- Following a recent round of company visits, we re-initiate coverage on the Oil and Gas Sector with a NEUTRAL rating. Despite the recent nascent rebound in share prices of the oil and gas companies – lifted by improved sentiment due to a recovery in oil prices off the lows – we believe it is too early to turn constructive on the sector. Admittedly, at USD57/barrel now, we are seeing a mixed consensus on the direction of the oil price, as compared to three months ago when oil prices were hovering at USD83/barrel. Our base case is that oil prices would be bouncing along the bottom at USD55/barrel –in line with the government’s projection.

- Our primary concern centres on the lagged impact of a steep collapse in oil prices and subsequent capex cuts by the oil majors,on earnings and balance sheet of the O&G companies. In the coming quarters, we expect to see weak earnings delivery and perhaps the impact of impairment of assets that were acquired when oil prices were at elevated levels. However, not all are bad and we do see some value emerging after the steep selldown.

- The pure-play fabricators would be impacted the most as orderbook replenishment would be a challenge amid the budget cuts and slowdown in E&P activities, as pointed out by MMHE during its briefing recently. To make matters worse, local fabricators have been facing intense competition from foreign yards and had recently lost out on major fabrication jobs, i.e. the Bergading and Bardegg2-Baronia CPPs.

- On the global front, dayrates of drilling rigs continued to soften in recent months due to the oversupply of rigs, coupled with lower demand amid a slowdown in planned drilling projects. The market has seen rig rates for top specification deepwater units drop to below USD400,000 per day, from its peak of USD650,000 per day in 2013. We believe the situation would cascade down to the lower spec rigs in this region. In a recent result briefing by Keppel Corp, it was highlighted that as many as 119 jack-ups and 53 deepwater rigs will enter the market over this year and next. A significant number of these have yet to be chartered, which would consequently lead to suppressed dayrates.

- On a similar note, we see the overcapacity in the offshore support vessel (OSV) market, especially for lower bhp vessels, as a challenge. While works in the existing production fields will remain relatively unaffected, we see muted growth prospects against the backdrop of a slowdown in upstream activities. Petronas has indicated that it will not proceed with contracts to award RSCs for new marginal oil fields unless the global oil prices settle at levels above USD80 per barrel – where breakeven costs for the marginal oil fields is at USD65 per barrel.

- From a valuation standpoint, the O&G stocks under our coverage are now trading at an average forward PE of 18x, which is below the historical mean of 22x. We believe valuations have yet to discount further earnings and impairment risks ahead. The risk of impairment would be an overhanging concern on select stocks that have acquired assets at relatively high prices, given the sharp fall in the oil price. SapuraKencana has acquired the Seadrill tender assisted rigs and Newfield’s PSC stakes in the production blocks when oil prices were higher. Nevertheless, it remains to be seen at this juncture if any asset impairments will be booked.

- We prefer established companies that are exposed to the production phase with long-term service contracts and recurring income, as these are less sensitive to the oil price fluctuations. We like Dialog (BUY; FV: RM1.95/share) for its execution track record – supported by recurring and strong cash-flow generating businesses, which will remain relatively insulated from the near-term fluctuations of the oil prices. We estimate that 70%-80% of the group’s pre-tax profit stems from recurring businesses, entrenched by its key focus in growing its tank terminal business which are mostly on a take-or-pay basis. Furthermore, Dialog’s engineering and construction arm benefits from the EPCC contracts for the construction of its tank terminals. Although the stock is now trading above the sector average at 29x, we believe the premium is justified given its consistent earnings track record and strong balance sheet.

- We also like the FPSO players for the good earnings visibility underpinned by the long-term nature of FPSO contracts. Within our stock universe, we prefer Bumi Armada (BUY; FV: RM1.55/share) where the group has secured earnings from its FPSO vessels with the earliest charter expiring in 2016 (excluding option for extension). Bumi Armada will see an uptick in earnings in FY15F, as significant contributions from 50%-owned FPSO Armada Sterling 2 kick in, followed by substantial contributions from the Kraken and 15/06 FPSOs in FY16F. The stock now trades at 15x FY15F PE against its historical mean of 28x. Its closest peer, Yinson (HOLD; FV: RM2.85/share), is currently trading at 20x.

- Our HOLD rating for SapuraKencana (FV: RM2.80/share) is premised on potential earnings weakness and impairment risks from its newly acquired assets. Furthermore, six of its rig charters will be expiring in the current year, although two have options for extension. We place MMHE (FV: RM1.50/share) on a HOLD rating due to the challenges faced in replenishing its orderbook amid a slowdown in order flows and intense competition.

Source: AmeSecurities