• We initiate coverage on two oil and gas services companies, Yinson Holdings (BUY, TP: RM4.30) and UMW Oil and Gas (HOLD, TP: RM0.33) with each representing two upstream sub-segments – (i) the production and (ii) exploration and development activities.

• We prefer Yinson over UMWOG as the former is a full-fledged FPSO owner and operator company with long-term charter contract. While we are optimistic that UMWOG may continue to maintain utilisation rate of above 70% in the near term, continuous depressed DCR remained a concern.

• Huge capex requirement for FPSO conversion provides high barrier to entry into FPSO market. Yinson’s strong balance sheet and proven track record enable it to win big project (FPSO JAK) amidst lesser competition in the market – not as intense as in jack-up rig market.

Review on crude oil price outlook

The strong oil demand growth amidst production cut by OPEC and its non-OPEC counterpart had resulted in global production deficit of c. 470k bpd in 2017 (according to OPEC estimate). This has helped the market to clear supply glut, evident by the decline in global oil inventory. Latest data from OPEC shows that OECD commercial stocks is now only 50m bbls above 5-year average (vis-à-vis 289m bbls in January 2017), pointing towards a balance market. We believe the current market is in demand-driven cycle, in tandem with strong global GDP growth. Hence, we expect crude oil to stabilise as strong oil demand should be able to absorb production boost from US shale production moving forward.

Recovery in upstream activities intact

In view of the crude oil price recovery, upstream services stocks have come into play in anticipation of these companies benefiting from the revival of E&P projects. However, we believe investors should be cautioned that it is not as straightforward as it may seem. For example, while Petronas has been more aggressive in pursuing for offshore development projects, its spending on upstream projects remain lower than before as it emphasises on cost-effective solutions and market consolidation. Hence, we expect daily charter rates (DCR) to remain low which led to depressed margins in the oil services sector.

Comparing two niche upstream services companies

In this report, we initiate coverage on two upstream services companies – Yinson and UMW Oil & Gas which represents two niche sub-segment in the upstream services sector – FPSOs (Floating, Production, Storage and Offload) and jack-up drilling rigs. We believe these segments aptly illustrate the dynamics within the upstream services segment; the FPSO market remains resilient while the drilling rigs are hampered by excess supply of rigs and thus, depressed DCRs. This is characterised by the generic nature of jack-up rigs as opposed to the FPSOs which have highly-customised design bespoke to the field.

Yinson is our top pick; UMWOG needs more time

On that note, our top pick for the upstream services is Yinson (BUY, TP: RM4.30) as it boasts long-term earnings visibility. Armed with its cash pile of RM1.3bn, Yinson looks to strike another JAK-equivalent FPSO contract in CY2018. Additionally, it is also awaiting the court’s approval to continue the long-delayed THHE’s FPSO Layang project. On the flipside, UMWOG’s rigs utilisation rate has improved significantly for FY17 and may continue to retain market share for local contracts. However, the sluggish recovery in DCRs have led to depressed rates hence warranting our HOLD call with an RM0.33 TP.

Modest global E&P capex spending expected in 2018

There could be a silver lining for the global oil and gas services industry in 2018 as more tangible signs of drilling activities resuming. A world-renowned research and consultant outfit, Wood Mackenzie, expects number of major projects sanctioned in 2018 to increase to 25 from just over 20 in 2017. We believe the improvement is affected by several factors:

• Stabilising crude oil price. Crude oil price has stabilised at over US$50/bbl. We believe the market recovery was demand-driven as the robust global economic activities underpinned by healthy oil consumption to outpace the global production for the first time in four years since 2014 (Chart 1). This is also on the back of production cut undertaken by OPEC and its partner Russia since end of 2016. As a result, this has led to a supply deficit of c. 470k bpd in 2017, according to estimate by OPEC. Consequently, global oil inventory also declined closer to its 5-year average, an indicator that OPEC used to gauge market supply-demand balance.

• Rock-bottom service rates. With stable crude oil prices and potential supply deficit, we believe the investment outlook for oil majors have improved while excess capacity within the services space have led to depressed rates, further strengthening confidence of oil majors to resume well developments.

There are more local jobs at compressed rates

In view of depressed rates, we believe the situation for upstream services is far from reverting to pre- 2014/15 crude oil price rout. Petronas, in its Activity Outlook (PAO) 2018-2020, plans to sanction c.50 developments projects comprising 20 greenfield and 30 brownfield projects. Comparatively, it planned to sanction 10-15 greenfield and 20-25 brownfield projects in its 2017-2019 PAO.

For the record, Petronas’ domestic upstream capex more than halved in 2016 at RM12bn as compared to RM28bn at its peak in 2014. This is much less than its 12-year average capex of c.RM19bn (Chart 2). While more projects are expected to be sanctioned by Petronas, we do not expect 2018 capex amount to surpass the 12-year average mainly as Petronas is serious with its cost-cutting measures. We also expect local services companies to face cost pressures from competing foreign players, something we note is prevalent in the drilling rigs market.

Stable but limited upside to crude oil in 2018

In CY2017, Brent crude oil ended higher at US$66/bbl, rose by 16.5% yoy and nearly 50% from its lowest point during the year (US$44.3/bbl at end of Jun). The price recovery was due to successful negotiation between OPEC and non-OPEC producers during the Nov 2017 meeting to further extend the supply cut agreement for the entire 2018 (a 9-month extension from the initial plan to end in Mar 2018). Several key highlights from the meeting are as below:

• The pact agreed to further strengthen the effect of production cut. This is including to put a production cap on Libya and Nigeria at an aggregate rate of 2.8mbpd for the year. This is as opposed to the exemption that both countries enjoyed during previous agreement.

• To pursue a balance market. Maintain its target to achieve a balance market by bringing OECD oil inventories down to its 5-year average.

• To convene next meeting in Jun 2018. The pact may consider further adjustment actions according to prevailing market condition (i.e. supply and demand growth) and progress achieved towards re balancing the oil market.

It should be highlighted that the desired result of the agreement is not solely for greater price, rather, to achieve a stable market that is conducive to encourage investment in new discovery and developments. Several market reports indicated that OPEC may exit the deal by Jun 2018 should market overheats.

On other hand, OPEC revised higher its 2018’s global oil supply forecast in its Monthly Oil Market Report (MOMR) for Mar 2018 – the second consecutive month. The raised forecast is due to expectation of higher supply from US shale oil following the rally in crude oil price. In aggregate, the Non-OPEC supply forecast was raised by +590kbpd to 59.53 million bpd (implying an impressive average supply growth of 1.66m bpd in 2018) (Table 1), underscoring the limited upside to Brent crude price and the need for OPEC to reduce production by some 250,000 bpd in 2018. We expect Brent crude to trade within US$55-70/bbl in 2018, averaging at US$65/bbl for the year.

Comparing two niche upstream services subsectors

We prefer Yinson (BUY, TP: RM4.30) over UMWOG (HOLD, TP: RM0.33) mainly on the back of the former’s exposure to the production segment which entails provision of bespoke FPSO/FSO vessels that are served with long-term charter rates. This insulates the sector from speculative vessel builds flooding the market and dilute DCRs while providing Yinson with stable cash flows.

Given the long tenure of its charters, agreements are typically imbued with various measures to mitigate Yinson’s risk against client defaults. Additionally, most of Yinson’s clients have strong profile and equally strong credit rating to match.

On the flipside, UMWOG provides exposure to the exploration and development segment with the provision of jack-up rigs. In the current condition where production from conventional wells are rivalled by shale, well developments have been slow to recover, dampening demand for jack-up rigs. The generic nature of its assets have also exposed the sector to speculative builds during elevated crude oil price levels. This has led to DCRs deteriorating while the nature of the charters are also short term.

Source: BIMB Securities Research - 29 Mar 2018