Highlights

• Recapping 2014… Overall, oil and gas sector has underperformed FBM KLCI index in 2014 driven by plunge in oil price and lack of contract newsflow. Large cap O&G has underperformed FBM KLCI by 37% while small cap O&G has underperformed by 28%.
• Prolong low oil price is needed to limit supply… In our view, the market floor price still fluid, but we believe prolong low oil price period is needed to slow US shale supply growth which suggest that oil price will only likely to rebound in 2H14 (average US$55/bbl in 2015). Overall, we expect any rebound will only be gradual given the longer period for supply issue to adjust to equilibrium as exit of higher cost or inefficiency producer eventually lead to production cut.
• Capex cut from oil producer… Domestically, Petronas announced that it will cut capex by 15% to 20% in 2015 and reduce operational expenditure in response to the fall in oil prices. However, RAPID project worth US$27bn that have received FID will not be affected and new RSC contracts will only be awarded if oil price is above US$80/bbl albeit breakeven cost of US$65/bbl.
• Alternative safe heaven: SPAC… Risk adverse investors can consider undergraduate oil and gas SPACs (Reach Energy, Cliq and Sona) which offer higher risk free returns (~8-9% pa) than FD rate while enjoying upside “option”.
• Dry spell ahead… Given that oil price is likely to continue stay low for next 6 months, negative sentiment, capex cut and lack of sizeable contract newsflow for upstream sector, we maintain Neutral call on the sector and reduced target P/E for small and mid-cap from 11 to 10x (to reflect lower liquidity) but maintained target P/E for big cap at 14x. Overall, TPs were reduced by average 13% across our universe.
• Prefer companies with… i) Higher earning visibility; ii) manageable gearing level; iii) exposure to services and maintenances related on producing field; and iv) RAPID development. We advise long term investors to accumulate Bumi Armada, KNM and Uzma on share price weakness to position ahead of any recovery.

Rating

NEUTRAL

Positives

• Capex plan from oil operators to continue tomaintain oil and gas production

Negatives

• Delay in contract rollout and low oil priceenvironment lead to competition and margin compression.

Valuation

• Top picks: Bumi Armada, KNM and Uzma.
• We maintain most of our recommendations with only one downgrade on Dayang from Buy to Hold mainly due to earnings cut given the potential delay from Petronas Carigali HUC contract.

Source: Hong Leong Investment Bank Research - 27 Jan 2015