The O&G industry is currently undergoing a structural change with cost rebasing to adapt to the low oil price environment. We believe there will be more asset write-downs to come after the two major write-downs by SKPETRO and ARMADA. Write-downs are inevitable, in our opinion, if oil price weakens to lower levels, especially for players with higher earnings correlation to oil prices, such as rig and OSV owners. We believe the worse is yet to come for the sector with potential valuation downgrades in the event of asset impairments as assetbased approach, i.e., PBV methodology, is favoured during times of earnings volatility. Major turning point for the industry is not expected any time soon with longer time need for rebalancing market dynamics. Moreover, a recovery in oil prices is expected to be an uneven affair given uncertainties in demand and production trends moving ahead. Maintain NEUTRAL.

In the midst of a structural change. With the industry players realising that the possibility of V-shaped oil price recovery is low for the medium-term, structural changes in the O&G sector kicked-in this year with oil producers rebasing their costs to weather the storm. Negative impact of this change is already felt with rig and OSV players experiencing a lull in rates and significant drop in utilisation. Gone were the days where 30%-35% net margins could be achieved for jack-up rig players and we believe margins could converge to the 15% level at best if the rebasing effect has fully taken effect.

More losses and write-downs? Since the plunge in oil prices, the industry has been seeing rate cuts and major oilfield projects deferred. The main question now is what could go south further for the industry and have we seen the worst yet? In our opinion, we believe the worst is not over with some consultants predicting USD20-30/bbl oil, which is possible given the weak demand trend and oil inventory build-up. Under such a scenario, some players like OSV and jack-up operators will run into losses while more asset impairments could be seen with oil price assumption curve changing, in our view.

Worst over? Maybe not. We have switched our earnings valuation method for some companies under coverage to PBV methodology from PER as it is more reflective of companies’ intrinsic value during such challenging times. The common question recently is what could be the trough levels for O&G stocks. Therefore, we have run through our numbers for the whole sector to find out what could be the trough valuations for the companies under our coverage. As expected, the worst hit are OSV & rig players with significant downside in target prices in the event of a 20% asset write down. SKPETRO (MP; TP: RM2.04) which is exposed to oil production will also not be spared if crude oil prices went south further (i.e. <USD40/bbl). Our sensitivity analysis shows that there will be a c.RM90m hit to SKPETRO’s earnings for every USD10/bbl change in oil price. This implies that the sector’s valuation may not have bottom yet and things could worsen further if oil price falls below USD40/bbl.

More details on bear case study. We have done an analysis on what valuations would the O&G stocks trade at if the oil prices continue to worsen (below USD40/bbl). Earnings-driven PER would not be relevant in the bear case as some players may register losses. Therefore, we have looked at asset-based valuation, for instance, PBV valuation. To find out the potential floor value of the companies under review, we have assumed a 20% discount on book value for more volatile players like OSV, oil producer and rig players before we ascribe our 0.5 PBV target multiple and it shows that some counters still have downside from current share prices if a bear case materialises. However, we opine that the possibility of a bear case is low for now given that the market could have already factored in the oversupply situation in the global oil market. Contract awards slow as expected. Upstream related project awards are slower than last year as anticipated, which is expected to continue for rest of 2015. Downstream project awards, for instance, RAPID, however, picked up steam in 3Q15 as the main contractors which mainly consist of international major downstream players started to dish out sub-contractor works to local contractors. This could help to fill the void left in the upstream industry with fabrication and pipe-related players such as MHB (OP; TP: RM1.00) & PANTECH (OP; TP: RM0.67) benefiting from this. We believe more jobs are in the pipeline from the RAPID project as it picks up steam in the nearterm coupled with bullish prospects for downstream players, especially for refiners under the low oil price environment.

Still not time yet, Maintain NEUTRAL. We believe the turning point is not in sight yet with an expectation of a major turnaround in late 2016 as oil market dynamics rebalances. In the meantime, we expect more volatility in the market with no obvious trends to be spotted for the coming months. An uneven recovery in oil prices is expected over the next two years and we advise investors to stay on the sidelines for now in view of uncertain industry direction in the near-term. Instead, near-term developments in the sector should be monitored closely to spot any potential signs of sustainable recovery before adding exposure to the sector. On the other hand, cut in tax rate will not have a meaningful impact on the sector’s earnings as some of the businesses are already enjoying tax allowances (therefore already low effective tax rates) due to its business nature. Moreover, if we assume a 1% tax cut across the board, the impact on earnings will be only 1-2%. For now, we still like players with safe and firm long-term contracts like ARMADA (OP; TP: RM1.17) and YINSON (OP; TP: RM3.89) as we opine that they will be able to ride out this volatility. Reiterate NEUTRAL on the sector.

Source: Kenanga Research - 7 Oct 2015