Highlights 

Red  October  to  O&G  sector…Since  beginning  of  Oct 14,  O&G  sector  has  lost  ~RM14bn  of  market capitalisation  due  to  concern  about  falling  oil  prices (Brent crude fell  from US$94.7/bbl  in beginning of Oct  to US$86/bbl )  coupled  with  global  market  sell  down.  On average,  O&G  companies  fell  by  17- 18%  (des pite  last Friday’s  rebound).  Some  small  to  mid-cap   were  hit harder  by falling  20-25%  (Ref  Fig 1).

How  low  could  oil  price  go?  In our  view, Brent crude could  settled  around  US$80- 90  level  in   the  midterm instead of >US$100  previously given  rising su pply  from US (US crude production ex pected to reach 8.54m/bbl in 2014  or  +14%  yoy)  which  is  highest  production  since 1970 with shale oil  contributing  about 3.9m/bbl  (Ref Fig 4&5). Given that  shale oil projects in US have breakeven price  range  from  US$50- 80/bbl  (Ref  Fig  2&  3),   we believe  near  term  oil  price  is  close  to  the  floor  as  any extended pric e below US$80 level  (Brent)  will slow down the production  growth  from US shale.

Premium valuation for  O&G  no  longer…In  view  of lower  midterm  oil  price  (from  >US$100  to  US$80 -90), negative  sentiment  and  lack  of  sizeable  contract news flow for upstream sector, we reduced target P/E for big cap from 20x to 16x with small and mid-cap  reduced from 14-16x  to 12-14x.

Despite  P/E  De-Rating, valuation still  compelling with average potential upside of ~27%… Perfect storm of negative news have  driven O&G stocks’

Valuation down  to  multiyear  low,  with  most  companies trading  close  to  1SD  below  average  or  near  trough  of P/E and P/B bands  (Ref Fig 6  & 7). We  thus believe  the recent  sell  down  has  overshoot  fundamentals  with opportunity  to  accumulate  emerging  as  production  and capex  from  oil  majors  will  continue.  From  channel checks, we understand that some prices  for  vessel and rigs  have  fallen,  this  will  encouraging  oil  major  to continue  drilling  as  cost  is  now  cheap er  for  future production.

Alpha  can  be  discovered  in  selective  areas   like RAPID  and  brownfield  development.  Favourite  picks fo r  RAPID  are  KNM  (BUY;TP  RM1.35),  Dialog  (Non Rated)  and  Pantech  (Non -Rated)  while  Scomi  Energy (BUY;TP:  RM1.07),  Uzma  (BUY;  TP:  RM3.66),  Dayang (BUY;TP: RM3.50) and Perdana (BUY; TP: RM1.87 ) will benefit  from increasing  brownfield  development s.

Catalysts 

• Upgrades:  New  Discoveries,  marginal  field  contract awards, M&A.
• Downgrades:  Sharp plunge  in oil prices.

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  picks:  Big  Cap:  Dayang  Mid  to  Small  cap:  KNM and Scomi Energy.

Source: Hong Leong Investment Bank Research - 20 Oct 2014