While we believe the sector has yet to enter into an up-cycle in view of sluggish capex growth, we reckon the current oil volatility will provide tactical trading opportunities on selective counters premising on: (i) oil prices will recover to an average USD55/bbl level backed by the case of OPEC members and non-OPEC nations continuing to trim production in 2H17, which would lift oil prices to as high as USD60/bbl, and (ii) better contracts flows. Having said that, should the oil prices continue to weaken and fall below the psychology support level of USD50/bbl level, we might see further selling-down pressure. In 1Q17, we saw better contract flows returning, despite most contract value not disclosed. Based on our channel checks, tenders and enquiries are picking up suggesting that the worst could have over. However, earnings are likely to be unexciting, at least for the first half of the year, but we expect gradual QoQ improvement in tandem with pick-up in activities. Our top pick for the sector is SKPETRO (OP, TP: RM2.09) which is a good proxy to ride on the gradual recovery of the sector while YINSON (OP, TP: RM4.08) is our top pick for non-Shariah compliant investors looking for earnings resiliency within the upstream space. Keep NEUTRAL view with positive bias.

Short pull-back in oil prices. Oil prices have weakened c.10% after a few months of stabilisation largely due to reignited concerns on swelling oil stocks and revival of rigs count in US coupled with moderation of oil demand growth. This is not surprising to us; as highlighted in our previous reports, there was a reversal of US oil rig count downtrend to 631 (+100%) from a bottom of 316 end of May last year. Additionally, US crude oil production has also climbed back to 9.1m bbl/day level, the highest since February last year, capping oil prices recovery path. Nevertheless, we are still expecting consistent compliance from the OPEC members and higher compliance from Russia from current level till end of June. Additionally, we reckon that the market is building in expectations for an extension after the six-month period which will be decided in the next OPEC meeting in May. All in, we retain our in-house Brent oil forecast of USD55/bbl in 2017.

Higher activities with better contracts flow in 2H17. Looking at the global scene, oil majors are maintaining the capex budget and we have yet to see oil investment returning in a big wave. Therefore, we believe capex and opex allocations will remain rather selective. Domestically, Petronas is looking to commit capex of c.RM60b (+17% YoY) this year with Brent crude oil prices pegged at an average of USD45/bbl. In the 1Q17, we saw better contracts flows returning, despite most contract value are undisclosed. Based on our channel checks, tenders and enquiries are picking up, suggesting that the worst could be over. However, earnings likely to be unexciting, at least for the first half of the year, but we expect gradual QoQ improvement in tandem with pick up in activities. Following the announcement of Pan Malaysia T&I contract to SKPETRO (OP; TP: RM2.09) and IMR contract to ALAM, we are expecting more contracts such as maintenance, construction and modification job to roll out in the next few months. Potential beneficiaries are DAYANG, PENERGY, and BARAKAH.

Limited downside risk. As at our report cut-off date, 10 March 2017, our local O&G core coverage has gained 6.4% YTD, outperforming the FBMKLCI’s gain of 4.6% over the same period despite crude prices lower by 9.6% since January. This outperformance is largely helped by investors bottom fishing on heavily bashed down stocks such as PANTECH (+20.2%), ARMADA (+18.2%) and ALAM (+13.2%). Interestingly, apart from counters that have direct correlation to oil prices such as HIBISCS (Not Rated) and SKPETRO with oil production profile, we observed that generally the O&G counters did not retrace much within the short span of two weeks when oil prices weakened by c.10% to USD50/bbl level. This possibly implies that the market is regarding the recent oil prices adjustment as short-term hiccups and not alarming. Having said that, should the oil prices continue to weaken and fall below the psychology support level of USD50/bbl level, we might see further sell-down pressure.

Keep NEUTRAL with positive bias. While we believe the sector has yet to enter into an up-cycle in view of sluggish capex growth, we reckon the current oil volatility will provide tactical trading opportunities on selective counters premising on: (i) oil prices will recover to an average USD55/bbl level backed by the case of OPEC members and non-OPEC nations continuing to trim production in 2H17, which would lift oil prices to as high as USD60/bbl as well as (ii) better contract flow. SKPETRO, in our view, remains the best proxy to trade the volatility in oil prices and ride on the gradual recovery of the sector given: (i) the company being the largest integrated oil and gas services player in Malaysia in terms of market capitalisation providing sufficient liquidity, (ii) its oil production profile which is directly related to stronger oil prices and (iii) its undemanding valuation at 0.9x FY18E PBV as the stock has fallen >60% from its peak in 2013. YINSON (OP, TP: RM4.08), on the other hand, is our top pick for non-Shariah compliant investors looking for earnings resiliency within the upstream space.

Source: Kenanga Research - 29 Mar 2017