Highlights

• Oil price recovery, sustainable? Brent oil prices have rallied from a low of US$27/bbl to a 2-month high of USD39/bbl since the speculation on output freeze by major oil producing countries (i.e. Saudi Arabia, Russia and other OPEC countries) to support the crude oil prices. Moreover, the recently concluded China’s National People’s Congress lauded a proposal to build underground cavern to cater for expansion of its strategic oil reserves by 2020 to improve energy security, taking advantage of low oil price.
• How far will the oil rally go? While the recent oil price rally has improved the sentiment towards the O&G industry, we believe such rally could be capped at US$50-55/bbl levels. It is always the OPEC’s intention to keep oil prices at sustainable levels of US$40-50/bbl without attracting the restart of active drilling in US shale oil fields which will send oil prices lower while disrupting current market share. Bear in mind that US shale production could still be ramped up without additional drilling as there is still an estimated of 322,000bbls/day of drilling yet to fracture.
• Oil fundamentals largely unchanged. In essence, the production freeze proposed by Saudi does not imply a significant shift in oil market fundamentals. In the latest short term energy outlook by EIA, global oil consumption is expected to grow by 1.2m bbls/day to 94.9m bbls/day, still below the expected supply of 96.4m bbl/day in 2016, yielding 1.6m bbls/day surplus. Surplus is only expected to narrow significantly to 640k bbl/day post 2016. We are of a view that oil price recovery beyond USD45-50/bbl levels would only materialise in 2017 or beyond. Barring a material change in global production via output freeze / cut, our target of USD30/bbl for 2016 remains unchanged for the time being. Therefore, our medium term view of weak activities in the O&G sector also remains unchanged.
• What if oil price rallies further? If the rally continues to gain strength, investors are advocated to go for companies with high price volatility and earnings sensitivity to crude oil prices. According to our correlation studies, SKPETRO has the highest earnings and share price sensitivity to crude oil price movements, making it the best proxy for trading on crude oil price rally. Similarly, rig players like UMWOG and PERISAI are also good trading stock on oil price movement with a higher than average share price correlation. While sustained oil price rally is positive for the industry, we believe 2016 overall earnings outlook for O&G is still not favourable due to the lagged effect on slower rebound in contract awards and revision in asset charter rates.

Rating

NEUTRAL

Positives

• : Signs of oil prices bottoming giving further stability in the sector.

Negatives

• : Sharp rally in oil price could bring back the extra barrels of oil, which will again destabilize the oil supplydemand equilibrium dynamics.

Valuation

• Top picks: Mid to Small cap: KNM

Source: Hong Leong Investment Bank Research - 14 Mar 2016