It was rather an underwhelming 1QCY16 for the sector with the disappointment ratio widening to 50% from 43% seen in the previous quarter even with the build-in anticipation of a seasonally weak quarter. Overall, we see no improvement in the operating environment despite oil prices stabilising above USD40/bbl as oil majors are still trimming their budgets to conserve cash. Contract awards flow remained sluggish and DCR are still subject to renegotiations for at least the next 6-12 months. We reckon a more sustainable oil price trend is a prerequisite to entice oil majors to reallocate capex/opex and reactivate postponed and cancelled projects to revive earnings. While sector’s valuation continues to diverge from oil price trend due to weakening fundamentals, we might encounter further earnings risks, which are likely to dampen share prices in the coming quarters. On the other hand, we expect no favourable outcome on production rationalisation from the OPEC meeting in view of the on-going market share fight. YINSON remains our preferred pick in the upstream segment for its resilient earnings outlook and we also like downstream players like PCHEM for its long-term growth story anchored by the RAPID project. Reiterate NEUTRAL call amidst gradual improvement in oil prices while awaiting re-rating catalysts.

Disappointing start for the local oil and gas players with 8 out of 16 results below expectations even with the anticipation of 1Q16 being a seasonally weak quarter. This is largely attributable to lower oil and gas activities as a result of massive budget rationalisation from oil majors. The sole outperformer beating expectations was PERISAI, which was not due to operational improvement but depreciation savings from MOPU being classified as "asset held for sale". On the flipside, we downgraded SKPETRO and DAYANG to MP and UP, respectively, on higher earnings risk in view of prolonged downturn but upgraded PETDAG and PETGAS to OP and MP due to better risk-reward ratio as a result of recent share price weakness. Meanwhile, asset impairment quantum seemed to have moderate following major kitchen sinking activities already done in 4Q15 to reflect value erosion in O&G assets.

Driller remains the worst performer. Our segmental analysis reveals that drillers continued to bleed with widening losses and substantial fall in revenue. Surprisingly, we noticed that the aggregate losses for OSV players narrowed QoQ despite falling revenue coupled with weakening utilisation. This suggests that the effect of cost optimisation and financial restructuring to lower cost have started to kick in. That said, according to our findings, ICON (Not-rated) appeared to be the worst performer among all the OSV players given its largest QoQ drop in vessel utilisation to 45% from 56.5% resulting in a core net loss of RM5.6m in 1Q16 from a net profit of RM11.0m in the previous quarter. We believe vessel utilisation will pick up QoQ post monsoon season but continue to decline YoY no thanks to a prolonged slowdown in offshore activities. Furthermore, we have not seen long-term contracts being offered by oil majors which could possibly indicate that daily charter rates have not reached the bottom yet, subject to further renegotiations. Share prices still diverging from oil price trend. We observed that share prices of our coverage do not seem to correlate with oil price trend since the beginning of the year and this trend had continued in the first two months of 2Q16. Brent crude prices recovered 26% to USD49.69/bbl in the past two months but the oil and gas stocks under our coverage have fallen 5.7% over the same period. The divergence could be mainly driven by: (i) disappointing earnings, and (ii) being in line with the underperformance of local bourse FBMKLCI which declined 5.3%. Going forward, we believe share prices are still sensitive to earnings risks amidst the slow contract awards environment.

Minimal expectations on OPEC meeting. OPEC is having their regular meeting in Vienna on 2nd June but the market generally is not expecting any fruitful outcome on oil production cut. Our view concurs with the consensus view that OPEC wants to defend its market share, including Iran, which is in the midst of ramping up production post lifting of sanction in January this year. With such minimal expectations, we do not foresee significant drop in oil prices post meeting but suggest that oil prices could soften in the next few months due to a possibility of normalisation of short-term supply disturbance and potential revival of shale production. Maintain forecast of 2016 year-end Brent crude price at USD47/bbl.

Retain NEUTRAL call. Overall, no improvement in operating environment is observed despite oil prices stabilising above USD40/bbl as oil majors are still trimming budget to conserve cash. Industry’s average net gearing level stays eased off slightly QoQ to 0.53x from 0.61x in 4Q15 and in our view, debt restructuring is needed for highly leveraged companies such PERISAI with idling assets. Contract awards remain sluggish and DCR are still subject to renegotiations for at least next 6-12 months. We reckon a more sustainable oil price trend is needed to entice oil majors to reallocate capex/opex into postponed and cancelled projects to revive earnings. While sector valuations continue to diverge from oil price trend due to weakening fundamentals, we might encounter further earnings risks, which are likely to dampen share prices in the coming quarters. Reiterate NEUTRAL amidst gradual improvement in oil prices while awaiting re-rating catalysts.

Source: Kenanga Research - 2 Jun 2016