversified clientele. Given the uncertainty, we are turning more positive towards resilient earnings plays such as Wasco (Not Rated) should valuations turn more appealing as the group currently trades at a 1-year forward PE of 11x – broadly at par with its 5-year mean given its peaked orderbook of RM3.2bil. The group recently announced that it intends to resume dividend distribution in FY25F, which we believe may translate to a yield of 3% based on the previous dividend per share of 4.5 sen.
     
  • Valuations, valuations, valuations. As most local oil & gas listed contractors’ share prices have risen by more than 30% year-to-date, we believe investors should look towards an even more compelling valuation entry point at close to 2- year forward 9x PE should a sector derating were to occur. Currently, the subsector trades at 12-13x, which we believe is expensive as it sits at close to +1 standard deviation to the 5-year average valuations of companies under our coverage.
     
• Maintain OVERWEIGHT on the sector. Our top picks are Dialog Group (BUY, FV: RM2.90) which is supported by its resilient non-cyclical tank terminal and maintenance-based operations; and Yinson (BUY, FV: 3.96), the primary beneficiary of the FPSO upcycle. We also like Petronas Gas (BUY, FV: 19.97), which offers a decent dividend yield of 5.4%, which can be raised further from the optimisation of its capital structure together with sustainable recurring earnings for its gas transportation and processing operations.

Source: AmInvest Research - 9 Jul 2024