Oil prices are largely expected to stay elevated over the immediate-term, boosted by recovery demand over the summer months, easing of lockdowns and slowdown of global Covid-19 cases. Stock drawdown had been aggressive in 1HCY21, with inventory levels already close to pre-pandemic levels. A strong 2HCY21 is likely to outpace OPEC’s return of 2.1m bpd production throughout MayJuly 2021, with further production increase anticipated in August. However, over the medium-term, some downwards correction in oil prices is expected as the end of persistent inventory drawdown, continued production growth in OPEC and U.S. may outpace decelerating growth in global consumption – thereby contributing to declining prices. As such, we have revised our 2021/2022 average Brent crude assumption to USD70/USD65 per barrel. Over the long term, increased adoption of energy transition may see demand plateauing, and could see oil prices re-balanced to around the ~USD50/barrel. Nonetheless, despite the elevated oil prices, local activity levels are still impeded by heavy lockdown measures. Petronas has recorded a capex spend decline of 39% QoQ / 21% YoY in 1QCY21 to RM6.7b, despite earmarking higher capex of RM40-45b per year for the next five years (versus RM33b in 2020). This is expected to impact local-centric contractor names (e.g. DIALOG, DAYANG, SERBADK, UZMA, VELESTO). However, recovery in global E&P spending may see internationally-exposed players benefiting from increased bidding opportunities (e.g. YINSON, MHB, SAPNRG). Overall, sector valuations remain lofty (with SERBADK being the huge outlier), thereby potentially limiting bottom-fishing opportunities. Maintain NEUTRAL on the sector. For trading ideas, we highlight PCHEM, HIBISCS, and LCTITAN as potential oil price proxy plays, and UZMA as a sector recovery play.

Oil prices continue strong rebound momentum. Crude oil prices have continued its strong rebound this year, with Brent crude recently breaching past the USD75/barrel mark. The quick recovery in oil demand has surprised the markets, backed by strong economic growth coupled with increased travelling during the summer months as global Covid-19 cases continued to be in decline. Together with ongoing vaccination efforts and easing of lockdowns, this has lent further optimism that the pandemic can be contained in the coming few months. As such, consumption is forecasted to further improve in 2HCY21 and significantly exceed 1HCY21 levels, outpacing OPEC’s returning 2.1m barrels per day (bpd) supply throughout the months of May to July 2021. OPEC is set to meet again in July to decide on further output increase for August and beyond. With strong stock draws YTD, coupled with inventory levels now close to pre-pandemic levels, near-term sentiment and technical picture of crude oil prices favours the upside for the immediate term. However, going into the medium-to-long-term, and especially into 2022, global oil production is expected to increase to match the elevated levels of consumption. This will end persistent inventory draws and should lead to a more balanced market. The continued growth in production, contributed by OPEC+ and the accelerating growth of U.S. oil production will outpace decelerating growth in global oil consumption and contribute to the gradual decline in prices. Hence, we may see oil prices peaking in 2HCY21 before correcting downwards to a more normalised level in 2022 and beyond under more balanced market dynamics. Over the long-term, increased adoption of energy transition is highly expected to contribute to the plateauing of oil demand. This could see long-term oil prices reaching a balance at ~USD50/barrel.

Nonetheless, we revised our 2021 average Brent crude assumption to USD70/barrel (from USD60/barrel previously), while keeping our 2022 assumption of USD65/barrel unchanged.

Local lockdown measures impeding recovery of activity levels. Despite the elevated oil prices of late, recovery of activity levels, especially for the local players, have experienced continued delays on the back of increased lockdowns. In 1QCY21, Petronas’ capex spending further declined 39% QoQ / 21% YoY to RM6.7b, despite having earmarked higher capex investments of RM40-45b per year (versus RM33.4b in 2020) for the next five years amidst the recovery. The movement restrictions had made it simply difficult to reinstate many of the local activities. Naturally, this will impact local-centric contractors e.g. DIALOG, DAYANG, SERBADK, UZMA, VELESTO. Meanwhile, internationally exposed players may stand to benefit from the recovery in global E&P spending. YINSON could likely benefit from increased bidding opportunities within the global FPSO space (outside of the current bids the group had already submitted), with this space seeing gradually dwindling competition. Meanwhile, under Saudi Aramco’s long-term agreement (LTA), SAPNRG and MHB could see bidding opportunities as the oil giant aims to spend USD1.5-2b per year for offshore brownfield and maintenance projects as part of the LTA programme (recap that SAPNRG and MHB were shortlisted to join Aramco’s LTA programme, together with six other global players, which enables them to participate in tenders issued under the programme).

Limited bottom-fishing opportunities. While valuations for the KL Energy Index saw a massive nosedive this year (refer to figure below in appendix), we note that this was mainly caused by price weakness in two heavyweight names (note that the index is market cap weighted) – namely: (i) SERBADK, which saw a massive sell-down after the company ran into issues with its audit, and (ii) DIALOG, which saw some price correction given consecutive quarters of results disappointment and lack of investment catalyst. However, holistically, most of the sector is still trading at somewhat elevated valuations, which we believe could limit bottom-fishing opportunities within the space. In fact, SERBADK is the only name trading at steeply discounted valuations as compared to its mean (defined by >50% discount from its mean). On a simple average, valuation of the sector is now already trading at a <20% discount from its historical mean, despite suffering from weaker fundamentals as compared to pre-pandemic levels. As such, underlying fundamentals may still need to see further improvements in order for sector valuations to become attractive again.

Maintain NEUTRAL. While we have no outright top picks from the sector for this quarter, we have highlighted several trading themes as below, depending on investor’s risk appetite:

• Oil price proxies: PCHEM (MP, TP: RM8.90), HIBISCS (NR), LCTITAN (NR) – given their high earnings and share price correlation to oil prices.
• Recovery play: UZMA (OP, TP: RM1.00) – proxy for the local brownfield space and relatively attractive valuations. Also one of the few names within the sector with concrete energy transition and diversification plans.

Source: Kenanga Research - 2 Jul 2021