1H2024 Flashback

In 1H2024, the KL Energy Index (KLEN) has outperformed the FTSE Bursa Malaysia KLCI Index (FBMKLCI). KLEN rose by 16.8% YTD while FBMKLCI increased 9.3% since the start of the year (Figure 1).

Oil and gas (O&G) players under our coverage in general showed mixed performances in 1H2024 (Figure 2). Our stock pick for 2024 annual strategy MISC soared 16.9% YTD as Mero 3 has arrived at its field and received provisional acceptance, hence lowering MISC’s cost-overrun and delivery risks. PANTECH surged 17.8% from the start of the year supported by its attractive dividend yield and bright prospects. VELESTO increased 15.2% YTD as average DCR continues to increase from contract renewals, translating into earnings improvement. In contrast, downstream petrochemical players such as PCHEM and LCTITAN plunged 11.9% and 9.6% respectively as product spread remains depressed from supply glut.

2H2024 Sector Outlook

We expect the following factors to be the main drivers for the sector in 2H2024:

i) Resilient oil prices from production curbs;

ii) Geopolitical tension as a wildcard affecting oil prices;

iii) Supply glut to drag downstream petrochemical sector.

i) Resilient Oil Prices as OPEC+ Extends Production Cut until End-2025

On 2 June 2024, OPEC+ producers agreed to extend their deep oil output cut of 3.66mn barrels per day (bpd) by a year until the end of 2025. Meanwhile, 8 members also agreed to extend voluntary production cuts of 2.2mn bpd into 3Q2024 from 2Q2024. The 8 members will gradually phase out the voluntary cuts over the course of a year from October 2024 to September 2025. Recap that the 2.2mn bpd of cuts include 1mn bpd by Saudi Arabia, 0.5mn bpd by Russia and the remaining from 6 other countries. However, OPEC+ did mention that the group could pause the unwinding of cuts or reverse them if demand is not strong enough to support oil prices.

Global oil demand remains relatively resilient despite rising interest rate environment. World largest oil importer China’s oil demand continues to be robust against the backdrop of property market and economic woes (Figure 4). The strong demand is mainly from China’s downstream petrochemical industry. China is expected to continue to be the main driver of demand growth moving forward albeit not as strong as in 2023 when the world’s second largest economy accounted for more than three quarter of global demand growth. We believe China will implement stimulus measures to stimulate its sluggish economy. Meanwhile, global crude demand is also expected to grow as global central bank cuts interest rate following the easing of inflation.

EIA’s latest estimates show that for 2024, global production of petroleum and other liquid fuels will increase by 0.8mn bpd. Meanwhile, global consumption of liquid fuels will increase by 1.1mn bpd. This suggests a slight supply deficit in 2024 provided OPEC+ continues to curb production and only relax some of its voluntary production curb in 4Q2024. Overall, we maintain our oil price assumption for 2024 at USD85/bbl (EIA estimates: USD84/bbl) and introduce our 2025 oil price assumption at USD83/bbl (EIA estimates: USD85/bbl). The resilient oil price is expected to benefit upstream oil and gas players such as VELESTO and PANTECH as this encourages continuous upstream capex spending.

ii) Geopolitical Tension as a Wildcard Affecting Oil Prices;

Brent crude oil started the year at c.USD76/bbl on the back of demand concerns but rallied to c.USD90/bbl in April as geopolitical tension in the Middle East increases the risk of supply disruption (Figure 3). The surge of oil price was due to concerns of widening of conflict to involve Iran directly in the Israel-Hamas war. However, in recent weeks, Brent price has eased and is ranging between USD80-USD85/bbl as concerns of widening geopolitical conflict in Middle East wanes. Although Israel-Hamas war, if contained, is unlikely to cause supply disruption, we expect any signs of rising geopolitical tension to lead to knee-jerk surge in oil price.

iii) Supply Glut to Drag Downstream Petrochemical Sector;

Supply glut remains a challenge for petrochemical players in 1H2024 as evidenced by margin squeeze and lacklustre performance. Product prices and product spreads remain subdued (Figure 5, 6, 7, 8).

Moving forward, capacity additions loom large on the Asian polyethylene (PE) markets, posing challenges to market balance and oversupply. China is poised for c.7.5mn tonnes of PE capacity addition in 2024, with a further 6.7mn tonnes slated for 2025. As a comparison, ICIS forecasts that global PE demand will grow by 3.4m tonnes per year in 2024-2040. Recovery of product spread seems unlikely if China continues its massive capacity expansion.

We believe improvement in the product spread of commodity chemicals remains unlikely in the near to medium term due to the massive capacity expansion from China. The upside, if any, will be from the specialty chemicals segment where the products are more niche and less volume dependent. With expectations of rate cuts from global central banks and stimulus in China to revive its sluggish economy and hopefully prop up its property sector, global demand from automotive and construction sectors are expected to improve and hence drive demand for specialty chemicals.

Recommendations

We maintain Overweight on the sector. On the back of production curbs from OPEC+ and relatively strong demand, we maintain our oil price assumption for 2024 at USD85/bbl. We also introduce our 2025 oil price assumption at USD83/bbl. The resilient oil price is expected to benefit upstream oil field owners such as HIBISCUS (Not Rated) and oil and gas services and equipment (OGSE) providers including VELESTO (Buy, TP: RM0.33) and PANTECH (Buy, TP: RM1.23) as this encourages continuous upstream capex spending.

Considering that product prices and product spreads for commodity chemicals are unlikely to improve in the short to medium term, we slash our product price assumptions for PCHEM for FY25/FY26, cutting our earnings forecasts by 9.1%/10.7% respectively. We maintain our Hold recommendation albeit at a lower TP of RM6.77/share based on 9x CY25 EV/EBITDA.

Our top picks for the sector are VELESTO and PANTECH. We like VELESTO as the group is expected to enjoy earnings growth from escalation in DCR considering that the jackup drilling rig market is still tight. Risks to our call include unscheduled outage of drilling rigs and plunge in oil prices leading to major oil companies pulling back their capex spending plans. We value VELESTO at RM0.33 based on 12x CY25 EPS. This is a slight premium compared with global peers that are trading at c.11.3x CY25 EPS as VELESTO has locked in contracts for most of its rigs for 2024 and 2025.

We also like PANTECH as the group offers an attractive dividend yield of c.6% and is poised to benefit from higher upstream investment from resilient oil prices and downstream growth supported by government policies and plans. Risks to our call include an unexpected plunge in oil prices. We value PANTECH at RM1.23 based on based on 10x CY25 EPS, 10% discount from its local peers trading at 11.1x CY25 EPS.

Source: TA Research - 2 Jul 2024