We  are  turning  more  cautious  on  the  implementation  and  execution risks of the  stocks  under our coverage,  going forward.  We believe  thesector’s  current  premium  valuation  is  unsustainable,  as  many  local O&G  players  venture  overseas  and  move  up  the  value  chain.  We  see this  resulting  in  a  narrowing  of  the  gap  between  local  and  global valuations. We downgrade this sector to NEUTRAL from Overweight.

Near-term  outlook  lacks re-rating catalysts.  We  believe  the  sector’s upside  is  limited  moving  forward,  and  think  that  oil  and  gas  (O&G) project timelines in Malaysia and worldwide may see  further delays. The increasing costs and  complexities of projects, uncertainties in  long-term expectations of O&G demand and the direction of crude oil prices haveand will likely continue to influence global O&G majors’ capex spending .

Current valuation unsustainable.  Malaysian O&G  players are moving away  from  the  domestic  front  and  becoming  regional  or  global companies  –  as  more  often  than  not,  overseas  markets  tend  to  offer more lucrative margins  –  which  is positive  for  the industry. However, we believe  that  as players expand abroad,  the big gap in valuations  (when compared  to  their  regional  and  global  peers)  should  narrow  andMalaysian O&G stocks should shed their  premium valuations. Currently, Malaysian O&G  stocks are  valued  higher than their regional and global peers,  albeit at a lower earnings base and market share. W e believe the premiums are unsustainable in the long run. 

Four  NEUTRAL  segments,  one  OVERWEIGHT  segment.  Under  our coverage  universe,  the  stocks  are  divided  into  five  segments.  We  are currently  NEUTRAL  on  the  following  segments:  i)  floating  production, storage  and  offloading  (FPSO),  ii)  drilling  rigs,  iii)  services  and fabrication,  and iv) downstream and petrochemicals. We are NEUTRAL on  these  segments  as  we  believe  the  outlook  going  forward  remains mixed. Having said that, we are still OVERWEIGHT on exploration  and production  as  we  believe  the  development  of  the  segment  remains positive, driven by Petronas’ need to sustain its production profile. 

Downgrading  four  stocks.  Over  the  past  two  months,  we  have downgraded  three  stocks  to  NEUTRAL  from  Buy  –  Perisai  Petroleum Teknologi  (Perisai)  (PPT  MK,  FV:  MYR1.46),  Muhibbah  Engineering(Muhibbah)  (MUHI MK, FV: MYR3.22)  and Daya Materials  (DAYA MK, FV: MYR0.31) – and one stock to SELL from Neutral, ie Malaysia Marine Heavy  Engineering  (MMHE)  (MMHE  MK,  FV:  MYR3.10).  Common themes  within  these  four  downgrades  were:  i)  a  slow  orderbook replenishment  rate,  ii)  underutilized  assets,  as  well  as  iii)  operational inefficiencies and uncertainties resulting in low margins.  (Please see overleaf for our summarised valuation table)

Sector Summary (Downgrade To NEUTRAL)

Valuations are stretched
Petronas’  capex  spending,  which  has  propelled  the  positive  sentiment in  the  O&G sector over the  past  several years,  we believe will remain robust at MYR40bn-60bn. However, we are turning more cautious on the implementation and execution risks going forward. We see limited upside  to the sector moving forward, and  believe  the current  premium ascribed to it is  unsustainable, as many local O&G players venture overseas and move  up the value chain. This should  move local valuations closer to global ones. We downgrade this sector to NEUTRAL from Overweight.

Downgrading the sector to NEUTRAL
O&G stocks under our coverage are divided into five segments. Of these, we are only OVERWEIGHT on exploration and production players as we believe their  outlook is still positive. Meanwhile, we are NEUTRAL on the rest of the segments as we believe the outlook of the companies is mixed.

Exploration  &  production  (E&P)  –  OVERWEIGHT  (maintained).  We  are OVERWEIGHT  on  the  E&P  segment  as  we  believe  there  is  still  some  upside  for companies involved in this very technically demanding  aspect of  the O&G industry. We believe growth for the segment would  come from three types of E&P:  i) marginal fields,  ii)  enhanced  oil  recovery,  and  iii)  deepwater  exploration.  Their  long-term values  would slowly unfold via  a production sharing contract (PSC) or a risk service contract (RSC) from Petronas.

FPSO  –  NEUTRAL (downgraded  from Overweight).  Although there is  continuous demand for FPSOs, the segment is notorious for  its  inherent risks  –  contract award delays,  execution  risks  and  cost  overruns.  Given  the  huge  capex,  fundraising  will likely involve 20-30% equity with the rest coming from borrowings. Earnings may only materialise after a 2-year conversion and construction period. We view that the global O&G industry is in a tightening global capex spending phase.  A downturn in global O&G outlook could delay project planning stages, which could lead to  lower contract awards.

Drilling  rigs  –  NEUTRAL (downgraded from Overweight). This is a key segment in the exploration phase. From our observation of crude oil prices and jack-up (JU) rig day rates,  and with the  current  price of  crude oil  hovering around the lower range of USD90-100, we believe JU rig rates could  stabilise around USD140,000-150,000,  if not lower. As we do not expect  day rates to go up, cost increases would  hurt theirbottomlines.  Other  risks  could  involve  delays  in  capex  spending  and  uncommitted projects from the oil majors. We note the expensive valuations of the Malaysian rig players, notably UMW Oil and Gas  (UMWOG)  (UMWOG MK, NR)  which is currently trading  at  20x/12x  EV/EBITDAs  for  FY14F/FY15F.  Global  players  are  valued  at EV/EBITDAs of 6-7x.

Offshore  supply  vessel  (OSV)  –  NEUTRAL  (downgraded  from  Overweight). While  the  industry  remains  bullish  over  future  contracts,  our  NEUTRAL  rating  is premised  on  our  belief  that  local  valuations  offer  limited  upside.  Malaysian  market valuations  of  13-15x  P/Es  are  above  that  of  regional  peers  (<10x)  despite  positive sector fundamentals  –  which is  partly due to the advantage they enjoy as a result of cabotage  policies. We  foresee  local  OSV  players  being increasingly  dependent  on overseas OSV contracts.  Hence, we  believe that local OSV valuations  could  move towards global valuations. On charter rates, we believe these would remain steady in the  near  future.  Recent  industry  consolidation  suggests  that  new  entrants  are  still coming into the market, with current players undergoing fleet modernisation.

Services and fabrication  –  NEUTRAL (maintained).  We believe the market haspriced in the long-term orderbook coming from the mega umbrella service contracts. Initially,  most  of  the  key  service  contractors  reported  lower  margins  due  to  slower work orders, and the depreciation, operating and interest costs that had been booked into the P&L for the additional assets and  vessels  required to prepare for  jobs. We expect these jobs to come into full swing by end-2014, which should help normalise margins.  Further  growth  for  the  service  players  would  come  from  moving  into  a higher  value  chain  such  as  engineering,  procurement,  construction  and commissioning jobs (EPCC), which entails new risks.

Downstream  and  petrochemicals  –  NEUTRAL  (maintained).  We  see  subdued excitement for downstream players in the near term, as major re-rating catalysts mayonly take place 3-5 years towards the completion of the refinery and petrochemicals integrated development (RAPID) project due in early 2019. We are NEUTRAL for the long term  on the storage industry. While the sector’s near-term outlook is supported by strong demand in Asia, we are concerned over the long-term impact on the Straits Hub terminals from rising capacity from regions like China, India and the Middle East.We believe the outlook for petrochemicals remains mixed. In the near term, ethylenebased product prices might be on an  upward trend due to major ethylene producers in Taiwan, South Korea and Japan undergoing major plant turnarounds. However, we expect prices for methane-based products, ie urea, ammonia and methanol, to soften in the near to mid term, as Chinese urea producers are expected to flood the market during the low tax window that lasts until the end of October. However, prices could recover, as the planting season in the northern hemisphere picks up pace in early- to mid-2015.

Downgraded stocks
Across the subsectors, we recently downgraded four stocks; three were downgraded from Buy to NEUTRAL while one was downgraded from a Neutral to a SELL. 

Perisai  Petroleum  Teknologi  (NEUTRAL  from  Buy).  Perisai  registered  a disappointing 1H core net loss, as its  Rubicone mobile offshore production unit  (MOPU)  and  Enterprise  3  derrick lay  barge  (DLB)  were  underutilised. We  do  not  expect  the  two  assets  to  be  deployed  in  FY14  and  potential contracts  may  only  be  in  FY15.  Perisai  has  two  more  rigs  due  to  be completed in mid-2015 and mid-2016.  Due to the lack of earnings visibility on new contracts for the idle vessels and the new JU rigs, we downgrade the stock to a NEUTRAL with a FV of MYR1.46 (from MYR2.07), which is based on 15x P/E to FY15 EPS. This is a 1x discount to the target P/E of 16x for other OSV players under our coverage. 

Muhibbah  Engineering  (downgraded  to  NEUTRAL  from  Buy).  Muhibbah’s 1HFY14 only came in at 25%/35% of our/consensus estimates  respectively. Due to the disappointing results, we cut our FY14/FY15 earnings  forecastsby 42%/43% respectively,  as we believe Muhibbah will be facing an uphill battle  in  replenishing  its  orderbook.  We  estimate  its  current  orderbook  at MYR2.0bn,  ie  1.1x  its  FY13  revenue.  This  implies  a  lack  of  earnings visibility. We  do  note  that  Muhibbah  holds  an  offshore  fabrication  license from Petronas and is a potential beneficiary of RAPID projects. To date, 11 infrastructure and production packages have been given out by Petronas for the project. Our lower SOP-based FV of MYR3.22 (from MYR3.38) implies an undemanding FY15F P/E of 10.7x.

MMHE (downgraded to SELL from Neutral). MMHE registered disappointing 1HFY14 results due to higher-than-expected operating costs at its offshore construction  division  while  the  marine  construction  wing  was  impacted  by lower margin projects. Its current situation has also been exacerbated by the load  out  of  three  major  projects  in  1HFY14.  This  is  because  most  of  the earnings from the projects have been booked in, leaving the company with a 50% yard utilisation rate. Our downgrade to SELL is based upon MMHE’s lack of  earnings  visibility  and continued  operational  inefficiencies. We  peg the  company to  18.7x  FY15F  P/E,  a  10%  discount  to the  large  cap  O&G counters under our coverage with a lower FV of MYR3.10 (from MYR4.08).

Daya Materials (NEUTRAL from Buy).  We downgraded Daya Materials on end-August, as we think the company deserves to trade at a lower P/E of 9x vs  our  13-16x  for  the  OSV  sector.  While  the  company’s  offshore  subsea construction  division  will  become  a  significant  earnings  driver  (7+2  years charter  in the  North  Sea  for  Technip),  we  believe  its  earnings  recovery  is overshadowed  by  near-term  share  price  overhang.  This  is  due  to uncertainties  from  fund-raising  risks  and  the  loss  of  a  key  management person who recently resigned from the board. Daya Materials plans to raise a total of MYR990m, mostly to fund the full acquisition of its vessels. Our exall FV could be MYR0.09-0.11 pegged to unchanged 9x P/E.

Valuations Are Stretched
Petronas’  capex  spending,  which  has  propelled the  positive  sentiment in  the O&G sector over the several years, is expected to  remain robust at MYR40bn-60bn.  However,  we  are  turning  more  cautious  on  the  implementation  and execution  risks  going  forward,  as  we  see  limited  upside  to  the  sector.  We believe  the  sector’s  current  premium  valuation  is  unsustainable,  given  that many  local  O&G  players  are  venturing  overseas  and  moving  up  the  value chain. This should result in  a narrowing of the gap between local and global valuations. We downgrade this sector to NEUTRAL from Overweight.We  believe  the  past  flurry  of  P/E  re-ratings  is  coming  towards  its  tail-end,  as  we believe many O&G companies are entering into  a more challenging phase of growth. 

In  2011-2013,  O&G  big  caps  outperformed  the  KLCI  index  at  an  average  of  12%while small caps outperformed by as much as 50% on average. During that period, the sector was driven by positive sentiment from Petronas’ 5-year MYR300bn capex roll-out  and  business  transformation/expansion  by  key  O&G  players.  However,  the sector’s  earnings  have  underperformed  market’s  expectations  as  a  result  of  lower margins.  This  was  mainly  due  to  a  couple  of  factors.  Firstly,  a  mismatch  in expectations of project timelines to the slow execution of work orders did not help to cover for depreciation, operating costs and interest charges. Secondly,  delayed rollouts of new contract awards complicated orderbook replenishment. Local  jobs  will  still  go  on.  We  opine  that  Petronas  will resume  its  annual  capex spending  at  our  estimates  of  MYR40-60bn  per  annum.  Through  2009-2013,  capex spending averaged MYR45bn per annum, whereby the  domestic capex average was MYR28bn (63%  of the total) while the international  investment  was MYR17bn (37%). 1H14 capex spending from Petronas was recorded at MYR26.3bn, of which domestic 
capex  stood  at  MYR16.8bn  (64%)  while  international  investment  was  booked  at MYR9.5bn (36%). We note that international capex has increased of late. The  market  expects  a  better  2H14.  The  industry  expects  2HCY14  to  be  better, driven by the pickup in operating activities  and  more contract awards. The contract awards  range  from  brownfield,  enhanced  oil  recovery  (EOR  –  at  least  10  EOR projects  expected  to  be  awarded)  and  risk  sharing  contracts  (RSCs)  to  fabricationand engineering, procurement, construction and commissioning (EPCC) works.We  are  turning  more  cautious.  Despite  the  market’s  bullish  view,  we  advise investors to weigh these against execution risk,  as  earnings recognition for some of these  contracts  may  be  backloaded.  Large  capital-intensive  projects  and/or  global expansion  usually  entail  higher  political  and  execution  risks.  There  will  also  be  a longer development period before reasonable returns from mega projects   are seen. We believe  that there will also be greater need for fund-raising with partnership risks and competition with the big boys. W e advise investors to focus on companies with clear  long-term  diversification  strategies,  have  proven  execution  track  records  and are niche players in the O&G sub-sectors.

Domestic  valuations  are  priced  in.  We  see  limited  upside  to  the  sector  moving forward, given the challenge to grow from a higher earnings base  as a result of  the influx  of  major  contracts  awarded  as  well  as  the  increasing  risks  in  the  current operating  and  financing  environment. While  contract  awards  are  still  expected,  we believe  O&G  activities  (Malaysia  and  worldwide)  will  see  further  delays  in  project timelines,  influenced  by  a  myriad  of  factors.  These  include  increasing  costs  and project complexities, uncertainties in the long-term expectations of O&G demand and the direction of crude oil prices. These factors have influence d the capex spending of global O&G majors in the past and will continue to do so moving forward.

We  believe  the  sector’s  premium  valuation  is  unsustainable.  Many  local  O&G companies  are  expanding  regionally,  signalling  the  growing  “independence”  from Petronas’ direction and capex spending. While the market’s outperformance in 2011-2013 represented an  overdrive  period for domestic O&G capex expansion, the future of many local O&G  players  will involve  global  expansion  and moving  up the  value chain. We interpret this to result in a  narrowing of the gap between  local  and  global valuations.

Source: RHB