Oil prices are expected to stay flattish at USD71/bbl in 2018-19 as potential supply drag from the troubled OPEC countries to be neutralised by incremental production from US, Saudi Arabia and Russia and moderation of oil demand growth. The prolonged scuffle between Sarawak government and Petronas creates uncertainties but we still favour jack-up rig drillers and FPSO players. Keep NEUTRAL on the sector and our BUY picks are Armada and Velesto.

Flattish oil prices outlook in 2018-19. Oil prices have gained 9% YTD, averaging at USD71/bbl in the 1H18 helped by several supply disruptions caused by (i) sanction against Iran, (ii) Venezuela crisis post the re-election of President Nicolas Maduro and (iii) military control over Libyan’s oil crescent. However, we reckon that oil prices will stay flattish on average basis at USD71/bbl in 2H18 and 2019 as potential supply drag from these troubled OPEC countries would be neutralised by incremental production from US, Saudi Arabia and Russia and moderation of oil demand growth dragged by the intensifying US-China trade war.

Unresolved scuffle between Petronas and Sarawak. The ongoing tussle between the Sarawak government and Petronas remained unsettled with the prior calling all the oil & gas players to obtain necessary licenses by 2019 whilst the latter defending its exclusive ownership of the petroleum resources and position as the sole regulator of the upstream sector in the country. While we understand that things are rather status quo as of now, any prolonged contention over this matter would lead to delay in business operations including award of PSCs and approval of opex/capex related contracts. Moreover, PH’s promises to increases oil royalty rate to 20% is another lingering issue which may affect the local oil & gas landscape. We opine that demanding higher oil royalty from existing/new PSCs is unlikely as it would reduce the profitability of the O&G projects in Sarawak, making it less appealing to investors/oil contractors. Requesting higher dividend from Petronas may also not be sustainable in the long run at the expense of its future capex spending.

Mixed outlook for different sub-segments. Despite no firm evidence on Petronas trimming its FY18 capex target of RM55bn, we do not discount such possibility given that some of the tenders, according to our channel checks, were on hold or postponed to 2H18 due to GE14, as evident by lower total announced contract value in 1H18. Petronas’ guided jack-up rig demand of 7-10 in 2018-19 should be able to keep the local drillers occupied while OSV players are still facing balance sheet issues given their huge debt repayment amidst half of the vessels being unutilised. Globally, we are positive on FPSO segment as job tenders are at the highest in the past three years with 9-12 FPSO contracts are expected to be dished out annually in 2018-19.

Keep NEUTRAL. Following the transfer of coverage and earnings adjustment, our forward three-year earnings forecasts are still 13%/27%/15% below consensus even building in expectations of pick-up in offshore activities. Valuation wise, we opt to stay conservative at 5-year mean valuation (vs oil prices trading between mean to +0.5 S.D) in view of flattish oil prices outlook in 2018-19. Post downgrade of REACH to HOLD, we have two BUY ratings in our core coverage, namely, Armada (TP: RM0.85; full acceptance of Kraken & potential new FPSO win) and Velesto (TP: RM0.34; turnaround story with better contract flow). We maintain our earnings, call and TP for Dayang (HOLD, TP: RM0.61), MISC (HOLD; TP: RM6.25), Petronas Dagangan (HOLD; TP: RM23.03) Sapura Energy (HOLD; TP: RM0.61) and Velesto (BUY; TP: RM0.34). Keep NEUTRAL view on the sector with gradual improvement within the upstream space.

Source: Hong Leong Investment Bank Research - 18 Jul 2018