Following OPEC’s tentative output freeze, we expect oil prices to trend higher over the nearterm due to the sentiment boost. However, we remain cautiously optimistic as the actual mechanism and quantum of cuts by each member have yet to be finalized pending a formal OPEC meeting in November. Meanwhile, volatility will persist on continuous oil inventories build-up and rebound in rigs count coupled with moderating growth in oil demand. On the domestic front, Petronas will continue to prioritise cash flow management amidst tight capex spending and thus, capex and opex allocation will be rather selective. Meanwhile, another round of kitchen sinking at smaller quantum is in sight in 4Q16 in view of weaker asset utilisation and, in our view, MHB, DAYANG, UZMA and COASTAL are susceptible to further earnings downgrade if the overall offshore activities do not improve in near-term. All in, we maintain our NEUTRAL call on the sector while awaiting for stronger contract flows for indication of firmer earnings recovery. 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.

Better short-term sentiment. Following OPEC’s tentative output freeze, we expect oil prices to trend higher over the near-term due to the sentiment boost. However, we remain cautiously optimistic as the actual mechanism and quantum of cuts by each member have yet to be finalized pending a formal OPEC meeting in November whilst volatility will persist on continuous oil inventories build-up and rebound in rigs count coupled with moderating growth in oil demand. Further upside could come from non-OPEC members such as Russia willing to participate in the global production cut. We maintain our forecast 2016-17 average Brent crude price at USD47-51/bbl.

Selective offshore capex allocation. The latest Baker Hughes international rig count shows opposing trend for different regions. In August, Middle East oil and gas rigs count fell to a three year-low at 379 (-3% or -11 rigs MoM) led by Pakistan and Qatar whereas Asia Pacific rigs count climbed to YTD high of 194 (+4% or 8 rigs MoM) backed by countries such as Malaysia, Thailand, Vietnam, Indonesia and India. It could be a little pre-mature to conclude that a recovery is on the way. However, the longer oil prices stabilises above USD40/bbl, the higher the confidence level for oil majors to sanction their investment accordingly. On the domestic front, Petronas will continue to prioritise cash flow management amidst tight capex spending. Hence, we expect capex and opex allocation to be rather selective. New round of contract awards from Petronas such as Pan Malaysia T&I contract, topside maintenance job and IRM Peninsular Malaysia are likely to materialise in the next six months and potential beneficiaries are SKPETRO, DAYANG and BARAKAH.

Limited catalysts to unwind valuations. As of our report cut -off date, 15th Sep 2016, the local oil and gas sector continued to underperform FBMKLCI with a YTD performance of -14.5% vs. FBMKLCI’s -2.3%, led by PERISAI (-53.6%), ALAM (-35.3%) and DAYANG (-30.0%) despite crude prices recovering 25% YTD. We attribute such weakness to poor earnings outlook and high financial risk. On the flipside, top performers were those that delivered stable earnings such as YINSON (+11.9%) and GASMSIA (+5.0%). Valuation-wise, we reckon the sector discount would only be narrowed under these circumstances, i.e. (i) stronger contract flow, (ii) better oil prices, and (iii) huge impairment driving down equity value. Another round of kitchen sinking could happen in 4Q16 in view of weaker asset utilisation and flattish oil prices, but we opine the quantum to be smaller compared to a year ago. Companies with relatively high impairment risk include PERISAI, UMWOG, WASEONG and ARMADA.

Unexciting earnings outlook. After continuous earnings forecast trimming for a few quarters, our FY16-17E earnings forecasts are 7-3% below consensus. Both our in-house/consensus numbers are anticipating earnings recovery in FY17-18E with build-in expectation of pick-up in offshore activities. Having said that, local services players’ earnings outlook is still under pressure due to slow contract award flows with slim margins. Fiercer competition is seen ahead and cost efficiency is the key to sail through the rough seas. In our view, MHB, DAYANG, UZMA and COASTAL are susceptible to further earnings downgrade if the overall offshore activities do not improve in near-term.

Keep NEUTRAL on the sector while awaiting for stronger contract flow to act as firm earnings recovery indicator. Keep in mind that stronger-than-expected oil prices will definitely serve as a strong catalyst to the sector should a collaboration between OPEC and non-OPEC members to prop up prices goes much smoother than expected. Higher crude oil prices will benefit SKPETRO (MP, TP: RM1.48) directly with its oil producing fields and PCHEM (OP, TP: RM7.18) owing to the high correlation between petrochemical prices and crude oil prices. Meanwhile, investors should avoid highly leveraged companies with poor earnings outlook. Note that the industry’s average net gearing level is currently at 0.55x (as of 2Q16). YINSON remains our preferred pick in the upstream segment for its resilient earnings outlook and we also like downstream players PCHEM for its long-term growth story anchored by the RAPID project.

Source: Kenanga Research - 6 Oct 2016