In the recently concluded earnings season, we saw more disappointing results, with seven players falling below expectations despite previous earnings adjustments. Domestic outlook remains sluggish this year with Petronas slashing up to a total of RM20b from its CAPEX and OPEX, indicating further slowdown in contract awards to the local services players. Drillers and OSV players are generally sliding into losses with no near-term reprieve in sight while long-term contracts backed players such as DIALOG and YINSON should be able to continue delivering stable earnings. Meanwhile oil prices stayed flattish YTD after it fell below USD30/bbl in mid-Jan but has regained its momentum on the back of a potential agreement among OPEC and non-OPEC producers to resolve the oversupply tumult. We expect prices to remain volatile but gradually improve, anticipating better oil supply-demand balance in 2H16. While the lacklustre outlook in the upstream segment is likely to persist, we prefer downstream players like PCHEM for its long-term growth story anchored by the RAPID project. SKPETRO could be a better proxy for trading on volatility in oil prices. Reiterate NEUTRAL.

Another disappointing quarter in 4Q15. Following the recent results season, we saw more disappointing results with only three companies, namely MHB (MP; TP: RM1.00), YINSON (OP; TP: RM4.04) and DAYANG (MP; RM1.43) beating expectations, out of the 16 O&G stocks under our coverage, largely attributable to stronger contract revenue recognition. On the flipside, as a result of slower upstream activities and margin erosion, seven companies underperformed despite several rounds of earnings adjustment throughout the year. Meanwhile, we downgraded PETDAG to UP from MP as we believe its share prices had moved ahead of valuation and upgraded MHB to MP in view of better project revenue recognition and stronger marine segment coupled with better risk/reward ratio.

Widely anticipated kitchen sinking quarter. Last month’s earnings season saw most oil and gas companies made provision on impairment to their oil and gas assets amounting to as high as 50% of their book value. This was not a surprise given that oil prices have fallen 68% from its high and operating environment has turned sour with fallen rates and utilisations. Based on our channel checks with the players, most firms have factored in current market condition but assumed some recovery in oil prices from the current USD30lbbl level over the next few years. Hence, in anticipation of a better 2H16, we expect minimal impairments in the 1H16, but we do not discount further impairment in 2H16 if oil prices continue pointing south. Adding to that, we also observed that the average net gearing increased to 0.61x from 0.42x last year mainly due to delivery of more assets as well as reduction in equity value as a result of impairment.

Slower 2016 with Petronas budget cut. Earlier on Monday, Petronas announced its FY15 results with core net profit plunging 45% YoY and cash flow from operations contracted by 33% compared to the previous year. The president and group CEO Wan Zulkiflee also mentioned that PETRONAS is looking to cut CAPEX and OPEX by up to RM20b, which is in line with the initial target of RM50b cut over the next 4 years. On top of that, Petronas is set to lay off 1,000 staff under the group-wide transformation plan to be more cost efficient. We believe the smaller CAPEX and OPEX allocation will mainly affect the entire upstream segment, including drillers, OSV, fabricators and even maintenance players. While the allocation details are not in sight with only PFLNG2 project confirmed delayed, we believe the E&P segment will experience further slowdown and projects such as the Canada Pacific NorthWest LNG project might be put on hold. For instance, PFLNG2 deferment could probably affect job replenishment for service players who had secured contracts for PFLNG1 such as ALAM (UP; TP: RM0.32), SKEPTRO (OP; TP: RM2.38) and BARAKAH.

Dropout risk from Shariah-compliant list. Based on the latest reported financial statements, both DAYANG and ARMADA (OP; TP: RM1.17) may be out of the shariah compliant list by May this year as they did not fulfil the 33% financial ratio benchmark. DAYANG aims to complete its refinancing of USD loans through sukuk by April in order to maintain the Shariah-compliant status while ARMADA is likely to maintain their debt portfolio to naturally hedge their business model, which is mainly denominated in USD.

Still a NEUTRAL call. O&G stocks continued to underperform the FBMKLCI in the first two months of 2016, recording an average 5.25% decline YTD vs. -1.58% registered by the key index over the same period. Top losers were WASEONG (-15.18%), followed by ALAM (-14.12%), and UZMA (-13.50%). On the other hand, GASMSIA (1.67%) and SKPETRO (1.49%) were the two gainers within our coverage in spite oil prices sliding 2.7% YTD. 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 the 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. SKPETRO could be a better proxy for trading on volatility in oil prices. Reiterate NEUTRAL on the sector.

Source: Kenanga Research - 3 Mar 2016