We expect crude oil prices to trade sideways from its June average price in 3Q20 (USD43/bbl) on slower demand recovery arising from potential re emergence of lockdown measures from Covid-19, which has worsened in north/south America, Brazil and India. However, we expect the recovery in demand from countries recovering from Covid-19 (Europe, Middle East and China) to mitigate the potential lost in demand from severely affected nations. We believe that the oil market would be closer to its equilibrium in 4Q20 (USD50/bbl) and we expect Brent crude oil to average at USD44/bbl in 2020. We believe that Petronas would remain conservative on its capex spending and we expect it to come below its planned capex cuts of 21%. We believe that it is still not the time to bottom fish for upstream O&G services names. Bumi Armada (TP: RM0.41; BUY) is our top pick for the sector as we believe it is relatively insulated from the volatility and fluctuations in oil prices and capex spending from oil majors.

Production cuts to continue into 3Q. We believe that OPEC+ would continue its 9.7mbpd production cuts target into 3Q20 to support oil prices. While compliance was only 85% in May and c.90% in June, we believe that OPEC+’s compliance would be higher going into July and Aug despite its plans to reduce production cuts by 2m to 7.7m bpd from Aug onwards, which would bring the oil market closer to equilibrium. Furthermore, the decline in US production from the closure of shale rigs would also act as an impetus for the oil market to reach equilibrium.

Petronas’ 2021 capex cuts. Petronas has announced that it has planned to cut capex by 21% (c.RM10bn) due to the crash in oil prices as a result of Covid-19 and we do not rule out the possibility of this going beyond its 21% pledged capex and our base case assumes a 30% cut. Malaysian O&G services players are predominantly dependent upon Petronas’ spending for its survival and any capex cuts from Petronas would directly impact most listed O&G players in Malaysia. We expect fabrication, engineering works to be deferred, significantly lower utilization for jack-up rigs/OSVs and deferrals of MCM, HUC and plant turnaround contracts. The majority of these contracts were previously awarded on an on-call basis and Petronas has the prerogative to halt or postpone projects if the need arises. We are negative on companies which are heavily reliant on Petronas’ capex spending as we believe that Petronas would be conservative on its capex spending at least until 1HFY21 and we remain neutral to positive on companies less reliant on Petronas’ capex.

Petrochemical products price recovery not enough to warrant an upgrade for PCHEM. Although we believe that PCHEM is in a better financial position right now since the recovery in crude oil and polyethylene prices, many product prices are still down by more than c.20% YTD. We also believe that the Covid-19 pandemic would still result in subdued demand for most petrochemical products and it has the potential to exacerbate demand of key products like methanol and paraxylene. We view that the share price of PCHEM has ran ahead of its near-term fundamentals as most product prices (except polyethylene and urea) are still significantly below its price at the start of the year, while PCHEM’s share price has recovered significantly.

Reiterate NEUTRAL. We like (i) Bumi Armada (BUY, TP: RM0.41 based on 10.3x FY20 EPS) for its stable and strong FPSO earnings contribution (>80% of revenue) and undemanding valuations and (ii) Dialog (BUY, TP: RM4.23 based on DCF with a WACC of 7%) for its stable and cash-strong business model as tanker rates are holding steady. We are negative on oil services companies with a heavy reliance on Petronas’ capex as we believe that it will be conservative on its capex for FY20.

Source: Hong Leong Investment Bank Research - 21 Jul 2020