Highlights

We believe offshore O&G production is in the early stages of a cyclical upswing and offshore drilling with margins of circa 30% and supporting services are one of the best exposures for alpha.

Although our top 5 buy calls have risen an average of 108% since initiation, we believe that the tsunami of drilling activity has not been fully factored into the forecasts, valuations sentiment and hence price of selected drilling related stocks.

Domestically, the ETP driven RM300bn Capex spending to enhance exploration, EOR and Marginal fields requires a massive level of drilling activity which we believe the financial markets underestimate. Channel checks indicate the 22 rigs operating domestically in 2012 will rise to 38 by end 2013 to meet the need for exploration, field development and enhanced oil recovery (EOR). Internationally, drivers of global demand are also robust as both rig number and utilisation are on an uptrend.

Domestically, there is a shortage of locally owned rigs, and drilling services, Petronas prefers locally owned rigs, consistent with its localisation policy. International concerns over overcapacity are overdone, while it is true that there is a boom in rig construction, the increase in the number of rigs is offset by the replacement cycle.

The average peak P/E for 3 proxy small cap companies in the last upcycle was 23x and sentiment was euphoric. We are still a long way from this level.

Catalysts

Upgrades: New Discoveries and marginal field contract awards, M&A.

Downgrades: Sharp plunge in oil prices.

Risks

Global recession.

Rating

OVERWEIGHT

Positives: We believe that the ETP driven RM300bn Capex spending to enhance exploration, EOR and Marginal fields will drive earnings in the sector.

Negatives: execution risk, delay in contract rollout and investors’ perceptions on previous disappointments.

Valuation

Top drilling plays in order of preference:

Scomi Energy (BUY, TP RM0.88)

Uzma (BUY TP: RM3.98)

Perisai (BUY, TP: RM2.00)

SapuraKencana (BUY RM4.74)

Perdana Petroleum (BUY, TP RM2.38)

UMW (Listing expected 2H13)

Source: Hong Leong Investment Bank Research - 5 Jun 2013