Reading through Petronas’s 1H16 report card with core earnings falling 10% YoY to RM17.6b from RM19.7b in 1H15, dragged by lower averaged realised product prices and lower crude oil and condensates, processed gas and petroleum sales volume but offset by better cost efficiency, we reckon Petronas may need to conserve more cash through higher cost savings or even at the expense of deferring further capex if Petronas remains committed to the RM16.0b dividend commitment given that it has no intention of raising debt at this juncture. That said, we would probably see stronger opex-related contracts award such as Pan Malaysia T&I and subsea IRM for both Peninsular Malaysia and East Malaysia in 2H16. While flattish oil prices will cap the sectors’ valuation, we advocate investors to be nimble and selective and look out for strong contract flow as firm earnings recovery indicator. In all, YINSON remains our preferred pick within the upstream segment on its resilient earnings outlook while we like PCHEM for its long-term growth story anchored by the RAPID project. 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.

1H16 core PATAMI down 10% YoY. Stripping off total net impairment of RM9.0b, Petronas’s core profit after tax and minority interest (PATAMI) improved by 13% to RM9.4b from RM8.3b in 1Q16, largely attributable to better crude prices (+34% QoQ), better cost efficiency. On a YoY basis, Petronas’s core PATAMI has fallen 7% from RM10.4b due to lower average realised prices recorded across all products (26% YoY weaker Dated Brent prices) and lower crude oil and condensate, processed gas and petroleum products but was partially offset by a 10% YoY weaker Ringgit in 2Q16. Cumulatively, Petronas’s core PATAMI weakened 10% YoY to RM17.6b in 1H16 from RM19.7b in 1H15 on similar reasons as mentioned above but was largely offset by the cost saving impact arising from continuous cost optimisation measures.

Improved QoQ cash flow from operations. Despite Petronas recording 64% QoQ improvement in operating cash flow (OCF) to RM15.9b in 2Q16, its cumulative OCF still fell 26% YoY to RM25.6b in 1H16. Meanwhile, Petronas recorded capex of RM13.9b in 2Q16 (+24% QoQ, -30% YoY), bringing its YTD capex to RM25.1b (-21% YoY). The investment made is mainly attributable to RAPID project in Pengerang, other domestic upstream projects and SAMUR project. Since the introduction of the five-year cost cutting programme, Coral 2.0 in 2015, Petronas has managed to save up to RM3.4b from the 11 core initiatives, including lost cost drilling, surplus materials management, renegotiations of current contracts and etc.. Furthermore, Petronas president and CEO, Datuk Wan Zulkiflee Wan Ariffin recently mentioned that Petronas had trimmed both capex and opex up to RM15.0b this year and is on track to pare down RM50.0b over four years.

Enough for dividend? Note that PETRONAS is committed to pay RM16.0b dividend this year, RM10.0b lower than a year ago. Petronas has paid RM6.0b worth of dividend in 1H16 and expected to pay the outstanding RM10.0b in 2H16. We believe it is challenging but possible for Petronas to fund the entire dividend payment from the excess of OCF after deducting cash flow from investing activities (RM3.5b as of 2Q16). Given that Petronas has no intention of raising debt at this juncture, we reckon that Petronas is required to conserve more cash through higher cost savings or even at the expense of deferring capex if Petronas remains committed to the RM16.0b dividend commitment. Hence, this would imply that services players are bound to stay cost effective, as they are likely to see continuous rates adjustment pressure from the oil major. Having said that, we would probably see stronger opex-related contract awards such as Pan Malaysia T&I and subsea IRM for both Peninsular Malaysia and East Malaysia in 2H16. Potential beneficiaries include SKPETRO (MP, TP: RM1.49) and BARAKAH.

Oil prices rally might not be sustainable. Crude prices have rebounded more than 15% in August from its three-month low after OPEC led by Saudi Arabia reinitiated the output freeze discussion in Algiers next month. We are sceptical on the talk to be fruitful in reaching any concrete deal given that the dynamics of relationship between OPEC members remain largely similar as the first discussion in April this year. Even if they agree to freeze their output at their respective record high level, it does not change the fundamental of supply-demand balance substantially but serve as a short-term catalyst to oil prices underpinned by improved trading sentiment.

Retain NEUTRAL. Overall, we believe Malaysia should be able to maintain its budget deficit target at 3.1% of GDP given the YTD average oil prices of USD42.4/bbl which is higher than the crude oil assumptions of USD30-35/bbl in the revised budget early of the year. While flattish oil prices will cap the sectors’ valuation, we advocate investors to be nimble and selective and look out for strong contract flow as firm earnings recovery indicator. In all, YINSON (OP, TP: RM3.90) remains our preferred pick within the upstream segment on its resilient earnings outlook while we like PCHEM (OP; TP: RM7.18) for its long-term growth story anchored by the RAPID project. 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.

Source: Kenanga Research - 23 Aug 2016