O&G  stocks  fell  by  5-20%  yesterday,  following Petronas’  signal  to  cut 15-20%  of  capex  in  FY15.  With  most  stocks  closing  at  6-8x  P/E,  we believe this level does not accurately reflect the fundamentals of a few quality O&G stocks under our coverage. Maintain NEUTRAL sector call, since  there  is  still  a  lack  of  any  signs  of  earnings  delivery,  but  see instead  only  selective  values  from  stocks  with  strong  cash  flow  and long-term firm orderbook.   
 
O&G stocks fell by 5-20% yesterday, following Petronas’ update to cut 15-20%  of  capex  in  FY15,  stop  awarding  new  marginal  oil  fields (even though the breakeven cost is at USD65/bbl) until oil prices recover above USD80/bbl, and rationalize operating expenditure.

What we think. During 2009-2013  Petronas’ capex spending averaged MYR45bn per annum.  Assuming a 15-20% cut in overall capex from its current  annualized  9M14  capex  of  MYR56bn  (2013:  MYR57bn)  would still be within our estimates of Petronas capex spending of MYR40-60bn per annum. Please see Figures 3 and 4 for details of Petronas’ historical capex  spending.  Petronas  reiterated  that  maintenance  capex  and ongoing projects will continue. We believe domestic contracts will still go on  albeit  at  a  slower  pace  compared  with  the  capex  up-cycle  of  2011-2013.  We  believe  Petronas  could  defer  any  of  the  planned  25-27 marginal  fields  and  10-14  enhanced  oil  recovery  (EOR)  projects  as  its    3-3.5% production growth targets can be achieved, via the Oct 2014 first oil  of  deepwater  Gumusut-Kakap  (peak  production  at  135k  bopd)  and Nov 2014 first gas of Kebabangan field (peak production at 130mboepd).  

Short-term  negative  sentiment  does  not  reflect  fundamentals.  The  sector  P/E  de-rating  of  O&G  stocks  since  Oct  2014  reflects  the  i) rationalisation of Petronas and international players’ capex, ii) absence of  bullish  expectations  of  contract  wins,  and  iii)  earnings  and  project risks. We revised our P/E valuations for mid-to-small cap stocks to 8-13x (slightly higher range for big caps)  from 10-15x previously.  In our view, in the short term Brent could further fall to USD65/bbl, before correcting to  our  long-term  estimate  of  USD90-100/bbl.  Nevertheless,  the  sector had  seen  its  P/E  derated  further to  6-8x  yesterday,  especially  amongst the  small  and  mid-cap  players.  In  our  view,  these  multiples  do  not accurately reflect the fundamentals of the sector, given that some stocks have  a  long-term  cash  flow  visibility,  proven  track  record  and  support from sizable firm orderbook.  

Focus  on  quality  service  players  and  long-term  execution.  We maintain  a  NEUTRAL  call  on  the  Malaysia O&G  sector  (a  call  we  held since  1  Oct),  as  the  sector’s  earnings  delivery  has  yet  to  show sustainability.  We  reiterate  selective  picks  that  reflect  our  focus  on execution  and  quality  rather  than  sentiment.  We  value  service  players and  O&G  operators  with  quality  offshore  assets,  proven  track  record, management  guidance,  long-term  firm  orderbook  and  diversification strategies. In this regard, we like Dialog (DLG MK, BUY, TP: MYR2.00), Dayang (DEHB MK, BUY, TP: MYR3.73) and Perdana (PETR MK, BUY, TP: MYR1.62). 

Last Friday, on November 28, Petronas announced that it would cut 15-20% of capex in FY15, stop awarding new marginal oil fields (even though the breakeven costs is at USD65/bbl)  until  oil  prices  recover  above  USD80/bbl,  and  rationalize  operating expenditure.

What we think  
Capex cut within our estimate of MYR40-60bn a year. Although not a new information to the market, the breakdown was not fully known. During 2009-2013 capex spending averaged  MYR45bn  per  annum,  with  domestic  capex  average  of  MYR28bn  (63%), and  international  capex  average  of  MYR17bn  (37%).  9M14  capex  spending  was MYR42.7bn;  domestic  capex:  MYR24bn  (56%)  and  international  capex:  MYR19bn (44%).  If  we  assume  a  15-20%  cut  and  annualised  9M14  capex  to  MYR56bn, Petronas’ future annual capex spending is still within our MYR40-60bn estimates. As capex  spending  momentum  is  still  in  place,  we  believe  contract  flows  will  probably continue  to  go  on albeit  at a  slower  pace  compared  to  the capex  upcycle  of  2011-2013 time-frame

Domestic  projects  will  probably  continue.  Petronas  stated  there  would  be  no changes for ongoing projects, maintenance capex and projects already granted final investment decision (FID). Looking at its history following the 2008’s oil price crash (Figure 3), Petronas’ capex fell to MYR34.9bn (March 2011) from MYR44bn (March 2009).  The  big  change  was  in  international  capex (MYR17.8bn/MYR10.3bn/MYR11.5bn  in  2009/2010/2011)  vs  domestic  capex (MYR26.2bn/MYR26.8bn/MYR23.4bn  in  2009/2010/2011).  Petronas  will  probably revise  or  defer  new  projects  with  less  commercial  viability.  For  onshore  projects,  it was reported that some Pengerang projects that have yet to be granted FID could be affected by the cut-backs.

Not  a  surprise  to  defer  Marginal  fields  and  possibly  EOR  projects.  Looking  at production,  the  Oct  2014  first  oil  of  deepwater  Gumusut-Kakap  (peak  production 135k bopd) and Nov 2014 first gas of Kebabangan gas field (130mboepd) will boost Malaysia’s Sept crude oil production at approximately 650k bopd. Note that Petronas has an internal target to boost production growth by 3-3.5% a year (3Q14 production was  2.08m  boe/d,  +4%  higher  than  3Q13).  Whereas  for  Malaysia,  the  production target was reported to be 5% per year to support O&G demand by 2020, according to Platts.  We  believe  the  production  contribution  from  these  projects  may  allow headroom  for  Petronas  to  defer  any  of  the  25-27  marginal  fields  and  10-14  EOR projects (which takes about USD14bn to develop), for its local upstream projects.

Opex  management  is  Petronas’  focus.  Petronas  had  been  carrying  out  its  cost optimisation  programme;  thus  service  players  with  inefficient  assets  e.g.  expensive fuel  costs  or  technology  for  offshore  support  vessels  (OSV),  and  uncompetitive pricing  and  performance  from  fabricators  will  probably  fall  out  of  Petronas’ favour. Only those local players that abide to strict policies, possess  good track record and efficient assets will probably continue to be competitive. Short-term negative sentiment may not be sustainable. The sector P/E de-rating of  O&G  stocks  since  Oct  2014  reflects  the  i)  rationalisation  of  Petronas  and international players’ capex and the ii) earnings and project risks. We revised our P/E valuations  for  mid-to-small  cap  stocks  to  8-13x  (slightly  higher  range  for  big  caps) from 10-15x previously.  The sector witnessed its P/E derated to 6-8x yesterday. What  investors  could  do:  focus  on  quality  service  players  and  long-term execution.  We  maintain  our  NEUTRAL  call  on  the  Malaysia  O&G  sector,  with selective BUYs, given that the sector’s earnings delivery and track record has yet to show sustainability. We reiterate our focus on execution and consider that investors should  focus  on  quality  rather  than  sentiment.  We  like  service  players  and  O&G operators  with  quality  offshore  assets,  proven  track  record,  and  players  with  long-term  firm  orderbook  and  diversification  strategies  such  as  Dialog,  Dayang  and Perdana.  

How risky are locked-in firm contracts? From our channel checks, some services contracts  such  as  hook-up  and  commissioning  works  are  subject  to  call-out  basis. During periods when the assets are not on call-out by the client, rates would unlikely be paid according to the agreed schedule of rates, but would be paid at a base rate. For most OSV contracts that are firm, the charters are fixed with termination clauses that  are  not  likely  to  be  exercised,  saved  for  situations  whereby  i)  the  drilling campaign or any related offshore activity had been completed ahead of schedule, ii) unsatisfactory  performance,  iii)  the  charterer  facing  insolvency  and  iv)  loss  or destruction of the vessel. Most contracts allow the clients the option to terminate the contract  upon  relatively  short  notice  and  after  the  client  pays  a  settlement  sum  or demobilisation charge.  However,  we  understand that  such  occurrences  are  rare  for the OSV sector.

Source: RHB