Oil prices declined more than 20% in 4Q15, hitting below USD40/bbl after OPEC decided to keep their taps open to defend market share and amid signs of slower growth in oil demand. Despite the bearish outlook, we believe oil prices could stabilise above the USD50/bbl level by 2H16 on expectations of production cut from non-OPEC countries. However, potential oil supply from Iran coupled with revival of shale oil will cap any oil price rebounds. Looking at the local oil and gas sector, we believe earnings will remain soft and uncertain in 2016 as upstream activities are expected to stagnate with projects being deferred further or put on hold coupled with unexciting rates in asset chartering and oilfield services. This would strain the companies’ cash flow under our coverage universe, but insolvency risk is still low with potential cash calls and refinancing arrangement. While the lacklustre outlook in the upstream segment is likely to persist, we prefer downstream players like PCHEM for its longterm growth story anchored by RAPID project. FPSO players like ARMADA and YINSON will continue to be resilient due to their robust recurring cash flow generation. Reiterate NEUTRAL on the sector.

Better oil prices in 2H16? We saw oil prices falling below USD40/bbl and 11-year’s low since 2004 after OPEC in a meeting concluded no oil production cut from member countries despite some proposals to reduce the oil output to prop up prices. Further pressurising oil prices and capping its recovery are non-OPEC countries such as Russia, which intended to maintain production, coupled with uncertain quantum of oil supply post lifting of sanction on Iran as well as shale oil production changing the oil market econometrics. Despite the pessimism, we view that oil prices could rebound and stabilise above USD50 level by 2H16. This is supported by latest EIA report forecasting non-OPEC crude oil and other liquids production to grow by 1.2m bbl/day in 2015 and then slide by 0.4m bbl/day in 2016. If the decline materialise, it will mark the first annual decline in non-OPEC production since 2008.

Earnings remain soft and uncertain in FY16. With the sluggish earnings performance in 3Q15, we cut our estimate FY15/FY16 earnings by as much as 77.7%/44.5% to reflect a more challenging operating environment for our stocks coverage. Upstream activities have been slow with projects being deferred or put on hold coupled with significant rate cuts in asset chartering and oilfield services. Despite realising the need to rebase their cost structures amid lower vessel utilisation, some asset players are still struggling with heavy fixed cost comprising depreciation, labour and overhead costs. In addition, with the strengthening of USD, companies with foreign debt will also be hit by increasing interest payment, especially if their loans are not naturally hedged. Therefore, cash flow management and balance sheet strength to weather the bad times are top priority at this juncture.

Stretched cash flow but low insolvency risk. As at 3Q15, the oil and gas companies under our coverage had an average net gearing of 0.65x, which is relatively comfortable. Our research tells us that companies such as ALAM (UP; TP: RM0.32), PERISAI (MP; TP: RM0.34), UZMA (UP; TP: RM1.77), DAYANG (MP; TP: RM1.43) and SKPETRO (OP; TP: RM2.38) will encounter stretched cash flow situation resulting from lower cash-flows from operation, high finance cost and repayment of short-term debt obligation if oil prices remain at low level. However, in our view, the risk of insolvency is not apparent at the moment as players with near-term debt obligations like SKPETRO, ARMADA have managed to refinance their debts. DAYANG is also looking to refinance its USD debt and lower its stake in PERDANA to lighten its immediate financial burden. Meanwhile, PERISAI might appear to have higher earnings risk in FY16 heightening its credit risk even though the company is pursuing private placement via issuance of call option and holds a put option to sell its pipe-lay barge at USD40m. All in, we do not discount the possibility of further cash calls in the sector if oil prices continue to dwindle.

Volatile oil movement offers trading opportunities. We notice that oil prices became more volatile in 2015 especially in the past three months. Despite uncertainties and challenges, there are short-term trading opportunities given the heightened volatility in oil prices. This can be done by selecting stocks, which are highly correlated to oil prices when oil prices enter oversold situation and take profit when oil prices undergo technical rebound. Based on our analysis, SKPETRO, ALAM, COASTAL (MP; TP: RM1.99) and PERISAI command the highest correlation at 70%-85% to crude oil prices within our coverage and almost mimic the performance of crude oil over the past one year. However, this strategy is only suitable for short-term investors with relatively higher risk appetite and disciplined trading style.

Still a NEUTRAL call. Valuations could have bottomed as latest earnings disappointments did not affect share prices significantly. We switched our valuation methodology to PBV for OSV players and companies with high earnings risk such as MHB (MP; TP: RM1.00) as using PER methodology is unsuitable due to the volatile and uncertain earnings during industry downturn. Meanwhile, we expect more impairment on oil and gas assets if utilisation continues to decline, which would drive our target prices lower. While the prolonged downturn and lacklustre outlook in the upstream segment is likely to persist, we like PCHEM (OP; TP: RM7.50) for its long-term growth story anchored by RAPID project. FPSO players like ARMADA (OP; TP: RM1.17) and YINSON (OP; TP: RM3.89) will continue to be resilient due to their robust recurring cash-flow generation. Reiterate NEUTRAL on the sector.

Can the supply-demand imbalance be resolved? According to the latest OPEC monthly report, the global market will need 30.8m bbl/day of oil from OPEC in 2016 based on the assumption of oil demand at 94.1m bbl/day. The same report also shows that OPEC has increased their production to 31.7m bbl/day in Nov 2015 from 31.5m bbl/day from the previous month. With the decision not to reduce production, we expect OPEC production to stay at the said level in the next couple of months, marking no clear solution to the oil tumult. The question is how long is OPEC willing to take the pain of low oil revenue as some of the OPEC members might encounter a fiscal crisis consequently. We foresee OPEC’s stance on excessive production to soften moving into 2H16, giving some breather to oil prices by then.

US production likely to taper. IEA is forecasting a decline of production from non-OPEC members in 2016. We concur with the view and we reckon the decline shall come from US. Note that US oil production has started to normalise to c.9.2m bbl/day in the past three months after tapering off from its peak in end of July in 2015. Recent data also suggest that US oil rig count has fallen to the lowest level since 2010, recording only 524 as of 11 Dec 2015. It marks a 67.4% decline from its historical high of 1,609 in Oct 2014. On the other hand, US commercial crude oil and refined products continue to pile up, approaching record level. In our view, oil inventories will drag near-term oil prices but normalisation of oil production resulting from lower rig count will eventually neutralise the supply from US. All in, we expect Brent to average at USD47/bbl and land above USD50/bbl at year end. 

Source: Kenanga Research - 7 Jan 2016