Volatile oil prices are expected to stay despite recent recovery from the bottom premised on slower supply-demand rebalancing and weaker demand. We also toned down our Brent crude forecast to average USD38/bbl and to end at USD47/bbl for 2016. A successful collaboration between OPEC and non-OPEC countries to address the oversupply imbalance could be a sector game changer. Tougher operating environment is expected, resulting from more opex and capex cut from oil majors. While the sector is currently trading at average to trough valuations, we believe such valuations have factored in the bleak earnings outlook. However, further missing the consensus forecasts materially will see further de-rating for affected players. YINSON remains our preferred pick within the upstream segment for its resilient earnings outlook while we like downstream players like PCHEM for its long-term growth story anchored by the RAPID project. Meanwhile, SKPETRO, in our view, remains the best proxy to trade the volatility in oil prices given its oil production profile, which will directly benefit from stronger oil prices despite weaker correlation observed in the past 30 days. Still a NEUTRAL call but slightly more bearish on the sector.

Oil prices recouped losses. We saw Brent crude oil prices rallying to above USD42/bbl for the first time since December last year, recovering from an 11- year low of USD27.88/bbl in mid-January after OPEC and non-OPEC countries decided to meet in April for a potential production freeze discussion regardless of Iran’s participation. Despite the optimism on better oil prices prospects and hopes for a production cut, the US Energy Information Administration (EIA) forecasted Brent crude to average at USD34/bbl and USD40/bbl, USD3/bbl and USD10/bbl lower in 2016 from its previous estimates, respectively, premised on slower than expected reduction in global oil production coupled with weaker-than-expected demand growth. Meanwhile, we also toned down our average 2016 Brent crude price assumption to USD38/bbl from USD47/bbl on similar reasons. We still anticipate a better 2H16 with oil prices exceeding USD45/bbl at year-end but reiterate that price recovery is capped beyond that by the potential revival of shale oil production from the drilled but unfracked wells in US.

Tougher operating environment. Even though the oil market sentiment has improved in the past two months, we did not observe much improvement within the upstream space, especially when local industry leader Petronas decided to cut CAPEX and OPEX up to RM20b this year. This will translate into further project deferrals and slower contract awards. Besides, based on our channel check, Petronas had initiated another round of service rate renegotiation with services providers on existing contracts beginning of this year and we believe some service players are under pressure to succumb in order to preserve client relationship. At the same time, asset players are facing challenges to maintain the vessel utilisation given more intense competition in job bidding as limited projects are available in the market. In view of oversupply of jack-up rigs and OSVs, local players have to tender for jobs overseas such as the Middle East.

Default and insolvent risk still manageable. In our last strategy report, we highlighted that players are facing stretched cashflows but insolvency risk is not apparent. Our view is largely reaffirmed as banks are supportive enough to reshuffle/refinance short-term debt so that these companies can sail better through the harsh times. Net gearing increased to 0.61x from 0.42x in 2014 due to more loan drawdowns upon asset deliveries coupled with impairment hurting equity value. However, moving forward the credit outlook continues to be put on test in this slow environment resulting in weaker cashflows from operations and cashflow management is the top priority at this juncture.

Trading at trough valuation. Most stocks under our coverage (except for Petronas-related companies) are trading at an average of 0.6x Fwd PBV, ranging from average to trough valuations. We believe the huge discount towards book value is justifiable since most companies have taken impairment hit last year, albeit at different quantums. Questions were raised whether book value is reflective of the intrinsic value given that many of these assets were acquired or committed during good times. In our view, such trough valuation has factored in bleak and poor earnings outlook unless these companies miss the consensus forecasts materially in the coming quarters. We reckon such deep discount will only be narrowed when impairment risk has largely subsided coupled with stronger cash generating ability on these assets.

Still a NEUTRAL call but slightly more bearish on the sector premised on slower supply-demand rebalancing and weaker demand. Investors should stay at the sideline on the sector given prolonged oil price recovery and sluggish outlook while awaiting for re-rating catalysts. YINSON (OP, TP: RM3.92) remains our preferred pick within the upstream segment on its resilient earnings outlook while we like downstream players, like PCHEM (OP, TP: RM7.50), for its long-term growth story anchored by the RAPID project. Meanwhile, SKPETRO (MP, TP: RM1.93), in our view, remains the best proxy to trade volatility in oil prices as its oil production profile, which will directly benefit from stronger oil prices despite weaker correlation observed in the past 30 days.

US production showed signs of tapering… While the expected non-OPEC production reduction is largely anticipated to come from US, it is crucial to understand how much more the US production can be reduced. Note that US oil production had already normalised to c.9.0m bbl/day level in end of March from its peak of c. 9.7m level in July 2015 while US oil rigs count also fell to the lowest level since 2010, recording only 372 as of 25 March 2016. Future production is bound to fall further with lesser drilling activities, particularly in horizontal wells drilled into tight formations, which have steep initial decline rate.

…but oil inventories are piling up… On the other hand, US commercial crude oil and refined products continue to pile up, approaching record high level. EIA forecasted global oil inventories to increase by an average of 1.6m bbl/day in 2016 and another 0.6m bbl/day in 2017. We believe the larger-than-expected global oil inventories are major hurdles to rebalancing the oil market. 

Source: Kenanga Research - 5 Apr 2016