The recent rally in oil prices which approached the USD67/bbl level, might be capped, in our view, as the market may refocus on the resurgence of US crude production. Based on our channel checks, tendering activities have been on the rise and oil majors are gradually reviewing projects on hand over the past few months, suggesting that oil majors are relatively more upbeat on the upstream sector following the stabilisation of oil prices. This is also evident by the upward revision of activities in the latest Petronas’ Activity Outlook Report 2018-2020. Having said that, work orders visibility is still uncertain without long-term contracts award in huge waves and many contracts are on call-out basis. For this quarter, while we continue to feature counters with strong earnings delivery/potential earnings upgrade such as SERBADK (OP; TP: RM3.65) and WASEONG (OP; TP: RM1.40), watch out for bombed out counters such as UMWOG and ICON (Not-Rated) for a valuation catch-up play should exploration activities pick up. Keep NEUTRAL view with positive bias on the sector when earnings still matter ultimately.

Stay conservative in oil forecast. Backed by the extension of OPEC and non-OPEC members’ deal to cut production for another 9 months till end of 2018, crude prices have enjoyed a good run, rallying by 18% to close at USD67/bbl and averaging USD57/bbl in 2017. We are positive on the outcome as the agreed members have demonstrated strong production discipline, which translated into meaningful recovery in oil market fundamentals. However, we do not discount the possibility that the market could refocus on the revival of US shale gas production. This is evident by US production approaching all-time high of 9.8m bbl/day. Nonetheless, any escalation of geopolitical tension would serve as a wildcard to lift oil prices one notch higher. All in, we maintain our conservative 2018 forecast of USD55-60/bbl capped by continuous growth in US production.

Improving outlook in 2018. Based on our channel checks, tendering activities have been on the rise and oil majors are gradually reviewing projects on hand over the past few months suggesting that oil majors are relatively more upbeat on the upstream sector following the stabilisation of oil prices above USD50/bbl level in 2017 coupled with improving financial results. At the same time, within the local scene, according to Petronas’ Activity Outlook Report 2018- 2020, most upstream sub-segments’ activities planned in 2018 have been revised higher as compared to the Activity Outlook Report 2017-2019 that was published last year. We believe the upward revision could be due to the delayed work orders last year being pushed to 2018. Thus, this may potentially lead to better contract flows and further provide order-book replenishment opportunities for selected services players. Among the submitted/on-going bids are onshore maintenance, construction and modification (MCM) contracts, RM4.0b Integrated Logistic Control Tower (ILCT) contracts, and expiring Pan Malaysia HUC contracts. Given industry cost have largely realigned to current market condition over these few years, margins are softer compared to the heydays and contractors have to be as efficient as possible to avoid project cost overrun.

Selective recovery across the sub-segments. Despite an improving outlook in 2018, work orders visibility remains uncertain as oil majors are still reluctant to commit long-term firm contracts in a big wave in favour of umbrella contracts. Thus, we believe the earnings improvement/recovery is still rather selective within different sub-segments. While opex-related services player such as DAYANG (OP; TP: RM0.73) and PENERGY are likely to secure higher maintenance work orders from existing/newly awarded contracts, we opine that UMWOG (Not-Rated), being the major local drillers, could benefit from the increasing jack-up rigs demand of 7-10 units for 2018-19. Meanwhile, OSV players such as ALAM (UP, TP: RM0.07), PERDANA (Not-Rated) and ICON (Not-Rated) are likely to prioritise vessel utilisation at the expense of daily charter rates although there are signs of rates bottoming out. Lastly, 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’ prospects are expected to stay challenging in view of the lack of new and substantial orders.

Eyeing potential earnings surprises. As at our report cut-off date of 15 Dec 2017, our local O&G core coverage has gained 13.7% in 2017, outperforming the FBMKLCI’s gain of 6.8% over the same period. The top three underperformers are SAPNRG (-51.5%), ALAM (-42.4%) and UZMA (-22.3%) which experienced earnings downgrade or liquidation risk. On the other hand, the top three performers within the sector in 2017 are SERBADK (+114.7% since IPO), DIALOG (+60.4%) and PANTECH (+44.9%). These strong share price performances are mostly backed by the anticipation of strong earnings recovery/delivery amidst volatile oil prices. Therefore, for the quarter, we highlight counters with potentials to beat expectations in the coming 4Q17 results season this February. WASEONG (OP; TP: RM1.40), in our view, has the chance to outperform backed by the full pipecoating production from its Nord Stream 2 project in 4Q17 as our/consensus implied 4Q17 earnings forecasts of RM28m/RM28m are still relatively conservative compared to its 3Q17 core earnings of RM34m. While keeping our preference to earnings resilient counters such as SERBADK and WASEONG, watch out for bombed-out counters such as UMWOG and ICON (Not-Rated) for a valuation catch-up play should exploration activities pick up. Keep NEUTRAL view with positive bias on the sector when earnings still matter ultimately.

SERBADK & WASEONG - our preferred picks.

SERBADK (OP; TP: RM3.65 @ 15x FY18 PER) We like this established MRO service provider with (i) superior 20% ROEs vs. industry average of 11%, (ii) FY17-18E CNP growth of +22%-+10% backed by RM5.3b order-book and modest RM2b annual replenishments, (iii) decent dividend yield 2% assuming 30% payout. Pegging to 15.0x FY18 PER which is at a 50% premium to its closest upstream maintenance players, DLUM and DAYANG due to larger market cap, higher margins and superior ROEs. Key catalyst would be strong earnings delivery which warrants potential earnings upgrade as our FY18E earnings is still 7% lower than consensus number.

WASEONG (OP; TP: RM1.40 @ 10x FY18 PER) Backed by RM3.4b order-book providing 2-year earnings visibility, we believe WASEONG is poised to turn around strongly in FY17 and further register earnings growth of 36% in FY18 (vs. industry average of 8%). Key re-rating catalyst is QoQ earnings improvement arising from EUR600m Nord Stream 2 pipe-coating project, which provides fixed profit margin followed by potential additional performance bonus upon excellent execution. The counter, in our view, has the chance to outperform backed by the full pipe-coating production from its NS2 in 4Q17 as our/consensus implied 4Q17 earnings forecasts of RM28m/RM28m are still relatively conservative compared to its 3Q17 core earnings of RM34m. Currently, WASEONG trades at undemanding valuation of 8x FY18E PER (vs. small cap O&G counter average of 10-11x and industry average of 19x). Thus, we maintain OUTPERFORM call on the stock with TP of RM1.40 pegged to 10x FY18E PER.

Source: Kenanga Research - 4 Jan 2018