Brent crude price resumed its downwards trend after rebounding to the USD60-70/bbl level in 2Q15, reflecting market’s fears of potential fresh supply from Iran post the sanctions lifting deal. We believe crude oil prices will remain at these levels at least until late 2016 given the economic slowdown in China, high US crude inventory and OPEC’s near-term decision to maintain its production level. Significant production cuts in crude oil are not expected in the near-term with the drop in US rig counts plateauing while the US production decline of 0.4m bbl/day hardly making a dent as the supply surplus in the global oil market is expected to be at c.2m bbl/day. Notwithstanding, we anticipate more meaningful decline in production, especially in non-OPEC countries as the lag-effect of current CAPEX cuts by oil majors take effect over the longer term. Sector valuations have not bottomed yet with Big Caps currently trading at 14.2x on average and Small Caps at 12.0x, still relatively higher than Big Caps/Small caps’ target PERs of 10x/7x based on our regression analysis at USD40/bbl oil price assumption. We believe that the O&G sector has not bottomed yet despite the recent decline in share prices with more earnings disappointments expected. Maintain NEUTRAL.

Disappointing quarter. A gloomy quarter for the sector with dismal 2QCY15 results seen in the sector with 8 out of 18 players under our coverage coming below expectations, in particular, OSV players and Jack-up rig asset owners, owing to reduction in asset utilisation and discounts in charter rates amid a slump in the O&G industry. On the flipside, downstream-related players fared better in the quarter, such as DIALOG (MP; TP: RM1.65) and YINSON (OP; TP: RM3.89) which were within expectations due to their stable earnings profile backed by locked-in contracts. PETDAG (MP; TP: RM22.15) beat expectations in the quarter due to favourable Mean of Plats Singapore (MOPS) movement. Overall, things could get worse in 2H15 as more assets reach the tail-end of their contracts with poor prospect of contract renewals amid the approaching monsoon season.

Oil resumed its slide again. After rallying to USD60-70/bbl in 2Q15, Brent crude prices resumed the downtrend post the peak US summer driving season. This is reflective of the market’s fear of: (i) persistently high oil inventory level, (ii) slowdown in China economy, and (iii) incoming sanction lifting on Iran’s oil exports, which would flood more oil to the already oversupplied crude oil market. This has sent local O&G sector market valuations (excluding downstream and Petronas stocks) down to an average of 9.2x CY16 PER.

Low prices here to stay. We believe the low oil price environment would remain at least until late 2016 after considering several factors such as: (i) incoming Iranian oil supply, which could add 400,000-600,000bbl/day to the market in 6sixmonths after sanction lifting, (ii) slowdown in China oil demand, (iii) high US crude inventory, and (iv) OPEC’s will to maintain or maybe even increase its output to defend market share. Therefore, instead of hoping for a sharp rebound in oil prices, industry players have to realign their costing structure and business model to survive in a prolonged oil price slump for the medium-term.

Significant production cuts unlikely. Those hoping for significant cuts in crude oil production might be disappointed at least until late 2016 with OPEC refusing output cuts while producing above its ceiling target of 30m bbl/day in the past few months. Meanwhile, reduction in US rig counts has plateaued in recent weeks with slight WoW uptick in rig count seen, further denying the prospect of huge production cut from shale in the near-term. In EIA’s August short-term energy outlook, US crude oil production is expected to decline 0.4m bbl/day to 8.96m bbl/day in 2016 from expected 9.36m bbl/day in 2015. In our opinion, the decline is not sufficient to offset the supply surplus in the global market as it only accounts for 0.4% of total forecasted world crude oil consumption in 2016 amounting to 95.1m bbl/day. Beyond 2016, however, a turning point in world oil supply could be seen as effects of CAPEX cuts by oil majors in the world starts to set in, resulting in oil production decline in the longer run.

Tougher times ahead, Maintain NEUTRAL. While the overall sector’s valuation has come down in the past six months due to market selldown, we believe a bottom has yet to be formed with more incoming earnings disappointments and volatility in crude oil prices expected. Investors should limit their exposure to the sector, for the time being, unless they adopt a longer investment horizon (>1 year) to justify the bottom-fishing approach. For now, we prefer players with more resilient earnings profile namely DIALOG, YINSON and ARMADA (OP; TP: RM1.17). Notwithstanding, oil prices and sector’s valuation should be continuously monitored for suitable entry opportunities. Meanwhile, we reiterate our NEUTRAL call on the sector. 

Source: Kenanga Research - 2 Sep 2015