We expect crude prices to remain volatile but recover from the current level to an average of USD68/bbl in 2019, premised on compliance of OPEC+ and moderation of US production growth. Upstream activities are likely to improve as evident by the upward revision in Petronas’ latest activities report amidst better local upstream capex spending. That said, in view of increasing volatility in oil prices which caps sector valuations, we lowered our valuation multiples but retain BUY ratings on Sapura (TP: RM0.41) and Dayang (TP: RM0.78). Reiterate NEUTRAL on the sector.

Brent forecast to average at USD68/bbl in 2019. Brent crude prices hit a 4-year high of USD85/bbl, and subsequently retraced to the 1.5-year low of USD50/bbl in 4Q18. We still expect prices to remain volatile but recover from current level to average USD68/bbl in 2019 (from previous forecast of USD71/bbl). This is premised on compliance of OPEC+ to cut 1.2m bbl/day of production with at least a 6-month extension in the scheduled review in April 2019 and moderation of US production growth (EIA’s FY19 average forecast at 12.1m bbl/day).

Higher activities level in 2019. In the latest Petronas Activity Outlook 2019-2021, we saw an upward revision in the guided activity level in the upstream space with a higher crude assumption of USD60-70/bbl (vs USD50-60/bbl previously). Key areas for upward revisions in activity include jack-up rigs, HWUs, tender rigs, OSVs, MCM while lower offshore fabrication works were guided. Decommissioning work was newly mentioned in the report as 11%/8% of the Malaysian upstream facilities/pipelines have been operating for >40years and >200 wells are confirmed to be plugged and abandoned permanently in the next few years. Therefore, we should see improvement in activity level in upstream segment especially for opex-related works and Malaysian upstream capex is expected to improve to RM14-15bn this year from the planned RM12bn in 2018. Nonetheless, margins could still be under pressure given that Petronas is still in tight cautious spending mode.

Volatile oil prices movement caps sector valuation. Following the sharp decline in crude prices in 4Q18, the sector average valuation has de-rated further to -0.5SD of its 5-year mean level (both PE and P/B). The sector average share prices were down 27% in 2018, underperforming broader market (KLCI’s -5.9%) amidst oil prices falling 19.5% over the same period. The poor performance is also largely attributable to earnings disappointment coupled with balance sheet concerns which heightened cash call risk. As such, we reckon that broad-based sector re-rating purely on crude prices may not be sustainable in view of the increasing volatility in oil price.

Added PCHEM in our core coverage. We also initiated coverage on PCHEM with a HOLD rating at a TP of RM9.74 pegging to 10x FY19 EV/EBITDA. While we like the solid absolute volume growth led by PIC starting from 2H19, we have concerns on potential O&D pricing weakness on a weaker oil prices outlook. Re-rating catalysts, in our view, would rest on stronger oil prices outlook and favourable transfer pricing guidance on PIC’s feedstock.

Reiterate NEUTRAL. As stated in our Strategy Report dated 19 Dec 2018, we continued to stay conservative by lowering down our valuation multiple (PE and P/B) by 0.5x-1x for services players, Dayang, MMHE, Uzma, Velesto and Wah Seong. Despite tuning down TPs, we kept our ratings on all the counters with our universe with two BUY ratings, namely, Dayang (TP: RM0.76; strong earnings delivery & undemanding valuation) and Sapura (TP: RM0.41; turnaround story with better contract flow post deleveraging). Keep NEUTRAL view on the sector with gradual improvement within the upstream space.

Source: Hong Leong Investment Bank Research - 11 Jan 2019