Given the absence of positive near-term catalysts, we maintain our NEUTRAL stance for the sector’s outlook in 2Q15. Despite the fairly strong recovery from lows of around USD40/bbl to above USD50/bbl currently, we believe crude oil prices could face an uphill struggle to return to above USD100/bbl over the medium-term due to strong oil production and tepid global economic growth. In 1Q15, the O&G sector was besieged by more bad news as Petronas made headways in its cost-cutting mission through renegotiating charter rates and partially deferring contracts previously awarded. OSV, fabricators and drillers are likely to be significantly impacted, in our opinion. We believe the sector is still not out of the woods yet due to lack of catalysts amid slowing contract flows and weak expected oil prices. Activities in the sector could only pick up earliest in 2H15. We have also cut our Brent crude oil price forecast to USD57/bbl from USD70/bbl previously. Our Top pick is COASTAL (OP; TP: RM3.42) on its strong orderbook with gas compression unit expected to provide recurring income from this year onwards.

A bearish 1Q15. Post the weak 4QCY14 quarterly results and negative news, the sector continued to be bogged down by stock downgrades. Huge impairments were seen in the 4QCY14 results of most local O&G payers as they partially wrote-off/down receivables and assets to reflect weaker prospects amid lower crude oil prices. In addition, contract awards have significantly slowed down in the wake of oil majors and NOC reviewing their budgets and OPEX. USD57/bbl in 2015, low oil prices the New Normal? Despite the recent recovery in Brent prices from its USD40/bbl low, we believe crude oil prices could struggle to recover above USD100/bbl as US crude inventory remains high and global economic growth remains anaemic. In addition, the short lead time for shale producers to restart production implies that supply can re-enter the market swiftly thus potentially capping near-term crude oil prices’ upside. Talks of Iran striking a nuclear deal also raised concerns of additional oil supply from the country which would re-enter the market post lifting of sanction. Such factors compelled our economics team to be more conservative and our in-house crude oil price assumption has been revised to USD57/bbl from US70/bbl previously.

Petronas wields cleaver to emerge leaner. Renegotiations are rumoured to be on-going with drilling and Offshore Supply Vessels (OSV) players while numerous fabrication contract awards are purportedly to have been temporarily deferred. Further RSC awards will not materialize as long as crude oil prices stay below the USD80/bbl level. Pan Malaysia HUC & T&I contractors whose contracts are on call-out basis also risk work re-scheduling this year. The recently awarded Pan Malaysia Umbrella contract to local OSV players are also on call-out basis with spot charter, implying higher volatility in charter rates. This is in contrast with long-term contracts secured in the past whereby rates are more visible.

Sector valuations maintained. We maintain our sector PER targets (Big Cap: 13-19.5x, Small cap: 7-10.x) despite oil price now being below our initial assumption of USD70/bbl earlier as we believe the strong sell-down seen in 1Q15 had reached a bottom. For companies with significant earnings risks, we have decided to switch to PBV valuation (0.6-0.7x in a down cycle) to reflect the companies’ liquidation value under a non-going concern scenario. At the moment, valuations for the sector appears to be more attractive than before with smallmid caps and non-Petronas Big Caps currently trading at 8.7x and 11.8x CY15 forward PER respectively, pointing towards a possible near term rebound in share prices due to bottom fishing. However, we still have doubts on the sustainability of the share price rebound.

Rebound ‘trap’? Despite lower sector valuation, we still believe the underlying environment remains unsupportive for a meaningful nearterm sector’s rebound. It could be a ‘rebound trap’ as the sector may face higher selling pressures post the potential short-term rebound whereby investors with higher entry cost much earlier may look to dispose their potentially loss-making position. More headwinds are expected in the industry with oil prices expected to be volatile still in 1H15 pending outcome of Iran nuclear deal, which could exert further supply pressure. Our in-house economics team have also revised our in-house Brent target to USD57/bbl from USD70/bbl previously, painting a weaker picture for the sector. Contract flow is expected to remain sluggish at least for the rest of 1H15 especially given that Petronas and other PSC contractors will still be adjusting their budgets, thereby impacting contract replenishment for companies. 1QCY15 quarterly results for the O&G industry are expected to be weak, which could prompt further earnings downgrades in the sector.

NEUTRAL maintained M & A possible. We expect the overall industry to be weaker this year compared to last year as activities slow down. Our NEUTRAL call on the sector is maintained in anticipation of lesser positive catalyst to the sector under the current low crude oil price environment. Top pick for the sector is COASTAL (OP; TP: RM3.42) given its strong orderbook on hand coupled with resilient balance sheet position. Investors are advocated to stay picky in the sector as earnings downgrade risk is still present. In the event of a turnaround in oil prices, early beneficiaries of the sector would be OSV and drilling players. We also do not discount the possibility of higher M&A activities in the sector given the recent sharp drop in share prices. For instance, PERDANA (UP; TP: RM0.93) could be a good takeover target for DAYANG, which needs more OSVs to support its future HUC contracts in the future. 

Source: Kenanga Research - 6 Apr 2015