As a result of the fundamental change in the crude oil landscape, this report addresses the impact of the lower crude oil price environment on the companies under our coverage.  For our Top Picks, we have chosen companies that are not materially affected by the lower crude oil price environment.  Our  top  BUYs  are  Dialog,  SapuraKencana,  and  Bumi Armada.

This time it is  different.  The  lower  crude  oil  price  environment  is  not new to the global scene. The fundamental reasons for the major swings in  crude  oil  prices  are:  i)  economic,  ii)  geopolitics,  and  iii)  natural disasters.  These  events/situatios,  given  time,  will  rectify  themselves and  allow  commodity  prices  to  revert  back  to  norm,  under  the  given demand and supply situation. This time, though, it is different. As a result of  the  US  shale  oil  revolution,  we  are  facing  a  change  in  the fundamentals in the dynamics of crude oil supply. 

Something has got to give.  At the moment, it seems that some of the higher cost producers are cutting capex/production. At the same time, it seems  that calls  from  weaker  Organisation  of  the  Petroleum  Exporting Countries  (OPEC)  members  to  cut  production  quotas  are  also  coming into play. Whatever happens, something has got t o give. We believe that crude  oil  prices  will  see  some  positive  movements,  possibly  over  the next  3-6  months,  as  supply  is  lowered  –  either  from  the  higher  cost producers  or  from  the  OPEC  members  cutting  production  quotas.  We expect that crude oil price will trade in the USD90-100/barrel (bbl) range, averaging USD95/bbl over the next 12-24 months.

Sensitivity analysis. For the 16 stocks under our coverage, we provide investors  with  sensitivity  analyses that  not  only  incorporate different  oil price  scenarios,  but  also  assumptions  of  changes  in  both  local  and global  oil  major  capex  spending.  Oil  price  movements  will  have  direct impact  on  exploration  &  production  (E&P)  players  like  SapuraKencanaPetroleum (SapuraKencana) (SAKP MK, BUY, TP: MYR5.33) and Dialog (DLG  MK,  BUY,  TP:  MYR2.25).  The  decision on capex  spending  will ffect  day  rates,  availability  of  future  contracts  and  orderbook replenishment  rates.  These  will  affect  asset  operators  in  the  rig  and offshore  support  vessels  (OSV)  segments,  as  well  as  pure  service players. For floating production systems  players, while production capex should be relatively sheltered from oil price movements, they could also face project award delays

Selective picks.  Our recommendation is on companies with clear longterm  diversification  strategies,  proven  eecution  track  record  and niche/top  players  in  oil  &  gas  (O&G)  subsectors.  Our  Top  Picks  are SapuraKencana,  Dialog  and  Bumi  Armada  (BAB  MK,  BUY,  TP: MYR2.24), while Dayang (DEHB MK, BUY,  TP: MYR4.52)  and  Coastal Contracts (COC MK,  BUY,  TP: MYR5.90) remain as our mid-  to smallcap Top Picks.

Investment Summary

The  fundamental  change  in  the  crude  oil  landscape.  As  a  result  of  this fundamental  change,  this  report  addresses  the  impact  of  the  lower  crude  oil  price environment  on  the  companies  under  our  coverage.  For  our  Top  Picks,  the  weak crude oil price environment will not have any material impact on earnings. Our top BUYS are Dialog, Ezion (EZI SP, TP: SGD2.65), Logindo Samudramakmur (Logindo) (LEAD IJ, TP: IDR6,200), Nam Cheong (NCL SP, TP SGD0.58) and PTT (PTT TB, TP  THB376.00).  Our  top  SELLS  are  Malaysia  Marine  and  Heavy  Engineering (MMHE MK, TP MYR2.01) and Vard Holdings (VARD SP, TP SGD0.57). This  time  it is  different.  The  lower  crude  oil  price  environment  is  not  new  to  the global scene. In recent history, crude oil prices have slumped to USD9/bbl and have skyrocketed to USD145/bbl. The fundamental reasons for the major swings in prices are:  i)  economic,  ii)  geopolitics,  and  iii)  natural  disasters.  These  events/situations, given time, will rectify themselves and allow commodity prices to revert back to norm. This  time,  though,  it  is  different.  This  is  because  we  are  facing  a  change  in  the fundamentals in the dynamics of crude oil supply and trade flows as a result of the US shale oil revolution.

Something has got to give. 

At the moment, it seems that some of the higher cost producers, ie shale oil/Canadian oil snds, now have to cut capex/production. At the same time, it seems that calls from weaker OPEC members to cut the organisation’s production quotas are also coming into play. Whatever happens, something has got to give. We believe that crude oil prices will see some positive movements, possibly over the next three to six months, as supply is lowered, either from the higher cost producers or from OPEC members cutting production quotas. Expect crude oil price to rise from here on.  We expect crude oil prices will trade in the  range  of  USD90-100/bbl,  averaging  USD95/bbl  over  the  next  12-24months.  At this  price,  the  highest  cost  producers,  namely  the  Canadian  oil  sands  and  Arctic producers, should be able to make relatively reasonable margins. Also, at this price range, most of the OPEC members will be able to finance their fiscal budgets with the oil dollars.

Lower crude oil environment impact. Fundamentally, weakening crude oil price will dampen the earnings of the E&P companies, refineries will report stock losses, and petrochemicals  spreads  will  be  dependent  on  the  demand  and  supply  of  each particular product. For the services segment, those in the exploration phase will be the first to be affected should there be a cut in spending. Those that are involved in the development and production part of the E&P business will be relatively safe from cuts, depending on the type of fossil fuels being developed. For our ASEAN O&G coverage.  We cover 44 companies in four countries across the value chain, ie from upstream to downstream. The coverage concentrates more on the services segment, where most of the listed oil and gas companies in Malaysia, Singapore and Indonesia are in. Thailand is an exception. Here, the listed names are dominated  by  oil  refinery  and  petrochemical  players.  A  majority  of  the  listed companies under coverage in the services segment will be relatively unaffected by the short-term crude oil price volatilities, as these firms have short -  to medium-term services contracts. For Thailand, the companies under coverage are directly affected by the crude oil price volatility via their revenue streams (for the E&P business) and through stock gains/losses (for the refineries).

This Time It Is Different
The lower crude oil price environment is not new to the global scene. In recent history,  we  have  sen  crude  oil  prices  plummeting  to  USD9/bbl  –  this  was  in  Dec 1998 when OPEC approved a 10% quota increase at a time when Asian economies were entering a prolonged slump. Crude oil prices have also skyrocketed to a high of USD145/bbl in Jul 2008. Hence, crude oil prices can swing in a wide range in some years while, in others, there are periods of high stability.

In 2008, crude oil prices were on a rollercoaster ride.  Brent crude  prices began the year at USD97/bbl, peaking at USD145/bbl and ending at USD41/bbl. The price of crude oil hit its lowest point at USD34/bbl. This plunge was caused mainly by the financial crisis that wreaked havoc on the global economy and triggered a fall in the overall demand for crude oil. Currently, we believe that the global economy is slowing down and that this will result in steady adjustments in crude oil demand/supply. As such, we do not foresee a crash in prices (as in 2008).

2011  was  another  year  of  major  swings.  Brent  crude  prices  began  the  year  at USD94.73/bbl,  peaking  at  USD126.74/bbl  and  ending  the  year  at  USD107.58/bbl. Crude  oil  prices  hit  their  lowest  point  at  USD92.98/bbl.  Two  major  events  caused these swings: 

The  Arab  Spring.  A  revolutionary  wave  of  demonstrations  that  began  in Dec 2010 and spread throughout the countries of the Arab League and the nations surrounding them.

Tsunami  in  Japan.  Nuclear  power  met  25%  of  Japan’s  electricity  needs but, after the  Fukushima Daiichi nuclear disaster, all nuclear reactors have been shut down on safety grounds. The country replaced the significant loss of  nuclear  power  with  generation  from  imported  natural  gas,  low-sulphur crude oil, fuel oil and coal.

The reasons.  The fundamental factors behind the major  swings in crude oil prices are:  i)  economic,  ii)  geopolitics  and,  iii)  natural  disasters.  These  events/situations, given time, will rectify themselves and allow commodity prices to revert back to norm, under given demand and supply situations.

This time it is different. This is because we are facing a change in the fundamentals in the dynamics of crude oil supply as a result of shale oil and the future shale gas revolutions. The current weaker crude oil price environment is a result of softer global demand  and  the  surge  in  shale  oil  production  in  the  US.  As  the  boost  in  US  oil production  has  lowered  the  country’s  ovrall  crude  oil  imports,  producers  such  as Nigeria and Saudi Arabia have had to  divert their exports to Asia. It seems like there could  be  a  rebalancing  of  crude  oil  trade  flows  as  the  global  crude  oil  market continues to adjust to the surge in supply due to the new North American shale oil reality.  Further details were discussed in  our full report published on 16 Oct:  Shale Oil Revolution Reality.Note:  Our  expectations  on  crude  oil  prices  are  based  on  the  fundamentals  of  the crude  oil  market.  It  does  not  take  into  consideration  speculation  and  sentiment  on crude oil prices, which can play a significant role in price volatility.

The showdown: shale oil producers vs OPEC 

Is there really a showdown between OPEC and the shale oil producers?  Below are excerpts from Bloomberg over the past week:

When US shale companies talk about having more staying power in a price war, it is the weaker members of OPEC, ie Venezuela, Nigeria, Ecuador and Iran,  that  are  the  weakest  links.  Iran,  Iraq  and  Algeria  need  at  least USD100/bbl. At current prices only Kuwait, Qatar and the United Arab Emirates (UAE)  will  earn  enough  to  balance  their  budgets.  Although  Saudi  Arabia  is awash  with  cash,  some  OPEC  members’  financials  are  deteriorating  quickly. Venezuela, for example, has burned though billions of dollars to stave off default, leaving its foreign reserves near a decade l ow. Nigerian officials are struggling to stem a sell-off in the NGN, which has left the currency at a record low. These financial strains have resulted in Venezuela, Libya and Nigeria calling for action. OPEC members are countries, not companies, so they tend to look not at the profitability of wells but at revenues for a fiscal or current account standpoint.

To win the showdown with US shale, the Saudis are trying to bring OPEC’s weaker members in line.  OPEC is lining up between the haves and the havenots. Iran, Venezuela, Nigeria and Ecuador are really going to be struggling very mightily at these prices. That is who the shale producers are counting on.

Shale oil drillers will be hurt by the fall in crude prices  before members of OPEC  because their costs  are higher, said the group’s secretary-general, Abdalla el-Badri.  As much as 50% of tight oil output will be “out of the market” at  current  prices.  Executives  at  several  large  US  shale  producers,  including Chesapeake  Energy  Corp  (CHK  US,  NR)  and  EOG  Resources  Inc  (EOG  US, NR)  have  vowed  to  maintain  –  and  even  raise  –  production  as  they  reported earnings. They say their success in bringing down costs meant that they make money  even  if  prices  slump  further.  OPEC  is  expected  to  decide  on  future production quotas when it meets in Vienna, Austria, on 27 Nov. 

Meanwhile,  the  slide  in  crude  oil  price  is  now  threatening  to  curb  the production boom in the US shale oil formations, Bloomberg reported. Peak rig count was 1,609 in October and the count is now down 49 ri gs since peak. It is expected to fall by more than 100 rigs by year -end. According to Halliburton (HAL  US, NR), the  second largest O&G services company by market  value, it was told by its US customers that they would not be changing fracking activities for 1H15.

Something has got to give
Weaker  OPEC  members  feeling  the  pain.  The  point  of  the  matter  is,  at  the moment, crude oil prices have slumped to a price point where many OPEC members are now calling for action as oil dollar revenues are falling. These members need oil dollar revenues to finance their fiscal budgets. As mentioned earlier, OPEC members are  countries  and they  look  at  the  revenues  from  a fiscal  standpoint. It  is  only the lower cost producers/oil-rich Gulf nations, ie Saudi Arabia, Qatar and Kuwait, that can stand lower crude oil prices.

Higher  cost  producers  are  also  in  pain.  At  this  price  point,  several  shale  oil producers, ie one of the higher cost producers, are also hurting. Shale oil producers work on the economies of the wells. They  also work on the pure technologies. With constant  improvements  and  innovation  in  technology,  the  economic  costs  of  such wells could be at much lower breakeven price points in the future. Will  OPEC  or  shale  oil  producers  fold  first?  As  global  oil  demand  has  slipped below expectations, due to weaker-than-expected global economic growth, crude oil production will have to readjust to balance out the market. Therefore, it will have to oither be the OPEC member countries having to cut crude oil production or the shale oil  producers  –  including,  possibly,  the  Canadian  oil  sands  and  Arctic  producers  –that will have to shut down their wells at the current – or lower – crude oil prices. Something has got to give.  At the moment, it seems that some of the higher  cost producers now have to cut capex/production while – at the same time – it seems that calls from weaker OPEC members to cut the organisation’s production quotas have also come into play. Whatever happens, something has got to give. We believe that crude oil prices will see some positive movements, possibly over the next three to six months, as supply – either way – is lowered.

OPEC meeting: 27 Nov 
Less  crude  oil  required  from OPEC.  OPEC  has  been  quoted  as  stating that  the world  will  need  less  of  its  oil  than  previously  estimated  for  most  of  the  next  two decades  as  growth  in  shale  production in the  US  grows.  The  organisation lowered every  forecast for its  crude  through  2035  except  for  next  year.  The market  is  now expecting  the  oil  cartel  to  possibly look  to  reducing its  production quota  by  around 500,000 barrels per day (bpd) to perhaps 1.5mbpd. (Source: Bloomberg)

Our take.  As such, we believe that 500,000bpd is a reasonable cut in production by with OPEC or the shale oil producers. We believe that the cut will have to come from OPEC  more  than  any  other  producers. We  believe  that  such  a  move  could  allow crude oil prices to rebound to our forecasted range of USD90-100/bbl over the next 12-24months.  Should  agreements  not  be  concluded  during  the  upcoming  round  of talks among OPEC members, we believe that the next round should bear fruit.

The Lower Crude Oil Price Environment
As  a  result  of  the  fundamental  change  in  the  crude  oil  landscape,  this  report addresses  the  impact  of  the  lower  crude  oil  price  environment  on  the  companies under coverage.

For our ASEAN O&G coverage, we cover 44 companies in four countries across the value chain, from upstream to downstream. The coverage concentrates more on the services segment, where most of the listed O&G companies  in Malaysia, Singapore and  Indonesia  are  in.  Thailand  is  an  exception,  where  the  listed  names  are dominated by oil refinery and petrochemical players.

Regression analysis: USD and crude oil price
Since crude oil is priced in USD, it seems that the market – at times – tends to look at the  strengthening  or  weakening  of  the  greenback  as  one  of  the  factors  for changes/impact on crude oil prices. We performed a simple regression analysis on the  correlation  between  crude  oil  prices  and  the  USD  index,  which  comprises  the EUR  (c.57.6%),  JPY  (13.6%),  GBP  (11.9%),  CAD  (9.1%),  SEK  (4.2%)  and  CHF (3.6%). Based on our simple regression analysis between crude oil price –  European Dated Brent and Forties-Oseberg-Ekofisk (BFOE) – and the USD index (using 1,235 observations  from  Jan  2010-Oct  2014),  we  found  no  relationship  between  the  two variables.  We regressed crude oil prices per day on the daily USD index to roughly estimate the impact of the change in the USD on oil prices. However, we found no significant  linear  relationship  between  the  two  variables.  Our  regression  model produced  a  low  R  square  value  of  only  16%.  The  reason  for  the  low  correlation between  the  two  variables  could  possibly lie  with  the  fact  that  crude  oil  prices  are dependent upon many other factors and not only the USD.

Crude oil market still adjusting to the new reality

The  crude  oil  market  is  currently  adjusting  to  the  new  global  demand  and  supply balance  reality.  This,  along  with  how OPEC manages  its  crude  oil trades  over  the medium term, will determine at what price crude oil settles at. It has become a rather difficult  task  to  pinpoint  where  prices  will  average  over  the  medium  to  long  term. According to media reports, it would seem that the market has put the crude oil price average  in  the  range  of  USD80-105/bbl. We  expect  prices to  trade  in  the  USD90-100/bbl range over the next 12-24 months. At this price, the highest cost producers (Canadian  oil  sands  and  Arctic  producers)  should  be  able  to  make  relatively reasonable margins.  Also,  at this  price  range, most of the  OPEC members  will  be able to finance their fiscal budgets with their oil dollars. As such, we expect crude oil prices to average USD95/bbl, down from our previous forecast of USD100-105/bbl. Please refer to our report dated 31 Oct on Exploration & Production (PTTEP) (PTTEP TB,  BUY,  TP:  THB167.00),  9M14  Net  Profit  Falls  6%  YoY,  dated  31stOctober, for more details.

Weakening/lower crude oil price environment
During times of weakening or lower crude oil prices, oil companies in general will look to  cut  their  spending  to  match  their  cash  flows  streams.  The  capex  budget  on individual  companies  will  be  separated  into  committed  and  uncommitted  spending. Committed spending will be for long-term projects under development and production phase.  Uncommitted  spending  will  be  for  the  likes  of  M&As  and  the  exploration portion of the E&P business. Spending cuts will first be on the uncommitted budgets. Further cuts can be on the committed budgets, should these projects be viewed as uneconomical  under  current/future  crude  oil  price  expectations.  Under  this  current environment, it will be the projects that are in the higher costs fossil fuels category (deepwater, Canadian oil sands, shale oil/gas). Once spending cuts occur, this will, in turn, have a negative impact on the overall spending environment going forward. Crude  oil  price  weakening  will  dampen  earnings  on  E&P  stocks, the  refineries  will report stock losses and petrochemical spreads will be dependent on the demand and supply  of  each  particular  product.  For  the  services  segment,  ie  chartered  vessels, drillings rigs, etc, which are in the exploration phase of the business, will be the first to  be  affected  should  there  be  a  cut  in  spending.  Services  companies  that  are invo lved  in  the  development  and  production  portion  of  the  E&P  segment  will  be relatively safe from cuts.

National  oil  companies  (NOCs)  like  Thailand’s  PTT,  Pertamina  and  Malaysia’s Petronas  operate  with  slightly  different  strategies  than  those  of  general  oil companies. NOCs look at the longer-term, with national interest being at the forefront of  their  strategies  going  forward  as  they  have  to  consider  the  long-term  economic benefits  of their  respective  nations.  However,  we  believe  that it  is  highly  likely  that some downward adjustments in capex are possible going forward, given the current global economic environment and crude oil price slump.

Source: RHB