• We maintain our OVERWEIGHT call on Oil and Gas sector as we remain upbeat on the upcycle in O&G capex spending thanks to the lagging effect from high oil prices to offshore activities.

• Oil price is set to remain higher-for-longer, to be supported by (i) higher demand for air travel post COVID-19 full economic reopening, ii) China’s recovery post COVID-19 lockdown measures, (ii) OPEC+ effective role in managing oil supply and stabilization role in the market, iv) demand recovery on the back of an expected weakening of USD against major currencies and v) prolonged disruption from Russia-Ukraine war particularly during the cold season in Northern Hemisphere which is set to place in less than 6 months. Note that OPEC+ is set to widen its production cut by 1.16mn bpd to 3.66mn bpd (beginning May), where this is equivalent to 3.7% of global demand. No change to our 2023 Brent crude forecast of USD90-100 pb.

• Under a worst-case scenario (i.e., global recession), Hibiscus Petroleum, DNeX and PChem could be at risk should there be a sharp pullback in oil price though most will be cushioned by diversified and lean business models.

• Currently, our top picks are MISC (TP: RM8.00), MMHE (TP: RM0.94), and T7 Global (TP: RM0.50). We also have a BUY call on DNeX (TP: RM0.77), Hibiscus (TP: RM1.30), Reservoir Link Energy (TP: RM0.52), Dayang (TP: RM1.78), Velesto (RM0.30), LC Titan (RM1.56) and Sapura Energy (TP: RM0.08).

Risk to Oil Price is Skewed to the Downside

Globally, rising inventories indicate that demand has weakened. For instance, there was a significant build up in the US commercial oil inventories in 1Q23 which rose by c.12% QoQ to 470mn bbls (Chart 1). This is also above its 5-year average (Chart 2). This suggests that crude oil market has improved from its tightness last year where inventories were at a 5-year low.

Recession fears has posed further downside risks to crude oil price. Recently, Brent crude benchmark price declined to below USD80/bbl amidst the unfolding of US banking crisis involving Silicon Valley Bank, New York’s Signature Bank, Credit Suisse etc. After all, the crude oil market is vulnerable to any sign of weakening demand such as credit event, taking cue from the 2008 Global Financial Crises. Based on the analysis by the World Bank, oil demand declined by a marginal 2-3% during the previous global recession but the impact to oil price was formidable. This has prompted OPEC+ to announce a widening in production cut by 1.16mn bpd to 3.66mn bpd (equivalent to 3.7% of global demand) which managed to calm the market.

Our View on Crude Oil Price

On that note, we maintain our 2023 average Brent crude forecast at USD90- 100/bbl, slightly higher than YTD average of USD82/bbl and consensus of USD87.25/bbl. Note that our oil price forecast is based on our base case scenario of no global recession this year. Hence, we expect a stronger oil price in 2H23, which is set to be driven by (i) post-lockdown Chinese recovery, (ii) rising demand for airtravel post COVID-19, (iii) limited supply given OPEC+ planned production cut, iv) demand recovery given the likely weakening of USD against major currencies and v) prolonged disruption from Russia-Ukraine war particularly during the winter season in Northern Hemisphere. According to IEA, demand is expected to surge by 3.2mn bpd from 1Q23 to 4Q23 due to China (note: post economic reopening), leading to market deficit in 2H23.

Besides that, oil price is also set to be supported in the long term by the decline in investment by US and Russia which together produce c.20-25% of global oil supply. In Russia, oil production has partially recovered from the immediate decline following the sanction (Chart 3) which has defied market expectation. However, its production may still decline in the long term as a result of curtailment of new investment, due to limited access to foreign technologies and financial markets. In Energy Outlook 2023, BP expects Russia’s oil production to drop by c.10-30% to 7-9mn bpd from current 10-11mn bpd by 2035, another driver to oil price.

Meanwhile, the number of drilled but uncompleted (DUCs) wells in the US declined to below 5,000 wells which is the lowest in the past decade (Chart 5). The drawdown in DUCs was inevitable during the COVID-19 pandemic as the number of operated oil rigs declined in tandem with lower WTI Crude Benchmark price. However, it failed to recover even as the number of oil rigs jumped subsequently (Chart 6). This suggests that the recent rise in US oil production to 12mn bpd was driven by the completion of existing DUCs rather than the drilling activities of new wells.

Impact of Oil Price Volatility to O&G Companies

Against the backdrop of potential global recession (global GDP 2023F: +2.8%; 2022A: +3.4%), we examine the impact of oil price volatility to the earnings of oil and gas companies under our coverage. Hibiscus came on top of the list as the most vulnerable to a plunge in oil price as it generatesits revenue directly from the sale of oil and gas. Hibiscus also does not hedge its oil production. Based on our estimate, for every USD10/bbl decline in oil price, Hibiscus would lose c.12% or RM200mn in annual revenue and c.25% or RM100mn in annual profits. However, we think it can maintain its profitability and withstand the impact of oil price volatility due to its lean operation cost with a low breakeven level c. USD50/bbl. Similarly, DNeX also derives a portion of their revenue from the sale of oil and gas, but this is cushioned by its income from IT and semiconductor segments. In FY22, energy segment made up c.26% of DNeX’s revenue. Based on our estimate, for every USD10/bbl decline in oil price, DNeX would lose c.3% or RM45mn in annual revenue and c.9% or RM25mn in annual profits.

Petronas Chemical (PChem) will also be affected by a decline in oil price as it has a positive strong correlation with the price of its commoditised products. Our previous study indicated both variables correlated at 0.945 over the period of 1993-2017. Hence, PChem’s margin will be under pressure if oil price declines sharply during recession. The impact to its counterpart Lotte Titan is neutral however because both its feedstocks (i.e., naphtha) and products have a positive correlation with oil price. Suffice to say, its profitability depends on the prevailing spread between naphtha and product prices.

The impact to the services companies such as MMHE, Velesto Energy, T7 Global, Reservoir Link Energy (RL), Sapura Energy and Dayang is also neutral because their revenue is not directly linked to oil price. Rather, it’s a function of capex expendure by oil and gas operator companies. We view that the planned capex projects will not be affected by the weakness in oil price as long as oil price is maintained above USD50-60/bbl (which is indicatively the breakeven level for many greenfield projects). However, their tenderbook may be affected if low oil price environment prolongs, of which we think is unlikely due to underinvestment in prior years.

On the contrary, there are some companies that may benefit from lower oil price. Petronas Dagangan (PetDag), for example, will benefit from lower oil price as its products price generally lags its product costs. This is in contrast with previous oil price crash where

PetDag suffered large losses from its holding inventories. This change is a result of its new operating model following the disposal of working inventory and deadstock (un-pumpable inventory) to PETCO, resulting in efficiency gains from lower inventory days. Last but not least, MISC could also benefit from lower oil price particularly when there are large inventories build in the market. This is evident during the COVID-19 pandemic where traders opportunistically lease oil tankers to store excess crude in anticipation of higher price in future.

Source: BIMB Securities Research - 2 May 2023