We remain NEUTRAL on the sector, with a continued preference for upstream service providers, especially those in brownfield projects. We trim our CY24 Brent crude price assumption to USD84/bbl (from USD86/bbl) to reflect a slightly weaker demand outlook. Nevertheless, we anticipate the upstream capex of Petronas, centred on brownfield projects, to sustain its upward trajectory in CY24 as its cost structure could easily accommodate slightly lower Brent crude prices. On a less encouraging note, the prospects of the downstream segment will remain subdued on weak global demand, while the midstream segment (in terms of tank terminal spot rates) may have bottomed out. Our sector top picks are DIALOG (OP; TP: RM3.10), YINSON (OP; TP: RM3.39) and UZMA (OP; TP: RM1.22).

1. Upstream

Crude oil price to hold up in CY24. We trim our CY24 Brent crude price assumption to USD84/bbl (from USD86/bbl) to reflect a slightly weaker demand outlook for crude oil, particularly, from China. At USD84/bbl, the oil price will be comparable to the estimated average of USD83/bbl in CY23, underpinned by an expected narrowing in the crude market’s surplus YoY in CY24 to 0.3m bbl/day, compared to 0.5m bbl/day in CY23. Also, our base case assumes oil demand to grow by 1.2m bbl per day in CY24, with production increasing at a slower rate of 1.0m bbls per day.

Our CY24 crude oil price assumption is considerably more conservative than the EIA's forecast of USD93/bbl (in its Nov CY24 outlook publication). This is due to our slightly more conservative assumption on global crude demand, with the EIA assuming a growth of +1.4m bbls per day YoY in CY24. In our view, demand for crude oil will remain the major concern for the oil market in CY24, primarily due to uncertainty in demand from China and the US, rather than supply. Hence, the upside to crude oil prices remains capped. Nevertheless, we believe the downside to Brent crude prices from the current level is also limited, as OPEC+ has shown resolve in cutting production to support prices.

Upstream capex target is still intact. Meanwhile, we anticipate the upstream capex of Petronas to sustain its upward trajectory in CY24 as its cost structure could accommodate Brent crude prices of as low as USD75/bbl. Anticipating a CY24 capex expenditure of around RM60b, with a larger proportion allocated to upstream activities, we expect Petronas to address the aging infrastructure of oil production platforms in Malaysia. This strategic move is anticipated to benefit upstream service providers under our coverage, particularly amidst the reduced supply of upstream contractors due to underspending by Petronas and other oil producers since the onset of COVID-19.

Spending would be focused on brownfields. We anticipate that the majority of Petronas' upstream capex will continue to be directed toward brownfield projects (existing fields or extensions to producing oil fields) due to their lower risk profile and capex requirements. While greenfield projects are expected to emerge in CY24, their scale is not likely to match the levels seen in CY13-CY14, as oil producers show less willingness to commit to major greenfield projects with long development cycles amid global energy transition trends. Consequently, maintenance players like UZMA are poised to benefit more than offshore supply vessel (OSV) and drilling rig players, at least in CY24.

Balancing new energy investment with a focus on upstream capex. We observe that in 9MFY23, there was no apparent crowding out of upstream capex by new energy investments, with only 16% allocated for new energy-related spending. It suggests that Petronas is likely to continue prioritizing the majority of its capex budget on its core business, predominantly upstream activities, while also making new energy investments to align with the energy transition agenda. Looking ahead to CY24, we anticipate a similar capex breakdown, with no significant shift compared to the observed pattern in 9MFY23.

OSV and drilling rig players are set to benefit from a supply squeeze. Unlike the historical correlation between OSV and rig daily charter rates (DCRs) and greenfield capex by oil producers, we expect DCRs to remain robust in CY24 due to supply tightness, both locally and globally. Underspending by OSV and rig owners due to ESG initiatives have constrained new builds for OSV and drilling, resulting in a significantly reduced supply of vessels and rigs in the market. This bodes well for existing OSV and drilling rig owners with working assets due to the lack of alternatives.

Labour costs may limit the upside from DCR. With no new build orders for new assets since CY19 due to uncertainties, the majority of rig and OSV players in Malaysia are experiencing a rise in DCRs for their existing fleet in CY23. Anticipating similar capacity levels in CY24, as no major players have announced fleet expansion plans, the DCR market is expected to strengthen with an uptick in upstream spending, driven by demand from brownfield projects. However, the sharp increase in labour costs may limit earnings improvement for OSV and drilling rig owners. Therefore, we believe this subsector deserves closer monitoring in the coming months to determine the upside potential in earnings in CY24.

2. Midstream and Downstream

Downstream outlook is largely benign. The downstream outlook remains largely unexciting with the polyolefin market exhibiting tepid conditions attributed to global demand concerns, especially from China amid a growth slowdown. We anticipate this trend to persist into CY24, restraining the recovery of polyethylene and polypropylene prices, which are not expected to significantly exceed USD1,000/MT. On the supply side, Wood Mackenzie estimates a 25% increase in ethylene and propylene capacities from CY23 to CY30, with China contributing half of the growth. Potential upside risks to our expectations include delays in major petrochemical plant startups and higher-than-expected global plant downtime which will cause occasional spike in chemical prices.

Urea prices to be flattish. We anticipate urea prices to experience a flattish trend in CY24, remaining at USD350/MT, in line with the average prices reported in CY23. The decline in Russian exports, resulting from imposed export quotas until the end of CY24, will be countered by weakened global demand, particularly from Brazil and India. The global downturn in corn prices, a major consumer of urea as fertilizer, has further contributed to reduced demand from Brazil. Concurrently, India has revitalised its older plants, boosting domestic urea production. Urea producers are likely to ramp up their production, facilitated by the substantial decrease in natural gas prices (the feedstock for urea manufacturing) from USD7.8/mmbtu to USD2.8/mmbtu in CY23.

Early signs of optimism for tank terminal markets. While global demand for crude petroleum storage has been in a subdued trend due to OPEC+ production cuts, the tank terminal market presents opportunities with rising demand for storage of new energy and sustainable feedstocks. DIALOG is well-positioned for long-term growth in low-carbon product storage capacity, particularly in Pengerang, Johor. We believe that spot storage rates have reached their low point in CY23, and we anticipate a gradual recovery in CY24 as demand for storage improves.

Tight refining capacity to ease in CY24. In CY24, we anticipate a decline in refining margins as the tight global refining capacity is expected to ease with the commissioning of new refining capacities. The period of CY22-CY23 witnessed a lag in refining capacities catching up with the recovery in demand for diesel and gasoline (refined products) due to the substantial refining capacity being shut down during the COVID-19 crisis. Subsequently, more capacities have been restarted due to the surge in refining margins, and additional capacities are expected to come online in CY24. Consequently, we expect refining margins to trend lower in CY24 due to growing concerns about the demand for gasoline and diesel amid a weak macro outlook.

3. Conclusion

We advocate focus on the upstream services subsegment within the local oil & gas sector, especially in brownfield projects, to capitalise on the sustained increase in Petronas' upstream capex. The downstream segment does not appear promising in the short to medium term due to global demand concerns. Additionally, we favour the midstream segment, particularly tank terminals, as the market indicates signs of bottoming out, and the surge in projects related to low-carbon storage offers growth opportunities for tank terminal operators.

Our top picks for the sector are:

1. DIALOG underpinned by: (i) recovery in demand for independent tank terminal storage from a weak FY23 marketwith utilisation generally above 90% for existing terminals, (ii) active diversification into upstream production assets(recent endeavour involves potential development of small field assets in Baram Junior cluster) which enables thegroup to capitalize on oil price rallies, and (iii) still significant expansion potential in Tanjung Langsat (200,000 cbmincremental capacity) and Pengerang with 500 acres of land to be developed on which coincides with a gradualramp up in activity observed in the Johor market.

2. YINSON due to: (i) a strong FPSO order book pipeline with multiple major FPSO jobs under the conversion stagewhich provides significant earnings growth in coming years, (ii) a strong project execution track record whichpositions the company to benefit from strong structural demand for FPSO contractors anticipated in the comingyears, and (iii) being one of the first local oil & gas company investing in green technology (solar, e-mobility, etc)which in our view would help with the company’s long-term energy transition agenda

3. UZMA due to: (i) it benefiting from the ongoing upcycle in upstream activities, resulting in increased oil & gas contractflows, (ii) actively engaging in sustainable businesses, as exemplified by the Sungai Petani Power Purchase Agreement(PPA), enhancing UZMA’s ESG appeal and securing future earnings, and (iii) anticipated margin improvements in itsupstream oil & gas division due to more favorable current contract terms for its upstream oil & gas division.

Source: Kenanga Research - 27 Dec 2023