Brent crude oil prices seem to have found its bottom for now, stabilizing at above USD60/bbl level due to a drop in US rig counts and declining US crude inventories. Notwithstanding, we are not likely to see USD100/bbl oil price level anytime soon as the incoming Iran sanction lifting and relatively quick production restart lead time by shale producers are expected to cap oil prices’ upside. We believe the O&G industry has to live with this for a while and it has just begun its consolidation phase with M&As and cost cutting. Under this environment, the impact is most severe for OSV and drilling rig players due to their high exposure to greenfield assets and market oversupply in certain sub-segments. This could continue for a while the vessel market rebalances back to parity. Valuation of the sector appears to be fair for now with ex- Petronas big caps trading at 15x and small caps at 9-11x. We believe the sector does not deserve a valuation rerating yet given still the low oil prices and near term earnings downgrade risk. Maintain NEUTRAL. Our top pick is ARMADA (OP; TP: RM1.55) due to its attractive valuation and long-term recurring FPSO contracts on hand.

Oil prices have stabilised, but upside capped in near term. Brent crude oil price seems to have stabilised at above USD60/bbl due to a drop in rig count and the start of declining crude inventories. However, we may not see it rallying all the way back to USD100/bbl anytime soon as the sanction lifting on Iran and quick production restart by the shale producers will bring more supply to the market once oil price recovers. We believe the industry could be living with this price level for quite a while and further upside could only be triggered by extreme factors, mainly a full-scale war or severe supply disruptions.

Era of consolidation. The O&G industry has just begun its consolidation phase with cost cuttings and M&A on-going to adapt to the potential new normal in oil prices. This does not bode well for OSV and drilling players due to their heavy exposure in greenfield assets. Rate cuts and drop in asset utilisations are already seen in 1H15, causing downward pressure on earnings. Under the current scenario, we believe this will last for some time and the players have to streamline their businesses with a focus on tighter market segment to seek for better charter rates to defend their profitability. On the other hand, aging and uncompetitive rigs and vessels have to be phased out from the market to bring the market supply back to balance.

Weakness expected ahead. We expect the 2QCY15 results to continue to be weak, reflecting slower activities and vessel utilisations. Full effect of rate cuts is expected to only be felt earliest in 2H15 and will mainly affect Petronas-dependent stocks as compromise for discounts on existing contracts could be finalized during that time period. We expect contract flows to be stronger in 2H15 compared to 1H15 as oil prices stabilises and oil majors finished recalibrating their CAPEX plans to operate optimally under the current oil price scenario. Overall, earnings for the sector in general are expected to decline YoY.

Are valuations cheap enough? Valuations might look cheap now with average big cap CY16 PER at 15X excluding Petronasrelated stocks and small caps at the range of 9-11x. However, we believe the market is only valuing the sector fairly given the lower oil price scenario and expectation of slower project awards from Petronas. The sector would only warrant a PER rerating if oil prices revert back to its heydays’ USD100/bbl or supply shock occurs in the volatile vessel and rig market. Near term earnings risks are still present for the majority of O&G players with Petronas’ unprecedented move to request for 30% discount from local services players, putting pressure on margins. On the flipside, market intelligence indicates that most players will not agree to the discount quantum proposed and we believe most of them would be within the range of 5-15% depending on the existing margin of projects the players enjoy.

Still not compelling enough, Maintain NEUTRAL. Under the current scenario, we have yet to find sufficient reasons to upgrade the sector despite the share price corrections in the past six months. We advocate investors to be on the defensive in this sector and be selective in their stock picking. We prefer PFSO players with lesser contract renegotiation risks and long-term recurring cashflows namely ARMADA (OP; TP: RM1.55) and YINSON (OP; TP: RM3.86). We also like downstream and maintenanceheavy players like DIALOG (MP; TP: RM1.70) and UZMA (RM2.58) due their stable earnings profile.  

Source: Kenanga Research - 3 Jul 2015