Brent forecasts will adjust upwards as global producers will keep supply-demand closely matched. While Petronas remains conservative, its declining entitled volume (vs higher capacity) is a concern. We concur with industry players that local activities must ramp up from a low base to resolve this issue. High oil prices may lend stronger confidence in better work orders. Maintain MARKET WEIGHT, but selected companies’ earnings visibility may improve in tandem with utilisation.

WHAT’S NEW

• Petronas recorded RM12b 1Q18 ex-impairment profit (+13% yoy growth). Upstream profits improved on higher O&G prices, despite being offset by lower entitled production volumes (-7% yoy). Downstream profit declined on volumes offsetting higher product prices. The group maintained cost control (-1% yoy to RM41b) and capex (+1% yoy to RM12b, 36% of the capex on RAPID). The Pengerang Integrated Complex is 90% completed.
• Overall, results are not impressive and Petronas remain conservative. 1Q18 capex appears to be behind the 2018 capex guidance of RM55b (based on US$52/bbl assumption). In our observation, this is because Petronas’ 1Q18 EBITDA of RM23m (1Q17: RM26m) is not impressive despite higher O&G prices - possibly dragged by weaker volumes and US$. Its operating cash flow (OCF)/capex ratio (depicted in the next page) surged up to 1.8x vs peer average of 1.4x. Petronas continues to stress that cost-effective measures must continue to ensure the industry’s sustainability.
• In our view, the entitled gas volumes decline (vs higher capacity) is hampering Petronas’ cash flow growth. We concur with industry players that maintenance and production enhancement activities must resume to ensure volume growth, which will in turn sustain Petronas’ cash flow and government obligations. Up till 1H18, Petronas only carried out numerous market surveys. Contract roll outs had been poor in comparison to the plans dictated by Petronas Activity Outlook. Sustainably higher oil prices should allow Petronas the confidence to boost utilisation for contractors, even if service rates continue to be low.

ACTION

• Sector MARKET WEIGHT. Local O&G stocks are still not benefitting from earnings visibility. Our sector theme is to invest in companies that have visibility for earnings upgrades, and do not depend on Petronas work orders. International contractors and FPSO players have a stronger correlation to international industry recovery.
• Picks. Our top BUY is Serba Dinamik (Target: RM4.30) - the international O&M/EPCC contractor should see earnings rerating from a growing orderbook to >RM7b. We like FPSO players: a) Bumi Armada (Target: RM1.06), as earnings and investor confidence will improve on higher Kraken/Olombendo recognition from May 18, and b) Yinson Holdings (Target: RM4.45), given long-term earnings rerating from FPSO Layang and another mega contract. For SELL calls, MISC and Deleum had trended below our target prices since we downgrade to SELL a few weeks ago due to earnings risk.

ESSENTIALS

• Surge in O&G prices imply that OPEC met their goal. According to Petronas, Brent prices averaged US$67/bbl in 1Q18 (2017: US$54/bbl). LNG long-term price (based on JCC benchmark) also improved to US$8.6-9.5/MMBtu in 1Q18 (2017: US$7-8/MMBtu). Brent last traded at US$75-80/bbl range, above consensus Brent forecasts of US$67-68/bbl for 2018/19. Pockets of supply shocks (ie Venezuela’s slump, OPEC’s over-compliance, and incoming Iran sanctions) hastened the crude market rebalancing and caused OECD oil inventories to drop below the five-year average in April. According to IEA, global oil supply averaged 98m bpd ytd, matching global demand which was at a seasonal low in 1Q18.
• Oil market dynamics are back in the hands of the cartel, in the current scenario where supply surplus is eliminated. Jun 18 will mark the next OPEC meeting which will be an important event for oil markets. The ultimate goal for OPEC and Russia is to ensure that supply-demand will remain closely matched. Based on market reports, the group is considering a more comprehensive way to measure market stability, potentially revamping the five-year average stock averages to a 10-year period, and including other measures such as inventory days. The producers may consider raising production ceilings (or lessen the output cuts), which is part of the rebalancing efforts in our view. The surge in US shale supply in 2H18, due to the ramp-up of the Permian basin production, is factored in by consensus (as depicted in the RHS). A supply shortage risk is still possible as global demand is set to grow in the coming quarters, especially if US shale segment falls behind expectations (bottleneck in transportation infrastructure) and the degree of the incoming Iranian sanctions. JBC Energy predicts that Iranian crude exports could be impacted from 0.1m bpd, to 0.5-0.7m bpd in the best case scenario.
• Slight upside risk to Brent/ WTI. By 2019, there could be a surge in demand of middle distillates and low-sulfur (sweet) crude to produce compliant marine fuels to meet IMO’s 2020 regulatory requirement (global sulfur cap to be cut from 3.5% to 0.5%). This does not change the overall oil demand of ~100mbpd. But in an already tight market scenario, about 4m bpd of marine fuel could switch to gasoil. This scenario assumes the alternatives like scrubbers and LNG fuel are not accepted as the preferred long-term solutions. Low-sulfur high quality crude (Tapis, Brent and WTI) may see wider price differentials against the lower-quality, high sulfur crude (Canada Western, sour Middle Eastern and Iranian heavy grades).
• LNG sales volume in 1Q18 was higher yoy but lower qoq. Natural gas is at about 65% of Petronas’ entitled upstream production, and roughly 65% of this is exported as LNG sales. Although the LNG volume increased vs 1Q17 due to higher capacity and trading volume, this is still weaker vs 4Q17. We believe the volatilty relates to spot trades, which is stronger during winter demand. According to Petronas, spot mix of its LNG was about 10% (i.e. 3mtpa out of 29mtpa in 2016), but we expect spot mix to grow substantially after the adjustment of the renewed long-term LNG contracts in March 18.

Source: UOB Kay Hian Research - 31 May 2018