Amid supply shocks and heightened geopolitical tensions from the Saudi drone attack, we expect this to provide an upside support to oil price. We expect 2019 oil price to average USD68/barrel (YTD avg: USD65/barrel), implying an average of USD77/barrel in 4Q19. While higher oil price is positive for Malaysia’s government oil revenues, the 2019 average will still likely fall short of MoF’s assumption at USD72/barrel. There could also be a higher fuel subsidy bill if RON95 pump prices are kept at RM2.08/litre. Sector winners are those in the O&G upstream while losers are aviation (higher jet fuel price), gloves (higher butadiene price) and wood based manufacturers (higher glue price).

NEWSBREAK

Drone strike on Saudi oil facilities. Over the weekend (Sat), drones attacked Saudi Arabia’s oil processing facilities at Abqaiq and Khurais. The attacks have caused Saudi Aramco to shut down the struck facilities, cutting the kingdom’s oil production by 5.7mbpd (-50%), which represents c.5% of daily global production. Although unconfirmed, Saudi is said to have restored close to 70% of the disrupted output.

Geopolitical tensions escalate. Yemen’s Houthi rebels, who have been at war with a Saudi-UAE led coalition, have claimed responsibility for the attack. However, US (a Saudi ally) have accused Iran, with President Trump hinting at possible military action.

HLIB’s VIEW

Limited spare capacity. According to Bloomberg, OPEC, US and Russia have a combined estimated spare capacity of up to 3.9mbpd, although the bulk of this is from Saudi Arabia (1.7mbpd) which remains largely incapacitated at this juncture. Much of the spare capacity in the US is limited by its lagging export infrastructure (terminals and pipelines are at maximum capacity and new infra won’t kick in until 2022 at earliest). The only 2 other countries with spare capacity are Iran (1.6mbpd) and Venezuela (>0.5mbpd) although it remains highly unlikely that the USA will remove sanctions on their oil anytime soon.

Reserves on hand. Based on EIA data, OECD countries have c.2.9bn barrels of oil in reserves (commercial) ex. strategic reserves, which translates to c.60 days of supply. The US has a strategic petroleum reserve (SPR) of c.645m barrels (as at June 2019), which President Trump has indicated that the US is willing to release to combat the supply shock risk. The Saudi’s have c.188m barrels in storage and can sustain over 30 days of supply to global markets.

Upside support to oil price. Information on the supply resumption remains unclear as we await further information on the extent of the damage done to those facilities. If the outage is longer than the initial guidance of a few weeks, we can expect oil prices to rally further as reserves run down and a supply shock manifests. Coupled with escalating geopolitical tensions in the Middle East, we believe that this will provide a near term upside support to oil price. Oil price (Brent) has averaged USD65/barrel YTD and we are keeping our full year 2019 average assumption at USD68/barrel; this implies oil price to average USD77/barrel in 4Q19.

Impact on Malaysia. Assuming oil price averages USD68/barrel for 2019 (our assumption as elaborated previously) vs current YTD average level of USD65/barrel, we estimate the additional fiscal revenue to be RM900m. However at USD68/barrel, this is still below MoF’s average assumption of USD72/barrel for 2019, indicating a possible budget shortfall of RM1.2bn. In addition, assuming the Government maintains fuel price of RON95 at RM2.08/litre, our back-of-envelop calculations suggest an additional RM1.8bn subsidy bill in 4Q19. Taken together, if oil price averages USD68/barrel in 2019 and RON95 is kept at RM2.08/litre, the budget shortfall for 2019 could be RM3bn (i.e. RM1.2bn + RM1.8bn). Nevertheless, we still think it is possible for the 2019 budget deficit target of -3.4% to be achieved as other additional Government revenue measures (e.g. voluntary tax disclosure, increased SST revenue) is estimated to give an additional RM3.6-4.9bn buffer.

KLCI correlation to oil price. In the past 6-years, there has been a modest 67% correlation between Brent oil prices and the KLCI. However more interestingly, the shorter term correlation (i.e. 60 days) between the 2 variables tends to be higher during periods of oil price decline (Figure #4). Simplistically, there is a higher tendency to observe market (i.e. KLCI) weakness during periods of oil price decline than there is market strength during an oil price rise.

Winners... Within the O&G space, those that are exposed upstream such as Reach (HOLD TP: RM0.18), Hibiscus (not-rated) and Sapura Energy (BUY, TP: RM0.35) are key winners from higher oil price. PCHEM (HOLD, TP: RM7.71) is also a beneficiary from higher oil prices (from possibly higher petrochemical prices) given its integrated cheap gas feedstock model from Petronas. For MISC (HOLD, TP: RM6.99), we reckon the impact to be neutral as weaker demand for VLCC tankers from the Middle East could be potentially offset by higher spot charters for their export lightering segment as shale producers are expected to ramp up production and exports.

…and losers. The aviation sector is a loser with higher oil price and consequently, higher jet fuel price. We understand that AirAsia (HOLD, TP: RM1.86) has hedged 85% of its jet fuel requirements for 4Q19 and 73% for 2020. Higher oil price would also result to higher butadiene price and increase nitrile prices, impacting nitrile glove makers; Hartalega (HOLD, TP: RM4.78) has 95% of its product mix in nitrile gloves, Kossan (HOLD, TP: RM4.35) at 77-78% and Top Glove (BUY, TP: RM5.31) at 50%. Lastly, glue prices may increase with higher oil price, impacting wood based manufacturers. For furniture players (Lii Hen (BUY, TP: RM4.22) and Homeritz (BUY, TP: RM0.71)), glue makes up c.15% of raw material cost while for the particleboard players (Heveaboard (SELL, TP: RM0.40) and Evergreen (SELL, TP: RM0.22)), it is higher at c.60%.

Source: Hong Leong Investment Bank Research - 18 Sept 2019