We believe the stabilisation of crude oil prices will entice oil majors to increase their activities. In our view, opex-related jobs in shallow waters will be prioritised to reap low hanging fruits. As such, domestically, we anticipate better contracts flow from the oil majors in 1H17, including the maintenance, construction and modification (MCM) and Pan Malaysia T&I contract. While we reckon that the average crude oil is likely to find a foothold above USD50/bbl this year, which is slightly below -1.0 S.D. of its historical means, we upgrade our valuation base assumptions for different sub-segments with the view that crude oil prices could have bottomed in 2016. Investors may take this opportunity to bottom fish for stocks which have been heavily de-rated while awaiting for stronger contracts flow as firmer earnings recovery indicator. Our top pick for the sector is SKPETRO (OP, TP: RM1.88) which is a good proxy to ride on the gradual recovery of the sector while YINSON (OP, TP: RM3.79) is our top pick for non-Shariah compliant investors looking for earnings resiliency within the upstream space. Keep NEUTRAL view with positive bias.

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Global production cut boost sentiment Following OPEC and non-OPEC members’ deal to cut production effective January 2017, crude prices have enjoyed a good rally, rising by 9.1% to the USD55/bbl level in December last year. However, we continue to stay cautiously optimistic as any execution glitch in the production rationalisation will lead to a correction of crude oil prices. Additionally, we reckon the crude oil price volatility will persist on continuous oil inventories build-up and rebound in rigs count. Nevertheless, we raised our forecast 2017 average Brent crude price to USD55/bbl from USD51/bbl.

Anticipating better contracts flow in the next two quarters... In a crude prices recovery, the direct beneficiaries will definitely be pure-play exploration and production companies such as HIBISCS (Not Rated) and integrated companies with oil production profile like SKPETRO (OP; TP: RM1.88). With only RM1.6b worth of contract award (-66% QoQ, -34% YoY) being announced in 4Q16, this sums up the total upstream contract award announced in 2016 to RM9.7b, which accounted for only slightly more than half of what was announced in 2015 and 1/3 of total contract awards value in 2014. We believe the stabilisation of crude prices will entice oil majors to increase their activities and in our view, opex-related jobs in shallow waters will be prioritised to reap the low hanging fruits. As such, we anticipate better contracts flow from the oil majors in 1H17, including the estimated RM5b maintenance, construction and modification (MCM) and c.RM1b Pan Malaysia T&I contract. Potential beneficiaries are SKPETRO, DAYANG (OP, TP: RM1.17), BARAKAH (Not Rated) and PENERGY (Not Rated).

…but FY17 earnings risk remains apparent. Even though we believe crude prices could have bottomed in 2016, the sector earnings disappointment risk remains apparent in 1H17 as higher news flow might not translate into immediate substantial earnings recovery. After several consecutive quarters of earnings cut, our two-year average forward earnings forecasts are 11- 10% below consensus. Both our in-house/consensus numbers are still projecting earnings rebound with the expectations of pick-up in offshore activities. If work orders start to revive in 2017, we should see better earnings prospect from 2018 onwards.

Selective recovery across the sub-segments. While opex-related services players DAYANG, PENERGY and UZMA (MP, TP: RM1.63) are poised to benefit from the first wave of recovery, we opine that the contracts flow will also benefit OSV players with shallow water fleets. OSV players such as ALAM (MP, TP: RM0.28) and ICON (Not Rated) are likely to prioritise vessel utilisation at the expense of daily charter rates amidst oversupply situation. Lately, oil majors are keener to lock in long-term contracts suggesting that DCR could have bottomed as well. On the other hand, fabricators would probably benefit at the later stage as we do not foresee massive project sanctions in the near-term while rig and ship builders’ prospect are expected to stay challenging in view of the lack of new orders.

Re-rating upstream space’s valuation. As at our report cut-off date, 22 Dec 2016, our local O&G core coverage gained 8.7% in December last year, outperforming the FBMKLCI’s minimal gain of 0.3% over the same period after OPEC and non-OPEC members agreed on trimming oil production. This outperformance is largely helped by investors bottom fishing on heavily bashed down stocks such as ALAM (+36.8%), DAYANG (+21.4%) and ARMADA (+19.6%). With better commitment demonstrated by the global oil-producing countries to trim production, we believe average crude price is likely to find a foothold above USD50/bbl this year, which is slightly below both -1.0 standard deviation historical 10-year mean and historical 5-year mean. Hence, we reckon that the sector offers better risk-reward ratio and upgrade our valuation base peg to -1.0 to -1.5 SD from the historical means depending on different sub-segments. (Refer table below for more details)

Keep NEUTRAL with positive bias. Post adjustment of our valuation basis (5 upgrades in TP resulting in 3 rating upgrades namely SKPETRO, DAYANG and ALAM), our weighted average upside for our core coverage has improved to 5.4% with five OP calls within the sector. However, the sector is yet to warrant an overall sector upgrade to OVERWEIGHT, being largely capped by heavy-weighted Petronas stocks but investors may take this opportunity to bottom fish for stocks which have been heavily de-rated while awaiting for stronger contracts flow as firmer earnings recovery indicator. Our top pick for the sector is SKPETRO, a good proxy to ride on the gradual recovery of the sector while YINSON (OP, TP: RM3.79) is our top pick for nonShariah compliant investors looking for earnings resiliency within the upstream space.

Source: Kenanga Research - 6 Jan 2017